UNIT - 1
Fundamentals Of International Finance
Meaning
International finance (also referred to as international monetary economics or international macroeconomics) is the branch of financial economics broadly concerned with monetary and macroeconomic interrelations between two or more countries. International finance examines the dynamics of the global financial system, international monetary systems, balance of payments, exchange rates, foreign direct investment, and how these topics relate to international trade.
It is also called as multinational finance. Multinational companies, individuals and investors need evaluate to take care of international issues like foreign exchange risk additionally governmental risk, including economic, transaction, and translation distinguish-ability.
Importance of International finance
International finance plays a pivotal role in the international trade and in the sphere of exchange of goods and services among the nations
The following points highlight the importance of international finance.
- International finance helps in calculating exchange rates of various currencies of nations and the relative worth of each and every nation in terms thereof.
- It helps in comparing the inflation rates and getting an idea about investing in international debt securities.
- It helps in ascertaining the economic status of the various countries and in judging the foreign market.
- International Financial Reporting System (IFRS) facilitates comparison of financial statements made by various countries.
- It helps in understanding the basics of international organizations and maintaining the balance among them.
- International finance organizations such as IMF, World Bank etc. mediate and resolve financial disputes among member nations.
Scope of international finance:
- Foreign Exchange Market: The foreign exchange market is the market where foreign exchange or foreign exchange currencies are bought and sold. The foreign exchange market places at the disposal of buyers and sellers of foreign currencies the specialized services of intermediaries. It implies that the buyers and sellers of claims on foreign money and intermediaries constitute the structure of foreign exchange market. In the words of Kindelberger, “…The foreign exchange market is the market for a national currency (foreign money) anywhere in the world, as the financial centre of the world is united in a single market.”
- Exchange Rates: Another aspect covered in the international finance is the Exchange rate and its determination. The foreign exchange rates are classified into two broad categories:
- In case of the fixed exchange rate or pegged exchange rate system, all the international transactions take place at the rate of exchange fixed by the monetary authority. The exchange rate is fixed by the government through legislation or it comes into existence through the intervention in the foreign exchange market by the authorities.
- While the flexible or fluctuating exchange rates are determined by the free working of the market forces. If there is an excess demand for foreign currency over its supply, the foreign currency appreciates whereas the home currency depreciates.
- Risk management: An understanding of foreign exchange risk is essential for managers and investors in the modern day environment of unforeseen changes in foreign exchange rates. In a domestic economy this risk is generally ignored because a single national currency serves as the main medium of exchange within a country. When different national currencies are exchanged for each other, there is a definite risk of volatility in foreign exchange rates. The present International Monetary System set up is characterised by a mix of floating and managed exchange rate policies adopted by each nation keeping in view its interests. In fact, this variability of exchange rates is widely regarded as the most serious international financial problem facing corporate managers and policy makers.
- Managing MNCs: International financial management is related to managing finance of MNCs. There are five methods by which firms conduct international business activities– licensing, franchising, joint ventures, management contracts and establishing new foreign subsidiaries.
Globalization of the World Economy
Economic globalization refers to the increasing interdependence of world economies as a result of the growing scale of cross-border trade of commodities and services, flow of international capital and wide and rapid spread of technologies. It reflects the continuing expansion and mutual integration of market frontiers, and is an irreversible trend for the economic development in the whole world at the turn of the millennium. The rapid growing significance of information in all types of productive activities and marketization are the two major driving forces for economic globalization. In other words, the fast globalization of the world’s economies in recent years is largely based on the rapid development of science and technologies, has resulted from the environment in which market economic system has been fast spreading throughout the world, and has developed on the basis of increasing cross-border division of labor that has been penetrating down to the level of production chains within enterprises of different countries.
The advancement of science and technologies has greatly reduced the cost of transportation and communication, making economic globalization possible. Today’s ocean shipping cost is only a half of that in the year 1930, the current airfreight 1/6, and telecommunication cost 1%. The price level of computers in 1990 was only about 1/125 of that in 1960, and this price level in 1998 reduced again by about 80%. This kind of ‘time and space compression effect’ of technological advancement greatly reduced the cost of international trade and investment, thus making it possible to organize and coordinate global production. For example, Ford’s Lyman car is designed in Germany, its gearing system produced in Korea, pump in USA, and engine in Australia. It is exactly the technological advancement that has made this type of global production possible.
Globalization of the financial sector has become the most rapidly developing and most influential aspect of economic globalization. International finance came into being to serve the needs of international trade and investment activities. However, along with the development of economic globalization, it has become more and more independent. Compared with commodity and labor markets, the financial market is the only one that has realized globalization in the true sense of ‘globalization’. Since 1970’s, cross-border flow of capital has been rapidly expanding. In 1980, the total volume of cross-border transactions of stocks and bonds of major developed countries was still less than 10% of their GDP. However, this figure had far surpassed 100% in 1995. The value of the average daily transactions of foreign exchanges has grown from US$ 200 billion in the middle of E c o n o m i c G l o b a l i z a t i o n : Tr e n d s , R i s k s a n d P r e v e n t i o n 3 1980’s to the present US$ 1,200 billion, which is 85% of the foreign exchange reserves of all the countries in the world and 70 times as large as the value of the daily export of commodities and services.
Goals of International Finance
1. Acquisition of Funds
This goal involves generating funds from internal as well as external sources. The goal of international finance is to acquire funds at the lowest possible cost.
2. Investment Decisions
International finance is concerned with the investment of acquired funds in an optimum manner in order to maximize shareholders’ as well as stakeholders’ wealth.
