Dear friends

Ref our fb correspondences

I had posted 26 articles on tip of Indian banking which will useful
to bank employees preparing for any bank exam in any scale or
grade . In case you have not gone through that I am sending the
consolidated post of the links of the 26 separate articles in one
post . Preserve it ,copy it, file it and prepare for exams wishing
you the very best .
s. srinivasan

THE TIP OF INDIAN BANKING ALL YOU WANT TO

KNOW
PART I
1. What do you mean by advances to weaker sections,
teaser rate?
2.
What are the developmental functions of RBI?
3. What do you mean by repo rate, reverse repo rate,
Cash Reserve Ratio, Statutory liquidity ratio?
4. What do you mean by financial inclusion, no frill
accounts, narrow banking, business facilitators and
business correspondents?
5. What do you mean by bankassurance, universal
banking, Regional Rural Banks, National Housing
Bank ?

6. What do you know by debit card, credit card, stale

cheque, post dated cheque, currency chest and
MICR?
7. What do you mean by treasury bill?
8. What do you know by call money, notice money and
term money?
9. What do you know by commercial banks?
10.
Whether the deposits can be opened in the
name of any minor in commercial banks?
11.
What are the functions of any bank?
12.
What do you mean by real investment trusts?
13.
Tips for Interview for recruitment as clerks and
officers in banks

See for answers in my( ambujchinu) scribd

notes
https://www.scribd.com/doc/311565684/Know-Tipof-Indian-Banking

THE TIP OF INDIAN BANKING PART II

1. What do you mean by real investment trusts?
2. What do you mean by fiscal deficit?

3. What do you mean by growth investing?

4. What do you mean by capital asset pricing model?
5. What are the investments for the purpose of
saving tax?
6. What do you mean by stop loss?
7. What do you mean by inflation indexation?
8. What do you mean by fixed maturity plan?
9. What do you mean by RBI Repo rate?
10. What do you mean by the building blocks for any
loan?

11. What are the reasons for which the cheques are
returned by the bankers?
12. What do you mean by fee and fund based
products?
13. What do you mean by an overdraft facility
available from a commercial bank?
14. What are the components of the capital structure
of a limited company

15. Committees and working groups

16. Recent committees and working groups
17. Whether signatures obtained in nominations
forms are to be witnessed?
18. The

official language policy came into force in India

from which date

19. What is the difference between lien and set off?

20. CIVIL PROCEDURE CODE

21. CONSUMER PROTECTION ACT- 1986(COPRA)

22. BANKIING OMBUDSMAN SCHEME
23.
24.
25.
26.

HRD MEASURES OF THE BANK

FOREX AT A GLANCE
NON RESIDENT EXTERNAL ACCOUNT
FCNR(B)

27. What is the formula for calculating tangible

networth?
28. Who is responsible for filing the particulars for
getting a charge registered with Registrar of
Companies?
29. When sub standard assets can be considered
as standard assets?
30. Whether foreign currency loans outside India is
available against the security of funds held in
FCNR accounts?
31. When the remission on stamp duty of a bill is
available ?
32. What is the risk weight of a non performing
asset purchased by one bank from another bank?
33. How the prepaid expenses in the shape of
share premium are classified in a balance sheet?
34. With whom an appeal against the decision of
DRT has to be made?

35. Who is responsible for compliance of Official

Language Policy of Government of India?
36. Whether identity is necessary in the case of a
bearer cheque?

FOR ANSWERS TO THESE QUESTIONS SEE MY

NOTES IN THE LINK
https://www.scribd.com/doc/311686381/The-Tip-ofIndian-Banking-Part-II

THE TIP INDIAN BANKING PART 3

CONTENTS
1. IBPS - BANKING AWARENESS RAPID READING
EXERCISE- PART: 001
2. RAPID READING EXERCISE PART:: 01
3.
CWE FOR RECRUITMENT AS CLERKS AND
PROBATIONARY OFFICERS IN NATIONALISED BANKS IN
INDIA FREQUENTLY ASKED QUESTIONS ON BALANCE
SHEET
4. COMMON WRITTEN EXAMINATION FOR RECRUITMENT
AS CLERKS AND PROBATIONARY OFFICERS IN
NATIONALISED BANKS IN INDIA FREQUENTLY ASKED
QUESTIONS

5. COMMON WRITTEN EXAMINATION FOR RECTUITMENT

TO PROBATIONARY OFFICERS AND CLERKS A MODEL
QUESTION ON BANKING SUBJECTS
6. BANKING RATIONALES PART: 010 to 001
7. CONSOLIDATION IN BANKING INDUSTRY THROUGH
MERGERS
8. CORPORATE SOCIAL RESPONSIBILITY
9. DATA WAREHOUSING & MINING
10.

HEDGE FUNDS

11.
12.

INDIAN DEPOSITORY RECEIPT (IDR)

MARGIN TRADING

13.

REAL TIME GROSS SETTLEMENT

14.

SUGGESTIONS SCHEMES FOR CUSTOMERS

15.

TRUNCATION OF CHEQUES

FOR ANSWERS TO THE ABOVE QUESTIONS

SEE MY NOTES
https://www.scribd.com/doc/311956990/The-Tip-of-IndianBanking-Part3

THE TIP INDIAN BANKING PART 4

CONTENTS
1. BANKING RATIONALES PART: 001
2. ATM FRAUDS
3. OFFICIAL LANGUAGE
4. BANK PROMOTIONS - INDIAN CONTEXT - RAPID
READING EXERCISE: PART: 011
5. CIVIL PROCEDURE CODE
6. CONSUMER PROTECTION ACT- 1986(COPRA)
7. BANKIING OMBUDSMAN SCHEME
8. HRD MEASURES OF THE BANK
9. FOREX AT A GLANCE
10.
NON RESIDENT EXTERNAL ACCOUNT
11.
FCNR(B)
12.
BANK PROMOTIONS - INDIAN CONTEXT - RAPID
READING EXERCISE - PART: 11 TO 1
13.
BANKING TERMINOLOGY - COMPUTER
ENVIRONMENT
14.
BANKING GLOSSARY PART: 007(IIB)
15.
COMMITTEE ON GLOBAL FINANCIAL SYSTEM
CGFS
16.
BANKING GLOSSARY PART: 006(IIB)
17.
COMMITTEE ON GLOBAL FINANCIAL SYSTEM
CGFS
18.
BANKING TERMS L SERIES
19.
BANKING TERMS K SERIES

20.
BANKING TERMS J SERIES
21.
IMPACT OF NON PERFORMING ASSETS ON THE
BANKS PROFITABILITY
22.
REASONS FOR THE GROWTH OF NON
PERFORMING ASSETS IN INDIA
23.
HOW TO REDUCE NON PERFORMING ASSETS IN
BANKS ?
24.
SUGGESTIONS FOR REDUCTION IN NON
PERFORMING ASSETS IN BANKS IN INDIA
25.
METHODOLOGIES FOR PREVENTION OF NON
PERFORMING ASSETS
26.
BANCASSURANCE
27.
BANKING GLOSSARY PART: 005(IIB)
28.
FILING OF CHARGE UNDER COMPANYS ACT, 1956
29.
BANKING TERMS I SERIES
30.
BANKING TERMS G SERIES
31.
BANKING TERMS = F SERIES
32.
BANKING TERMS E SERIES
33.
BANKING TERMS D SERIES
34.
BANKING TERMS C -SERIES
35.
BANKING TERMS B SERIES
36.
BANKING TERMS A SERIES
FOR ANSWERS TO THE ABOVE QUESTIONS
SEE MY NOTES
https://www.scribd.com/doc/311959765/The-Tip-of-IndianBanking-Part-4

PART 5

All about Capital Adequacy Ratio made easy in slide

forms

http://economictimes.indiatimes.com/all-about-capital-adequacy-ratio/why-dobanks-have-to-maintain-car/slideshow/6222225.cms

PART 6 Banking terms you must know & how to use them

Sign a PAP or MCC, even better do an NEFT or RTGS, but then you will need to
know the IFSC. Does this sentence make sense to you? Banking has become
easier today than ever before, but banking jargons may still flummox you.
If you havent encountered them already, you are bound to do so at some point
soon. In fact, knowing them may make some of your banking tasks much simpler.
We spoke to six major banks in the country to simplify six common terms for you.
MICR: Magnetic ink char acter recognition
What is it: MICR code (pronounced my-ker) is a nine-digit number printed on
banking instruments such as a cheque or a demand draft using a special type of ink
made of magnetic material. The first three digits denote the city. The fourth to sixth
digits denote the bank, while the last three digits denote the branch number. The
code is read by a machine, minimizing the chances of error in clearing of cheques,
thereby making funds transfer faster. For example, in the MICR code 400240019,
400 denotes Mumbai, 240 denotes HDFC Bank Ltd and 019 denotes the Colaba
branch of the bank.
You will find the number on the right of the cheque number at the bottom of the
cheque leaf.
When do you need it: MICR code allows money to drop directly into your bank
account for payments such as salaries and dividends. Your tax refund will come to
you faster if you remember to mention this on the refund form. Refunds of

unwanted money in initial public offers, too, drop back if you put down your code
on the application form.
RTGS: Real time gross settlement
What is it: Its a fund transfer mechanism that enables money to move from one
bank to another on a real time and gross basis. Simply put, real time means the
transaction is settled instantly without any waiting period and gross means that it is
not bunched with any other transaction.
You can transfer a minimum of Rs1 lakh through RTGS; there is no upper ceiling
though. The bank will charge you Rs25-Rs50 for an outward RTGS transaction,
inward transactions are free. RTGS is the fastest inter-bank money transfer facility
available through secure banking channels in India. But not all branches in India
are RTGS enabled. Visit the Reserve Bank of Indias (RBI) website for a list of
branches where you will get this facility.
When do you need it: This facility would be handy during an emergency, when
you need to transfer funds quickly, imagine an ill child studying in another city or a
parent in an emergency situation and needing money at once. You would be able to
use this facility if you use Internet banking as a channel.
It is mostly used by high networth individuals and businessmen, who have at least
Rs1 lakh to be transferred business associates or clients.
NEFT: National electronic funds transfer
What is it: NEFT enables funds transfer from one bank to another but works a bit
differently than RTGS since the settlement takes place in batches rather than
individually, making NEFT slower than RTGS.
The transfer is not direct and RBI acts as the service provider to transfer the money
from one account to another. You can transfer any amount through NEFT, even a
rupee.

You wont have to pay any fee for inward transfer of funds, but for outward
transactions the charges can be from Rs5-Rs25 depending on the amount
transferred.
When do you need it: You can use this facility if you want to transfer funds online
in a day or two.
NEFT can make life easier for those who need to send money to their parents or
children living in another city. It cuts the trouble of issuing a cheque or draft and
posting it.
NEFT, too, can be done only through Internet banking. Visit RBI website for a list
of branches where you will get this facility.
IFSC: India financial system code
What is it: An 11-digit alphanumeric (letters and numbers) code that helps identify
bank branches. The first four numbers represent the banks code (alphabetic), the
fifth number is a control character (0), and the next six numbers denote a bank
branch. For example, the IFSC for HDFC Bank Ltds Colaba branch in Mumbai
reads as HDFC0000085. This code is mentioned on your cheque. Different banks
mention it at different places on the cheque.
When do you need it: When sending money through RTGS or NEFT, you need to
know the IFSC of the receiving branch.
CVV: Card verification value
What is it: CVV is an anti-fraud security feature that helps verify that you are in
possession of your credit card and making the transaction. CVV is usually a threedigit number printed on the signature panel at the back of your credit card.
When do you need it: You need this number when shopping online or over the
phone. You need to be careful with this number as it can make you a victim of
fraud. Its best to remember this number and blacken it off from your card.

PAP: Payable at par or MCC: Multi-city cheques

What is it: PAP or MCC cheques can be encashed anywhere in India, irrespective
of the city they were issued in. They are treated as local clearing cheques across the
country. The amount is credited in the account the same day and there are no intercity collection charges associated with a normal cheques being encashed in another
city.
A cheque issued at a branch in Chennai, can be encashed at a branch in Dibrugarh
as if it were a local cheque.
There would be a notation on the top or the bottom of a cheque indicating its status
as as PAP or MCC cheque.
When do you need it: By issuing a PAP or MCC cheque, you can save demand
draft or cheque clearing costs.
Usually, these cheques are issued by companies to disburse dividends or
redemption amounts.

PART 7
Bank Guarantees
What is a Bank Guarantee?
A Bank Guarantee is an undertaking given by a bank, on behalf of a customer, to
pay money to a nominated person (commonly referred to as the Beneficiary). It is a
formal financial obligation or promise to pay and is secured with cash or against
the assets of the person giving the promise (commonly referred to as the Grantor).
It is not uncommon for contracts to involve a Bank Guarantee. For example, a
Bank Guarantee may be used rather than a bond or deposit to secure a Tenant or a
Purchaser's obligations to a Landlord or Vendor. Other typical relationships
involving Bank Guarantees include development and joint venture agreements and
larger service agreements.

Why use a Bank Guarantee?

A Bank Guarantee can provide security for a Beneficiary with a valid claim for
payment. For example in a contract for services, the provider of services may seek
to have a Bank Guarantee in place to ensure they will be paid for their labour.
Enforcing a Bank Guarantee
A Bank Guarantee is governed by the agreement between the parties. Accordingly,
it is important the contract clearly states the terms of the Bank Guarantee.
Broadly speaking, a Bank Guarantee is payable by the bank on demand by the
Beneficiary. Recent legal developments suggest that a Beneficiary should act
reasonably when enforcing a Bank Guarantee.
Important Tips

Keep the original Bank Guarantee in a secure location. A bank may not
honour the guarantee if the original is not supplied;

Check expiry dates of the Bank Guarantee;

Become familiar with the terms and conditions of the relevant banking
institution; and

Ensure your contract reflects the terms of the Bank Guarantee, clearly
stating the intention of the parties such as who can call on the guarantee and
in what circumstances.
PART 8financial terms and ratios
and ratios definitions
These financial terms definitions are for the most commonly used UK financial
terms and ratios. They are based on UK Company Balance Sheet, Profit and Loss
Account, and Cashflow Statement conventions.
Certain financial terms often mean different things to different organizations
depending on their own particular accounting policies. Financial terms will have
slightly different interpretations in different countries. So as a general rule for all
non-financial business people, if in doubt, ask for an explanation from the person
or organization responsible for producing the figures and using the terms - you
may be the only one to ask, but you certainly will not be the only one wodering
what it all means. Don't be intimidated by financial terminology or confusing
figures and methodology. Always ask for clarification, and you will find that most
financial managers and accountants are very happy to explain.

The business dictionary contains many other business terms and definitions.
Sales related terms are in the glossary in the sales training section.
business financial terms definitions
acid test
A stern measure of a company's ability to pay its short term debts, in that stock is
excluded from asset value. (liquid assets/current liabilities) Also referred to as the
Quick Ratio.

assets
Anything owned by the company having a monetary value; eg, 'fixed' assets like
buildings, plant and machinery, vehicles (these are not assets if rentedand not
owned) and potentially including intangibles like trade marks and brand names,
and 'current' assets, such as stock, debtors and cash.
asset turnover
Measure of operational efficiency - shows how much revenue is produced per of
assets available to the business. (sales revenue/total assets less current liabilities)
balance sheet
The Balance Sheet is one of the three essential measurement reports for the
performance and health of a company along with the Profit and Loss Account and
the Cashflow Statement. The Balance Sheet is a 'snapshot' in time of who owns
what in the company, and what assets and debts represent the value of the
company. (It can only ever be a snapshot because the picture is always changing.)
The Balance Sheet is where to look for information about short-term and long-term
debts, gearing (the ratio of debt to equity), reserves, stock values (materials and
finsished goods), capital assets, cash on hand, along with the value of shareholders'
funds. The term 'balance sheet' is derived from the simple purpose of detailing
where the money came from, and where it is now. The balance sheet equation is
fundamentally: (where the money came from) Capital + Liabilities = Assets (where
the money is now). Hence the term 'double entry' - for every change on one side of

the balance sheet, so there must be a corresponding change on the other side - it
must always balance. The Balance Sheet does not show how much profit the
company is making (the P&L does this), although pervious years' retained profits
will add to the company's reserves, which are shown in the balance sheet.
budget
In a financial planning context the word 'budget' (as a noun) strictly speaking
means an amount of money that is planned to spend on a particular activity or
resource. This is typically over a trading year, although budgets apply to shorter
and longer periods, and may refer to costs allocated to projects of flexible
timescales. An overall organizational plan usually contains the budgets within it for
all the different departments and costs held by them. The verb 'to budget' means to
calculate and set a budget, although in a looser context it also means to be careful
with money and find reductions (effectively by setting and maintaining a lower
'budgeted' or reduced level of expenditure). The word budget is also more loosely
used by many people to mean the whole organizational business or operating
financial plan. In this context a budget means the same as a plan (and a business
plan, or an operating plan or trading plan, etc). For example in the UK the
Government's annual plan is called 'The Budget'. A 'forecast' in certain contexts
means the same as a budget - either a planned individual activity/resource cost, or a
whole business/ corporate/organizational plan. A 'forecast' more commonly (and
precisely in my view) means a prediction of performance - costs and/or revenues,
or other data such as headcount, % performance, etc., especially when the 'forecast'
is made during the trading period, and normally after the plan or 'budget' has been
approved. In simple terms: budget = plan or a cost element within a plan; forecast
= updated budget or plan. The verb forms are also used, meaning the act of
calculating the budget or forecast.
capital employed
The value of all resources available to the company, typically comprising share
capital, retained profits and reserves, long-term loans and deferred taxation.
Viewed from the other side of the balance sheet, capital employed comprises fixed
assets, investments and the net investment in working capital (current assets less
current liabilities). In other words: the total long-term funds invested in or lent to
the business and used by it in carrying out its operations.

cashflow
The movement of cash in and out of a business from day-to-day direct trading and
other non-trading or indirect effects, such as capital expenditure, tax and dividend
payments.
cashflow statement
One of the three essential reporting and measurement systems for any company.
The cashflow statement provides a third perspective alongside the Profit and Loss
account and Balance Sheet. The Cashflow statement shows the movement and
availability of cash through and to the business over a given period, certainly for a
trading year, and often also monthly and cumulatively. The availability of cash in a
company that is necessary to meet payments to suppliers, staff and other creditors
is essential for any business to survive, and so the reliable forecasting and
reporting of cash movement and availability is crucial.
cost of debt ratio (average cost of debt ratio)
Despite the different variations used for this term (cost of debt, cost of debt ratio,
average cost of debt ratio, etc) the term normally and simply refers to the interest
expense over a given period as a percentage of the average outstanding debt over
the same period, ie., cost of interest divided by average outstanding debt.
cost of goods sold (COGS)
The directly attributable costs of products or services sold, (usually materials,
labour, and direct production costs). Sales less COGS = gross profit. Effetively the
same as cost of sales (COS) see below for fuller explanation.
cost of sales (COS)
Commonly arrived at via the formula: opening stock + stock purchased - closing
stock.
Cost of sales is the value, at cost, of the goods or services sold during the period in
question, usually the financial year, as shown in a Profit and Loss Account (P&L).
In all accounts, particularly the P&L (trading account) it's important that costs are
attributed reliably to the relevant revenues, or the report is distorted and potentially
meaningless. To use simply the total value of stock purchases during the period in

question would not produce the correct and relevant figure, as some product sold
was already held in stock before the period began, and some product bought during
the period remains unsold at the end of it. Some stock held before the period often
remains unsold at the end of it too. The formula is the most logical way of
calculating the value at cost of all goods sold, irrespective of when the stock was
purchased. The value of the stock attributable to the sales in the period (cost of
sales) is the total of what we started with in stock (opening stock), and what we
purchased (stock purchases), minus what stock we have left over at the end of the
period (closing stock).
current assets
Cash and anything that is expected to be converted into cash within twelve months
of the balance sheet date.
current ratio
The relationship between current assets and current liabilities, indicating the
liquidity of a business, ie its ability to meet its short-term obligations. Also referred
to as the Liquidity Ratio.
current liabilities
Money owed by the business that is generally due for payment within 12 months of
balance sheet date. Examples: creditors, bank overdraft, taxation.
depreciation
The apportionment of cost of a (usually large) capital item over an agreed period,
(based on life expectancy or obsolescence), for example, a piece of equipment
costing 10k having a life of five years might be depreciated over five years at a
cost of 2k per year. (In which case the P&L would show a depreciation cost of
2k per year; the balance sheet would show an asset value of 8k at the end of year
one, reducing by 2k per year; and the cashflow statement would show all 10k
being used to pay for it in year one.)
dividend
A dividend is a payment made per share, to a company's shareholders by a
company, based on the profits of the year, but not necessarily all of the profits,

arrived at by the directors and voted at the company's annual general meeting. A
company can choose to pay a dividend from reserves following a loss-making year,
and conversely a company can choose to pay no dividend after a profit-making
year, depending on what is believed to be in the best interests of the company.
Keeping shareholders happy and committed to their investment is always an issue
in deciding dividend payments. Along with the increase in value of a stock or
share, the annual dividend provides the shareholder with a return on the
shareholding investment.
earnings before..
There are several 'Earnings Before..' ratios and acronyms: EBT = Earnings Before
Taxes; EBIT = Earnings Before Interest and Taxes; EBIAT = Earnings Before
Interest after Taxes; EBITD = Earnings Before Interest, Taxes and Depreciation;
and EBITDA = Earnings Before Interest, Taxes, Depreciation, and Amortization.
(Earnings = operating and non-operating profits (eg interest, dividends received
from other investments). Depreciation is the non-cash charge to the balance sheet
which is made in writing off an asset over a period. Amortisation is the payment of
a loan in instalments.
fixed assets
Assets held for use by the business rather than for sale or conversion into cash, eg,
fixtures and fittings, equipment, buildings.
fixed cost
A cost which does not vary with changing sales or production volumes, eg,
building lease costs, permanent staff wages, rates, depreciation of capital items.
FOB - 'free on board'
The FOB (Free On Board) abbreviation is an import/export term relating to the
point at which responsibility for goods passes from seller (exporter) to buyer
(importer). It's in this listing because it's commonly misunderstood and also has
potentially significant financial implications. FOB meant originally (and depending
on the context stills generally means) that the seller is liable for the goods and is
responsible for all costs of transport, insurance, etc., until and including the goods
being loaded at the (nominated FOB) port. An importing buyer would typically ask
for the FOB price, (which is now now often linked to a port name, eg., FOB

Hamburg or FOB Vancouver), knowing that this price is 'free' or inclusive of all
costs and liabilities of getting the goods from the seller to the port and on board the
craft or vessel. Logically FOB also meant and still means that the seller is liable for
any loss or damage up to the point that the goods are loaded onto the vessel at the
FOB port, and that thereafter the buyer assumes responsibility for the goods and
the costs of transport and the liability. From the seller's point of view an FOB price
must therefore include/recover his costs of transport from factory or warehouse,
insurance and loading, because the seller is unable to charge these costs as extras
once the FOB price has been stated. The FOB expression originates particularly
from the meaning that the buyer is free of liability and costs of transport up to the
point that the goods are loaded on board the ship. In modern times FOB also
applies to freight for export by aircraft from airports. In recent years the term has
come to be used in slightly different ways, even to the extent that other
interpretations are placed on the acronym, most commonly 'Freight On Board',
which is technically incorrect. While technically incorrect also, terms such as 'FOB
Destination' have entered into common use, meaning that the insurance liability
and costs of transportation and responsibility for the goods are the seller's until the
goods are delivered to the buyer's stipulated delivery destination. If in doubt ask
exactly what the other person means by FOB because the applications have
broadened. While liability and responsibility for goods passes from seller to buyer
at the point that goods are agreed to be FOB, the FOB principle does not correlate
to payment terms, which is a matter for separate negotiation. FOB is a mechanism
for agreeing price and transport responsibility, not for agreeing payment terms. In
summary: FOB (Free On Board), used alone, originally meant that the
transportation cost and liability for exported goods was with the seller until the
goods were loaded onto the ship (at the port of exportation); nowadays FOB (Free
On Board or the distorted interpretation 'Freight On Board') has a wider usage - the
principle is the same, ie., seller has liability for goods, insurance and costs of
transport until the goods are loaded (or delivered), but the point at which goods are
'FOB' is no longer likely to be just the port of export - it can be any place that it
suits the buyer to stipulate. So, if you are an exporter, beware of buyers stipulating
'FOB destination' - it means the exporter is liable for the goods and pays transport
costs up until delivery to the customer.
forecast
See 'budget' above.

gearing
The ratio of debt to equity, usually the relationship between long-term borrowings
and shareholders' funds.
goodwill
Any surplus money paid to acquire a company that exceeds its net tangible assets
value.
gross profit
Sales less cost of goods or services sold. Also referred to as gross profit margin, or
gross profit, and often abbreviated to simply 'margin'. See also 'net profit'.
initial public offering (ipo)
An Initial Public Offering (IPO being the Stock Exchange and corporate acronym)
is the first sale of privately owned equity (stock or shares) in a company via the
issue of shares to the public and other investing institutions. In other words an IPO
is the first sale of stock by a private company to the public. IPOs typically involve
small, young companies raising capital to finance growth. For investors IPOs can
risky as it is difficult to predict the value of the stock (shares) when they open for
trading. An IPO is effectively 'going public' or 'taking a company public'.
letters of credit
These mechanisms are used by exporters and importers, and usually provided by
the importing company's bank to the exporter to safeguard the contractual
expectations and particularly financial exposure of the exporter of the goods or
services. (Also called 'export letters of credit, and 'import letters of credit'.)
When an exporter agrees to supply a customer in another country, the exporter
needs to know that the goods will be paid for.
The common system, which has been in use for many years, is for the customer's
bank to issue a 'letter of credit' at the request of the buyer, to the seller. The letter of
credit essentially guarantees that the bank will pay the seller's invoice (using the
customer's money of course) provided the goods or services are supplied in
accordance with the terms stipulated in the letter, which should obviously reflect

the agreement between the seller and buyer. This gives the supplier an assurance
that their invoice will be paid, beyond any other assurances or contracts made with
the customer. Letters of credit are often complex documents that require careful
drafting to protect the interests of buyer and seller. The customer's bank charges a
fee to issue a letter of credit, and the customer pays this cost.
The seller should also approve the wording of the buyer's letter of credit, and often
should seek professional advice and guarantees to this effect from their own
financial services provider.
In short, a letter of credit is a guarantee from the issuing bank's to the seller that if
compliant documents are presented by the seller to the buyer's bank, then the
buyer's bank will pay the seller the amount due. The 'compliance' of the seller's
documentation covers not only the goods or services supplied, but also the
timescales involved, method for, format of and place at which the documents are
presented. It is common for exporters to experience delays in obtaining payment
against letters of credit because they have either failed to understand the terms
within the letter of credit, failed to meet the terms, or both. It is important therefore
for sellers to understand all aspects of letters of credit and to ensure letters of credit
are properly drafted, checked, approved and their conditions met. It is also
important for sellers to use appropriate professional services to validate the
authenticity of any unknown bank issuing a letter of credit.
letters of guarantee
There are many types of letters of guarantee. These types of letters of guarantee are
concerned with providing safeguards to buyers that suppliers will meet their
obligations or vice-versa, and are issued by the supplier's or customer's bank
depending on which party seeks the guarantee. While a letter of credit essentially
guarantees payment to the exporter, a letter of guarantee provides safeguard that
other aspects of the supplier's or customer's obligations will be met. The supplier's
or customer's bank is effectively giving a direct guarantee on behalf of the supplier
or customer that the supplier's or customer's obligations will be met, and in the
event of the supplier's or customer's failure to meet obligations to the other party
then the bank undertakes the responsibility for those obligations.
Typical obligations covered by letters of guarantee are concerned with:
Tender Guarantees (Bid Bonds) - whereby the bank assures the buyer that
the supplier will not refuse a contract if awarded.

