Question: What are the sources of industrial finance?

INDUSTRIAL FINANCE
Need for industrial finance
Finance is the life –blood of industry. Adequate finance is absolutely
necessary to oil the wheels of the industrial machine, to ensure its smooth
working and to prevent its breakdown. Lack of adequate and timely finance
is one of the causes of slow development of industries of India.
Industry needs funds for block or capital expenditure, i.e. , for the
purchase of land, erection of the factory building, for installation of
machinery, etc, and in the case of a going concern, for extensions and
replacements. Besides this, funds are also required for the purchase of raw
materials, for stores, for other expenses incidental to production and
marketing, and for meeting the day- to –day requirements of the industry.
This is known as the working capital.
Sources of industrial finance
There are 2 broad sources of finance: internal and external.
The internal sources mean internal funds e.g., free reserves of an
industrial concern, its depreciation funds and retained profits. The external
sources on the other hand, mean sources outside the businesses, i.e., raising
fresh capital and issuing debentures, long and short- term loans from various
sources, accepting deposits, etc.
The following are the main sources from which the Indian industry draws
finance:
Shares and debentures
The bulk of the capital is raised through the sale of share. Debentures are
also issued but till recently these accounted for a small proportion of capital
raised for industry. However, lately they have become immensely popular
with the investors, especially the convertible debentures/bonds for e.g., in
1986-87 Rs. 1369 crores were raised through debentures out of the total
capital issues [paid up] of Rs 1774 crores in 1987-88 to Rs 3117 crores in
1988 -89 from Rs. 664 croress in 1987-88.thus, debenture issues formed
67.8 percent of the total new capital issues in 1988-89.
In recent years, however, the role of equity or share capital has
declined for 2 reasons [a] compulsive of the mixed economy that we have,
[b] progressive institutionalization of community’s savings. The term –
financial institutions have now emerged as major suppliers of industrial
finance. They underwrite 92.97% of the share capital offered to the public.
Public deposits
Deposits from the public are another source. In fact, the Ahmedabad
textile industry was set up on the basis of this source. In recent years, owing
to a policy of restraints on bank credit, a large number of industrial concerns
all over the country have been inviting deposits from the public for one to
three years and paying attractive rates of interest which are much higher than
are allowed by banks on their fixed deposits. In order to protect the interest
of depositors, the RBI has imposed certain restrictions on the receipt of
deposits by companies. At the march –end 1997, the deposits held by2,376
public limited companies stood Rs. 223873 crores. This method however, is
not satisfactory it is not a sound policy to finance schemes of long –term
investment with short-term deposit of 1 to 3 years.
Commercial banks: short term loans, on the cash-credit system, can be
obtained by the industrial concerns from the commercial banks on the
security of stock and, in some cases, till recently, on the additional guarantee
of the managing agent.
‘’while the traditional policies of Indian banks contribute quite successfully
to meeting short-term needs of existing industries and merchants, their
contributions to the longer term needs of industry and requirement of
potential new industrialists have been either indirect or peripheral” .
Although the commercial banks have been mostly providing self-liquidating
finance for short-term purposes, yet they have now entered the field of
medium-term finance particularly since the establishment of the industrial
development bank of India (IDBI) which provides refinance facilities to
them.
“Now in India, from the time an industrialist conceives a new project;
his bank is with him always guiding and advising. His bank may underwrite
the new capital issue in part, collect the allotment and call money of
subscribed shares, furnish guarantees for deferred payment in respect of
plant and equipment to be imported, and when the project comes to fruition
provide working capital requirement to run the factory satisfactorily”.
According to Reserve Bank study on 621 non- govt and non-financial large
public limited companies, short term bank borrowings as percentage of
inventories increased from 44.8% in 1984-85, to 48.2%in 1987-88.
Indigenous bankers
In urban areas especially medium sized industries, can obtain finance
