UNIT 2- FOREIGN EXCHANGE MARKETS: AN INDIAN

PERSPECTIVE

I. Meaning of Foreign Exchange Dealers in India

Foreign Exchange Dealers in India are financial institutions, banks,

and specialized firms that facilitate the buying, selling, and
exchange of foreign currencies. They serve as intermediaries
between individuals, businesses, governments, and international
markets. These dealers provide services for converting one currency
into another, offering currency-related products, and managing
currency risks.

In India, foreign exchange dealers are typically licensed by the

Reserve Bank of India (RBI) to ensure they follow proper regulatory
guidelines. These dealers engage in both spot (immediate)
transactions and forward (future) contracts, offering various
financial products to cater to different clients' needs.

II. Role of Foreign Exchange Dealers in India

1. Currency Conversion:

o Foreign exchange dealers facilitate the conversion of Indian

Rupees (INR) into foreign currencies (like USD, EUR, GBP) and
vice versa. This is essential for businesses engaged in
international trade or individuals traveling abroad.

2. Market Making:

o As market makers, foreign exchange dealers provide buy and

sell prices for currencies, ensuring there is liquidity in the
foreign exchange market. They play a key role in determining
the exchange rates by offering continuous two-way quotes.

3. Facilitating International Trade:

o They support exporters and importers by providing foreign

exchange services to settle cross-border transactions,
ensuring businesses can pay or receive money in foreign
currencies.

4. Hedging Currency Risk:

o Forex dealers offer hedging products like forward contracts

and currency options to help businesses and investors
protect themselves against fluctuations in currency exchange
 rates. This is particularly useful for importers/exporters who
need to manage risks arising from exchange rate volatility.

5. Speculation and Investment:

o Dealers also engage in speculative activities by trading

currencies to profit from market movements, while providing
investment options like currency futures to institutional
investors.

6. Remittances:

o They assist in the transfer of remittances from overseas,

helping individuals send money back to India or abroad. This
service is particularly important for the large Indian diaspora.

7. Regulatory Compliance:

o Foreign exchange dealers are regulated by the RBI and need

to adhere to guidelines set under the Foreign Exchange
Management Act (FEMA). They must ensure compliance
with rules related to transactions in foreign exchange,
managing limits on currency exchange, and reporting
transactions to the authorities.

III. Importance of Foreign Exchange Dealers in India

1. Enhancing Global Trade:

o Forex dealers play an integral role in India's import and export

activities. By providing timely and efficient currency exchange
services, they enable seamless cross-border transactions for
Indian businesses, which is essential for global trade.

2. Stabilizing Exchange Rates:

o Foreign exchange dealers help in stabilizing currency

exchange rates by providing liquidity and executing large-
volume transactions. Their actions in the market contribute to
less volatility, which is beneficial for businesses and investors.

3. Promoting Investment:

o They enable international investments into India by offering

services like currency futures and options, which make foreign
investments easier. Also, they provide mechanisms for
hedging currency risks, making India a more attractive
destination for foreign investors.

4. Supporting Economic Growth:

 o The foreign exchange market is critical for the overall
economic growth of India. By facilitating efficient currency
conversions, they help in the inflow of foreign investments,
remittances, and international trade, all of which contribute to
India's GDP growth.

5. Providing Risk Management:

o With the increasing volatility of global currency markets, forex

dealers offer businesses and individuals essential risk
management products, reducing the potential adverse effects
of currency fluctuations. This is especially vital for sectors like
IT, automobile, and pharmaceuticals, which deal with large
international transactions.

6. Ensuring Liquidity in the Market:

o By continuously quoting prices and trading in currency pairs,

foreign exchange dealers ensure liquidity, helping clients
easily exchange currencies without major price fluctuations.

7. Supporting Government Policies:

o Foreign exchange dealers work in line with government

policies aimed at stabilizing the currency market and
controlling inflation. For example, the RBI intervenes in the
forex market through these dealers to prevent excessive
depreciation or appreciation of the Indian Rupee (INR).

Thus, foreign exchange dealers in India are essential players in the

financial system, helping facilitate global trade, manage currency risk, and
promote investment. By ensuring the smooth functioning of the forex
market, they contribute significantly to the economic stability and growth
of the country.

IV. SETTING UP A FOREX DEALERSHIP

Setting up a Foreign Exchange (Forex) Dealership in India involves several

regulatory, legal, and operational steps. Since foreign exchange
transactions are heavily regulated, particularly in countries like India, it
requires strict adherence to the guidelines set by the Reserve Bank of
India (RBI) and the Foreign Exchange Management Act (FEMA).

1. Regulatory Requirements

Regulatory Authority: The foreign exchange market in India is regulated by

the Reserve Bank of India (RBI) under the Foreign Exchange Management
Act (FEMA). The RBI provides licenses to financial institutions, banks, and
non-banking financial companies (NBFCs) that wish to deal in foreign
exchange. The dealers must comply with the RBI’s Foreign Exchange
Dealer Guidelines and other provisions under FEMA.