 Performance Guarantee - This guarantees that the goods or services are

delivered in accordance with contract terms and timescales.
Advance Payment Guarantee - This guarantees that any advance payment
received by the supplier will be used by the supplier in accordance with the
terms of contract between seller and buyer.
There are other types of letters of guarantee, including obligations concerning
customs and tax, etc, and as with letters of credit, these are complex documents
with extremely serious implications. For this reasons suppliers and customers alike
must check and obtain necessary validation of any issued letters of guarantee.
liabilities
General term for what the business owes. Liabilities are long-term loans of the type
used to finance the business and short-term debts or money owing as a result of
trading activities to date . Long term liabilities, along with Share Capital and
Reserves make up one side of the balance sheet equation showing where the
money came from. The other side of the balance sheet will show Current Liabilities
along with various Assets, showing where the money is now.
liquidity ratio
Indicates the company's ability to pay its short term debts, by measuring the
relationship between current assets (ie those which can be turned into cash) against
the short-term debt value. (current assets/current liabilities) Also referred to as the
Current Ratio.
net assets (also called total net assets)
Total assets (fixed and current) less current liabilities and long-term liabilities that
have not been capitalised (eg, short-term loans).
net current assets
Current Assets less Current Liabilities.

net present value (npv)

NPV is a significant measurement in business investment decisions. NPV is
essentially a measurement of all future cashflow (revenues minus costs, also
referred to as net benefits) that will be derived from a particular investment
(whether in the form of a project, a new product line, a proposition, or an entire
business), minus the cost of the investment. Logically if a proposition has a
positive NPV then it is profitable and is worthy of consideration. If negative then
it's unprofitable and should not be pursued. While there are many other factors
besides a positive NPV which influence investment decisions; NPV provides a
consistent method of comparing propositions and investment opportunities from a
simple capital/investment/profit perspective. There are different and complex ways
to construct NPV formulae, largely due to the interpretation of the 'discount rate'
used in the calculations to enable future values to be shown as a present value.
Corporations generally develop their own rules for NPV calculations, including
discount rate. NPV is not easy to understand for non-financial people - wikipedia
seems to provide a good detailed explanation if you need one.
net profit
Net profit can mean different things so it always needs clarifying. Net strictly
means 'after all deductions' (as opposed to just certain deductions used to arrive at
a gross profit or margin). Net profit normally refers to profit after deduction of all
operating expenses, notably after deduction of fixed costs or fixed overheads. This
contrasts with the term 'gross profit' which normally refers to the difference
between sales and direct cost of product or service sold (also referred to as gross
margin or gross profit margin) and certainly before the deduction of operating costs
or overheads. Net profit normally refers to the profit figure before deduction of
corporation tax, in which case the term is often extended to 'net profit before tax' or
PBT.
opening/closing stock
See explanation under Cost of Sales.
p/e ratio (price per earnings)
The P/E ratio is an important indicator as to how the investing market views the
health, performance, prospects and investment risk of a public company listed on a
stock exchange (a listed company). The P/E ratio is also a highly complex concept

- it's a guide to use alongside other indicators, not an absolute measure to rely on
by itself. The P/E ratio is arrived at by dividing the stock or share price by the
earnings per share (profit after tax and interest divided by the number of ordinary
shares in issue). As earnings per share are a yearly total, the P/E ratio is also an
expression of how many years it will take for earnings to cover the stock price
investment. P/E ratios are best viewed over time so that they can be seen as a trend.
A steadily increasing P/E ratio is seen by the investors as increasingly speculative
(high risk) because it takes longer for earnings to cover the stock price. Obviously
whenever the stock price changes, so does the P/E ratio. More meaningful P/E
analysis is conducted by looking at earnings over a period of several years. P/E
ratios should also be compared over time, with other company's P/E ratios in the
same market sector, and with the market as a whole. Step by step, to calculate the
P/E ratio:
1. Establish total profit after tax and interest for the past year.
2. Divide this by the number of shares issued.
3. This gives you the earnings per share.
4. Divide the price of the stock or share by the earnings per share.
5. This gives the Price/Earnings or P/E ratio.
profit and loss account (P&L)
One of the three principal business reporting and measuring tools (along with the
balance sheet and cashflow statement). The P&L is essentially a trading account
for a period, usually a year, but also can be monthly and cumulative. It shows
profit performance, which often has little to do with cash, stocks and assets (which
must be viewed from a separate perspective using balance sheet and cashflow
statement). The P&L typically shows sales revenues, cost of sales/cost of goods
sold, generally a gross profit margin (sometimes called 'contribution'), fixed
overheads and or operating expenses, and then a profit before tax figure (PBT). A
fully detailed P&L can be highly complex, but only because of all the weird and
wonderful policies and conventions that the company employs. Basically the P&L
shows how well the company has performed in its trading activities.

overhead
An expense that cannot be attributed to any one single part of the company's
activities.
quick ratio
Same as the Acid Test. The relationship between current assets readily convertible
into cash (usually current assets less stock) and current liabilities. A sterner test of
liquidity.
reserves
The accumulated and retained difference between profits and losses year on year
since the company's formation.
restricted funds
These are funds used by an organisation that are restricted or earmarked by a donor
for a specific purpose, which can be extremely specific or quite broad, eg.,
endowment or pensions investment; research (in the case of donations to a charity
or research organisation); or a particular project with agreed terms of reference and
outputs such as to meet the criteria or terms of the donation or award or grant. The
source of restricted funds can be from government, foundations and trusts, grantawarding bodies, philanthropic organisations, private donations, bequests from
wills, etc. The practical implication is that restricted funds are ring-fenced and
must not be used for any other than their designated purpose, which may also entail
specific reporting and timescales, with which the organisation using the funds must
comply. A glaring example of misuse of restricted funds would be when Maxwell
spent Mirror Group pension funds on Mirror Group development.
return on capital employed (ROCE)
A fundamental financial performance measure. A percentage figure representing
profit before interest against the money that is invested in the business. (profit
before interest and tax, divided by capital employed, x 100 to produce percentage
figure.)

return on investment
Another fundamental financial and business performance measure. This term
means different things to different people (often depending on perspective and
what is actually being judged) so it's important to clarify understanding if
interpretation has serious implications. Many business managers and owners use
the term in a general sense as a means of assessing the merit of an investment or
business decision. 'Return' generally means profit before tax, but clarify this with
the person using the term - profit depends on various circumstances, not least the
accounting conventions used in the business. In this sense most CEO's and
business owners regard ROI as the ultimate measure of any business or any
business proposition, after all it's what most business is aimed at producing maximum return on investment, otherise you might as well put your money in a
bank savings account. Strictly speaking Return On Investment is defined as:
Profits derived as a proportion of and directly attributable to cost or 'book value' of
an asset, liability or activity, net of depreciation.
In simple terms this the profit made from an investment. The 'investment' could
be the value of a whole business (in which case the value is generally regarded as
the company's total assets minus intangible assets, such as goodwill, trademarks,
etc and liabilities, such as debt. N.B. A company's book value might be higher or
lower than its market value); or the investment could relate to a part of a business,
a new product, a new factory, a new piece of plant, or any activity or asset with a
cost attached to it.
The main point is that the term seeks to define the profit made from a business
investment or business decision. Bear in mind that costs and profits can be ongoing
and accumulating for several years, which needs to be taken into account when
arriving at the correct figures.
share capital
The balance sheet nominal value paid into the company by shareholders at the
time(s) shares were issued.
shareholders' funds
A measure of the shareholders' total interest in the company represented by the
total share capital plus reserves.

t/t (telegraphic transfer)

Interntional banking payment method: a telegraphic transfer payment, commonly
used/required for import/export trade, between a bank and an overseas party
enabling transfer of local or foreign currency by telegraph, cable or telex. Also
called a cable transfer. The terminology dates from times when such
communications were literally 'wired' - before wireless communications
technology.
variable cost
A cost which varies with sales or operational volumes, eg materials, fuel,
commission payments.
working capital
Current assets less current liabilities, representing the required investment,
continually circulating, to finance stock, debtors, and work in progress.

The glossary above attempts to cover the main terms used in business. There are of
course many other terms and ratios not listed here
PART 9Mortgage Language made simple
Annual Percentage Rate (APR): The APR is a calculation of the overall cost of a loan expressed as an annual rate.
It takes into account all costs involved over the term of the loan, such as any set-up charges and the interest rate. We
calculate it to a standard set out in consumer protection legislation.
Annuity Mortgage: This is the standard mortgage type (see Mortgage below) where part of the initial amount you
borrow - the capital (see Capital below) - is paid back every month along with interest. Once all the capital and
interest is paid back the property is mortgage free.
Arrears: If you fall behind in your mortgage repayments it means your mortgage is in arrears. There may be
additional charges associated with a mortgage in arrears.

Building Energy Rating (BER): A BER is the similar to the energy label for household appliances and tells you how
energy efficient your new home will be. The label has a scale of A to G, with A-rated homes being the most energy
efficient. A BER certificate is compulsory on homes being sold or rented.
Buy to Let: This is a mortgage to purchase a property for investment purposes, usually where you want to let or rent
it to a tenant.
Capital: This is the original amount of money you borrow.
Contract / Contract for Sale: A contract is a legal agreement between two or more people. When you wish to buy a
house, you first sign a Contract for Sale with the seller. The Contract for Sale should be in the form approved by the
Law Society (the professional body for solicitors) and your solicitor will guide you on it. The Contract for Sale will set
out the steps that need to be taken before you sign the Deed (see Deed below). Usually you pay a deposit when
signing the Contract for Sale (see Deposit below).
Conveyancing: This is the legal process that includes researching, documenting and transferring ownership of a
property. It also involves filing records in state registries, such as the Property Registration Authority (see Property
Registration Authority below) and paying government stamp duty on the sale. Generally a solicitor must look after
this.
Deed: A legal document in a special form. The document used to transfer ownership of a property must be in the
form of a deed it is signed by both the vendor and the purchaser as evidence of transferring ownership.
Deposit:A sum of money paid by the purchaser when an offer to purchase is made. Two deposits may be payable
the first is a refundable booking deposit. You normally have 21 days after paying this deposit, generally referred to as
the cooling off period, before signing the Contract for Sale. On signing the Contract, a deposit is paid to secure the
property purchase. In general this deposit is non-refundable.
Drawdown: Once all of the conditions of the mortgage have been fulfilled to the satisfaction of the Bank and the
contracts have been exchanged, the Bank will draw down the loan funds and send them to your solicitor so that the
property purchase can be completed.
Equity: This is the difference between the value of your property and what you owe under your mortgage loan (see
Negative Equity below).
Equity Release: If you have equity in your home, i.e. if the value of your home is greater than what you owe under
your mortgage loan, then you may be able to release some of this equity by taking out an Equity Release, that is, an
additional mortgage loan secured on the property.
Equity Release could be an ideal option to fund significant expenses like home improvements, a garden makeover,
even education expenses.
First Time Buyer (FTB): A first-time buyer is a person who has never before, either on his or her own or with others,
purchased a house, a site to build a house or an apartment in Ireland or abroad.
Interest rate: This is the cost to you of borrowing money. The rate is usually expressed as a percentage rate per
annum (i.e. per year). Interest rates can be either fixed or variable.

Letter of Offer: Once your application is approved, a Letter of Offer detailing your mortgage offer from the Bank is
issued to you and to your solicitor. It will include the Interest Rate, how you are to repay your loan and the duration
(see Term below) of the mortgage loan. Full Terms and Conditions are included. It must be signed and returned to
the Bank within 30 days of the date of the Offer Letter to remain valid.
Loan to Value Ratio (LTV): LTV is the amount that you are borrowing compared to the value of the property you are
buying. For example, if you buy a property valued at 300,000 and borrow 240,000, your LTV is 80%.
Mortgage: A Deed you sign to create security over a house or land and sometimes over other types of property. For
example, security in the form of a mortgage is usually given to a bank or building society to enable it lend to a
borrower to finance the purchase of a property. A loan secured by a mortgage can be called a mortgage loan.
Mover: If you already own a home (or have owned one before) and are moving to a new home you will be considered
a Mover. You may be seeking a mortgage loan to allow you move home.
Negative Equity: This is where the market value of your property is less than what you owe under your mortgage
loan.
Owner Occupier Mortgage: A mortgage given to a person(s) to purchase a house in which he or she intends to live.
Property Registration Authority: The state registry where dealings concerning land are filed (usually by solicitors)
and registered. The Property Registry Authority runs two registration systems at present. The older system is the
Registry of Deeds in which details of Deeds concerning land are filed. This older system is being phased out. The
more modern system is the Land Registry which is map-based and which records who owns land, who holds a
mortgage over land and other details.
Property Registration Authority Fee: A fee paid to the Property Registration Authority to register you as the new
owner of the property after you buy your home. This fee will be included in the legal costs charged by your solicitor.
Redeemed / Redemption: When a mortgage loan is fully repaid the mortgage is said to be redeemed and
redemption of a mortgage is full repayment of the mortgage loan. We must release our mortgage once you redeem
it.
PART 10
Repayment: The amount you agree to pay us each month on your mortgage loan.
Searches: Searches are carried out by your solicitor in the Property Registration Authority and other state registries
to ensure that the person selling the property has a legal right to sell it and that there is nothing on the title (such as a
mortgage from the seller to a bank) which would affect you (see Title below). Your solicitor should also carry out
searches to ensure any house or building has full planning permission.
Stamp Duty: A government tax on the purchase of a property.
Switcher: Someone who moves a mortgage loan secured on a house from one financial institution to another without
moving home.
Term: The term of the mortgage loan is the length of time over which you agree to pay off the loan. The longer the
term the less you pay each month, but a longer term also means paying more interest over the duration of the loan.

Title: The right to ownership of property, especially land. Types of title include freehold (where the owner owns land
outright) and leasehold (where the owner has a lease of the land). For technical legal reasons some apartment
owners own their property under leases that last hundreds of years.
Underwriter: A professional employed by lenders or insurers to assess the level of risk in providing lending /
insurance cover.
Valuation: A report which describes a property and estimates its market value. It is prepared by a professional valuer.
When we agree to lend a mortgage loan, we require such a report (called a Valuation Report). The valuer must be
acceptable to the Bank. Remember, the Valuation Report is not a detailed structural survey or planning survey and
we strongly recommend you have your own surveyor or valuer carry out a survey / valuation for your own peace of
mind.

PART 11

Correlation between Repo Rate and Base Rate

Whenever RBI reduces its Repo Rate, there is a widespread demand for reduction of Base
Rate by banks in India. The media also gives greater publicity to changes particularly
reductions - in Repo Rate. There is a tremendous pressure from Ministry of Finance and RBI
too on the banks to reduce their Base Rate, as when a reduction effected in Repo Rate by RBI.
Lets see how far the RBIs Repo Rate impacts the interest rates of scheduled commercial
banks be it in private sector or public sector.
Statutory Reserve Requirements
1. As per Sec. 42(1) of RBI Act, 1934, all scheduled commercial banks in India are
required to keep a portion of their Demand and Term Deposits with RBI. This
mandatory deposit with RBI will act as emergency cash reserve, so as to ensure short
term liquidity of the banks.
2. RBI has powers to stipulate any CRR without any floor or ceiling rate.
3. At present, the CRR stands at 4% (in June 2015) (For latest Policy Rates CLICK
HERE) and banks do not earn any interest on deposits parked with RBI for CRR
purpose.
4. To the extent of CRR, banks loanable funds are brought down. In other words, out of
every deposit of Rs.100, banks have to earmark Rs.4 towards CRR and this will be an
idle reserve generating zero income.

5. In addition to CRR, all banks in India have to invest a portion of their demand and term
deposits in gold, cash and other approved securities. Percentage of this additional
reserve is known as Statutory Liquidity Ratio (SLR) and it is imposed on banks in
accordance with Sec.24 of Banking Regulation Act, 1949.
6. While RBI has powers to fix SLR at the maximum level of 40%, the present SLR (in
June 2015) is at 21.50%. (For latest Policy Rates CLICK HERE) Here, only cash
balances over and above the mandatory CRR will be reckoned for SLR purpose.
7. While cash and gold do not generate any income, investments made in approved
securities fetch returns, but they are usually less than the returns on the credit / loans
8. Thus, to the extent of CRR and SLR, banks loanable funds are brought down. In other
words, out of every deposit of Rs.100, banks have to earmark Rs.25.50 towards CRR
and SLR and only the balance of Rs.74.50 can be given as loans and advances.
Rate of Interest contracted for Term Deposits is fixed and cannot be altered
1. As we all know, deposits constitute a major source of funds for the banks.
2. Rate of Interest offered on bank deposits are fixed and cannot be changed until the
maturity of such deposits. Thus, cost of funds for a scheduled bank does not change
much in the short term.
3. Whenever the interest rates are falling, it will result in reduction in cost of deposits for
the banks. But, since more than 60% of the banks term deposits fall in the time bucket
of 1 to 3 years, banks do not gain anything in the short term, even in the falling interest
rate regime.
4. When average cost of deposits goes up, banks will be constrained to increase their
Base Rate too (Base Rate is the minimum lending rate).

Size of funds mobilised through Repo route is very small

1. Banks can borrow funds from RBI through Repo window only up to the ceiling of 2% of their net
demand and time liabilities.
2. Funds mobilised through Repo are meant only to bridge the gap in short term liquidity
requirements of banks.
3. Average borrowings made by banks under Repo range only from 0.5% to 1% of their total
deposits, at a given point of time.
4. Thus, size of funds mobilised through repo route, in relation to bank deposits is very small and
funds borrowed by banks through Marginal Standing Facility (Repo) create little impact on the
average cost of funds of commercial banks.
Play of Market Forces

1. Since RBI has freed the interest rates, except on DRI advances, each bank enjoys autonomy in
fixing their own Base Rate, but it shall be non-discriminatory in nature.
2. Thus, the business strategies and operational efficiency of each bank will decide its Base Rate.
Base Rate undergoes changes many times in a year.
3. Market forces also greatly influence the interest rates. So, a banks average cost of funds alone
cannot determine its Base Rate.

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Asset Liability Mismatch

1. As already mentioned, while most of the banks term deposits fall in the 1 to 3 years time
bucket, the average tenor of bank advances is from 3 to 5 years (for infrastructure loans it
extends even upto 10 years or so). Thus, there is a general mismatch in the assets and
liabilities of banks.
2. This is another reason for the banks vying with each other to vigorously go for higher proportion
of CASA in their Deposit Mix on an on-going basis (while the primary reason is to bring down
the average cost of deposits).
Others
1. Now, coming to the point, as and when RBI reduces its repo rate, banks cannot
immediately pass on the benefits to the borrowers.
2. No doubt, Repo funds inject further liquidity into the system, but it cannot be said that
the economy is willing and capable of increasing their credit off-take.
3. Credit expansion takes place over a period of time and it cannot happen quickly.
4. Composition of advances is also a key determinant in credit expansion. Demand for
additional credit will vary with different geographical regions and the activities/sectors
which are ready to borrow more also vary from one region to another.
5. To make credit cheaper, banks cannot unilaterally reduce the interest rates on their
deposits, as crores of people still depend on interest income for their sustenance.
6. It will be difficult for the banks to satisfy the aspirations of depositors and borrowers at a
time.
7. Each bank has its own business strategies and priorities. Financial health of each bank
also varies from each another. Such being the case, we cannot expect all banks to
react in the same way to changes in RBIs Repo Rate.
Date: 15-06-2015

Comments by Rajesh Goyal

I have no hesitation to say that Mr Pannvalan has wonderfully

explained the relationship between Repo Rate and Base Rate. Having
worked in Treasury Division and Risk Management Division of large PS bank for long time, I
know only few people know this concept in depth. To understand such intricacies may be
difficult for common banker (as they never got a chance to work in such departments). With my
experience of discussing these with top management people, I can confirm that these are not
even understood by many GMs, EDs and CMDs, and these are harder to be learnt by officials in
Finance Ministry. Let me sum up the truth of pulls and pushes of present day situation in Indian
banking industry / economy :(a) On number of occasions CMDs of PS Banks (without understanding the concept and its
implications) strongly advocate reduction in Repo Rates and blame the high credit costs to
higher Repo rate. Such statements give a wrong impression to the public and specially
media and corporates, that reduction in Repo Rates will result in corresponding reduction in
Base Rate immediately. This is a fallacy as explained above in the article. There is a need
to dispel this wrong notion. Reduction in Repo Rate will certainly impact Base Rate but only
marginally and that too with a time lag.
(b) The real reduction in Base Rate can be brought only by sizeable reduction in term deposits
rates. (CASA is relevant for a particular bank not for the industry as a whole). The inflation in
India in recent years has been very high and thus any large reduction in deposit rates would
have resulted in negative net returns which seriously affects the senior citizens and
savings. Thus, the real culprit is inflation for high Repo Rates;
(c) Corporates unnecessarily create a hype of high rate of interests so as to extract as much
concession as possible from banks. In the total cost of a product the interest on loans is only
a small fraction and thus reduction of even 1% to 2% will never reduce the cost to the extent
that it will increase the demand in the corresponding rate.
(d) RBI Governor is constantly kept under pressure by FM and corporates for reduction of Repo
Rate which is hyped by media with drumming that this is the only panacea for reduction in
prices of goods.
(e) There is a need to reduce other wasteful expenditure by the corporate and reduce corruption
so that the cost of the products can be reduced.
(f) We should not compare our high lending rates with almost near to 3%-4% lending rates
prevailing in countries like USA and Japan. In these countries the term deposit rates also
very low as inflation is almost zero percent. In India where we do not have social security,
the deposit rates have to be such that these gives senior citizens enough income on their
savings so that they can survive. In recent times, we have seen that IBA and UFBU have
even reduced the pension of future retirees. In such situations, it will never be possible to
reduce the deposit rates to say 2% or 3%.

PART 11
FINANCIAL RATIOS EXPLANATION
Financial ratios are useful indicators to measure a companys performance and
financial situation. They can be also used to analyze trends and to compare a firms
financial figures to those of competitors or those of the business sector in which it
belongs to. Financial ratios can be classified according to the information they
provide. ICAP has included in its products the majority of the most commonly used
ratios in order to support companies directors and executives during decisionmaking. The present document describes the calculation of ratios applied either in
companies or in sectoral business reports.
https://www.icapb2b.gr/b2b_web/CMSContent/FINANCIAL_RATIOS.pdf

PART 12
This section defines financial terms and ratio used in this publication.

Total Advances = Bills purchased & discounted (Short term) + Cash credits, overdrafts & loans
(Short term) + Term loans

Total Deposits = Demand Deposits + Savings Bank Deposit + Term Deposits

CASA Deposits = Demand Deposits + Savings Bank Deposits

CASA Ratio (%) = CASA Deposits/Total Deposits

Total Business = Total advances + Total deposits

Net-worth = Capital + Reserves & Surplus

Total Borrowings = Secured Borrowings (In India and Outside India) + Unsecured Borrowings (In
India and Outside India)

Total Assets = Cash in hand + Balances with RBI + Balances with banks inside/outside India +
Money at call + Investments + Advances + Fixed Assets + Other Assets

Average Total Assets = [Total Assets CY+ Total Assets PY]/2

Total Liabilities = Capital + Reserves & surplus + Deposits + Borrowings + Other liabilities &
provisions

Free Funds = CASA + Net-worth

Funds Deployed = [Total Assets {Fixed Assets + Other Assets}]

Average Funds Deployed = [Funds Deployed CY + Funds Deployed PY]/2

Funds in carry Business = Funds Deployed Non SLR Investments

Average Funds in carry Business =[Funds in carry Business CY + Funds in carry Business PY]/2

Borrowed Funds = Borrowings + Deposits + Bills Payable

Average Borrowed Funds = [Borrowed Funds CY + Borrowed Funds PY]/2

Incremental Free funds = Free funds CY Free funds PY

Net Interest Income = Interest Earned Interest Expended

Net Interest Margin (%) = Net Interest Income/Average Assets

Non Interest Income Margin (%) = Other Income/Average Assets

Interest Cost (%) = Interest expended/Average Borrowed funds

Yield in carry business (%) = Interest earned/Average funds in carry business

Spread (%) = Yield in carry business Interest cost

Core fee income = Other income [Net Profit/Loss sale of investments, land and other assets +
Net profit/Loss on revaluation of investments + 50% of the miscellaneous income]

Core fee income Ratio (%) = Core fee income/Average funds deployed

Operating Expense Ratio = Operating Expenses/Average funds deployed

Operating Profit Margin (%) = [Net interest income Operating expenses]/Interest earned

Cost to Income Ratio (%) = Operating expenses/[Net interest income + Other income]

Cost to Net Income Ratio (%) = Operating expenses/[Net interest income + Other income {Net
P&L from sale & revaluation of other assets, land and investments}]

Net Profit Margin (%) = Spreads + Core fee income Ratio Operating expense Ratio

Return on Assets (%) = Net Income or Profit/Average Total Assets

Return on Equity (%) = Net Income or Profit/Net-worth

Cash/Deposit Ratio (%) = [Cash in hand + Balances with RBI]/ Total deposits

Credit Deposit Ratio (%) = Total Advances/Total Deposits

Incremental Credit (Advances) = Total Advances CY Total Advances PY

Incremental Deposit = Total Deposits CY Total Deposits PY

Incremental Credit Deposit Ratio (%) = Incremental Advances/ Incremental Deposits

Investment Deposit Ratio (%) = Total Investments/Total Deposits

Incremental Investment = Total Investment CY Total Investments PY

Incremental Investment Deposit Ratio (%) = Incremental Investments/Incremental Deposits

SLR Investments = Investment in Government Securities + Investment in Approved Securities

SLR Investment Ratio (%) = SLR Investments/Total Investments

Statutory Liquidity Ratio (%) = SLR Investments/Total Deposits

Slippage Ratio (%) = Additions to Gross NPA/Opening Standard Assets

Provisioning cover (%) = NPA Provisions/ Gross NPA

Restructured Assets = Corporate Debt Restructured {Standard/Sub-standard/Doubtful} + Other

than Corporate Debt Restructured {Standard/Sub-standard/Doubtful}

Off-balance sheet exposure = Outstanding Forward Exchange Contracts + Guarantees given on

behalf of constituents + Acceptances & Endorsements + Other contingent liabilities

Sensitive Sector Advances = Capital Markets Sector Advances + Real Estate Sector Advances +
Commodity Sector Advances

Total Branches = Rural + Semi-urban + Urban + Metros

Total Branches (including ATMs) = Branches {Rural + Semi-urban + Urban + Metros} + ATMs {Onsite/ Off-site}

Business per branch = Total Business/Total Branches

Business per branch (including ATMs) = Total Business/Total Branches (including ATMs)

Business per employee = Total Business/ Total Employees

Profit per branch = Net Profit/ Total Branches

Profit per branch (including ATMs) = Net Profit/Total Branches (including ATMs)

Profit per employee = Net Profit/ Total Employees

Employee per branch = Total Employee/Total Branches

Employee per branch (including ATMs) = Total Employee/Total Branches (including ATMs)

PART 13Marginal Cost Of

Funds
DEFINITION of 'Marginal Cost Of Funds'
The incremental cost of borrowing more money to fund additional asset
purchases or investments. In its simplest calculation, the marginal cost of funds is
simply the interest rateon the new loan balance. Marginal cost of funds is often
confused with the average cost of funds, which would be calculated by computing
a weighted-average of all the combined loans' interest rates.
1.

