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0JNANA VARDHINI
SIBSTC MONTHLY NEWSLETTER -COVERING
CONTEMPORARY BANKING RELATED TOPICS
23RD ISSUE
JUNE -2012
SOUTHERN INDIA BANKS’ STAFF
TRAINING COLLEGE
No.531, Faiz Avenue, 11th Main, 32nd Cross
IV Block, Jayanagar, BANGALORE-560 011
Website: www.sibstc.edu.in
Email:
[email protected]
[email protected]
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RUPEE WEAKENING AND ITS IMPACT
We have been witnessing steep depreciation of rupee in the recent past and everyone is
concerned about exchange rates volatilities in the market. This article explores the
reasons behind the rupee depreciation, how RBI is trying to defend the rupee value and
how it is going to affect the industries.
Exchange Rates and its impact
In any transaction involving two currencies Exchange Rates play an important role in
determining the value/cost of the transaction and any adverse exchange rates may cause
loss to the concerned in such transactions.
For example an exporter from India having export receivables in USD may lose if the
Indian Rupee becomes strong (appreciates) versus USD on the date of realization. The
exporter under this situation will ultimately get less in terms of rupee and hence may
suffer a loss.
On the other hand the same exporter will gain if our Indian Rupee weakens (depreciates)
versus USD on the date of realization as he gets more in terms of rupee on the date of
realization.
Similarly an Importer having payables in a foreign currency and funding the transaction
from rupee sources may lose when our rupee weakens and will gain when the rupee
strengthens.
The above examples may help us to understand the cost implications that revolve around
exchange rates. Unpredictable movements in exchange rates may thus erode the profit
margins/cause losses in transactions involving a foreign currency.
How exchange rates are determined
Free and full Float
When a country's exchange rates are purely based on market situations through supply
and demand for that particular currency relative to other currencies it is normally known
as “free float regime”. Thus floating exchange rates change freely and are
predominantly determined by market situations. This is in contrast to a "fixed exchange
rate" regime.
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Dirty Float
A system of floating exchange rates in which the government or the country's central
bank occasionally intervenes to change the direction of the value of the country's
currency is normally known as “dirty float” regime. 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.
Clean Float
Also known as a pure exchange rate, a clean float occurs when the value of a currency,
the exchange rate, is determined purely by supply and demand. Clean floats can only
exist where there is no government interference, as would be the case in a purely
capitalistic economy. A clean float is the opposite of a dirty float, which occurs when
government rules or laws affect the pricing of currency. Virtually none of the currencies
in the western world float cleanly, without support or some other form of relationship
with a central bank. Swiss francs, German marks (earlier) and Canadian dollars tend to be
among the "cleanest" of the western currencies.
Factors determining exchange rates
There are many factors to decide the currency’s values and it can be understood in
simpler terms too. A currency will tend to become more valuable when its demand is
higher than the supply. A currency will tend to become less valuable when its demand is
less than supply. It is the basic theory. We need to understand in the global economy
terms, when the currency will have more demand and when it will have less demand.
Exchange rates are expressed as a comparison of two currencies and it almost
reflects the economic strength of those two currencies. Interest rates, Inflation and
exchange rates are highly inter-related. Reserve Bank changes the interest rates, may be
too often, primarily to control the Inflation and the exchange rates.
Take the example of stock market investment to understand the above principle. As we
know our stock market is dominated by the overseas investors (outside India), because of
the simple fact that domestic investors collectively do not have that much investible
surplus funds for making investments.
When our economy is doing well and market is performing better than other countries,
overseas investors would invest heavily in our markets. How they would invest in our
markets? They will sell their currency and convert to our currency (rupee) and invest in
India subject to the facilitating policy guidelines. It is clear that when more investors are
coming to India, the demand for the home currency will be very high. Our rupee value
will thus increase (appreciates) against dollar. In the same way, when they are pulling out
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of market or winding up their investments in India, demand for USD will rise making
USD costlier versus Indian Rupee and hence value of home currency gets depreciated.
Major Factors Influencing the Currency Value
The following are the major factors among others influencing the changes in the value of
domestic currency:

Inflation
As a general rule, a country with a consistently lower inflation rate exhibits a
rising currency value, as its purchasing power increases relative to other
currencies.

Interest Rates
A higher interest rates offer good returns compared to other countries. It will
result in the foreign capital funds come into the country. Lower interest rates
decrease the currency value. Exchange rates too have the close relation with
interest rates. The currency value would not be affected only based on the interest
factor as it is often impacted based on the other conditions like inflation or
economic/political situations too.

Current Account Deficits
Basically current account of a country represents the status on the trade
surplus/deficit level versus other trading partners. If there is any deficit in the
current account means country is doing more trading outside the country then its
actual earning inside the country. This situation is not good for a country because
the country needs to buy more foreign currency to fulfill its need inside the
country. A country needs to manage its deficit as otherwise it will lead to an
economic problem. More demand for the foreign currency would reduce the value
of that country’s home currency and this is the starting point for inflation.

