Module 7

Foreign Exchange Market

Concept• Foreign exchange is the system or process of converting one national

currency into another, and of transferring money from one country toanother (Paul Einzig)

• Foreign exchange is used to refer to foreign currencies

• But in a broader sense, it includes, foreign currency and drafts,travellers’ cheques, letters of credit, bills of exchange etc. drawn in anational currency, but payable in any foreign currency

• FOREX market is where foreign exchange transactions take place

• In other words, a market in which national currencies are bought andsold against one another

• FOREX is the result of international trading of goods and services

FunctionsA foreign exchange market performs three important functions

1. Transfer of purchasing power

• Primary function, by transferring purchasing power from onecountry to another

• International clearing function

• FOREX market facilitates international liquidity

• Facilitates international trade and capital movements

2. Provision of credit

• Growth of international trade depends on the extent of creditfacilities

• Credit facility is available to exporters and importers

• Exporters may get pre-shipment and post-shipment credit

3. Provision of hedging facilities

• Provides mechanism for exporters and importers to guardthemselves against losses arising fluctuations in exchange rates

• This facility is provided by agreeing an exchange rate on a futuredate

• Forward exchange rate regime is generally followed in this regard

Methods of International PaymentsInternational payments are effected through five methods

1. Telegraphic transfer

2. Mail transfer

3. Cheques and Bank drafts

4. Foreign bills of exchange

5. Documentary (reimbursement) credit

Fixed and Flexible Exchange rate• Fixed exchange rate a system of exchange rate where the countries

keep their currencies at a fixed or pegged rate.

• The exchange rate is changed only at infrequent intervals when theeconomic situation forces them to do so.

• Also called pegged or stable exchange rate

• The exchange rate is officially determined

• This system broke down in early 1970s

Arguments for Fixed Exchange rate systemNecessary for orderly growth of foreign trade, avoiding uncertainties

Prevent continuous depreciation

Attracts foreign investment and prevents capital flight

Eliminates speculation in foreign exchange market

Facilitates international borrowings

a.Under flexible exchange rate system, exchange rates are freelyby the inter-play of demand and supply mechanism

b.This is due to variations in BoPs

c. There is no official intervention in the foreign exchange market

d.Also called floating or unstable exchange rate

e.Flexible exchange rate system is theoretically sound

Arguments against flexible exchange rate system

• Flexible exchange rate system presents a situation of instability,creating uncertainty and confusion

• The market uncertainties make it impossible for exporters andimporters to certain about prices and thereby will have dampeningeffect on foreign trade

• There will be widespread speculation in the foreign exchange market,and which will have a destabilizing effect

• The system of flexible exchange rate gives an inflationary bias to aneconomy, due to persistent depreciation

Determinants of E-R

Two important theories :

• Purchasing power parity theory

• BoP theory OR demand & supply theory

Purchasing Power Parity (PPP) theory

• Propounded by Gustav Cassel (1920)

• States that the E-R between one currency and another is inequilibrium when their domestic purchasing powers at that rateof exchange are equivalent.

• To Cassel “the E-R between two currencies must standessentially on the quotient of the internal purchasing powers ofthese currencies”

• Based on the purchasing powers of respective currencies in theirdomestic economies; this is called PPP

• In short, a bundle of goods should cost the same in one country and theother, once the exchange rate is taken into account

• For eg; a particular bundle of goods in India costs Rs. 48/- and the samein USA costs $1/-, then the E-R will be in equilibrium if it is $1 = Rs. 48.

• A change in the purchasing power of currencies will be reflected in theirE-Rs

• The index number of prices may be made use of to determine the PPP

PdER = Er x

Pf

If there is a change in prices, the new equilibrium rate of exchange can be foundout by the following formula

Where:ER – equilibrium exchange rateEr – exchange rate in the reference periodPd – domestic price indexPf – foreign country’s price index

Critical evaluationMerits

• Indicates the relationship between international price levels

• Explains the state of the trade of a country

Demerits

• It suffers from the limitations of price index

• The type of goods and services (commodity basket) in various countriesis not same

• The cost of international transport is ignored

• Ignored the effect of international capital on foreign exchange

• Only long term change is significant

Balance of payments (BoP) Theory (DD & SS, General EquilibriumTheory)• Holds that exchange rate of the currency of a country depends upon the demand

for and supply of foreign exchange.

