Foreign Exchange Market in India: Exchange Rates, RBI's Role, Convertibility and NRI Accounts for RBI Grade B Finance

Last updated: 2026-11-13 · MockMentor

The foreign exchange (forex) market is the first market named in the Financial Markets line of the RBI Grade B Finance syllabus. Because RBI manages India's reserves and administers FEMA, questions on it are common: the meaning of NEER and REER, the categories of authorised dealers, the limit under the Liberalised Remittance Scheme, the difference between NRE and NRO accounts, and how RBI intervenes to smooth the rupee. This chapter covers how the market works, what drives exchange rates, how India manages its currency and the path towards rupee internationalisation.

In one line: the forex market is where currencies are bought and sold; in India it is a managed float in which market forces set the rupee's value while RBI intervenes to curb excessive volatility, using reserves of around US$ 720 billion, under the rules of FEMA, 1999.

Basic concepts

• Foreign exchange: money in the currency of another country, and claims on it such as deposits, bills and cheques. Under FEMA, it includes all deposits, credits and balances payable in a foreign currency.
• Exchange rate: the price of one currency in terms of another, such as ₹88 per US dollar.
• Direct quote: the price of one unit of foreign currency in the home currency (US$ 1 = ₹88). India has used direct quotes since 1993.
• Indirect quote: the amount of foreign currency per unit of home currency (₹100 = US$ 1.14).
• Bid and ask: the bid is the price at which a dealer buys a currency, the ask (or offer) the price at which it sells. The difference is the spread.
• Appreciation and depreciation: a rise or fall in the value of a currency under a floating rate, driven by the market.
• Revaluation and devaluation: a deliberate official rise or cut in the value of a currency under a fixed rate. India devalued the rupee in 1949, 1966 and 1991.

Why in News?

1. India's foreign exchange reserves were around US$ 720 billion in the week ended 23 October 2026, enough to cover many months of imports.
2. RBI has intervened in both the spot and forward markets in 2025 and 2026 to smooth large movements in the rupee caused by global uncertainty, US tariff changes and foreign portfolio outflows.
3. RBI has widened the use of the rupee in trade through Special Rupee Vostro Accounts and local currency settlement arrangements with countries such as the UAE, Indonesia and the Maldives, and has allowed banks to lend in rupees to non-residents in neighbouring countries for trade.
4. The Liberalised Remittance Scheme limit remains US$ 250,000 a year per resident individual, with tax collected at source on many remittances above a threshold.

Functions of the forex market

1. Transfer of purchasing power: lets importers, exporters, travellers and investors convert one currency into another.
2. Credit function: provides short-term credit for trade through bills, letters of credit and buyer's credit.
3. Hedging: lets firms protect themselves from currency risk through forwards, swaps, futures and options.
4. Price discovery: sets exchange rates through demand and supply.
5. Clearing: settles international payments.

Features of the forex market

• It is the largest financial market in the world, with daily turnover of over US$ 9 trillion globally (Bank for International Settlements survey of 2025).
• It works around the clock on working days, moving across time zones from Asia to Europe to America.
• Most trading is over the counter, between banks, rather than on exchanges.
• The US dollar is on one side of nearly 90% of all trades.
• London is the largest centre, followed by New York, Singapore and Hong Kong.

Types of transactions

Forward premium and discount

If the forward rate is higher than the spot rate for a foreign currency, that currency is at a forward premium; if lower, it is at a discount. Under covered interest parity, the forward premium on the US dollar against the rupee roughly equals the interest rate difference between India and the United States.

Example: if the spot rate is ₹88 per US dollar and the one-year forward rate is ₹90.20, the forward premium is (90.20 − 88) ÷ 88 = 2.5%, roughly the gap between rupee and dollar interest rates.

Participants in India

Exchange rate regimes

The rupee's journey

Determinants of the exchange rate

Theories

• Purchasing Power Parity (PPP): in the long run, exchange rates adjust so that the same basket of goods costs the same in different countries. Relative PPP says the rate changes by the inflation difference.
• Interest Rate Parity: the forward premium or discount reflects the interest rate difference between two currencies.
• Balance of payments approach: the exchange rate depends on the demand for and supply of foreign exchange from trade and capital flows.