2. Obtain a License from RBI

To operate as a foreign exchange dealer in India, it is needed to obtain a

license from the RBI. There are different types of licenses, such as:

 Authorized Dealer (AD) License: This license allows banks and

financial institutions to deal in foreign exchange transactions,
including buying and selling of foreign currencies, forex trading, and
remittances.

 Authorized Dealer Category II (AD-II) License: This allows other

entities such as NBFCs and certain other non-bank financial
institutions to operate in foreign exchange dealings.

Steps to Obtain the License:

 Application: Submitting an application to the RBI requesting

authorization to operate as a foreign exchange dealer is the first
step. The application should include the business structure, financial
standing, and details of business operations.

 Documents: Provide necessary documents, such as company’s

legal status, capital structure, business plan, internal systems, and
compliance policies.

 Approval Process: The RBI will reviews application. The decision

will depend on you’re the company’s financial standing, credibility,
and the overall market conditions.

3. Meet Capital and Infrastructure Requirements

Foreign exchange dealerships in India require adequate capital to manage

large volumes of transactions. The RBI may impose minimum capital
requirements for those seeking to obtain an authorized dealer license.

 Capital Requirements: It is important to ensure the required

minimum capital to operate as a forex dealer. For instance, banks
and NBFCs generally need substantial paid-up capital to engage in
forex transactions.

 Infrastructure and Systems: Set up of a robust infrastructure,

including technology platforms for handling transactions, risk
management systems, and compliance tools is important. Many
forex dealers use specialized software to handle currency
exchanges, foreign exchange risk, and regulatory reporting.
 4. Comply with Anti-Money Laundering (AML) and KYC
Guidelines

Forex dealers must adhere to KYC (Know Your Customer) and AML
(Anti-Money Laundering) guidelines. This includes:

 Customer Verification: Maintain detailed records of customers

and ensure that all transactions are traceable to prevent money
laundering and fraud.

 Transaction Reporting: Implement systems for reporting large or

suspicious transactions to regulatory authorities.

5. Develop a Business Plan and Offerings

Designing a comprehensive business plan that outlines the services

intended to offer is important. Following are the services generally offered
by Forex Dealers:

 Spot Forex Trading: Facilitating immediate exchange of

currencies.

 Forward Contracts: Allowing customers to lock in exchange rates

for future transactions.

 Currency Options & Futures: Offering risk management products.

 Remittance Services: Helping individuals and businesses send

money internationally.

Ensuring business model aligns with the customer needs in the

market (e.g., for businesses, exporters, and importers) is a part of
this step

6. Set Up Risk Management Framework

Due to the volatile nature of foreign exchange markets, it's crucial to set
up a strong risk management framework. There should be systems in
place for:

 Hedging: To protect the business and clients from adverse currency

fluctuations.

 Position Limits: To control exposure to large positions.

 Liquidity Management: Ensuring you have enough liquidity to

meet obligations.

7. Hire Qualified Professionals

Foreign exchange dealing requires specialized knowledge. There is a need
to employ professionals who are qualified and experienced in forex
markets. This includes:

 Currency Traders: For executing and managing transactions.

 Compliance Officers: To ensure adherence to RBI, FEMA, and other

regulations.

 Risk Managers: To assess and manage the financial risks

associated with forex dealings.

8. Obtain Other Necessary Approvals

In addition to the RBI license, approvals or registrations are needed with

other authorities, including:

 SEBI (Securities and Exchange Board of India): For dealing in

foreign exchange derivatives, futures, or options.

 Goods and Services Tax (GST) Registration: If the plan is to

offer forex services subject to GST, you need to register under the
GST Act.

9. Marketing and Customer Acquisition

Once the necessary licenses are obtained and operations are set up, you
will need to market your foreign exchange dealership to potential
customers. Some of the strategies include:

 Targeting Exporters and Importers: These businesses will

require forex services for cross-border transactions.

 Offering Competitive Exchange Rates: Services should be

attractive by offering competitive rates to businesses and
individuals.

 Educational Content: Provide valuable content to help customers

understand foreign exchange and services can help them manage
currency risks.

10. Regular Auditing and Compliance Checks

Once operational, the foreign exchange dealership will be subject to

regular audits and compliance checks by the RBI and other regulatory
bodies to ensure that it is adhering to the rules and regulations. There are
regular inspections and dealerships are required to comply with all
reporting requirements.

Conclusion
Setting up a foreign exchange dealership in India is a regulated and
complex process, involving compliance with RBI and FEMA guidelines,
acquiring the necessary licenses, and setting up robust risk management
and technological systems. With the right infrastructure, qualified
personnel, and a clear understanding of the legal landscape, a foreign
exchange dealership can succeed in India’s dynamic forex market.

V. CURRENCY CONVERTIBILITY

Meaning- Currency convertibility is the ability to exchange a country's

currency for other currencies at the market exchange rate. It's an
important factor in international trade, as it allows countries to pay for
goods and services in the currency of the seller.

Currency convertibility is an important factor for international commerce.

Ie. How quickly the home currency can be converted to some other
currency or gold. Some governments which do not have large reserves of
hard forex currencies restrict currency convertibility since they may not be
able to handle large currency market operations to support their own
currency when necessary. Many a times governments also try to protect
local trade/ investors and hence restrict currency convertibility.
Convertibility of currency also implies absence of exchange controls and
other such restrictions.

