Indian Economy, 5th edition (72 page)

Financial Stability and Development Council (FSDC)

As a follow-up to the announcement made in the Budget 2010–11, with the
objective
to strengthening and institutionalising the mechanism for maintaining financial stability and enhancing inter-regulatory coordination, an apex-level Financial Stability and Development Council under the Chairmanship of the Finance Minister has been set up.

A sub-committee of the FSDC has also been set up under the chairmanship of the Governor RBI. Under the aegis of the FSDC, two empowered Technical Groups (i.e., Technical Group on Financial Literacy and Financial Inclusion and Inter-Regulatory Technical Group) have been formed.

Financial Sector Legislative Reforms Commission (FSLRC)

Fulfilling the announcement of the Budget of 2010–11, to
rewrite
and
harmonise
financial sector legislations, rules and regulations the GoI constituted the FSLRC under the chairmanship of Justice (Retd.) B. N. Srikrishna in March 2011 (tenure is 2 years). This had become necessary as the institutional framework governing India’s financial sector was built over a century.

There are over 60 Acts and multiple Rules/Regulations in the sector and many of them are decades old, when the financial landscape was very different from what it is obtaining today. Large number of amendments made in in these Acts over time has increased the
ambiguity
and
complexity
of the system.

The Commission would simplify and re–write financial sector legislations, including subordinate legislations, to bring them in line with the requirements of the sector to achieve harmony and synergy among them, making them more coherent and dynamic and help cater to the requirements of a large and fast growing economy in tune with the changing financial landscape in an inter-connected financial world. In the long-term, it would help usher in the
next generation of reforms,
contribute to efficient financial intermediation enhancing the growth potential of the nation. The Commission handed over its report end-March 2013 (see Chapter 11 sub-topic ‘Financial Regulators’).

Financial Action Task Force (FATF)

The FATF is an inter-governmental policymaking body that has a ministerial mandate to establish international standards for combating
money laundering
and
terrorist financing.
India joined the FATF as its 34th member in June 2010. At present, the FATF has 36 members comprising 34 countries and two organisations (European Union and Gulf Cooperation Council).

DeFINITION

All economic activities of an economy which take place in foreign currency fall in sectors such as export, import, foreign investment, external debt, current account, capital account, balance of payment, etc. to name a few (
definition
).
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Foreign Currency Assets

The sum total of all the foreign currencies an economy possesses at a particular time is its foreign currency assets/reserves.
2
As per the Ministry of Finance, India’s total foreign exchange reserves (comprising foreign currency assets, gold reserves, SDRs and Reserve Tranche in IMF) was at US $ 304.8 billion on March 31, 2013 ($ 294.4 billion on March 31, 2012).

The total capacity of an economy to manage liquid foreign exchange is its foreign exchange (Forex) reserve. This contains basically three components—the foreign currency assets, the total gold reserves and the total special drawing rights (SDRs) of an economy in the IMF.
3

Fixed currency Regime
4

A method of regulating exchange rates of world currencies brought by the IMF. In this system exchange rate of a particular currency was fixed by the IMF keeping the currency in front of a basket of importanft world currencies (they were UK£, US $, Japanese ¥, German Mark DM and the French Franc FFr). Different economies were supposed to maintain that particular exchange rate in future. Exchange rates of currencies were modified by the IMF from time to time.

Floating Currency Regime
5

A method of regulating exchange rates of world currencies based on the market mechanism (i.e., demand and supply). In the follow up to the fixed currency system of exchange rate determination, it was the UK which blamed the system for its payment crisis of late 1960s. Looking at the major loopholes in this system, the UK Government decided to switch-over to the floating currency regime in 1973—the same year the IMF allowed an option to its member countries to go for either of the currency systems.

In the floating exchange rate system, a domestic currency is left free to float against a number of foreign currencies in its foreign exchange market and determine its own value. Such exchange rates, are also called as
market driven
or
based
exchange rates, which are regulated by the factors such as the demand and supply of the domestic and the foreign currencies in the concerned economy.

