UNIT-1

Foreign exchange Determinations Systems

If a Kashmiri shawlmaker sells his goods to a buyer in Kanyakumari, he will receive in terms
of Indian rupee. This suggests that the domestic trade is conducted in terms of domestic
currency.

Within the country, transactions are, then, simple and straight-forward. But if the Indian
shawlmaker decides to go abroad, he must exchange Indian rupee into Jap yen or dollar or
pound or euro. To facilitate this exchange form, banking institutions appear. Indian
shawlmaker will then go to a bank for foreign currencies.
The bank will then quote the day’s exchange rate—the rate at which Indian rupee will be
exchanged for foreign currencies. Thus, foreign currencies are needed for the conduct of
international trade. In a foreign exchange market comprising commercial banks, foreign
exchange brokers and authorised dealers and the monetary authority (i.e., the RBI), one
currency is converted into another currency.
A (foreign) exchange rate is the rate at which one currency is exchanged for another. Thus, an
exchange rate can be regarded as the price of one currency in terms of another. An exchange
rate is a ratio between two monies. If 5 UK pounds or 5 US dollars buy Indian goods worth
Rs. 400 and Rs. 250 then pound-rupee or dollar-rupee exchange rate becomes Rs. 80 = £1 or
Rs. 50 = $1, respectively. Exchange rate is usually quoted in terms of rupees per unit of
foreign currencies. Thus, an exchange rate indicates external purchasing power of money.

A fall in the external purchasing power or external value of rupee (i.e., a fall in the exchange
rate, say for Rs. 80 = £1 to Rs. 90 = £1) amounts to depreciation of the Indian rupee.
Consequently, an appreciation of the Indian rupee occurs when there occurs an increase in the
exchange rate from the existing level to Rs. 78 = £1. In other words, the external value of
rupee rises. This indicates strengthening of the Indian rupee. Conversely, the weakening of
the Indian rupee occurs if external value of rupee in terms of pound falls.

Remember that each currency has a rate of exchange with every other currency. Not ail
exchange rates between about 150 currencies are quoted since no significant foreign
exchange market exists for all currencies. That is why exchange rate of these national
currencies are quoted usually in terms of the US dollars and euros.

Determination of Exchange Rate:

Now two pertinent questions that usually arise in the foreign exchange market are to be
answered now. First, how is the equilibrium exchange rate determined, and secondly, why
does exchange rate move up and down?
There are two methods of foreign exchange rate determination. One method falls under the
classical gold standard mechanism and another method falls under the classical paper
currency system. Today, gold standard mechanism does not operate since no standard
monetary unit is now exchanged for gold. All countries now have paper currencies not
convertible to gold.

Under inconvertible paper currency system, there are two methods of exchange rate
determination. The first is known as the purchasing power parity theory and the second is
known as the demand-supply theory or the balance of payments theory. Since today there is
no believer of purchasing power parity theory, we consider only demand-supply approach to
foreign exchange rate determination.

Demand-Supply Approach of Foreign Exchange:

Or, BOP Theory of Foreign Exchange Rate Determination:

Since the foreign exchange rate is a price, economists apply supply-demand conditions of
price theory in the foreign exchange market. A simple explanation is that the rate of foreign
exchange equals its supply. For simplicity, we assume that there are two countries: India and
the USA. Let the domestic currency be rupee.

The US dollar stands for foreign exchange and the value of rupee in terms of dollars (or
conversely, the value of dollars in terms of rupee) stands for foreign exchange rate. Now the
value of one currency in terms of another currency depends upon the demand for and the
supply of foreign exchange.

Demand for Foreign Exchange:

When Indian people and business firms want to make payments to the US nationals for using
US goods and services or to make gifts to the US citizens or to buy assets there, the demand
for foreign exchange (here dollar) is generated. In other words, Indians demand or buy dollars
by paying rupee in the foreign exchange market. A country releases its foreign currency for
buying imports. Thus what appears in the debit side of the BOP account are the sources of
demand for foreign exchange. Larger the volume of imports, greater is the demand for
foreign exchange.

The demand curve for foreign exchange is negative sloping. A fall in the price of foreign
exchange or a fall in the price of dollar in terms of rupee (i.e., dollar depreciates) means that
foreign goods are now more cheaper. Thus, an Indian could buy more American goods at a
low price. Consequently, imports from the USA would increase—resulting in an increase in
the demand for foreign exchange, i.e., dollar.

Conversely, if the price of foreign exchange or the price of dollar rises (i.e., dollar
appreciates) foreign goods will now be expensive leading to a fall in import demand and,
hence, fall in the demand for foreign exchange. Since price of foreign exchange and demand
for foreign exchange move in opposite directions, the importing country’s demand curve for
foreign exchange is downward sloping from left to right.

In Fig. 6.6, DD1 is the demand curve for foreign exchange. In this figure, we measure
exchange rate expressed in terms of domestic currency that costs 1 unit of foreign currency
(i.e., dollar per rupee) on the vertical axis. This makes the demand curve for foreign exchange
negative sloping. If the exchange rate is expressed in terms of foreign currency that could be
purchased with a 1 unit of domestic currency (i.e., dollar per rupee), the demand curve would
exhibit positive slope. Here we have chosen the former one.

Supply of Foreign Exchange:

In a similar fashion, we can determine the supply of foreign exchange. Supply of foreign
currency comes from receipts for its exports. If the foreign nationals and firms intend to
purchase Indian goods or buy Indian assets or give grants to the Government of India, the
supply of foreign exchange is generated. In other words, what the Indian exports (both goods
and invisibles) to the rest of the world is the source of foreign exchange. To be more specific,
all the transactions that appear on the credit side of the BOP account are the sources of supply
of foreign exchange.

A rise in the rupee-per-dollar exchange rate means that Indian goods are cheaper to foreigners
in terms of dollars. This will induce India to export more. Foreigners will also find that
investment is now more profitable. Thus, a high price or exchange rate ensures larger supply
of foreign exchange. Conversely, a low exchange rate causes exchange rate to fall. Thus, the
supply curve of foreign exchange, SS1, is positive sloping.

Now we can bring both the demand and supply curves together to determine foreign
exchange rate. The equilibrium exchange rate is determined at that point where the demand
for foreign exchange equals the supply of foreign exchange. In Fig. 6.6, DD1 and SS, curves
intersect at point E. The foreign exchange rate thus determined is OP.

At this rate, quantities of foreign exchange demanded (OM) equals quantity supplied (OM).
The market is cleared and there is no incentive on the part of the players to change the rate
determined. Note that at the rate OP, (say, Rs. 50 = $1) demand for foreign exchange is
matched by the supply of foreign exchange.

If the current exchange rate OP, (suppose, pc 55 = $ 1) exceeds the equilibrium rate of
exchange (OP), there occurs an excess supply of dollar by the amount ‘ab’. Now the bank and
other institutions dealing with foreign exchange, wishing to make money by exchanging
currency, would lower the exchange rate to reduce excess supply.

Thus, exchange rate will tend to fall until OP is reached. Similarly, an excess demand for
foreign exchange by the amount ‘cd’ arises if the exchange rate falls below OP, i.e., OP.
Banks would then experience a shortage of dollars to meet the demand. The rate of foreign
exchange will rise till demand equals supply.

The exchange rate that we have determined is called a floating or ‘flexible exchange’ rate.
(Under this exchange rate system, the government does not intervene in the foreign exchange
market.) A floating exchange rate, by definition, results in an equilibrium rate of exchange
that will move up and down according to a change in demand and supply forces. The process
by which currencies float up and down following a change in demand or a change in supply
forces is thus illustrated in Fig. 6.7.

Let us assume that national income rises. This results in an increase in demand for imports of
goods and services and, hence, demand for dollar rises. This results in a shift in the demand
curve from DD1 to DD2. Consequently, exchange rate rises as determined by the intersection
of the new demand curve and supply curve. Note that dollar appreciates while rupee
depreciates.

Similarly, if the supply curve shifts from SS1 to SS2 as shown in Fig. 6.8, the new exchange
rate thus determined would be OP2. If Indian goods are exported more following an increase
in national income of the USA, the supply curve would then shift rightward. Consequently,
dollar depreciates and rupee appreciates. New exchange rate is settled at that point where the
new supply curve SS2 intersects the demand curve at E2.
This is the balance of payments theory of exchange rate determination. Wherever government
does not intervene in the market, a floating or a flexible exchange rate prevails. Such a
system may not necessarily be ideal since frequent changes in demand and supply forces
cause frequent as well as violent changes in the exchange rate. Consequently, an air of
uncertainty in trade and business would prevail.

Such uncertainty may be damaging for the smooth flow of trade. To prevent this awkward
situation, government intervenes in the foreign exchange rate. It may keep the exchange rate
fixed. This exchange rate is called a ‘fixed exchange’ rate system where both the demand and
supply forces are manipulated or calibrated by the central bank in such a way that the
exchange rate is kept pegged at the old level.