from the indigenous bankers. But they charge exorbitant rates of interest
which few industries can bear. Not many industries approach the now. Since
the setting up of the state financial corporations, this source of finance is,
therefore becoming less and less important.
Term lending institutions
In view of the inadequacy of the above mentioned source s, several
new financial institutions have been started since independence to meet the
financial requirement of the Indian industries. These are the industrial
finance corporation [IFCI], industrial credit and Investment Corporation of
India {ICICI}, industrial development bank of India [IDBI] and small
industries development bank of India [SIDBI] at the all India level and state
finance corporation[SFC], state industrial development corporation
[SIDCO] in states. Besides, UTI, LIC, general insurance companies [GIC]
etc, also provide finance for industries. With their rapidly growing scale of
operations, this term –lending institutions have, in recent years, emerged as
the most important source of industrial finance of India. Aggregate
assistance sanctioned by them in 2000 stood at Rs 10, 3748.9crores.
Leasing and financial companies
A novel source of industrial finance has to late start emerging in India,
viz., leasing and finance companies. They lease costly plant and equipment
to industrial finance concerns and also sometimes sell them equipment on
hire- purchasing basis, by installing leased plant and machinery, an
industrial concern saves on fixed capital and can thus reinforce its working
capital. Lease rental being an allowable expenditure for tax purposes, is
another attractive feature of leasing. During the last 5-6 years, a large
number of leasing companies have been formed and they bid fair to emerge
as a significant source of industrial finance, as it has done in the U.S.A and
U.K. as of march 1986, 470 leasing and composite financial companies
accounted for leasing out assets worth Rs, 839 crores, according to the
information available with the reserve bank of India.
Retained profits
So far we have mentioned the external sources of finance for industry.
There is besides an internal source, the own savings of an a industrial i.e.
industrial profits or, in other words, the profits that, instead of being,
distributed among share holders, are Ploughed back into the industry for its
replacements, modernization, Up gradation of technology, expansion and
diversification. Depreciation funds and investment allowance reserved funds
accumulated over period of time constitute other internal sources for
industrial concerns. Once an industrial concern is started and gets going, its
retained profits are an important source of finance for its further growth.
According to a recent survey of 1942 non- government non- financial public
limited companies by the reserve bank of India, the retained profits of these
companies were Rs 297 crores. However, in the case of 621 non-
government and non financial large public limited companies the profits
retained were estimated at Rs 203 crores at the march –end 1987. These data
establish that at present the relative importance of retained profits is quite
low.
In recent years, the capital market has shown buoyancy as is evident
from the increasing trend of public issues of shares and debentures. The
funds raised from such issues have been increasing.
Foreign capital
Another source of industrial finance of forging capital. Foreign capital can
take the form of [a] direct private investment by foreigners in industrial
concerns,[b] collaboration of foreign business with Indian business in
starting new industrial units,[c] loans or grants by foreign governments for
industrial projects, and [d] loans by international institutions, like the world
bank and its soft loan affiliate, the industrial development association[IDA]
for industrial enterprises.
Several old industries in India like tea, jute, mining, owe their
development to foreign enterprises and forging capital. Of course, since
independence the share of foreign capital in these industries has been
considerably reduced. But a large number of foreign collaborations have
come up in starting new industries. A substantial amount of forging capital,
particularly in the form of government loans and loans from international
instructions, has gone into the expansion of the public sector industries like
steel plants, heavy electrical, machine tools, fertilizer plants and petroleum
refining. It may be added that in order to safeguard national interested, the
government allows forging capital on a selective basis and does not follow
an open-door policy in regard to it. However, the new trade policy
announced on july4, 1991 liberalized the trade policy towards foreign
capital.