3. Minimization of financial risks: The primary financial risk associated with international finance is foreign exchange fluctuations. Every country has its own currency and the value of that currency may change over time due to myriad factors that affect foreign exchange rates. These risks are tried to be minimized by International Finance by its various instruments like Hedging, Insurance etc.
4. Maintain political stability: Another risk that firms may encounter in international finance is political risk. Political risk ranges from the risk of loss (or gain) from unforeseen government actions or other events of a political character such as acts of terrorism to outright expropriation of assets held by foreigners. MNCs must assess the political risk not only in countries where it is currently doing business but also where it expects to establish subsidiaries.
5. Increase global competitiveness: Competition has increased manifold due to technological advancements and financial liberalization. A new class of nonbank financial entities, including institutional investors, has also emerged.
The Emerging Challenges in International Finance
1. Challenge of Protection of Natural Resources
When there is more international finance; its growth will affect the natural resources. For example, after increasing the number of banks in India, ACs is used at large scale due to this, there is increasing the temperature of India. Who is responsible for this. Surely international banks are responsible who are opening the branches in India.Every increase in the number of bank branch means, 5 new installation of ACs which increases open environmental temperature. So, this is big challenge of international finance. It has to reduce by planting the tree and not to use ACs in office.
2. Terrorism
Terrorism is also main challenge of International Finance. If any country will increase the terrorism in other country, its international finance will affected. Motherland is first and then, there is any international finance. India should ban all international finance and business relating to the countries which are promoting terrorism in India. Other countries which have the problem of terrorism, should strict ban on it if it has to increase its international finance with other countries.
3. Culture
International finance has also challenge of culture of each country. Culture is most often viewed as the language or religion of a country, but there is obviously more to culture than these two component. A successful international business manager must know what cultural matters may affect developing relationships and the impact they have financially on a business venture.
Financial issues are very much affected by language. Negotiations between a buyer and seller include price, delivery dates, shipping methods, and methods of payment. If either party is not completely fluent in the other party’s language, misunderstandings may arise which could lead to late payment or no payment at all.
4. Follow the Political Policies and Law of Nation
If business people have to grow international finance in any country, they have to make their policy according to the law and political policy of same country. Issues such as ill-defined or unstable policies and corrupt practices can be hugely problematic in emerging market. Changes in governments can bring changes in policy, regulations, and interest rates that can prove damaging to foreign business and investment.
5. International Currencies
International finance also affects from international currencies. You have some foreign currency if you have to deal with foreign country. At the time of dealing, you know what the current market rate of forex is.. Foreign investments are complicated by currency fluctuations and conversions between countries. A high-quality investment in another nation may lose money because that country's currency declined. Foreign-denominated debt used to purchase domestic assets has also led to bankruptcies in many emerging market economies.
Movements in currencies can have a substantial impact on the returns from foreign investments. Investing in securities that are denominated in an appreciating currency can boost total returns. However, investing in securities denominated in a depreciating currency can reduce profits.
6. Trade Restrictions: Countries in order to protect their economies apply methods of restrictions such as tariffs, quotas, subsidies and exchange controls. By applying protectionism a country can gain from it in such as protecting infant industries, dumping and protecting manufacturing industries, but on the other hand can also have problems such as firms remaining inefficient, retaliation, and misallocation of resources, and related directly to international trade countries benefit on comparative and absolute advantage, and economies of scales it affects the international trade and finance.
7. Issues in Communication: Methods of communication vary among cultures. Some emphasize direct and simple methods of communication; others rely heavily on indirect and complex methods. The latter may use circumlocutions, figurative forms of speech, facial expressions, gestures and other kinds of body language. In a culture that values directness, such as the American or the Israeli, you can expect to receive a clear and definite response to your proposals and questions. In cultures that rely on indirect communication, such as the Japanese, reaction to your proposals may be gained by interpreting seemingly vague comments, gestures, and other signs. What you will not receive at a first meeting is a definite commitment or rejection.
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Key Takeaways
3. Goals of International Finance e. Acquisition of Funds f. Investment Decisions g. Minimization of financial risks h. Maintain political stability i. Increase global competitiveness
4. The Emerging Challenges in International Finance
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Introduction to Balance Of Payments
Balance Of Payment (BOP) is a statement which records all the monetary transactions made between residents of a country and the rest of the world during any given period. This statement includes all the transactions made by/to individuals, corporates and the government and helps in monitoring the flow of funds to develop the economy. When all the elements are correctly included in the BOP, it should sum up to zero in a perfect scenario. This means the inflows and outflows of funds should balance out. However, this does not ideally happen in most cases.
BOP statement of a country indicates whether the country has a surplus or a deficit of funds i.e when a country’s export is more than its import, its BOP is said to be in surplus. On the other hand, BOP deficit indicates that a country’s imports are more than its exports. Tracking the transactions under BOP is something similar to the double entry system of accounting. This means, all the transaction will have a debit entry and a corresponding credit entry.
A country’s BOP is vital for the following reasons:
- BOP of a country reveals its financial and economic status.
- BOP statement can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.
- BOP statement helps the Government to decide on fiscal and trade policies.
- It provides important information to analyze and understand the economic dealings of a country with other countries.
By studying its BOP statement and its components closely, one would be able to identify trends that may be beneficial or harmful to the economy of the county and thus, then take appropriate measures.
Accounting Principles in Balance of Payments
The balance of payments of a country is a systematic record of all its economic transactions with the outside world in a given year. It is a statistical record of the character and dimensions of the country’s economic relationships with the rest of the world.