Often ‘managed exchange rate’ is suggested. Under this system, exchange rate as usual is
determined by the demand for and the supply of foreign exchange. But the central bank
intervenes in the foreign exchange market when the situation demands to stabilise or
influence the rate of foreign exchange. If rupee depreciates in terms of dollar, the RBI would
then sell dollars and buy rupee in order to reduce the downward pressure in the exchange
rate.

Foreign Trade & Economic growth

Foreign trade enlarges the market for a country’s output. Exports may lead to increase in
national output and may become an engine of growth. Expansion of a country’s foreign trade
may energise an otherwise stagnant economy and may lead it onto the path of economic
growth and prosperity.

Due to Increased foreign demand may lead to large production and economies of scale with
lower unit costs. Increased exports may also lead to greater utilisation of existing capacities
and thus reduce costs, which may lead to a further increase in exports.
Expanding exports may provide the great employment opportunities. The possibilities of
increasing exports may also reveal the underlying investment in a particular country and thus
assist in its economic growth.

The foreign trade contributes to economic growth are as follows:

1. Foreign trade generates pressure for dynamic change through

(a) Competitive pressure from imports

(b) Pressure of competing export markets

(c) A better allocation of resources;

2. The primary function of foreign trade is to explore means of procuring imports of

capital goods, without which no process of development can start;

3. Trade provides for flow of technology, which allows for increases in productivity,
and also result in short-term multiplier effect;

4. Foreign trade increases most workers’ welfare. It does so at least in four ways:

(a) Larger exports translate into higher wages

Supply Factor

1. Factor endowments:

Most of today’s developing countries are much less endowed with natural resources (except
for petroleum- exporting countries) than were the western countries during the 19th century.

2. Population growth:

Most of today’s developing countries are overpopulated. This means that the major portion of
any increase in their output of food and raw materials is absorbed domestically, leaving, very
little, if any, export surplus.

3. Factor mobility:

There is much less flow of capital in developing countries today than was observed in the
19th century. At the same time there is outflow of skilled labour from such countries on a
fairly large scale.
4. Neglect of agriculture:

Finally, until recently, developing nations have somewhat neglected their agriculture in
favour of more rapid industrialisation. This has hampered their export growth in particular
and development prospects in general.

(b) Because workers are also consumers, trade brings them immediate gains through products
of imports
(c) It enables workers to become more productive as the goods they produce increase in value
(d) Trade increases technology transfers from industrial to developing countries resulting in
demand for more skilled labour in the recipient countries.

5. Exports allow fuller utilisation of capacity resulting in achievement of economies of

scale, separates production pattern from domestic demand, increases familiarity with
absorption of new technologies;

6. Increased openness to trade has been strongly associated with reduction in poverty in
most developing countries. As the historian Arnold Toynbee said ‘civilisation’ has
been spread though ‘mimesis’, i.e. emulation or simply copying.

In short, trade promotes growth enhancing economic welfare by stimulating more efficient
utilisation of factor endowments of different regions and by enabling people to obtain goods
from efficient sources of supply.

Various types of Exchange Rate Regimes

There are three broad exchange rate systems—currency board, fixed exchange rate and
floating rate exchange rate. A fourth can be added when a country does not have its own
currency and merely adopts another country’s currency. The fixed exchange rate has three
variants and the floating exchange rate has two variants.

1. Fixed (or Pegged) Exchange Rate:

This consists of – (i) rigid peg with a horizontal band, (ii) crawling peg and (iii) crawling
band.

Variants of a Fixed Exchange Rate System:

1. Rigid Peg with a Horizontal Band:

It is an exchange rate system under which the exchange rate fluctuation is maintained by the
central bank within a range that may be specified (Iceland) or not specified (Croatia). The
specified band may be one-sided (+7% in Vietnam), a narrow range (+ 2.25% in Denmark) or
a broad range (+ 77.5% in Libya).

2. Crawling Peg:

The par value of the domestic currency is set with reference to a selected foreign currency (or
precious metal or currency basket) and is reset at intervals, according to pre-set criteria such
as change in inflation rate. The central bank decides the new par value based on the average
exchange rate over the previous few weeks or months in the foreign exchange market. The
biggest advantage of the crawling peg is its responsiveness to the market value of the
domestic currency.

3. Crawling Band:
The domestic currency is on a crawling peg which is maintained within a range (band).
2. Floating Exchange Rate:

This consists of – (i) managed float and (ii) free float.

When a country has its own currency as legal tender, it can choose between the three broad
types of exchange rate systems. Within the fixed exchange rate, a country can choose a rigid
peg or a crawling peg. Again within each peg, it can choose to have a horizontal band within
which its exchange rate would be permitted to fluctuate. Within the floating exchange rate
system, a country can choose a free float or a managed float. The main source of the
exchange rate system followed by any country is the IMF’s Annual Report on exchange rate
arrangements.

Many countries declare that they follow a particular exchange rate system, but may
follow another system in practice:

1. Exchange Arrangements with No Separate Legal Tender:

A few countries (such as Micronesia and San Marino) select another country’s currency as
legal tender. This is called Dollarization, since the selected foreign currency is usually the US
dollar.

1. Currency Board:

The central bank of the country promises to convert domestic currency (on demand and at
any point in time) for a predetermined number of units of a specific foreign currency. In order
to fulfill this promise, the central bank has to hold foreign exchange reserves in the selected
foreign currency. Usually a government decides to adopt a currency board when the holders
of domestic currency lose confidence in it is as a medium of exchange, triggered by rampant
inflation, unbridled government debt (resulting in fiscal deficits) and recession. A currency
board is expected to restore faith in the domestic currency.
The first currency board was set up in Mauritius in 1849. Hong Kong has had a currency
board since 1983 when its currency was linked to the US dollar. Argentina chose the currency
board in 1991 and Bosnia in 1997. Argentina’s currency board promised to convert each peso
into one US dollar. The Central Bank held only 66% of the peso as dollar reserves, when it
should have held 100% (given the 1:1 peso/dollar currency board arrangement). In 2001,
Argentina defaulted in repayment of its external debt and confidence in the Argentine peso
plunged. There was a run on the banking system, and the government abandoned the currency
board.

iii. Fixed Exchange Rate:

It is also called the pegged exchange rate. The par value of the domestic currency is set with
reference to a selected foreign currency (or precious metal or currency basket). The exchange
rate fluctuates with a range (usually +1% of the par value).

The domestic currency’s par value is fixed by the monetary authorities against any of
the following:
 1. A precious metal (gold in the gold standard)

2. A single currency, which can be an artificial currency (such as the SDR), or an

existing currency (such as the US dollar or the pound sterling). When a single
currency is chosen, in some cases colonial legacy determines the choice—most
former French colonies chose the French franc, while former British colonies tended
to choose the pound sterling. Sometimes, a fixed exchange rate is adapted to arrest the
steep fall in value of the domestic currency. In September 1998, the Malaysian
monetary authorities announced a rigid peg of 3.8 ringgit/USD after the Ringgit
plunged by 60% against the US dollar.

3. A currency basket as in the case of the Indian rupee in 1975; the Indian rupee was de-
linked from the pound and linked to a basket of currencies. The central bank may
keep the currencies in the basket a secret, or make the currency In 2005, China
pegged its yuan to a currency basket whose composition and weights are undisclosed.

Variants of a Floating Exchange Rate System:

1. Managed Float:

A floating exchange rate (or flexible exchange rate) is the opposite of the fixed exchange rate.
Market forces determine the value of the domestic currency against a selected foreign
currency. A managed float (or dirty float) is a floating exchange rate in which the monetary
authorities influence the exchange rate (through direct or indirect intervention without
specifying the target exchange rate. India is on a managed float.

2. Free Float or Clean Float:

Here, the exchange rate is purely determined by market forces (demand and supply of the
currency).
De Facto and De Jure Exchange Rate Systems:

A de facto exchange rate is the one that a country actually follows. A de jure exchange rate
system is the one that the country claims to follow. Both systems need not always be the
same. China’s de facto system was the fixed rate but it insisted that its de jure system was a
managed float. The IMF conducts surveys of exchange rate systems around the world. The
surveys take into account both the de facto and de jure systems for each country.
Fixed versus Floating Exchange Rate:

Which exchange rate system is the best? The answer depends upon the objectives of the
monetary authorities in a country.

There are three possible objectives:

1. Maintain stable exchange rates

2. Allow mobility of capital

iii. Have control over monetary policy.
With a floating exchange rate, the last two objectives can be attained but there will be
exchange rate volatility. With a fixed exchange rate, the first two objectives can be attained
but there will be no control over the monetary policy. In other words, irrespective of whether
the fixed rate or the floating exchange rate is selected, only two of the three objectives can be
attained. Thus, the three objectives are called the impossible trinity. In practice, countries can
and do fine-tune their exchange rate systems, and need not choose either extreme.

Some countries (Canada, USA) consistently follow a particular exchange rate while others
(Argentina, Russia) shift from one exchange rate to another. Canada has followed a flexible
exchange rate since 1971, Hong Kong has had a currency board since 1983 and Argentina
moved from a flexible exchange rate to a currency board in 1991. India moved from a fixed
exchange rate to a partially floating rate in 1993 and a full float in 1994.

