Determination of Foreign Exchange:
The foreign exchange rate is defined as the price of one unit of foreign currency expressed in terms of the unit of home currency. In another words, it is the amount of the local currency required to purchase one unit of foreign currency. Foreign exchange rate is important in modern economies because it is essential for the trading of foreign currency, which is required for three basic reasons:
- Carrying out international trade on merchandise goods and services between two countries.
- Smooth movement of natural person across the border for all purposes.
- Accounting purpose for recording the capital transfers and capital investment.
The foreign exchange rate is determined in the foreign exchange market by the interaction of demand and supply of foreign exchange, as similar to the determination of price of a commodity or services in a free commodity market. In such type of market based exchange rate regime, the rate of foreign exchange floats with the changes in demand and supply forces. The foreign exchange rate that is determined in this type of market structure is referred as floating exchange rate and the market structure is known as floating exchange rate regime. It is thus in floating exchange rate regime, the rate of exchange is automatically adjusted without an intervention of the monetary authority in the foreign exchange market. As against the market mechanism, if the foreign exchange rate is determined by the monetary authority and is revised by the same then such exchange rate is known as fixed exchange rate and the market structure is known as the fixed exchange rate regime. It is thus in fixed exchange rate system, the monetary authority comes into action each time for the revision of exchange rates.
The process of foreign exchange rate determination in free foreign exchange market is explained below. As stated above the dynamics of demand and supply are responsible for the determination of foreign exchanges rates.
Demand for Foreign exchange:
The major factors that affect the demand for foreign exchange are
- Merchandise imports
- Payment for foreign services
- Volume of transfer-both current and capital
- Amortization of foreign loans and
- Expenses for diplomatic offices and missions.
Amongst these components, the extent of merchandise imports and foreign services depends on the rate of foreign exchange. The other factors are almost inelastic to the rate of foreign exchange i.e. their functioning is independent to the rate of exchange.
When the rate of foreign exchange increases (i.e. domestic currency devaluated), the cost of foreign goods will be higher in the domestic market, the result of which the prices of imported goods increases. This decreases the demand for imported goods and thus the volume of total imports also decreases. This ultimately reduces the demand for foreign currency. This is true for foreign services also. We can thus say that an increase in foreign exchange rate reduces the demand for foreign exchange.
The demand for foreign exchange is an inverse function of foreign exchange rate. It increases with the decrease in foreign exchange rate and therefore the demand curve of foreign currency slopes downwards to the right. The slope of demand curve, however, depends on the nature of goods that are being imported. For instance, if a country imports goods of bare necessities, the demand curve will be inelastic.
Supply of Foreign Exchange:
The major factors that affect the supply of foreign exchange are
- Merchandise exports
- Incomes from foreign services provide to foreigners
- Volume of transfers-both current and capital i.e. remittances and other transfers.
- Receipt from donors as foreign assistance and
- Expenses form diplomatic offices and missions.
Amongst these components, the extent of merchandise exports and foreign services depend on the rate of foreign exchange. The other factors are almost inelastic to the rate of foreign exchange i.e. their functioning is independent to the rate of exchange.
When the rate of foreign exchange increases (the domestic currency devalue), the export earnings will increase because the exporter will gain form the devaluation of domestic exchange rate. This act promotes exports and thus its volume increases thereby increasing the supply of foreign currency. This is true in the case of services provided to foreigners also. We can thus say, an increase in foreign exchange rate increases the supply for foreign exchange.
The supply of foreign exchange is a direct function of rate of exchange. It increases with the increase in foreign exchange rates and thus the supply curve slopes to the right. The slope of supply curve may have different elasticity according to the nature of goods being exported. For instances, if the country is exporting goods of bare necessities the supply curve will be inelastic in nature.
Equilibrium Rate of Exchange:
The equilibrium rate of foreign exchange is arrived at a point where the demand for foreign exchange equals its supply. This is shown in the figure below.
In the figure both demand and supply curves intersect at point E, and thus the equilibrium exchange rate is ‘r’. This is stable equilibrium because any distortions in the exchange rate will not last long and the original equilibrium is re-attained. For instance at ‘r1’ rate, supply exceeds demand. Due to excess supply the price falls and the original equilibrium is attained. Similarly at ‘r2’ rate, demand exceeds supply. Due to excess demand, the rate increases, and the original equilibrium is attained.
The shift in the demand and supply curves will give rise to a new equilibrium rate of foreign exchange. The demand curve and supply curve or both may shift if the demand for or supply of foreign currency changes due to the reasons other than change in rate of foreign exchange. This show the market forces automatically adjusts the rate of foreign exchange in the free foreign exchange market.