According to Bo Sodersten, “The balance of payments is merely a way of listing receipts and payments in international transactions for a country.” B.J. Cohen says, “It shows the country’s trading position, changes in its net position as foreign lender or borrower, and changes in its official reserve holding.”
The balance of payments account of a country is constructed on the principle of double-entry book-keeping. Each transaction is entered on the credit and debit side of the balance sheet. In balance of payments accounting, debits (-) are shown on the right side and credits (+) on the left side of the balance sheet. When a payment is received from a foreign country, it is a credit transaction while payment to a foreign country is a debit transaction.
The principal items shown on the credit side (+) are exports of goods and services, unrequited (or transfer) receipts in the form of gifts, grants etc. from foreigners, borrowings from abroad, investments by foreigners in the country and official sale of reserve assets including gold to foreign countries and international agencies.
The principal items on the debit side (-) include imports of goods and services, transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending to foreign countries, investments by residents to foreign countries and official purchase of reserve assets or gold from foreign countries and international agencies.
These credit and debit items are shown vertically in the balance of payments account of a country according to the principle of double-entry book-keeping. Horizontally, they are divided into three categories: the current account, the capital account and the official settlements account or the official reserve assets account.
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The second basic principle concerns the timing of recording, that is, the time at which transactions are deemed to have taken place. In general, various rules are possible, such as the payments basis (transactions are recorded at the time of the payment), the contract or commitment basis (transactions are recorded at the time of contract), the movement basis (transactions are recorded when the economic value changes ownership). The principle adopted is that suggested by the Fund’s Manual, namely the change of ownership principle. The term “economic ownership” is introduced in the sixth edition of the Manual, which is central in determining the time of recording on an accrual basis for transactions in goods, non-produced non-financial assets and financial assets. By convention, the time of change of ownership is normally taken to be the time that the parties concerned record the transaction in their books. Rules of thumb have to be applied in the case of transactions that do not actually involve a change of ownership (for example goods made available under financial lease arrangements), for which we refer the reader to the Manual.
It should be noted that under this principle an import of goods with deferred payment gives rise to a debit entry in the current account at the moment of change of ownership of the goods, with a simultaneous credit entry in the capital account for the increase in liabilities (the importer’s debt). When the importer settles the debt (possibly in a different period from that covered by the balance of payments in which the import was recorded), there will be two offsetting entries in the capital account: a debit for the decrease in foreign liabilities (the extinction of the debt), and a credit for the decrease in foreign assets or increase in foreign liabilities involved in the payment of the debt.
The third basic principle is that of the uniformity of valuation of exports and imports. Commodities must be valued on a consistent basis, and this may give rise to problems if, for example, the exporting country values exports on a f.o.b. (free on board) basis, whilst the importing country values the same commodities as imports on a c.i.f. (cost, insurance, and freight) basis. The Fund suggests that all exports and imports should be valued f.o.b. to achieve uniformity of valuation.
Components of Balance Of Payments
There are three components of balance of payment viz current account, capital account, and financial account. The total of the current account must balance with the total of capital and financial accounts in ideal situations.
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Current Account
The current account is used to monitor the inflow and outflow of goods and services between countries. This account covers all the receipts and payments made with respect to raw materials and manufactured goods. It also includes receipts from engineering, tourism, transportation, business services, stocks, and royalties from patents and copyrights. When all the goods and services are combined, together they make up to a country’s Balance Of Trade (BOT).
There are various categories of trade and transfers which happen across countries. It could be visible or invisible trading, unilateral transfers or other payments/receipts. Trading in goods between countries are referred to as visible items and import/export of services (banking, information technology etc) are referred to as invisible items. Unilateral transfers refer to money sent as gifts or donations to residents of foreign countries. This can also be personal transfers like – money sent by relatives to their family located in another country.
Capital Account
All capital transactions between the countries are monitored through the capital account. Capital transactions include the purchase and sale of assets (non-financial) like land and properties. The capital account also includes the flow of taxes, purchase and sale of fixed assets etc by migrants moving out/in to a different country. The deficit or surplus in the current account is managed through the finance from capital account and vice versa.
There are 3 major elements of capital account:
- Loans & borrowings – It includes all types of loans from both the private and public sectors located in foreign countries.
- Investments – These are funds invested in the corporate stocks by non-residents.
- Foreign exchange reserves – Foreign exchange reserves held by the central bank of a country to monitor and control the exchange rate does impact the capital account.
Financial Account
The flow of funds from and to foreign countries through various investments in real estates, business ventures, foreign direct investments etc is monitored through the financial account. This account measures the changes in the foreign ownership of domestic assets and domestic ownership of foreign assets. On analyzing these changes, it can be understood if the country is selling or acquiring more assets (like gold, stocks, equity etc).
Table 2.1. Balance Of Payment Account of India Table 2.2. Items included in the U.S Balance of Payment Accounts
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Balance Of Payment Identity Indian Heritage in Business , Management, Production and Consumption
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India had faced pressures on BOP from time to time either due to certain domestic compulsions or due to external factors. The whole period, covering nearly six decades, can be divided into two sub-periods, viz. (i) Before 1991, and (ii) since 1991.
i) Period I (Before 1991) The entire period was very difficult for India’s BOP, partly because of slow growth of exports in relation to import requirements and partly because of adverse external factors. Foreign exchange reserves were at a low level, generally less than necessary to cover three months’ imports. Almost the entire CAD (92 per cent) was financed by inflows of external assistance.