There has been a gradual shift from fixed exchange rate (and its variants) to flexible
exchange rate. While a majority of developing countries had a fixed exchange rate in 1975,
less than half had a fixed exchange rate 20 years later. Economists advocate a fixed exchange
rate when an economy is affected by shifts in the demand for money that can affect price
levels.

They advocate a flexible exchange rate when an economy is affected by changes in demand
for products. A country that makes a successful transition from a fixed to a floating rate has a
deep foreign exchange market, a well thought out policy of intervention by the central bank,
and effective mechanisms to manage exchange rate risks.

The pegged exchange rate was popular in the early 1990s among countries that were making
the transition to becoming market economies. Countries moved away from the hard peg
towards the crawling peg. The efficacy of a particular exchange rate system is a function of
each country’s unique economic circumstances, stage of development, strength of the
financial system, and the degree of autonomy enjoyed by its monetary authority. No single
exchange rate system has been an unqualified success across countries in terms of
improvement in growth rates or financial stability.

The fixed exchange rate did not accelerate growth rates in countries that adopted it, nor did it
protect them from currency crises. The same is true of the floating exchange rate. On the
other hand, the central banks of many developing countries fear the impact a floating
exchange rate would have through a sharp appreciation or depreciation of their currency on
their exports and imports, as well as their capacity to repay overseas debt.

Exchange Rate Systems in Selected Emerging Markets (1980-2010):

The Brazilian real – The crawling peg was replaced by a floating exchange rate in 1990.

The Hong Kong dollar – It is on a currency board.

The Indonesian rupiah – The managed float was replaced by a floating exchange rate in 1997.

The Malaysian ringitt – The currency peg to a currency basket was replaced by a fixed
exchange rate in 1998.
The Phillipine peso – It is on a floating exchange rate.

The Singapore dollar – The currency peg to a currency basket was replaced by a fixed
exchange rate in 1985.

The South Korean won – The currency peg to the US dollar was replaced by a managed float
in 1980.

The Thai baht – It is on a managed float.

Differences between Flexible and Fixed Exchange Rate System:

Flexible Exchange Rate System:

Advantages:
1. It permits quicker adjustments in the exchange rate to changes in macro-economic
factors such as changes in inflation rate, growth rate, and interest rates.

2. There is less likelihood of currency overvaluation. So the country’s growth prospects

are brighter.

Disadvantages:
1. Exchange rate risk is high due to greater volatility in the short- and long-term. This
makes exchange rate forecasting extremely important as well as extremely difficult.
2. There is a tendency for capital inflows through foreign portfolio investment, or ‘hot
money’.

3. Imports and overseas debt repayment are adversely affected by depreciation of

domestic currency.

Fixed Exchange Rate System:

Advantages:

1. There is stability in exchange rate and exchange rate risk is nil.

2. Capital inflows through foreign direct investment are higher because there is no
exchange rate volatility. FDI is a ‘desirable’ capital inflow due to its stable and long-
term nature.
3. Inflation rates tend to be lower and therefore real interest rates (nominal interest rates
adjusted for inflation) are higher.

Disadvantages:
1. The exchange rate does not reflect macro-economic changes. The entire foreign
exchange entering and leaving the country has to be converted at the fixed exchange
rate.
2. Punitive action for contravening rules.
In a fixed exchange rate regime, the entire institutional infrastructure is geared towards
identifying evasion of foreign exchange controls and imposing penal punishments. A fixed
exchange rate creates a flourishing parallel market for foreign exchange in which the ‘true’
value of the domestic currency is determined by market forces. This is because the par value
of the domestic currency is very often at variance with what the exchange rate would be if
left to the vagaries of supply and demand.

Very often countries fix a separate par value for exports and a separate one for imports. This
is done to boost its exports and deter imports. This merely increase the draconian system
needed to monitor foreign currency inflows and outflows.

The problems with a fixed exchange rate are described below:

1. The possibility of overvaluation of the domestic currency is quite high. Suppose the
rupee is on a fixed exchange rate of Rs. 40/$ instead of Rs. 43/$ when left to market
forces. So, instead of 1$ being able to buy Rs. 43 worth of goods, it can buy only Rs.
40 worth of goods). This would hurt the competitiveness of India’s exports and
therefore hamper its growth prospects.

2. When the country on a fixed exchange rate is seen consistently to have trade
surpluses, it generates a lot of ill will, and a perception that the trade surpluses are the
result of currency manipulation of keeping the exchange rate artificially high (or low
as the case may be). Consider the hypothetical example below. If the Chinese yuan
should have an exchange rate of yuan 5.60/$ but is instead kept at yuan 7.00/$,
Chinese exports have extremely competitive prices in world markets, and China has a
trade surplus.

Sustained trade surpluses should make the yuan appreciate, and this should be reflected by
moving the fixed exchange rate to yuan 5.60/$. The trade surpluses would decrease, and
perhaps result in a trade deficit. This was USA’s argument for several years preceding the
2010 G20 Summit in Seoul. In Table 11.5, you can see the change in balance of trade (BOT)
when the yuan-dollar exchange rate moves from fixed to flexible rate mechanism.

3. There is a loss of control over monetary policy. When a country is on a fixed

exchange rate, inflows of capital lead to an increase in money supply and lending by
domestic banks, whereas outflows of capital lead to contraction of commercial bank
credit and money supply. When there are huge inflows, money supply in the country
increases, and inflation rises. The central bank cannot contract money supply and rein
in inflation because the country’s money supply is dependent on inflows and outflows
unless the central bank undertakes sterilization of foreign exchange.
4. Regular intervention by the central bank in the foreign exchange markets to maintain
the rigid peg could either lead to accumulation of enormous foreign exchange reserve
by the central bank (as in China between 2001 and 2010) or a drain of the country’s
foreign exchange reserves. When there are sustained foreign exchange inflows,
sterilization causes the central bank to accumulate foreign exchange reserves.
China pegged its currency at 8.28 yuan/USD in 1998. Due to inflows of capital and a balance
of trade surplus with the United States, the Chinese central bank (People’s Bank of China or
PBOC) used government bonds and central bank bills to conduct sterilization, and had to
purchase billions of US dollars to maintain the yuan/dollar peg. Sustained intervention can
cause a depletion of foreign exchange reserves. The Thai baht was pegged to the US dollar. In
1997, speculative attacks on the baht forced the Bank of Thailand to sell $40 billion until all
its reserves were depleted, and it was forced to abandon the peg.

5. Any instability in the anchor currency is immediately transmitted to the domestic

currency. If a country’s currency is pegged to the US dollar, then all the ups and
downs of the dollar become the ups and downs of the country’s currency. If the anchor
currency’s value drops, so does the value of the country’s currency.

6. Market participants are unable to anticipate and manage exchange rate risk.
7. It is difficult for the country to make changes in fiscal policy and still retain overseas
investor confidence in the economy. To make the country recover from recession, the
standard fiscal response is to increase government spending. This is what USA did in
the aftermath of the subprime crisis of 2007. But the US was on a floating exchange
rate.

However, when a country on a fixed exchange rate increases government spending, overseas
investors may view it as a signal that the country may not recover from the recession. It
prompts capital to flow out of the country. So the fiscal policy response has an unintended
consequence of increasing capital outflows.
8. The official exchange rate does not adjust quick enough to reflect the new purchasing
power of the country’s currency.

9. A huge country on a fixed exchange rate, with massive surpluses, can destabilize the
entire global financial system. China is a case in point—it faces a problem of plenty—
its rising forex reserves have to be continuously invested. It chose to buy US Treasury
Bills, and is now one of the largest overseas holders of US government bonds.

When US bond prices fell in 2009, China issued a veiled warning to the US asking it to
ensure that its portfolio of US bonds does not lose more of its value. When China chooses to
sell its US bond portfolio, it will result in a steep fall in US bond market prices quickly
transmitting to stock markets in the US and around the world due to integration of financial
markets, thus causing a meltdown in global stock markets, and severely destabilizing the
financial markets.

Determination of Floating Exchange Rates:

There are four theories that explain how floating exchange rates are set. The first theory (the
demand and supply theory) is called a flow theory because it studies how the demand for and
supply of a domestic currency over a period of time results in a particular level for the
exchange rate. The other three theories (the monetary theory, the asset price theory, and the
portfolio balance theory) are called stock theories, since they study the amount of currency
available at a certain time—the stock of currency—and peoples’ willingness to hold the
currency. They are also called modern theories of exchange rate determination.

Supply and Demand Theory:

This theory states that the exchange rate is the intersection of the supply of domestic currency
(shown as the supply curve) and its demand (shown as the demand curve). The supply of
domestic currency is determined by imports and the demand is determined by exports.