BREAKING DOWN 'Marginal Cost Of Funds'

While many investors only think of the marginal cost of funds in terms of money
borrowed from someone else, it's also important to think of it in terms of money
borrowed from oneself or a company's own assets. In this instance, the marginal
cost of funds is the opportunity costof not investing existing funds elsewhere and
receiving interest on it. For example, if a company uses $1,000,000 of its own
cash to build a new factory, the marginal cost of funds would be the rate of
interest it could have earned if it had invested that money instead of spending it
on construction.
PART1 4
NOTES ON FOREIGN EXCHANGE
https://www.scribd.com/document/322950749/Notes-on-Indian-Foreign-ExchangeMarket

PART1 5

Indian Foreign Exchange Market -Basic Information

Visiting the Foreign Exchange Market

We all know that the Indian Rupee serves as the medium of exchange backed
by legal tender status for making payments towards purchases and towards
discharging all other types of payment obligations within the country. But as
modern trade and commerce extend beyond the boundaries of a country, the
question naturally arises as to how to settle payments for cross-border sales,
purchases and other money dealings? We also need to incur expenditure in
foreign countries towards travel and temporary halt, medical care, educational
purposes, maintenance of an office at the foreign centre etc. This is a
widespread and frequent need of many persons in every country. But each
country has a different currency, serving as a medium of exchange exclusively
within its boundaries. Then how to make payment in Indian Rupees in our
country and enable the foreign seller to get payment in his currency? Let us
look at the answer.
If an exporter in India sells readymade garment, say to a Canadian firm, the
Canadian importer can make payment in Canadian Dollars, while the Indian
Exporter desires to be provided with Indian Rupees. This problem is solved by
the Canadian Importer in the first instance purchasing Indian Rupees against
payment of Canadian Dollars in his country from an authorised source dealing
with foreign money (foreign exchange) and remitting Indian Rupees to the
Indian Exporter. Or in case the consignment is invoiced in Canadian Dollars,
the Indian exporter gets Canadian Dollars, which he sells in this country to an
authorised dealer (of foreign exchange) to get Indian Rupees. Thus as money
is used as a medium of exchange to secure supplies of goods and services, it
can also be so used to secure supply of currency/money of another country,
which can thereafter be used to discharge our payment obligations in that
country.
So in every business deal or other types of money transaction extending
outside the borders of a country, there are in fact two set of transactions, i.e.
first the one relating to the goods traded and secondly trading (buying/selling)
of the foreign money called foreign exchange to settle payment to the
overseas seller. In fact in actual practice there would be three sets of
transactions. In the above example, since in India, it would be difficult to get
Canadian Dollars readily in the spot market, or vice versa to get Indian

Rupees in Canada the transaction will be normally settled in US$. The

Canadian Importer will buy US$ in his country against payment of Canadian
Dollars to remit to his Indian seller. On receipt of US $, the Indian Exporter will
exchange it into Indian Rupees in his country by selling the same in the
foreign exchange market. Thus there is the movement of readymade
garments from India to Canada in the first place. In the second place there is
the exchange of Canadian Dollars to US Dollars taking place within Canada.
Lastly there is the exchange of US$ to Indian Rupees in India.
The transactions involving the buying and selling of inter-country currencies
are called foreign exchange transactions and the term Foreign Exchange
Market refers to all the market participants involved in such dealings, i.e. the
buyers, sellers, the market intermediaries and finally the Monetary Authority
(market Regulator) of the country regulating exchange rate mechanisms. The
Indian foreign exchange market is a huge financial market exceeding an
annual turnover of 400 bn valued in US$ in terms only by public dealings (i.e.
excluding inter-bank transactions). It is the third wing of the Financial markets
in India, the others being the money market and the capital market. As per
statistics released by RBI, The average monthly turnover in the merchant
segment of the forex market increased to US$ 40.5 billion in 2003-2004 from
US$ 27.0 billion in 2002-2003. In the inter-bank segment, the turnover has
moved up from US$ 103 billion in 2002-2003 to US$ 134.2 billion in 20032004. Consequently, the average monthly total turnover increased sharply to
US$ 174.7 billion in 2003-2004 from US$ 130 billion in the previous year. The
inter-bank to merchant turnover ratio hovered in the range of 2.9 3.9 during
the year.
Main Centres of Business
Mumbai is the principal centre. Other important centres are Calcutta, New
Delhi, Madras, Bangalore, Cochin and Pondicherry. Until recently the various
centres functioned as fragmented markets leading to wide variations in
exchange rates. With the improvement in telecommunication facilities the
various centres are being increasingly integrated and they are now functioning
as part of a single geographically extended market. In the context of recent
developments in telecommunication and computer facilities, individual market

centres are just conduits and foreign exchange business can be transacted
from any centre without jeopardizing efficiency
Composition of the Indian Market
Foreign exchanged market in India is totally structured, well regulated both of
RBI and also by a voluntary association (Foreign Exchange Dealers
Association). Only Dealers authorised by RBI can undertake such
transactions. All inter-bank dealings in the same centre must be effected
through accredited brokers, who are the second arm in the market-structure.
However, dealings between the authorised dealers and the RBI and also
between the AD (Authorised Dealers) and overseas Banks are effected
directly without the intervention of the brokers. In addition to the authorised
dealers covering commercial banks, who undertake comprehensive
transactions covering all spheres of foreign exchange, there are also a
peripheral market consisting of licensed money changers and travel agents,
who enjoy limited authorisation especially for encashment of travelers
cheques, notes. Specified hotels and Government owned Shops are also
given restricted licenses to accept payment from non-residents in foreign
currencies. IDBI, and Exim Bank are permitted handle and hold foreign
currencies in a restricted way.
The spot and forward exchange markets
In a spot transaction the seller of exchange has to deliver the foreign
exchange he has sold 'on the spot' (usually within 2 days). Similarly the buyer
of exchange will receive the foreign exchange he has bought immediately.
There is another important market, the Forward Market. In a forward market
when the bargain is settled, the seller agrees to sell at a certain amount of
foreign exchange to be delivered at a future date at a price agreed upon in
advance. Analogously a buyer agrees to buy certain amount of foreign
exchange at a future date at a predetermined price. Commonly used forward
contracts are for duration of one month(30 days) 3 months (ninety days),six
months (180 days), nine months (270 days) and one year (360 days). The
linkage between the spot and forward exchange rates come from the actions
of three groups of economic agents who use the market, viz. arbitrageurs,
hedgers, and speculators.

Foreign Exchange Rate

If the Indian Exporter has received US Dollar and desires to convert the same
into Indian Rupees, at what would he receive Indian rupees for each US $?
This is decided by the prevailing exchange rate between Indian Rupee and
US $. Exchange rate is the price of one currency expressed in terms of
another. It is the relationship between two monetary units. Exchange rate is
the medium though which one currency is exchanged for another. In this
exchange two currencies are hold. We are holding one currency, normally the
home currency, i.e. Indian rupees in our case. We need to buy foreign
currencies like Pound Sterling or U.S. Dollars. Vice versa, we also desire to
sell these foreign currencies, whenever we get them to convert into Indian
Rupees. In this case the home currency (the Indian Rupee) is the Base
currency and the foreign currency that we need to buy say U.S. Dollars is the
variable or offered currency.
We have two options. One is to quote so many Rupees for each Dollar and
the second option is to quote so many Dollars per rupee or per hundred
rupees. The first is called the Direct Method and the second is called the
Indirect method. The two methods are further explained as under:
a. Direct Method (Home Currency Quotation):
Under the above method, the unit of foreign currency remains fixed and
local currency varies.
Example
US$ = Rs.43.20 (Spot)
Pound = Rs.75.20 (Spot)
b. Indirect Method (Foreign Currency Quotation):
Under this method, a given unit of local currency remains fixed and
foreign currency varies In India the unit for quoting foreign currencies is
always taken as hundred rupees.
Example
Rs.100 = US$ 2.35 (Spot)
Rs.100 Pound 1.33 (Spot)

Earlier foreign exchange rates for various types of merchant transactions

(both spot and forward) were fixed by the Foreign Exchange Dealers
Association of India (FEDAI) in consultation with RBI. Recently however this
arrangement was abolished and the Individual Banks are permitted to quote
competitive rates, based on the on-going inter-bank or overseas market rates.
This freedom with the relaxation of some of the provisions of the exchange
control gave a fillip to the growth of Indian market.
The Maxim applicable for each Method of Quotation.
Authorised Dealers quote exchange rates on daily basis. These dealers are
mostly branches of commercial Banks, which are authorised to do all sorts of
foreign exchange transactions by the R.B.I. The Bank which offers the
exchange rate is known as the Quoting Bank ands the
Bank/person/Organization asking for the rate/price is known as the asking
bank/firm/person. The quoting Bank always quote two way price,
a. A price at which it buys
b. A price at which it sells.
Both rates are quoted against a common currency.
While quoting rates the Quoting Bank keeps a spread between the buying and
selling rate. The spread is kept to cover operational costs and margin of profit.
Example A Bank quotes:
Rs.100 US$ 2.3500/50.
This means it is prepared to sell US$2.3500 for Rs.100/- and is
Prepared to buy US$2.3550 for Rs.100
This spread is 50 cents.
The maxim applied is "Buy High and Sell Low" for Indirect quotes. For Direct
Quotes the maxim is reversed "Buy Low and Sell High". The objective of
buying and selling operations is to cover the operational costs and also to
earn an exchange profit. Bankers consider exchange profit as an important
source of income. It is earned without the buyer/seller being aware of this
income.

The Monetary Authority/Market Regulator

In India Exchange Control function is regulated by the Central Bank of the
country, i.e. Reserve Bank of India, through its Exchange Control
Department.. The various functions of this department are discussed
elsewhere in another module dealing with functions of RBI and can be viewed
through the link. FEDAI (Foreign Exchange Dealers Association. the Foreign
Exchange Dealers Association of India) is a self-regulatory organisation
formed by authorised dealers. It plays a constructive role in market
development by initiating debates on important issues, organising training
programmes and providing technical expertise on various matters
Exchange Rate Regimes
The term exchange rate regime refers to the mechanism, procedures and
institutional framework for determining exchange rates at a point of time and
changes in them over time, including factors which induced the changes. In
theory, there are a very large number of exchange rate regimes are possible.
At two extremes, are the perfectly rigid or fixed exchange rates, and the
perfectly flexible or floating exchange rates. Between them are hybrids with
varying degrees of limited flexibility.
The exchange rate regime in India underwent a major change in March 1993,
when after a brief experience with dual exchange rates, the country adopted a
unified market determined exchange rate system. Under this system, the
exchange rate was left to the determined by the market forces, while the
Reserve Bank of India intervened when there was a high degree of volatility or
instability in the market. More about Exchange Rate Regime is discussed in
another article.
By way of understanding basic concepts relating to the functioning of Indian
foreign exchange market, we would be discussing about Current/Capital
Account convertibility in the next article .Various other features relating to
Foreign Exchange Market of India are discussed in the succeeding articles
Indian Foreign Exchange Market -Basic Information

"Current Account and Capital Account Convertibility

Current account includes all transactions, which give rise to or use of our
National income, while Capital Account consist of short term and long term
capital transactions. As per FEMA "capital account transaction" means a
transaction which alters the assets or liabilities, including contingent liabilities,
outside India of persons resident in India or assets or liabilities in India of
persons resident outside India. Those which are not Capital Account
transactions are current Account transactions.
Current Account Transactions covers the following.
1. All imports and exports of merchandise
2. Invisible Exports and Imports (sale/purchase of services
3. Inward private remittances to & fro
4. Pension payments (to & fro)
5. Government Grants (both ways)
Capital Account transactions consist of the following
1. Direct Foreign Investments (both inward & outward)
2. Investment in securities (both ways)
3. Other Investments (both ways)
4. Government Loans (both ways
5. Short-term investments on both directions.
The substance of convertibility is to dispense with the discretionary
management of foreign exchange and exchange rates and to adopt a more
liberal and market driven exchange allocation process. All transactions are still
conducted within the framework of exchange controls, as prescribed by the
RBI. Full convertibility on current account is manifested as below:

 On trade account and on account of the receipt side of the invisibles,

the rupee is fully convertible at market determined exchange rates.
The payment side of the invisible and receipts and payments of capital
account are subject to exchange control
However, exchange rates for all these permissible transactions are
undertaken at the free market exchange rates
Capital Account is deemed convertible when residents and non-residents are
allowed to effect such transactions without any restrictions i.e. without prior
permission of the RBI. In such a context without any restrictions Indians
should be able to secured foreign direct investment from abroad. Foreigners
at their discretion should be able to make portfolio investments in this country.
Presently these transactions are subject to prior permission of R.B.I. However
R.B.I. is following a constructive and promotional approach and encouraging
foreign investments in India. Indian Industrialist having good projects for direct
foreign investment or foreign institutional investors desiring to make portfolio
investments in this country are encouraged and they do not face problems on
account of exchange control by R.B.I. Exchange control is limited to exchange
monitoring.
In a strict sense a currency can be considered convertible, only if both
residents and non-residents have full freedom to use and exchange it for any
purpose whatsoever, at some definite rate of exchange. However in practice
large number of currencies are considered convertible with various degrees of
restrictions and controls.
The International Monetary Fund provides a working definition of convertibility
under Article VIII, which states as under:
No member shall, without the approval of the fund, impose restrictions on
making of payment and transfers for current transactions.
The IMF concept considers convertibility only for current account transactions,
thus leaving at the discretion of the country to regulate flows on capital
account. Generally countries with currency convertibility have practised

various degree of controls to suit their national interests from time to time.
Thus currency convertibility implies absence of restrictions on foreign
exchange transactions and not necessarily on trade or capital flow. This point
has been clarified properly by IMF, which states as under:Thus, although measure formulated as quantitative limitation on imports will
have the indirect effect, it is not for that reason a restriction on payments
within the meaning of the provisionRestrictions on trade do not become
restrictions on payment within the meaning of Article VIII, because they are
imposed for balance of payments reasons.
Under the present floating system, exporters can realise their entire export
earnings at the free market rate. All imports, including the Government imports
consisting of petroleum, food, fertilizers and defence have to be paid at free
market rates. The substance of convertibility efforts is to dispense with the
discretionary management of foreign exchange and exchange rates and to
adopt a more liberal and market driven exchange allocation process. It needs
to be noted that here that the full convertibility does not mean the unrestricted
use of the rupee for all types of Indias external transactions. All transactions
are still conducted within the framework of exchange controls, as prescribed
by the R.B.I.
Foreign Exchange Reserve & its Management by the Monetary Authority of
the Country
(quoted from IMF Publication titled "Guidelines for Foreign Exchange Reserve Management ")

"Reserves consist of official public sector foreign assets that are readily
available to and controlled by the monetary authorities. Reserve asset
portfolios usually have special characteristics that distinguish them from other
foreign currency assets. First and foremost, official reserve assets normally
consist of liquid or easily marketable foreign currency assets that are under
the effective control of, and readily available to, the reserve management
entity. Furthermore, to be liquid and freely useable for settlements of
international transactions, they need to be held in the form of convertible
foreign currency claims of the authorities on nonresidents"
"Reserve management is a process that ensures that adequate official public
sector foreign assets are readily available to and controlled by the authorities

for meeting a defined range of objectives for a country or union. In this

context, a reserve management entity is normally made responsible for the
management of reserves and associated risks. Typically, official foreign
exchange reserves are held in support of a range of objectives including to:
i.

"support and maintain confidence in the policies for monetary and

exchange rate management including the capacity to intervene in
support of the national or union currency;

ii.

"limit external vulnerability by maintaining foreign currency liquidity to

absorb shocks during times of crisis or when access to borrowing is
curtailed and in doing so;

iii.

"provide a level of confidence to markets that a country can meet its

external obligations

iv.

"demonstrate the backing of domestic currency by external assets;

v.

"assist the government in meeting its foreign exchange needs and

external debt obligations; and

vi.

"maintain a reserve for national disasters or emergencies.

"Sound reserve management practices are important because they can

increase a country's or region's overall resilience to shocks. Through their
interaction with financial markets, reserve managers gain access to valuable
information that keeps policy makers informed of market developments and
views on potential threats. The importance of sound practices has also been
highlighted by experiences where weak or risky reserve management
practices have restricted the ability of the authorities to respond effectively to
financial crises, which may have accentuated the severity of these crises.
Moreover, weak or risky reserve management practices can also have
significant financial and reputational costs. Several countries, for example,
have incurred large losses that have had direct, or indirect, fiscal
consequences. Accordingly, appropriate portfolio management policies
concerning the currency composition, choice of investment instruments, and
acceptable duration of the reserves portfolio, and which reflect a country's

specific policy settings and circumstances, serve to ensure that assets are
safeguarded, readily available and support market confidence.
"Sound reserve management policies and practices can support, but not
substitute for, sound macroeconomic management. Moreover, inappropriate
economic policies (fiscal, monetary and exchange rate, and financial) can
pose serious risks to the ability to manage reserves."
The objectives of sound Reserve Management are defined by the Fund (IMF)
as under:"Reserve management should seek to ensure that: (i) adequate foreign
exchange reserves are available for meeting a defined range of objectives; (ii)
liquidity, market, and credit risks are controlled in a prudent manner; and (iii)
subject to liquidity and other risk constraints, reasonable earnings are
generated over the medium to long term on the funds invested."
Foreign Exchange Reserves of India
The foreign exchange Reserves of our country took its lowest dip, In the year
1990-91, when balance of payments position facing the country became
critical and foreign exchange reserves had been depleted to dangerously low
levels, less than 1 bn US #$. It heralded the onset of liberalisation of Indian
Economy releasing a chain of economic and financial reforms, resulting in the
progressive building up of our reserves. It has now reached a formidable level
around 120 bn US $ now. The earlier problem of managing chronic shortages
is now replaced by the Dilemma of handling a bulging pool, the problem of a
growing plenty. This leads one to ponder over the costs & benefits and the
attendant risks. This matter is analysed in depth by the former Governor of
RBI Dr. Bimal Jalan, while addressing a conference of 14th National Assembly
of Forex Association of India 14.8.2003 .
"Another issue, which has figured prominently in the current debate, relates to
foreign exchange reserves. As is well known, Indias foreign exchange
reserves have increased substantially in the past few years and are now
among one of the largest in the world. The fact that most of the constituents of
Indias balance of payments are showing positive trends on the current as

well as capital accounts is a reflection of the increasing competitiveness of

the Indian economy and strong confidence of the international community in
Indias growth potential. For the first time after our Independence 56 years
ago, the fragility of the balance of payments is no longer a concern of policy
makers. This is a highly positive development and regarded as such by the
country at large.
"Nevertheless, there are two concerns that have been expressed by expert
commentators one is about the "cost" of additional reserves, and second
concerns the impact of "arbitrage" in inducing higher inflows. So far as the
cost of additional reserves is concerned, it needs to be borne in mind that the
bulk of additions to reserves in the recent period is on account of non-debt
creating inflows. Indias total external debt, including NRI (Non-Resident
Indian) deposits, has increased relatively slowly as compared with the
increase in reserves, particularly in the last couple of years. In fact, India prepaid more than $ 3 billion of external debt earlier this year. It may also be
mentioned that rates of interest paid on NRI deposits and multilateral loans in
foreign currency are in line with or lower than prevailing international interest
rates.
"On NRI rupee deposits, interest rates in the last couple of years have been in
line with interest rates on deposits by residents, and are currently even lower
than domestic interest rates. So far as other non-debt creating inflows (i.e.,
foreign direct investment, portfolio investment or remittances) are concerned,
such inflows by their very nature are commercial in nature and enjoy the same
returns and risks, including exchange rate risk, as any other form of domestic
investment or remittance by residents. The cost to the country of such flows is
the same whether they are added to reserves or are matched by equivalent
foreign currency outflow on account of higher imports or investments abroad
by residents. On the whole, under present conditions, it seems that the "cost"
of additional reserves is really a non-issue from a broader macro-economic
point of view.
"Indian interest rates have come down substantially in the last three or four
years. They are, however, still higher than those prevailing in the U.S.,
Europe, U.K. or Japan. This provides an "arbitrage" opportunity to holder of
liquid assets abroad, who may take advantage of higher domestic interest

rates in India leading to a possible short-term upsurge in capital flows.

However, there are several considerations, which indicate that "arbitrage" per
se is unlikely to have been a primary factor in influencing remittances or
investment decisions by NRIs or foreign entities in the recent period. Among
these are :
"The minimum period of deposits by NRIs in Indian rupees is now one
year, and the interest rate on such deposits is subject to a ceiling rate of
2.5 per cent over Libor. This is broadly in line with one-year forward
premium on the dollar in the Indian market (interest rates on dollar
deposits by NRIs are actually below Libor).
"Outside of NRI deposits, investments by Foreign Institutional Investors
(FIIs) in debt funds is subject to an overall cap of only $ 1 billion in the
aggregate. In other words, the possibility of arbitrage by FIIs in respect
of pure debt funds is limited to this low figure of $ 1 billion (excluding
investments in a mix of equity and debt funds).
"Interest rates and yields on liquid securities are highly variable abroad
as well as in India, and the differential between the two rates can
change very sharply within a short time depending on market
expectations. It is interesting to note that the yield on 10 year Treasury
bills in the U.S. had risen to about 4.4 per cent as compared with 5.6
per cent on Government bonds of similar maturity in India at the end of
July 2003. Taking into account the forward premia on dollars and yield
fluctuations, except for brief period, there is likely to be little incentive to
send large amounts of capital to India merely to take advantage of the
interest differential.
" On the whole, it is likely that external flows into India have been motivated by
factors other than pure arbitrage. Figures on sources of reserve accretion
available upto the end of last year (2002-03) confirm this view. It is also
pertinent to note that domestic interest rates among industrial countries also
vary considerably. For example, in Japan, they are close to zero. In the U.K.,
they are above 4 per cent, and in the U.S. about 1.5 per cent. There is no
evidence that capital has been moving out of U.S. to U.K. or Europe merely

on account of interest differential. Within a certain low range, capital flows are
likely to be more influenced by outlook for growth and inflation than pure
arbitrage even among industrial countries with full CAC"
More about Exchange Rate Regime is discussed in the following articles.
Indian Foreign Exchange Market -Basic Information - Exchange Rate Regime
In the earlier article it was specified that the term 'Exchange Rate Regime'
refers to the mechanism, procedures and institutional framework for
determining exchange rates at a point of time and changes in them over time,
including factors which induced the changes. In theory, a very large number of
exchange rate regimes are possible. At two extremes, are the perfectly rigid or
fixed exchange rates, and the perfectly flexible or floating exchange rates.
Between them are hybrids with varying degrees of limited flexibility. The
exchange rate regime of a country determines the parity of its currency to the
major currencies of the world like US Dollar, Pound Sterling and Euro.
Exchange Rate Regime thus implies an international monetary system,
specifying rules and procedures by which different national currencies are
exchanged for each other in world trade. Such a system is necessary to
define a common standard of value for the world's currencies. The first
modern international monetary system was the gold standard. Operating
during the late 19th and early 20th centuries, the gold standard provided for
the free circulation between nations of gold coins of standard specification.
Under the system, gold was the only standard of value. During the 1920s the
gold standard was replaced by the gold bullion standard, under which nations
no longer minted gold coins but backed their currencies with gold bullion and
agreed to buy and sell the bullion at a fixed price. This system, too, was
abandoned in the 1930s.
Finally came the Gold Exchange Standard, which was defined by
Encyclopedia Britannica as the monetary system under which a nation's
currency may be converted into bills of exchange drawn on a country whose
currency is convertible into gold at a stable rate of exchange. A nation on the
gold-exchange standard is thus able to keep its currency at parity with gold
without having to maintain as large a gold reserve as is required under the
gold standard. Although this adjustment process under gold standard worked
automatically, it was not problem-free. The adjustment process could be very
painful, particularly for the deficit country. As its money stock automatically fell,
aggregate demand fell. The result was not just deflation (a fall in prices) but

also high unemployment. In other words, the deficit country could be pushed
into a recession. During the great depression of Thirties the Gold Standard
was finally abandoned.
Bretton Woods System
After the second world war the monetary authorities from the victorious allied
powers, principally the US and UK took up the task of thoroughly overhauling
the world monetary system for the non-communist world. The outcome was
the so called "Bretton Woods system and the birth of two new supra national
institutions the IMF and the World Bank. The exchange rate regime that was
put in place can be characterised as the Gold Exchange Standard. The
Bretton Woods system was history's first example of a fully negotiated
monetary order intended to govern currency relations among sovereign states
It had the following features:
i.

the US Government undertook to convert the US dollar freely into gold

ii.

Other member countries of the IMF agreed to fix the parities of their
currencies vis-a-vis the dollar with variation of 1% on either side of the
central parity being permissible. If the exchange rate hits either of the
limits, the monetary authorities of the country were obliged to defend it
by standing ready to buy or sell dollars against their domestic currency
to any extent required to keep the exchange rate within the limits.

Ultimately it was the United States, still the leading member of the system,
that had to abandon the same in 1971. Concerned about America's rapidly
deteriorating payments situation, as well as rising protectionist sentiment in
the U.S. Congress, President Richard Nixon suspended the convertibility of
the dollar into gold on 15 August 1971, , freeing the dollar to find its own level
in currency markets. With these decisions, both the par value system and the
gold exchange standard, the two central elements of the postwar monetary
regime, were effectively terminated. The Bretton Woods system passed into
history.
Although the post-World War II Bretton Woods regime with its adjustable peg
exchange rate arrangement maintained an indirect link with gold, the
convertibility into gold was abandoned. Henceforth, the goals would be
internal domestic economic stability and especially "full" employment. The net
effect was to set off the Great Inflation of the 1960s and 1970s. The
experience promoted many monetary authorities worldwide to again
emphasize the goal of low inflation and some sort of rules-based monetary

regime. Indeed, by the 1990s a rules-oriented monetary regime became

increasingly popular as a means for restoring and preserving the credibility of
monetary authorities and central banks.
Features of Present Day Exchange Rate Regime of Countries in the World
(Source IMF Publication - www.imf.org/external/pubs/ft/op/193/chap1.pdf )

The exchange rate regimes in todays international monetary and financial

system, and the system itself, are profoundly different in conception and
functioning from those envisaged at the 1944 meeting of Bretton Woods
establishing the IMF and the World Bank. The conceptual foundation of that
system was of fixed but adjustable exchange rates to avoid the undue
volatility thought to characterize floating exchange rates and to prevent
competitive depreciations, while permitting enough flexibility to adjust to
fundamental disequilibrium under international supervision. Capital flows were
expected to play only a limited role in financing payments imbalances and
widespread use of controls would insulate the real economy from instability
arising from short-term capital flows. Temporary official financing of payments
imbalances, mainly through the IMF, would smooth the adjustment process
and avoid undue disturbances to current accounts, trade flows, output, and
employment
In the present system, exchange rates among the major currencies fluctuate
in response to market forces, with significant short-run volatility and
occasional large medium-run swings. International private capital flows
finance substantial current account imbalances, and fluctuations in these
flows appear to be either a cause of major macroeconomic disturbances or an
important channel through which they are transmitted to the international
system. The industrial countries have generally abandoned control and
emerging market economies have gradually moved away from them.
Three features of the modern international monetary and financial
environment are particularly noteworthy. First, the revolution in
telecommunications and information technology has dramatically lowered
transaction costs in financial markets and spurred financial innovation and the
liberalization and deregulation of domestic and international financial
transactions. This, in turn, has facilitated further innovation and capital market
integration. As a result, capital mobility has reached levels not matched since
the heyday of the to move toward increased exchange rate flexibility. gold
standard obstacles to trade in assets have been dramatically reduced and
capital movements are highly sensitive to risk-adjusted yield differentials and
to shifts in perception of risks. Financial markets have also become globalized

in the sense that the balance sheets of major financial and industrial
companies around the world are increasingly interconnected through currency
and capital markets. As a result, shocks to important individual markets or
countries tend to have greater systemic repercussions.
Second, developing countries have been increasingly drawn into the
integrating world economy, in terms of both their trade in goods and services
and in financial assets. As a consequence, these countries have been able to
reap many of the benefits of globalization. However, they also have become
more exposed to some of its risks and dangers, notably to abrupt reversals in
capital flows. At the same time, private capital flows have come to play a
dominant role in emerging economies financing and adjustment.
Third, the emergence of the euro may mark the beginning of a trend toward a
bi- or tri-polar currency system, away from reliance on the U.S. dollar as the
systems dominant currency. An important issue is whether the exchange
rates between major currencies will continue to exhibit the wide swings and
occasional misalignments that characterized the 1980s and 1990s. This is an
important issue for the system as a whole because such swings have
important repercussions for third countriesdeveloping countries, in
particular. For the latter, a wide variety of exchange rate arrangements will
prevail with tendency to move toward increased exchange rate flexibility.
Evolution of Exchange rate Regime in India
During the period 1950-1951 until mid-December 1973, India followed an
exchange rate regime with Rupee linked to the Pound Sterling, except for the
devaluations in 1966 and 1971. When the Pound Sterling floated on June 23,
1972, the Rupees link to the British units was maintained; paralleling the
Pounds depreciation and effecting a de facto devaluation.
On September 24, 1975, the Rupees ties to the Pound Sterling were broken.
India conducted a managed float exchange regime with the Rupees effective
rate placed on a controlled, floating basis and linked to a basket of
currencies of Indias major trading partners.
In early 1990s, the above exchange rate regime came under severe
pressures from the increase in trade deficit and net invisible deficit, which led
the Reserve Bank of India (RBI) to undertake downward adjustment of Rupee
in two stages on July 1 and July 3, 1991. This adjustment was followed by the
introduction of the Liberalized Exchange Rate Management System (LERMS)
in March 1992 and hence the adoption of, for the first time, a dual (official as

well as market determined) exchange rate in India. However, such system

was characterized by an implicit tax on exports resulting from the differential in
the rates of surrender to export proceeds.
Subsequently, in March 1993, the LERMS was replaced by the unified
exchange rate system and hence the system of market determined exchange
rate was adopted. However, the RBI did not relinquish its right to intervene in
the market to enable orderly control.
The exchange rate regime in India has undergone significant changes since
independence and particularly during the beginning of 1990. The following
provides a bird's eye view of major changes.
Year

Type of Change

196
6

The rupee was devalued by 57.5% against the sterling on June 6th.