If the convertibility of currency is easier, it implies the following:

 It's a measure of how liquid a country's currency is.

 It's a sign of a country's economic health.

 It's a way to attract foreign investment.

 It's a way to guide domestic businesses to make efficient production

and investment decisions which are export oriented.

Categories of Currency Convertibility:

The two types of currency convertibility are:

1. Convertibility for current international transactions

2. Convertibility for international capital movement

Types of Currency Convertibility

1. Full Convertibility

A currency is fully convertible when it can be exchanged freely for any

foreign currency without restrictions, for both current account (trade,
remittances) and capital account (investment, borrowing) transactions.
Example: US Dollar, Euro.
 2. Partial Convertibility

A currency is partially convertible when certain restrictions are imposed,

especially on capital account transactions. India follows this model, with
full convertibility for current account transactions under the Foreign
Exchange Management Act (FEMA) but partial convertibility for capital
account transactions.

3. Non-Convertible

A currency is non-convertible when the government or central bank

imposes strict controls, preventing its free exchange in the foreign
exchange market. Example: North Korean Won.

FACTORS AFFECTING CURRENCY CONVERTIBILITY

1. Economic Stability

Currency convertibility is closely linked to the overall economic health of a

country. Key aspects of economic stability include:

 GDP Growth Rate: A strong and consistent growth rate indicates a

stable economy, boosting confidence in the domestic currency.

 Inflation Control: High inflation undermines the value of a

currency, making it difficult to allow unrestricted conversion. A low
and stable inflation rate fosters trust in the currency.

 Fiscal Discipline: Countries with low fiscal deficits are better

positioned to handle currency fluctuations, encouraging
convertibility.

2. Foreign Exchange Reserves

A sufficient level of foreign exchange reserves ensures that the central

bank can intervene in the forex market to stabilize the currency when
needed. India’s partial convertibility model relies heavily on maintaining
adequate reserves to manage the volatility arising from external shocks or
speculative flows. Low reserves can deter full convertibility as the country
may face challenges in meeting international payment obligations.

3. Balance of Payments (BoP)

The BoP position reflects the country’s ability to manage international

transactions without external pressure.

 Current Account: A surplus or balanced current account supports

convertibility by ensuring that export earnings and remittances are
sufficient to cover imports.
  Capital Account: A stable capital account with controlled capital
inflows and outflows reduces risks of destabilization, especially in
the case of speculative movements.

In India, convertibility on the capital account is partial due to concerns

about sudden capital flight and large BoP deficits.

4. Inflation Rates

A country with high inflation sees a decline in the purchasing power of its
currency, making it unattractive in the global market. High inflation
creates uncertainty, leading to hesitancy in allowing unrestricted capital
or current account transactions. Controlled inflation (as seen in India over
the years) enhances the prospects of convertibility.

5. Exchange Rate Regime

The type of exchange rate regime plays a significant role:

 Flexible Exchange Rate: When exchange rates are determined by

market forces, it allows for smoother currency convertibility, as the
market naturally adjusts to demand-supply dynamics.

 Fixed Exchange Rate: A pegged or fixed system may require

stricter controls on currency convertibility to maintain the pegged
value.

 India follows a managed float system where the Reserve Bank of

India (RBI) intervenes to prevent excessive volatility, balancing
partial convertibility.

6. Capital Market Development

The strength and depth of financial markets determine how well a country
can handle foreign capital flows. A robust and liquid financial market can
absorb large inflows or outflows without excessive volatility, encouraging
convertibility. Weak financial markets make the economy vulnerable to
speculative attacks, limiting the scope of full convertibility. India has
strengthened its capital markets but still imposes restrictions to avoid
destabilizing effects of hot money (short-term capital flows).

7. Political Stability

Political stability fosters confidence among foreign investors and trading

partners. Stable governments ensure consistent economic policies, which
are essential for managing foreign exchange risks. Frequent policy
changes or political uncertainty can deter full convertibility due to fears of
abrupt changes in currency value or policy reversals. India’s steady
political framework and progressive reforms have supported its partial
convertibility model.

8. External Factors

Global economic conditions and geopolitical factors also influence

convertibility:

 Global Financial Markets: High volatility or crises (e.g., global

financial crises) can force countries to tighten controls on
convertibility.

 Trade Relationships: A country engaged in stable and diversified

trade partnerships can better manage its currency’s demand and
supply.

 Geopolitical Risks: War, sanctions, or other geopolitical tensions

may compel a country to restrict convertibility.

9. Risks of Speculative Flows

Speculative capital flows can destabilize an economy by causing sharp

fluctuations in currency value. To mitigate these risks, countries with less
developed financial markets, such as India, adopt partial convertibility.
This ensures that short-term capital flows are controlled, while long-term
investments (FDI) are encouraged.

VI. CURRENT ACCOUNT CONVERTIBILITY

Meaning: The term “current account convertibility” refers to the

movement of funds into and out of an account that is not linked to any
sort of capital income or expense. Transactions which are considered part
of current account convertibility usually include commercial transactions
such as the purchase of goods or services, travel, tourism, etc. This is
distinct from capital account convertibility, which would entail
transactions like making loan payments or utilizing cash to buy large scale
investments or capital assets.