Monetary Theory:

This theory links money supply and prices to the exchange rate. An increase in money supply
leads to an increase in prices (inflation). According to the monetary theory, the exchange rate
is the ratio of prices in two countries, so an increase in price causes the exchange rate to be
reset. Consider two countries A and B. When the money supply in each country rises, the
prices in each country rise. If the growth of money supply in A is greater than the growth of
money supply in B, then A experiences a higher inflation rate than B.

According to the Purchasing Power Parity theory, the exchange rate is nothing but the ratio of
prices between two countries. Since A has had a relatively greater rise in prices, A’s currency
depreciates, will fall, and a new exchange rate will get established.

The monetary theory states that there is a direct connection between relative changes in
money supply in two countries and the exchange rate between both countries, provided there
are no transportation costs in moving goods between both countries.
Asset Price Theory:

The theory states that currency is an asset just as real estate or securities or gold. The desire to
hold a particular type of asset is driven by the perception of the asset’s future value. If the
value is likely to rise, people will want to buy the asset now and sell it at a higher price so as
to make a profit. Conversely, if they think the asset’s value will drop, all those holding the
asset now will start selling the asset fearing a greater decline in price in the near future.
Therefore, the asset’s current attractiveness is a function of what the market believes its value
is going to be in future. In other words, future expectations decide current buy/sell decisions.

This is true even for currency. If the market believes that the domestic currency is going to
rise in value, everyone will start buying it. If the current exchange rate is Rs. 43/$, and the
expectation is that the rupee will appreciate over the next six months. Participants will start
purchasing the rupee and this will drive up demand. Because demand rises, the rupee will
appreciate against the dollar, and the exchange rate will settle at Rs. 42/$.

If on the other hand, the market expects the rupee to depreciate, there will be selling pressure
and the rupee will depreciate, probably settling at Rs. 44/$. At any point in time, the current
exchange rate contains market expectations of the future value of the domestic currency.

Portfolio Balance Theory:

The portfolio balance theory connects money supply, supply and demand for domestic
securities, demand for foreign securities, and the exchange rate.

Its assumptions are:

1. Investors can hold only two types of assets—currency and bonds (domestic bonds
issued in domestic currency and foreign bonds issued in foreign currency).

2. Investors in two countries have identical asset preferences.

3. When the wealth of investors in either country increases, they would prefer to hold
more of the asset that they already hold in excess.

Foreign Exchange as stock

The International Stock Exchange (TISE) is a stock exchange headquartered in St. Peter Port,
Guernsey. The TISE provides a responsive and innovative listing facility for international
companies to raise capital from investors based around the globe. It offers a regulated
marketplace, with globally recognisable clients and a growing product range, from a location
within the European time zone but outside the EU.
TISE is the trading name of The International Stock Exchange Group Limited. It wholly
owns The Channel Islands Securities Exchange Authority Limited which trades as The
International Stock Exchange Authority (TISEA) which is licensed to operate an investment
exchange under The Protection of Investors (Bailiwick of Guernsey) Law, 1987, as amended,
by the Guernsey Financial Services Commission.

Forex is a portmanteau of foreign currency and exchange. Foreign exchange is the process of
changing one currency into another for a variety of reasons, usually for commerce, trading, or
tourism.

The foreign exchange market is where currencies are traded. Currencies are important
because they allow us to purchase goods and services locally and across borders.
International currencies need to be exchanged to conduct foreign trade and business.

The exchange lists a wide range of securities:

• Primary and secondary listings of securities issued by Guernsey, Jersey and overseas
trading companies.

• Investment vehicles, including open and closed ended funds and Real Estate
Investment Trusts (REITs).

• Specialist debt securities for sophisticated investors, including the use of Special
Purpose Vehicles (SPVs) and the Quoted Eurobond Exemption for convertible bonds,
intra-group financing, structured products and warrants.

• There are specific rules for equities and corporate debt securities issued by extractive
industries.
• Special Purpose Acquisition Companies (SPACs) were introduced in November 2015.
The New York Stock Exchange

The New York Stock Exchange (NYSE) is part of NYSE EURONEXT, which now has
exchanges in the U.S. and Europe. It estimates that its exchanges represent a third of all
equities traded in the world. The NYSE continues to be one of the primary exchanges in the
world and the largest in terms of the nearly $10 trillion in stock market capitalization it
represents.

The NYSE has been around since 1792 and it is believed that Bank of New York, which is
now part of Bank of New York Mellon, was the first stock traded. The ringing of the NYSE
bell at the start and end of the day is a common occurrence in today’s media.

The business has grown incredibly competitive in recent years. In a recent filing with the
Securities and Exchange Commission (SEC), the company notes that it must compete for the
listings of cash equities, exchange traded funds, structure products, futures, options and other
derivatives.

The Tokyo Stock Exchange

The Tokyo Stock Exchange (TSE) is the largest exchange in Japan and also number two
behind the NYSE in terms of the more than $3 trillion in market capitalization the companies
on its exchange represent. A stronger national currency is part of the reason behind the
increasing size of the TSE. Around 2,000 firms are listed on the TSE.

The exchange was estimated to have first opened in 1878 and partners with other exchanges
around the world, such as the London Stock Exchange below. The Nikkei 225 index is one of
the primary and most popular indexes that represent some of the largest and most successful
firms in Japan.

The London Stock Exchange

The London Stock Exchange (LSE) qualifies as a top-five stock market, with an estimated
$2.2 trillion in stock market capitalization from the companies listed on its exchange. Its
estimated founding was 1801, or nearly a decade following the opening of the NYSE.

The LSE considers itself the most international of global exchanges, based on the fact that
around 3,000 companies from around the world trade on the LSE and its affiliated exchanges.

The Hong Kong Stock Exchange

The Hong Kong Stock Exchange is one of the top 10 largest stock exchanges. The firms that
are listed on the Hong Kong Stock Exchange represent close to $2 trillion in total market
capitalization. Roughly 1,500 companies are listed on the exchange, which dates back to just
prior to 1900, when it first started operating. Most importantly, the exchange represents one
of the primary avenues for global investors to invest in China.

The Shanghai Stock Exchange

The Shanghai Stock Exchange is one of the newest in the world. It opened in late 1990, and
1,500 companies trade on its exchange. Trading volume continues to increase but has fallen
dramatically since 2008, which marked a peak in terms of investment interest in China.

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Balance of Payments

The balance of payments (henceforth BOP) is a consolidated account of the receipts and
payments from and to other countries arising out of all economic transactions during the
course of a year.

In the words of C. P. Kindleberger : “The balance of payments of a country is a systematic

record of all economic transactions between the residents of the reporting and the
residents of the foreign countries during a given period of time.” Here by ‘residents’ we
mean individuals, firms and government.

By all economic transactions we mean individuals, firms and government. By all economic
transactions we mean transactions of both visible goods (merchandise) and invisible goods
(services), assets, gifts, etc. In other words, the BOP shows how money is spent abroad (i.e.,
payments) and how money is received domestically (i.e., receipts).

Thus, a BOP account records all payments and receipts arising out of all economic
transactions. All payments are regarded as debits (i.e., outflow of money) and are recorded in
the accounts with a negative sign and all receipts are regarded as credits (i.e., inflow or
money) and are recorded-in the accounts with a positive sign. The International Monetary
Fund defines BOP as a “statistical statement that subsequently summarises, for a specific
time period, the economic transactions of an economy with the rest of the world.”

Components of BOP Accounts

(A) The Current Account

The current account of BOP includes all transaction arising from trade in currently produced
goods and services, from income accruing to capital by one country and invested in another
and from unilateral transfers— both private and official. The current account is usually
divided in three sub-divisions.

The first of these is called visible account or merchandise account or trade in goods account.
This account records imports and exports of physical goods. The balance of visible exports
and visible imports is called balance of visible trade or balance of merchandise trade [i.e.,
items 1(a), and 2(a) of Table 6.1].

The second part of the account is called the invisibles account since it records all exports and
imports of services. The balance of these transactions is called the balance of invisible trade.
As these transactions are not recorded—in the customs office—unlike merchandise trade we
call them invisible items.
It includes freights and fares of ships and planes, insurance and banking charges, foreign
tours and education abroad, expenditures on foreign embassies, transactions out of interest
and dividends on foreigners’ investment and so on. Items 2(a) and 2(b) comprise services
balance or balance of invisible trade in table 6.1.

The difference between merchandise trade and invisible trade (i.e., items 1 and 2) is known as
the balance of trade.

There is another flow in the current account that consists of two items [3(a) and 3(b)].
Investment income consists of interest, profit and dividends on bonus and credits. Interest
earned by a US resident from the TELCO share is one kind of investment income that
represents a debit item here.

There may be a similar money inflow (i.e., credit item). Unrequited transfers include grants,
gifts, pension, etc. These items are such that no reverse flow occurs. Or these are the items
against which no quid pro quo is demanded. Residents of a country received these cost-free.
Thus, unilateral transfers are one-way transactions. In other words, these items do not involve
give and take unlike other items in the BOP account.

Thus the first three items of the BOP account are included in the current account. The current
account is said to be favourable (or unfavourable) if receipts exceed (fall short of) payments.