196
7

Rupee-sterling parity changed as a result of devaluation of sterling.

197
1

Bretton woods system broke down in August. Rupee briefly pegged to the US dollar at rupee 7.5 before repegging to
sterling at Rs.18.967 with a 2.25 % margin on either side.

197
2

Sterling was floated on June 23rd. Rupee sterling parity revalued at Rsa.18.95 and then in October to Rs.18.80

197
5

Rupee pegged to an undisclosed currency basket with margins of 2.25% on either side. Intervention currency was
sterling with a central rate of Rs.18.3084.

197
9

Margins around basket parity widened to 5% on each side in January

199
1

Rupee devalued by 22% between July 1st and July 3rd. Rupee-Dollar rate depreciated from Rs.21.20 to Rs.25.80.

199
2

LERMS (Liberalised Exchange Rate Management System) introduced with 40-60 dual rate for converting export
proceeds, market determined rate for all specified imports and market rate for approved capital transactions

199
3

Unified market determined exchange rate introduced for all transactions. RBI would buy spot US dollar and sell US
dollars for specified purposes. It will not buy or sell forward through it will enter into dollar swaps

In the next two articles we will deal with the historical evolution/development
of the Indian Foreign Exchange Market, a presentation from the Keynote

Address by Dr.Y.V.Reddy, present Governor, RBI at the 3rd South Asian

Assembly,at Katmandu, Nepal, on September 3, 1999. Dr. Reddy was the
Dy.Governor in 1999 when the address was delivered.
PART 17
Development of Forex Markets: Indian Experience
[Keynote Address by Dr.Y.V.Reddy, at the 3rd South Asian Assembly,
at Katmandu, Nepal, on September 3, 1999]

Evolution of Indian Forex-Market

Market players in forex became active in the seventies, consequent upon the
collapse of Bretton Woods Agreement. However, India was somewhat
insulated since stringent exchange controls prevailed and banks were
required to undertake only cover operations and maintain a square or near
square position at all times. In 1978, the RBI allowed banks to undertake
intra-day trading in foreign exchange and as a consequence, the stipulation of
maintaining `square' or `near square' position was to be complied with only at
the close of business hours each day. This perhaps marks the beginning of
forex market in India. As opportunities to make profits began to emerge, the
major banks started quoting two-way prices against the rupee as well as in
cross currencies and gradually, trading volumes began to increase. During the
period, 1975-92 the exchange rate regime in India was characterised by daily
announcement by the RBI of its buying and selling rates to Authorised Dealers
(ADs) for merchant transactions. Given the then prevalent RBIs obligation to
buy and sell unlimited amounts of the intervention currency arising from the
banks merchant purchases, its quotes for buying/selling effectively became
the fulcrum around which the market was operated. The RBI performed a
market-clearing role on a day-to-day basis, which naturally introduced some
variability in the size of reserves. Incidentally, certain categories of current and
capital account transactions on behalf of the Government were directly routed
through the reserves account.
Recommendations of High Level Committee on Balance of Payments
The recommendations of the High Level Committee on Balance of Payments
(Chairman: Shri C. Rangarajan) provided the basic framework for policy
changes in external sector, encompassing exchange rate management and,

current and capital account liberalisation. The Report indicated the transition
path also. Accordingly, the Liberalised Exchange Rate Management System
involving dual exchange rate system was instituted in March 1992, no doubt,
in conjunction with other measures of liberalisation in the areas of trade,
industry and foreign investment. The dual exchange rate system was
essentially a transitional stage leading to the ultimate convergence of the dual
rates made effective from March 1, 1993. This unification of exchange rates
brought about the era of market determined exchange rate regime of rupee,
based on demand and supply in the forex market. It also marks an important
step in the progress towards current account convertibility, which was finally
achieved in August 1994 by accepting Article VIII of the Articles of Agreement
of the International Monetary Fund.
The appointment of a 14 member Expert Group on Foreign Exchange
(Sodhani Committee) in November 1994 was a follow up step to the above
measures, for the development of the foreign exchange market in India. The
Group studied the market in great detail and in its Report of June, 1995 came
up with far-reaching recommendations to develop, deepen and widen the
forex market as also to introduce various products, ensure risk management
and enable efficiency in the forex market by removing restrictions, introducing
new products and tightening internal control and risk management systems.
Implementation of the Recommendations of Sodhani Committee
The Sodhani Committee had made 33 recommendations and of these, 25
recommendations called for action on the part of the RBI. RBI has accepted
and implemented in full or to some degree, 20 out of the 25
recommendations. In the process, the banks have been accorded significant
initiative and freedom to participate in the forex market. These include:
freedom to fix net overnight position limit and gap limits although RBI is
formally approving these limits, replacing the system of across-the board or
RBI prescribed limits; freedom to initiate trading position in the overseas
markets; freedom to borrow or invest funds in the overseas markets (up to 15
per cent of Tier I Capital unless otherwise approved); freedom to determine
the interest rates (subject to a ceiling) and maturity period of Foreign Currency
Non-Resident (FCNR) deposits (not exceeding three years); exempting interbank borrowings from statutory pre-emptions (subject to minimum statutory

requirement of 3 per cent and 25 per cent in respect of Cash Reserve Ratio
(CRR) and Statutory Liquidity Ratio (SLR) for the total net liabilities
respectively); and freedom to use derivative products for asset-liability
management.
Corporates also have been accorded noticeable freedom to operate in the
forex market. Thus, they are permitted to hedge anticipated exposures though
this facility has been temporarily suspended after the Asian crisis. Exchange
Earners Foreign Currency (EEFC) account eligibility has been increased and
the permissible end-uses widened. They were given freedom to cancel and
rebook forward contracts, though currently due to the Asian crisis effect,
freedom to rebook cancelled contracts is suspended while rollover is
permissible. Banks can, however, offer cross-currency options on back-toback basis. Corporates can also avail of lower cost option strategies like
range forwards and ratio range forwards and others as long as they do not
end up as net writers of options. Also available are some degrees of freedom
to manage exposures in External Commercial Borrowings without having to
approach authorities for hedging permission, and to access swaps with rupee
as one of the currencies to hedge longer term exposures.
The Committee recognised that improvements in internal controls and market
strategies go hand in hand with liberalisation and towards this end, RBI
accepted and implemented several suggestions of the Sodhani Committee.
These include: revamping internal control guidelines of the RBI to banks and
making them available to corporates as well; putting in place appropriate
market intervention strategies to deal with market developments; adopting
internationally accepted documentation standards; framing comprehensive
risk management guidelines for banks; adopting Basle Committee norms for
computing foreign exchange position limits and recommending capital backing
for open positions; and setting up a foreign exchange market committee to
discuss market issues and suggest solutions. Recommendation on publishing
critical data on forex transactions, has been implemented, and in fact the
standards of disclosure by RBI are considered to be very high now.
A few recommendations of the Sodhani Committee which have not been
implemented include, inducting Development Financial Institutions (DFIs) as
full-fledged Authorised Dealers (ADs), setting up a forex clearing house,

legally recognising netting of settlements, permitting corporates to undertake

margin trading and setting up of off-shore banking units in Mumbai. Let me
briefly dwell on each of these issues. Induction of DFIs as full-fledged ADs is
linked to future role of development financial institutions and indeed the
approach to universal banking. Till then, their activity in the forex market can
only be incidental to what they are permitted to do as a DFI. The position on
setting up of a Forex Clearing House and the position on setting up of offshore banking units will be detailed in the latter part of this address. Margin
trading by its very nature is considered to be potentially speculative, and
therefore, has not been seriously considered so far for implementation.
Recommndations of Tarapore Committee
Tarapore Committee on Capital Account Convertibility, 1997, had
recommended a number of measures relating to financial markets, especially
forex markets. Some of the measures undertaken in regard to forex may fall
short of the indicative quantitative limits given in the Report, but the purpose
and the spirit of such measures are in line with the recommendations of the
committee. Among such various liberalisation measures undertaken are those
relating to foreign direct investment, portfolio investment, investment in Joint
Ventures/wholly owned subsidiaries abroad, project exports, opening of Indian
corporate offices abroad, raising of EEFC entitlement to 50 per cent, forfaiting,
allowing acceptance credit for exports, allowing FIIs to cover forward their
exposures in debt and part of their exposures in equity market, etc. In respect
of the recommendations of the Committee to develop financial markets also,
significant progress has been made. In the money market, as part of
improving the risk management, recently, guidelines for interest rate swaps
and FRAs have been issued to facilitate hedging of interest rate risks and
orderly development of the fixed income derivatives market. Measures have
also been undertaken to further develop the Government securities market.
Permission has also been given to banks fulfilling certain criteria to import
gold for domestic sale. As will be explained later in this address, this aspect of
gold policy is a major step in bringing off-market forex transactions into forex
markets by officialising import of gold. Efforts are also underway to expedite
the implementation of the announcement made in October 1997 by RBI to

permit SEBI registered Indian fund managers including Mutual Funds to invest
in overseas markets subject to SEBI guidelines.
Features of Forex Market
There are several features of Indian forex market which, are briefly stated as
under.
Participants
The foreign exchange market in India comprises of customers, Authorised
Dealers (ADs) in foreign exchange and Reserve Bank of India. The ADs are
essentially banks authorised by RBI to do foreign exchange business. Major
public sector units, corporates and other business entities with foreign
exchange exposure, access the foreign exchange market through the
intermediation of ADs. The foreign exchange market operates from major
centres - Mumbai, Delhi, Calcutta, Chennai, Bangalore, Kochi and
Ahmedabad, with Mumbai accounting for the major portion of the transactions.
Foreign Exchange Dealers Association of India (FEDAI) plays an important
role in the forex market as it sets the ground rules for fixation of commissions
and other charges and also involves itself in matters of mutual interest of the
Authorised Dealers. The customer segment is dominated by Indian Oil
Corporation and certain other large public sector units like Oil and Natural Gas
Commission, Bharat Heavy Electricals Limited, Steel Authority of India
Limited, Maruti Udyog and also Government of India (for defence and civil
debt service) on the one hand and large private sector corporates like
Reliance Group, Tata Group, Larsen and Tubro, etc., on the other. Of late, the
Foreign Institutional Investors (FIIs) have emerged as a major component in
the foreign exchange market and they do account for noticeable activity in the
market.
Segments
The foreign exchange market can be classified into two segments. The
merchant segment consists of the transactions put through by customers to
meet their transaction needs of acquiring/offloading foreign exchange, and
inter-bank segment encompassing transactions between banks. At present,

there are over 100 ADs operating in the foreign exchange market. The banks
deal among themselves directly or through foreign exchange brokers. The
inter-bank segment of the forex market is dominated by few large Indian
banks with State Bank of India (SBI) accounting for a large portion of turnover,
and a few foreign banks with benefit of significant international experience.
Market Makers
In the inter-bank market, SBI along with a few other banks may be considered
as the market-makers, i.e., banks which are always ready to quote two-way
prices both in the spot and swap segments. The market makers are expected
to make a good price with narrow spreads both in the spot and the swap
segments. The efficiency and liquidity of a market are often gauged in terms of
bid-offer spreads. Wide spreads are an indication of an illiquid market or a one
way market or a nervous condition in the market. In India, the normal spot
market quote has a spread of 0.5 to one paisa, while the swap quotes are
available at 2 to 4 paise spread. At times of volatility, the spread widens to 5 to
10 paise.
Turnover
The turnover in the Indian forex market has been increasing over the years.
The average daily gross turnover in the dollar-rupee segment of the Indian
forex market (merchant plus inter-bank) was in the vicinity of US $ 3.0 billion
during 1998-99. The daily turnover in the merchant segment of the dollarrupee segment of foreign exchange market was US $ 0.7 billion, while
turnover in the inter-bank segment was US $ 2.3 billion. Looking at the data
from the angle of spot and forward market, the data reveals that the average
daily turnover in the spot market was around US $ 1.2 billion and in the
forward and swap market the daily turnover was US$ 1.8 billion during 199899.
Forward Market
The forward market in our country is active up to six months where two way
quotes are available. As a result of the initiatives of the RBI, the maturity
profile has since recently elongated and there are quotes available up to one

year. In India, the link between the forward premia and interest rate differential
seems to work largely through leads and lags. Importers and exporters do
influence the forward markets through availment of/grant of credit to overseas
parties. Importers can move between sight payment and 180 days usance
and will do so depending on the overseas interest rate, local interest rate and
views on the future spot rate. Similarly, importers can move between rupee
credit and foreign currency credit. Also, the decision, to hedge or not to hedge
exposure depending on expectations and forward premia, itself affects the
forward premia as also the spot rate. Exporters can also delay payments or
receive funds earlier, subject to conditions on repatriation and surrender,
depending upon the interest on rupee credit, the premia and interest rate
overseas. Similarly, decision to draw bills on sight/usance basis is influenced
by spot market expectations and domestic interest rates. The freedom to avail
of pre/post-shipment credit in forex and switch between rupee and foreign
currency credit has also integrated the money and forex markets. Further,
banks were allowed to grant foreign currency loans out of FCNR (B) liabilities
and this too facilitated integration as such foreign currency demarcated loans
did not have any use restriction. The integration is also achieved through
banks swapping/unswapping FCNR (B) deposits. If the liquidity is
considerable and call rates are easy, banks consider deployment either in
forex, government or money/repo market. This decision also affects the
premia. Gradually, with the opening up of the capital account, the forward
premia is getting aligned with the interest rate differential. However, the fact
remains that free movement in capital account is only a necessary condition
for full development of forward and other forex derivatives market. The
sufficient condition is provided by a deep and liquid money market with a welldefined yield curve in place. Developing a well integrated, consistent and
meaningful yield curve requires considerable market development in terms of
both volume and liquidity in various time and market segments. No doubt, the
integration between the domestic market and the overseas market operates
more often through the forward market. This integration is facilitated now by
allowing ADs to borrow from their overseas offices/correspondents and invest
funds in overseas money market up to the same amount.
Data on Forex Markets

The RBI publishes daily data on exchange rates, forward premia, foreign
exchange turnover etc. in the Weekly Statistical Supplement (WSS) of the RBI
Bulletin with a lag of one week. The movement in foreign exchange reserves
of the RBI on a weekly basis are furnished in the same publication. The RBI
also publishes data on Nominal Effective Exchange Rate (NEER) and Real
Effective Exchange Rate (REER), RBI's purchases and sales in the foreign
exchange market along with outstanding forward liabilities on reserves etc. in
the monthly RBI Bulletin with a time lag of one month. Since July 1998, the
Reserve Bank of India started publishing the 5-country trade based NEER and
REER in addition to 36-country NEER and REER in the RBI Bulletin. Way
ahead of many developing and industrial country central banks, the RBI has
been publishing the size of its gross intervention (purchase and sale) each
month and its net forward liability position
Development of Forex Markets: Indian Experience
[Keynote Address by Dr.Y.V.Reddy, at the 3rd South Asian Assembly,
at Katmandu, Nepal, on September 3, 1999]

Linkages among Markets and Policy Responses

Since the introduction of the reform measures, broad segments of the market, viz., money market,
Government securities market, capital market, and foreign exchange market, have exhibited some degree
of integration. The markets have become inter-linked to the extent participants can move freely from one
market to another. The linkages between the forex market and domestic markets essentially depend on
the foreign currency liabilities and assets banks can maintain and the extent and degree to which they are
swapped into rupees and vice versa. Thus, on the liabilities side, we have foreign currency borrowings
from overseas offices/correspondents, borrowings for lending to exporters, FCNR-B deposits and
EEFC/RFC deposits. These funds can be used either for raising rupee resources through swaps or for
lending in foreign currency. A significant step was taken by the RBI when it allowed banks to lend in
foreign currency to companies in India for any productive purpose without linking to exports or import
financing. This effectively meant that companies had the choice to borrow either in foreign currency or
rupees depending on the cost, taking into account both exchange risk and interest cost. Thus, companies
can substitute rupee credit for foreign credit freely. Similarly, exporters also have the ability to substitute
rupee credit for foreign currency credit.
The integration of foreign exchange market with other markets like money market and government
securities market meant closer co-ordination of monetary and exchange rate policy. For instance, in
January 1998, when the foreign exchange market came under severe pressure, Reserve Bank of India
undertook strong monetary policy measures leading to sharp withdrawal of liquidity and increase in shortterm interest rates. The impact of monetary management was such that by February 1998 orderly
conditions were restored in the forex market and normalcy was attained in money market. At times of
highly speculative exchange rate movements, simultaneous intervention in foreign exchange and
domestic market is called for to have an immediate strong effect on both the exchange rate and money
market conditions. Thus, to maximise the effectiveness of the foreign exchange market intervention as a

signaling device, it is also carefully co-ordinated with monetary management. These co-ordinated
intervention strategies require close day-to-day monitoring of the supply of banking system liquidity and
an active use of open market operations to adjust liquidity conditions. However, driving a wedge between
money and forex markets at times, becomes necessary when it is felt that liquidity conditions may put
pressure on the forex market, while tightening liquidity could hurt the real sector.
The recent initiatives of RBI to usher in the rupee interest rate derivatives should facilitate the
development of rupee term money market and define the rupee yield curve across maturities. Besides
bringing about greater integration of the money and forex markets, the move has set the stage for the
take-off of rupee-foreign currency derivatives.
Unique Features of Indian Forex Market
Gold Policy
Liberalisation of gold policy had an indirect but, significant impact on the forex market. The logic behind
the changes in the gold policy was explained in my earlier speeches on the subjects of capital flight and
gold. The major thrust of the liberalisation process in gold policy centred around opening up of additional
channels of import, a logical consequence of which was the reduction in differential between the
international and domestic price of gold. The price differential of gold was as high as 67 per cent in 1992
when the structural reform process was initiated; it fell to 6 per cent by the end of 1998. The unofficial
market in foreign exchange which drew its sustenance from the illegal trade in gold went out of existence
as an immediate fall out. In essence, the import of gold which was largely on unofficial account in earlier
years, was officialised, and correspondingly the foreign exchange used to finance such unofficial imports
was also officialised, mainly through enhanced flow under invisibles account.
NRI Deposits
Various deposit schemes have been designed from time to time to suit the requirements of non-resident
Indians (NRIs). Currently, we have three NRI deposit schemes, viz., Non Resident External (NRE)
account which is denominated in rupees, Non Resident Non Repatriable (NRNR) account, which is nonrepatriable rupee account except for the interest component which is repatriable, and the Foreign
Currency Non Resident (Bank) (FCNR-B) account which is a foreign currency account. Banks have also
been allowed considerable freedom in deployment of these funds. Of interest to forex markets is the
operation of FCNR-B scheme, because banks have to bear exchange risk. Banks either hold these
deposits in foreign currency investing them abroad or lend in foreign currency to corporates in India or
swap into rupees and lend to Indian corporates in rupees. When corporates borrow in foreign currency,
there is an inflow into the market but there may be hedging by corporates. When banks swap into rupees
and lend, there is an impact on forex markets but forward premia and lending rates in rupees are critical.
Thus, tracking the use of FCNR (B) deposits is essential in appreciating forex markets.
Public Enterprises
Operations of large public sector undertakings have a significant impact especially on spot market, and
their procedures for purchase or sale of foreign currency also impact on market sentiments. To this end,
and in order to enable Public Sector Enterprises (PSEs) to equip themselves in formulating an approach
to management of foreign currency exposure related risks, the Government of India had set up a
Committee in January 1998. The Report of the Committee explicitly brings out the approach that is

appropriate for risk management with reference to the foreign currency exposure of PSEs. PSEs with
large volume of foreign exchange exposure were also advised by the Committee to consider setting up
Dealing Room for undertaking treasury functions both for rupee and foreign exchange which include
management of rupee resources, foreign exchange transactions and risk management. Adoption of
approaches recommended would enable the PSEs to spread their demand and supply in forex market, in
a non-disruptive way to the benefit of both the PSE concerned and functioning of forex market in India.
Off-shore Banking Units
The setting up of Off-shore banking units at this advanced stage of financial liberalisation in our country is
considered by many to be unnecessary and that the time for an offshore banking unit has gone. In a
country of our size, the issue of linkages between off-shore sector and the domestic sector is undoubtedly
an important one. We need to make a clear distinction between the financial issues and the non-financial
issues on the subject. From the central bank's perspective, designing appropriate regulatory framework is
important and the most important issue is ensuring of a firewall between the off-shore transactions and
domestic transactions. Physical location is not relevant, especially when deposit taking and cash
transactions are not permitted in off-shore business. In fact, we do not have a good model of real offshore centre in a country with capital controls. Confederation of Indian Industry (CII) with assistance from
the Government of Maharashtra is engaged in a detailed study of the various issues to make
recommendations to the RBI and the Government of India.
Clearing House
The idea of establishing a Foreign Exchange Clearing House (FXCH) in India was mooted in 1994. The
Expert Group on Foreign Exchange Markets in India also recommended introduction of foreign exchange
clearing and making netting legally enforceable. The Scheme was conceived as multilateral netting
arrangement of inter-bank forex transactions in US dollar. The membership would be open to all ADs in
foreign exchange participating in the inter-bank foreign exchange market. RBI will also be a participating
member. The net position of each bank arrived at the end of the trading day would be settled through a
Clearing Account to be maintained by RBI. It was recognised that a substantial reduction in number of
Nostro account transactions of the participating banks would lead to economy in settlement cost and
efficiency in settlement. Other benefits include easing the process of reconciliation of Nostro accounts
balances by banks, reduction in size of credit and liquidity exposure of participating banks and hence
systemic risk, etc. The long-term objective is to establish clearing house as a separate legal entity with
risk and liquidity management features, infrastructure and operational efficiency akin to other leading
clearing systems. However, to start with, we may aim at commencing the operation with such minimum
modification to the scheme as may be necessary. For the present, the focus areas are legal, risk and
liquidity aspects and operational infrastructure, and all these issues are under examination in the RBI.
Role of FEDAI
In a regime where exchange rates were fixed and there were restrictions on outflow of foreign exchange,
the RBI encouraged the banks to constitute a self regulatory body and lay down rules for the conduct of
forex business. In order to ensure that all the banks participated in the arrangement, the RBI placed a
condition while issuing foreign exchange licence that every licensee agree to be bound by the rules laid
down by the bankers body the FEDAI. FEDAI also accredited brokers through whom the banks put
through deals. There is increasing emphasis now on competition, and fixing or advising charges by
professional bodies is being viewed with disfavour and often treated as a restrictive trading practice. It is

currently argued by some that with the growth in volumes and giant strides in telecommunication, banks
may no longer need to deal through brokers when efficient match making arrangements exist. As in some
other markets, the deals are concluded on the basis of voice broking and it is sometimes held that this
often results in conclusion of deals which are less than transparent, evidenced by instances where deals
have been called off on payment of differences. Under the circumstances, there is perhaps a need to
review several aspects, viz., compatibility of advising or prescribing fees with pro-competition policy; role
of brokers; electronic dealing vis--vis voice broking; and relationship between the RBI, FEDAI and
authorised dealers.
Issues that Require Further Consideration

First, there are some limits on freedom accorded to banks, such as ones on borrowing and
investing overseas; ceilings on interest rates and maturities of non-resident foreign currency
deposits; and these could be reviewed at appropriate time, with a view to liberalising them
prudently.

Second, the medium-term objective of reducing cash reserve requirements to the minimum
prescribed in the statute and the longer term objective of proposing amendments to the statute to
make all the reserve requirements flexible will be pursued, consistent with developments in fiscal
and monetary conditions.

Third, the restoration of freedom to corporates to hedge anticipated exposures is continuously

under review. However, the issue of restoration of facility to rebook cancelled contracts needs to
be reviewed with caution.

Fourth, the extension of facility of forward cover to FIIs is also under continuous review, though
facilities available now are yet to be fully utilised by FIIs.

Fifth, trading in derivatives is a desirable objective, but a number of preconditions are to be

satisfied in the matter of institutional as well as regulatory arrangements. This is a complex task,
but certainly is on the agenda of reform.

Sixth, setting up a forex clearing house is on the agenda and it is essential to design it on par with
other leading clearing systems in the world.

Seventh, a number of recommendations of Tarapore Committee have been accepted, and others
are also reviewed from time to time. A view will have to be taken on each one of them only in the
context of overall liberalisation of capital account, which in turn, depends on, among other things,
progress of our financial sector reforms and evolving international financial architecture.

Eighth, development of deep and liquid money market with a well-defined yield curve in place is
an accepted objective of RBI. The actions taken and those contemplated to perform this hard task
have already been articulated in my earlier speeches on money and debt markets, and the recent
Monetary and Credit Policy Statement of April 1999 has provided evidence of RBI's approach in
this regard.

Ninth, implementation of the recommendations of the Report on Public Sector Enterprises will
facilitate the efficient management of their foreign currency risks and also even out lumpy
demand and supply situations in the forex market.

Tenth, while there is a dominant view that setting up Mumbai as an off-shore financial centre is no
longer a necessity, the views of CII, which is posing the issue, may have to be awaited and
considered seriously.

Eleventh, in any effort to develop markets, role of self regulatory bodies is critical. The role of
FEDAI in achieving greater competition, efficiency and transparency in the forex markets needs
to be reviewed on a continuous basis, so as to keep pace with developments in technology and
financial sector reforms.