Table- Key indicators of India’s Balance of Payments (As percent of GDP)
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Source- RBI: Annual report
ii) After 1991 The prominent features of the BOP situation as it has emerged over the last two decades can be briefly summarised as follows:
1) On the current account: (i) Trade deficits have been widening. Both exports and imports have multiplied fast, but imports have risen at a faster rate than exports. Expanding imports in turn reflect (a) the impact of liberalisation measures, and (b) increasing manufacturing activity in the domestic economy.
(ii) There has been a phenomenal increase in net surplus on account of invisibles. This, in turn, is principally due to (a) buoyancy in private transfers (i.e., inward remittances), and fast expansion in exports of services, especially software. India is unique among emerging economies to have a sizable invisible surplus that substantially offsets the merchandise trade deficit. As a result, although India has been running a current account deficit (except during 2002-04 when India experienced a current account surplus), the deficit has been conveniently manageable, largely because of huge surplus on capital account.
2) On the capital account, India has been running a big surplus. The size of surplus has been much more than what is required to finance the current account deficit. As a result, India has been rapidly building up its foreign exchange reserves. The capital account demonstrates following features: (i) Both inflows and outflows of capital have increased, especially since 2003. (ii) The composition of capital flows is undergoing a change: (a) Official external assistance has been gradually losing out its significance; (b) FDI and portfolio investment have surged, and among the two, the inflows on account of FDI have been more than on account of portfolio investment (except 2010-11 when the trend got reversed).
(c) With easing of controls, external commercial borrowings have been coming back into prominence.
Key Takeaways 1) Balance Of Payment (BOP) is a statement which records all the monetary transactions made between residents of a country and the rest of the world during any given period. 2) The balance of payments of a country is a systematic record of all its economic transactions with the outside world in a given year. 3) There are three components of balance of payment viz current account, capital account, and financial account. 4) The whole period, covering nearly six decades, can be divided into two sub-periods, viz. (i) Before 1991, and (ii) since 1991. |
1.3.International Monetary Systems
Evolution of International Monetary System
An international monetary system consists of rules, practices, instruments, facilities and organizations for effecting international payments. A good international monetary system is one that maximizes the flow of international trade and investments and brings about an equitable distribution of the gains from trade among the countries of the world. An international monetary system can be evaluated in terms of its capacity to facilitate adjustments in BOP disequilibrium, provision of assurance of adequate liquidity or international reserves for the correction of BOP deficits and imparting confidence in the ability of the system to ensure efficient adjustments.
There have been four phases/ stages in the evolution of the international monetary system:
- Gold Standard (1875-1914)
- Inter-war period (1915-1944)
- Bretton Woods system (1945-1972)
- Present International Monetary system (1972-present)
GOLD STANDARD
The gold standard is a monetary system in which each country fixed the value of its currency in terms of gold. The exchange rate is determined accordingly.
Let’s say- 1 ounce of gold = 20 pounds (fixed by the UK) and 1 ounce of gold = 10 dollars (fixed by the US).
Hence, the dollar-pound exchange rate will be 20 pounds = 10 dollars or 1 pound = 0.5 dollars
The Gold standard created a fixed exchange rate system.
There was free convertibility between gold and national currencies.
Also, all national currencies had to be backed by gold. Therefore, the countries had to keep enough gold reserves to issue currency.
One advantage of the gold standard was that the Balance of payments (BOP) imbalances were corrected automatically.
Let’s say- there are only two countries in the world – The UK and France. The UK runs a BOP deficit as it has imported more goods from France. France runs a BOP surplus.
This will obviously result in the transfer of money (gold) from the UK to France as payment for more imports.
The UK will have to reduce its money supply due to a decline in gold reserves. The reduction in the money supply will bring down prices in the UK.
The opposite will happen in France. Its prices will increase. Now, the UK will be able to export cheaper goods to France. On the other hand, the imports from France will slow down. This will correct the BOP imbalances of both countries.
Another advantage was that the gold standard created a stable exchange rate system that was conducive to international trade.
Inter-war period
After the world war started in 1914, the gold standard was abandoned.
Countries began to depreciate their currencies to be able to export more. It was a period of fluctuating exchange rates and competitive devaluation.
BRETTON WOODS SYSTEM
In the early 1940s, the United States and the United Kingdom began discussions to rebuild the world economy after the destruction of two world wars. Their goal was to create a fixed exchange rate system without the gold standard.
The new international monetary system was established in 1944 in a conference organised by the United Nations in a town named Bretton Woods in New Hampshire (USA). The conference is officially known as the United Nations Monetary and Financial Conference. It was attended by 44 countries. India was represented in the Bretton-woods conference by Sir C.D. Deshmukh, the first Indian Governor of RBI. [The conference also led to the creation of the International Monetary Fund (IMF), World Bank, and GATT. GATT is the predecessor of WTO.
The Bretton-woods created a dollar-based fixed exchange rate system. In the Bretton-woods system, only the US fixed the value of its currency to gold. (The initial peg was 35 dollars = 1 ounce of gold). All the other currencies were pegged to the US dollar instead. They were allowed to have a 1 % band around which their currencies could fluctuate.
The countries were also given the flexibility to devalue their currencies in case of an emergency.
It was similar to the gold standard and was described as a gold-exchange standard.
There were some differences. Only the US dollar was backed by gold. Other currencies did not have to maintain gold convertibility.
Also, this convertibility was limited. Only governments (not anyone who demanded it) could convert their US dollars into gold.