Theories of Rate of Exchange:
There are following three major theories of foreign exchange rate determination.
- Mint par parity theory
- Purchasing power parity theory
- Balance of Payment theory
Mint Par Parity Theory:
According to S.E. Thomas, “The mint par is an expression of the ratio between the statutory bullion equivalents of the standard monetary units of two countries on the same metallic standard”. The mint par parity theory of foreign exchange rate, therefore, explains the determination of exchange rate between two countries that are on the same metallic standard. This theory, however, has become synonymous with the determination of the exchange between countries those adopted the gold standard. When two countries are the fully on the gold standard, their currency units are either made up of gold or their values are expressed in terms of gold. A nation is said to be fully on the gold standard if the government of that country
- Defines the standard monetary unit in terms of gold
- Buys and sell gold in an unlimited quantity at an officially fixed price
- Permits an unrestricted gold flows into and out of the country.
According to the mint par parity theory, under the gold standard, the exchange rates between two currencies stay close to the ratio of their gold values or the mint parity. This means that under the gold standard, the exchange rate between two gold standard countries is determined by the gold equivalents of the concerned currencies.
The parity of the exchange rate is determined in different ways according to the monetary system of the concerned countries. The mint par is defined differently under four types of monetary situations:
- When both countries are on the same metallic standards
- When two counties adopt different metallic standards, say a country adopts gold standard and another one adopts silver standard.
- When a country is on a metallic standard and another country is on inconvertible paper currency standard
- when both the countries are on inconvertible paper currencies standard
- When both the countries are on the same metallic standard:
When both countries are on the same metallic standard, their exchange rate is determined as the ratio of between the bullion equivalents of the standard monetary unit of two countries on the same metallic standard.
For example, during the late 1920s both USA and UK were on the gold standard. The Sterling Pound contained 113.0016 grains of gold and the American dollar was equivalent to 23.220 grains of gold. The exchange rate between the Pound and Dollar was determined on the basis of the mint parity. Thus,
1 Pound = 113.0016/23.2200= 4.866 dollar
Alternatively, 1 Dollar= 23.113.0016= 0.205 Pounds
However, 1 pound equals to 4.866 dollar was the mint rate between the two countries but the actual rate of exchange is determined by the balance of payments could be more or less than the mint part of exchange depending upon the demand and supply of Dollars.
- When two countries adopt different metallic standards, say a country adopts gold standard and another one adopts silver standard:
Let’s first assume that one of the countries is adopting gold standard and the other one adopting the silver standard. To find the mint par between these two currencies, we will first need to find the quantity of fine gold contained in the standard coin of the country adopting the gold standard. Likewise, it is also necessary to find the amount of fine silver contained in the standard coin of the country adopting silver standard. After that we have to find out the gold value of the silver coin and vice-versa.
For example, till 1898 the Indian Rupee contained 165 grains of fine silver which was equivalent to 7.53344 grains of fine gold. At the time, the American Dollar was equivalent to 23.2200 grains of gold. Thus the mint par exchange rate between the American Dollar and Indian Rupee was
1 Dollar= 23.2200/7.53344 = 3.082 Indian Rupee
Alternatively, 1 Indian Rupee= 7.53344/23.2200 = 0.324 Dollar
- When a country is on a metallic standard and another country is on inconvertible paper currency:
Under such a situation, the mint parity between two countries is determined by the quantity of the gold that is purchased by the currencies of individual countries. The gold value of the currency of the country is declared by the government. The gold value of the country adopting inconvertible paper currency changes from time to time according to the situation in the market.
- When both the countries are on inconvertible paper currency standard:
When both the countries are on inconvertible paper currency standard, the rates of exchange between the two countries are determined by the demand and supply of foreign exchange. Their rate of exchange is not determined by the gold or silver points because under the paper currency standard, the currencies of the country have no link with metals like gold or silver.
Gold points are an integral part of the whole discussion concerning the determinations of foreign exchange rate under the gold standards. They determine the maximum fluctuations to which the market rate of foreign exchange is subjects to in the free foreign exchange market. In the long run, the forces of the demand and supply of the foreign exchange change and there is a new equilibrium rate of exchange equal to the ratio of gold values. However, in reality, the actual market rate of exchange may differ form the long run mint parity equilibrium owing to the change in the demand and the supply forces. Gold points refer to the limits within which the market rate of exchange between two countries on gold standard fluctuates from the mint parity equilibrium level. The upper and the lower gold points indicate the upper and the lower limit within which the currency can fluctuate from the normal mint parity.