Twelfth, a number of legislative changes are under contemplation, and of these the ones relating
to Foreign Exchange Management and Money Laundering are critical to development of forex
markets. Harmonisation between existing institutions, regulations and practices, including
transition path to new legislative framework would be a significant task in the context of forex
market development.

Thirteenth, several representations have been received by Regulations Review Authority to

simplify, streamline and rationalise some of the regulatory and reporting requirements pertinent to
foreign exchange. The RRA should be taking a final view in the matter, on the basis of expected
report of group of Amicus Curiae, within a few weeks.

Fourteenth, in the area of technology, on-line connectivity has been initiated in respect of data
transmission by market to the RBI. Once this system is fully established, it will lead to a very
prompt and effective on-line monitoring by RBI as well as reduction in multiplicity of reporting
statements. Similarly, initiatives are underway to expedite back office linkage between banks
themselves and with RBI for settlement, which will fructify once the VSAT is fully operational.
Conclusion

To conclude, the medium-term objective of developing an efficient and vibrant forex market continues to
be an important priority within the overall framework of development of financial markets. Naturally, the
pace and sequencing have to be determined by both the domestic and international developments. In
particular, the unique features of Indian forex markets, legal, institutional and technological factors, and
developments related to macro-economic policies would govern the path of moving towards the mediumterm objective, without sacrificing freedom in tactical measures to respond to unforeseen circumstances
in the very short-term.

PART 18
Exchange Market Management by RBI in the Post Liberalisation Period &
Capital Account Convertibility
[Key Note Address at the Assembly of the Forex Dealers' Association of India at Bangalore on
September 28, 2002 delivered by Smt K.J.Udeshi, Executive Director, RBI]

Regulation of foreign exchange market by RBI is indeed verfy effective in recent years with forex reserves burgeoning on a
continuous basis. The speech sets out the rationale of the changes in exchange control in the context of the overall policy
of liberalisation and move towards full capital account convertibility in the background of widespread expectations in the
external sector, that India is marked out as a country which has opted for a gradual and measured liberalisation.

We have completed a decade of liberalisation in the foreign exchange market.

The exchange rate policy has been fashioned, more specifically after 1992, to
enhance the role of market forces without disrupting the basic fabric of the
market structure. There has been consistent effort to bring about selective
linkage between the global and domestic money markets through the forex
market. With these objectives in view over the years operational freedom both
to the end users and the intermediaries have been extended
The Onset of Market Determined Exchange Rate
The major change came about in 1992 with LERMS and subsequently unified
exchange rate in 1993 when RBI withdrew from fixing daily prices in currency.
While the unification of exchange rates and a market determined exchange
rate regime was a major step in the liberalisation process there was also
progressive liberalisation of transactions both on current and capital accounts.
The introduction of the direct quotation system in 1993 and the termination of
RBI announcing it's buying and selling rates in 1995 were important miles
stones in moving towards a market determined exchange rate.
The dilemma posed to the policy makers was to manage volatility without
deviating from the path of market development.
How RBI as Market Regulator Dealt with Volatalities in Exchange Rate
Movement
RBI's response to volatile exchange rate movements has been a combination
of monetary policy and administrative measures together with intervention. A
significant change in approach was made in 1998 following the sharp volatility
experienced in international markets. The provisions, which allowed incentives
for speculation to end-users and intermediaries, were identified and
withdrawn. The focus of operation shifted directly from intervening in the
market to identifying those demands that could rectify the imbalance viz. oils
payments and bunched demands were smoothened by RBI. The RBI does not
target any exchange rate or resist fundamentals. Thus leads and lags have

become the major focus of exchange rate management. The RBI's operations
have all along aimed at evening out the imbalances and smoothening the
process of two-way changes. The market has developed greater strength, has
become much deeper and liquid, credibility of the currency has enhanced in
the eyes of the global players and greater confidence in the system among
investors. The entire spectrum of relaxations which were temporarily
withdrawn have been more or less restored. The Central Bank and the market
participants are exploring issues at the frontiers and I do hope that tomorrows'
deliberations will be constructive and enable us to jointly forge ahead.
A careful analysis of the RBI's stance would reveal the balance it had to
establish between freedom on flows in the capital account and the need for
increasing the degree of operational freedom to the market participants. The
objective was to ensure efficient price discovery mechanism reflecting the
economic fundamentals not distorted by the speculative instincts of a few. The
issue of volatility is not the preoccupation of only the RBI. As recently as 20th
September 2002 the Bank of England Governor stated and I quote "The recent volatilities seen in the financial markets are frustrating. The
movements are disjointed from the economic fundamentals."
Earlier in the year in the context of the USD gyrations US Treasury Secretary
stated :
"...The people who benefit from roiling the world currency market are
speculators and as far as I am concerned they provide not much useful
value."
RBI had to craft a careful strategy to address the elements of speculation
without injuring the genuine interests of the market players. The endeavour to
develop a deep and liquid market reflecting domestic and global realities
within our constraints has been preserved
The market today provides freedom for risk management, freedom for asset
substitution, freedom for taking limited view on rates by corporates without
foreign currency exposures, freedom for anticipatory cover. The basic
philosophy around which the market has been built is that any entrant to the
market must have an underlying exposure. As stated by the Reserve Bank
Governor, today we can look back at the developments with a reasonable
degree of satisfaction.

The issue of capital account convertibility (CAC) is discussed in the second

part of the speech and covered in the next article.
Observations made by the then Governor of RBI, Dr.Bimal Jalan about the
policy of exchange rate management by RBI are appropriate in this context
and are quoted here below:
"......what should be the correct or right policy stance for the management of
exchange rate in India in the present environment? In RBIs periodic credit
policy statements, as well as other public statements, RBI has highlighted the
main pillars of its strategy for the management of the exchange rate. These
are: RBI does not have a fixed "target" for the exchange rate which it tries to
defend or pursue over time; RBI is prepared to intervene in the market to
dampen excessive volatility as and when necessary; RBIs purchases or sales
of foreign currency are undertaken through a number of banks and are
generally discrete and smooth; and market operations and exchange rate
movement should, in principle, be transaction-oriented rather than purely
speculative in nature.
"It is perhaps fair to say that the actual results of the exchange rate policy
followed by the RBI, since the Asian crisis in particular, have been highly
positive so far. In addition to sharp increase in reserves and generally
"orderly" movements in exchange rates with lower volatility, the confidence
level of domestic and foreign investors in the Indian external sector policies is
strong. Indias policies have also been described by the IMF as being
"comparable to the global best practices" in a recent study of 20 select
industrial and developing countries. Interestingly, a leading global news
agency, in an international journal, has recently described Indias currency
model as being "ideal" for Asia. India is now one of the very few developing
countries which has set up its own clearing house for dollar-rupee transaction
with the concurrence of the Federal Reserve System, New York"
[Quoted from the speech of Dr.Bimal Jalan, then Governor, RBI, delivered on
August 14, 2003 at 14th National Assembly of Forex Association of India]
Convertibility of Exchange Rate - FAQ
- - - : ( o0o ) : - - 1. Give a brief account of Exchange Rate Developments that took place after
the B.O.P. crisis of 1992

In the year 1990-91 balance of payments position facing the country became
critical and foreign exchange reserves had been depleted to dangerously low
levels. Imports had to be severely curtailed in the course 1990-91 because of
shortage of foreign exchange. Importers were asked to deposit an amount
equal to 200% of the L.C. value with Banks in advance to be eligible for
getting the L.Cs opened. This affected the availability of many essential items
and also led to distinct slow down of industrial growth.
The urgent need of the hour was assessed as under:1. To aim at quick revival of the momentum of exports.
2. To create strong incentives to economise on imports, without resorting
to proliferation of licensing controls, which promote delay and
inefficiency, generate arbitrariness and stifle enterprise.
3. There was urgent need to create an environment free from Bureaucratic
controls in which our exporters will be able to respond with speed and
flexibility to changing international conditions.
4. To recognise the change that is taking place in the world economy,
where countries are shedding isolation ands getting increasingly
integrated, and to shape our economic policies as part of the prevailing
global environment.
Government announced an initial package of trade policy reforms on 4th July
1991. Its main features are as under:
1. Essential imports such as POL and fertilizers were fully protected.
2. Import of other raw materials and components were linked to export
performance through an enlargement and restructuring of the
replenishment licensing system.
3. A tradeable Exim Scrip allowing for free foreign exchange for import of
goods up to 30% of the F.O.B. export value was allowed to exporters.
These scrips were freely tradable in the open market, which fetched
about 30% premium to the exporters.
4. Government abolished cash compensatory support for exporters.
5. Licensing complexities were reduced.

6. In view of procedural anomalies the Exim Scrip system was

subsequently withdrawn and Government announced partial
convertibility of the rupee in the Central Budget for 1992-93 by way of a
dual exchange system, which allowed conversion of 60% of the foreign
exchange earnings at the rate determined in the foreign exchange
market. The balance 40% foreign exchange was to be surrendered to
the Reserve Bank at official exchange rate for financing of essential
imports. The exporters were getting a rate equivalent to the weighted
average of market rate (for 60%) and official rate (for 40%), while private
imports were paid at market rates.
7. Shortly thereafter in March 1992, the Government announced 100%
convertibility on Current Account, under which 100% foreign exchange
earnings can be converted at market rates.
After years of administered exchange rate full convertibility came to India. A
fully convertible currency provides freedom to both residents and nonresidents to trade in goods, services and assets, thereby, integrates the
domestic economy into the world economy. Convertibility in current account
along with trade liberalization measures are bound to enhance
competitiveness of domestic tradables and make world prices to prevail in the
domestic economy. Convertibility measures that accompany the easing of
controls on foreign investment and capital inflows are expected to boost
technology transfers and enhance productive growth of the domestic
economic distortions of an otherwise inward looking trade regime.
The rupee convertibility process has thus been implemented since July 1991,
involving several important elements as under:
a. The relaxation of QR (Quantitative Restrictions) Regime involving import
quotas and licensing.
b. The reduction of the level and dispersions of import tariff rates
c. The elimination of several export subsidization schemes;
d. The liberalization of exchange restrictions on capital inflows, particularly
the inflow the foreign direct and portfolio investments, and
e. The introduction of market driven exchange rates of the rupee, instead
of administered system through the mechanism of basket peg

Full convertibility of the currency does not prevent our discretion to protect our
essential trade interests. Generally countries with currency convertibility have
practiced various degree of controls to suit national interests from time to time.
Full convertibility does not mean the unrestricted use of rupee for all types of
external transactions. All transactions are still conducted within the framework
of exchange controls, as prescribed by the R.B.I. On trade account and on
account of the receipt side of the invisible, the rupee is fully convertible at
market determined exchange rates. The payment side of the invisible and
receipts and payment of capital account are subject to exchange control.
However exchange rate for all these permissible transactions are undertaken
at free market exchange rates.
- - - : ( o0o ) : - - 2.Define "Convertibility"
In a strict sense a currency can be considered convertible, only if both
residents and non-residents have full freedom to use and exchange it for any
purpose whatsoever, at some definite rate of exchange. However in practice
large number of currencies are considered convertible with various degrees of
restrictions and controls.
The International Monetary Fund provides a working definition of convertibility
under Article VIII, which states as under:No member shall, without the approval of the fund, impose restrictions on
making of payment and transfers for current transactions.
The IMF concept considers convertibility only for current account transactions,
thus leaving at the discretion of the country to regulate flows on capital
account. Generally countries with currency convertibility have practised
various degree of controls to suit their national interests from time to time.
Thus currency convertibility implies absence of restrictions on foreign
exchange transactions and not necessarily on trade or capital flow. This point
has been clarified properly by IMF, which states as under:Thus, although measure formulated as quantitative limitation on imports will
have the indirect effect, it is not for that reason a restriction on payments
within the meaning of the provisionRestrictions on trade do not become
restrictions on payment within the meaning of Article VIII, because they are
imposed for balance of payments reasons.

Under the present floating system, exporters can realise their entire export
earnings at the free market rate. All imports, including the Government imports
consisting of petroleum, food, fertilizers and defence have to be paid at free
market rates. The substance of convertibility efforts is to dispense with the
discretionary management of foreign exchange and exchange rates and to
adopt a more liberal and market driven exchange allocation process. It needs
to be noted that here that the full convertibility does not mean the unrestricted
use of the rupee for all types of Indias external transactions. All transactions
are still conducted within the framework of exchange controls, as prescribed
by the R.B.I.
The full convertibility features are LERMS (Liberalized Exchange Control
Management System) and its main features are summarised as under: The exchange rates of the rupee are determined by the free market
forces of demand and supply. Free market rates are quoted by
authorised dealers (ADs).
Like any other market prices, the exchange rates both spot and forward
can vary within a day, between days and even around medium term
rend.
All commercial transactions in the current account and capital account
are undertaken at the free-market driven rates, whether on government
or private account.
Foreign exchange remittances abroad are subject to exchange control
regulations although the AD can remit in many areas upto certain
amounts without Reserve Banks permission. This implies full
convertibility is not applicable to the invisible trade.
All export proceeds and inward remittances need to be surrendered with
a 156% retention option in a foreign currency account with the AD.
The intervention currency continues to be U.S. dollar, which the
Reserve Bank can buy and sell from and to the Ads at its discretion.
This route can provide temporary stability in the exchange markets.
The Reserve Bank provides two way quotes of the U.S. Dollar, which
can change several times in a day, depending on market pressures.

 The Reserve Bank will not ordinarily buy or sell any other currency,
either spot ort forward; rather will undertake swap transactions with the
Ads. A swap involves the Reserve Bank buying the U.S. Dollar spot and
selling forward simultaneously for delivery in two to six months.
The RBI will sell U.S. Dollars to the AD at the market rate, for debt
service payments on Government Account and other payments, only a
transitory arrangement, such as for meeting 40% value of imports under
advance licences, special import licences, REP licences for import of
raw materials, gems and jewellery exports, and for meeting the full
value of imports under the outstanding EXIM scrips and such other
licences treated on part with these scrips.
For trade with Russian Republics where the invoicing is in freely
convertible currency the market related exchange rate are applicable.
Transactions routed through the ACU arrangement (except those settled
in the Indian rupees) will be based on Reserve Banks rate for ACU
currencies and for the Asian Monetary Unit.
- - - : ( o0o ) : - - 3. What do you understand by the term Current Account and Capital
Account Convertibility?
Current account includes all transactions, which give rise to or use of our
National income, while Capital Account consist of short term and long term
capital transactions.
Current Account Transactions covers the following.
1. All imports and exports of merchandise
2. Invisible Exports and Imports (sale/purchase of services)
3. Inward private remittances to & fro
4. Pension payments (to & fro)
5. Government Grants (both ways)
Capital Account transactions consist of the following:

1. Direct Foreign Investments (both inward & outward)

2. Investment in securities (both ways)
3. Other Investments (both ways)
4. Government Loans (both ways)
5. Short-term investments on both directions
The substance of convertibility is to dispense with the discretionary
management of foreign exchange and exchange rates and to adopt a more
liberal and market driven exchange allocation process. All transactions are still
conducted within the framework of exchange controls, as prescribed by the
RBI. Full convertibility on current account is manifested as below:
On trade account and on account of the receipt side of the invisibles,
the rupee is fully convertible at market determined exchange rates
The payment side of the invisible and receipts and payments of capital
account are subject to exchange control.
However, exchange rates for all these permissible transactions are
undertaken at the free market exchange rates.
Capital Account is deemed convertible when residents and non-residents are
allowed to effect such transactions without any restrictions i.e. without prior
permission of the RBI. In such a context without any restrictions Indians
should be able to secured foreign direct investment from abroad. Foreigners
at their discretion should be able to make portfolio investments in this country.
Presently these transactions are subject to prior permission of R.B.I. However
R.B.I. is following a constructive and promotional approach and encouraging
foreign investments in India. Indian Industrialist having good projects for direct
foreign investment or foreign institutional investors desiring to make portfolio
investments in this country are encouraged and they do not face problems on
account of exchange control by R.B.I. Exchange control is limited to exchange
monitoring.
Convertibility of Exchange Rate - FAQ (Part: 2)
- - - : ( o0o ) : - - -

How convertibility was achieved through LERMS?

LERMS representing Liberalised Exchange Management System was
introduced in the year 1992 as part of a package of reforms intended to
secure instant and permanent remedies for the problems ailing the Indian
economy at that time. Some of the problems facing the country at that timer
were as under:1. The balance of payments position facing the country had become
critical and foreign exchange reserves had depleted to dangerously low
levels i.e. $585 million, which was sufficient for financing just one week
of Indias exports.
2. . Export momentum built during 1986-87 to 1989-90 was lost and
exports decelerated to 9% in U.S. Dollars.
3. Imports had to be severely curbed in 1990-91 because of shortage of
foreign exchange. This affected the availability of many essential items
and also led to a distinct slow down in industrial growth.
4. Inflation was rocking the country and fiscal deficit was going
uncontrolled, resulting domestic prices unfavourable for export
promotion.
5. The system of administered exchange allocations and rate fixation gave
rise to parallel markets in foreign exchange, trade mis-invoicing and
capital flights. Persons who required foreign exchange and were unable
to get the same under the regulations in force had recourse to the
hawala markets and brought the required foreign exchange at premium
rates. Exporters under-invoiced their export earnings and moved away
foreign exchange abroad or repatriated the same at a premium through
the hawala route. There was considerable leakage of accruals in foreign
exchange earnings due to NRI remittances being routed through these
markets.
6. The unauthorised market also acted as conduits for financing smuggling
operations into and out of the country. The black market for foreign
exchange was supported by the unofficial gold movements into India.
7. There was urgent need to usher in a policy to end economic isolation of
the country, remove the controlled economic regime, and follow market
oriented economic policy to link India with the global economy

The package of urgent economic reforms not only to put an end to the above
problems facing the country, but also to permanently curb their occurrence
included the following:
i.

The Liberalised Exchange Control Management Scheme

ii.

A liberal trade policy for both exports and imports

iii.

Curbing fiscal deficit and government spending and hold inflation under
control

In March 1992 the Government announced the full convertibility of the Rupee
in Current Account. A fully convertible rupee provides full freedom to both
residents and non-residents to trade in goods, services and assets, thereby to
integrate the domestic economy into the world economy. Convertibility on
current account along with trade liberalization measures has enhanced the
competitiveness of the domestic tradables and has made the world prices to
prevail in the domestic economy. The rupee convertibility process has been
implemented since July 1991, involving several important elements:
The relaxation of quantitative restrictions on imports by doing away with
import quotas and licensing.
The reduction of the level and dispersion of import tariff rates
The elimination of several export subsidization schemes
The liberalization of exchange restrictions on capital flows, particularly
the inflow in foreign direct investments and portfolio investments, and
Introduction of the market-driven exchange rates of the rupee, instead
of the administered system through the mechanism of the basket-peg.
Liberalization of Trade Policy:
1. In July 91, trade policy introduced EXIM scrips at a standard rate of 30
per cent of the FOB value of exports to Exporters. These scrips were
freely tradable in the open market, which fetched about 30% premium to
the exporters.
2. Due to operational difficulties the system of EXIM scrips were abolished
in 1992-93 budget and the partial convertibility of the rupee was

introduced with effect from 1st March 1992. whereby 60% of all exports
and inward remittances were convertible into rupees at the market
determined rates and the remaining 40 per cent being surrendered to
Reserve Bank at the official exchange rate for financing of the essential
imports.
3. A new export and import policy (EXIM Policy) came into force on 1st
April 1992. The new EXIM policy allows licence-free import of all goods
except those specified in the negative list. The negative list contained 3
banned items, 68 restricted items and canalised items.
4. The EPGC (Export Promotion Capital Goods) allowed exporters to
import capita goods at concessional duty subject to prescribed export
obligation.
5. With regards to exports a negative list of 79 items was drawn up. Of
these 7 items are banned items, 51 items are exportable subject to
licensing, 11 items are exportable subject to quantitative ceilings and 10
items are exported through canalising agencies
It is in this background that the full convertibility of the rupee in Current
Account was announced. The measure abolished the dual exchange system,
and thus it completely floats the rupee in the market exchange markets. Under
the present float, exporters an realise their entire earnings at the free market
rates, while all imports, including the government imports consisting of
petroleum, fertilizers and defence have also to be paid at free market rates.
Basically two types of macroeconomic constraints are sought to be resolved in
the new regime: the balance of payments and the inflation regimes. The
balance of payment of constraint is sought to be alleviated through a market
driven exchange allocation and exchange rate process. Once exchange rates
are market determined and import controls abolished, firms who will be paying
at the market rates would be using the imported inputs. The market rate is
expected to self-balance the demand and supply of foreign exchange, thus,
curbing the excess demand situation and correcting the present trade
imbalances.
The inflation constraint is embedded in the monetary fiscal policy mix that may
become inconsistent with the desired exchange rate. Along with liberal trade
and exchange policies, the Government in addition taking all steps for export
promotion also controls fiscal deficit and government spending. Government

of India in fact has been highly successful in maintaining generally inflation

below 5% level since 1992.
- - - : ( o0o ) : - - 5.Do you foresee full convertibility in coming future?
Capital account captures short-term and. Long term internal borrowing and
lending. So also investment in business acquisitions of assets in a foreign
country, investment in shares and securities in overseas market, debt
repayment are examples which involve outflow of capital from the country. If
full convertibility on capital account is to be introduced, the rupee should be
freely convertible into any other foreign currency in the market. But in a free
market there can be only one price for the currency i.e. one exchange rate. A
national currency cannot be said to be convertible, if it has more than one
exchange rate. This is the situation, which exists at present in India. The
rupee has become fully convertible on trade and current account, but not on
capital account. The term Capital Account Convertibility (CAC) means that
the Rupee can be freely converted into foreign currencies for acquisition of
capital assets abroad. In this context it will not be out of context to reproduce
the statement made by the then Finance Minister Dr. Man Mohan Singh. He
saidThere are certain risks involved in the capital account convertibility. Therefore
for the time being, we would concentrate on making the rupee convertible in
current account. It is after that the logical step would be to think of rupee
convertibility on the capital account.
Even though the above statement was made in March 1993., essential
conditions are not fulfilled so far for Indian rupee to be made fully convertible
which will necessitate relaxation of capital controls, i.e. capital outflows and
inflows. The positive gains made by the Indian economy since introduction of
current account convertibility and trade liberalization are as under.
1. The Indian Economy has been showing signs of growth after
liberalisation.
2. The country enjoys comfortable foreign exchange reserve and balance
of payment position.
3. Changes in exchange rate of the rupee are gradual and there are no
violent fluctuations.

4. Rate of inflation is showing downward trend over a long period.

5. Reserve Bank of India is following a liberal credit policy.
6. Interest rates are declining.
On the other hands the negative factors are as under;
1. Infrastructural inadequacies.
2. Fiscal deficit is not contained at desired/budgeted levels
3. Huge amount of non-performing assets in banking system
4. Government revenue expenditure has not been brought under total
control
5. The coalition government at the centre is not in a position to quickly take
firm or tough decisions
In this connection the Committee of Capital Account convertibility set up by
Reserve Bank of India under former R.B.I. Dy. Governor, Mr.S.S.Tarapore to
lay the Road Map to capital account convertibility submitted its report
sometimes back. The Committ5ee has recommended that the implementation
CAC be spread over a three-year period, 1997-98, 1998-99 and 1999-2000.
Its major recommendations are:
i.

The gross fiscal deficit be brought down from the budgeted 5 percent in
1997-98 to 3.5 per cent by 2000.

ii.

A consolidated sinking fund be created which will address the crisis of a

ballooning public debt.

iii.

The inflation be brought down to an average 3.5 percent between 1997

to 2000.

iv.

Reducing gross NPA level in the Banking sector to 5 per cent

v.

Bringing down the average CRR drastically to 3 per cent

The Indian economy is predominantly dependent even today on monsoon.

Government controls on industry, which has been a way of life for over four

decades. These are now being gradually dismantled. The reforms on financial
sectors and banking sectors remain an unfinished task.
It is therefore clear that convertibility as in USA, UK, Germany and some other
developed countries will be a feasible proposition for Indian Rupee only if the
economic fundamentals of the country are positive and further progress made
in all the crucial areas.
Views expressed by the Governor, Dy.Governor of RBI on the subject by way
of speeches delivered at important forums are appended to focus current RBI
thinking on the subject
i.

Speech by Dr. Y.V. Reddy Governor, Reserve Bank of India at the

Central Bank Governors Symposium convened by the Bank of England
in London on June 25, 2004 - Subject "Remarks on capital account
liberalisation and capital controls"

ii.

Speech by Dr.Bimal Jalan (then Governor RBI) on Capital Account

Convertibility, Address a the 14th National Assembly of Forex
Association of India on 14.8.2003

iii.

Key Note Address b Smt K.J.Udeshi Executive Director, RBI at the

Assembly of the Forex Dealers' Association of India at Bangalore on
September 28, 2002 delivered by I -Subject - "The Issue of Capital
Account Convertibility"
Convertibility of Exchange Rate - FAQ (Part: 3)
Remarks on capital account liberalisation and capital controls
[by Dr. Y.V. Reddy, Governor, Reserve Bank of India at the Central Bank
Governors Symposium convened by the Bank of England
in London on June 25, 2004]

There is evidence of a threshold effect in the relationship between financial

globalisation and economic growth, and the heightened risks of volatility in
capital flows to developing countries gets reduced only after a particular level
of integration. In contrast, empirical evidence shows that trade liberalisation
has had beneficial impact. A review of evidence provides no road map for the
optimal pace and sequencing of financial integration. Many questions in this
regard are best addressed only in the context of country-specific
circumstances and institutional features.

In this background, based on the Indian experience, I will present some issues
relating to managing capital account.
i.

First, capital account liberalisation is a process and it has to be

managed keeping in view elasticities in the economy, and vulnerabilities
or potential for shocks. These include fiscal, financial, external, and
even real sector say, oil prices and monsoon conditions for India.
Professor Rogoff's presentation places special emphasis on
government borrowings as a vulnerability.

ii.

Second, caution is needed in moving forward with each step in capital

account liberalisation, recognising that reversal of any step in
liberalisation is very difficult since markets tend to react very negatively
to reversals, unless there is already a crisis situation.

iii.

Third, the capital account itself needs to be managed during the process
of capital account liberalisation. There is a hierarchy in the nature of
different types of capital flows in real life. For example, foreign direct
investment is preferred for stability, and quantum of short-term external
debt, by residual maturity, should not be excessive. Furthermore,
adequate reserves, keeping in view the national balance sheet
considerations, which include public and private sectors, provide
comfort. Public policy can achieve these desirable conditions only
through some sort of management of capital account

iv.

Fourth, the management of capital account will be effective under

enabling conditions, such as, reasonable confidence in macro policies,
in particular tax regimes, and safeguards against misuse of liberalised
current account regime to effect capital transfers. Sound management
will also avoid dollarisation of the domestic economy and
internationalisation of domestic currency.

v.

Fifth, operationally, management of capital account involves a

distinction not only between residents and non residents or between
inflows and outflows but also between individuals, corporates and
financial intermediaries. The financial intermediaries are usually a
greater source of volatility amongst these. If such financial
intermediaries operating in the developing countries are owned or
controlled by foreign entities / investors, there is perhaps greater
tendency to volatility in the flows. It is noticed that such foreign owned /
controlled intermediaries are often influenced by considerations other
than domestic economy and have less appreciation of local conditions

apart from the issues relating to cross-border supervision of financial

intermediaries by the host country supervisor.
vi.