(B) The Capital Account

The capital account shows transactions relating to the international movement of ownership
of financial assets. It refers to cross-border movements in foreign assets like shares, property
or direct acquisitions of companies’ bank loans, government securities, etc. In other words,
capital account records export and import of capital from and to foreign countries.
The capital account is divided into two main subdivisions: short term and the long term
movements of capital. A short term capital is one which matures in one year or less, such as
bank accounts.
Long term capital is one whose maturity period is longer than a year, such as long term bonds
or physical capital. Long term capital account is, again, of two categories: direct investment
and portfolio investment. Direct investment refers to expenditure on fixed capital formation,
while portfolio investment refers to the acquisition of financial assets like bonds, shares, etc.
India’s investment (e.g., if an Indian acquires a new Coca- Cola plant in the USA) abroad
represents an outflow of money. Similarly, if a foreigner acquires a new factory in India it
will represent an inflow of funds.

Thus, through acquisition or sale and purchase of assets, capital movements take place.
Investors then acquire controlling interests over the asset. Remember that exports and imports
of equipment do not appear in the capital account. On the other hand, portfolio investment
refers to changes in the holding of shares and bonds. Such investment is portfolio capital and
the ownership of paper assets like shares does not ensure legal control over the firms.

[In this connection, the concepts of capital exports and capital imports require little elabo-
ration. Suppose, a US company purchases a firm operating in India. This sort of foreign
investment is called capital import rather than capital export. India acquires foreign currency
after selling the firm to a US company. As a result, India acquires purchasing power abroad.
That is why this transaction is included in the credit side of India’s BOP accounts. In the
same way, if India invests in a foreign country,, it is a payment and will be recorded on the
debit side. This is called capital export. Thus, India earns foreign currency by exporting
goods and services and by importing capital. Similarly, India releases foreign currency by
importing visible and invisibles and exporting capital.]

(C) Statistical Discrepancy Errors and Omissions

The sum of A and B (Table 6.1) is called the basic balance. Since BOP always balances in
theory, all debits must be offset by all credits, and vice versa. In practice, it rarely happens—
particularly because statistics are incomplete as well as imperfect. That is why errors and
omissions are considered so that the BOP accounts are kept in balance (Item C).
(D) The Official Reserve Account

The total of A, B, C, and D comprise the overall balance. The category of official reserve
account covers the net amount of transactions by governments. This account covers
purchases and sales of reserve assets (such as gold, convertible foreign exchange and special
drawing rights) by the central monetary authority.

Now, we can summarise the BOP data

Current account balance + Capital account balance + Reserve balance = Balance of Payments

(X – M) + (CI – CO) + FOREX = BOP

X is exports,

M is imports,
CI is capital inflows,
CO is capital outflows,

FOREX is foreign exchange reserve balance.

BOP Always Balances

A nation’s BOP is a summary statement of all economic transactions between the residents of
a country and the rest of the world during a given period of time. A BOP account is divided
into current account and capital account. Former is made up of trade in goods (i.e., visible)
and trade in services (i.e., invisibles) and unrequited transfers. Latter account is made up of
transactions in financial assets. These two accounts comprise BOP

A BOP account is prepared according to the principle of double-entry book keeping. This
accounting procedure gives rise to two entries— a debit and a corresponding credit. Any
transaction giving rise to a receipt from the rest of the world is a credit item in the BOP
account. Any transaction giving rise to a payment to the rest of the world is a debit item.

The left hand side of the BOP account shows the receipts of the country. Such receipts of
external purchasing power arise from the commodity export, from the sale of invisible
services, from the receipts of gift and grants from foreign governments, international lending
institutions and foreign individuals, from the borrowing of money from the foreigners or from
repayment of loan by the foreigners.

The right hand side shows the payments made by the country on different items to the
foreigners. It shows how the total of external purchasing power is used for acquiring imports
of foreign goods and services as well as the purchase of foreign assets. This is the accounting
procedure.

However, no country publishes BOP accounts in this format. Rather, by convention, the BOP
figures are published in a single column with positive (credit) and negative (debit) signs.
Since payments side of the account enumerates all the uses which are made up of the total
foreign purchasing power acquired by this country in a given period, and since the receipts of
the accounts enumerate all the sources from which foreign purchasing power is acquired by
the same country in the same period, the two sides must balance. The entries in the account
should, therefore, add up to zero.

In reality, why should they add up to zero? In practice, this is difficult to achieve where
receipts equal payments. In reality, total receipts may diverge from total payments because of:

(i) The difficulty of collecting accurate trade information

(ii) The difference in the timing between the two sides of the balance

(iii) A change in the exchange rates, etc.

Because of such measurement problems, resource is made to ‘balancing item’ that intends to
eliminate errors in measurement. The purpose of incorporating this item in the BOP account
is to adjust the difference between the sums of the credit and the sums of the debit items in
the BOP accounts so that they add up to zero by construction. Hence the proposition ‘the
BOP always balances’. It is a truism. It only suggests that the two sides of the accounts must
always show the same total. It implies only an equality. In this book-keeping sense, BOP
always balances.

Thus, by construction, BOP accounts do not matter. In fact, this is not so. The accounts have
both economic and political implications. Mathematically, receipts equal payments but it
need not balance in economic sense. This means that there cannot be disequilibrium in the
BOP accounts.

A combined deficit in the current and capital accounts is the most unwanted macroeconomic
goal of ,an economy. Again, a deficit in the current account is also undesirable. All these
suggest that BOP is out of equilibrium. But can we know whether the BOP is in equilibrium
or not? Tests are usually three in number:

(i) Movements in foreign exchange reserves including gold

(ii) Increase in borrowing from abroad

(iii) Movements in foreign exchange rates of the country’s currency in question.

Firstly, if foreign exchange reserves decline, a country’s BOP is considered to be in

disequilibrium or in deficit. If foreign exchange reserves are allowed to deplete rapidly it may
shatter the confidence of people over the domestic currency. This may ultimately lead to a run
on the bank.

Secondly, to cover the deficit a country may borrow from abroad. Thus, such borrowing
occurs when imports exceed exports. This involves payment of interest on borrowed funds at
a high rate of interest.
Finally, the foreign exchange rate of a country’s currency may tumble when it suffers from
BOP disequilibrium. A fall in the exchange rate of a currency is a sign of BOP disequilibrium.

Thus, the above (mechanical) equality between receipts and payments should not be
interpreted to mean that a country never suffers from the BOP problems and the international
economic transactions of a country are always in equilibrium.

Implications of an Unbalance in the BOP

Although a nation’s BOP always balances in the accounting sense, it need not balance in an
economic sense.

An unbalance in the BOP account has the following implications:

In the case of a deficit

(i) Foreign exchange or foreign currency reserves decline,

(ii) Volume of international debt and its servicing mount up, and

(iii) The exchange rate experiences a downward pressure. It is, therefore, necessary to correct
these imbalances.
BOP Adjustment Measures:

BOP adjustment measures are grouped into four:

(i) Protectionist measures by imposing customs duties and other restrictions, quotas on
imports, etc., aim at restricting the flow of imports,

(ii) Demand management policies—these include restrictionary monetary and fiscal policies
to control aggregate demand [C + I + G + (X – M)],

(iii) Supply-side policies—these policies aim at increasing the nation’s output through greater
productivity and other efficiency measures, and, finally,

(iv) exchange rate management policies— these policies may involve a fixed exchange rate,
or a flexible exchange rate or a managed exchange rate system.

As a method of connecting disequilibrium in a nation’s BOP account, we attach importance

here to exchange rate management policy only.

Balance of Payments: Understanding, Analysis & Interpretation

The balance of payments (BOP) is the place where countries record their monetary
transactions with the rest of the world. Transactions are either marked as a credit or a debit.
Within the BOP there are three separate categories under which different transactions are
categorized: the current account, the capital account, and the financial account. In the current
account, goods, services, income and current transfers are recorded. In the capital
account, physical assets such as a building or a factory are recorded. And in the financial
account, assets pertaining to international monetary flows of, for example, business or
portfolio investments, are noted. In this article, we will focus on analyzing the current
account and how it reflects an economy’s overall position.

The Current Account

The balance of the current account tells us if a country has a deficit or a surplus. If there is a
deficit, does that mean the economy is weak? Does a surplus automatically mean that the
economy is strong?
Not necessarily. But to understand the significance of this part of the BOP, we should start by
looking at the components of the current account: goods, services, income and current
transfers.

1. Goods– These are movable and physical in nature, and for a transaction to be
recorded under “goods,” a change of ownership from/to a resident (of the local
country) to/from a non-resident (in a foreign country) has to take place. Movable
goods include general merchandise, goods used for processing other goods, and non-
monetary gold. An export is marked as a credit (money coming in), and an import is
noted as a debit (money going out).
2. Services– These transactions result from an intangible action such as transportation,
business services, tourism, royalties or licensing. If money is being paid for a service,
 it is recorded like an import (a debit), and if money is received, it is recorded like an
export (credit).

