After the inception of the Indian foreign exchange market in 1978, only banks were allowed to undergo intra-day trading. However, the market witnessed some changes with currency market reforms that took place in 1990.
The Central Government of India regulates the Indian Foreign Exchange Market under the FEMA Act 1999. Earlier, the Reserve Bank of India (RBI) used to look after the affairs of the international remittances under the FERA Act 1947. As far as the regulation of interbank trading in India is concerned, a self-regulatory body called the Foreign Exchange Dealers Association of India (FEDAI) was formed in 1958. The association is responsible for devising a regulatory framework concerning the scope of interbank transactions.
The FEDAI also prescribes commissions and associated fees for the businesses that deal with interbank foreign exchange in India. On the other hand, Clearing Corporation of India Limited (CCIL) takes care of the settlement and clearing issues in the Indian Foreign Exchange Market.
There are three main segments of the Indian Foreign Exchange market, including;
- The Reserve Bank of India (RBI) and the Authorized Dealers (ADs) – All transactions taking place between the RBI and ADs fall under this segment.
- The Interbank Market – It caters to the transactions occurring between concerned authorized dealers.
- ADs & Corporate Customers – It involves the transactional settlement of the authorized dealers and their corporate clients.
The foreign exchange market is derived by the mechanism of demand and supply. The price of a currency depends upon its shortage or excess in the market. For example, if there is an increased demand for the Indian Rupee, then the price of the INR is likely to increase. Similarly, the excess of the Indian Rupee in the market might become the reason for the depreciation of the INR over a specific time. Before the 1990s, RBI used to determine the fixed exchange rate of the Indian Rupee (INR).
The Rangarajan committee for the first time proposed a flexible exchange rate for the Indian Rupee during the early years of liberalization. Between 1990-1993, the Indian Foreign Exchange Market shifted from a fixed exchange rate to a market-determined currency regime.
Let’s take a quick look at how the market-determined currency regime works.
The currency rate primarily depends on its demand and supply in the market. However, some other factors also contribute to the appreciation or depreciation of a currency over a given time period. I’ve listed below a few such factors that relate to the Indian Foreign Exchange Market;
Intervention of the Reserve Bank of India (RBI)
When the INR/USD rate shows increased volatility, the RBI intervenes to bring it under control, protecting the worth of the local economy. The RBI buys the US Dollars to offset the increasing price of the Indian Rupee and vice versa.
Inflation in a country occurs due to the excessive demand of international products as compared to locally manufactured goods. Thus, the low demand for home-based products and services results in a deflated exchange rate of the local currency.
Current Account – Imports and Exports
The activity level of imports and exports of the country also affects the Indian Foreign Exchange market. When the country imports goods or services to fulfill the in-house demand, the payment is made in foreign currency. As a result, the value of foreign currency appreciates. On the other hand, export exceeding imports strengthens the INR against the foreign currency.
Interest Rates on Government Bonds & Securities
Interest rates on Government bonds also play a vital role to attract foreign investors. When the Government pays higher interest rates to foreign investors, then the inflow of foreign proceeds increases. This makes the demand for the INR to grow and the exchange rate for the Indian Rupee appreciates.
The foreign exchange market of India is also affected by its operations. The forces of supply and demand play a vital role in making currencies appreciate or depreciate. The sources of supply of the Indian foreign exchange market include receipts of sale proceeds on account of exports and cash inflows in the Indian Capital account, such as portfolio investments, NRI’s deposits, external commercial borrowings (ECB), etc.
While the demand for foreign exchange increases from invisible payments in the current account of the country and imports activity. The amortization of ECB and NRI deposit redemption also makes the demand of the foreign exchange grow.
Operations of the Foreign Exchange Market in India
i) Spot Market (Current Market): The Spot forex market deals with transactions that are done on the spot rate. This is the most common form of the forex market. However, traders are not allowed to carry out spot forex trading in India. Read article titled Is Forex Trading Legal In India? to learn more.
ii) Forward market (Derivatives Market): The forward market is also known as the futures derivatives market. In this market, clients enter a future contract that is to be honored on a predefined exchange rate in the future. Futures market instruments include currency futures, exchange forwards, currency swaps, and options contracts. Forex trading in currency derivatives is widely followed in India. You may find our selected FX brokers over here.
iii) Exchange Dealings & Settlements: The dealing and settlements of foreign exchange transactions.
To facilitate foreign exchange transactions, there are two accounts involved;
1) Nostro Account – It is an overseas foreign currency bank account opened by the Indian government, for example, RBI’s US dollar account with Citibank.
2) Vostro Account – A rupee account maintained within India owned and operated by foreign banks, for example Citi bank’s Rupee account with RBI.
I hope the article helped you understand the structure of the foreign exchange market in India. I tried my best to cover all relevant details from the perspective of Forex Trading in India. If you still find anything missing, then submit a comment under this post and we’ll address your query at the earliest.