Sixth, the prudential regulations over financial intermediaries, especially

over banks, in respect of their forex exposures and forex transactions
must be effective and a dynamic component of management of capital
account as well as financial supervision. Such prudential regulations
should not be treated as capital controls.

vii.

Seventh, capital controls should be treated as only one of the

components of management of capital account. As liberalisation
advances, the control-regime would contract, and thus, it is the
changing mix of controls that charecterises the process of liberalisation
in management of capital account

viii.

Eighth, capital controls may be price based, including tax-regimes, or

administrative measures. Depending on the legal framework and
governance structures, the mix between the two would vary. As
liberalisation advances, the administrative measures would get reduced
and price-based increased, but the freedom to change the mix and
reimpose controls should always be demonstrably available. Such
freedom to exercise the policy of controls adds comfort to the markets at
times of grave uncertainty.

ix.

Finally, as mentioned by Professor Kenneth Rogoff, a distinction needs

to be made between de jure and de facto financial integration in general
and hence, in the context of capital account in particular. In practice,
there are difficulties in measuring the degree of financial integration.
However, the institutional structures, both of public policy and markets,
need to be evolved to meet the imperatives of liberalised capital
account. In the final analysis, the basic issue in any policy context is
whether capital controls lead to distortions in exchange rate or the
liberalised capital flows that lead to distortions in exchange rate. In
respect of emerging economies, the conduct of market participants
shows that automatic self-correcting mechanisms do not operate in the
forex markets. Hence, the need to manage capital account which may
or may not include special prudential regulations and capital controls.
There are many subtleties and nuances in such a management of
capital account which encompasses several macro issues and micro
structures.
- - - : ( <> ) : - - -

Dr.Bimal Jalan (then Governor RBI) on Capital Account Convertibility

[Extract from Address at 14th National Assembly of Forex Association of India on 14.8.2003]

"A frequently discussed question is about Capital Account Convertibility

(CAS), i.e. when is India going to move to full CAC? As you are aware,
we have already liberalized and deregulated a whole host of capital
account transactions. It is probably fair to say that for most transactions
which are required for business or personal convenience, the rupee is,
for all practical purposes, convertible. In cases, where specific
permission is required for transactions above a high monetary ceiling,
this permission is also generally forthcoming. It is also the declared
policy of the Government and the RBI to continue with this process of
liberalization. In this sense, Capital Account Convertibility continues to
be a desirable objective for all investment and business related
transactions and India should be able to achieve this objective in not too
distant a future.
" There are, however, two areas where we would need to be extremely
cautious one is unlimited access to short-term external commercial
borrowing for meeting working capital and other domestic requirements.
The other area concerns the question of providing unrestricted freedom
to domestic residents to convert their domestic bank deposits and idle
assets (such as, real estate), in response to market developments or
exchange rate expectations.
" In respect of short-term external commercial borrowings, there is
already a strong international consensus that emerging markets should
keep such borrowings relatively small in relation to their total external
debt or reserves. Many of the financial crises in the 1990s occurred
because the short-term debt was excessive. When times were good,
such debt was easily accessible. The position, however, changed
dramatically in times of external pressure. All creditors who could
redeem the debt did so within a very short period, causing extreme
domestic financial vulnerability. The occurrence of such a possibility has
to be avoided, and we would do well to continue with our policy of
keeping access to short-term debt limited as a conscious policy at all
times good and bad.
"So far as the free convertibility of domestic assets by residents is
concerned, the issues are somewhat more fundamental. It has to do
with the differential impact of "stock" and "flows" in determining external
vulnerability. The day-to-day movement in exchange rates is determined

by "flows" of funds, i.e. by demand and supply of spot or forward

transactions in the market. Now, suppose the exchange rate is
depreciating unduly sharply (for whatever reasons) and is expected to
continue to do so for the near future. Now, further suppose that
domestic residents, therefore, decide perfectly rationally and
reasonably that they should convert a part or whole of their stock of
domestic assets from domestic currency to foreign currency. This will be
financially desirable as the domestic value of their converted assets is
expected to increase because of anticipated depreciation. And, if a large
number of residents so decide simultaneously within a short period of
time, as they may, this expectation would become self-fulfilling. A severe
external crisis is then unavoidable.
"Consider Indias case, for example. Today, our reserves are high and
exchange rate movements are, by and large, orderly. Now, suppose
there is an event which creates external uncertainty, as for example,
what actually happened at the time of the Kargil or the imposition of
sanctions after Pokhran, or the oil crises earlier. Domestic stock of bank
deposits in rupees in India is presently close to US $ 290 billion, nearly
three and a half times our total reserves. At the time of Kargil or
Pokhran or the oil crises, the multiple of domestic deposits over
reserves was in fact several times higher than now. One can imagine
what would have had happened to our external situation, if within a very
short period, domestic residents decided to rush to their neighbourhood
banks and convert a significant part of these deposits into sterling, euro
or dollar.
" No emerging market exchange rate system can cope with this kind of
contingency. This may be an unlikely possibility today, but it must be
factored in while deciding on a long term policy of free convertibility of
"stock" of domestic assets. Incidentally, this kind of eventuality is less
likely to occur in respect of industrial countries with international
currencies such as Euro or Dollar, which are held by banks, corporates,
and other entities as part of their long-term global asset portfolio (as
distinguished from emerging market currencies in which banks and
other intermediaries normally take a daily long or short position for
purposes of currency trade)
[Note: we present another more detailed speech exhaustively covering all
issues about CAC in the next article. the speech was by Smt K.J.Udeshi,
Executive Director, RBI] The Issue of Capital Account Convertibility

[Key Note Address at the Assembly of the Forex Dealers' Association of India at Bangalore on
September 28, 2002 delivered by Smt K.J.Udeshi, Executive Director, RBI]

The Asian financial crisis led to a rethinking of the various issues relating to
the CAC. Earlier, CAC was the mantra on everyone's lips and even
international agencies like the IMF were nudging - not too gently - countries
like India towards liberalising the capital account. While on the subject of
capital account convertibility, I recall the observations of our Governor,
Dr.Bimal Jalan and I quote, "...It must be understood that merely by lifting all
capital controls, the markets of a developing country do not get as deeply
integrated as a developed country's markets. As such, each country would
need to decide on its own path of capital account liberalization with regard to
the timing and sequencing". The critical role played by a well capitalised, well
managed and well-regulated financial system which has all along been
stressed by the Indian authorities has come into sharper focus. Further, the
dangers from a highly leveraged corporate structure without proper norms for
corporate governance are better appreciated. Needless to say, the fiscal
position has to be taken into account.
As far as developing markets in general are concerned, there would be six
tenets that would need to be kept in mind by the authorities while deciding on
the pace of capital account liberalisation.
First, it is not necessary for a country to have a totally open capital
account.
Secondly, it is imperative to make a distinction between controls that
hinder efficient international intermediation and those that are necessary
to control potential problems while sequencing the capital account
liberalisation.
Thirdly, a developing country with underdeveloped financial markets
should reserve the right to reimpose controls if warranted. By a well
paced calibration of the liberalisation process we have had a
remarkable record of minimal backtracking.

 Fourthly, it is important to remember that it is necessary to have an

overall environment where the measures on outflows are well
sequenced.
Fifthly, the Asian Crisis clearly demonstrated the dangers of hidden risks
in the balance sheets of highly leveraged corporates. Therefore,
information about the potential impact of corporate activity at times of
crisis could prove very useful to the authorities. Reserve Bank took a
definite step in this regard recently by directing banks to collect
information relating to unhedged exposures of their clients.
Finally, it is important to recognise that the more we liberalise the more
we would need to monitor flows and we need not be defensive of the
monitoring of flows.
Some facts about capital account liberalisation.
In the absence of a well chalked out sequencing, the liberalisation of capital
account has often been followed by crisis in many countries. It is often a
mistake to over emphasise the permissive factor of capital account
liberalisation while under estimating the importance of weakness in fiscal
policy as well as the compatibilities between the desirable monetary and
exchange rate policies and the actual ones followed in practice. At the same
time, it also stands to reason that the cost of maintaining controls and the
inefficiencies and distortions that result should be carefully evaluated.
Nevertheless, given the fact that effect of a crisis is often of a long term nature
as far as real sector of the economy is concerned, economists are
increasingly recognising the merit of a gradual, well thought out, prioritised
opening up of capital account.
What lessons do we need to draw from the episodes of crises in other
countries?
First, countries need to pursue sound macro economic and trade
policies to minimise risk while carefully opening up the capital account.

 Secondly, countries should strengthen their financial and supervisory

systems before going capital account convertible.
Thirdly, a strong corporate sector with good governance is an essential
pre-requisite for a faster opening up of the capital account.
Fourthly, CAC essentially pre-supposes a market determined exchange
rate system.
This brings me to the issue of India's march towards CAC, which has
hastened in recent times and our efforts at liberalising various procedures.
There is an erroneous impression in certain quarters which are meant to be
otherwise well informed. It is stultifying to claim that the Indian approach to
CAC is one of encouraging inflows while discouraging outflows. Nothing could
be farther from the truth. Capital inflows were always encouraged and
repatriability assured. In fact, the thrust of the policy in recent years has been
to minimise or totally abolish administrative hurdles. The added emphasis in
the last few years has been a gradual and measured opening up of outflows
by residents e.g.:
i.

Resident individuals can now get upto $ 500 without filling any form or
submission of any documents.

ii.

Remittance of foreign exchange for medical treatment upto $ 50,000 is

also without submission of any documents.

iii.

Remittance of foreign exchange for travel and education or gifting of

funds upto $ 5000 had already been freed.

iv.

Individual professionals can now retain upto 100% of his foreign

exchange earning in EEFC accounts.

To the NRIs we have sent a strong and unequivocal signal and thereby to the
world at large about our commitment to convertibility
i.

Repatriable status accorded to all non-resident depositors except

balances in NRO accounts.

ii.

Capital transfers for NRIs upto $ 1,00,000 out of sale of immovable

property as also inheritances and legacies, permitted.

iii.

Even for balances in NRO accounts greater freedom for repatriation of

balances for medical treatment, studies, etc.

For exporters, suffice it to say, that it is a continuous process of rationalisation

of procedures, with a view to minimising transaction costs, and to ensure
easier and cheaper availability of credit.
i.

To increase the competitiveness of the Indian corporates, limits for

Indian direct investments under the automatic route has been doubled
to US$ 100 million.

ii.

- Software exporters are encouraged by permitting them to receive 25%

of the value of their exports in the form of equity of start-up companies.

iii.

Two-way fungibility of ADRs/GDRs were operationalised to bring about

alignment in the prices of Indian stocks in the domestic vis--vis
international markets.

iv.

Corporates have also been accorded greater freedom to raise (upto $

50 million) and prepay foreign currency borrowings (upto US$ 100
million).

v.

Corporates have also been accorded greater freedom to raise shortterm suppliers/buyers credit for imports (up to US$ 20 million).

vi.

An even greater relief to corporates and banks alike is the relaxation in

the submission of exchange control copy of Bills of Entry for imports
upto US$ 25,000.

The freedom of FIIs in the Indian financial market has been substantially
increased and they are allowed to trade in exchange traded derivatives.
Alongside, liberalisation has also been effected in the foreign exchange
market. For instance, the freedom to rebook cancelled contracts has been
restored, so also booking of contracts based on past performance. Swap and

open position limits available to banks have been enhanced to enable banks
to offer finer rates to the customers.
RBI is also actively considering introducing rupee based currency options. A
Committee constituted to look into various related aspects is expected to
submit its recommendations to the Reserve Bank very soon. I also understand
that the Forex association has aptly arranged a panel discussion on this
subject tomorrow. I hope that my colleagues who will be participating in the
discussions will carry back several useful suggestions on the subject.
The issue of capital account convertibility also leads me to the current spate of
debates and opinions in respect of the level and cost of reserves. Should
countries hold larger reserves or less reserves? Countries need to set their
reserves holding on the basis of capital as well as current account variables.
Apart from the computable charge on the reserves arising out of commitments
relating to capital account transactions both long and short term, as well as
trade requirement, the impact of external and internal shocks have to be kept
in view in formulating policy on reserves. As the capital account becomes
more open and international capital flows more readily, the demand for
reserves will increase. Merely comparing global interest rates with domestic
interest rate as a proxy for cost of reserves may not be appropriate. It is not
the arithmetical difference in interest rate on substitutable assets but the
various other unquantifiable benefits that the economy derives on account of
strong reserves which needs due recognition in such discussions.
Two aspects relating to liberalisation need reiteration even at the cost perhaps
of repetition. First and more important for the fruits of liberalisation to reach
the common man the role of officials at the bank branches is crucial. Our
experience based on the feedback from media reports and the public in this
regard is unfortunately not too encouraging. There is just no purpose in talking
about CAC from high podiums if action at the grass roots level is still
embedded in FERA mindsets. Let me emphasise on one important irritant that
a common man is concerned about. He is becoming increasingly intolerant
and sensitive to too much documentation particularly for small value
transactions. Our efforts in this direction are yet to bear satisfactory results.
My message to you, perhaps the most important one, is, to put in special
efforts to ensure hassle free service to customers.

Second, a more technical one. Recent market developments have

underscored the importance of improved risk management practices in the
financial sector. To amplify this let me recapitulate the exchange rate
movements in recent times. Moving away from pronounced one way
movement; the market has started exhibiting fair degree of two-way
movements and finer prices. Unlike the earlier periods when market spreads
narrowed down faster even at times of volatility the observed pattern of
merchant supply and demand viz. falling supplies with a weakening rupee in
anticipation of further weakness and shooting up demand due to worry of
further weakness and vice versa continue. The more volatile the currency
gets, it is the end-users, rather than the intermediaries, who get hurt in the
process. It is therefore disconcerting that the two-way movements have not
resulted in activating risk management strategies among the end users.
Instead, two-way movements have been looked at as opportunities for staying
away from the market by opposing segments. Corporates are looking at the
treasury as a profit centre. There is a great deal of work to be done by the
banks in widening the awareness of risk management among business
entities who are yet to look at the market as a place for disposal/acquiring
currency rather than a place for profit maximisation. It is necessary that the
business entities do not look at exchange rate movements as an exclusive
source for profit enhancement of the business. Corporates must appreciate
the risks involved. RBI has cautioned banks extending foreign currency loans
about the need for assessing the market risk in their clientele books arising
out of unhedged currency risks. There is a convincing need for banks and
corporates to look at the business balance sheets and identify the sources of
market risk, implicit and explicit, and mange it meaningfully in tune with the
business objectives of corporates.
Another aspect that needs to be given serious thought is the invoicing of
trade. The market seems to be very much focussed on the USD -Re rate and
the opportunity available in other currencies appears to have been completely
over looked. The invoicing pattern of trade reveals that USD continues to be
the major currency of invoice. RBI communicates with the market in the
language of USD-Re. The stability of Rupee against USD does not mean that
Re is equally stable against all the other currencies. Though it is not the
intention to discuss invoicing strategy here it is necessary that the end users

look at the global currency movements and effectively use the relaxation
permitted to evolve appropriate risk management strategies. The increasing
integration of the economy with the global markets may bring about change in
the currency composition of trade. Recognising this possibility in the long run
Government of India recently permitted RBI to use Euro as another currency
for intervention.
In the context of the market one of the other issues is transparency in rate
quotations. Electronic trading platforms are taking over the role of brokers and
gradually the volumes through these platforms are increasing in the global
markets. With an outright offer and bid price and volume available price
discovery has become superior. India cannot be away from the developments
and I am sure this development would gain further ground in the times ahead.
The recent development in the context of capital markets transactions,
relaxing several regulations are an indicator of the emerging trend. The
country is committed to a gradual and well calibrated move to capital account
convertibility. Convertibility is not a one-time affair; it is a process of evolution
and the process is an on-going one. As we move towards an increased level
of convertibility, it must be emphasised that the responsibility of the end users
and the intermediaries becomes significant. The freedom would bring in two
way capital flows and the impact of these flows must be absorbed in an
efficient manner. It is necessary that the market develop adequate risk transfer
mechanisms, which would provide shock absorption capability in the event of
adverse movements. We have to move together to develop risk management
products beyond the current age-old product viz. the forwards
Foreign Exchange market in India
The foreign exchange market in India is actively influenced by macro level
changes in the international foreign exchange market. Hence to understand
the present scenario of Indian Foreign Exchange Market, it is necessary to
focus on the major developments in the international Fex. Markets that have
taken place in the recent past that have an impact in Indian environment.
1. Liberalisation of trade and economic activities creating global pattern of
trade and commerce

Globalisation process has taken deep roots in the world and every
country now looks to the world as the market for its product. Trade
barriers are being dismantled world over and a closer integration of the
world economy is taking shape
2. Revolutionary change in the composition of FEX business
Secondly in recent years foreign exchange markets have assumed a life
and momentum of their own independent of the underlying commercial
transaction. Until mid-70s commercial transactions provided the raison
detre for foreign exchange transactions, But today financial transactions
and intra-day trading constitute more than 90-95% of daily turnover in
the market.
3. With the progressive elimination of exchange and capital control and the
revolutionary developments in telecommunication and computer
technology, an active 24-hour trading in foreign exchange has emerged.
4. Due to instantaneous dissemination of information simultaneously to all
centres around the world, exchange rates in all centres are today
closely aligned.
Composition of the Indian Market
Foreign exchanged market in India is totally structured, well regulated both of
RBI and also by a voluntary association (Foreign Exchange Dealers
Association). Only Dealers authorised by RBI can undertake such
transactions. All inter-bank dealings in the same centre must be effected
through accredited brokers, who are the second arm in the market-structure.
However, dealings between the authorised dealers and the RBI and also
between the Ads and overseas Banks are effected directly without the
intervention of the brokers.
The Market for foreign exchange in India consists of distinct segments, viz.
1. Apex segment covering transactions between the RBI and the
authorized Dealers, i.e. commercial banks authorised to deal. In foreign
exchange. RBI used to act as the rate setter as well as the residual

partner in respect of commercial transactions. The exchange rate is

now, largely, market-determined through the forces of supply and
demand, a feature of the liberalisation process and growing economic
stability of the country.
2. The Inter-bank market is the second segment. This segment covers the
dealings of Authorised Dealers among themselves and with overseas
banks.
3. The Primary Segment covering dealings of Authorized Dealers with
customers, the general public, trade and commerce, who have to buy
and sell currencies in the normal course of commercial business.
4. In addition to the authorised dealers covering commercial banks, who
undertake comprehensive transactions covering all spheres of foreign
exchange, there are also a peripheral market consisting of licensed
money changers and travel agents, who enjoy limited Authorisation
especially for encashment of travelers cheques, noted. Specified hotels
and Government owned Shops are also given restricted licenses to
accept payment from non-residents in foreign currencies. IDBI, and
Exim Bank are permitted handle and hold foreign currencies in a
restricted way.
Main Centres of Business
Mumbai is the principal centre. Other important centres are Calcutta, New
Delhi, Madras, Bangalore, Cochin and Pondicherry. Until recently the various
centres functioned as fragmented markets leading to wide variations in
exchange rates. With the improvement in telecommunication facilities the
various centres are being increasingly integrated and they are now functioning
as part of a single geographically extended market. In the context of recent
developments in telecommunication and computer facilities, individual market
centres are just conduits and foreign exchange business can be transacted
from any centre without jeopardizing efficiency.
Infrastructure facilities to the Authorized Dealers

These include Reuter Screens (displaying moment to moment changes in

exchange rates, market news, interest rates, and other relevant information,
updated on-going quotations for major currencies by market makers in the
Indian Market against the rupee etc. Special direct telephone and voiced
contact with main brokers, teleprinter, telex and electronic mail for contacts
with selected overseas dealers, Banks etc. The dealing rooms of some Banks
in India are comparable to the Dealing Rooms of in Overseas markets.
Exchange Rate for Merchant Transactions
Earlier foreign exchange rates for various types of merchant transactions
(both spot and forward) were fixed by the Foreign Exchange Dealers
Association of India (FEDAI) in consultation with RBI. Recently however this
arrangement was abolished and the Individual Bank were permitted to quote
competitive rates, based on the on-going inter-bank or overseas market rates.
This freedom with the relaxation of some of the provisions of the exchange
control gave a fillip to the growth of Indian market.
Another major change in recent years is that an active rupee-dollar segment
has emerged, which is sufficiently deep enough for dealers to switch over to
dollar based cross rate quotations in the market in contrast to the traditional
cross rates via. the rupee-sterling rate. Thus the Indian market is
progressively moving towards the international practice of quoting cross rates
via the dollar
Another progressive change to take place recently is the adaptation of twoway rate quotation, leaving the earlier practice of quoting one way. Banks as
well as brokers were earlier unfamiliar with the two-way quotations and the
attendant accounting and dealing positions. In the recent past some of the
active foreign banks and a few Indian Banks began quoting two-way rates. In
the International market two-way quotations are only given. It is also accepted
that the spread between the buying and selling rates, in keeping with
International Market traditions, should not be more than 10 points and only in
very uncertain markets it widens to 20 or points. FEDAI has drawn up a code
of conduct and encouraging dealers and brokers to switch universally to twoway quotations.

However forward quotes generally in the form of Swaps (ranging from 2 days
to one month are not given in India in two way quotes, but continue to be
quoted one way. These swaps are frequently undertaken for adjusting in
foreign currency funds position of the banks. This segment cannot develop in
India due to exchange controls on fund flows between India and overseas
markets. Swaps and forward rates are determined in India purely by demand
and supply factors, and consequently they are subject to wide fluctuations.
Objectives of RBI Exchange control Policy
In recent years the objective of RBI is to develop an active inter-bank market
in India. The advantages of this policy are:
a. It enables greater matching of sales and purchases of currencies within
the country, thereby reducing operating expenses.
b. This helps competition finer rates to merchants as more and more Ads
can have access to Indian Market than to Overseas Market.
c. Need to maintain larger balances abroad is reduced
Main provisions of the Exchange Control by RBI
1. ADs (Authorised Dealers) are required to maintain square or near
square position in each currency, including both spot and forward
transactions
2. Foreign currency balances commensurate with normal business
requirements alone are permitted
3. Lending foreign currency to branches/correspondent banks or investing
them abroad is not permitted.
4. Total credit or loan facilities that can be availed from
branches/correspondents globally is limited to Rs.20 lakhs, any excess
must be adjusted within 5 days;

5. Purchases/sales of any permitted foreign currency both spot and

forward, and swaps of any foreign currency can be done against the
rupee or any other currency in the inter-bank market but such
transactions should not create mismatched maturities or overbought or
oversold position at the end of the day;
6. Spot purchases and sales of permitted currency against any other
permitted currency (not against the rupee) can be done freely to cover
genuine merchant transactions. Or for purposes of adjustment of the
ADs own position.
7. Sales of Sterling, the U.S. Dollar, Deutsche Mark and Yen by the ADs to
RBI is permitted only as cover for genuine merchant transactions or to
dispose of counterpart funds obtained from international markets as
cover for merchant transactions. Sales to RBI of currency purchase
from the inter-bank market or international markets are not permitted.
RBI does not sell any currency other than pound sterling. With effect
from February, 87 RBI started selling U.S. Dollars to Ads to cover their
genuine merchant transactions. This facility was allowed only at
Bombay.
8. As far as possible banks should seek cover in the inter-bank market.
ADs could take resort to International Market only as a last resort.
Compared to the markets in the Developed countries of Europe, Japan and
U.S. the foreign exchange market is small. But it is growing rapidly and has
potential to emerge to the frontline position.
Payment Terms Generally Adopted in Foreign Trade
As delivery is the essence of the contract for the importer (overseas buyer),
timely and sure receipt of payment is the matter that is of prime interest to the
exporter. In a contract for export of goods, it is natural that there are a number
of clauses defining in exact terms how the payment is to be made to the
exporter. There are different modes of making payment to the exporter. Some
of the payment terms generally adapted in foreign trade are:

1. Clean payments:
This is the direct form of settlement between the Exporter and Overseas
buyer, without the intermediation of a Commercial Bank. The
merchandise is shipped by the exporter and the shipping documents
and invoice are directly forwarded to the overseas buyer. The buyer
then remits the payment. This mode of transacting carries an element of
risk for the exporter, if the foreign buyer defaults to make payment. If the
payment is remitted in advance, there is An element of risk for the
buyer. Hence this form of settlement can be resorted to only in
exceptional cases, where the transaction is for a small value, or that the
exporter and overseas buyer belong to a same group of concerns. Or
the two parties have long-standing satisfactory dealings.
2. Documentary Bills on D/A terms:
Under this system, the goods are consigned by ship, the shipping
documents and commercial invoice are attached to a Demand Draft and
send to the overseas banker of the Buyer for collection. The documents
are delivered to the buyer against payment at the overseas centre.
These are called D/P Bills. When a L/C cannot be established this is the
ideal mode of payment. The exporter can also attach the after sight bill
for a specified No. of days and advise the Banker to deliver the Bill of
Loading and other documents against acceptance of the after sight
draft. The banker will deliver the documents and on the due date of the
Draft he will collect the amount and remit to the exporter. This is called
D.A. Bill. The exporters bank may also purchase both DP or DA export
bills and make the funds available to the exporter immediately less their
discount and charges and reimburse itself eventually when the bills are
paid by the overseas buyer. Normally Indian Banks allow packing credit
facilities to the exporters to procure and export the goods. The packing
credit advance is adjusted by purchasing the export bills. It cannot be
adjusted by any other mode. This is called a FOBP (Foreign outward
bills Purchased) facility. When the Bills are not purchased, the Banker
renders a collection service, when presents the bill to the overseas
buyer, collects the amount and places to the credit the exporters
account after collection.