Limitations of existing industrial financing system

The system of industrial finance prevalent at present is still far from
satisfactory even though several new institutions have been started in recent
years to fill gas in the structure of industrial finance. The following are main
unsatisfactory features:
1) Inadequacy
The facilities for industrial finance are, at least have been till recently,
inadequate. In industrially advanced of countries there are industrial banks,
but there are few such banks in India. Elsewhere, there are also the issuing
houses and several special intuitions which play a very important role in
financing industries. Until recently we have no such institutions. Even
though some new institutions have been set up in recent years, the financial
facilities continue to be inadequate.

2) Defects:
The existing sources of finance are not only inadequate, but also
suffer from very serious drawbacks. As has been mentioned already, the
deposits from the public are only fair –weather friends, the managing agents
extracted a heavy price for providing finance, and the commercial banks
work on too rigid and orthodox lines to be of much use to industries. They
are usually unwilling to advance loans on personal security or on the
security of block capital, and on the other hand, insist on full backing of
easily –realizable security besides, thy supply working capital only and not
block capital.
3) Costly
Not only is industrial finance inadequate it is very costly too. The
small scale and medium sized industries are seldom able to borrow from the
banks. Usually they borrow from indigenous bankers on personal security at
high very rates the banks also charge quite high rates of interests which our
industries are hardly able to bear.
4) State’s role insignificant
Another obvious feature of our industrial finance is the insignificant
role played by the state in this sphere. There exist, no doubt, state aid to
industries acts in all states by which the state governments advance funds for
industrial ventures. But the finance provided under these acts has been
meager. Owing to the elaborate and irksome procedure which has to be
observed for obtaining loans from the state, such loans have not been
popular.
 Foreign exchange market: is one of the important components of the
international financial system. Especially for the developing economy, the
foreign exchange market is necessary for the conversion of currencies for
short term capital flows or long term investments in the financial physical
assets of another country. The services of foreign exchange markets are
necessary not only for other financial receipts or payments between
countries involving a foreign exchange transaction.
Instruments of credit traded
In addition to conversion of forging currency notes and cash, a
number of instruments of credit are used for effecting conversion in the
foreign exchange market. These instruments are:
Telegraphic transfers [TT]
Mail transfers [MT]
Drafts & cheques
Bills of exchange.
Foreign exchange market components: there are 3 major components
in this mkt, depending upon the transaction:
1 transaction between the public and the base level;
2 transaction between the banks dealing in foreign exchange involving
conversions of currencies;
3 transaction b/w banks and central bank involving purchase and sale of
foreign currencies.
Foreign sector and foreign exchange mkt: each economy has a
foreign sector representing that economy’s external transactions. All such
external transactions are either economic or financial transactions. These
result in receipts into and payments out of the domestic economy. Such
receipts and payments involve the exchange of domestic currency as against
all foreign currencies of countries with which domestic economy has
dealings. Such exchange transaction are put through in the exchange mkt for
that country’s currencies vis-à-vis other currencies. These national exchange
mkts are components of international financial system.
There is thus, as for any other currency, a mkt for the rupee. If an
Indian bank buys dollars, it will pay rupees for dollars & if it sells dollars, it
will receive rupees for dollars. The origin of these transactions is an or
export or an import, inward or outward remittences or any similar
transactions between Indian residents and foreign residents. An exporter in
inia receives dollars from say, USA & he surrenders the bill of exchange
along with other documents t ohis bank. Th bank would have bought that
currencies from th exporter. The bank has been since been on the look –out
for selling those dollars In foreign exchange mkts for those in need of
dollars. Let us say an importer in india importing from the USA is in need of
dollars t opay to the exporters. Another bank is apporoched by the importer
with a demand for dollars and former must have sold dollars to the importer.
Having sold dollars, that bank would then buy the dollars t ocoverup their
position from the former bank.
The foreign exchange mkt in india today arose considerable more
interest than ever before. Over the past 2 years, moments changes have need
brought to bear on the exchange rate regime. This stands today as part of the
overall strategy to improve the functioning of the financial systems. The
EXIM scrip scheme which was introduced in july1991 was followed by dual
exchange rate arrangement & determine exchange rate system and the
system has worked very well. The remarkable stability of the rupee that has
attracted world wide attention.
 In the forgien exchange, the instrument of forward covered is the only
hedging product now available. The forward mkt, however, has tended to be
illiquid and virtually non existent for maturities beyond 6 months.
Historically, with the rupee depreciating steadily , exporter have been
reluctant to supply forward dollars leading to a supply – demand imbalance.
This situation has changed and the forward mkt may develop depth &
liquidity in th future. Banks have been to raise currency operations from jan
1994 for their customers. These options will be on back to back basis. Banks
will not take any exposures on these transactions and will wright auctions on
a fully converted cover basis, i.e they will buy fro overseas auctions i.e
identical to the 1 sold to the customer. With the abolition of the NCNRA
scheme, the foreign exchange exchange risk on such deposits are now to be
borne by the commercial banks. The banks while attracting such deposit
will have to manage the exchange risk o n their own. The possibility of
providing credit in foreign currency to exporters is an important factor that
will be of assistance in this regard. the exchange rate of rupee in the past
15months has moved within the narrow range. The ability to operate in
foreign exchange mkt where the rates can fluatuate is something that the
banks in india need to acquire, as the Indian mkt gets more and more
intrgrated with the global financial system.
Role of reserve bank
The RBI as the central banking authority also controls the foreign currency
operations. As pound, the sterling continues to remain as a currency of
intervention, the RBI fixes the buying and selling exchange rate from time to
time based on the parity of unspecified currencies- basket of currencies
whole the RBI does not enter the foreign exchange mkt to support the Indian
rupee like bank of England.
 It buys spot and forward sterling up to 9 months forward and sells
only spot sterling thus; RBI continues to maintain external value of the
Indian rupee. Also the RBI buys major currencies like us dollars, deutsche
mkt and Japanese yen, both spot and forward up to 6 months at exchange
rates based on the previous day’s closing rate in the London exchange mkt
for the respective currencies.
The RBI’s role in the Indian foreign exchange mkt has been more
towards guiding the banks in their exchange operations and developing the
exchange mkts by giving appropriate directive from time to time.
The RBI has so for not found it necessary to operate directly in the
foreign exchange mkt with a view stabilizing the external value of the India
rupee.
While at present it may not been felt necessary for the RBI to be
operating in the foreign exchange mkt directly. It will be seen that under the
present system. There is a possibility of the currencies enumerated above
being dumped in to the hands of RBI, when these are weak in the
international mkts. To plug this loophole, it may be advantageous for the
apex bank to intervene from time to time to support Indian rupee. However,
one has to bear in mind the expertise required for this operation and present
functions of RBI, which are very onerous compare to the function similar
institutions in other countries. Hence the question of RBI’s direct operations
in the exchange mkts may not be viewed with favour in a country like ours.
However, with the increasing reserves and growing international trade, it
will not be out of place to suggest that the RBI should vocationally intervene
with a view to regulating the mkt and to maintaining the external [overseas]
value of Indian rupee.
The central banking authority in india, that is the RBI, should also play
apostive role in deloping mkts by entering the exchange mkts at all centers
from time to time.