The Bretton Woods system collapsed in 1971. The United States had to stop the convertibility to gold due to high inflation and trade deficit in the economy.
Inflation led to an increase in the price of gold. Hence, the US could not maintain a fixed value of 35 dollars to 1 ounce of gold.
In 1973, the world moved to a flexible exchange rate system.
In 1976, the countries met in Jamaica to formalize the new system.
The floating exchange rate system means that the exchange rate of a currency is determined by the market forces of demand and supply.
Flexible Exchange Rate Regimes(1973-present)
The flexible exchange rate regime that followed the demise of the Bretton Woods system was ratified in January 1976 when the IMF members met in Jamaica and agreed to a new set of rules for the international monetary system. The key elements of the Jamaica Agreement include:
Flexible exchange rates were declared acceptable to the IMF members, and central banks were allowed to intervene in the exchange markets to iron out unwarranted volatility.
II. Gold was officially abandoned (i.e., demonetized) as an international reserve asset. Half of the IMF’s gold holdings were returned to the members and the other half was sold, with the proceeds to be used to help poor nations.
III. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.
The IMF continued to provide assistance to countries facing balance-of-payments and exchange rate difficulties. The IMF, however, extended assistance and loans to the member countries on the condition that those countries follow the IMF’s macroeconomic policy prescriptions. This “conditionality,” which often involves deflationary macroeconomic policies and elimination of various subsidy programs, provoked resentment among the people of developing countries receiving the IMF’s balance-of-payments loans.
Following the U.S. presidential election of 1980, the Reagan administration ushered in o period of growing U.S. budget deficits and balance-of payments deficits. The U.S. dollar, however, experienced o major appreciation throughout the first half of the 1980s because of the large-scale inflows of foreign capital caused by unusually high real interest rates available in the United States. To attract foreign investment to help finance the budget deficit, the United States had to offer high real interest rates. The heavy demand for dollars by foreign investors pushed up the value of the dollar in the exchange market.
The value of the dollar reached its peak in February 1985 and then began to persistent downward drift until it stabilized in 1988. The reversal in the exchange rate trend partially reflected the effect of the record-high U.S. trade deficit, about $160 billion in 1985, brought about by the soaring dollar. The downward trend was also reinforced by concerted government interventions. In September 1985, the so-called G-5 countries (France, Japan, Germany, the U.K. and the United States) met at the Plaza Hotel in New York and reached what became know as the Plaza Accord. They agreed that it would be desirable for the dollar to depreciate against most major currencies to solve the U.S. trade deficit problem and expressed their willingness to intervene in the exchange market to realize this objective. The slide of the dollar that had begun in February was further precipitated by the Plaza Accord.
As the dollar continued its decline, the governments of the major industrial countries began to worry that the dollar may fall too far. To address the problem of exchange rate volatility and other related issues, the G-7 economic summit meeting was convened in Paris in 1987. The meeting produced the Louvre Accord, according to which:
The G-7 countries would cooperate to achieve greater exchange rate stability.
b. The G-7 countries agreed to more closely consult and coordinate their macroeconomic policies.
The Louvre Accord market the inception of the managed-float system under which the G-7 countries would jointly intervene in the exchange market to correct over or under valuation of currencies. Since the Louvre Accord, exchange rates have become relatively more stable.
Current exchange rate arrangements
Flexible or free float systems
FREE FLOAT or FLEXIBLE In a flexible exchange rate system, the value of the currency is determined by the market by the interactions of thousands of banks, firms and other institutions seeking to buy and sell currency for purposes of transactions clearing, hedging, arbitrage and speculation.
The largest number of countries Eg. US,UK, JAPAN,AUSTRALIA,CANADA
Fixed exchange rate systems
Fixing the exchange rate of a currency by matching it’s value to the value of another single currency ( $ or euro or Yen) or to a basket of other currencies, or to another measure of value, such as gold or silver.Adopted by small countries and those economies which are based on exports. E.g. Countries that primarily export oil or have direct trade with the U.S.
Hybrid exchange rate systems- Managed Floating
A managed floating rate system is a hybrid of a fixed exchange rate and a flexible exchange rate system. In a country with a managed floating exchange rate system, the central bank becomes a key participant in the foreign exchange market. the central bank has an implicit target value for their currency: it intervenes in the foreign exchange market by buying and selling domestic and foreign currency to keep the exchange rate close to this desired implicit value. It is also known as a dirty float. About 45 countries E.g. SINGAPORE, INDIA, RUSSIA
European Monetary System (1979–1998)
In March 1979, the European Union or EU (then called the European Economic Community or EEC) announced the formation of the European Monetary System (EMS) as part of its aim toward greater monetary integration among its members, including the ultimate goal of creating a common currency and a Community-wide central bank. The main features of the EMS were (1) the European Currency Unit (ECU), defined as the weighted average of the currencies of the member nations, was created. (2) The currency of each EU member was allowed to fluctuate by a maximum of 2.25 percent on either side of its central rate or parity (6 percent for the British pound and the Spanish peseta; Greece and Portugal joined later).
The EMS was thus created as a fixed but adjustable exchange rate system and with the currencies of member countries floating jointly against the dollar. Starting in September 1992, however, the system came under attack, and in August 1993 the range of allowed fluctuation was increased from 2.25 percent to 15 percent (see Case Study 20-2). (3) The European Monetary Cooperation Fund (EMCF) was established to provide shortand medium-term balance-of-payments assistance to its members. When the fluctuation of a member nation’s currency reached 75 percent of its allowed range, a threshold of divergence was reached, and the nation was expected to take a number of corrective steps to prevent its currency from fluctuating outside the allowed range. If the exchange rate did reach the limit of its range, intervention burdens were to be shared symmetrically by the weak- and the strong-currency member. For example, if the French franc depreciated to its upper limit against the German mark, then the French central bank had to sell Deutsche mark (DM) reserves and the German central bank (the Bundesbank) had to lend the necessary DM to France.
