the foreign exchanges and foreign excahnge control session 21-22

8/7/2019 The foreign Exchanges and foreign excahnge control session 21-22

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MEANING OF FOREIGN EXCHANGESThe Foreign Exchange is used in two senses

1) Wide sense : According to some economists, the term ForeignExchange refers to that entire operation by which two countriesclear of f their indebtedness. It includes i) all those institutions

which facilitate foreign payments . Ii) all those methods andmechanisms which are made use of for making internationalpayments and iii) the rate at which the currency of one countryis converted into the currency of anothercountry.

2) Narrow sense : some economists have used the term Foreign

Exchange in a narrow sense. According to them, foreignexchange refers to the rate of exchange or the rate at which thecurrency the sale and purchase of foreign currencies. Accordingto still some economists, the term Foreign Exchange refers tothe rate of exchange or the rate at which the currency of onecountry is converted into the currency of another country.

THE FOREIGN EXCHANGES


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PROBLEM OF FOREIGN EXCHANGE

Every country has its own currency.

For international payments the currency of one country has to beconverted into the currency of another country, because every countrywants the payments for its exports to be made in terms of its own currency.


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METHODS OF FOREIGN PAYMENTS

A country can make payments to another country in three ways:

1. Export of commodities : payment are made not in terms ofcurrency or gold, but in terms of commodities. This method ishighly defective.

2. Export of gold . The payment for foreign goods can also bemade in terms of gold. But this system is also defectivebecause the cost of transporting gold from country to anotheris quite prohibitive these days.

3. Payment through Foreign Exchange Bills. The foreign payments

these days mostly made through foreign exchange bills.According to this method, the trader of a country makes thepayment for the imported goods through the medium offoreign exchange bills.


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The foreignexchange bills are generally of three types.

1. Bill of Exchange : Most of the international payments these days are

made through the medium of exchange bills. The exchange bill isgenerally for a period of three months . Taking exchange bill in the bank toget his payment , as one cannot wait for three months for the receipt ofpayments.

2. Bankers Draft : this is the second method of making international

payments. An importer can make the payment for the imported goods bysending the banker s draft to the exporter of the country. The bankersdraft is always drawn in terms of foreign currency.

3. Telegraphic Transfer. The third method of making international

payments is telegraphic transfer. Generally, making payments throughbank drafts is a time consuming process. If the foreign exporter has to bepaid immediately, then the importer makes the payment throughtelegraphic transfer. Telegraphic transfer, like bankers drafts are issued bythe Exchange Bank. The importer can purchase the telegraphic ttransfersby depositing national currency with the Exchange Bank


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DEMAND AND SUPPLY OF FOREIGN CURRENCY

The demand for foreign currency arises from those traders who have to make

payments for imported goods to the foreign in exporter. They need foreignexchange because the exporter of the foreign country insists upon receiving thepayment in his national currency. The demand for foreign currency arises fromthose individuals who imports goods and services or wish to make investment inforeign countries. The supply of foreign currency comes from those people whohave exported their goods.

Thus the price of any foreign currency ( or , the rate of exchange ) at any time isdetermined by the demand and supply of that currency.


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EQUILIBRIUMRATE OF EXCHANGE

The rate of exchange refers to the rate at which the currency of onecountry can be converted into the currency of another country. The rateof exchange thus, indicates the exchange ratio between the currencies ofthe two countries. Let us suppose that one Indian Rupee is equal to0.0476 Pound sterling. What this implies is that one Indian rupee canfetch 0.0476 Pound sterling in the exchange market. Just as the price of a

commodity is determined by the demand and supply, in the samemanner , the price of foreign currency is also determined by its demandand supply. Any changes taking place in the demand and supply offoreign currency will certainly affect its price in foreign exchangemarket .

In fact the rate of exchange keeps on changing in the foreign exchangemarket on account of the changes in the demand and supply of foreigncurrency.


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DETERMINATION OF EXCHANGE RATE UNDER GOLD STANDARD ANDPAPER CURRENCY STANDARD A COMPARISION

The following differences are found in the determination of exchange rate

between two countries on the gold standard and two countries on inconvertiblepaper currency standard:1. The rate of exchange between two countries on the gold is determined by

mint par of exchange. But the rate of exchange between two countries oninconvertible paper currency standard is determined by the purchasingpower parity of the currencies .

2. The rate of exchange between two countries on the gold standard isdetermined by the purchasing powers of their currencies in terms of gold.But the rate of exchange between two countries on inconvertible paperstandard is determined by the purchasing power of their currencies interms of goods and services.