Feasibility of decentralization of foreign exchange bank: the recent edition

of the exchange control manual contains specific relaxations to activise and
decentralize exchange mkts in India. This emerges to be clearly indicative
of the importance monetary authorities attach to the subject of development
of exchange mkts in India, but it is doubtful wherever these measures alone
will achieve the desired objective. The exchange mkts in india, although
evolved over a period of time, still continue to be a relic of fixed rate system
totally unrealistic in the context of floating rate system, since foreign
exchange mkt is fast becoming international in nature without the time zone
differences, there is a greater need to look at the entire system, practices and
procedures obtaining the latest mkt informations in india to revive the mkts
wherever possible. Multiplicity of exchange mkts appears to be the answer
to the present day floating rate system. Exchange mkts in India have so far
tended to develop only in Mumbai & Calcutta with even new Delhi &
Chennai serving as secondary mkts. This situation needs to be rectified
keeping in mind the size of our country.

The govt has maintained the role of sterling as an intervention currency and
the RBI announces the external value of rupee in terms of sterling based on
the ‘basket of currencies’. The merchant rats for pound sterling are
published by exchange dealers’ association of india based on RBI buying &
selling rates with forward purchase sterling quoted at discount. The rupee
rates for currencies other than pound sterling are based on London closing
rates which are historical. With the emergence of the active exchange mkts
in Frankfurt, Paris, Bahrain, Singapore, & hong kong, there has emerged
considerable scope for quoting the competitive rates. There is also growing
awareness amongst exporters- importers that exchange rats quoted by banks
are not competitive as dealing spreads are still very wide. It should be
studied whether we can quote more realistic rates by changing the basis of
our quotations ending the role of sterling as an intervention currency and
allow the rupee to float in international mkts either in relation to the basket
or without. It is anticipated that the comfortable reserve position will
continue for the next 5 years and the experiment of permitting the Indian
rupee to float in the international mkts may be worthwhile.