Current account convertibility occurs when the transactions in question

necessitate some form of currency conversion to be performed. For
instance, if a customer in India wants to buy a CD from a company in the
US using cash from his or her account, the transaction would require
currency conversion from INR to USD.

Whether a transaction involves current account convertibility or capital

account convertibility is usually determined by the application of certain
financial and trade regulations. These rules are typically set by the
countries involved in the transaction. The total value of the transaction is
sometimes the focus, with smaller sums being regarded as a current
account transaction and amounts above a certain threshold being
considered a capital account transaction. Transactions involving
specialized assets such as heavy equipment are processed as capital
account convertibility in some nations, regardless of the amount of money
involved.

Thus, all financial exchanges between countries are made up of current

account transactions include transactions such as a country’s exports and
imports of commodities and services.

Advantages of Current account convertibility

1. Facility to freely transmit your foreign income to India:

Current account convertibility enables you to receive and convert the

income sent by your family members working abroad, without going
through a complicated procedure prior.

2. Promote international trade:

Current account convertibility facilitates the conversion of foreign

currency into domestic currency and vice versa. This helps to integrate
trade across countries around the world. By eliminating trade barriers, it
increases international trade links among countries.

3. Encouragement to exports:

A major advantage of current account conversion is that it promotes

exports by improving profits. Export convertibility grows because the
exchange rate of the market exchange is higher than the government
fixed exchange rate. This means that exporters can receive more foreign
exchange rupees from exporters’ exports (e.g. US dollars). In particular,
currency convertibility favors low-import exports.

4. Encouragement to import substitution:

Imports become more expensive following a currency’s convertibility

because the free or market-determined exchange rate is higher than the
prior government-regulated exchange rate. This discourages imports and
encourages the replacement of imports.

5. An incentive to send remittances from abroad:

Rupee convertibility gave more incentives for Indian employees residing

overseas and NRIs to send remittances of foreign exchange. It also makes
illegal remittances like “hawala money” and gold smuggling less
appealing.

6. A self-balancing mechanism:
The self-balancing mechanism is another key advantage of current
account convertibility. When the balance of payments is in deficit due to
exchange rates being overvalued, the currency of the country is under
convertibility and it degrades, boosting its exports, on the one hand, by
cutting prices and discouraging imports, on the other, by increasing
prices. This automatically corrects the balance of payments deficit without
the Government or its Central Bank interference. Instead, the balance of
payments is excess because the exchange rate is undervalued.

7. Comparative advantage specialization:

Another advantage of currency convertibility gives a production pattern in

line with its relative advantage and resources for different trading
countries. When currencies are convertible, the exchange rate simply
represents the purchasing power of the currencies, which is based on
prices and expenses in different nations.
Exports will be encouraged since prices in a competitive market reflect
reduced pricing for those goods in which the country has a comparative
advantage. On the other hand, in a country that has a comparative
disadvantage, it will be prone to import such products into production. As
a result, currency convertibility ensures specialization and international
trade based on comparative advantage, which benefits all countries.

8. Integration of the World Economy:

Lastly, currency convertibility promotes global economic integration.

Currency convertibility facilitates the growth of trade and capital flows
between countries by providing simple access to foreign exchange. Trade
and capital flow between countries will expand, ensuring significant
economic growth in the world’s economies. Indeed, currency convertibility
is regarded to be a precondition for globalization success.

Disadvantages of Current account convertibility

1. Effects on Balance of Trade and Exports:

In overseas markets, a rising, unregulated currency makes Indian exports

less competitive. Export-based economies such as India and China prefer
to keep their exchange rates down so that the low-cost benefit remains.
Once the exchange-rate rules fall away, India is in danger of losing its
worldwide competitiveness.

2. Developing Economic Conditions:

In well-regulated nations with a strong infrastructure, the convertibility of

full current accounts has worked successfully. India’s fundamental issues
— high export dependency, rising populations, corruption, socio-economic
complexities, and bureaucratic challenges — may cause economic failures
after full rupee convertibility.

3. High Volatility:

High degrees of volatility, devaluation, or inflation in forex rates may

occur due to a lack of appropriate regulatory control and rates subject to
open markets with a large number of global market participants, posing a
threat to the country’s economy.

4. The burden of Foreign Debt:

Businesses can readily take on international loans, but they run the
danger of having to make large repayments if exchange values
deteriorate. Consider an Indian company taking out a 4 percent U.S. dollar
loan versus a 7 percent credit offered in India. However, if the US dollar is
up to the Indian rupee, more rupees will be needed to receive the same
amount of dollars, making the refund expensive.

VII. CAPITAL ACCOUNT CONVERTIBILITY

Meaning: Capital account convertibility (CAC) is the freedom to convert

local financial assets into foreign financial assets and vice versa. It allows
for the unrestricted flow of capital between countries.

What does CAC allow?