3. Income– Income is money going in (credit) or out (debit) of a country from salaries,
portfolio investments (in the form of dividends, for example), direct investments or
any other type of investment. Together, goods, services, and income provide an
economy with fuel to function. This means that items under these categories are actual
resources that are transferred to and from a country for economic production.

4. Current Transfers– Current transfers are unilateral transfers with nothing received in
return. These include workers’ remittances, donations, aids and grants, official
assistance and pensions. Due to their nature, current transfers are not considered real
resources that affect economic production.

Now that we have covered the four basic components, we need to look at the mathematical
equation that allows us to determine whether the current account is in deficit or surplus
(whether it has more credit or debit). This will help us understand where any discrepancies
may stem from, and how resources may be restructured in order to allow for a better
functioning economy.

The following variables go into the calculation of the current account balance (CAB):

X = Exports of goods and services

M = Imports of goods and services

NY = Net income abroad

NCT = Net current transfers

The formula is:

CAB = X – M + NY + NCT

What Does It Tell Us?

Theoretically, the balance should be zero, but in the real world this is improbable, so if the
current account has a surplus or a deficit, this tells us something about the government and
state of the economy in question, both on its own and in comparison to other world markets.

A surplus is indicative of an economy that is a net creditor to the rest of the world. It shows
how much a country is saving as opposed to investing. What this means is that the country is
providing an abundance of resources to other economies, and is owed money in return. By
providing these resources abroad, a country with a CAB surplus gives other economies the
chance to increase their productivity while running a deficit. This is referred to as financing a
deficit.
A deficit reflects government and an economy that is a net debtor to the rest of the world. It is
investing more than it is saving and is using resources from other economies to meet its
domestic consumption and investment requirements. For example, let us say an economy
decides that it needs to invest for the future (to receive investment income in the long run), so
instead of saving, it sends the money abroad into an investment project. This would be
marked as a debit in the financial account of the balance of payments at that period, but when
future returns are made, they would be entered as investment income (a credit) in the current
account under the income section.

A current account deficit is usually accompanied by depletion in foreign-exchange assets

because those reserves would be used for investment abroad. The deficit could also signify
increased foreign investment in the local market, in which case the local economy is liable to
pay the foreign economy investment income in the future.

It is important to understand from where a deficit or a surplus is stemming because

sometimes looking at the current account as a whole could be misleading.

Analyzing the Current Account

Exports imply demand for a local product while imports point to a need for supplies to meet
local production requirements. An export is a credit to a local economy while an import is a
debit; an import means that the local economy is liable to pay a foreign economy. Therefore a
deficit between exports and imports (goods and services combined) – otherwise known as
a balance of trade (BOT) deficit (more imports than exports) – could mean that the country is
importing more to increase its productivity and to eventually churn out more exports. This, in
turn, could ultimately finance and alleviate the deficit.

A deficit could also stem from a rise in investments from abroad and increased obligations by
the local economy to pay investment income (a debit under income in the current account).
Investments from abroad usually have a positive effect on the local economy because, if used
wisely, they provide for increased market value and production for that economy in the
future. This can allow the local economy eventually to increase exports and, again, reverse its
deficit.

So, a deficit is not necessarily a bad thing for an economy, especially for an economy in the
developing stages or under reform: an economy sometimes has to spend money to make
money, so it runs a deficit intentionally. However, an economy must be prepared to finance
this deficit through a combination of means that will help reduce external liabilities and
increase credits from abroad. For example, a current account deficit that is financed by short-
term portfolio investment or borrowing is likely riskier. This is because a sudden failure in an
emerging capital market or an unexpected suspension of foreign government assistance,
perhaps due to political tensions, will result in an immediate cessation of credit in the current
account.

The Bottom Line

The volume of a country’s current account is a good sign of economic activity. By
scrutinizing the four components of it, we can get a clear picture of the extent of activity of a
country’s industries, capital market, services and the money entering the country from other
governments or through remittances. However, depending on the nation’s stage of economic
growth, its goals, and of course the implementation of its economic program, the state of the
current account is relative to the characteristics of the country in question. But when
analyzing a current account deficit or surplus, it is vital to know what is fueling the extra
credit or debit and what is being done to counter the effects (a surplus financed by a donation
may not be the most prudent way to run an economy). On a separate note, the current account
also highlights what is traded with other countries, and it is a good reflection of each
nation’s comparative advantage in the global economy.

Basic Concepts Relating to Foreign exchange

Foreign exchange market is one of the important components of any economy today. It
involves currency exchange, remittances, import & export, investments etc. This article gives
an idea about what is foreign exchange & foreign exchange market. It also throws light on
basic terminology involved in foreign exchange transactions.

In this era of globalization and highly interconnected economies, foreign exchange market
has become very prominent. In fact, it has a huge role to play in a developing economy like
India. Financial institutions like banks are constantly looking for professionals well-versed in
foreign exchange market as the volume of transactions & the participation is increasing at a
rapid rate. In this article we will try to get the basics of foreign exchange.

Meaning of foreign exchange

In simple terms, foreign exchange means exchange of currency of one nation into that of
another nation. You can relate it directly with the export & import of the commodities
between two nations. So an import-export relationship between two people in USA and India
would involve exchange of Dollar & Rupee. In broader terms, however, the definition of
foreign exchange encompasses a lot of other things. The Foreign Exchange Management Act
(FEMA), 1999, has given a broad definition of foreign exchange. To keep the things simple
for the beginners, foreign exchange in this article refers to foreign currency & exchange of
one currency into another. Foreign exchange is also called Forex.

Foreign exchange market

So what is a foreign exchange market? Is it a market based out of some place? No, we can’t
define the foreign exchange market in the same way as we define a normal market, say a
commodity market. This is because forex market is not bounded by any boundary. It is not
confined to 4 walls in a particular place. Moreover, it is a 24*7 market and works round the
clock.
A forex market refers to a market where different participants can buy, sell and exchange
currencies. It’s a decentralized market i.e. the foreign exchange activities take place across
the globe in different time zones. So, even when the Indian market is calling it a day, the US
market is initiating its daily operations. In this way it keeps on going across the world. As the
world economies are highly interconnected today, forex market is always open at some place.

Forex participants

We mentioned the word participants in the definition of forex market. Who are the
participants actually? The participants are the entities who seek foreign exchange for their
needs. They can be banks, investors, or any individual etc. Let’s go through the different
types of participants in the forex market.
Central & commercial banks: A central Bank, like RBI, make use of forex market to
manage their reserves and take corrective steps whenever home currency (say Rupee) faces
abrupt devaluation. Commercial banks, on the other hand, need forex market for the
exchange of currencies for their clients. They also use it for the purpose of investments.
Investment Banks: As their name implies, investment banks primarily use forex market for
the purpose of investment.
Broker: A broker, like the one in the stock market, works as a middleman between two
participants of forex market.
Individuals: Normal people who seek forex market for different purposes like investment,
business, travel etc.

Basic terminology related to foreign exchange

Exchange Rate

An exchange rate refers to the rate at which one currency can be exchanged with another. So
if someone says that exchange rate between USD and Rupee is 64 that means one USD can
be exchanged for INR 64. We understand the exchange rate by looking at the quotes.

Direct & Indirect Quotes

A quote is a way of expressing one currency in certain units of the other currency. So 1 USD
= Rs. 64 would mean 1 unit of USD is equivalent to 64 units of Indian Rupee. The quotes can
be given in two ways – direct and indirect. Under direct method, local currency or the home
currency is variable. For instance, the quote we mentioned above is a direct quote as we can
get the value of home currency against USD directly. Direct quote is also known as Home
currency.

In indirect quote, the foreign currency is variable while home currency is fixed. For instance,
Rs. 128 = 2 USD is an indirect quote. Generally direct quotes are used across the globe with
few notable exceptions

Cross Rate Mechanism

Sometimes, in a particular market, we might not get a quote between two currencies and we
need to exchange them. In such a case we make use of cross rate mechanism. Under this, we
make use of a currency having quotes with both of the above currencies. The most common
example is that of USD. So we will obtain direct quotes involving USD for both the
currencies and by simply crossing them out using plain mathematics, we can get the desired
quote.

Spot Rate

Most of the forex transactions are not necessarily settled on the same day. They may be
settled in future also. So, depending on the settlement time, the exchange also varies.
Generally, the settlement of forex transactions takes place on the second working day. The
rate then applied is called Spot rate. Even though the word ‘spot’ indicates a quick settlement,
the actual transaction is completed only on the second working day.

Forward Rate

If settlement of funds takes place after second working day i.e. spot date, then the rate applied
is called forward rate. This rate is derived from the spot rate.

Ready/Cash

When the settlement takes place on the same day of the deal, it is called Ready or Cash.
Tom

If settlement takes place on next working day of the deal, it is referred to as Tom.