There is also a need to examine whether the present organizational structure

of banks requires to be changed where positions are maintained either at
their head offices or at Mumbai. In view of the new environment in foreign
exchange dealing, the traditional practice of maximizing the profits by ‘
‘marrying’ transactions under fixed exchange rate system may not be
suitable in the floating rat system when dealing spreads are very narrow. We
must accept that exchange mkts can be activiesed in small centers, only if
exporters and importers can get a competitive rate when they approach their
bankers. The rates quoted to costumers at the up-country centers are
sometimes as old as a week.

Asian clearing union: for many now, regional cooperation for benefiting
trade and payments has been a subject of serious consideration all over the
world. In the asian region, the initiative on these matters for taken by ht
ECAFE [since renamed as economic and social council for asia &pacific ]
and as a 1st step for securing regional cooperation amongst its members, the
Asian clearing union[ASU] was established on 9th dec 1974. there are 6
member countries, viz, bangaldesh, india, iran, Nepal, Pakistan& srilanka its
head quarter are based in Tehran. The clearing operations under the
arrangement commenced on the 1st nov 1975, ACU was set up with the
objective of-

1] facilitating payments for current international transactions within the

ECAFE region on a multilateral basis
2] reducing the use of extra regional reserve currencies to settle such
transactions by promoting the use of the participant’s currencies or AMU,

3] effecting thereby economies in he use of foreign exchange and a

reduction in the cost of marketing payments for such transactions and;
4] contributing to the expansion of trade and promotion of monetary
cooperation among the countries of the area.

Asain currency unit: the term ‘asian currency unit’ refres to the deposits
placed with banks in singpore which are specially licensed by the monetary
authority of singpore to operate in the asian dollars mkt. the deposits are
usually non resident US. dollar deposits but deposits in deutsche marks, duct
h gulider, swiss francs and Japanese yen are also transacted.

The mkt for ACU has grown up fast, making singpore a prominent world
financial centre. Singpore’s geographical location [which gives it access to
both asian and European mkts same day], a liberal monetary policy and
wide range of international banking facilities have helped that centre to gain
this position. The monetary authority of Singapore have recently
commenced issuing licenses to the foreign banks t oexclusively operate as
off- shore units; dealing in the inter bank asian dollar mkt. this step is likey
to induce further development of the asian dollar mkt.

The secondary mkts: in addition to the traditional short term money mkt in
which the discount houses are prominent , secondary money mkts have
developed in short term funds, in both sterling aand other currencies.
The secondary sterling mkts are mainly in inter –bank deposits, deposits
with local authorities and finance houses, and inter- company loans. The
other currency or ‘eurocurrency’ mkts are mainly in deposits from overseas
residents, in ter- banks deposits and dollar certificates of deposit, the
merchant banks, british overseas banks, foreign banks and [since stp 1971]
the clearing banks are peominient in most of these mkts, and the discount
houses provide a secondary mkt in sterling and dollars certificates of
deposit; several north American dealers particioate also in a secondary mkt
in the dollars certificate of deposit.
These activities gained impetus during the 1950’s as britian and other
countries removed official resticitions on the flow of short term funds.
Transations were encouraged by the granting of the convertibility to
external current sterling dec 1958, and since then such funds have been free
to move from abroad into the various London short term money mkts or out
again In resopnse to the level of interest rates and other factors at home and
aboard.
The domestic demand for funds has come fro m3 groups of borrowers: the
loca lauthorites , which were required from 1955 t oobtai na larger
proporatio nof their funds from private sources; the hre- purchase finance
houses, which have also obtained a substaional part of their funds by
borrowing at short term; and industrial & Commercial companies especially
during periods of credit restrictions at home.