 Investment: Allows for the free movement of investment capital,

dividend payments, and interest payments

 Foreign direct investment: Allows for the free movement of

foreign direct investments in domestic projects and businesses

 Trading: Allows for the free trading of overseas equities by local

citizens and domestic equities by foreigners

 Remittances: Allows for the free movement of foreign remittances

 Real estate: Allows for the free sale or purchase of immovable

property

Advantages of Capital Account Convertibility

1. Increased Foreign Investment

CAC encourages inflows of Foreign Direct Investment (FDI) and Foreign

Portfolio Investment (FPI), as foreign investors gain unrestricted access to
the domestic economy. This provides much-needed capital for
infrastructure development, industrial growth, and technology transfer,
fostering long-term economic development.
 2. Global Economic Integration

CAC enables a country to seamlessly integrate with the global economy,

facilitating cross-border financial transactions. This global integration
encourages trade, investment, and partnerships, boosting the economy’s
competitiveness.

3. Efficient Allocation of Resources

Free capital movement allows funds to flow to sectors, industries, or

regions where they can be used most productively. This improves overall
economic efficiency and enhances the productivity of both domestic and
foreign capital.

4. Access to Cheaper Capital

With CAC, domestic companies and governments can access international

financial markets to secure capital at lower costs. This can reduce
borrowing costs, especially for developing countries, making investments
in key sectors more feasible.

5. Accelerated Economic Growth

Capital inflows from abroad can help bridge savings and investment gaps
in developing economies, driving growth and infrastructure expansion.
Access to foreign technology and expertise also supports innovation and
modernization.

6. Portfolio Diversification

Domestic investors can diversify their portfolios globally, reducing risks

associated with dependence on the domestic market. Similarly, foreign
investors can gain exposure to promising opportunities in emerging
markets, benefiting both sides.

7. Market Discipline and Policy Efficiency

CAC can incentivize governments to maintain sound economic policies,as

any mismanagement (e.g., high inflation, fiscal deficits) could lead to
capital flight. It instills fiscal and monetary discipline, promoting better
governance and transparency.

Disadvantages of Capital Account Convertibility

1. Financial Volatility and Instability

Unrestricted capital flows can lead to sudden and massive inflows or

outflows, causing exchange rate fluctuations and financial market
volatility. A rapid withdrawal of foreign investments during economic or
political uncertainty can destabilize the economy.
 2. Risk of Capital Flight

In times of instability, domestic residents and foreign investors might

move their capital out of the country, depleting foreign exchange reserves
and pressuring the currency. For instance, capital flight during crises can
lead to severe balance-of-payments problems and economic downturns.

3. Loss of Monetary Policy Autonomy

Free capital movement can limit a central bank’s ability to control

domestic monetary policy, as external factors begin to influence domestic
interest rates and money supply. For example, high foreign capital inflows
could force the central bank to raise interest rates or intervene in the
forex market, potentially leading to inflationary pressures.

4. Vulnerability to External Shocks

Economies with CAC are more exposed to global financial crises,

geopolitical events, or interest rate changes in major economies like the
U.S. or EU. For example, a rise in U.S. interest rates could lead to capital
outflows from emerging markets, destabilizing their economies.

5. Encouragement of Speculative Investments

CAC can attract short-term speculative investments ("hot money") that

focus on quick profits rather than long-term productive investments. This
speculative activity can lead to asset price bubbles, which, when they
burst, can have devastating effects on the economy.

6. Economic Inequality

Capital inflows often benefit specific sectors like real estate, finance, or
urban regions, potentially neglecting rural or underdeveloped areas. This
can exacerbate regional and sectoral inequalities, leading to social and
economic disparities.

7. Regulatory and Supervisory Challenges

CAC requires strong regulatory frameworks to monitor and manage capital

flows effectively. Weak regulatory systems can lead to misuse of foreign
capital, tax evasion, money laundering, and other financial crimes.

8. Balance of Payments and Debt Risks

Unchecked external borrowing due to CAC can increase a country’s

external debt burden. If the borrowed funds are not invested in productive
ventures, it can lead to repayment crises and long-term economic
challenges.

VIII. FOREIGN EXCHANGE CONTROL IN INDIA

Foreign exchange control in India is primarily managed by the Reserve
Bank of India (RBI) under the legal framework of the Foreign Exchange
Management Act (FEMA), 1999. The government and RBI adopt various
methods to regulate the inflow and outflow of foreign exchange, ensuring
the country's economic stability

Methods of Foreign Exchange Control in India

Foreign exchange control in India is primarily managed by the Reserve

Bank of India (RBI) under the legal framework of the Foreign Exchange
Management Act (FEMA), 1999. The aim is to regulate the inflow and
outflow of foreign exchange to ensure economic stability and maintain
foreign reserves. India’s foreign exchange control methods are part of a
comprehensive strategy to ensure a stable external economic
environment, support domestic growth, and maintain foreign exchange
reserves. By regulating the inflow and outflow of foreign exchange, the
government aims to balance the interests of various stakeholders while
promoting economic stability.

Below are the key methods of foreign exchange control in India, explained
in detail:

1. Exchange Rate Management

India follows a managed floating exchange rate system, where the value
of the Indian Rupee is determined by market forces of demand and supply
but is occasionally influenced by the RBI. The RBI intervenes in the foreign
exchange market to stabilize the rupee, especially during significant
volatility. These interventions include buying or selling foreign currencies
to influence supply and demand. For instance, during periods of excessive
rupee depreciation, the RBI may sell U.S. dollars to increase the supply
and stabilize the exchange rate.