The gold points are determined by the cost of shipping (transportation, packing charges etc.) gold from one country to another. If the cost of shipping gold to UK is 5 cents and the mint parity exchange rate of 1 Pound is 4.886 dollar from the above example. Hence,
The upper gold point: 1 Pound = 4.886+0.05 = 4.891 Dollars;
The lower gold point: 1 Pound = 4.886-0.05 = 4.881 Dollars
The upper gold point is also known as the gold export point because if a country gets a rate beyond this for the gold, it will export its gold. Likewise, the lower gold point is also known as the gold import point because if a country gets a rate below this rate, it will import gold. Under the mint parity theory, the exchange rates between two currencies can vary between the upper and the lower gold points.
This theory of exchange rate is now considered obsolete because in today’s world no country adopts any metallic standard to determine the exchange rates of its currency versus other currencies.
Purchasing Power Parity Theory:
The purchasing power parity theory (PPT) was first propounded by Wheataly in 1802. But the theory was brought back and properly developed by Swedish Economist Gustavo Cassel in the year 1918. Under the system of autonomous paper standard, each currency has a purchasing power in its own country. Therefore, when the domestic currency is exchanged for the foreign currency, it is the exchange of domestic purchasing power for the foreign purchasing power, thus it is the relative purchasing power between two currencies that determine the exchange rate. In such an exchange rate system, the exchange rate between the two currencies must equalize the purchasing power of both the currencies.
The purchasing power parity theory has two versions, an absolute version and a relative version. These versions will be examined hereunder.
- Absolute Purchasing power theory:
According to the absolute purchasing power parity theory, the equilibrium exchange rate between two countries should be equal to the ratio of price levels in two nations measuring that the rate of exchange should reflect the ratio required to purchase particular goods at home as compared with the purchase of the same goods abroad. For example, if it requires Rs 700 to purchase a particular goods in Nepal and if the same can be obtained at $10 in America, then,
The purchasing power of $10= the purchasing power of Rs 700
Now, the exchange rate between American Dollar and Nepalese Rupee will be:
$1= Rs 70
Re 1 = 1/70 = 0.014 US Dollar
R= Pa/Pb where,
R= Exchange rate (price) of country A’s currency in terms of country B’s currency
Pa= The General Price level in country A;
Pb= the General Price level in country B
Thus, in this version of purchasing power parity theory, the rate of exchange is the rate of internal purchasing power of the foreign currency and the internal purchasing power of the domestic currency. This ratio is known as purchasing power parity.
The absolute version of the purchasing power parity theory has some of the inherent weaknesses. Fist of all it completely disregards capital account transactions. Secondly, this version of PPT cannot give the exchange rate that equilibrates trade in goods and services because of the existence of many non-traded goods (for example construction products such as cement and bricks which has a very high transportation cost barring their entry into international trade) and serves (for example those of family doctors, beauticians etc that do not enter in the international trade). Beside, it doesn’t take into account obstructions like a high transportation cost that hinders the free flow of international trade. Thus relative version of purchasing power theory was propounded to get over the afore-mentioned weakens.
Relative Purchasing Power Parity Theory:
This is more refined version of PPT which deals with the relationship between the change in the internal purchasing power and the change in the exchange rate. The theory suggests that the change in the exchange rate over the period of time should be proportional to the relative change in the prices level in the two nations over the same period of time. Symbolically, the relative version of the PPT theory can be expressed as,
R1 = Ro x Pa1/Pao
Ro is the equilibrium rate of exchange in the base year 0
R1 is the equilibrium rate of exchange in the current year
Pao is the price index of country A in the base year 0
Pa1 is the price index of country A in the current year 1
Pbo is the price index of country B in the base year 0
Pb1 is the price index of country B in the current year 1
Now, let us suppose that between America and Nepal the exchange rate in the base year was $1= RS 70. The price index at the base year is 100 in both in Nepal and America. Let’s now assume that that in the current year the price index in Nepal climbed up by 3 times to 300 in the current year while the price level went up by 50% in USA to 150 compared to the base year, then the equilibrium dollar exchange rate in terms of Nepalese rupee (R1) will be:
R1 = 70*300/100
Rs 140 is the new parity between the currencies
The purchasing power parity theory has been criticized on several grounds. These include the arguments as under:
- The index numbers used in PPT use past prices and ignore the present prices. Besides that, index number in different countries use different commodities that may not be identical and even if they are identical the weight assigned to them may vary. The base year of different countries is different and usually not comparable.
- The direct relationship between purchasing power and exchange rate is questionable. Exchange rate is determined by various other factors except purchasing power.