Effective exchange rates

RBI publishes NEER and REER indices for a 40-currency basket and a 6-currency basket, with trade weights. A REER above 100 suggests the rupee is overvalued relative to the base year, which hurts export competitiveness.

Effects of depreciation and appreciation

Role of RBI in the forex market

Legal framework

The Foreign Exchange Management Act (FEMA), 1999, effective June 2000, replaced the Foreign Exchange Regulation Act (FERA), 1973. FERA treated violations as criminal offences; FEMA treats them as civil matters, with penalties and compounding. The Prevention of Money Laundering Act covers criminal aspects.

Functions

1. Licensing authorised dealers and money changers.
2. Framing rules for current and capital account transactions, with the government for capital account matters such as FDI.
3. Holding and managing foreign exchange reserves.
4. Intervening in spot, forward and futures markets to curb excessive volatility.
5. Developing the market through new products, such as rupee derivatives in GIFT City and access to NDFs for Indian banks from 2020.
6. Monitoring external commercial borrowing (ECB), trade credit and overseas investment.

Foreign exchange reserves

RBI manages reserves with the objectives of safety, liquidity and return, in that order.

Intervention and sterilisation

When RBI buys dollars to stop the rupee from rising, it releases rupees into the system. To prevent this from raising inflation, it may absorb the rupees through open market sales of bonds, reverse repo, the Market Stabilisation Scheme (MSS) or swaps. This is called sterilisation. When it sells dollars to support the rupee, it absorbs rupee liquidity, which it may offset with liquidity injections.

Convertibility of the rupee

• Current account convertibility: freedom to convert currency for trade, travel, education, medical treatment and remittances. India has had this since 1994, with some limits under the LRS.
• Capital account convertibility (CAC): freedom to convert currency for investment and borrowing across borders. India has partial CAC: FDI and FPI are largely open, but borrowing abroad and investment by residents abroad are regulated.

The Tarapore Committees (1997 and 2006) recommended preconditions for full CAC: fiscal consolidation, low inflation, strong banks and a sound external position. India has followed a gradual, calibrated approach.

Schemes for residents and non-residents

Liberalised Remittance Scheme (LRS)

Introduced in 2004 with a limit of US$ 25,000, the LRS now allows a resident individual to remit up to US$ 250,000 per financial year for permitted current and capital account purposes, such as education, travel, medical treatment, gifts and investment in shares and property abroad.

NRI accounts

Rupee internationalisation

An Inter-Departmental Group of RBI (2023) recommended steps to make the rupee a currency used in global trade and finance, such as:

• Trade invoicing and settlement in rupees through Special Rupee Vostro Accounts (from July 2022).
• Local currency settlement systems with partner countries.
• Linking UPI with fast payment systems abroad.
• Allowing foreigners to invest rupee surpluses in Indian government securities.
• Making the rupee a part of the IMF's SDR basket in the long term.

Benefits include lower currency risk for Indian firms, lower dependence on the US dollar and lower need for reserves. Risks include more volatile capital flows and loss of some control over monetary policy.

Challenges

• Volatility from global events and FPI flows.
• Dependence on oil imports and a structural trade deficit in goods.
• A large offshore NDF market that can influence the onshore rupee.
• The cost of holding large reserves, which earn low returns.
• Balancing export competitiveness and inflation control.

Way forward

1. Keep a flexible exchange rate with intervention only to smooth volatility.
2. Build a deeper onshore market, so that more rupee trading moves from offshore to India and GIFT City.
3. Raise exports of goods and services to reduce the current account deficit.
4. Continue gradual capital account liberalisation as fiscal and financial conditions improve.
5. Expand rupee trade settlement and UPI links.

Possible exam and interview questions

1. Explain the role of RBI in the foreign exchange market. Why does it intervene, and what is sterilisation? (620 words)
2. What factors determine the exchange rate of the rupee? Discuss the effects of rupee depreciation on the Indian economy. (420 words)
3. Distinguish between NEER and REER. What does a rising REER mean for exports?
4. Compare NRE, NRO and FCNR-B accounts.
5. Interview: Should India move to full capital account convertibility?

Related reading: global financial system, international banking, and balance of payments.

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