foreign exchange systems

8/14/2019 Foreign Exchange Systems

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FOREIGN EXCHANGE

M.Bashyakar


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Rate of Exchange The rate at which one unit of a countrys

currency is exchanged for a number of units ofthe currency of another is the "exchange rate"between them. Presently one pound sterlingexchanges for Rs. 78 and U.S. dollar for Rs.48.50 This is our rate of exchange with theU.K. and the U.S.A respectively.

Every country has a currency different fromothers. There is no common medium ofexchange. It is this feature that, among others,

distinguishes international from domestictrade.

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Rate of Exchange ( cont)

When the imports and exports of a country areequal, the demand for foreign currency andits supply, or, conversely, the supply of homecurrency and the demand for it will be equal.The exchange rate will be at par.

If the supply of foreign currency is greater thanthe demand, it falls below par and the homecurrency will appreciate.

If on the other hand, the home currency is in

greater supply, there will be higher demandfor the foreign currency.



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Under the Gold Standard

If two currencies are on the gold standard andtheir currencies are expressed in terms of aweight of gold, the rate of exchange isdetermined simply by reference to the goldcontent of the two currencies. Suppose Indiaand the United States are on the goldstandard, the rupee being equal to 1 grain ofgold and the dollar 50 grains of gold, the rateof exchange between these two countries will

be:1 Rupee = 1/50 = 1/50 dollar or

One Dollar = Rs. 50/-



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Thus, the rate of exchange is determined in a directmanner by equating the gold content of the twocurrencies. This rate of exchange is known as the Mint

Par of Exchange; So at the Indian mint, one rupee willbe equal to one grain of gold.

The actual rate in the foreign exchange market will beslightly different from the Mint Par of Exchange to

allow for certain expenses, such as bank commission,shipping and insurance charges of sending gold fromone country to the other. However, the actual rate ofexchange between currencies will not depart muchfrom the mint par and will move between the two

points of export and import of gold.



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These points are also called "Specie Points" or "Gold

Points". These points are worked out by adding orsubtracting the various charges, viz., bankcommission, shipping and insurance charges ofsending gold from one country to the other. Thus,

under gold standard, the rate of exchange is fixedby gold content. Rate may deviate slightly from theratio of gold contents by the amount of bankcommission and the transportation charges, etc.



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Gold ExchangeStandard

Take two countries, one having gold standard,say Britain, and the other silver standard, sayIndia. How will the rate of exchange between the

British pound and Indian rupee be determined? Inorder to clear their dues, the Indian importerswish to buy the British currency, which is goldwith the Indian rupees, which is silver. Hence, therate in Bombay will depend on the price of gold interms of silver. In the same manner, in Londonthe rate of exchange will depend on the price ofsilver in terms of gold.



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u y :Purchasing Power Parity

TheoryNo country today is rich enough to have puregold standard - not even the (U.S.A). Allcountries are on paper currencies. Theexchange situation is difficult in such cases. It

becomes complex when both the countrieshave inconvertible paper currencies or one is ona gold standard and the other on aninconvertible paper standard. In such

circumstances, the ratio of exchange betweenthe two currencies is determined by theirrespective purchasing powers.



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Thus, the rate of exchange, according topurchasing power parity theory, will be 1= Rs.82.At a particular time, the rate ofexchange between the two countries maynot reflect the relative purchasing power of

the two currencies; yet we might say thatsuch forces will be set into motion that theparity between the purchasing powers of

the two currencies will be restored. Thus,between countries on inconvertible paper,the place of the mint par is taken by thepurchasing power parity.



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The difference is that the former is a fixed par

while the latter moves with movement of theprice levels in the two countries concerned.Day-to-day fluctuations around this par willtake place as before due to changes in thesupply of and demand for the currency in

question. The limits of these fluctuations willbe set by the cost of transporting goods fromone country to another. Hence, these limits willnot be definite as were the specie points.



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Criticism

The purchasing power parity theory has been

subjected to the following criticism.1.The actual rates of exchange between the two

countries seldom reflect the relative purchasingpowers of the two currencies. This may be due to

the fact that governments have either controlledprices or controlled exchanges or imposedrestrictions on import and export of goods.

2. The theory is true if we consider the

purchasing power of the respective currencies interms of goods, which enter into internationaltrade, and not the purchasing power of goods ingeneral. But we know that all articles produced ina country do not figure in international trade.



