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Dirty Float Exchange Rate System

Finance Essay
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What is an exchange rate. Are terms like managed float, dirty float, fixed exchange rates,
floating exchange rate, pegged exchange rate, crawling peg the same? Which type of
exchange rate regime does India follow? What is a currency crisis? In recent times the
rupee is becoming weaker against the dollar every day, what are the reasons for the
same and what steps is the RBI taking to control the same. So, is the rupee depreciating
or devaluing against the dollar? Support your conclusion by giving a dollar rupee
graphical trend for the last three months?

Exchange rate Meaning


When the price of another country's currency is expressed in one country's currency Or
it can be said that the rate at which another currency can be exchanged for one currency.
The exchange rate is that rate at which another currency can be converted into one
currency. The exchange rate can be used in order to convert one currency to
another currency or for indulging oneself into speculation or trading in
the foreign exchange market. The factors which influence the exchange rate
are interest rates, inflation, and the state of politics and the economy in each
country. The exchange rate is also called foreign exchange rate or currency
exchange rate. The exchange rate between two currencies may be defined as the
rate at which currencies can be exchanged for one another. It can also be defined as the
value of currency of one country in terms of currency of another country. The current
exchange rate is also known as spot exchange rate. The exchange rate that is quoted
and traded today but for delivery and payment on a specific future date is known as
forward exchange rate.

Example

The amount at which exchange rate will be higher for one euro in terms of
one yen, the lower the relative value of the yen.

Dirty float exchange rate system


The dirty float exchange rate is also called managed float. The dirty float or managed
float exchange rates are those rates in which the government of country or the central
bank of country occasionally intervenes to change the direction of the value of the
currency of the country. In most instances, the intervention aspect of a dirty float
system is meant to act as a buffer against an external economic shock before its effects
become truly disruptive to the domestic economy. Also known as a "managed float".

Managed float
The managed float is a type of float in which a process of floating of a currency takes
place where the exchange rate is controlled by the central bank managed float is
also called dirty float

Dirty Float
Managed float and dirty float are same thing which can be understood by the example
below
For example, country X may find that some hedge fund is speculating that its
currency will depreciate substantially, thus the hedge fund is starting to short massive
amounts of country X's currency. Because country X uses a dirty float system,
the government decides to take swift action and buy back a large amount of its
currency in order to limit the amount of devaluation caused by the hedge fund.
A dirty float system isn't considered to be a true floating exchange rate because,
theoretically, true floating rate systems don't allow for intervention.

Fixed exchange rate system


The fixed exchange rate system is also known as pegged exchange rate system. The fixed
or pegged exchange rate system may be defined as a country's exchange rate regime
under which the government or central bank ties the official exchange rate to
another country's currency (or the price of gold). The main motto of fixed exchange

rate system is to maintain a currency of country value into a very narrow band. The
fixed exchange rate system may also be referred as the rates which are fixed may provide
greater certainty to exporters and importers. This also helps the government to
maintain inflation at low rate, which in the long run should keep interest rates down and
stimulate increased trade and investment

Floating exchange rate system


The floating exchange rate may be defined as a country's exchange rate regime where
currency of a country is set by the foreign-exchange market through supply and demand
for that particular currency relative to other currencies. Thus, floating exchange rates
are those rates which changes freely and may determine by trading in the forex
market.

India follows managed float exchange rate system


for the determination of the exchange rate.
Currency Crisis
The situation arises which makes the value of currency unstable, makes it difficult
for the currency to be used as a reliable medium of exchange. The effect of a currency
crisis can be mitigated by sufficient reserves in foreign country. A currency crisis can
also be termed as crisis. The currency crisis can also be termed as balance-ofpayments crisis, occurs when currency gets devaluated suddenly due to chronic balanceof-payments deficits which usually ends in a speculative attack in the foreign
exchange market. The currency crisis happens when the value of a currency changes
quickly, reducing its ability to serve as a medium of exchange or a store of value.
The currency crisis is generally associated with a real economic crisis. Currency crises
can be especially destructive to small open economies or bigger, but not sufficiently
stable ones. Governments often take on the role of fending off such attacks by satisfying
the excess demand for a given currency using the country's own currency reserves or
its foreign reserves

Graphical representation of downfall of rupee

http://www.thehindubusinessline.com/multimedia/dynamic/01123/bl25_rupee_col_e
ps_1123618f.jpg

June 24, 2012:


Over the past year, the rupee has dropped nearly 26 per cent against the dollar. In just
the last three months, the rupee has dropped 12.6 per cent, closing at 57.15 to the dollar
last Friday. This is the sharpest fall in any quarter for the rupee. Even during the crisis
of 2008, there was not so much depreciation in such a short time. Most companies,
especially importers, have found their capacity for tolerance of such volatility stretched.

Reasons for downfall of rupee


ECONOMIC FACTORS
Balance of payment
The balance of payment may be defined as systematic record of all economic transaction
between residents of country and rest of the world. The exports or selling goods or
services from one country to other country and imports or purchases of goods and
services from one country to other country.. The country get foreign currency for exports
and the country pays foreign currency for imports. The net position of this is the balance
of payment. India has a deficit balance of payment because the import payments of
India are more than the export receipts. This deficit is compensated by receipts from
money sent by NRIs and borrowings.. Hence India is forced buy dollars to pay the
deficits. The price goes up with the demand of something. So the rupee fetches lesser
dollar rupee and starts falling.