Member nations were assigned a quota in the EMCF, 20 percent to be paid in gold (valued at the market price) and the remainder in dollars, in exchange for ECUs. The amount of ECUs grew rapidly as member nations converted more and more of their dollars and gold into ECUs. Indeed, ECUs became an important international asset and intervention currency. One advantage of the ECU was its greater stability in value with respect to any one national currency. It was anticipated that the EMCF would eventually evolve into an EU central bank. By the beginning of 1998, the total reserve pool of the EMCF was over $50 billion and the value of the ECU was $1.1042. From March 1979 to September 1992, there was a total of 11 currency realignments of the EMS. In general, high-inflation countries such as Italy and France (until 1987) needed to periodically devalue their currency with respect to the ECU in order to maintain competitiveness in relation to a low-inflation country such as Germany. This points to the fundamental weakness of the EMS in attempting to keep exchange rates among member nations within narrowly defined limits without at the same time integrating their monetary, fiscal, tax, and other policies.
As pointed out by Fratianni and von Hagen (1992), inflation in Italy and France during the 1979–1987 period was restrained by the presence of Germany in the EMS, and this reduced the need for higher real appreciations of the Deutsche mark. France and Italy, however, paid a price in terms of greater unemployment for the gradual convergence toward Germany’s low inflation rate. The EU’s desire to stabilize exchange rates was understandable in view of the large exchange rate fluctuations since 1973 (see Case Study 20-2). Empirical evidence (see Giavazzi and Giovannini, 1989, and MacDonald and Taylor, 1991) indicates that variations in nominal and real exchange rates and money supplies among EMS members were smaller than among nonmembers, at least until September 1992.
Fixed and Flexible Exchange Rate System
There may be variety of exchange rate systems (types) in the foreign exchange market. Its two broad types or systems are Fixed Exchange Rate and Flexible Exchange Rate as explained below.
(a) Fixed Exchange Rate System:
Fixed exchange rate is the rate which is officially fixed by the government or monetary authority and not determined by market forces. Only a very small deviation from this fixed value is possible. In this system, foreign central banks stand ready to buy and sell their currencies at a fixed price. A typical kind of this system was used under Gold Standard System in which each country committed itself to convert freely its currency into gold at a fixed price.
In other words, value of each currency was defined in terms of gold and, therefore, exchange rate was fixed according to the gold value of currencies that have to be exchanged. This was called mint par value of exchange. Later on Fixed Exchange Rate System prevailed in the world under an agreement reached in July 1994.
Merits:
(i) It ensures stability in exchange rate which encourages foreign trade,
(ii) It contributes to the coordination of macro policies of countries in an interdependent world economy,
(iii) Fixed exchange rate ensures that major economic disturbances in the member countries do not occur,
(iv) It prevents capital outflow,
(v) Fixed exchange rates are more conducive to expansion of world trade because it prevents risk and uncertainty in transactions,
(vi) It prevents speculation in foreign exchange market.
Demerits:
(i) Fear of devaluation. In a situation of excess demand, central bank uses its reserves to maintain foreign exchange rate. But when reserves are exhausted and excess demand still persists, government is compelled to devalue domestic currency. If speculators believe that exchange rate cannot be held for long, they buy foreign exchange in massive amount causing deficit in balance of payment. This may lead to larger devaluation. This is the main flaw or demerit of fixed exchange rate system.
(ii) Benefits of free markets are deprived;
(iii) There is always possibility of under-valuation or over-valuation.
(b) Flexible (Floating) Exchange Rate System:
The system of exchange rate in which rate of exchange is determined by forces of demand and supply of foreign exchange market is called Flexible Exchange Rate System. Here, value of currency is allowed to fluctuate or adjust freely according to change in demand and supply of foreign exchange.
There is no official intervention in foreign exchange market. Under this system, the central bank, without intervention, allows the exchange rate to adjust so as to equate the supply and demand for foreign currency In India, it is flexible exchange rate which is being determined. The foreign exchange market is busy at all times by changes in the exchange rate. Advantages and disadvantages of this system are listed below:
Merits:
(i) Deficit or surplus in BOP is automatically corrected,
(ii) There is no need for government to hold any foreign exchange reserve,
(iii) It helps in optimum resource allocation,
(iv) It frees the government from problem of BOP
Demerits:
(i) It encourages speculation leading to fluctuations in foreign exchange rate,
(ii) Wide fluctuation in exchange rate hampers foreign trade and capital movement between countries,
(iii) It generates inflationary pressure when prices of imports go up due to depreciation of currency.
Key Takeaways
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1.4. An Introduction to Exchange Rates
Foreign Bank Note Market
A banknote (often known as a bill (in the US and Canada), paper money, or simply a note) is a type of negotiable promissory note, made by a bank or other licensed authority, payable to the bearer on demand. Historically, the banknotes were issued by the commercial banks but now, the production and distribution of new banknotes, and destruction of the unfit banknotes is the responsibility of the central bank of the respective countries. One of the crucial responsibilities of the national banks is to ensure the adequate confidence of the citizens in their nations currency. A country’s monetary policy serves the purpose of designing strategies related to money supply in the economy.