Premium & Discount

If the forward rate is more than spot rate of a currency, then that currency is said to be at
premium. On the other hand, if the forward rate is less than spot rate, the currency is said to
be at discount. This relationship can be expressed as
Forward Rate = Spot rate +Premium ( or – discount)
Bid & Offered rate
They are nothing but buying & selling rates of currencies. So a bid rate refers to the rate at
which a financial institution is ready to buy currency while offer rate is the rate at which it is
ready to sell currency.

Authorized Dealers
The authorized dealers are the entities who are authorized to deal in foreign exchange. They
are basically financial institutions who have been allowed to undertake transactions
pertaining to forex by RBI. There was a change in the definition of the authorized dealers in
the year 2005. As per new definition, these entities are called Authorized Persons. Moreover,
they have been divided into three different categories.

Authorised Person: Category I refer to financial institutions that are authorized to handle
all types of forex transactions.

Authorised Person: Category II refers to entities who can deal with buying/selling of
foreign currency, remittances, travelers cheques etc.
Authorised Person: Category III refers to entities who are authorized for purchasing of
foreign currency and traveler’s cheques only.

Forex Earnings

Foreign exchange earnings refer to the monetary gain made by selling goods and services
OR by exchanging currencies in global markets. Such markets are known as Foreign
Exchange markets/ Forex markets. Foreign exchange earnings are denominated in convertible
currencies, which means that even though the earnings come in the respective currencies of
the countries where the products or services are sold, they have to be exchanged with the
home currency in order to be calculated.

Foreign exchange earnings can have two components:

(a) Profits from the export of goods and services

(b) Profits from the conversion of currencies due to the difference in exchange rates
The exchange rates of the currencies are a function of the demand and supply of money in a
given country and fluctuate with time.

As explained by the money market equilibrium equation (LM curve), if the money supply
increases in a country, the price of the currency generally decreases, and the converse holds
true. The interest rate, set by the government, also affects the demand for money, and thus the
amount of foreign exchange earnings that can be made from it.

Money Market Equilibrium (LM curve) –>L= kY -hi

• L= Money demand
• h= Sensitivity of money demand w.r.t interest
• k=Sensitivity of money demand w.r.t. Y

• Y= Aggregate demand

• i= Interest rate

Exchange Rate System prior to IMF

Gold currency Standard, Gold Bullion standard

The gold standard is a monetary system where a country’s currency or paper money has a value
directly linked to gold. With the gold standard, countries agreed to convert paper money into a
fixed amount of gold. A country that uses the gold standard sets a fixed price for gold and buys
and sells gold at that price. That fixed price is used to determine the value of the currency. For
example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar would be
1/500th of an ounce of gold.
The gold standard is not currently used by any government. Britain stopped using the gold
standard in 1931 and the U.S. followed suit in 1933 and abandoned the remnants of the system
in 1973.1 2 The gold standard was completely replaced by fiat money, a term to describe
currency that is used because of a government’s order, or fiat, that the currency must be
accepted as a means of payment. In the U.S., for instance, the dollar is fiat money, and for
Nigeria, it is the naira.

The appeal of a gold standard is that it arrests control of the issuance of money out of the hands
of imperfect human beings. With the physical quantity of gold acting as a limit to that issuance,
a society can follow a simple rule to avoid the evils of inflation. The goal of monetary policy
is not just to prevent inflation, but also deflation, and to help promote a stable monetary
environment in which full employment can be achieved. A brief history of the U.S. gold
standard is enough to show that when such a simple rule is adopted, inflation can be avoided,
but strict adherence to that rule can create economic instability, if not political unrest.

The gold standard was originally implemented as a gold specie standard, by the circulation of
gold coins. The monetary unit is associated with the value of circulating gold coins, or the
monetary unit has the value of a certain circulating gold coin, but other coins may be made of
less valuable metal. With the invention and spread in use of paper money, gold coins were
eventually supplanted by banknotes, creating the gold bullion standard, a system in which gold
coins do not circulate, but the authorities agree to sell gold bullion on demand at a fixed price
in exchange for the circulating currency.

Lastly, countries may implement a gold exchange standard, where the government guarantees
a fixed exchange rate, not to a specified amount of gold, but rather to the currency of another
country that uses a gold standard. This creates a de facto gold standard, where the value of the
means of exchange has a fixed external value in terms of gold that is independent of the inherent
value of the means of exchange itself.

The British Gold Standard Act 1925 both introduced the gold bullion standard and
simultaneously repealed the gold specie standard. The new standard ended the circulation of
gold specie coins. Instead, the law compelled the authorities to sell gold bullion on demand at
a fixed price, but “only in the form of bars containing approximately four hundred ounces troy
[12 kg] of fine gold”. John Maynard Keynes, citing deflationary dangers, argued against
resumption of the gold standard. By fixing the price at a level which restored the pre-war
exchange rate of US$4.86 per pound sterling, as Chancellor of the Exchequer, Churchill is
argued to have made an error that led to depression, unemployment and the 1926 general strike.
The decision was described by Andrew Turnbull as a “historic mistake”.

The advantages of the system lay in its stabilizing influence. A nation that exported more than
it imported would receive gold in payment of the balance; such an influx of gold raised prices,
and thus lowered the value of the domestic currency. Higher prices resulted in decreasing the
demand for exports, an outflow of gold to pay for the now relatively cheap imports, and a return
to the original price level (see balance of trade and balance of payments).

A major defect in such a system was its inherent lack of liquidity; the world’s supply of money
would necessarily be limited by the world’s supply of gold. Moreover, any unusual increase in
the supply of gold, such as the discovery of a rich lode, would cause prices to rise abruptly. For
these reasons and others, the international gold standard broke down in 1914.

During the 1920s the gold standard was replaced by the gold bullion standard, under which
nations no longer minted gold coins but backed their currencies with gold bullion and agreed
to buy and sell the bullion at a fixed price. This system, too, was abandoned in the 1930s.

Gold exchange standard

gold-exchange standard, monetary system under which a nation’s currency may be converted
into bills of exchange drawn on a country whose currency is convertible into gold at a stable
rate of exchange. A nation on the gold-exchange standard is thus able to keep its currency at
parity with gold without having to maintain as large a gold reserve as is required under the gold
standard.

The gold-exchange standard came into prominence after World War I because of an inadequate
supply of gold for reserve purposes. British sterling and the U.S. dollar have been the most
widely recognized reserve currencies. The requirement of a fixed rate of exchange for the
reserve currency has the effect of limiting the freedom of the reserve-currency country’s
monetary policy to solve domestic economic problems. The use of gold reserves is now limited
almost exclusively to the settlement of international transactions, on rare occasions.

The objective of the gold standard is to prevent inflation and to provide certainty in the market.
Basically, the populace can feel confident in the value of a countries currency if the currency
represents and can be readily exchanged for a certain amount of gold. In 1933, the US moved
away from the Gold Standard. The US population traded in gold currency for fiat currency
issued by the US Government. The currency, however, was still backed by the possession of
gold. The dollar could readily be exchanged for gold. In 1944, the US formalized this model
as a signatory of the Bretton Woods Agreement. This agreement was negotiated among 44
countries to create a new financial and monetary system. In 1971, the truly split from the gold
standard. At this point, the US dollar could no longer be exchanged for gold and was no longer
pegged to gold prices.

Exchange Rate System under IMF: Bretton woods system, The Smithsonian Agreement,
The Flexible Exchange Rate Regime

The original scheme of the IMF therefore, provided that:

1. Each member-country would peg their own currency for exchanging with other
currency of the globe, in terms of gold. In addition to the gold, most of the countries
of the globe, have declared values of their currencies in terms of US dollar. The
pegging of the currency value with gold and/or US Dollar is named as ‘par value’ of
the currency.

2. At the time of finalization of valuation of currency with gold, to make the easement
the value of fine and pure gold per ounce was fixed at US dollar 35.
 3. The Cold and US Dollars were agreed upon as the official monetary reserves of
member-countries.

4. The market value of member country currency accepted within a margin of 1% of the
par value. If the market value of currencies deviates to the extent of more than the
permitted level, the country should take steps to devalue or up value the currency to
correct the position.

5. The member countries of IMF were allowed to devalue their currencies on their own.
If the member country would like to devalue their currency more than 1 % then the
approval of the IMF should be obtained. The IMF had no power to reject the proposal
of member country, only they can advise the member country for course of action
they feel correct.

6. To come out from the temporary imbalance in the balance of payment situations, the
IMF can grant short-term financial assistance to its member-countries. But if the
problem of Balance of Payment is chronic, and seems to be permanent nature, then
IMF suggest the member country to use permanent solutions like devaluation.

Working of the System:

For the smooth running of the system, the major industrialised countries other than the USA
endeavoured to keep exchange rate changes to the minimum and maintain a common price
level for tradable goods. As other countries were supposed to maintain the exchange rate,
USA had to remain passive in foreign exchange markets.

On the other hand, USA had to follow a monetary policy that could provide a stable price
level for tradable goods. Europe and Japan found it convenient to rely upon the USA to
supply a stable price environment, and support US dollar as unit of account and means of
settlement of international transactions.
The system provided a distinct advantage to the USA, viz., the seigniorage gains. A
seigniorage gain means prerogative gains, by issuing coins and currency above their intrinsic
value. It means that USA could obtain goods and services from abroad by merely printing US
dollar, so long as the other countries were willing to accept dollar as the key currency.