Local authority temporary finance

The financial needs of the local authorities in Britain greatly stimulated the
growth of the parallel money markets. The local authorities’ total
outstanding debt in march 1974 was $21,721 million (including $6,501
million from the central govt) , of which their temporary debt (that is, debt
repayable within 12 months) amounted to over $3500 million the temporary
debt of the local authorities was reported to be raised mainly from the banks
( by overdrafts and more especially by temporary loans through the inter
bank market), other financial institutions and industrial commercial
companies. A limited amount was also likely to be raised through the issue
of revenue bills. Specially at times of high interest rates, the local authorities
have turned towards borrowings. The bigger authorities are in daily contact
with the money market. The instrument of borrowings is a deposit receipt in
amounts normally of $50,000and upwards. the majority of the loans are
repayable at either 2 years or seven’s days notice from the leader or
borrower, htough some are initially for a longer period, such as 3 months.
Merchant & overseas banks and industrial and commercial companies are all
prominent in the mkt.

Deposits with finance houses: the mkt for deposits with finance houses is
perhaps the smallest of the parallel mkts and it has contracted further since 6
of the houses obtained recognition as banks b/w Jan 1972 and Jan 1973.. in
general, finance houses provide installments credit and leasing finance,
obtaining the funds they require from banks loans, discounted bills and
deposits. At the end of march 1974, their liabilities totaled $1,079million, of
which the major items were; deposits $445 million , bills discounted with
British banks and discount houses-$176million –and other net borrowing
from banks- $160 million.

Authorized banks: to deal in foreign exchange in ht UK, banks must be duly

authorized by the treasury on the recommendation of the bank of England.
Currently, there are some 224 authorized banks, although with the opening
of branches and subsidies of foreign banks in London foreign and various
consortium banks, this number is constantly increasing. These banks
generally deal with other banks in London through the medium of brokers.
For a brokerage firm to operate in the London foreign exchange market,
membership of the foreign exchange and currency brokers’ association
(FECDBA) is obligatory, and moreover the firm must be specifically
authorized by the association to provide brokerage service. Banks are free to
deal directly with other banks overseas, and do so by means of telephone or
telax while dealings through banks within Britain are generally conducted by
direct telephone lines.

The euro currency mkt: is an a international mkt which was initially based
on US dollars held in Europe, but now also involves banks outside Europe
and includes leading western European currencies. The banks making up he
mkt are located mainly in Europe: in London, british and the british offices
of overseas, banks are active. In recent yrs, an important share of the euro
currency business has been taken by the transactions in some of the major
west European currencies notably in Deutsche marks and Swiss francs.

Operations of currency exchange markets : settlement of international trade

markets usually takes place in denominated currencies which are well
accepted by international trading community, in the process, currencies are
traded. For example if UK exporters sells goods to the German , he may
want payment in pounds, and for this the importer have to secure the pounds
buy exchanging it with the DM. this nessitates the existence of the foreign
exchange market which will reflect the intractions b/w th suppliers and the
demand for currencies. Currency exchange markets functions thro
suphisticated network of communications, usually computer terminals,
with such located in major centers like Newyork, London, Tokyo, etc, their
operations ae 24hrs and the daily turnover is in billons of dollars, thus these
markets are the critical element of the worlds’ financial mkt participants, are
usually dealers who buy and sell currencies, commercial banks and the
dealers- speculators. The official monitory authorities are also important
participants in that they intervene to smoothen the fluctuation. The
transactions done in spot and forward basis.
Authorized banks participating in the market normally have a separate
dealings room, where telephone lines are arranged on indirect switch broads,
enabling all dealers to listen in, thus keeping themselves informed on
exchange rate movements. The dealers have direct lines to brokers and to
other banks and important customers. In addition, dealers have telax
machines, sometimes with direct lines to their exchange braches in the
provinces and to banks in foreign centers. A deal concluded by telephone is
confirmed in writing.
Mkt operation: the foundation of the mkt is the existence of international
trade, the growth of which depends on an efficient mkt where currencies
may be bought and sold. The mkt provides also the basic mechanism fro the
operation of the international monetary system, with intervention being
made from time to time by central banks to buy and sell currencies in order
to stabalize errectic movements in exchange rates which can fluctuate from
minute to minute, any appreciation and depreciation of currency, whether
brought about by floating or by a change of parity, is reflected in the market
and is instantly known through out the world, affecting market rates
accordingly.