3. Bankers Documentary Letter of credit:

A Letter of credit is established by the Banker of the Overseas buyer, in
favour of Exporter. The Letter of credit is advised and generally
confirmed by a local Bank in the country of the exporter. This enables
the exporter to deal with the advising Bank in his country for all
purposes. In terms of the Letter of Credit, the Bank establishing the L/C
irrevocably undertakers to negotiate bills tendered by the exporter
confirming to the terms of the L/C upto a specified amount and within a
period. Normally the Letter of credit is made available by the overseas
buyer, while sending is order initially or within a short time thereafter,
and based on the Letter of credit, the Exporters Bank may allow
packing credit to the Exporter to procure and export the goods. The
Letter of credit safeguards the interests of both the exporter and the
overseas buyer and offers the best mode of transacting for both.
Normally the exporter should insist on a confirmed irrevocable credit.
The terms of an irrevocable credit cannot be modified by the issuing
bank without the consent of the beneficiary i.e. the exporter. When the
domestic Bank representing the foreign Bank opening the L/C adds its
own conformation to the credit, it is called confirmed credit.
4. Consignment terms:
Under consignment terms the goods are not sold to the buyer, but sent
to the agent of the exporter in the foreign country. The exporter
continues to own the goods even if the agent in the overseas country
remits an advance payment. The consignment agent arranges to sell
the goods at the foreign country on behalf of the exporter and remit the
amount of sales from time with an account current. He is paid only
commission on the sales for his margin. The exporters bank can only
allow packing credit against the stocks remaining at the overseas centre
on consignment basis and no bill can be purchased.
Distinction between L.C and Guarantee
A letter of credit is a written undertaking issued by buyers bank to pay a
certain sum of money within a stipulated period against a specified set of
documents. It is a conditional undertaking. It undertakes to pay a certain
amount of money on presentation of stipulated documents and the fulfillment

by the exporter of all the terms and conditions incorporated in the L/C. The
Letter of credit is a separate and distinct contract from the underlying sale
contract, and the bank is not responsible for the fulfillment of the terms of the
sale contract. The essential and basic provisions of the sale contract must be
incorporated in the letter of credit. In addition, the amount of credit, its expiry
date, the tenor of the draft to be drawn, party on whom the draft is to be
drawn, the documents to be presented, brief description of the goods, must be
precisely stated in the letter of credit.
A guarantee is understood as a supplementary contract. A (designated as
debtor) and B (designated as creditor) enter into a main contract in terms of
which A promises to do something to B. Now B wants safeguards in case A
fails to perform what he has promised and demands from A to provide him a
guarantor. In this contract C at the request of A comes forward and enters into
a Contract of Guarantee with B. This is thus a supplementary contract entered
by C with B. In terms of this contract of guarantee C promises to B that in
case A fails to perform his obligations under the main contract to B, C will
perform the same or compensate the loss of B, as may be provided in the
contract of Guarantee. A contract of guarantee is called a contingent
guarantee.
The differences between the two i.e. L/C and guarantee are given below.
1. In a letter of credit there are only two contracting parties, i.e. the Banker
and the beneficiary. The Banker opens the L/C on behalf of the buyer,
but the buyer is not a contracting party, AS THE Letter of credit is a
distinct and independent contract. In a Guarantee there are always
three parties, 1. The Debtor 2. The Creditor (beneficiary of the
guarantee) and 3.the Guarantor.
2. The guarantee is a supplementary contract based on an already
existing original contract between the Debtor and Creditor (beneficiary
of the guarantee. The Letter of credit however is a distinct contract
(original contract) and it is not in any way linked with any supply contract
excising between the seller (beneficiary of the guarantee) and the buyer
(on whose behalf the Bank issues the Guarantee to the beneficiary

3. In a letter of credit the Banker accepts accept certain obligations

distinctly and directly, upon the beneficiary fulfilling the terms and
conditions of the L/C. In a guarantee however, the agreement is
between the Debtor and the beneficiary (i.e. seller and buyer). In a
guarantor however the rights of the beneficiary on the guarantor is of a
contingency right. The beneficiary can have recourse to the guarantor,
only in case of failure of the principal debtor to perform the contact.
4. Cancellation of the original sale/purchase agreement between the seller
and buyer will not automatically affect the Letter of credit, since it is an
independent contract. However cancellation of the original contract
between the Debtor and the beneficiary will have the effect to nullify the
guarantee and the beneficiary will not be Able to claim the benefits of
the guarantee, when he has no valid claim on the debtor.
5. L/C creates two way obligations. The beneficiary of the L/C can claim
payment for his bills only after consigning the goods and presenting the
documents drawn strictly in terms of the L/C to the Banker. This sort of
enforcement of dual discipline is not possible, in case of a Guarantee.
6. In a guarantee only one Branch of the Bank will be normally be involved
with the beneficiary. But in a L/C the L/C is established by the overseas
Bank and it is advised by a local correspondent normally, who adds his
confirmation. This is the established convention and sellers will only
accept such an L/C
7. A documentary L/C covering merchandise provides a ready security (or
collateral) to the Banker, as the Banker gets a general lien on the goods
covered by the consignment. No such security accrues to the Bank in a
guarantee transaction in the normal course, and hence the Banker will
seek in addition to Margin deposit, mortgage of immovable properties as
collateral security. In view of this a L/C is deemed a self-liquidating
credit, while a Guarantee is deemed as an unsecured commitment.
8. Letter of credit can be negotiated in parts stretched over a period. A
guarantee cannot be invoked more than once.

9. In view of several limitations of Guarantee it is not normally availed of a

facility in export or Inland Trade. Letters of credit either Foreign or Inland
is considered as the convenient tool. It is possible to issue a single
revolving Letter of credit and cover all sales/purchases done periodically
during a course of a year. Such flexibility and ease are not available
under a guarantee. However a Guarantee from a Bank is considered
appropriate in case deferred payment sale of equipment. The seller
supplies (sells) a costly equipment on deferred payment (quarterly/half
year or annual payments) over 3 to 5 years. As the seller has no
security in case of default by the buyer, he insists of a Bank guarantee.
Such a guarantee called Deferred Payment Guarantee is normally
issued by the Bank.
10.
. A Letter of credit initiates a new line of operations and serves as
an integral part thereto. On the other hand a Guarantee being a
provision for a specific contingency comes into focus only when there is
a break in the regular transactions and an exception development (i.e.
default by the guarantee giver) takes place. If there is no such default by
the guarantee giver, the guarantee never comes into focus and gets
automatically discharged on the completion of the transaction. Based on
this criterion we may say that the L/C is a driving force, while the
guarantee is an exception handle
Various Types of Risks Encountered by Corporate Units in Cross Border
Business & Methods of Managing such Risks
As part of the Liberalisation and globalisation of national economies,
Governments in the process of trying to boost the export of goods and
services, will try to encourage Corporate units to get involved in cross-border
trade and cross border technology tie-ups. However the process of increasing
cross border trade, cross border financing and cross border technology tieups will also imply that the cross border risks is an important element in any
Corporate plan to go in for cross border markets.
1. Delivery Risk
Delivery risks refer to the uncertainties involved in procuring,
manufacturing and delivering the goods to the buyer. This will result in

defaults in effect deliveries as per schedule. Consequently Documentary

L.Cs established by the buyer may expire before the goods could be
shipped.
2. Country Risk or Political risk
Country risk refers to the possibility that the Government or the Central
Banks of the buyer country. When goods are shipped they have to pass
through International water implying potential risks of war and
disturbances enroute. Custom regulations, quality control regulations,
export/import procedures of the buyer or seller country may also delay
delivery schedules
3. Credit Risk
Credit risk refers to the possibility that the Government or the Central
Bank may not pay or may delay payments due to crisis of BOP.
4. Currency Risk
Currency risk or exchange risk refers to the threat as faced by the
volatility or fluctuations in exchange rate. If the exchange rate between
the buyers currency and the sellers currency changes violently during
the course of the transaction, one of the two parties will have to bear
substantial losses.
5. Interest Rate Risk
Interest rate risks are due to floating interest rate system, which is
prevalent in many of the developed countries. Floating interest rate
means that the cost of borrowing changes constantly.
Managing of Cross Border Risks
Many of the perils, which are potential in export/import trade, can be avoided if
prudently handled. Except the risk of exchange and currency fluctuations most
of the other risks are classified as Commercial or Political risk. Exporters can
cover these risks by opting for Insurance from Export Credit Guarantee
Organizations, which protect both the exporters and the financing banks. The
risks for an importer of these categories are comparatively less and the
importer have avail maximum benefit from establishing Documentary Credits

with suitable terms and conditions intended to ward off all conceivable risks.
Opting for forward cover can cover currency and exchange risk. Trade and
commerce are better established through person to person contacts. Regular
Exporters and Importers will do well to visit at least once in a year their
counterparts in their countries, which substantially builds mutual confidence.
The exporters/importers may also avail the facility of collecting credit reports
on their overseas counterparts through their Bankers.
A closed analysis of the list of threats faced will indicate that credit risk and
delivery risk is common to internal transactions as well. However currency and
interest rate risks are peculiar to cross-border business.
Delivery Risks
Buyers from sellers face the risk. Buyers can ensure that no advance
payments is sent to the sellers blindly and purchases are normally covered
under Letters of Credit established through first class Banks. Domestic
exporters should counteract against their peril, by streamlining inventory
management and proper planning material movement schedules proving a
small margin ahead of the contracted schedule.
Credit risks
A safety net for this is the Mode of transactions through Letters of credit,
which protect both the seller and buyer.
Interest Rate Risk
Where there is scope for this threat, it is advisable to go in for shorter-delivery
schedules and consignments for ad-hoc sale and purchase instead of overstretched despatch schedules extended over a long period. The assumption is
that this threat does not unfold itself in the short-term, even if it occurs, its
impact is within tolerance level.
Currency Risk Management
Risk management is met through both internal, and external hedging as under

Internal Methods
i.

Currency of Billing:
In this method risk is eliminated by contracting the sale transactions in
the home currency.

ii.

Leading, Lagging and Matching:

This is possible if the Corporate unit has a stream of exports & imports,
resulting in both payment, as well as receipt of foreign currency. It is
possible to match the export and import schedules to provide for
matching funds-flow in either direction.

iii.

Currency Hold Accounts:

It is a method of opening a foreign currency account and depositing
export earnings and other exchange receipts in the said account, to
generate risk-free funds for payment of the imports.

iv.

Lending and borrowing methods:

In this method a Company which has to make a foreign exchange
payment at a future date, and wishes to avoid a possible appreciation of
exchange rate, can buy Dollars at the current spot rate and invest the
money by lending or depositing in a foreign currency account, upto the
date of payment, to be used at the time of payment.
External Methods

i.

Forward Contracts:
Forward contracts are offered by Banks. In forward contracts Banks
quote an exchange rated today for sale or purchase of foreign exchange
at a future date.

ii.

Futures Contract:
Currency futures are exactly similar to forward contracts except that the
deal is put through a futures exchange, which functions on lines similar
to a stock exchange. These contracts are available for fixed amount and
standard period, and thus do not command the same flexibility as
forward contract

iii.

Swaps:
Swaps are long term hedging instruments to manage exchange rate
and interest rate risks. It is possible when there are two parties
interested in converting foreign currency in domestic currency and
interested in covering the transaction over a long span of time. A major
advantage of swap is that it allows tbat parties to hedge exchange rate
fluctuations over a long period of time.

iv.

Options
Options, as an instrument is an improvement over forward and futures
contracts. In a forward contract the Bank as well as the customer are
under obligation to complete the transaction art the specified date
irrespective of the exchange rate movement. In an option the bank has
an obligation but the customer has a right and no obligation
PART 19
Country Risk Monitoring
Definition and purpose of country risk monitoring

Cross border trading and cross border financing exposes the trader to several
risks not normally faced in the domestic trade. These risks can be categorized
according their nature and catalogued. In addition to normal commercial risk
inherent in all business transaction, overseas trade exposes the trader to risks
of political, currency and exchange rate fluctuations, not normally faced in
domestic trade.
Country risk is one such category. Countries of the Globe operate under
varying political and legal system, economic development and financial
strength. Most of the currencies of the third world countries are not stable and
subject to wide fluctuations in the international market. These countries
always suffer an adverse balance of trade and balance of payments. They
need huge imports of essential goods and capital equipment, while they are
unable to boost their export trade on account of limitations posed by the under
developed status of the economy. It is possible that the importer of goods in
this country is a sound party and he makes payment to the Bank for the export
bill in his native currency. But due to adverse balance of payments position

continuously suffered by the country, it does not possess the foreign exchange
and hence unable to remit the amount to the exporter. This in particular is an
example of the country risk that may be faced by an exporter.
A country risk monitoring implies an assessment and rating of the various
risks like political, economic or commercial threats inherent in dealing with
overseas counterparts in a particular country. The risks emanate from the
Country, due to political or economic conditions, or due to the Policy of its
government or its Central Bank This assessment takes into consideration the
recent past record of that country (say for the last 5 years) and then makes an
intelligent projection of future anticipated trends. Such a study at the outset
involves the selection of relevant parameters or criteria for identification of the
risk perception. It is of particular relevance that the parameters selected
should be prioritised and given weightage in terms of their relative importance,
A relatively insignificant risk will naturally carry a low priority and an equally
low weightage.
Categorizing and sub-categorizing Country risks.
Broadly the risks inherent in respect individual countries may be studied under
categories.
1. Economic or Commercial Factors
2. Political factors
Whether the country is having a sound economy And economic solvency to
perform its financial obligations? Is there political turmoil in the country and in
case there is a dispute with the importer of the country, whether the countrys
legal system provides safeguards for quick remedies?
These are the two factors that come in the way of deciding the countrys
record. Economic factors reflect the countrys inherent strength or weakness.
There are countries with stable economies, as also country suffering from
acute balance of payment problems. The political system prevailing in a
country shapes its external policy. There are dictatorships, theocratic states,

monarchies and democracies, each based on different legal systems and

political culture and ethics.
Parameters for assessment of Economic Risks:
1. Debt Service Ratio:
This refers to relevant data relating to the amount needed to service the
external debt (i.e. annual payment of interest and principal on external
borrowings), as compared to the countrys earnings from export of
goods and services. This indicates the capacity of the country to pay.
And the balance of payment solvency. Many under developed countries
depend on fresh external loans for repayment of previous loans. A
higher weightage can be given to this criteria and
2. Debt-GNP Ratio:
Debt-GNP ratio represents the external debt as a percentage of GDP.
This indicates the extent of debt as a ratio of GDP.A high Debt-TGDP
Ratio in excess of 40% indicates long-term financial problems for the
country.
3. Debt-Maturity:
This concepts highlights the maturity-wise table of the existing debt
burden and focuses the short term debt burden accruing in the next 2 to
3 years. A higher incidence of short-term debts indicates a more likely
possibility of default in the immediate future. On the other hand if major
part of the loan is long-term, the country has more time to plan and set
its house in order.
4. Current Account Deficit to GNP Ratio:
The current account deficit (except for transfer payments) represents
the excess of expenditure over income for the country. A deficit of 5% is
deemed a fairly difficult situation, while that of 7.5% indicates deepseated weakness.
5. GNP Per capita:
The GNP per capita indicates how rich and developed is the country. A

high GNP enables the country to take adequate steps for improving its
earnings and overcome problems of default and rescheduling.
6. Inflation Rate:
Inflation rate above 5% is a serious threat, while double-digit inflation
represents a state beyond control. In developed countries inflation is
controlled and this provide them a stable price /cost structure.
7. Savings Ratio:
A high Savings rate indicates higher mobilization internally of capital and
thus reducing reliance on external borrowings. A higher savings rate
usually indicates better ability of the Government to manage and
therefore less country risk.
Parameters for Assessment of Political risks
1. Internal Stability:
A stable government is able to undertake long term planning and
execute Development plans on a continuous basis. It automatically
increases external ratings of the country.
2. External Stability:
The country that promotes good relations with its neighbours and with
other whom, it has interactions, is better placed to promoter its foreign
trade and attracts foreign investment,
3. Other factors like legal system:
The location of the country, its educational and cultural systems and
legal systems for enforcement of remedies in case of disputes in trade
transactions are other criteria.
Swap as a Financial Market Product
Swap literally implies exchange In Foreign exchange market the term
Swap connotes simultaneous spot purchase and forward sale of a foreign
currency against another and vice versa. The term has acquired a distinct
usage in the financial market. Here Swap means an exchange of specific
streams of payments over an agreed period of time between two parties. The

Bank for International Settlements defines the term a swap is in financial

transaction in which two counterparties agree to exchange streams of
payments over time
Origin of Swap as a widespread Money Market Product
Swap, as mechanism for widespread use is a development of recent origin
during the last two decades. This is due to the progressive elimination of
exchange and capital controls and the revolutionary developments in
telecommunication and computer technology, active 24-hour trading in foreign
exchange has emerged. As a result of these innovations the process of
liberalisation and consequent integration of markets is under way. The high
volatility of exchange rates and interest rates have opened up opportunities
for large profit to market participants in the spot as well as in the forward
markets, provided they are on the right side of the market. Trading is now
increasingly guided by new decision techniques, particularly chart-based by
sell recommendations, rather than considerations of the underlying economic
factors as hitherto done. Such a move towards sophistication and
globalization of markets in turned opened up arbitrage opportunities, which
are increasingly availed through swaps and options in an effective manner.
Currency Swap and Interest Swap
The most commonly used types of Swaps are currency and interest rate
swaps. The currency swap began in 1981, while interest rate swap started in
1982. Currency Swap. A Currency swap enables contracting parties to
exchange predetermined streams of payments denominated in another
currency during an agreed period of time. Two types of Currency Swaps are
commonly transacted:
1. Fixed/fixed Currency Swap ((both terms fixed refer to interest rates)
2. Cross currency Interest Rate Swaps.
Fixed/Fixed Currency Swap
In this type of swap contracts, fixed interest payments on a specified principal
amount of one currency is swapped for fixed interest payment on an agreed

equivalent principal amount of another currency. Unlike in the case of interest

rate swap, where principal currency amount being in the same currency and
therefore not exchanged on the final maturity exchanged, in a currency swap
the principal amount may be exchanged on the final maturity date of the swap
contract at pre-determined exchange rate. Sometimes the principal amount in
the respective currency may be exchanged initially and then re-exchanged at
the maturity of the contract.
An example will make clear the elements of fixded/fixed currency swap clear.
Suppose Party A agrees to pay a Swap Bank 0 percent interest in Dollars
payable at half-yearly rests for a three year period on a principal amount of $
100 million. In return Party A received 5% interest in DM, on DM-180 Million
payable half yearly during the 3-year contract period (the DM equivalent is
calculated at the spot $/DM rate, say DM 1.00). On each 6 monthly interest
payment date, A pays $ 4 million to Swap Bank and received in return DM 4.5
million. At the end of the 3-year period Party A pays $ 100 million to the Swap
Bank and received DM 180 Million (at the agreed exchange rate of $/DM at
1.80
There are four main elements in a fixed/fixed currency swap.
1. There are fixed interest payments on due dates in the respective
currencies.
2. There are specified principal amounts in two currencies on which
interest payments at the specified interest rates are calculated.
3. There is an exchange rate involved. In this case it is the spot rate on
contract date. It can even be a mutually agreed forward rate. The same
exchange rate is used for computing the principal amount for calculating
the interest payments and also for the exchange of principal on the
initial date and re-exchange on the maturity date of the swap contract.
4. There is a specified maturity period.
Cross currency Interest rate Swaps

Often a currency swap may involve exchange of one currency at fixed interest
rate in return for receipts on a floating interest rate on another currency during
the contract period. This is termed as Cross Currency Interest Swap. The
transaction works on the same way as fixed/fixed currency swap, except that
one of the currencies involved will carry a floating interest rate in exchange for
the fixed rate in the other. Similar to the fixed rate currency swap, cross
currency interest rate involves a final exchange of principal at the agreed spot
exchange rate (or at agreed forward rate) prevailing on the date of the swap
contract. Most of the cross currency interest swaps involve the swapping of
fixed rate deutsche mark or Swiss franc or Japanese Yen against floating
(interest) rate US Dollars.
Interest Rate Swap
An interest rate swap is a transaction in which two parties agree to exchange
interest payments on an underlying notional amount but carrying interest
payments based on differing terms according to agreed rules, It is important to
note two points:
1. There is no exchange of principal amount either initially or on maturity,
as the notional principal amount is the same, And
2. On each interest payment date, only the net amount will be
paid/received by the counterparties.
There are three types of interest rate swaps.:
a. Coupon swaps:
A coupon swap is a fixed or floating rate interest swap in which two
parties exchange fixed interest payments with floating interest payments
on an underlying principal amount denominated in the same currency.
For example Party A agrees to exchange Fixed Interest rate at 10% on
$ 10 million for floating interest rate based on 6 months LIBOR for $ 10
million with a swap Bank for a period of 3 years.
b. Basic Swaps:
A basic swap involves exchange of interest payments calculated on

different terms, such as 6 month LIBOR and prime rate (or triple A
commercial paper rate).
c. Cross currency Interest swaps:
In this type of swaps exchange of payment on different currencies is
involved. For example Dollar 6 months floating rate with fixed yen
interest rates for a specified period on equivalent not notional principal
amounts, or fixed rate dollar with fixed rate yen.
d. Whether Option as an instrument can be considered one sided to the
extent
it favours option buyer rather than the option seller
e. In every transaction involving a sale/purchase of a tangible value
(article), it is generally the buyer that makes the choice or option. The
seller merely makes the offer to sell. The seller can woo the buyers, can
display and advertise his products to catch the eye of the buyer, but he
has right to demand any buyer to buy his products. It is that there is
scope for the buyer to select his sellers, but not such a scope for the
seller, who can only thank a buyer, when he buys his goods.
f. But this is not to be considered as a one-sided phenomenon prevailing
in a market environment. When the seller is strong he knows his
products will be sold, that every year normally his turnover will improve.
This is because his product has a utility and the buyers need his
products for their satisfaction. The seller has salesmanship and
marketing skills and he can predict the psychology of buyers.
g. This is the general pattern of all buying and selling. Viewed in this sense
the case of the Option seller is not different. The option seller is in the
business not under compulsion, but because he finds this business
paying and it further suits his interests. He is in the business because,
the business benefits him and he will not continue in the business
unless it is so.

h. This being the background of the commercial system, we may consider

in more details various features of the Currency & Interest rate Sale/buy
options in foreign exchange market
i. An option is a contract between two parties in which one party grants
the other to buy/sell an asset at a specified price while the counter party
assumes an obligation to sell/buy that asset at the agreed price. The
party retaining the right to buy/sell is the option buyer ort holder and the
party granting the right to buy or sell is the option writer or grantor. It is
important to note that an option contract confers the right but not an
obligation on the option buyer. On the other hand, an option contract
imposes an obligation (to buy or sell as the case may be) on the option
writer.
j. A foreign currency option is the contract that provides the buyer the right
(but not the obligation) to buy/sell specified quantity of foreign currency
at an agreed upon exchange rate on payment of a specified amount as
fee. The exporter buys a put option to sell his export earnings, while the
Importer buys a call option to buy foreign currency.
k. Thus the Indian exporter who buys a put option on Dollars will exercise
the option and sell his currency only if the exchange rate for RupeeDollar is adversely affected. If the value of the Dollar appreciates in
terms of the rupee, the Exporter in the normal course will receive a
higher payment on account of the market fluctuation and he will not buy
the option. Similarly the Importer who buys a call option to buy Dollars
will exercise the option when the value of rupee falls and he has to
make a higher payment in rupees for the import transaction. On the
other hand if the Rupee appreciates and he has to pay at market rates
less rupees towards payment, he will not buy the option.
l. In either cased the Option Writer gains the income by way of premium.
This income is a non-fund based income i.e. an income generated
without any investment or sale or purchase.
m. In the technical and legal sense, the options are loaded one sided i.e. a
pairing of right and an obligation between two parties. On other hand

the buyer of the option when he does not make the buy/sell, does incurs
a sacrifice since he has to make payment of the premium or fee to the
option writer, without getting anything in return. Thus the option writer
will be gaining a good income even if most of the option buyers close
the transaction with a buy/sell. Trading of options is thus a trading of
risks, and the consideration is the premium charges, When risk
materialises the option is exercised, otherwise it will not be. This is a
financial service and the option writer is equipped and possess the
expertise to undertake this service. He continues the business because
the business is overall lucrative to him. Thus though the statement is
formally or technically correct, it may not be so materially.
PART 20
Management of Risks of Foreign Exchange Market
Foreign Exchange Derivatives Market in India

The contents of this article are by way of extracts from a Research Paper titled "Foreign Exchange Derivatives Market in India Status and Prospect" authored by Neeraj Gambhir & Manoj Goel ICICI Bank Ltd and published on the website of The Indira Gandhi
Institute of Development Research (IGIDR) . IGIDR is an advanced research institute (& Deemed University) established by the
Reserve Bank of India for carrying out research on development issues from a multi-disciplinary points of view. The objective of this
paper (Foreign Exchange Derivatives Market in India - Status and Prospec) is to review the development of the foreign exchange
derivatives market in India under the current regulatory regime with limited capital account convertibility. Evolution of a broad based,
active and liquid forex derivatives markets would provide corporates/businesses with a spectrum of derivative products to manage
their foreign exchange exposures. This paper details the hedging mechanism currently used by Indian corporates, as well as
conjecture how the hedging mechanisms might change with a continuously evolving regulatory regime and increasing convertibility
on the capital account This paper is a part of a comprehensive project on "Derivatives Markets in India.2003" coordinated by
Mr.Susan Thomas, faculty of IGIDR

In India, the economic liberalization in the early nineties provided the

economic rationale for the introduction of FX derivatives. Business houses
started actively approaching foreign markets not only with their products but
also as a source of capital and direct investment opportunities. With limited
convertibility on the trade account being introduced in 1993, the environment
became even more conducive for the introduction of these hedge products.
Hence, the development in the Indian forex derivatives market should be seen
along with the steps taken to gradually reform the Indian financial markets. As
these steps were largely instrumental in the integration of the Indian financial
markets with the global markets

The forex derivative products that are available in Indian financial markets can
be sectored into three broad segments viz. forwards, options, currency swaps.
We take a look at all of these segments in detail:
Rupee Forwards
An important segment of the forex derivatives market in India is the Rupee
forward contracts market. This has been growing rapidly with increasing
participation from corporates, exporters, importers, banks and FIIs. Till
February 1992, forward contracts were permitted only against trade related
exposures and these contracts could not be cancelled except where the
underlying transactions failed to materialize. In March 1992, in order to
provide operational freedom to corporate entities, unrestricted booking and
cancellation of forward contracts for all genuine exposures, whether trade
related or not, were permitted. Although due to the Asian crisis, freedom to
rebook cancelled contracts was suspended, which has been since relaxed for
the exporters but the restriction still remains for the importers.
RBI Regulations Covering Rupee Forwards
The exposures for which the rupee forward contracts are allowed under the
existing RBI notification for various participants are as follows:
1. Residents: Genuine underlying exposures out of trade/business
o Exposures due to foreign currency loans and bonds approved by
RBI
o Balances in EEFC accounts
2. Foreign Institutional Investors:
o They should have exposures in India
o Hedge value not to exceed 15% of equity as of 31 March 1999
plus increase in market value/ inflows
3. Non-resident Indians/ Overseas Corporates:
o Dividends from holdings in a Indian company
o Deposits in FCNR and NRE accounts

o Investments under portfolio scheme in accordance with FERA or

FEMA
The forward contracts are also allowed to be booked for foreign currencies
(other than Dollar) and Rupee subject to similar conditions as mentioned
above. The banks are also allowed to enter into forward contracts to manage
their assets - liability portfolio. The cancellation and rebooking of the forward
contracts is permitted only for genuine exposures out of trade/business upto 1
year for both exporters and importers, whereas in case of exposures of more
than 1year, only the exporters are permitted to cancel and rebook the
contracts. Also another restriction on booking the forward contracts is that the
maturity of the hedge should not exceed the maturity of the underlying
transaction.
The liquidity in the Indian forwards market is mainly for the end maturity
contracts, where the bid-offer spread is also low. Standard maturity contracts
like for 3 months and 6 months are not quoted in the inter bank markets.
Hence, the cost of entering into a standard maturity contract is much higher as
compared to a month end contract. Other eccentricities such as the tenuous
links with the interest rate differential still prevail in a market driven primarily
by supply/demand. The forward premia has been gradually aligning to
fundamentals of "interest rate parity", a process that should accelerate with
increased convertibility on the capital account. One of the drivers for this could
be that the integration between the domestic market and the overseas market
has been facilitated now by allowing ADs to borrow from their overseas offices
and invest funds in overseas money market up to 25% of Tier I capital.
Cross Currency Forwards:
Cross currency forwards are also used to hedge the foreign currency
exposures, especially by some of the big Indian corporates. The regulations
for the cross currency forwards are quite similar to those of Rupee forwards,
though with minor differences. For example, a corporate having underlying
exposure in Yen, may book forward contract between Dollar and Sterling.
Here even though its exposure is in Yen, it is also exposed to the movements
in Dollar vis a vis other currencies. The regulations for rebooking and
cancellation of these contracts are also relatively relaxed. The activity in this
segment is likely to increase with increasing convertibility of the capital
account.
Outlook: Currency Futures:

As mentioned earlier, Indian forwards market is relatively illiquid for the

standard maturity contracts as most of the contracts traded are for the month
ends only. One of the reasons for the market makers reluctance to offer these
contracts could be the absence of a well- developed term money market. It
could be argued that given the future like nature of Indian forwards market,
currency futures could be allowed.
Some of the benefits provided by the futures are as follows:
Currency futures, since they are traded on organized exchanges, also
confer benefits from concentrating order flow and providing a
transparent venue for price discovery, while over-the-counter forward
contracts rely on bilateral negotiations.
Two characteristics of futures contract- their minimal margin
requirements and the low transactions costs relative to over-the-counter
markets due to existence of a clearinghouse, also strengthen the case
of their introduction
Credit risks are further mitigated by daily marking to market of all futures
positions with gains and losses paid by each participant to the
clearinghouse by the end of trading session.
Moreover, futures contracts are standardized utilizing the same delivery
dates and the same nominal amount of currency units to be traded.
Hence, traders need only establish the number of contracts and their
price.
Contract standardization and clearing house facilities mean that price
discovery can proceed rapidly and transaction costs for participants are
relatively low
However given the status of convertibility of Rupee whereby residents cannot
freely transact in currency markets, the introduction of futures may have to
wait for further liberalization on the convertibility front.
Option: Cross currency options:
The Reserve Bank of India has permitted authorised dealers to offer cross
currency options to the corporate clients and other interbank-counterparties to
hedge their foreign currency exposures. Before the introduction of these
options the corporates were permitted to hedge their foreign currency

exposures only through forwards and swaps route. Forwards and swaps do
remove the uncertainty by hedging the exposure but they also result in the
elimination of potential extraordinary gains from the currency position.
Currency options provide a way of availing of the upside from any currency
exposure while being protected from the downside for the payment of an
upfront premium.
RBI Regulations
These contracts were allowed with the following conditions
These currency options can be used as a hedge for foreign currency
loans provided that the option does not involve rupee and the face value
does not exceed the outstanding amount of the loan, and the maturity of
the contract does not exceed the un-expired maturity of the underlying
loan.
Such contracts are allowed to be freely rebooked and cancelled. Any
premia payable on account of such transactions does not require RBI
approval
Cost reduction strategies like range forwards can be used as long as
there is no net inflow of premia to the customer.
Banks can also purchase call or put options to hedge their cross
currency proprietary trading positions. But banks are also required to
fulfill the condition that no stand alone transactions are initiated. If a
hedge becomes naked in part or full owing to shrinking of the portfolio, it
may be allowed to continue till the original maturity and should be
marked to market at regular intervals.
There is still restricted activity in this market but we may witness increasing
activity in cross currency options as the corporates start understanding this
product better.
Outlook Rupee currency options
Corporates in India can use instruments such as forwards, swaps and options
for hedging cross-currency exposures. However, for hedging the USD-INR
risk, corporates are restricted to the use of forwards and USD-INR swaps.
Introduction of USD-INR options would enable Indian forex market

participants manage their exposures better by hedging the dollar-rupee risk.