The acceptance of dollar depended on the confidence the other countries had that their US
dollar reserves could be used for settlement of their international debts or that they could
convert their reserves into gold. This aspect proved to be both a strength and weakness of the
system.

It was strength because dollar became a reserve asset in addition to gold providing additional
base for creation of money supply to keep pace with increase in international trade. It was a
weakness in the sense the system depended excessively on a single currency. This
dependence ultimately brought the fall of the system.
Collapse of the System:
For about two decades the system worked smoothly. Slowly during the late sixties, the
deficiencies of the system began to surface. One of the major difficulties was that the growth
of means of settlement of international debts (international liquidity) did not keep pace with
the increase in the volume of international trade.
Many countries began to experience balance of payments problems. The reason can be
attributed to the fact that increase in international liquidity depended upon the availability of
gold. The supply of gold did not increase because its official price was fixed at US dollar 35
per ounce. With inflation and increased cost of mining, many countries found it
uneconomical to mine gold.

Bretton woods system

The Bretton Woods system of monetary management established the rules for commercial
and financial relations among the United States, Canada, Western European countries,
Australia, and Japan after the 1944 Bretton Woods Agreement. The Bretton Woods system
was the first example of a fully negotiated monetary order intended to govern monetary
relations among independent states. The chief features of the Bretton Woods system were an
obligation for each country to adopt a monetary policy that maintained its external exchange
rates within 1 percent by tying its currency to gold and the ability of the International
Monetary Fund (IMF) to bridge temporary imbalances of payments. Also, there was a need to
address the lack of cooperation among other countries and to prevent competitive devaluation
of the currencies as well.

Preparing to rebuild the international economic system while World War II was still being
fought, 730 delegates from all 44 Allied nations gathered at the Mount Washington Hotel in
Bretton Woods, New Hampshire, United States, for the United Nations Monetary and
Financial Conference, also known as the Bretton Woods Conference. The delegates
deliberated from the 1st to the 22nd of July, 1944, and signed the Bretton Woods agreement
on its final day. Setting up a system of rules, institutions, and procedures to regulate the
international monetary system, these accords established the IMF and the International Bank
for Reconstruction and Development (IBRD), which today is part of the World Bank Group.
The United States, which controlled two-thirds of the world’s gold, insisted that the Bretton
Woods system rest on both gold and the US dollar. Soviet representatives attended the
conference but later declined to ratify the final agreements, charging that the institutions they
had created were “branches of Wall Street”. These organizations became operational in 1945
after a sufficient number of countries had ratified the agreement. According to Barry
Eichengreen, the Bretton Woods system operated successfully due to three factors: “low
international capital mobility, tight financial regulation, and the dominant economic and
financial position of the United States and the dollar.”
Smithsonian Agreement:

The state of instability and confusion led the other countries to devote immediate attention to
the issue. Ten major industrialised countries of the world (the USA, Canada, Britain, West
Germany, France, Italy, Holland, Belgium, Sweden and Japan) which came to be known as
the ‘Croup of Ten’ met at the Smithsonian building in Washington during December 1971 to
solve the dollar crisis and to decide about the realignment of the currencies. The agreement
entered into known as the ‘Smithsonian Agreement’, and came into effect from December 20,
1971.
The following actions where decided and taken:

1. The US dollar was devalued by 7.87% and the new dollar-gold parity was fixed at US
dollar 38 per ounce of gold.
2. The other major countries decided to revalue their currencies. Japan revalued its
currency in relation to dollar by 7.66% and West Germany by 4.61 %. This meant that
in relation to gold, the Japanese yen was revalued by 16.88% and the Deutsche Mark
by 12.6%.

3. It was provided for a wider band of fluctuation in exchange rates. The exchange rates
were allowed to fluctuate within 2.25% on either side instead of 1% existing
previously. This step was taken with a view to affording greater flexibility to
exchange rates in the market.

4. The USA removed the 10% surcharge on its imports, but the non-convertibility of
dollar into gold continued.

The USA faced unprecedented balance of payments deficit for the year 1971 characterised by
increased imports due to domestic boom. Dollar continued to fall in the exchange market. A
number of countries tried to save the situation by purchasing dollar in large quantities. The
situation was beyond repair by these methods and hence the USA devalued dollar for the
second time on February 13, 1973.

The extent of devaluation this time was 10% with the gold value increasing from US dollar
38 to US dollar 42.22 per ounce. Following the second devaluation of US dollar, many
countries, including Japan, West Germany and UK, started floating their currencies. Thus, the
Smithsonian Agreement came to an end.
Abolition of Gold and Emergence of Special Drawing Rights (SDR):

The turmoil in the exchange market continued. The dollar continued to fall and Japanese Yen
and Deutsche Mark emerged strong. Major currencies of the world continued to float.
The Committee which had 20 principal members both from developed and developing
countries made a number of far-reaching recommendations on reforming the IMF system.
The major recommendations relate to the place of gold in the IMF system and the use of
Special Drawing Rights (SDR).

SDR is an artificial international reserve created by IMF in 1970. The SDR, which is a basket
of currency comprising major individual currencies, was allotted to the members of the IMF.
The members of IMF could use it for transactions among themselves or with the IMF. In
addition to gold and foreign exchange, countries could use the SDR to make international
payments.
The official price of gold was abolished in November 1975f putting an end to the gold era.
The countries were free to purchase or sell for monetary reserve gold at the prevailing market
price. SDR emerged as the international currency. No agreement could, however, be reached
on a new system of exchange rates. The USA advocated floating rates, while France was for
fixed rates and return to par values.

Fixed exchange rates

The rules of Bretton Woods, set forth in the articles of agreement of the International
Monetary Fund (IMF) and the International Bank for Reconstruction and Development
(IBRD), provided for a system of fixed exchange rates. The rules further sought to encourage
an open system by committing members to the convertibility of their respective currencies
into other currencies and to free trade.

What emerged was the “pegged rate” currency regime. Members were required to establish a
parity of their national currencies in terms of the reserve currency (a “peg”) and to maintain
exchange rates within plus or minus 1% of parity (a “band”) by intervening in their foreign
exchange markets (that is, buying or selling foreign money).

In theory, the reserve currency would be the bancor (a World Currency Unit that was never
implemented), proposed by John Maynard Keynes; however, the United States objected and
their request was granted, making the “reserve currency” the U.S. dollar. This meant that
other countries would peg their currencies to the U.S. dollar, and—once convertibility was
restored—would buy and sell U.S. dollars to keep market exchange rates within plus or
minus 1% of parity. Thus, the U.S. dollar took over the role that gold had played under the
gold standard in the international financial system.

Meanwhile, to bolster confidence in the dollar, the U.S. agreed separately to link the dollar to
gold at the rate of $35 per ounce. At this rate, foreign governments and central banks could
exchange dollars for gold. Bretton Woods established a system of payments based on the
dollar, which defined all currencies in relation to the dollar, itself convertible into gold, and
above all, “as good as gold” for trade. U.S. currency was now effectively the world currency,
the standard to which every other currency was pegged. As the world’s key currency, most
international transactions were denominated in U.S. dollars.

The U.S. dollar was the currency with the most purchasing power and it was the only
currency that was backed by gold. Additionally, all European nations that had been involved
in World War II were highly in debt and transferred large amounts of gold into the United
States, a fact that contributed to the supremacy of the United States. Thus, the U.S. dollar was
strongly appreciated in the rest of the world and therefore became the key currency of the
Bretton Woods system.

Member countries could only change their par value by more than 10% with IMF approval,
which was contingent on IMF determination that its balance of payments was in a
“fundamental disequilibrium”. The formal definition of fundamental disequilibrium was
never determined, leading to uncertainty of approvals and attempts to repeatedly devalue by
less than 10% instead. Any country that changed without approval or after being denied
approval was denied access to the IMF.

The Flexible Exchange Rate Regime

A floating (or flexible) exchange rate regime is one in which a country’s exchange rate
fluctuates in a wider range and the country’s monetary authority makes no attempt to fix it
against any base currency. A movement in the exchange is either an appreciation or
depreciation.
Free float (Floating exchange rate)

A floating exchange rate is a regime where the currency price of a nation is set by the forex
market based on supply and demand relative to other currencies. This is in contrast to a fixed
exchange rate, in which the government entirely or predominantly determines the rate.

Under a free float, also known as clean float, a currency’s value is allowed to fluctuate in
response to foreign-exchange market mechanisms without government intervention.

Managed float (or dirty float)

Under a managed float, also known as dirty float, a government may intervene in the market
exchange rate in a variety of ways and degrees, in an attempt to make the exchange rate move
in a direction conducive to the economic development of the country, especially during an
extreme appreciation or depreciation.

A monetary authority may, for example, allow the exchange rate to float freely between an
upper and lower bound, a price “ceiling” and “floor”.