3. The mint par of exchange between two countries on the gold standard

remains constant. But the purchasing power parity between two countries oninconvertible paper currency standard instead of being constant, is subject tochanges from time to time as a result of the exchanges in the price- levels ofthe two countries.

4. The changes in the exchange rate of exchange between two countires on thegold standard remain confined to the gold points. But the rate of exchange

between two countries on inconvertible paper currency standard can riseabove or fall below the purchasing power parity.


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PARITYOF EXCHANGEThe rate of exchange is determined by the demand and supply of foreignexchange. When the demand for foreign exchange is exactly equal to its supply

than the rate of exchange is said to be at par or there is said to be equal parity ofexchange . But in actual life, the demand for foreign exchange is seldom equalto its supply.

Now the question arise as to what extent can the actual rate of exchange riseabove or fall below the parity of exchange? There certain limits within which

the actual rate of exchange fluctuates round the parity of exchange. This limitsare different under different conditions. This parity of exchange itself isdetermined in different ways under different conditions .

Four problems under the determination of the rate of exchange under fourdifferent situations.

1. When both the countries are either on the gold or on the silver standard ;2. When one country is on the gold standard while other is on the silver

standard ;3. When one country is on gold standard while the other is on inconvertible

paper currency standard ;

4. When both the countries are on inconvertible paper currency standard.


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PURCHASING POWERPARITY THEORY

This theory was propounded by the well known Swedisheconomist, Prof. Gustav Cassel after the First World War.According to some economists, the theory was first

mooted by John Wheatley in 1802.

According to Gustav Cassel the rate of exchange betweentwo currencies must stand essentially on the quotient ofthe internal purchasing powers of these currencies . In

other words , the rate of exchange tends to rest at thatpoint which expresses equality between the respectivepurchasing powers of the two currencies . This point iscalled the purchasing power.


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CRITICISMSOF THE PURCHASING POWERPARITY THEORY

1. It is difficult to measure accurately the purchasing powers of the currencyunits of the two countries. A) The index number are connected with the pastprice. They do not deal with the present prices in the two countries . B) Theprice-index number s include the prices of even those commodities which arenot internationally traded . C) The third defect of these index numbers is thatthey do not include the same commodities in the both countries .2. It neglects the cost of transportation.3. It neglects the quality of goods

4. It does not study other elements which influence the balance of payments5. The changes in the rate of exchange influence the price level.6. This is contrary to general experience.7. This theory does not explain the demand for foreign currencies.8. This theory assumes a given rate of exchange.9. This theory is based on a wrong conception of elasticity of demand.

10. The theory offers a long term explanation of the rate of exchange but notconsiders the short-term rate of exchange .

It concludes that the purchasing power parity theory is useful theory. Whilefixing a rate of exchange between the two countries , the purchasing powerparity of their currencies cannot be ignored or overlooked in any manner. In the

long period the rate of exchange has a tendency to coincide with the purchasingpower parity of the currencies of the two countries .


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THE BALANCE OF PAYMENTS THEORYOF EXCHANGE RATE

This theory is also known as the general equilibrium theory of exchange rate.

This theory at present is supposed to be the most satisfactory theory ofexchange rate. According to this theory , the rate of exchange between the twocountries is determined by the supply of and demand for foreign exchange inthe exchange market . The rate of exchange is only a price, the price of foreigncurrency in terms of the domestic currency.

Most satisfactory theory

1. This theory is in conformity with general theory of value.2. This theory brings the determination of the rate of foreign exchange withinoverall framework of the general equilibrium.3. This theory points out that there are several important forces, besides exports

and imports which influence the supply and demand for foreign exchange .4. This theory points out the disequilibrium in the balance of payments of acountry can be corrected by making appropriate adjustments in the rate ofexchange.


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FLUCTUATIONS IN THE RATE OF EXCHANGE

As pointed above , the rate of exchange between two countries is seldom constant.O

n contrary , it keeps on fluctuating from time to time both under gold standardas well as under the inconvertible paper currency standard. The rate of exchangebetween two countries on the gold standard either above or below mint parity.Likewise, the rate of exchange between two countries on inconvertible papercurrency standard may either below or above purchasing power parity.

These fluctuations in the rate of exchange create a good deal of uncertainty whichcan have harmful repercussions on the flow of foreign trade.