INFLATION AND FISCAL DEFICIT


The inflationary problems are being faced by the country since last many months.
Though the government and Reserve Bank are taking various steps, the inflation is not
getting reduced. Due to the deficit, and the inflation the foreign investors are not
interested to invest their money and hence the needed continuity in inflow of dollar
becomes less and the rupee falls against dollar.

FALLING FOREX RESERVES


if a country has huge forex reserves, the money for imports can be paid from the
reserves. But if the forex reserves are poor the country is forced to buy its forex at a high
price. Forex reserves of India had a drastic fall and therefore country is forced to buy
dollar requirements. This causes rupee to fall.

SHORT TERM BORROWINGS REPAYMENT


The foreign exchange market evaluates the debt repayments of a country in the
immediate short term. India has amounts of repayment shortly due, to the country has
poured of dollar reserves in the recent months to intervene against falling rupee.
Hence market has sensed the demand for dollar against rupee.

Political and policy factors behind falling Rupee


Though the India is politically stable, there are many indirect signals giving hint that the
political government is not strong enough. The weak show of Congress, the main ruling
party at centre, in most of the elections and by-elections give a suspicion that it may not
come back in the next elections. The buckling of the central government under pressure
from its minor coalition parties and withdrawing from many policy decisions make the
foreign investors suspicious. This sentiment works against the country, and foreign
investors are discouraged from investing till a stronger and clearer picture emerges. This
affects the strength of rupee and leads to its fall.

OTHER FACTORS FOR FALLING OF RUPEE


Currencies react to both the fundamentals of demand and supply as well as sentiment.
Sentiment is down - a spate of bad news on the economic front - slowing GDP, rating
downgrades, policy drift, high inflation, lack of rate cuts etc., contributed to it.On the
fundamentals side, India is a net importer and therefore needs more dollars to pay for
oil and gold (its two main imports) as well as other imports. India imported $180 billion
more of goods than it exported (last year's total imports were $480 billion while exports
were $300 billion). This greater demand for dollars is of course reduced partially by
capital inflows, borrowings, remittances, software earnings etc.

OIL PRICES

India imports 83 per cent of its oil requirements (last year's bill was $150 billion). The
monthly demand (of $12 billion) on this account as well as rising oil prices has usually
kept the rupee under pressure. Apart from oil, there are gold imports for which the
country paid nearly $60 billion last year.
Now, ironically, prices of both oil and gold have been coming down - which is expected
to have favourable impact on the trade deficit this year. Brent crude prices have dropped
to $90 a barrel, a drop of nearly 30 per cent since early 2012. A $1 decline in oil prices
should help reduce current account deficit by about $1 billion. The drop in oil prices has
allowed markets to project that trade deficit will be down by $25 billion this year. Such
inferences should in the normal course have led to an appreciation of the rupee. This is
something market experts say will still happen - eventually - perhaps in six months to
one year. But in the short term there is a mood of panic and poor sentiment and dire
predictions that the rupee is heading for 'retirement' - the euphemism for its value
touching 60 to the dollar. There is now a unidirectional and sustained downtrend in the
short-term, market experts say.
For example experts say that importers are increasing the tenor of their cover - the
protection they buy against a further decline in the rupee. In simple terms, if importers
covered their import bills for 2 months earlier, they are now doing it for three to four
months. This, they say is contributing to panic, further volatility and uncertainty. In
contrast, exporters, revenue earners such as software industries, are not selling dollars
that they earn, waiting for the rupee to depreciate further.

HIGH HEDGING COST


The cost of hedging through one-year forward contracts has been high. The forward
premium was as high as 6.6 per cent a few weeks ago, before falling to 4.83 per cent just
before the RBI policy. The disappointment at not getting the expected cut has resulted
in forward premiums once again jumping to 5.5 per cent now. Even CII President, Mr
Adi Godrej, told Business line recently, that the cost of hedging was prohibitively
high and he preferred not to hedge.

BUNCHING PAYMENTS

Experts say that bunching of payments by oil companies (for oil imports) in the spot
market has increased demand for dollars in the short term. Normally, oil companies
avail of short-term buyer credit of between 3-6 months and stagger their payments.
However, with the rupee depreciating so drastically, they prefer to pay their bills
immediately rather than buying on credit. This creates a further pressure in an already
frayed market.

STEPS BY RBI
Normally, the Reserve Bank is trying to cool this down by opening a special window for
oil companies (so that they don't buy more dollars in the market) for a short period of
time. There has been such talk in the market although there is no official word yet. RBI
recently indicated that it will sell dollars directly to oil companies in order to ease
pressure from the currency. Besides, the central bank has already taken steps to curb
speculation in the forex market and tried to increase the inflow of foreign currency.
Since early March, rupee has lost about 13 per cent against the dollar driven by a
combination of deteriorating global risk sentiment and weak domestic fundamentals.
The rupee gained 27 paise to close at 55.37 after RBI intervened on currency breaching
the 56-level in early trade.