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3.It is very difficult to measure purchasing power ofthe currency. It is usually done with the help ofIndex Numbers. But we know that the IndexNumbers are not infallible. Among the difficultiesconnected with Index Numbers are the followingimportant ones; (i) Different types of goods enter

into the calculation of Index Numbers; (ii) Manygoods which may enter into domestic trade maynot figure in international trade; (iii)Internationally traded goods also may not have

the same prices in all the markets because ofdifferences in transport costs.



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4.The theory of purchasing power applies to astationary world. Actually the world is not static butdynamic. Conditions relating to money and prices,

tariffs, etc., constantly go on changing and preventus from arriving at any stable conclusion about therates of exchange. The internal prices and the costof production are constantly changing. Therefore, anew equilibrium between the two currencies isalmost daily called for. As Cassel observes,"Differences in two countries' economic situation,particularly in regard to transport and customs, maycause the normal exchange rate to deviate to a

certain extent from the quotient of the currencies'intrinsic purchasing powers. If a country puts uptariffs, the exchange value of its currency will risebut its price-level will remain the same.



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5.Besides, many items of balance of paymentslike insurance and banking transactions and

capital movements are very little affected bychanges In general price-levels. But theseitems do influence exchange rates by actingupon the supply of, and the demand for,foreign currencies. The Purchasing Power Parity

Theory ignores these influences altogether.

6.The theory, as propounded by Cassel, says thatchanges in price level bring about changes inexchange rates but changes in exchange ratesdo not cause any change in prices. This latterpart is not true, for exchange movements doexercise some influence on internal prices.



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7. Purchasing power parity theory assumes thatthere is a direct link between the purchasing

power of currencies and the rate of exchange.But in fact there is no direct relationshipbetween the two. Exchange rate can beinfluenced by many other factors, such astariffs, speculation and capital movements.

8. Purchasing power parity theory compares thegeneral price levels in two countries withoutmaking any provision for distinction beingdrawn between the price level of domesticgoods and that of the internationally tradedgoods. The prices of internationally traded

goods will tend to be the same in all countries(transport costs are, of course, omitted).Domestic prices, on the other hand, will bedifferent in the two countries, even betweentwo areas of the same country.


BALANCE OF PAYMENTS


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BALANCE OF PAYMENTSTHEORY

The most satisfactory explanation of th

determination of the rate of exchange is that afree exchange rate tends to be such as toequate the demand and supply of foreignexchange. For example, the external value of

the rupee in Chennai depends on the demandfor and supply of rupees on the foreignexchange market in Chennai. The demand forrupees comes from those who offer foreignexchange in order to obtain rupees, while thesupply of rupees comes from those people whoare offering rupees to obtain foreign exchange.



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The Indian exports to the U.K. constitute thedemand for rupees, for they have a claim on poundsterling which they want to convert into rupees; and

the Indian importers who have to make payments tothe U.K. offer rupees in order to get pound sterling.

The intersection of the sterling supply curve and thesterling demand curve gives the equilibrium price ofsterling that equates the amount of pound sterling

offered and the amount of pound sterling demanded. That is why the modern theory is also called theBalance of Payments Theory of Foreign Exchange.

The demand for foreign exchange arises from thedebit items in the balance of payments, whereas thesupply of foreign exchange arises from credit items.



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As an illustration, if India has a net debit, its demandfor foreign exchange, say pound sterling, must exceedits supply of pound sterling with the result that the

rupee price of pound sterling will go up or, what comesto the same thing, the external value of the rupeesmust go down relative to pound sterling. The rupeebecomes cheaper in terms of . Conversely, a netcredit in Indias balance of payments will lead to a fall

in the rupee price of , which means a higher value ofthe rupee or expensive rupee relative to the .

When the balance of payments is unfavorable, thecountry will have a weak exchange rate position.



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If a country has a surplus on currentaccount, it is said to have a favorable

balance of payments. There are morepeople abroad who have to makepayments to this country. The demandfor this countrys currency will increaseabroad. The result will be that theexternal value of the domestic currencywill appreciate. This is how the balance of

payments affects demand for and supplyof foreign exchange that determines therate or exchange.



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Merits of the Theory The main merit of the theory is that it brings the determination of

exchange rate problem within the purview of the general

equilibrium analysis.

Secondly, the theory stresses the fact that there are many other

forces besides merchandise items (exports and imports of goods)

included in the balance of payments which influence the supply of

and demand for foreign exchange, which in turn determine the rate

of exchange. Thus, the theory is more realistic in that the domestic

price of foreign money is seen as a function of many significant

variables, not just purchasing power expressing general price levels.



