History of Forex Market in India

Until the early seventies, given the fixed rate regime, the foreign exchange market was perceived as a mechanism merely to put through merchant transactions. With the collapse of the Breton Woods agreement and the floatation of major currencies, the conduct of exchange rate policy posed a great challenge to central banks as currency fluctuations opened up tremendous opportunities for market players to trade in currency volatilities in a borderless market.

The market in Indian, however, remained insulated as exchange rate controls inhibited capital movements and the banks were required to undertake cover operations and maintain a square position at all times.

Slowly a demand began to build up that banks in India be permitted to trade in FOREX. In response to this demand the RBI, as a first step, permitted banks to undertake intra-day trade in FOREX in 1978. As a consequence, the stipulation of maintaining square or near square position was to be complied with only at close of business each day. The extent of position which conduct be left uncovered overnight (the open position) as well as the limit up to which dealers conduct trade during the day was to be decided by the management of the banks.

As opportunities to make profit began to emerge, the major banks started quoting two-way prices against the Rupee as well as in cross-currencies (Non-rupee) and gradually, trading volumes began to increase. This was enabled by a major change in the exchange rate regime in 1975 whereby the Rupee was delinked from the Pound Sterling and under a managed floating arrangement; the external value of the rupee was determined by the RBI in terms of a weighted basket of currencies of India’s major trading partners. Given the RBI’s obligation to buy and sell unlimited amounts of Pound Sterling (the intervention currency), arising from the bank’s merchant trades, its quotes for buying/selling effectively became the fulcrum around which the market moved.

As volumes increased, the appetite for profits was found to lead to the observance of widely different practices (some of which were irregular) dictated largely by the size of the players, their location, expertise of the dealing staff, and availability of communications facilities, it was thought necessary to draw up a comprehensive set of guidelines covering the entire gamut of dealing operations to be observed by banks engaged in FOREX business. Accordingly, in 1981 the “Guidelines for Internal Control over Foreign Exchange Business” was framed for adoption by banks.

During the eighties, deterioration in the macro-economic situation set in, ultimately warranting a structural change in the exchange rate regime, which in turn had an impact on the FOREX market. Large and persistent external imbalances were reflected in rising level of internal indebtedness. The graduated depreciation of the rupee could not compensate for the widening inflation differentials between India and the rest of the world and the exchange rate of the Rupee was getting increasingly overvalued. The Gulf problems of August 1990, given the fragile state of the economy, triggered off an unprecedented crisis of liquidity and confidence. This unprecedented crisis called for the adoption of exceptional corrective steps. The country simultaneously embarked upon measures of adjustment to stabilize the economy and got in motion structural reforms to generate renewed impetus for stable growth.

As a first step in this direction, the RBI effected a two-step downward adjustment of the Rupee in July 1991. Simultaneously, in order to provide a closer alignment between exports and imports, the EXIM scrip scheme was introduced. The scheme provide a boost to exports and with the experience gained in the working of the scheme, it was thought prudent to institutionalize the incentive component and convey it through the price mechanism, while simultaneously insulating essential imports from currency fluctuations. Therefore, with effect from March 1, 1992, RBI instituted a system of dual exchange rates under the Liberalised Exchange Rate Management System (LERMS). Under this, 40% of the exchange earnings had to be surrendered at a rate determined by the RBI and the RBI was obliged to sell foreign exchange only for imports of essential commodities such as oil, fertilizers, life saving drugs etc., besides the government’s debt servicing. The balance 60% could be converted at rates determined by the market. The scheme worked satisfactorily preparing the market for its emerging role and the Rupee remained fairly stable with the spread between the official and market rate hovering around 17%.

Even through the dual exchange rate system worked well, it however, implied an implicit tax on exporters and remittances. Moreover it distorted the efficient allocation of resources. The LERMS was essentially a transitional mechanism and in March 1993, the two legs of the exchange rates were unified and christened Modified LERMS. It stipulated that form March 2nd 1993, all FOREX receipt could be converted at market determined rates of exchange. Over the next eighteen months restrictions on a number of other current account transactions were relaxed and on August 20th 1994, the Rupee was made fully convertible for all current account transactions and the country formally accepted obligations under Article VIII of the IMF’s Article of Agreement.

  • 1966 The Rupee was devalued by 57.5% against on June 6
  • 1967 Rupee-Sterling parity change as a result of devaluation of the sterling
  • 1971 Bretton Woods system broke down in August. Rupee briefly pegged to the USD @ Rs 7.50 before reneging to Sterling at Rs. 18.8672 with a 2.25% margin on either side
  • 1972 Sterling floated on June 23. Rupee sterling parity revalued to Rs 18.95 and the in October to Rs 18.80
  • 1975 Rupee pegged to an undisclosed basket with a margin of 2.25%on either side. Sterling the intervention currency with a  central bank rate of Rs 18.3084
  • 1979 Margins around basket parity widened to 5% on each side in January
  • 1991 Rupee devalued by 22% July 1st      and 3rd. Rupee dollar rate depreciated from 21.20 to 25.80. A version of dual exchange rate introduced through EXIM scrip scheme, given exporters freely tradable import entitlements equivalent to 30-40% of export earnings.
  • 1992 LERMS introduced with a 40-60 dual rate converting export proceeds, market determined rate for all but specified imports and market rate for approved capital transaction. US Dollar became the intervention currency from March 4th. EXIM scrip scheme abolished.
  • 1993 Unified market determined exchange rate introduced for all transactions. RBI would buy/sell US Dollars for specified purposes. It will not buy or sell forward Dollars though it will enter into Dollar swaps.
  • 1994 Rupee made fully convertible on current account from August 20th.
  • 1998 Foreign Exchange Management Act – FEM Bill 1998, which was placed in the Parliament to replace FERA.
  • 1999 Implication of FEMA start.

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