Managed Exchange Rates

A managed-exchange-rate system is a hybrid or mixture of the fixed and flexible exchange rate systems in which the government of the economy attempts to affect the exchange rate
directly
by buying or selling foreign currencies or
indirectly
,
through monetary policy
6
(i.e., by lowering or raising interest rates on foreign currency bank accounts, affecting foreign investment, etc.).

Today, most of the economies have shifted to this system of exchange rate determination. Almost all countries tend to intervene when the markets become
disorderly
or the
fundamentals
of economics are challenged by the exchange rate of the time. Some of the major examples of the managed exchange-rate system have been given below
7
:

(i)
Some countries allow to
free float
their currencies and allow the market forces to determine their exchange rate with rare government intervention. This is the idea from which the
floating currency regime
basically emerged. The USA and the EU are the major examples in this category.

(ii)
Some economies have
managed but flexible
exchange rates, under which the governments buy or sell its currency to reduce day-to-day volatility of currency fluctuations and sometimes go for systematic intervention for desired objectives. Canada and Japan fall in this category, besides many developing countries. India too falls under this category which follows the
dual currency regime
since 1992–93 financial year.
8

(iii)
Some economies, particularly small ones, peg their currencies to a major currency or to a
basket
of currency in a fixed exchange rate—known as the
pegging of currencies.
At times, the peg is allowed to glide smoothly upward or downward—a system which is known as
gliding
or
crawling peg.
Some economies have a
hard fix
of a
currency board.
A
currency board
is working well in Hong Kong while the fsame failed in Argentina in 2002.

Foreign Exchange Market

The market where different currencies can be bought and sold is called the foreign exchange market.
9
Out of the trades in different currencies, the exchange rate of the currency is determined by the economy.
10
This is an institutional framework for the exchange of one national currency for another.
11
This is particularly correct either in the case of a free float exchange (i.e., floating currency) regime or is a managed or hybrid exchange rate system. It is altogether not allowed either in a
fixed currency system
or a
hard fix
(in a hard fix this happens once the currency to which the hard fix has been done itself starts fluctuating).

Exchange Rate in India

Indian currency the ‘rupee’ was historically linked with the British Pound Sterling till 1948 which was fixed as far back as 1928. Once the IMF came up, India shifted to the fixed currency system committed to maintain rupee’s external value (i.e., exchange rate) in terms of gold or the US ($ dollar). In 1948,
`
3.30 was fixed equivalent to US $ 1.

In September 1975, India delinked rupee from the British pound and the RBI started determining rupee’s exchange rate with respect to the exchange rate movements of the basket of world currencies (£, $, ¥, DM, Fr.). This was an arrangement between the fixed and the floating currency regimes.

In 1992–93 financial year, India moved to the floating currency regime with its own method which is known as the ‘dual exchange rate’
12
.
There are two exchange rates for rupee, one is the ‘official rate’ and the other is the ‘market rate’. Here the point should be noted that it is the everyday’s changing market-based exchange rate of rupee which affects the official exchange rate and not the other way round. But the RBI may intervene in the forex market via the demand and supply of rupee or the foreign currencies. Another point which should be kept in mind is that none of the economies have till date followed an ideal free-floating exchange rate. They require some mechanism to intervene in the foreign exchange market because this is a highly speculative market.

Trade Balance

The monetary difference of the total export and import of an economy in one financial year is called trade balance. It might be positive or negative, known to be either favourable or unfavourable, respectively to the economy.

Trade Policy

Broadly speaking, the economic policy which regulates the export-import activities of any economy is known as the trade policy. It is also called the
f
oreign
t
rade
p
olicy or the Exim Policy. This policy needs regular modifications depending upon the economic policies of the economies of the world or the trading partners.
13

Depreciation

This term is used to mean two different things. In foreign exchange market, it is a situation when domestic currency loses its value in front of a foreign currency if it is market-driven. It means depreciation in a currency can only take place if the economy follows the floating exchange rate system.

In domestic economy, depreciation means an asset losing its value due to either its use, wear and tear or due to other economic reasons. Depreciation here means
wear and tear
. This is also known as
capital consumption.
Every economy has an official annual rates/for different assets at which fixed assets are considered depreciating.

