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-of-payments crisis, occurs when currency gets devaluated suddenly due to chronic balance-of-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_eps_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.