Globally, the demand growth for banknotes remained robust with volume of circulating banknotes growing decently and exceeding GDP growth rates in several nations. The global banknote market is highly dominated by production of banknotes with security threads.
In terms of geographical areas, the U.S. and Eurozone are major contributors to the global banknote market supported by their economies and high production volumes and values. However, the production volume of Euro banknotes continued to decline in the previous year.
The global banknote market is expected to grow in future due to improving economic conditions, rising global population and growing number of ATMs. In the recent years, the banknote market has gone through several reforms. A new concept called ‘security by design’ has been introduced by banknote suppliers. Through this concept, new designs of banknotes would be introduced including new safety features, brighter color etc. Despite all the growth factors, there are some factors which can hinder the market growth including counterfeiting of banknotes and rapid growth of electronic payments.
The global banknote market is majorly dominated by De La Rue Plc. and Giesecke & Devrient Group. De La Rue is increasingly investing into developing innovative and more secure features for bank notes. Commercial bank note market is also dominated by De La Rue Plc. However, the scenario is quite different in polymer substrate market. Only two companies, CCL and De La Rue, hold the absolute share of the polymer market in which CCL holds the lions share.aller purchases and expenses.
Spot Foreign Exchange Market
A key component of the foreign exchange market is the spot market. The spot market facilitates foreign exchange transactions that involve the immediate exchange of currencies. The prevailing exchange rate at which one currency can be immediately exchanged for another currency is referred to as the spot exchange rate (or spot rate). For example, the Canadian dollar's value has ranged between $0.60 and $0.80 in recent years. When U.S. firms purchase foreign supplies or acquire a firm in another country, and when U.S. investors invest in foreign securities, they commonly use the spot market to obtain the currency needed for the transaction.
During the so-called Bretton Woods era from 1944 to 1971, exchange rates were virtually fixed. They could change by only 1 percent from an initially established rate. Central banks of countries intervened by exchanging their currency on reserve for other currencies in the foreign exchange market to maintain stable exchange rates. By 1971 the boundaries of exchange rates were expanded to be 2.25 percent from the specified value, but this still restricted exchange rates from changing substantially over time.
In 1973 the boundaries were eliminated. This came as a result of pressure on some currencies to adjust their values because of large differences between the demand for a specific currency and the supply of that currency for sale. As the flow of trade and investing between the United States and a given country changes, so does the U.S. demand for that foreign currency and the supply of that foreign currency for sale (exchanged for dollars).
Because the demand and supply conditions for a given currency change continuously, so do the spot rates of most currencies. Thus most firms and investors that will need or receive foreign currencies in the future are exposed to exchange rate fluctuations.
Exchange Rate Quotations
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A forex quote is the price of one currency in terms of another currency. These quotes always involve currency pairs because you are buying one currency by selling another. For example, the price of one Euro may cost $1.1404 when viewing the EUR/USD currency pair.
Exchange rate quotations can be quoted in two ways – Direct quotation and Indirect quotation. Direct quotation is when the one unit of foreign currency is expressed in terms of domestic currency. Similarly, the indirect quotation is when one unit of domestic currency us expressed in terms of foreign currency.
Since the US dollar (USD) is the most dominant currency, usually, the exchange rates are expressed against the US dollar. However, the exchange rates can also be quoted against other countries’ currencies, which is called as cross currency.
Now, a lower exchange rate in a direct quote implies that the domestic currency is appreciating in value. Whereas, a lower exchange rate in an indirect quote indicates that the domestic currency is depreciating in value as it is worth a smaller amount of foreign currency.
Every quote could potentially be a direct one, or an indirect one at the same time. This generally depends on your geographical location, and your domestic currency. To simplify, a direct quote is a foreign exchange price quotation that can be easily understood, even by a person who doesn't necessarily know the exchange rate of their domestic currency in relation to the foreign one. Let's look at this with an example: Assuming you are from the United States, your domestic currency is the US dollar.
In this case, a USD/GBP quote of 0.66 will be a direct quote for you, and it will mean that one US dollar can be used to purchase 0.66 GB pounds. Conversely, if you were not from the US, and instead from the UK, you would see a USD/GBP quote of 0.66 as an indirect one, whereby one US dollar could be bought for 0.66 GBP, yet you would not be provided with the knowledge of how many US dollars can be bought with one unit of your domestic currency, without calculating it.
In other words, a Forex direct quote shows how many foreign currency units could be bought for a single unit of your domestic currency. This is rather simple and useful for people that want to easily transfer foreign prices into the currency that is more common for them.
Indirect quotes show the exact opposite of direct quotes. Instead of displaying the value of a foreign currency in the domestic one, it shows the value of the domestic currency in a foreign one. Here's an example of an indirect Forex quote: Assume you are from a European country, where the local currency is EUR, and you can see a quote like this: USD/EUR 0.8765. This means that one US dollar is sold for 0.8765 euros. However, you have to note that if you were an American, this quote would be a direct one for you.
Cross Currency Rates
A cross rate is an exchange rate of two currencies expressed in a third different currency, such as the exchange rate between the euro and the yuan expressed in yen.
For example, if you were calculating the cross rate of the British pound versus the euro, you would first determine that the British pound, as of Dec. 18, 2020, was valued at 0.74 to one U.S. dollar, while the euro was valued at 0.82 to one U.S. dollar.
The Major Currency Pair
Foreign exchange (forex) traders use the term cross rate to refer to price quotes between any pair of currency in which neither is the U.S. dollar.