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Furthermore, the greatest significance of the

theory is that it shows that disequilibrium inthe balance of payments position can becorrected by marginal adjustments in theexchange rate by devaluation or revaluation

rather than through internal price inflation ordeflation as implied by the mint parity theory.



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Criticisms

1.The fundamental defect of the theory is that itassumes perfect competition, including nointerference with the movement of money fromone country to another. This is very unrealistic.

2. According to the theory, there is no causalconnection between the rate of exchange andthe internal price level. But, In fact, there shouldbe some such connection, as the balance ofpayments position may be influenced by theprice-cost structure of the country.



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3. The theory advocates that the rate of exchange isthe function of the balance of payments. But, inpractice it has also been found that the balance ofpayments position of a country is very muchaffected by the changes in the rate of exchange.

Thus, it is equally true that the balance ofpayments is the function of the rate of exchange.In this sense, the theory is indeterminate as itconfuses as to what determines what

4. According to the theory, the optimum value of acurrency is the gold content embodied in it. This isnot true for a flat paper standard. Thus, thedemand-supply theory fails to explain the basic

value incorporated in currencies.



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5. In fact, the balance of payments theory of

exchange rate is merely a truisma self-evident factwithout any casual explanatory significance. Criticsargue that if payments must necessary balance,there can be no meaning to a decline in theexchange rate during an unfavorable trade balance,

an uncovered balance simply does not exist.



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CAUSES OF FLUCTUATIONS INEXCHANGE RATE

The various theories of exchange rate determinationseek to explain only the equilibrium or normal longperiod exchange rates. Market rates (or day-to-dayrates) of exchange are however subject to fluctuationsin response to the supply of and demand forinternational money transfers. In fact, there are variousfactors which affect or influence the demand for andsupply of foreign currency (or mutual demand for eachothers currencies) which are ultimately responsible for

the short-term fluctuations in the exchange rate.Important among these are:



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1. Trade Movement

Any change in imports or exports willcertainly cause a change in the rate ofexchange. If imports exceed exports, thedemand for foreign currency rises; hencethe rate of exchange moves against thecountry. Conversely, if exports exceedimports, the demand for domesticcurrency rises and the rate of exchangemoves in favour of the country.



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2. Capital Movements

International capital movements from one country toanother may either be for short periods to avail of thehigh rate of interest prevailing abroad or for longperiods for the purpose of making long-terminvestment abroad. Any export or import of capital

from one country to another will bring about a changein the rate of exchange. If a large amount of capital isshifted from England to India the demand for Indianrupees (or the supply of British pounds) in theexchange market increases so that the exchange valueof the rupee in terms of pound increases. That is to say

rupee will appreciate in value in terms of pounds. Thereverse will happen when there is a flight of Indiancapital to England.


3 S k E h


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3. Stock ExchangeOperations

These include granting of loans, payment of interest onforeign loans, repatriation of foreign capital, purchaseand sale of foreign securities etc. which influencedemand for foreign funds and through it, the exchange

rates. For instance, when a loan is given by the homecountry to a foreign nation the demand for foreignmoney increases and the rate of exchange tends tomove unfavourably for the home country. But, whenforeigners repay their loan, the demand for home

currency exceeds its supply and the rate of exchangebecomes favourable.


4 S l ti


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4. SpeculativeTransactions

These include transactions ranging fromanticipation of seasonal movements inexchange rates for the extreme one viz.,

flight of capital. In periods of politicaluncertainty there is heavy speculation inforeign money. There is a scramble for

purchasing certain currencies and somecurrencies are unloaded. Thesespeculative activities bring about wide

fluctuations in exchange rates. 3002/08/10 M.Bashyakar


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5. Banking Operations

Banks are the major dealers in foreign exchange. They sell drafts, transfer funds, issue letters ofcredit, accept foreign bills of exchange, take uparbitrage operations etc. These operationsinfluence the demand for and supply of foreignexchange and hence the exchange rates. Bank ratealso exerts a significant influence on the rate ofexchange. A rise in bank rate attracts foreign fundshence the demand for home currency rises and therate of exchange moves up. The opposite happenswhen the bank rate is lowered.



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6. Monetary Policy

An expansionist monetary policy has generally aninflationary impact, while a contractionist policytends to have a deflationary influence. Inflation anddeflation bring about a change in the internal value

of money. This reflects itself a similar change in theexternal value of money. Inflation means a rise inthe domestic price level, fall in the internalpurchasing power of money, and hence a fall in the

exchange rate. On the other hand, a deflationarypolicy leads to a fall in the domestic prices and risein the exchange rate.