Spot and forward rates: dealing rates are quoted spot, for foreign currency
bought and sold for immediate delivery 9in fact, it is normally delivered
after 2 days to allow fro time differences and for payment instructions and
confirmations to reach the most distant parts of the world0 or forward fro
currency to be deliverd on a date in the future at an agreed rate of exchange.
The forward dates most commonly quoted are 1,2, 3,and 6 months and one
year. Forward exchange cover is made available to traders as a from of
insurance that protects them against exchange risks arising fro ma move in
foreign exchange rates b/w the time when currency is to be received or paid.
An exchange rate coated for a forward date thus usually involves a premium
or discount as compared with the spot rate, depending on interest differential
rates b/w various international centers and general expectations about
relative movements b/w the currencies.

Currency dealings:
Eurocurrencies, mostly dollars but also some of the leading European
currencies, received on deposit by authorized banks can be lent either in
the same currency or converted by the banks in to another currency,
including sterling. Members of the FECDBA usually act as intermediaries
b/w authorized banks in currency deposit business, although banks are free
to deal direct with other banks in the UK, if they so desire as well as with
banks aboard.
UK residents other than banks are normally given the exchange control
permission for foreign currency borrowing is for a period of at least 2
years. The financing of overseas as distinct from investments by resident
thru foreign currency borrowing is not affected by this restriction and is
normally allowed by the bank of England.
The term ;foreign exchange’ covers in its broadest sense, all payments an
receipts denominated in foreign currency. There are , however, other
separate markets, for example, in investments currency and in foreign banks
notes. Because of the specialized nature of these markets, transactions are
normally handled within the banks by specific departments or officials.

An Interest Rate swap is a legal agreement two or more parties to exchange

only their interest obligations in the same currency. This, obviously , does
not entail the exchange of the principal sums. By swapping his interest
obligations for another, a borrower can raise funs at a fixed rates, when
interest rates are rising and then switch to a floating rate in case interest rates
fall. And vice versa.
Any borrower of foreign currency exposes himself to two types of risks:
exchange risks and interest rates risk. Raising a long term foreign currency
loan at a fixed rate of interest in a rising interest rate environment is all right.
But if interest rates stop rising and, on the contrary, fall sharply in a short
period of time, the decision to borrow at a fixed rate may prove to be wrong.

An expert group on the foreign exchange market in India was setup by the
RBI in November 1994, headed by shri O P Sodhani executive director ,
RBI, to recommend measures for developing an active, efficient and orderly
foreign exchange market in India. The group examined the terms of
reference in 4 different sub groups , issue- wise. The final report was
submitted towards the close of June 1995, an executive summary of which
has been released recently.

The report has identified constraints and short comings of the forex market
in India which was in its early stage of development and has now
considerably mature. It consist of a hand full of players, with a few public
sector banks dominating in merchant business and foreign banks leading in
inter- bank business. Owing to lack of integration between money and forex
markets and restrictions on borrowing and lending n international markets,
the forward rates do not reflect interest rate differentials. Prohibitions of
initiating transaction in international markets has restricted the cross
currency market. In hedging, free access is available only for forward
contracts and cross- currency options . ceilings on open positions have
inhibited the process of developing mkt in forex dealings. Against this back
drop: reccomdations of the panel have been grouped as flows:
A] areas of relaxation :

1Guidelines on booking forward contracts should be amended, permitting

co-operates to take a hedge on dealaring the existence of an a exposure.
2. Banks should be permitted to decide their open exchange position limits
subject to earmarking of capital to the extent of 5% of the limits based on
international standards. They should similarly be permitted to have their
own ceiling on exposure gap based on capital and risk taking capacity.
3. banks should be given freedom to initiate cross- currency positions over
seas and to borrow or lend short term funds[up to 6 months] with a ceiling.
4. financial institutions should be permitted to freely trade in foreign
exchange to enlarge the market and encourage competition.
5. instead of a continuous presence in buying side, RBI’s intervention
ensures orderliness in the market. RBI may consider influencing forward
rates by initiating swaps.
6. authorized dealers [banks] should be permitted to fix interest rates and
maturity periods for FCNR[ B] deposits, subject to a cap,
7. exporter should be allowed to retain the entire export earnings in India
after repayment of credit against export bills.