Most transactions on the forex are in major currency pairs. That is, one of the currencies being swapped is the U.S. dollar. For example, if you see on a financial news site that USD/CAD is quoted at 1.28, it means that one U.S. dollar is currently equal to 1.28 Canadian dollars.
A cross rate also refers to a currency pair or transaction that does not involve the currency of the party initiating the transaction.
An exchange rate between the euro and the Japanese yen is considered to be a commonly quoted cross rate because it does not include the U.S. dollar. In the pure sense of the definition, however, it is considered a cross rate if it is referenced by a speaker or writer who is not in Japan or one of the countries that use the euro as its official currency. While the pure definition of a cross rate requires that it be referenced in a place where neither currency is used, the term is primarily used to reference a trade or quote that does not include the U.S. dollar.
Spread and Spread %
In financial terms, the spread definition is the difference between the bid price and ask price of an asset, security or commodity. It is a term that is used across the board in the financial industry. In stock trading it’s the difference between the ask and bid prices for a stock. In futures trading, it relates to the difference in price for the same commodity between delivery months. In trading of bonds, it refers to the difference in yield between bonds of different maturities and similar quality or vice versa.
In short, the spread definition is the difference between two related quantities. To investors, these differences can provide a trade opportunity.
In a general sense, the spread definition is simply the difference between two measures.
- In stock markets, it is the difference between the ask or offer price that a trader is willing to pay when buying shares and the price that they intend to sell it at.
- In foreign currency markets, the same principle applies. Spread is the cost for traders and the profit for dealers.
- The spread has a slightly different meaning in bond markets and similar fixed-income securities. Whilst still denoting difference, it refers to the difference in yields on similar bonds. For example, if the yield on a US Treasury bond is 5% and that of a UK Government bond is 6%, then the spread is 1%. With bonds it can also refer to the difference in yields on securities of different qualities but with the same maturity date. For example, a high-yield bond that pays 9% and a US Treasury bond of 5% has a spread of 4%.
- In futures, the spread is the difference between prices for the same commodity or security at different delivery dates. For example, in wheat futures contracts, there is generally a spread between the price of January wheat futures contracts and October ones. Changes in the market, in this case the wheat market, cause the spread to narrow and widen.
In financial markets, the price at which you can sell an asset is referred to as a bid, while the price at which you can readily purchase is known as ask. The smaller the difference between the bid and ask prices, also known as the spread, the more liquid the financial asset in question is said to be. Investors prefer liquid assets.
The bid-ask spread is the difference between the bid price for a security and its ask (or offer) price. It represents the difference between the highest price a buyer is willing to pay (bid) for a security and the lowest price a seller is willing to accept. A transaction occurs when a buyer either accepts the ask price or a seller takes the bid price.
Example 1: Consider a stock trading at $9.95 / $10. The bid price is $9.95 and the offer price is $10. The bid-ask spread, in this case, is 5 cents. The spread as a percentage is $0.05 / $10 or 0.50%.
A buyer who acquires the stock at $10 and immediately sells it at the bid price of $9.95—either by accident or design—would incur a loss of 0.50% of the transaction value due to this spread. The purchase and immediate sale of 100 shares would entail a $5 loss, while if 10,000 shares were involved, the loss would be $500. The percentage loss resulting from the spread is the same in both cases.
Consider a stock trading at $8.75 / $10. The bid price is $8.75 and the offer price is $10. The bid-ask spread, in this case, is 1.25 cents. The spread as a percentage is $1.25 / $10.
Factors affecting Exchange Rates
The exchange rate is defined as "the rate at which one country's currency may be converted into another." It may fluctuate daily with the changing market forces of supply and demand of currencies from one country to another. For these reasons; when sending or receiving money internationally, it is important to understand what determines exchange rates.
1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another's will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest rates
2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates, and inflation are all correlated. Increases in interest rates cause a country's currency to appreciate because higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates
3. Country’s Current Account / Balance of Payments
A country’s current account reflects balance of trade and earnings on foreign investment. It consists of total number of transactions including its exports, imports, debt, etc. A deficit in current account due to spending more of its currency on importing products than it is earning through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its domestic currency.
4. Government Debt
Government debt is public debt or national debt owned by the central government. A country with government debt is less likely to acquire foreign capital, leading to inflation. Foreign investors will sell their bonds in the open market if the market predicts government debt within a certain country. As a result, a decrease in the value of its exchange rate will follow.
5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export prices to import prices. A country's terms of trade improves if its exports prices rise at a greater rate than its imports prices. This results in higher revenue, which causes a higher demand for the country's currency and an increase in its currency's value. This results in an appreciation of exchange rate.
6. Political Stability & Performance
A country's political state and economic performance can affect its currency strength. A country with less risk for political turmoil is more attractive to foreign investors, as a result, drawing investment away from other countries with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country with sound financial and trade policy does not give any room for uncertainty in value of its currency. But, a country prone to political confusions may see a depreciation in exchange rates.
7. Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate.
8. Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in order to make a profit in the near future. As a result, the value of the currency will rise due to the increase in demand. With this increase in currency value comes a rise in the exchange rate as well.
Key Takeaways
e. Inflation Rates f. Interest Rates g. Country’s Current Account / Balance of Payments h. Government Debt i. Terms of Trade j. Political Stability & Performance k. Recession l. Speculation |
Reference books
- Economic Globalization: Trends, Risks and Risk Prevention by Gao Shangquan.
- International Finance and Open-Economy Macroeconomics by Giancarlo Gandolfo.
- International Economics by Dominick Salvatore