The following are the causes of instability in the rate of exchange during shortperiod;

1. Changes in the demand and supply of foreign currencies.2. Trade conditions i) stock exchange Influences a) sale and purchase of stocks ,

shares and securities. b) loan transactions2. Banking influences .... i) bank rate ii) Issuing credit Instrumentsiii) Arbitrage Operations for speculative gains in different stock exchange

3. Currency conditions The currency conditions also deeply influences the rate ofexchange of a country.


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i) Inflation : the onset of the inflation in a country results in the repatriation offoreign capital from countryii) Deflation : The onset of deflation results in the inflow of foreign capital into the

country . To make financial gains .

4. Political conditions . i) Policy of protection ii) Exchange controliii) financial Policy of the government iv) Peace and security in the country.

Limits of fluctuations in the exchange rate

1)L

imits of Fluctuations under gold Standard : The rate of exchange between twocountries on the gold standard is governed by the gold points.

2) Limits of Fluctuations under Inconvertible paper currency standard : it is basedon the purchasing power parity. No definite limit for fluctuation of rate ofexchange of the foreign currency.

How check fluctuations in the rate of exchange ?The fluctuating rate of exchange is influenced by a large variety of factors. Thus,

it becomes important to check the violent fluctuating rate of exchange. Thestability of the rate of exchange depends upon the equilibrium in the balance ofpayments. The stability in the rate of exchange can also be achieved to someextent by making appropriate changes in the bank rate of the country.


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STABLE VS. FLUCTUATING RATE OF EXCHANGE

IT IS CONTROVERSIALWHETHERTHE SHOULD HAVE STABLE OR

FLUCTUATING EXCAHNGE RATE ?

Arguments for stable Exchange rates.

1. A developing country should invariably opt for a stable rate of exchange to achieve itsplanned economic development. While fluctuating rate of exchange will retard thedevelopment of the country by impeding the inflow of capital from abroad.

2. A country should adopt a policy of stable rate of exchange in order to develop andpromote foreign trade. A stable rate of exchanges enables the importers and exportersto know in advance how much they are going to gain from the trade or to pay for it.A fluctuating rate of exchange , by creating uncertainty will discourage thedevelopment of the foreign trade of the country .

3. A stable rate of exchange is also essential for sustained and uninterruptedinternational lending on a large scale . A f luctuating rate of exchange , by creating

uncertainty in the minds of the lenders and borrowers, discourages internationalcapital movements.

4. A stable rate of exchange is also necessary for small country in whose economyforeign trade plays a significant role such as Britain and Denmark.

5. A stable rate of exchange also appears to be indispensible for the smooth functioningof the currencies blocs.


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Arguments against Stable Exchange rates

1. A system of stable exchange rate places the burden of adjustment in thebalance of payments of a country on domestic incomes and prices.

2. A system of stable exchange rate does not reflect the true cost pricerelationship between the currencies of the countries.

Arguments for fluctuating Exchange rates1. It is wrong to say that a fluctuating rate of exchange hampers the development

of foreign trade of a country. The technique of forward exchange transactionsprotects the importers and exporters from financial losses consequent uponfluctuating exchange rates.

2. A system of fluctuating foreign exchange rates enables a country to find outits natural rate of exchange in course of time.

3. A system of fluctuating exchange rates automatically brings aboutequilibrium in the balance of payments of a country.

4. A fluctuating rate of exchange is no hindrance in the smooth functioning ofthe currency blocs.

5. A fluctuating rate of exchange protects the domestic economy of a countryfrom the shocks generated by disturbances originating abroad .


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Arguments against fluctuating exchange rates

1. No country will can allow its rate of exchange to drift from day to day in

response to international events, because such the fluctuating exchange ratewill have serious repercussions on the entire structure of that country bychanging the prices of imported and exported goods from time to time .

2. A system of freely fluctuating exchange rate induces unnecessary andunwarranted international capital movements.

3. Speculative capital movements engendered by a system of fluctuating rates of

exchange may, in turn, create the problem of an extremely high liquiditypreference amongst the people.4. Hindering in long term investments by creating uncertainty .5. It is essential to bring the rate of exchange to enable country to reach its natural

rate of exchange.

ConclusionWe conclude that neither the constantly f luctuating nor a rigidly stable rate ofexchange is in the interest of country. Both of them are harmful. The bestsolution would be to devise an arrangement which allows a country to changeits rate of exchange within certain well defined limits in response to changes inthe international economy. This flexibility has been provided by theInternational monetary fund ( IMF).


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A DJUSTABLE PEG AND CRAWLING PEG SYSTEMS OF EXCAHNGE RATES

The adjustable peg system of exchange rate was provided in the constitution of theIMF. According to this system, the exchange rate of the country was allowed todeviate from the par value of its currency within the margin of 1% on either sideof the exchange parity.

