Foreign Exchange Rate is the amount of domestic currency that must be paid in order to get a unit of

foreign currency. According to Purchasing Power Parity theory, the foreign exchange rate is
determined by the relative purchasing powers of the two currencies.

Example: If a Mac Donald Burger costs $20 in the USA and Re 100 in India, then the exchange rate
between India and the USA will be (100/20=5), 1 $ = 5 Re.

Forces Behind Exchange Rate Determination

Foreign Exchange is a price of one country currency in relation to other country currency, which like
the price of any other commodity is determined by the demand and supply factors. The demand and
1supply of the foreign exchange rate come from the residents of the respective countries.

Demand for Foreign Exchange (Foreign Money Supply of Foreign Exchange (Foreign
goes out) Money Comes in)

The source of foreign currency available to

Foreign Currency is needed to carry out transactions
the domestic country are foreigners
in foreign countries or for the purchase of foreign
purchasing our goods and services
goods and services (IMPORTS).
(Exports).

Foreigners investing in Indian Stock

Foreign currency is needed to invest in foreign
markets, Assets, Bonds etc. (FPIs and
country assets/shares/bonds etc.
FDIs)

Foreign currency is needed to make transfer Transfer payments. Example: Indian

payments. Example: Indian Parents sending Money working in the USA, sending money to
to his/her son/daughter studying in the USA. his/her old aged parents.

Indians holding money in overseas Banks Foreigners holding assets in Indian Banks.

Indians Travelling abroad for Tourism Purpose. Foreigners travelling to India.

Exchange Rate Management in India

Over the last six decades since independence the exchange rate system in India has transited from
fixed exchange rate regime where the Indian Rupee was pegged to the UK Pound to a basket of
currencies during the 1970s and 1980s and eventually to the present form of market determined
exchange rate regime since 1993.

 Par Value System (1974-1971): After Independence Indian followed the ‘Par Value System’
whereby the rupee’s external par value was fixed with gold and UK pound sterling. This system was
followed up to 1966 when the rupee was devalued by 36 percent.
 Pegged Regime (1971-1992): India pegged its currency to the US dollar (1971-1991) and to
pound (1971-75). Following the breakdown of Breton Woods system, the value of pound collapsed,
and India witnessed misalignment of the rupee. To overcome the pressure of devaluation India pegged
its currency to a basket of currencies. During this period, the exchange rate was officially determined
by the RBI within a nominal band of +/- 5 percent of the weighted average of a basket of currencies of
India’s major trading partners.
 The period since 1991: The transition to market-based exchange rate was in response to the
BOP crisis of 1991. As a first step towards transition, India introduces partial convertibility of rupee
in 1992-93 under LERMS.
 Liberalised Exchange Rate Management System (LERMS): The LERMS involved partial
convertibility of rupee. Under this system, India followed a dual exchange rate policy, where 40
percent of the exchange rate were to be converted at the official exchange rate and the remaining 60
percent were to be converted at the market-based exchange rate. The exchange rate converted at the
official rate were to be used for essential imports like crude, oil, fertilizers, life savings drugs etc. All
other imports should be financed at the market-based exchange rate.
 Market-Based Exchange rate Regime (1993- till present): The LERMS was a transitional
mechanism to provide stability during the crisis period. Once the stability is achieved, India transited
from LERMS to a full flash market exchange rate system. As a result, since 1993, exchange rate
fluctuations are marker determined. In the 1994 budget, 60:40 ratio was removed, and 100 percent
conversion at market-based rate was allowed for all goods and capital movements.

Historical Background of Law relating to Foreign Exchange

I. Foreign Exchange Regulation Act, 1947 and Foreign Exchange Regulation Act, 1973
Scarcity of Foreign Exchange in India led to its control since the beginning of World War II.
Exchange control was introduced in India under the Defence of India Rules on September 3, 1939 on
a temporary basis. The statutory power for exchange control was provided by the Foreign Exchange
Regulation Act (FERA) of 1947.
Foreign Exchange Regulation Act, 1947 was enacted initially for a period of ten years in temporary
basis. However, 10 years of economic development did not ease the foreign exchange constraint,
FERA permanently entered the statue book in the year 1957. Subsequently, Foreign Exchange
Regulation Act, 1947 was replaced by the Foreign Exchange Regulation Act, 1973 (FERA,
1973),which came into force with effect from January 1, 1974. FERA, 1973 came into force, for
regulating certain payments, dealings in foreign exchange and securities, transactions indirectly
affecting foreign exchange and the import and export of currency, for the conservation of the foreign
exchange resources of the country and the proper utilization thereof in the interests of the economic
development of the country.
II. Foreign Exchange Regulation Act, 1973, ‘The Major Constraints’
a. In the year 1974, FERA was completely overhauled with all violations being considered as criminal
offences with mens rea. The Enforcement Directorate was empowered to arrest any person without
even an arrest warrant.
b. In 1991 government of India initiated the policy of Economic Liberalization, Privatization and
Globalization. Foreign investments in many sectors were permitted. This resulted in increased flow of
foreign exchange in India and foreign exchange reserves increased substantially, hence the
government engaged itself in framing a law containing a comprehensive framework for dealing and
regulating the foreign exchange inflow and outflow in India.
c. In 1997, the Tarapore Committee on Capital Account Convertibility (CAC) constituted by the
Reserve Bank, which recommended change in the legislative framework governing foreign exchange
transactions.
d. Keeping in view the changed environment, the Foreign Exchange Management Act (FEMA) was
enacted in 1999 to replace FERA. FEMA became effective from June 1, 2000. The philosophical
approach was shifted from that of conservation of foreign exchange to the management of foreign
exchange, facilitating trade and payments as well as developing orderly foreign exchange market.
Main Features of Foreign Exchange Management Act, 1999

1. It gives powers to the Central Government to regulate the flow of payments to and from a
person situated outside the country.
2. All financial transactions concerning foreign securities or exchange cannot be carried out
without the approval of FEMA. All transactions must be carried out through “Authorised
Persons.”
3. In the general interest of the public, the Government of India can restrict an authorized
individual from carrying out foreign exchange deals within the current account.
4. Empowers RBI to place restrictions on transactions from capital Account even if it is carried
out via an authorized individual.
5. As per this act, Indians residing in India, have the permission to conduct a foreign exchange,
foreign security transactions or the right to hold or own immovable property in a foreign
country in case security, property, or currency was acquired, or owned when the individual
was based outside of the country, or when they inherit the property from individual staying
outside the country.

Categories of Authorised Persons under FEMA

Category Authorized Dealer – Authorized Dealer Authorized Full Fledged Money

Category I Category – II Dealer Changers
Category – III

Entities 1.Commercial Banks 1. Upgraded FFMC 1. Select 1. Department of Post

2.State Co-operative 2. Co-operative Banks Financial and 2.Urban Co-operative
Banks other Institutions Banks
3. Regional Rural Banks
3.Urban Co-operative (RRB’s), others 3. Other FFMC
Banks

Activities As per RBI guidelines, All activities permitted to Foreign Purchase of foreign
Permitted all current and capital FFMC and specified non- exchange, exchange and sale for
account transactions trade related current transactions private and business
account transactions related visits abroad
Structure of FEMA.

1. The Head Office of FEMA, also known as Enforcement Directorate, headed by the Director is
located in New Delhi.

Under Fema, the adjudicator (an officer with the ED) can impose a penalty three times the size of the
contravention involved where the sum is quantifiable. In case the contravention is not quantifiable, the
penalty is set at Rs 2 lakh. Further, where the violation is a continuing one, an additional penalty of Rs
5,000 per day of contravention can be imposed.