• Thus according to the theory, E-R is determined just like the prices of anycommodity by the free play of the forces of dd & ss in the market

• If the demand for foreign exchange is higher than its supply, the price of foreigncurrency will go up (appreciation).

• In case, the demand of foreign exchange is lesser than its supply, the price offoreign exchange will decline (depreciation)

• The demand for foreign exchange comes fromthe debit side of balance of payments.

• The debit items in the BoP are import of goodsand services and loans and investments madeabroad

• The supply of foreign exchange arises from the credit side of the BoP

• It is made up of the exports of goods and services and capital receipts.

• When the BoP is in equilibrium, the ss & dd for currencies are equal

• If the BoP of a country is in deficits (dd for foreign exchange > ss of foreignexchange), the rate of foreign exchange declines.

• On the other hand, if the BoPs is in surplus (dd for foreign exchange < ss offoreign exchange), the rate of exchange will go up.

• The domestic currency can purchase more amounts of foreign currencies

Evaluation

• An ideal theory as it gives importance to BoP in determining E-R

• E-R is the price of currencies in the foreign exchange market, hence DD &SSmechanism is logical in the determination of E-R

• Indicates the possibility of correcting BoP, through adjusting exchange rates

Concept of Balance of Payment (BoP)A systematic record of all economic transactions of a reportingcountry with the rest of the world during a given period of time,usually one year

BoP includes both visible (physical goods) and invisible (services)items of trade

Balance of trade (BoT) is the difference between exports and importsof merchandise items alone

Where as BoP comprises BoT plus exports and imports of services

The items included in the Bop are merchandise items of trade,investment flow, service of banking insurance, banking, education,tourism, transportation, communication, consultancy, expenses ondiplomatic arrangements, interest and dividend payments, NREdeposits, unilateral payments etc.

Hence, BoP represents a better picture of a country’seconomic and financial transactions with the rest of the world

BoPs are recorded in standard double-entry book-keeping

There are four components of BoPs

Current account

Capital account

Unilateral payment account

Official reserve asset account

Convertibility of Rupee• Convertibility of a currency implies that a currency can be transferred into

another currency without any limitations or any control.

• Convertibility of currency can be related as the extent to which a country'sregulations allow free flow of money into and outside the country.

• A currency is said to be fully convertible, if it can be converted into some othercurrency at the market price of that currency.

• Current account convertibility refers to currency convertibility required in thecase of transactions relating to exchange of goods and services, money transfersand all those transactions that are classified in the current account.

• Capital account convertibility refers to convertibility required in the transactionsof capital flows that are classified under the capital account of BoP

• Similarly, an exporter had to surrender the foreign exchange to RBIand get it converted at a rate pre-determined by RBI.

• Till 1990, one had to get permission from the Government or RBI toprocure foreign currency for any purpose.

• In 1991, India began to lift restrictions on its currency.

• A series of reforms were introduced to remove restrictions on currentaccount transactions including trade, interest payments andremittances and capital transactions

• After liberalization 1991,as a first concrete step, the governmenteased the movement of foreign currency on trade account (currentaccount)

• Presently, there is almost full convertibility on thecurrent account and partial convertibility on thecapital account.

• The government liberalized the flow of foreign exchange to includeitems like amount of foreign currency that can be procured forpurposes like travel abroad, studying abroad, engaging the servicesof foreign consultants etc.

• These relaxations coincided with the liberalization on the industryand commerce

• There is also simultaneous relaxation on the restriction on the fundsthat foreign investors can bring into India to invest in companiesand the stock market in the country (partial convertibility in thecapital account).

• Capital Account convertibility in its entirety would mean that anyindividual, be it Indian or foreigner will be allowed to bring in anyamount of foreign currency into the country and take any amount offoreign currency out of the country without any restriction.

• Indian companies were allowed to raise funds by way of equities(shares) or debts.

• In 2000, the FOREX policy was further relaxed that allowedcompanies to acquire other companies abroad without having to gothrough series of getting permission on a case to case basis.

• Further, Indian debt based mutual funds were also allowed to invest inAAA rated government /corporate bonds abroad.

• With India's FOREX reserves increasing steadily, it has slowly andsteadily removed restrictions on movement of capital on many counts.

Ref:

Cherunilam: International Business, 3rd edn

Cherunilam: Intl trade & Export Management