To get over the difficulties ofPeg system an alternative proposal known as CrawlingPeg system was mooted by James Meade. This system allows a wider margin forthe rate of exchange to fluctuate either side of the par value of the currency of themember country. It may crawl up to 2.25% to more wider range up to 4.5%

Forward Exchange : after First world war adoption of system of inconvertible papercurrency to avoid violent fluctuations. The forward exchange rates aredetermined by the demand for and supply of foreign currency .

Forward exchange trading thus, means the sale and purchase of foreign exchange inthe future market. It plays significant role in international trade.

Arbitrage : this refers to the act of simultaneously buying foreign exchange, securitiescommodities, etc. In one market and selling them in another market at a higherprice. Though the term arbitrage is wide one, it is generally used in relation toforeign exchange transaction s.


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Foreign Exchange & Exchange Control (EC); Convertibility

of Indian Rupee)

Foreign Exchange (FE)

All those institutions which facilitate foreign payments.

System (methods / mechanisms/ principles) whereby different nations clear

off their international obligations / payments / indebtedness

Rate of exchange at which currency of a country is converted into thecurrency of another country

Methods of Foreign Payments

Export of Commodities

Export of Gold Payments through Foreign Exchange Bills

Bills ofExchange

Bankers Draft

Telegraphic/Electronic (swift code) Transfer


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Demand & SS of Foreign Currency/Equilibrium Rate of Exchange

Demand comes from Importer of goods & services and those who wish to invest in foreigncountries.

Supply comes from Exporter of goods & services & those who have imported capital fromabroad + foreign investments.

Equilibrium Rate of Exchange

That rate of exchange at which currency of one country can be converted into the currencyof another country.

Shows exchange ratio

Eg: ExchangeRate ofRupee

1 U.S. $ = 48.60or 1Rupee = .0205 US$

Determined like price of commodities

It keeps changing on a/c of Dd. & SS of foreign currency


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*Favorable & Unfavorable R.O. Exchange

1. When expressed in National Currency

Lower rate is favorable (1 U.S. $ = 26 Rs.)

Higher rate is unfavorable (1 U.S. $ = 48 Rs.)

2. When expressed in Foreign Currency

Higher rate is favorable (1 Rupee = .0285 U.S.$)

Lower rate is unfavorable (1 Rupee = 0.0266 U.S.$)

Single Rate or Multiple Rates

SingleRate One r.o. exchange for all types of transaction

MultipleRate Many exchange rates

one rate for exports

one rate for imports one rate for tourists

cash / Travelers cheques / electronic transfer

(based on service charge)


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Spot Rate and forward Rate

Spot Rate: Delivery of foreign exchange is made available to buyer by the seller on the spot.

Forward Rate Seller contracts to deliver to the buyer foreign exchange at some future dateat a ratesettled in the present (includesdiscount or premium over the spot rate )

Purchasing Power Parity: Relative Price / ends in two countries.

Factors affecting rate of exchange

Changer in dd & ss. Of foreign currencies (BOP situation) (Net surplus or Net Debit inBOPs)

Banking Influence BR, CRR

Currency Conditions Inflation & Deflation

Political Conditions ProtectionPolicy, exchange control, financial policy(deficit financing in internal value of currency)

Peace and security in a country


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EXCHANGE CONTROL

When Govt. of a country utilise its foreign exchange earnings for well defined objects asthrough Central Bank

EC can be partial or full (all currencies)

Objectives of EC To check violent f luctuations in exchange rate (over valuations & under valuation)

To check flight of capital

To remove imbalances in foreign trade

To import essential commodities & import prohibition

To earn foreign exchange from exports

To practice trade discrimination

To earn profits


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Methods of Exchange Control

Observe: Convertibility of Rupee on Current and capital account

A. Unilateral

R

egulation ofBR

Regulation of foreign trade

Rationing of foreign exchange (FERA,FEMA)

Blocked Accounts

Multiple Exchange Rates

Exchange pegging

Pegging up overvaluationPegging down undervaluation

(Cheaper Exports)

B. Bilateral

Payment agreement (between creditor &

Debtorcountry)

Clearing agreements (payment domesticcurrencies)

Transfer moratoria (payment of importedgoods & investment on foreign capital ismade after lapse of certain pre-determinedtime)

(Authoritiesaregiven enough

time to solve their FE problem

or put their house in order) ST into LI debtor gradual repayment.

the foreign exchanges and foreign excahnge control session 21-22

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