B] Development of derivative products: for this, the report has

recommended both short term and long term measures.
Short term measures include:
1. exemption of inter bank borrowings from statutory pre-emptions
which will facilitate an inter bank term money market and a well
developed rupee-dollar forward market.
 2. Corporates should be permitted to cancel and re- book option
contracts. Banks may be allowed to offer low cost stratergies like
“range forwards”.
3. banks should be allowed to offer any derivative, on a fully covered

basis, like swaps, caps, dollers, etc. they should be free to use such
products for their assets-liability management.
4. derivatives should be exempted from withholding tax.
5. while margin trading should not be allowed to export earners foreign
currency deposits may be used by corporates for access to hedging
products over seas. Among the long term measures are :
i. RBI should invite proposals from banks for offering rupee based
derivatives.
ii. Comprehensive risk management guidelines maybe formulated for
banks by RBI so that all products can be offered but not strictly on
a fully covered basis.
iii. Exchange control regulations should refocus on risks rather hen
products.

C] Risk management , Accounting and Disclosure standards:

1. risk management polices and internal control systems of internationally

accepted standards should be put in place by all market participants and
followed by banks, corporates and their auditors,
2. the foreign exchange dealers’ association of India[FEDAI] should
ensure uniform documentation and market practices.
3. The institute of chartered accountants of India should develop
accounting and disclosure standards for all the market participants.
 The companies act and banking regulation act should be amended
suitably to provide for disclosure of derivative exposures.
4. a uniform provisioning methodology, adopted by the group, should be

stipulated.
D] Others:

1. RBI should set up a foreign exchange market committee to advise it on

policy issues.
2. Offshore banking units should be set up in Mumbai. There should also
be a forex clearing house for settlement of inter bank forex transactions.
3. the role of FEDAI should be reviewed and enlarged.

The recommendation constitute an ideal combinations of autonomy with

safe guard for all participants necessary for the widening and deepening of a
nascent forex market.

The bulk of the govt of India’s foreign debt service payment, except its
repayment obligations to the inter national monetary fund will increasingly
be routed through commercial banks and not through the RBI. The
repayment obligation to the IMF will continue to be met through RBI.

Conclusion:
In the yrs to come the foreign exchange market is likely to play a pivotal
role in strengthening financial system and accelerate the process of
economy development.
Forex Terminology:
Authorized dealers: banks which are engaged in the business of purchase &
sale of currencies. They require the RBI ‘s permission under sec6 of FERA.

Exchange control: 1st introduced in India in the wake of 2nd world war in
1939, exchange control aims at conserving foreign exchange resources of the
country & optimize utilization in accordance with economic priorities.

Exchange rate: the rate at which 1 currency is converted into another

exchange rate can be quoted in 2 ways –by direct method in which the local
currency varies [$1 =rs.45.6]; indirect method in which the foreign currency
varies[$2.50=rs 45].

Forward and spot rates: the forward rate is the 1 at which currency can be
bought or sold today for delivery at some future date. Spot transactions are
settled in 2 working days.

Intervention currency : the currency used in transactions are undertaken by

central bank to structure the exchange rate of its currency or the level of its
foreign exchange reserves.

2 way price: any quoting bank always a 2 way price, a price at which it buys
and a price at which it sells the currency. The spread between the buying &
selling rates should be sufficient to at least cover its costs.
Vostro account: if an American bank has an a/c with an Indian bank in
Bombay, it is the American bank’s vostro a/c for the Indian bank.

Nostro account: if an Indian bank has an a/c with an American bank in New
York, it is the Indian bank’s nostro a/c.

Debt concept:
A variety of concept are used to measure and assess the economic burden of
debt. Debt stock, which is often reported as debt outstanding and disbursed ,
measures the total liabilities of the debtor. The payment obligation arising
from this is debt service and companies interest and principal payments. The
debts stock does not necessarily predict the debt service.
Two concepts describe the net effect of borrowings and repayments on the
flow of financial resources .

Public debt:
Public debt is raised by govt to meet the gap b/w the budgeted receipts and
payments. It has a far reaching consequences upon production andnn
distribution of a country. Public debt thus govt or state debt. The state
generally borrows to:
To meet budget deficits;
To cover other expenses ;and
To finance development activities.