2. Regulation of Foreign Exchange Transactions

All foreign exchange transactions in India are regulated under FEMA,

ensuring compliance with legal and policy frameworks. Transactions are
divided into two categories:

o Current Account Transactions: These include trade

payments, remittances for travel, education, and services.

o Capital Account Transactions: These relate to investments,

foreign borrowings, and transfers of financial assets.

Only authorized dealers (ADs), such as banks, are permitted to handle

foreign exchange transactions under strict RBI guidelines.
3. Import and Export Regulations

The government enforces strict documentation requirements for all import

and export-related foreign exchange transactions. Exporters are
mandated to repatriate foreign earnings within a specific time frame and
must report these earnings to the RBI. Imports require documentation like
bills of entry, and payments are monitored to prevent unauthorized
foreign exchange outflows.

4. Foreign Direct Investment (FDI) Policies

FDI is regulated through sectoral caps and approval routes:

o Automatic Route: Investments in certain sectors do not

require prior government approval.

o Government Route: Investments in sensitive or restricted

sectors require prior government clearance.

Sector-specific restrictions aim to promote domestic economic growth and

protect national interests.

5. External Borrowing Control

The government closely monitors and regulates External Commercial

Borrowings (ECBs) by Indian companies. ECBs are subject to limits on the
amount that can be borrowed and restrictions on the end-use of the
borrowed funds. This prevents excessive accumulation of foreign debt and
ensures that borrowings are used for productive purposes.

6. Foreign Portfolio Investment (FPI) Regulation

Foreign institutional investors (FIIs) and foreign portfolio investors (FPIs)

are required to register with the Securities and Exchange Board of India
(SEBI). There are limits on the amount of investment foreign entities can
make in Indian securities such as stocks and bonds. This regulation
ensures market stability and prevents excessive foreign ownership of
Indian assets.

7. Restrictions on Foreign Currency Holding

Indian residents are not allowed to hold significant amounts of foreign

currency. Any foreign currency earnings or holdings must be repatriated
within a specified time frame unless otherwise permitted by law. This
prevents hoarding of foreign currency and ensures a steady flow of forex
into the economy.

8. Incentives for Foreign Exchange Earnings

Exporters and other foreign exchange earners are encouraged through
various incentive schemes:

o Duty Drawback Scheme: Refunds on duties paid for

imported inputs used in export production.

o Export Promotion Capital Goods (EPCG) Scheme: Allows

exporters to import capital goods at reduced customs duties.

o Remittance Incentives: Indian expatriates are encouraged

to remit money back home, supported by favorable exchange
rates and reduced transaction costs.

9. RBI Intervention in Forex Markets

The RBI actively intervenes in the forex market to manage liquidity and
control volatility in the rupee’s exchange rate. For example, if there is an
excess supply of foreign currency, the RBI may purchase it to maintain the
value of the rupee. These interventions ensure financial stability and
protect foreign reserves.

10. Regulation of Outward Remittances

Under the Liberalized Remittance Scheme (LRS), individuals are allowed to

remit up to a prescribed limit annually for purposes like education, travel,
or investments abroad. The RBI monitors outward remittances to ensure
compliance with these limits and prevent unauthorized capital flight.

11. Controls on Speculative Activities

Speculative trading in foreign exchange markets is heavily regulated to

prevent market manipulation and financial instability. Currency derivatives
and trading in foreign exchange futures are allowed only through
authorized exchanges and under RBI oversight.

12. Monitoring of International Trade

The RBI monitors all import and export transactions through systems like
the Import Data Processing and Monitoring System (IDPMS) and Export
Data Processing and Monitoring System (EDPMS). These systems ensure
timely reporting of trade transactions and compliance with foreign
exchange laws.

IX. ROLE OF FEDAI IN FOREX MARKETS IN INDIA

The Foreign Exchange Dealers' Association of India (FEDAI) is a

self-regulatory, non-governmental organization established in 1958. It
represents banks and financial institutions authorized by the Reserve
Bank of India (RBI) to deal in foreign exchange. FEDAI provides
guidelines, training, and support to its member institutions for conducting
forex operations, with the aim of standardizing practices and ensuring
smooth functioning of the foreign exchange market in India.

The Foreign Exchange Dealers' Association of India (FEDAI) plays a

significant role in the functioning and regulation of the forex markets in
India. It is an association of banks and financial institutions authorized to
deal in foreign exchange under the purview of the Reserve Bank of India
(RBI). Here are its key roles and functions:

1. Regulatory Framework

FEDAI formulates and prescribes operational guidelines and rules for its
member banks concerning foreign exchange business in India. It ensures
uniformity and standard practices in forex operations among its members.

2. Training and Education

FEDAI conducts training programs, seminars, and workshops to enhance

the knowledge and skills of bank employees in foreign exchange and
international trade practices. It helps in disseminating information related
to updates in forex markets, global financial trends, and regulatory
changes.

3. Facilitating Compliance

The association ensures that member banks adhere to the RBI's rules and
guidelines related to foreign exchange transactions. It monitors
compliance with ethical practices in forex dealings.