Foreign Funds Outflow
It is the major concern of Indian economy now. Because of the global uncertainty
and economic crisis in Europe, US and elsewhere, coupled with subdued growth
in India and dull capital market, the global investors are in search for the safe
heavens to shift their investments. They are quickly pulling out the money from
Indian markets and investing in other safe investments like Gold or US dollar.
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
Government Deficit is High
The government finances (combined central and state government) deficit has
stubbornly stayed around 10 per cent of GDP. It is unmanageably high causing
panic and loss of faith for overseas investors.

Political Uncertainty and paralysis in decision taking
This is one of the major factors for any country towards stabilizing the economy.
Indecisions at political levels and lack of will for reforms seem to capture the
attention of global media and also the global investors.
Impact of Rupee weakening

The cost of imports will go up and leading to pushing up the inflation.

The current account deficit will further widen.

Travel/study/medical treatment abroad and all remittances abroad and also
servicing a foreign currency loan will become costlier as the dollar becomes
costly and more rupee funds will be required to buy the requisite dollars.

Companies depending on imported inputs could see profitability and market
capitalization take a beating.

The foreign investors who have invested in India may be prompted to take back
their investments as they may ultimately get back lesser in terms of USD when
the rupee crashes. Fearing further depreciation, the overseas investor may press
the panic button and this may trigger mass exodus of investments thus exerting
further stress on declining rupee

The ultimate earnings in rupee will become more only for exporters and
beneficiaries of inward remittances and hence they may be happy temporarily.

Falling rupee may have got the IT industry windfall gains but industry body
NASSCOM feels weakening of the Indian currency will benefit big companies
like TCS and Infosys only in the long run and the rupee depreciation may help to
some extent to retain competitiveness in the industry.

NASSCOM feels that a stable currency is now required to remove possible
uncertainties in the ultimate export earnings as so many companies have already
lost heavily, in cases of unhedged/open exposures in receivables, when the rupee
suddenly goes strong. When rupee suddenly started depreciating so deeply those
who had hedged exposures in receivables lost heavily. In such situations of high
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uncertainty in exchange rates hedged as well as unhedged exposures may cause
dents and all of them vociferously advocate for stable exchange rates.
Why RBI intervenes?
Sometimes we have seen RBI intervening to stop the erosion of rupee value against the
dollar currency. What it does is to release the dollar currency (out of buffers) into the
markets to temporarily prop up the value of rupee. But it is very difficult for the Reserve
Bank to adjust the value of the currency in this fashion for ever and the long term
solution would be to trigger long term measures to boost the domestic economy, to
accelerate the flow of foreign exchange under capital and current accounts and to bring
the inflation into control.
India is heavily dependent on the import of raw materials and Oil for its industrial
development. In the depreciating rupee scenario, the outgo of money will be much
higher. This would affect the expenses for the companies who imports raw materials
for their factory and all the Oil Marketing Companies (OMC) as they will have to
incur heavy payment to import the Oil. This is the reason as to why the Petrol prices
have been on the increase in the recent past.
Thus to protect the value of rupee to certain extent inter-alia imports, RBI intervenes in
the market, not on regular basis but occasionally.
Hedging Instrument to protect Exchange Rate Movements
To take care of uncertainties in exchange rates, certain hedging tools came into existence
and one such tool is FORWARD CONTRACT, the most popular, simplest and easiest
and widely used derivative instrument to hedge exposures in foreign currencies.
In finance, a forward contract or simply a forward is a non-standardized contract
between two parties to buy or sell an asset at a specified future date at a price agreed
upon today. This is in contrast to a spot contract, which is an agreement to buy or sell an
asset today. The party agreeing to buy the underlying asset in the future assumes a long
position, and the party agreeing to sell the asset in the future assumes a short position.
The price agreed upon is called the contract rate and date of transaction is called delivery
date.
The forward price of such a contract is commonly contracted with the spot price, which is
the price at which the asset changes hands on the spot date. The difference between the
spot and the forward price is the forward premium or forward discount.
Forwards, like other derivative products, can be used to hedge risk (typically currency or
exchange rate risk).
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Forward Contracts- Definition
It is an agreement between two parties (usually a Bank and a customer or a Bank versus
another Bank) to buy or sell a specified quantum of foreign exchange at a pre-determined
future date at a pre-determined exchange rate.
In a forward contract three things are pre-determined mutually for a transaction to take
place at a specified future date.

