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Historic Perspective on India's Forex Position

India's approach to foreign exchange reserve management, until the balance of payments crisis of 1991 was to maintain an appropriate level of reserves required for importing goods and services. It was defined in terms of number of months of imports equivalent of reserves.

For example, let us say India's import for a year was USD 36 billion and India had a foreign exchange reserve of USD 4.5 billion, then it was expressed as our reserves being the equivalent of one and a half months of imports. Emphasis on import cover constituted the primary concern to managing foreign exchange reserves till 1993-94.

The approach to reserve management underwent a paradigm shift in the mid 90s.

The relevant extracts are:

It has traditionally been the practice to view the level of desirable reserves as a percentage of the annual imports-say reserves to meet three months imports or four months imports. However, this approach would be inadequate when a large number of transactions and payment liabilities arise in areas other than import of commodities.

These started happening with the liberalization that led to foreign investors investing in Indian companies either through the Foreign Institutional Investor (FII) route (Morgan Stanleys of the world investing in Indian stock markets) or through Foreign Direct Investment (FDI) route (Enron investing in Dabhol Power Corporation!!). These were instance of foreign currency coming into the country. For each of these inflows, there will be a future outflow either when the FIIs repatriate their investments or the FDIs taking back profits of their investments.

In addition, liabilities may arise either for repaying loans or paying interest on loans. The new approach was aimed at determining the level of forex reserve, by paying attention to the loan repayment and interest payment obligations in addition to the level of imports.

In addition, with the opening up of the economy since the early 90s, the impact of changes in global currency markets is bound to affect Indian shores as well. Further, emphasis was placed on gaining the ability to take care of the seasonal factors in any balance of payments (foreign exchange inflows - foreign exchange outflows) transaction with reference to the possible uncertainties in the monsoon conditions of India and to counter speculative tendencies or anticipatory actions amongst players in the foreign exchange market.

Exchange Rate - Fixed Regime to Market Determined Floating Regime

During the period 1991 to 1995, India moved from a fixed exchange rate system to partial float exchange rate system to a free float or floating rate market determined exchange rate system.

In the fixed exchange regime, which India followed till 1991, the exchange rate was fixed by the RBI and was pegged to a basket of currency - US Dollars, Pound Sterling (UK), Deutsche Marks (Germany) and few other currencies.

After the Balance of Payment crisis in 1991, as part of the IMF's stabilization program, India moved to a partial float mechanism. As per this mechanism, the inward flow of foreign currency into the country by way of exports was converted into Rupee in the following ratio - 60% at a rate fixed by RBI which was around Rs.28 to a USD and the balance 40% at a market determined rate - which was generally higher at Rs.32 to a USD. However, anyone in India who wants to buy foreign currency for importing goods has to pay the market determined higher rate of Rs, 32 to a USD.

This partial float of the currency was later changed to fully floating or a market determined exchange rate system, where neither RBI nor the Government of India fixed the exchange rate and allowed the players in the market determine the exchange rate. So any foreign exchange that was brought into the country was converted at a rate determined by the market. It was the same case when anyone wanted to procure dollars for imports or to travel abroad or to buy a book from Amazon.com
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