- Ascertaining equilibrium rate, i.e. the knowledge of base rate is difficult. Although this theory states that the exchange rate should reflect the price level of all goods and services but it rarely happens because all goods and services do not enter international trade. Besides this theory only consider the merchandise goods and invisible items and capital movements reflected in the balance of payments are ignored.
- This theory also ignores the impact of trade cycle on the exchange rate. Similarly, it also ignores restriction like import quota, export duties etc as these factors separate the price structure of one country form another.
Balance of Payment or Modern Theory of Exchange rates:
Before going to this theory, it is necessary to understand the relationship between balance of payments and the demand and supply of foreign currency. This phenomenon can be explained thus: Demand for a particular currency arises from the importing countries to make the payments of the imports done by them. This demand is reflected as debit in the balance of payments. Similarly, exporting countries are the supplier of these currencies as they have to make the payments to the countries exporting to them and this makes the credit side of the balance of payment.
The theory states that the balance of payments, meaning the market balance between the demand for a particular currency and its supply determines the exchange rate of that currency versus another currency. If the supply of the foreign exchange exceeds its demand, it leads to the surplus in the balance of payments. This in turn would lead to a fall in the rate of exchange or an appreciation in the external value of that currency in terms of the foreign currencies.
For example let’s suppose that the current rate of exchange between the Nepalese Rupee and the American Dollar is 1 USD = 72 Nepalese Rupees (NPR). Now, if there is a surplus in Nepal’s Balance of Payments, this means that the supply of USD in Nepal is greater than its demand. This will make the exchange rate fall so that let’s suppose that the new rate of exchange is 1 USD = 71 Rupees. At this exchange rate, Nepalese exports to America will be costlier and American imports to Nepal will be cheaper. This means that more dollars will be demanded for imports from America. This in turn will restore the original rate of exchange between USD and Nepalese Rupees such that 1 USD = 72 Rupees.
Converse will be the scenario if the demand for the foreign exchange is greater than its supply. At such situation, the country’s balance of payment will face a deficit leading to depreciation in the external value of the currency versus foreign currencies. This in turn will lead to a rise in the rate of exchange or depreciation in the external value of that currency in terms of foreign currencies.
Again, lets suppose that the initial rate of exchange between the Nepalese Rupee and the American Dollar is 1 USD = 72 Nepalese Rupees. Now, if there is a deficit in Nepal’s Balance of Payments, meaning that the demand of USD in Nepal is greater than its supply. This will make the exchange rate rise so that let’s suppose that the new rate of exchange is 1 USD = 73 Rupees. At this exchange rate, Nepalese exports to America will be cheaper and American imports to Nepal will be dearer. This means that more dollars will be supplied to pay for Nepalese exports. This in turn will lead to a surplus in the Nepalese balance of payments and will also restore the original rate of exchange between USD and Nepalese Rupees such that 1USD= 72 Rupees.
This is to say it is the balance of payments of country that determines its exchange rate vis-à-vis another currency, provided that the exchange rate is permitted to respond fully to the dynamics of demand and supply. However, one of the serious weakness of this theory is that the theory considers exchange rate is the function of the balance of payments. This may not always hold true because balance of payments is also affected by the rate of exchange.
Foreign Exchange System in Nepal:
The history of foreign exchange system in Nepal can be traced back with the history of Nepal Rastra Bank. The history of Nepalese foreign exchange, in turn, can be broadly categorized under two distinct categories:
With Indian Currency: In 1956 when NRB was established, Indian currency was more predominant in the Nepalese market than the Nepalese rupee. There was a problem with an adequate supply of home currency and at the same time, people had little faith in it in spite of it being the legal tender. NRB as the monetary authority then faced the mountainous task of abolishing the dual currency system to restore the suffering economy as well as to establish Nepalese Currency as the legal tender. NRB took the following steps to correct this:
- Fixed an exchange rate between two currencies on the basis of demand and supply and the purchasing power of these currencies.
- Adopted a policy of free and unlimited convertibility of Nepalese currency vis-à-vis Indian currency
- Established/Opened large number of exchange counters throughout the country
- Enforced the foreign exchange regulation acts.
In 1966, only 10 years after taking the above mentioned steps did NRB succeeded in abolishing the dual currency system. Nepalese currency succeeded in being established as the legal tender of the country. NRB also succeeded in abolishing the dual currency system by devaluing the Nepalese versus IC (initially the exchange rate between the two currency was fixed at NRS 160= IRS 100) and also by maintaining an increased reserves of Indian currency. The devaluation continued and the exchange rate appreciated up to NRS 101= IRS 100. The new exchange rate helped people believe in the strengths of their own currency. This also incurred a huge loss to the holders of the Indian currency. As a result people began dishoarding IC, ensuring the dominance of NC over IC.