Quantum

Delivery date

Exchange Rate
Delivery Date
For the delivery date also, the buyer of the contract has got options

Fixed date

Any day during a week

Any day during a fortnight

Any day during a month
Deliverable contracts versus non-deliverable contracts
Sometimes there may not be any physical exchange of currencies between the parties.
Only the price difference (calculated based on market rate and contract rate) will be
settled in cash. Such contracts are non-deliverable contracts.
An example:
Assume an Exporter takes a contract for USD 100,000 at a contract rate 55.20 when the
market rate was 55.00. The exporter thus gets a premium of 20 paisa per USD and the
locked rate of 55.20 is assured by the Bank.
Two possible scenarios on the due date (delivery date)
Scenario No 1
Assume the spot rate (market rate) as on delivery date moves to 56.20. Under this
situation, the customer may not sell USD to the Bank under the contract and hence the
contract becomes a non-delivery. The Bank will now cancel the contract and recover the
loss (suffered by the Bank) from the customer. The Bank has to now buy the USD from
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the open market at a cost of 56.20 (prevailing market rate) and the loss of Rs. 1 per USD
(difference between market rate and contract rate) will be recovered from the customer.
Scenario no 2
Assume the spot (market) rate as on the rate of delivery becomes 54.20 (against the
contract rate 55.20) and here also the customer may not sell USD and request the Bank to
treat the contract as cancelled. Here again the contract becomes a non-delivery. However
the Bank here gets the profit on account of non-delivery as they can get the USD from the
open market at a rate (54.20) cheaper than the contract rate 55.20. The profit of Rs.1 per
USD earned by the Bank can be passed on to the customer or retained by the Bank
depending on guidelines prevailing at that point of time.
(It is to be noted that all forward contracts under the present FEMA guidelines shall
be on deliverable basis only)
Salient features of a Forward contract

It is OTC (over the counter) product. The opposite of a OTC product is an
Exchange Traded product (like futures)

Exchange rates are fixed for transactions (either sale or purchase) at a future date.
The uncertainty in exchange rates thus gets eliminated. Forward contract is
therefore considered as an ideal instrument for hedging currency risk (exchange
rates risk) in foreign exchange transactions/exposures.

Once a forward contract is entered into, the exchange rate gets locked. Neither
party can benefit if the spot rate on maturity is favorable.

The last day of the contract happens to be Sunday/Saturday or a public holiday the
contract will mature one day earlier to the due date.
Forward rates- How calculated and quoted?
The exchange rate for settlement on a day beyond the spot date is normally different and
is called “forward rate”.
Let us take an illustration as to how and why the forward rates are different from the spot
rates.
Assume Spot USD1=EUR0.8
Assume interest rate for USD 3% per annum and EURO 6% per annum.
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In the above scenario there is an opportunity for arbitrage if the exchange rates remain
constant for one year.
One can borrow USD 100 at 3% (lower interest rate) and the interest for the same works
out to USD3 at the end of a year and total receivables on maturity becomes USD103.
This person can very well use this borrowed amount of USD100 for buying EUR 80 at
the above exchange rate and places that money EUR80 at a higher interest rate of 6% for
one year. On maturity the investor will get EUR84.8 (80+ interest at 6%). If the total cash
inflow of EUR 84.8 is converted to USD at the same exchange rate, the investor gets
USD106 resulting in a net gain of USD3. The person having USD will not go for this
arbitrage operation if the return in both the currencies is the same after adjusting the
exchange rates. For example in the above case if the forward exchange rate at the end of a
year happens to be USD1=EUR0.8233, then the total yield in EUR 84.8 also becomes
equal to USD103 only.
In the above example if Spot rates are USD1=EUR0.8, then forward rates for 1 year
should be USD1=EUR 0.8233 and in this process the arbitrage opportunity gets
eliminated as the forward rates have perfectly offset the interest rate differentials between
the two currencies..
In the above example USD is costly in the forwards compared to EURO because the
interest rate for USD happens to be lower than the interest for EURO. The thumb rule is
that a currency having a lower interest rate will be at premium vis-à-vis the other
currency having higher rate of interest which will be naturally at discount against the
former.
Premium/Discount
Premium: When a currency is costlier in future (forward) compared to Spot, the currency
is said to be at premium vis-à-vis the other currency.
In a direct quote system, premium is always added to the both the buying and selling
rates and in Indirect Rates premium is deducted from both buying and selling rates.
Discount: When a currency is cheaper in future (forward) as compared to spot the
currency is said to be a discount vis-à-vis the other currency.
In direct quotes the discount is deducted from both the buying and selling rates and in
indirect rates it is always added to both the buying and selling rates.
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A model forward rate quotation say as on 04-07-12
Spot
USD1= INR55.3175/55.3275
Jul 12
03/04
Aug 12
07/08
Sep 12
11/12
Oct 12
17/18
How to compute forward rates (an example)
In the above case USD is at premium versus INR in the forward markets.
For an importer to retire an Import bill due on the last day of Sep 12, the forward rate to
be quoted can be arrived as under:
Spot selling rate USD1= 55.3275
Add premium Sep 12
.12
Add exchange margin say
.08 ( for Bill Selling)
Forward (Sep 12) Bill Selling rate will be USD1=INR 55.5275
Early Delivery
Suppose in the above example if the Importer wants to use the contract during August
2012 itself (as the import bill may have to be paid ahead of original due date) and wants
the USD on 31-08-2012 itself at the contract rate 55.5275, this situation is known as
“Early Delivery” and this will trigger a swap transaction for the dealing room of the
Bank.
The Bank has to now buy USD at the market rate to be delivered to the customer seeking
early delivery. On the original due date contracted value of USD to be bought from the
inter-bank market (which was earlier earmarked for sale to the Importer) will have to be
sold in the market (instead of to the Importer). The dealer under this scenario will have to
do a buy spot and sell forward transaction on the same day and this is known as a swap
transaction. Any loss/gain in this swap will be to the account of the customer.
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Late Delivery
Late delivery under any circumstances is not permitted. In the above example if the
Importer wants to avail the contract at the original contract rate 55.5275 at a later date say
as on 31-10-2012 (one month beyond original due date) it is known as Late Delivery.
The customer here has to get the existing contract cancelled and simultaneously book a
fresh contract (for delivery date 31-10-2012) at a fresh rate (depending on forward rates
prevailing in the market as on the date of cancellation ) and this is known as “ roll over”.
Who will really require a forward contract?