Devaluation

In the foreign exchange market when exchange rate of a domestic currency is cut down by its government against any foreign currency, it is called devaluation. It means official depreciation is devaluation.

Revaluation

A term used in foreign exchange market which means a government increasing the exchange rate of its currency against any foreign currency. It is official appreciation.

Appreciation

In foreign exchange market, if a free floating domestic currency increases its value against the value of a foreign currency, it is appreciation. In domestic economy, if a fixed asset has seen increase in its value it is also known as appreciation. Appreciation rates for different assets are not fixed by any government as they depend upon many factors which are unseen.

Current Account

It has two meanings—one is related to the banking sector and other to the external sector:

i.
In banking industry, a business firm bank account is known as current account. The account is in the name of a firm run by authorised person or persons in which no interest is paid by the bank on the deposits. Every withdrawal from the account takes place by cheques with limitations on the number of deposits and withdrawals in a single day. The
overdraft
facility or the
cash-cum-credit
(c/c Account)
facility to business firms is offered by the banks on this account only.

ii.
In the external sector, it refers to the account maintained by every government of the world in which every kind of current transactions is shown—basically this account is maintained by the central banking body of the economy on behalf of the government. Current transactions of an economy in foreign currency all over the world are—export, import, interest payments, foreign investment in shares.

All transactions are shown as either inflow or outflow (credit or debit). At the end of the year, the current account might be positive or negative.The positive one is known as a surplus current account, and the negative one is known as a deficit current account. India had surplus current accounts for three consecutive years (2000–03)—the only such period.

Current account deficit is shown either numerically by showing the total monetary amount of the deficit, or in percentage of the GDP of the economy for the concerned year. Both the data are used in analysis as per the specific requirement.

Capital Account

Every government of the world maintains a capital account which shows the capital kind of transactions of the economy with the outside economies. Every transaction in foreign currency (inflow or outflow) considered as capital is shown in this account—external lending or borrowing, private remittance’s inflow or outflow, issuing of external bonds, etc.

There is no deficit or surplus in this account like the current account.

Balance of Payment (B
o
P)

The outcome of the total transactions of an economy with the outside world in one year is known as the balance of payment (BoP) of the economy.
14
Basically, it is the net outcome of the current and capital accounts of an economy. It might be favourable or unfavourable for the economy. However, negativity of the BoP does not mean it is unfavourable. A negative BoP is unfavourable for an economy if only the economy lacks the means to fill the gap of negativity.

The BoP of an economy is calculated on the principles of accountancy (
double-entry book-keeping
)
15
and looks like the balance sheet of a company—every entry shown either as credit (inflow) or debit (outflow). If there is a positive outcome at the end of the year, the money is automatically transferred to the foreign exchange reserves of the economy. And if there is any negative outcome, the same foreign exchange is drawn from the country’s forex reserves. If the forex reserves are not capable of fulfilling the negativity created by the BoP, it is known as a BoP crisis
and the economy tries different means to solve the crisis in which going for forex help from the IMF is the last resort.

Convertibility

An economy might allow its currency full or partial convertibility in the current and the capital accounts. If domestic currency is allowed to convert into foreign currency for all current account purposes, it is a case of full current account convertibility. Similarly, in cases of capital outflow, if domestic currency is allowed to convert into foreign currency, it is a case of full capital account convertibility. If the situation is of partial convertibility, then the portion allowed by the government can be converted into foreign currency for current and capital purposes. It should always be kept in mind that the issue of currency convertibility is concerned with foreign currency
outflow
only.

Convertibility in India

India’s foreign exchange earning capacity was always poor and hence it had all possible provisions to check the foreign exchange outflow, be it for current purposes or capital purposes (remember the draconian FERA!). But the process of economic reforms has changed the situation to unidentifiable levels—

Current Account

Current account is today fully convertible (operationalised on August 19, 1994). It means that the full amount of the foreign exchange required by someone for current purposes will be made available to him at official exchange rate and there could be an unprohibited outflow of foreign exchange (earlier it was partially convertible). India was obliged to do so as per Article VIII of the IMF which prohibits any exchange restrictions on current international transactions (keep in mind that India was under pre-conditions of the IMF since 1991!).

Capital Account