The advantages of currency options in dollar rupee would be as follows
Hedge for currency exposures to protect the downside while retaining
the upside, by paying a premium upfront. This would be a big advantage
for importers, exporters (of both goods and services) as well as
businesses with exposures to international prices. Currency options
would enable Indian industry and businesses to compete better in the
international markets by hedging currency risk
Non-linear payoff of the product enables its use as hedge for various
special cases and possible exposures. e.g. If an Indian company is
bidding for an international assignment where the bid quote would be in
dollars but the costs would be in rupees, then the company runs a risk
till the contract is awarded. Using forwards or currency swaps would
create the reverse positions if the company is not allotted the contract,
but the use of an option contract in this case would freeze the liability
only to the option premium paid upfront.
The nature of the instrument again makes its use possible as a hedge
against uncertainty of the cash flows. Option structures can be used to
hedge the volatility along with the non-linear nature of payoffs. Attract
further forex investments due to the availability of another mechanism
for hedging forex risk.
Hence, introduction of USD-INR options would complete the spectrum of
derivative products available to hedge INR currency risk.
Exotic options
Options being over the counter products can be tailored to the requirements of
the clients. More sophisticated hedging strategies call for the use of complex
derivative products, which go beyond plain vanilla options.
These products could be introduced at the inception of the Rupee vanilla
options or in phases, depending on the speed of development of the market
as well as comfort with competencies and Risk Management Systems of
market participants. Some of these products are mentioned below:
Simple structures involving vanilla European calls and puts such as rangeforwards, bull and bear spreads, strips, straps, straddles, strangles, butterflies,
risk reversals,etc.

 Simple exotic options such as barrier options, Asian options, Lookback

options and also American options.
More complex range of exotics including binary options, barrier and
range digital options, forward-start options, etc
Some of the above-mentioned products especially the structure involving
simple European calls and puts may even be introduced along with the
options itself.
Management of Risks of Foreign Exchange Marke
Foreign Exchange Derivatives Market in India (Part:2)

The contents of this article are by way of extracts from a Research Paper titled "Foreign Exchange Derivatives Market in India Status and Prospect" authored by Neeraj Gambhir & Manoj Goel ICICI Bank Ltd and published on the website of The Indira Gandhi
Institute of Development Research (IGIDR) . IGIDR is an advanced research institute (& Deemed University) established by the
Reserve Bank of India for carrying out research on development issues from a multi-disciplinary points of view. The objective of this
paper (Foreign Exchange Derivatives Market in India - Status and Prospec) is to review the development of the foreign exchange
derivatives market in India under the current regulatory regime with limited capital account convertibility. Evolution of a broad based,
active and liquid forex derivatives markets would provide corporates/businesses with a spectrum of derivative products to manage
their foreign exchange exposures. This paper details the hedging mechanism currently used by Indian corporates, as well as
conjectures how the hedging mechanisms might change with a continuously evolving regulatory regime and increasing convertibility
on the capital account This paper is a part of a comprehensive project on "Derivatives Markets in India 2003" coordinated by Mr.
Susan Thomas, faculty of IGIDR

Other derivatives product

Foreign currency - rupee swaps
Another spin-off of the liberalization and financial reform was the development
of a fledgling market in FC- RE swaps. A fledgling market in FC- RE swaps
started with foreign banks and some financial institutions offering these
products to corporates. Initially, the market was very small and two way
quotes were quite wide, but the market started developing as more market
players as well as business houses started understanding these products and
using them to manage their exposures. Corporates started using FC- RE
swaps mainly for the following purposes:
Hedging their currency exposures (ECBs, forex trade, etc.)
To reduce borrowing costs using the comparative advantage of
borrowing in local markets (Alternative to ECBs - Borrow in INR and
take the swap route to take exposure to the FC currency)

The market witnessed expanding volumes in the initial years with volumes
upto USD 800 million being experienced at the peak. Corporates were actively
exploring the swap market in its various variants (such as principal only and
coupon only swaps), and using the route not only to create but also to
extinguish forex exposures. However, the regulator was worried about the
impact of these transactions on the local forex markets, since the spot and
forward markets were being used to hedge these swap transactions.
So the RBI tried to regulate the spot impact by passing the below regulations:
The authorized dealers offering swaps to corporates should try and
match demand between the corporates.
The open position on the swap book and the access to the interbank
spot market because of swap transaction was restricted to USD 10
million.
The contract if cancelled is not allowed to be rebooked or reentered for
the same underlying.
The above regulations led to a constriction in the market because of the onesided nature of the market. However, with a liberalizing regime and a buildup
in foreign exchange reserves, the spot access was initially increased to USD
25 million and then to USD 50 million. The authorized dealers were also
allowed the use of currency swaps to hedge their asset-liability portfolio. The
above developments are expected to result in increased market activity with
corporates being able to use the swap route in a more flexible manner to
hedge their exposures. A necessary pre-condition to increased liquidity would
be the further development and increase in participants in the rupee swap
market (linked to MIFOR) thereby creating an efficient hedge market to hedge
rupee interest rate risk.
Foreign Currency Derivatives
There is some activity in other cross currency derivatives products also, which
are allowed to be used to hedge the foreign currency liabilities provided these
were acquired in accordance with the RBI regulations.
The products that may be used are Currency swap

 Coupon Swap
Interest rate swap
Interest rate cap or collar (purchases)
Forward Rate Agreement (FRA) contract
However the regulations require that:
The contract should not involve rupee
The notional principal amount of the hedge does not exceed the
outstanding amount of the foreign currency loan, and
The maturity of the hedge does not exceed the un-expired maturity of
the underlying loan
Outlook: Some proposed products
Finally some innovative products may be introduced which satisfy specific
customer requirements. These are designed from the cash and derivative
market instruments and offer complex payoffs depending on the movement of
various underlying factors. Some of the examples of these products are
provided below:
1. Accrual forward:
With an accrual forward, for each of the daily fixings up to expiry that
spot remains within the range, the holder gets longer 1 unit of USD/INR
at the Forward Rate. For example, for each of the daily fixings up to
expiry that spot remains within the range let us say 48.50 to 48.60, the
holder accrues 1 unit at the forward rate of 48.56.
2. Enhanced accrual forward: Enhanced accrual forward is similar to
accrual forward, but this contract has two forward rates, which apply for
different ranges. For example, Accrue long 1 unit per fixing at forward
rates of 48.56(Range 1 - 48.50 to 48.60) or Long 1 unit per fixing at
48.47(Range 2- below 48.50). So for each of the daily fixings up to
expiry that spot remains within the 48.50 - 48.60 range the holder
accrues 1 unit at 48.56. For each of the daily fixings up to expiry that
spot is below 48.50 the holder accrues 1 unit at 48.47. If spot is ever

above 48.60 then nothing will be accrued on that day. Note that the two
ranges do not overlap, so the holder will never accrue more than 1 unit
per fixing.
3. Higher yield deposits: This product can be developed to offer a
comparable higher yield than on a traditional Rupee money market
deposit.
Exercise price : 48.80 per 1 USD
Instrike: : 48.70 per 1 USD
There are three possible scenarios at maturity:
o If spot never trades at or beyond the instrike before expiration, the
investment plus interest at certain rate r will be paid in rupee.
o If spot trades at or beyond the instrike before expiration and
closes above the exercise price, the investor is paid the invested
capital plus interest r paid in rupee.
o But if spot trades at or beyond the instrike before expiration and
closes below the exercise price, the investor is paid in USD. The
sum paid in USD corresponds to the amount of invested capital
plus interest of r converted at the exercise price.
Conclusion
The Indian forex derivatives market is still in a nascent stage of development
but offers tremendous growth potential. The development of a vibrant forex
derivatives market in India would critically depend on the growth in the
underlying spot/forward markets, growth in the rupee derivative markets along
with the evolution of a supporting regulatory structure. Factors such as market
liquidity, investor behavior, regulatory structure and tax laws will have a heavy
bearing on the behavior of market variables in this market.
Increasing convertibility on the capital account would accelerate the process
of integration of Indian financial markets with international markets. Some of
the necessary preconditions to this as suggested by the Tarapore committee
report are already being met. Increasing convertibility does carry the risk of
removing the insularity of the Indian markets to external shocks like the South
East Asian crisis, but a proper management of the transition should speed up
the growth of the financial markets and the economy. Introduction of derivative

products tailored to specific corporate requirements would enable corporate to

completely focus on its core businesses, derisking the currency and interest
rate risks while allowing it to gain despite any upheavals in the financial
markets
[Concluded]

PART 22

What is CRR, SLR, Repo Rate & Reverse

Repo Rate?
RBI (Reserve Bank of India) has cut interest rates.
RBI has increased the interest rates.
RBI keeps the key rates unchanged..
Have you heard or seen these kind of headlines? Hmmm, I am sure you might have.
So, what are these interest rates? How are they going to impact our finances? Let us try to
understand about these interest rates in this post.
One of the primary functions of RBI is to control the supply of money in the economy
and also the cost of credit. Meaning, how much money is available for the industry or
the economy and what is the price that the economy has to pay to borrow that money.
Availability of money is nothing but liquidity and cost of borrowing is interest rates.

These two things (Supply of money and cost of credit) are closely monitored and
controlled by RBI. The inflation and growth in the economy are primarily impacted by
these two factors.
To control inflation and the growth, RBI uses certain tools like CASH RESERVE
RATIO, STATUTORY LIQUIDITY RATIO, REPO RATE, REVERSE REPO RATE etc.,

What is CRR (Cash Reserve Ratio)? SEE PICTURE

It is the ratio of Deposits which banks have to keep with RBI. Under CRR a certain
percentage of the total bank deposits has to be kept in the current account with RBI.
Banks dont earn anything on that.
Banks will not have access to this amount. They cannot use this money for any of their
economic or commercial activities. Banks cant lend this portion of money to corporate
or individual borrowers.
Example You deposit say Rs 1000 in your bank. Then Bank receives Rs 1000 and has
to put some percentage of it with RBI. If the prevailing CRR is 6% then they will have to
deposit Rs 60 with RBI and they are left with Rs 940. Your bank can not use this Rs 60 for

its commercial activities like lending or investment purpose. This Rs60 is deposited in

current account with RBI.

The current CRR is 4%. If RBI cuts CRR in its next monetary policy review which is
scheduled on 2nd, December then it means banks will be left with more money to lend or
to invest. So, more money can be released into the economy which may spur economic
growth.
What is Statutory Liquidity Ratio (SLR)?SEE PICTURE
Besides CRR, Banks have to invest certain percentage of their deposits in specified
financial securities like Central Government or State Government securities. This
percentage is known as SLR.

This money is predominantly invested in government securities which mean the banks
can earn some amount as interest on these investments as against CRR where they do
not earn anything.
Example You deposit say Rs 1000 in your bank. Then Bank receives Rs 1000 and has
to put some percentage of it with RBI as SLR. If the prevailing SLR is 20% then they will
have to invest Rs 200 in Government securities.

So to meet both CRR and SLR requirements, bank have to earmark Rs 260 (Rs 60 + Rs
200).
What is Repo Rate?

When we need money, we take loans from banks. And banks charge certain interest rate
on these loans. This is called as cost of credit (the rate at which we borrow the money).
Similarly, when banks need money they approach RBI. The rate at which banks borrow
money from the RBI by selling their surplus government securities to the central
bank (RBI) is known as Repo Rate. Repo rate is short form of Repurchase Rate.
Generally, these loans are for short durations (up to 2 weeks).
It simply means the rate at which RBI lends money to commercial banks against the
pledge of government securities whenever the banks are in need of funds to meet their
day-to-day obligations.
Banks enter into an agreement with the RBI to repurchase the same pledged government
securities at a future date at a pre-determined price. RBI manages this repo rate which is
the cost of credit for the bank.
Example If repo rate is 5% , and bank takes loan of Rs 1000 from RBI , they will pay
interest of Rs 50 to RBI.
So, higher the repo rate higher the cost of short-term money and vice verse. Higher repo
rate may slowdown the growth of the economy. If the repo rate is low then banks can
charge lower interest rates on the loans taken by us.
If RBI cuts Repo rates in its next monetary policy review which is scheduled on 2 nd,
December then it means the cost of short-term credit can come down.

So whenever the repo rate is cut, can we expect that both the deposit rates and lending
rates of banks to come down to some extent?
This may or may not happen every time. The lending rate of banks goes down to the
existing bank borrowers only when the banks reduce their base rates, as all lending rates
of banks are linked to the base rate of every bank. In the absence of a cut in the base rate,
the repo rate cut does not get automatically transmitted to the individual bank customers.
This is the reason why you might have observed that your loan EMIs remain same even
after RBI lowers the repo rates.
Banks check various other factors (like credit to deposit ratios etc.,) before reducing the
Base rates.
( Base Rate is the minimum rate below which Banks are not permitted to lend)
What is Reverse Repo Rate?
Reverse repo rate is the rate of interest offered by RBI, when banks deposit their surplus
funds with the RBI for short periods. When banks have surplus funds but have no lending
(or) investment options, they deposit such funds with RBI. Banks earn interest on such
funds.
Current CRR, SLR, Repo and Reverse Repo Rates:

The current rates are (as of last week of October 2014) CRR is 4 % , SLR is 22%,
Repo Rate is 8% and Reverse Repo Rate is 7%.
Impact of Repo Rate cut or CRR cut : SEE PICTURE
Currently crude oil (petrol/fuel) prices, commodity prices and inflation have eased.
Against this backdrop, there is a high expectation of RATE CUT this time. So, if there is
a rate cut what is the general impact on the economy?

Hope you liked

this post. Do track the RBIs next Monetary Policy review on 2nd December. Analyze the
impact of CRR or rate cuts (if any)..Cheers!

Latest News 02-Feb-2016 RBI has kept all the key rates CRR/SLR/Repo Rate
unchanged in its first bi-monthly monetary policy of 2016. The current Repo Rate
is unchanged at 6.75%.

Latest News (05-April-2016) : RBI cuts Repo Rate & SLR by 25 basis points. The
latest Repo Rate is 6.50% and SLR is 21.25%. CRR is unchanged at 4% . Reverse
Repo Rate has been increased by 25 basis points to 6%.

(A term called as Basis Points is often used in monetary policy reviews. What is Basis
Point? . 1% is equivalent to 100 basis points.e.g. If Repo Rate is 7.75% and RBI
increases it by 25 basis point, then new rate will be 8% as 25 basis point will be equal to
0.25% )

PART 23

What is the difference between

Benchmark Prime Lending Rate (BPLR)
and Base Rate?
Benchmark Prime Lending Rate (BPLR) is the rate at which commercial
banks charge their customers who are most credit worthy. According to the
Reserve Bank of India (RBI), banks can fix the BPLR with the approval of their
Boards. However, the RBI stipulates the interest rates as BPLR is influenced by
the Repo rate and Cash Reserve Ratio (CRR) apart from individual bank's policy.
However, the BPLR system failed to bring transparency in the lending rates of the
banks. The calculations of BPLR is not that transparent and sometimes the banks

under this system could lend to customers below the BPLR. So, Base Rate was
introduced subsequently.
Base rate is the minimum interest rate of a bank, below which it cannot lend,
except for DRI allowances, loans to bank's own employees and loans to bank's
depositors against their own deposits. The base rate system has replaced the
BPLR from July 1, 2010. Since then the BPLR is gradually losing its importance
except for the loans taken before July 1, 2010. In such cases, RBI has allowed to
continue with BPLR at which the loans were approved. They were, however,
given the option of switching to the base rate before the expiry of their loans.
RBI does not fix the base rate. Individual banks fix their own base rates and so
each bank has its own base rate. The calculations of base rate involve elements
which can be clearly identified and are common across buyers. Banks have to
declare their respective base rates in the website in order to make lending more
transparent.

PART 24
PDF]Basel

III: Implications for Indian Banking - Indian Institute of B

http://www.iibf.org.in/documents/reseach-report/Report-25.pdf

PART 25

MCLR : New Lending Rate on Bank Loans

w.e.f Apr 2016 Details, Components &
Review
6

The Reserve Bank of India has issued new guidelines for setting lending rate (on
loans) by commercial banks under the name Marginal Cost of Funds based Lending
Rate (MCLR). It will replace the existing base rate system from April 2016 onwards.

Base rate system was introduced by RBI in July 2010 to ensure that banks can not lend
below a certain benchmark. Also, to ensure that the changes in interest rate policy is
effectively transmitted to the bank customers.
However, policy transmission could not become very effective as banks adopted various
methods in calculating their cost of funds. At present, the banks are slightly slow to
change their interest rate in accordance with Repo Rate change by the RBI.
You might have observed that RBI has cut interest rates to the tune of 125 basis points in
this fiscal year. But, this has not been effectively transmitted to lending rates offered by
the banks. Banks have so far lowered their base rate by only 50-60 basis points.
( A term called as Basis Points is often used in monetary policy reviews. What
is Basis Point? . 1% is equivalent to 100 basis points)
Same is the case when interest rates are increased by the RBI. If RBI increases rates by
say 100 basis points, banks increase their benchmark rates by say 50 basis points. So, the
base rate system has turned out to be not so effective method.
In this post let us understand What is Marginal Cost of Lending Rate? Difference
between MCLR and Base rate methods? How is MCLR calculated or determined? Is new
MCLR system beneficial to borrowers & banks? What is the impact of MCLR on
existing and new home loan buyers?
(YOU MAY LIKE READING MY POST ON WHAT IS CRR / SLR / REPO RATE / REVERSE REPO RATE SEE MY NEXT POST )

How is MCLR calculated? (Components of MCLR calculation)

Let us first understand as to how banks make money or profit. The primary function of a
bank is to lend money and to accept deposits from the public. The difference between
advances and deposits is the income earned by the banks.
So, how is the base rate or Standard Lending Rate calculated by the banks? The main
components of base rate system are;
Cost of funds (interest rates offered by banks on deposits)
Operating expenses to run the bank.
Minimum Rate of return ie margin or profit
Cost of maintaining CRR (Cash Reserve Ratio).
As you can see, the banks do not consider repo rate in their calculations. They primarily
depend on the composition of CASA (Current accounts & Savings Accounts) and
deposits to calculate the lending rate. Most of the banks are currently following average
cost of fund calculation. So, any cut or increase in rates (especially key rate like Repo
Rate) by the RBI is not getting transmitted to the bank customers immediately.
(What is repo rate? When we need money, we take loans from banks. And banks charge
certain interest rate on these loans. This is called as cost of credit (the rate at which we
borrow the money)

Similarly, when banks need money they approach RBI. The rate at which banks borrow
money from the RBI by selling their surplus government securities to the central bank
(RBI) is known as Repo Rate.)
As per the RBIs new guidelines, it is mandatory for the banks to consider the repo rate
while calculating MCLR with effective from 1st April, 2016. The new method
Marginal Cost of funds based Lending Rate (MCLR) will replace the present base rate
system.
The main components of MCLR calculation are;
Operating Expenses
Cost of maintaining CRR
Marginal Cost of funds
After considering interest rates offered on savings / current / term deposit
accounts.
Based on cost of borrowings i.e., short term borrowing rate which is repo
rate & also on long-term borrowing rates.
Return on Net-worth

2 Tenor Premium (an additional slab of interest over the base rate, based on the
loan tenure & commitments).

The main differences between the two calculations are i) marginal cost of funds & ii)
tenor premium. The marginal cost of funds will have high weightage while calculating
MCLR. So, any change in key rates (increase or decrease) like repo rate brings changes
in marginal cost of funds and hence the MCLR should also be changed by the banks
immediately.
(In economics sense, marginal means the additional or changed situation. While
calculating the lending rate, banks have to consider the changed cost conditions or the
marginal cost conditions.)

RBIs key guidelines on MCLR

All loans sanctioned and credit limits renewed w.e.f April 1, 2016 will be priced
based on the Marginal Cost of Funds based Lending Rate.
MCLR will be a tenor-based benchmark instead of a single rate. This allows banks
to more efficiently price loans at different tenors based on different MCLRs,
according to their funding composition and strategies.
Banks have to review and publish their MCLR of different maturities every month
on a pre-announced date.
The final lending rates offered by the banks will be based on by adding the
spread to the MCLR rate.
Banks may specify interest reset dates on their floating rate loans. They will have
the option to offer loans with reset dates linked either to the date of sanction of
the loan/credit limits or to the date of review of MCLR.
The periodicity of reset can be one year or lower.
The MCLR prevailing on the day the loan is sanctioned will be applicable till the
next reset date (irrespective of changes in the benchmark rates during the interim
period). For example, if the bank has given you a one-year reset period in your
loan agreement, and your base rate at the beginning of the year is say 10%, even if

the interest rate comes to 9% in the middle of the year, you will continue at 10%
till the reset date. Same will be the case even if the interest rate increases above
10%.
Existing borrowers with loans linked to Base Rate can continue with base rate
system till repayment of loan (maturity). An option to switch to new MCLR
system will also be provided to the existing borrowers.
Once a borrower of loan opts for MCLR, switching back to base rate system is not
allowed.
Loans covered by government schemes, where banks have to charge interest rates
as per the scheme are exempted from being linked to MCLR.
Like base rate, banks are not allowed to lend below MCLR, except for few
categories like loans against deposits, loans to banks own employees.
Fixed Rate home loans, personal loans, auto loans etc., will not be linked to
MCLR.

How MCLR Works? (Example)

For instance, for salaried individuals, ICICI Bank has set a floating rate home loan at
one-year MCLR of 9.20% with a spread of 25 bps for loans of up to Rs.5 crore. So, the
interest rate will be 9.45% (9.20% +0.25%). This interest rate is valid till 30th April,

2016 (as given in the banks website). ICICI Bank has decided to set one-year MCLR as
the benchmark rate for their home loans.
Though the MCLR is reviewed monthly, your home loan will be reset every year
automatically, depending on the agreement with the bank.
So, if you take a Rs.50-lakh home loan on 10th April,2016, your home loan interest rate
would be 9.45% . You have to pay EMI installments at this rate of interest for the next 12
months.
Lets say one-year MCLR gets revised to 9.% in April, 2017 and the spread remains the
same then your home loan interest rate will be reset at 9.25% (MCLR of 9% plus spread
of 25 bps).
My Opinion
If interest rate cycle is in a downward trend, MCLR can be beneficial to borrowers
of loans like home loan buyers.
But do remember that the interest rates may not remain low forever, when the
trend changes the MCLR rate hike can be swift.
If you are an existing home loan buyer and planning to repay your home loan in
say next few years, you can consider switching to MCLR method (as of now the

charges applicable to move to MCLR is not available, you have to account for
these charges and then take final decision).
If you are planning to buy a property through a home loan, you may take the loan
under existing base rate before 31st Mar, 2016. Based on the prevailing economic
factors, the RBI may not cut interest rates in the very near future, you may
continue with base rate and anyways you have the option to move to MCLR at a
later point of time, if RBI cuts rates.
It is too early to say if the change in base rate will actually be completely passed
on to consumers. Because, do remember that banks still have the option to set a
spread on loans. Banks are free to determine the range of spread for a given
category of borrower or type of loan. (For example, if the loan interest rate offered
to you is 10.25% and the new base rate as per MCLR is say 10%, 0.25% is the
spread)
As far as banks are concerned, their margins might take a hit in the range of Rs
15,000 to Rs 22,000 crore assuming a 75 basis point decline (source
ICRA). Banks may lose when interest rates drop but will gain when rates increase.
So, it all depends on how many instances of rate cuts will happen in the future.

Latest News (07-April-2016) : SBI has decided to set one-year MCLR as the benchmark
rate for their home loans. SBI in a statement said that it has fixed its home loan interest
rate at 9.45%, which is 0.25 % (spread) more than its one-year MCLR of 9.20%.
However, women borrower would get the loan 0.20% (spread) above the MCLR at
9.40% (9.20%+0.20%).
Latest News (05-April-2016) : RBI cuts Repo Rate & SLR by 25 basis points. The latest
Repo Rate is 6.50% and SLR is 21.25%. CRR is unchanged at 4% . Reverse Repo Rate
has been increased by 25 basis points to 6%. (Read : What is CRR/SLR/Repo
Rate/Reverse Repo Rate?)

Do you believe that this new base rate system will be beneficial to loan
borrowers? Kindly share your views on Marginal Cost of Funds based Lending Rate?

PART 26 BANK PROMOTION TEST SITES

DEAR BANK WORKERS :

i have culled out some important sites augmenting on bank promotion tests . they are not my own creation but collected from
different websites/internet/FB. I am just trying to put together everything I could find on internet. For copying/printing these files,
just right click on the link. The file will open in Google Drive/Doc. Click on the Down Arrow to download the file. Wishing the spirants
the very best.
s.srinivasan

Bank Promotion Tests - Bank Internal Promotion Tests

http://www.allbankingsolutions.com/Internal-Promotions/Bank-Promotions-Main.htm

http://www.bankpromotionexams.com/sample.php
http://www.bankpromotionexams.com/material.php
http://nstoor3553433.wiziq.com/course/6698-bank-promotion-exam-preparation-ebook-for-clerical-staff
http://www.aiabaeu.com/Circulars/PROMOTION%20STUDY%20MATERIAL.pdf
https://www.wiziq.com/online-tests/5107-mock-test-promotion-exam