4. Standardization of Practices

FEDAI standardizes procedures for various forex-related activities,

including documentation, trade settlement, and accounting practices. It
provides guidelines for foreign exchange contracts, including forward
contracts and derivative transactions.

5. Dispute Resolution

It acts as an arbitrator to settle disputes between member banks related

to forex transactions. This role ensures smooth and efficient resolution of
conflicts, maintaining stability in the forex market.

6. Exchange Rates and Benchmarking

FEDAI plays a role in determining reference rates for foreign currencies,
used by member banks for their forex operations. It provides daily rates
for various currencies, which serve as benchmarks in the interbank forex
market.

7. Policy Advocacy

The association serves as a liaison between member banks and regulatory

bodies like the Reserve Bank of India (RBI) and the Government of India. It
provides feedback and recommendations on policy changes to ensure the
development and stability of the forex market.

9. Market Development

FEDAI promotes the growth and stability of the forex market by fostering
trust and collaboration among its members. It helps create a robust
framework for handling international trade and foreign exchange
transactions.

In summary, FEDAI acts as a facilitator, regulator, and educator in India's

forex markets, ensuring the smooth functioning of the system and
compliance with global and domestic standards.

X. TRANSITION FROM FERA TO FEMA

The Foreign Exchange Regulation Act (FERA) was enacted in 1973 to

regulate foreign exchange transactions and control the flow of foreign
exchange in India. However, as India opened up its economy in the 1990s,
the need for more liberalized foreign exchange regulations arose. This led
to the introduction of the Foreign Exchange Management Act (FEMA)
in 1999, which replaced FERA. The transition from FERA to FEMA marked a
significant shift in India's approach to foreign exchange control.

Main Changes from FERA to FEMA:

1. Objective:

 FERA: Focused primarily on regulating and controlling foreign

exchange transactions. It aimed to conserve foreign exchange and
prevent capital outflows.
 FEMA: Focused on managing foreign exchange transactions in a way
that facilitates external trade and payments while promoting the
orderly development and maintenance of the foreign exchange
market in India.
2. Regulatory Approach:

 FERA: Emphasized stringent regulations and controls. Foreign

exchange transactions were tightly regulated, and any violation was
considered a criminal offense.
 FEMA: Adopted a more liberalized and market-driven approach. It
focuses on civil penalties for violations instead of criminal penalties,
offering greater flexibility to individuals and businesses in their
foreign exchange dealings.

3. Foreign Exchange Transactions:

 FERA: Strict controls were imposed on foreign exchange

transactions. Every transaction involving foreign exchange had to
be approved by the Reserve Bank of India (RBI), and there were
stringent restrictions on remittances and capital movement.
 FEMA: Introduced the concept of "current account transactions" and
"capital account transactions." It allowed greater freedom in current
account transactions (e.g., imports, exports, services) while
imposing restrictions only on capital account transactions (e.g.,
foreign investments, loans).

4. Liberalization and Globalization:

 FERA: FERA's rigid structure hindered India’s integration into the

global economy and restricted foreign direct investment (FDI) and
foreign portfolio investment (FPI).
 FEMA: Provided a more liberalized framework that encouraged
foreign investments, international trade, and capital flow, helping to
integrate India’s economy into the global financial system.

5. Focus on Compliance:

 FERA: Non-compliance with foreign exchange regulations was

treated as a criminal offense, with severe penalties, including
imprisonment.
 FEMA: Non-compliance is treated as a civil offense with penalties
such as fines rather than imprisonment. This shift made it easier for
individuals and businesses to operate without the fear of criminal
prosecution.

6. Capital Account Convertibility:

  FERA: Imposed strict controls on capital account transactions,
severely limiting the ability of residents to invest abroad or bring
foreign investments into India.
 FEMA: Allowed capital account convertibility in a more controlled
manner, making it easier for businesses and individuals to invest
and trade internationally.

7. Flexibility in Foreign Exchange Reserves:

 FERA: Foreign exchange reserves were strictly controlled and

heavily monitored.
 FEMA: Encouraged a more flexible foreign exchange market by
liberalizing the process of dealing in foreign currencies.

8. Regulatory Authority:

 FERA: The RBI had a significant role in the administration of foreign

exchange under FERA.
 FEMA: The RBI still plays a critical role in overseeing FEMA, but it
also provides more flexibility to authorized dealers and financial
institutions in managing foreign exchange.

9. Implementation of Foreign Investments:

 FERA: Foreign investments were regulated under the FERA

framework, with high levels of scrutiny and control over foreign
ownership in Indian companies.
 FEMA: Allowed for easier foreign direct investments (FDI) and
foreign portfolio investments (FPI) with fewer restrictions.

FEMA BILL, 1997

The Foreign Exchange Management Act (FEMA), 1997, was enacted to

replace the older Foreign Exchange Regulation Act (FERA), 1973. FEMA
was introduced to bring about greater liberalization of India's foreign
exchange regulations and to facilitate external trade and payments. It
aimed at promoting the orderly development of foreign exchange markets
in India and gave greater flexibility in the handling of foreign exchange
transactions.