An exporter to prevent the loss on account of rupee going strong on the date of
export realization

An Importer to prevent the loss on account of rupee going weak on the date of
import payments

An investor to prevent the loss on account of adverse exchange rates on the date
of maturity and conversion of maturity proceeds to another currency. NRIs and
PIOs also enjoy this facility when they make investments in NRE Term
Deposits and in FCNR deposits. However they cannot book against funds lying
in NRESB accounts.

A borrower in foreign currency may suffer a loss if the foreign currency has to
be funded out of domestic currency and the home currency keeps weakening
and the cost of borrowings will shoot up in case of weak home currency. The
rate of depreciation of the home currency will get added up to boost the overall
cost of borrowings.

A remitter in foreign currency may also require hedging to contain the overall
cost of the remittances

A beneficiary of an inward remittance may lose when the home currency goes
strong and may need hedging to get definite cash flows in domestic currency.

Investors under FDI/FII routes are also offered the facility of forward contract
to be assured of definite cash flows back in their original foreign currency on
maturity or unwinding of the investments in India.
In India forward contracts are available for genuine underlying exposures (subject to
applicable FEMA guidelines) to fix the exchange rates. It is not available for speculative
purposes.
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Risk on account of floating exchange rates can also be hedged through other hedging
products such as “Currency Options” or “Currency Futures” about which, we would
cover in future issues.
INDIA’S FOREIGN TRADE 2011-12
(Ref: RBI Bulletin June 2012)

During 2011-12, Exports stood at USD 303.70 Billion and recorded a growth of 20.9%
as compared to 40.5% during the previous year.

Export performance during first half was good, however, there was deceleration in the
second half as global trading conditions deteriorated caused by Euro zone crisis.

During 2011-12, the Imports stood at USD 488.60 Billion and registered a growth of
32.1% as compared with 28.2% in the preceding year.

There has been a significant rise in import of oil and lubricants, gold, silver and
machinery.

Trade Deficit during 2011-12 amounted to USD 184.90(USD 488.60- USD 303.70)
as compared with USD 118.70 Billion during 2010-11.

India’s Export of principle commodities are:
Commodities
%age out of Total Exports
Agriculture & Allied products
11.20
Ores and Minerals
2.60
Engineering goods
21.90
Gems and Jewellery
15.10
Textile & Textile products
9.00
Chemicals & Related products
12.00
Petroleum products
19.10
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
India’s Import of Principle Commodities:
Commodities
%age out of Total Imports
Petroleum, Crude and Products
30.60
Capital goods
19.90
Gold & Silver
12.60
Pearls, Precious
precious stones

&
Semi
6.70
Organic & Inorganic chemicals
3.90
Coal & Coke
3.70
Fertilizers
2.60
Iron & Steel
2.50
Global Trade:
According to IMF, the value of world merchandize export grew by 15.10% during
2011-12, lower than 20.60% for 2010-11.
According to WTO, India had the fastest export growth among major economies in
2011 followed by China (9.3%).
World trade growth in 2011 was weighed down by the ongoing sovereign debt crisis
in euro zone economies, supply chain disruptions from natural disasters in Japan &
Thailand, and turmoil in Arab countries.
RBI POLICY RATES
SLR
CRR
Bank Rate
Repo
Reverse Repo
Marginal Standing
Facility Rate
24%
4.75%
9.0%
8.00%
7.00%
9.00%
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