What is Foreign Exchange?
Foreign Exchange refers to interchanging one currency with another currency. For example, exchanging Rupee for Dollar and Dollar for Pound and so on. Foreign currencies are interchanged or converted at a specified rate known as the Foreign Exchange Rate. Foreign Exchange Rate differs from currency to currency. For instance, the exchange rate of Rupee to Dollar is different from Dollar to Pound or Rupee to Yen. In India, Foreign currencies are exchanged through authorized dealers (person who is authorized by the Reserve Bank of India to deal in foreign exchange) which are mainly banks in exchange of certain amount of fee or commission which is charged by the dealer for providing the exchange service.
What are Uses of Foreign Exchange?
Foreign exchange is important as it is deployed by individuals, business organizations as well as government for various purposes which are discussed below:
1. Government: Government utilizes foreign exchange for multiple functions such as covering the expenditure on imports, foreign investment, payment of interest on international borrowings, repayment of international borrowings, foreign aid and currency stabilization (currency stabilization refers to buying or selling foreign currency to stabilize or remove excess volatility in domestic currency).
2. Business Organizations: Business organizations deploy foreign currencies for numerous reasons like international trade (buying or selling goods or services on an international level), multinational treasury operations (centralized treasury operations), interest and principal repayment on foreign currency borrowing, foreign investment and international market expansion (such as setting up new factory or office or store in a foreign country. For example, Coca Cola manufactures and sells its drinks in India and for that Coco Cola deploys Indian Currency.
3. Individuals: Individuals use foreign currency for multiple purposes such as Education (whenever an Indian Resident goes abroad for education, that person needs to convert Indian currency into Foreign Currency so as to spend that money in abroad), Healthcare (for medical treatment in abroad) and tourism (while travelling to abroad individual needs foreign exchange for travel expenses).
Relevance of Foreign Exchange
An increase or decrease in foreign exchange rate can create lot of financial implications on its users. To give an example, if an Indian business sells its goods in US and the value of dollar increases, it is beneficial for the business as the business is earning in dollars and now the business will get more in Rupee terms and vice versa. In a similar manner, if an Indian student wishes to study abroad and value of rupee declines then it is unfavourable for the student as now the student has to pay more rupee for the same amount of dollar and vice versa.
Different Types of Foreign Exchange System
Foreign Exchange Rate can be determined through one of these two systems: Fixed Exchange Rate System and Floating Exchange Rate System.
A. Fixed Exchange Rate System:
Fixed Exchange Rate System is a system wherein Government of Central Bank decides or fixes the exchange rate for the currency as per the macroeconomic conditions and government policies. For instance, if the government aims to decrease imports, government will depreciate (decrease in value) the domestic currency so as to make imports more expensive. Similarly, if the objective of government is to decrease Foreign Direct Investment (FDI) in domestic country, government will appreciate (increase in value) the domestic currency.
Some countries also associate the value of domestic currency with any commodity (such as gold, silver, oil, etc) or with the currency of a particular nation. For example, Saudi Arabia has fixed the exchange rate of its domestic currency Riyals to US Dollar at 3.75 on the basis of commodity (oil). Likewise, currency of UAE is also associated with oil and gas. In a like manner, Singapore dollar is also associated with a basket of currencies. These currencies are assigned weight as per Singapore’s trading relations with rest of the world. This trade weighted exchange rate is allowed to fluctuate within a policy band.
B. Floating Exchange Rate System
Floating Exchange Rate System is a system wherein the exchange rate is determined and
influenced by the demand and supply of currencies. The rate at which both the level of demand and the level of supply of currency is equal (equilibrium price) is considered as the foreign exchange rate. Let’s take example of Rupee and Dollar, on a particular day, at Rs 82, Demand is more than supply and at Rs 84, supply is more than demand, here, both Rs 82 and Rs 84 cannot be considered as exchange rates, however at 83 Rs both demand and supply are equal, hence, 83 Rs will be regarded as the exchange rate. Now, the current exchange rate of Rupee and Dollar is 83 Rs, on the next day, if the demand of dollar rises, the price of dollar will also rise (say 84) and vice versa. In a similar manner, if the supply of dollar increase, the price of dollar will fall (say 82) and vice versa. This is a widely used exchange rate system in the world.
Demand and Supply of a currency is influenced by various macroeconomic factors such as
imports, exports, interest rates, inflation, economic policies, trade balances, economic growth outlook, political stability or conflicts, money supply, foreign exchange reserves and financial obligations of the country.
Even in Floating Rate System, there are certain times when central banks intervene in the
market so as to keep the price of their domestic currency in contrast with the government
policies and in a favourable position. Presently, India is intervening in the open market by selling foreign currency (increasing supply) with the aim of removing excess volatility in the value of Rupee and to keep it in a favourable price range.
Major countries like India, Unites States, United Kingdom follows flexible exchange rate system. China’s exchange rate system has also been changed from fixed exchange rate system to a more flexible system where market forces play significant role in determining the exchange rate, however, it is still carefully managed. Foreign Exchange is one of the key considerations for any economy as it has the potential to create a lot of impact on the economy at the macro level making due diligence a must.