With Other Currencies: The foreign currency rate of Nepalese currency with other currencies was initially fixed by the government on the basis of the exchange rate that prevailed in the Indian market between the Indian Currency and other convertible foreign currencies.
Since 1960, when NRB announced its first IC/NC parity at 160 to 100, the government allowed NRB to fix the exchange rate with other convertible currencies on the basis of cross exchange rate of these currencies with the Indian Currency.
Initially, NRB quoted the rate of foreign exchange of American Dollar, Sterling Pound and Swiss Franc. Burmese Kyat was added later. As of now, NRB quotes the foreign exchange rat of 10 currencies and also the buying rate of 8 different currencies.
During hose days, NRB used to peg Nepalese currency with the American Dollar and then quote the exchange rate between Nepalese currency and other convertible currencies as per the exchange rate between those currencies and American dollar in the International market say Tokyo.
The system worked till 1983. But since the Indian currency maintained the flexible exchange rate system with the convertible currencies, it was much difficult for Nepal to have control over the foreign currency market during 1983. Nepal had a fixed exchange rate with IC and USD but the exchange rate between IC and USD could change anytime. The currency market was prone to arbitrage and speculation. Controlling the outflow of convertible currency became even more difficult.
This means an end of the pegged exchange rate system. A basket system was introduced instead. Under this system, the exchange rate between NRS and USD was subject to change without any control. The exchange rate was based on the following tenets:
- Number of convertible currencies in the basket
- Weight of each convertible currency
- Cross exchange rate of dollar with each of these currencies in the international currency market.
The NRS/USD exchange rate was revised time to time after analyzing the exchange rate within the basket and with this exchange rate the exchange rate of all other convertible could be adjusted easily.
The system prevailed till 1992 when NRB opted for partial convertibility of the currency. The government in 1992 announced that the foreign exchange rate would be partly fixed by the NRB and partly by market. The commercial banks were allowed to deal 65% of their foreign exchange transaction in prevailing market prices and the remaining 35% at the exchange rate fixed by the NRB.
The system gradually scrapped before allowing the full convertibility of foreign currency in the domestic market at the market exchange rate determined by the demand and supply forces. On 4th March 1992 Foreign Exchange Dealers Association of Nepal (FEDAN) was established and all the commercial banks became its member. The rate of USD was then determined by the open market operation. The exchange rate of other currencies were quoted in terms of the cross rate with the USD. The same system is in force now.
Dilemma of Foreign Exchange System in Nepal:
Despite the fact that Nepal maintains a dual exchange rate system with Indian and rest of the convertible currencies and each of the system are independent of each other, the fact remains that the Nepalese foreign exchange policy is much governed by the Indian foreign exchange rate policy.
Nepalese currency ahs been adjusted time and again in tandem with the revaluation and devaluation of the Indian currency. This proves the fact that the Nepalese foreign exchange market is much dependent on the Indian foreign exchange market.
Although the economic growth of Nepal and India is not same, we have maintained a stable exchange rate with India. A small change in this parity can have a huge effect on the trade volume and net foreign currency outflows.
Justification for fixed exchange rate with Indian Currency:
Although an issue is raised time and again to let the parity between the Nepalese Currency and the Indian Currency to be determined by the market forces, it is still desirable to maintain fixed exchange rate with IC because of the following reasons:
- Huge trade volume characterized with a large number of unorganized traders: India is by far the major trading partner of Nepal. Almost tow third of Nepalese exports and half of our imports goes to and comes from India respectively. This is aggravated by a large number of unregistered traders in the trade between Nepal and India.
Such a situation compels the adoption of the fixed exchange rate system. This helps the domestic market assume price stability and decline any chances of price instability due to changes in exchange rate. Also, the floating exchange rate, adopted in such a scenario makes it difficult in maintaining the records making it tough to check the irregularities of the market.
- Open border and full convertibility access: Nepal and India maintains an open border for almost 1050 Kilometers that ties two countries economically. In such a case it becomes an utmost necessity to maintain a fixed exchange rate system.
- Applicability of Monetary Policy: In the situation like ours where people prefer to hold IC to NC, adopting a floating exchange rate with India will increase the people’s tendency to hoard the stronger currency (here the IC) so as to gain from the price difference on exchange rates. If people begun to hold a large amount of IC, foregoing their own, the NRB will have a tough time implementing monetary policy and it will then be difficult to maintain NC as the country’s legal tender.
- Minimizing the risk if International Trade: Fixed exchange rate helps to avoid the risk from the changes in foreign exchange rate between two currencies. Exporters and importers will have to take high risk in case of a floating exchange rate system.