Objective and Purpose of FEMA:

  The primary objective of FEMA was to manage foreign exchange in a
manner that facilitates the orderly growth and development of the
foreign exchange market in India.
 FEMA sought to simplify the process for current account
transactions (such as trade and services) while restricting capital
account transactions (such as foreign investments, loans, and
capital movement).
 The Act aimed at promoting the liberalization of foreign exchange
transactions while ensuring proper management and control where
necessary.

Scope:

 FEMA was designed to cover both residents and non-residents

and aimed at creating an environment that supports external trade
and payments while regulating the flow of foreign exchange.
 Unlike FERA, FEMA focused on civil penalties rather than criminal
penalties for violations, making it more user-friendly and business-
oriented.
 Works with RBI and also covers Enforcement Directorate (ED)

Regulation of Foreign Exchange Transactions:

 Current Account Transactions: These transactions (such as

payments for imports/exports, services, etc.) were freely permitted
under FEMA.
 Capital Account Transactions: These transactions (involving
foreign investments, loans, and capital movement) were restricted
and could only be undertaken within the framework of guidelines
provided by the Reserve Bank of India (RBI).

XI. HAWALA MARKET AND FOREX PROBLEMS IN INDIA

Meaning

The hawala market refers to an informal and illegal system of money

transfer that operates outside the regulated banking and financial
institutions. In the hawala system, funds are transferred across borders or
within countries without the actual movement of money, typically
involving a network of brokers or intermediaries. These brokers facilitate
transactions by using a system of trust and ledger-keeping, often avoiding
formal channels like banks and adhering to no official regulations.
The hawala system is commonly used for transferring funds between
countries, especially in regions where currency controls or foreign
exchange restrictions exist, or where banking systems are not easily
accessible. It is widely used for purposes such as remittances, trade, or
even money laundering.

Operating system of a Hawala Transaction:

1. Parties Involved:

o Sender: The individual or business who wants to send money.

o Hawala Dealer (Broker): The intermediary facilitating the

transfer, usually based in the sending or receiving country.

o Receiver: The individual or business who receives the money.

2. Process:

o The sender contacts a hawala broker in the country they are

sending money from.

o The sender provides the money to the broker and is given a

code or reference.

o The broker contacts another hawala dealer in the receiving

country, instructing them to pay the specified amount to the
receiver.

o The receiver presents the reference code and collects the

money without any physical movement of cash across
borders.

3. No Formal Records: Hawala transactions are often untraceable,

and there is no formal record keeping in the official financial system,
making it difficult for authorities to track the flow of funds.

XII. FOREX PROBLEMS IN INDIA DUE TO THE HAWALA

MARKET

While the hawala system is a convenient method for money transfers, it

poses several challenges and problems for the foreign exchange market in
India. These issues are often linked to the unregulated nature of hawala
transactions and their impact on the formal financial system.

1. Loss of Foreign Exchange Reserves:

 Since hawala operates outside the formal banking system, large

sums of money are transferred across borders without being
 recorded in official forex channels. This leads to a drain on foreign
exchange reserves, as transactions bypass the official channels
regulated by the Reserve Bank of India (RBI).

 It prevents accurate tracking of the flow of foreign exchange into

and out of the country, leading to discrepancies in India's official
balance of payments.

2. Currency Volatility:

 The hawala market often operates in parallel with the official forex
market. Large-scale hawala transactions can cause disruptions in
the official market, leading to exchange rate volatility. The
demand for foreign currency in the hawala market may create
artificial scarcity, pushing up the value of foreign currencies against
the Indian Rupee.

3. Loss of Tax Revenue:

 Hawala transactions are unrecorded and evade the regulatory

oversight of tax authorities. This means that funds transferred
through hawala channels are not taxed properly, resulting in a loss
of tax revenue for the government.

 It also fuels the black market economy, leading to increased levels

of unaccounted wealth.

4. Undermining of Exchange Control Regulations:

 FERA (Foreign Exchange Regulation Act) and FEMA (Foreign

Exchange Management Act) are designed to regulate the flow of
foreign exchange and prevent illegal transactions. The existence of
the hawala market undermines these laws, making it difficult for the
RBI and government authorities to enforce currency control
measures.

 It creates an informal, parallel market for foreign exchange,

which operates outside the purview of the official regulatory
framework.

5. Money Laundering and Terrorism Financing:

 Since hawala transactions are not subject to the strict scrutiny of

formal financial institutions, they are often exploited for money
laundering and the financing of illegal activities, including
terrorism.
  India, like many other countries, has raised concerns about hawala
being used to fund cross-border terrorism or other illicit activities, as
money can be easily transferred across borders without detection.

6. Distortion of the Forex Market:

 The presence of a parallel hawala market often leads to distorted

exchange rates, especially when large amounts of money are
funneled through informal channels. This can affect the functioning
of the official forex market and hinder the development of a
transparent and stable exchange rate system in India.

7. Weakening of Financial Integrity:

 Hawala markets encourage a lack of transparency in financial

transactions, weakening the integrity of the financial system in
India.

 It also promotes the use of illegal methods of remitting money,

reducing the effectiveness of the regulatory and financial systems
designed to control such activities.