What is a currency exchange floor rate?

According to a recent UNCTAD* survey, India is the third-most attractive nation after China and the United States for Foreign Direct Investment. Over the last decade, the Indian economy has witnessed a boom and become a marketplace for huge international conglomerates.

India’s financial system has transformed from being limited to being a liberal setup. Indian markets never cease to provide a plethora of opportunities for international institutions. As a result, currency markets in India are skyrocketing.

Foreign Exchange or the Currency Market is a marketplace to buy and sell various international currencies. A currency exchange rate is the value of a country’s currency against that of another currency. Exchange rates are correlative and demonstrated as a comparison of currencies of two countries. Foreign exchange rates may be fixed or floating.

Types of Exchange Rates

Yes, there's more than one! Foreign exchange rates can be broadly divided into the following categories:

  • Fixed exchange rates
    It is also known as a pegged exchange rate. A fixed exchange rate is a regime imposed by the government or RBI. It ties the official exchange rate of the country's currency with the currency of another country or the current gold prices. Such a mechanism allows the government to maintain low inflation, keep interest rates down and stabilize trade and investment.
  • Floating exchange rates
    Unlike fixed currency, a floating currency is a monetary system that is not backed by gold or underlying assets. Floating exchange rates are determined by the forces of demand and supply in the market. They are adjusted in tandem with global events or crises. Since the liberalization of India, the floating exchange rate has been well adopted.
  • Spot vs. Forward rates
    Spot rates refer to the current price of a currency whereas forward rate refers to the expected, future rate of the currency. The forward rate fluctuates with changes in price expectations.
  • Onshore vs. Offshore rates
    This is a dual-rate system where an onshore (within country borders) and offshore (outside country borders) rate is maintained for each currency. The onshore or domestic rate is more beneficial for international transactions.

What is the Currency Exchange Floor Rate?

The currency exchange rate is one of the most important indicators of the financial health of a country. Hence, they are actively tracked, analyzed, and controlled by the government. The value of a currency is inversely proportional to the cost of imports i.e., the higher the value of a currency, the lower is the import cost and vice-versa.

Currency exchange rates are determined by multiple factors that include:

  • Inflation
  • Interest rate differentials
  • Trade deficits
  • Public debt
  • Terms of trade
  • Economic performance

From the above, the relationship between foreign exchange rates and interest rates is highly interdependent.

As you may know, foreign exchange rates are a function of various factors and tend to change continuously. This means foreign exchange rates in India are the floating type. The Reserve Bank of India (RBI) monitors and regulates the money supply in the economy. An increase or decrease in the supply of money has a direct impact on the interest rates and an indirect impact on the currency exchange rate.

Scenario 1
Let’s consider that the RBI resolves to increase the money supply in the economy. In this case, interest rates will reduce and so will the yield. Thus, a foreign investor may liquidate his investment and rather plow money into a higher-yielding asset. Consequently, the supply of money increases, and the value of the domestic currency depreciates.

Scenario 2
Conversely, if the RBI decides to decrease the money supply in the economy, the demand for liquidity increases. Interest rates also see an increase since the availability of capital is relatively controlled. Foreign investors are presented with an opportunity to earn higher yields which leads to an increase in investments and an increase in demand for the domestic currency leads to value appreciation. A prudent investor aims for maximum rewards at the lowest possible risk.

A revision in the interest rates of a nation may have a bearing on the exchange rates of other economies too. For example, an interest rate hike in the US may lead to a reduction in the value of the Indian Rupee because the investors with access to global markets may withdraw capital from India and invest it in the US. Essentially, changes in interest rates of developed countries with established economies have an impact on the exchange rates of developing nations.

The scenarios presented above may be oversimplified. However, the bottom line is that foreign exchange rates are subject to volatility. To control extreme volatility, the concept of foreign exchange floor rates comes into play.

Floor rates refer to the lowest possible limits as restricted by the controlling parties. In terms of foreign exchange, the Government and/or the Central Bank (RBI) may decide that the value of the domestic currency must not fall beyond a certain level. Such a value is referred to as the exchange rate floor.

As the free-floating trading of the currency moves closer to the exchange rate floor, the RBI intervenes. RBI will in such a case, purchase huge amounts of the domestic currency to create artificial demand and prevent the price from breaching the threshold floor rate. With foreign exchange floor rates, the foreign exchange rate system is a combination of fixed and floating exchange rates.

Advantages of Foreign Exchange Floor Rate

Foreign Exchange Floor Rates inculcate a degree of stability in the movement of exchange rates. Simultaneously, they also provide flexibility in the case of the country subject to a foreign exchange inflow. The exchange rate responds to external shocks and corrects itself. However, in extreme situations, the Central Bank intervenes and lends support.

The Foreign Exchange Floor Rate also limits the degree of speculative loss. Investors may use the floor rate as a reference to predict the rate movement. Devaluation of the currency can be strictly monitored and restricted if required. Macroeconomic indicators of a country affect the exchange rate in global markets and the investment flow, resulting in an overall increase in market efficiency. Foreign exchange reserves maintained by the Central Bank reduce significantly. The balance of payments position is also better managed.

Final Word

The current exchange rate mechanism in India offers an ideal mix for foreign exchange transactions. With a formidable economy, favorable factors of production, and an active workforce, India ticks all the boxes for foreign investment. Shortly, the currency markets in India are expected to be more organized, stronger, and stable.