FOREX concept

The flow of funds across the national boundaries happens because of the trade and personal remittances. Inward remittances are on account of exports and remittances from Indians working abroad. These remittances result in flow of foreign currency into the country. The foreign funds accumulate with the Indian banks that pay out equivalent Indian rupees to the beneficiaries of the remittances in India.

Indian banks accumulate the foreign currency funds in current accounts maintained with banks at foreign centers such as London and New York. Thus, foreign inward remittances result in increase in money in circulation. On the other hand, foreign outward remittances lead to contraction of money in circulation and outflow of foreign currency from the stock with Indian banks.

Banks having surplus foreign currency funds sells the funds to other Indian banks in exchange of Indian Rupees. If all banks have surplus foreign currency funds they sell these to the RBI. Balances in the foreign currency accounts of RBI become the foreign exchange reserve of the country. 

Impact on money supply

In context of the Indian financial system, the relevant factor is that the increase in foreign currency reserves as a result of the larger foreign inward remittances, lead to increase in money supply; finding its way into the money market and capital market through the banking system.

Banks create credit and any inflow into the banking system gets multiplied by a factor. This factor depends on the reserves maintained by banks. If banks maintain n average reserve of 25%, any inflow into the banking system will increase money supply four times.

Similarly, any contraction of funds available with the banks will result in a four-fold reduction in money supply. Increase and decrease in the foreign exchange reserves of the country impact the financial system through increase or decrease in money supply.

Foreign Direct Investment [FDI] & Foreign Institutional Investors [FII]

Another aspect of Foreign Exchange market is that apart from flows resulting from personal and trade remittances, banks and corporate borrow funds from abroad and foreign entities invest in Indian business entities, such as Foreign Direct Investment [FDI], foreign funds and Foreign Institutional Investors [FII] that invest in the Indian capital markets. These flows are large in magnitude and have a great impact on capital market and the exchange rate.

However, there is also the danger that if FIIs pull out, the stock markets could crash which in turn can adversely impact the economy. This danger is not only on account of the impact of share prices but also because of the impact on exchange rate, which can adversely affect foreign trade and consequently the price level in the country.