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7. Political Conditions

Political stability of a country can help very much tomaintain a high exchange rate for its currency, forit attracts foreign capital which causes the foreignexchange rate to move in is favour. Political

instability on the other hand causes a panic flightof capital from the country; hence the homecurrency depreciates in the eyes offoreigners andconsequently its exchange value falls. In fact,

political conditions in a country are a potent factorboth in exchange speculation and in theinternational movement of capital.



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However, fluctuations in the rate of exchangein the short period are confined within certainlimits. Under the gold standard system,these limits were set by gold or specie points

as determined by the mint par. Underinconvertible paper standard, however, thepurchasing power parities of the twocountries set such limits. The purchasing

power par, however, unlike the mint par, isnot fixed.


FIXED AND FLEXIBLE


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FIXED AND FLEXIBLEEXCHANGE RATES

Under inconvertible paper currency standard,there can be two types of exchange rates - fixedand flexible. Under the present monetary systemof the International Monetary Fund (IMF), fixed or

stable exchange rates are known as peggedexchange rates or par values.

Under the system of fixed pars, as adopted by the

IMF member nations, the exchange rate isdetermined by the government and enforcedeither by pegging operations, or by resorting tosome form of exchange control and sometimes bya healthy combination of both these methods.


FIXED AND FLEXIBLE


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FIXED AND FLEXIBLEEXCHANGE RATES (cont)

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Under the pegging operation, the government fixes anofficial par of exchange and tries to enforce it throughcentral bank or a kind of exchange stabilization fundwhich enter the foreign exchange market and purchaseits currency when the market rate falls below the

specified level and sell it when the rate rises above aparticular mark. This system of pegged rates ofexchange is government propped up. There is,however, one major defect in this system is that if themarket rate of exchange has a consistent tendency todecline, pegging operations would be very expensive,

as it would lead to a heavy reduction in the exchangereserves of the country concerned.



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CASE FOR FIXED EXCHANGERATES

The following advantages are claimed for thesystem of stable or fixed exchange rates asagainst the flexible exchange rates:

Stable exchange rates ensure certainty andconfidence and thereby promote internationaltrade. Foreigners can easily know how muchthey will have to pay and how much they will

receive in terms of the home currency. Instabilityin exchange rates constitutes an additional riskin international trade, which hampers its growth.



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A system of stable exchange rateswill facilitate long-term internationalinvestments. With an unstableexchange rate, lenders and investors

will not be prepared to lend for long-term investments. Thus, a system ofstable exchange rates is essential forthe orderly growth of internationalinvestment markets.



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A fixed rate of exchange is more suited to a world ofcurrency areas, such as the sterling area.

Fixed exchange rates will remove the dangerous possibilitiesof speculation. In a system of stable exchange rate, there willbe no panic flight of capital from one country to another.

A stable exchange rate will also assist in internationaleconomic stabilization. On the other hand, freely fluctuatingexchange rates encourage abnormally high liquidtypreference, which leads to hoarding, to higher rates ofinterest, to shrinking of investment and to unemployment



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For small countries like Singapore, Hong

Kong, Denmark and Great Britain in whoseeconomy foreign trade plays a crucialrole, stabilization of the exchange rate isthe only right policy. For if the countrydoes not stabilize her exchange ratefluctuations in the rate of exchange, it willdisturb her foreign trade and with it the

prosperity and growth of the country.


d f l ibl


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Advantages of Flexible Rates

(i) The system of flexible exchange rates is a simpleone. The exchange rate moves in a freemarket to equate supply and demand, so that themarket is cleared off and the problem of scarcity or

surplus of any one currency is automaticallysolved. Hence, under the flexible exchange ratesystem, the countries do not have to make extraefforts in inducing changes in prices and incomesin order to maintain or re-establish equlibrium in

the balance of payments.



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(II) Being very sensitive, the system of flexiblerates facilitates continuous adjustments, so that

the adverse effect of prolonged periods ofdisequilibrium is avoided (which is commonlyfound in the present fixed rate system.)

(III) It is the only system, which permits thecontinued existence of free trade andconvertible currencies. This system does not

require the use of exchange controls, which isgenerally associated with the system of peggedrates.



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(iv) The flexible exchange rates system also confersmore Independence on the countries in theirdomestic policies.

(v) Sohmen argues that flexible rates system tends toreinforce the effectiveness of monetary policy. Forexample, when a country seeks to expand output,

it may lower interest rates. But the lowering ofinterest rate, under the flexible exchange ratessystems, will cause an outflow of capital, a rise inthe spot rate, and a rise in exports relative toimports. The trade balance, as such will move

favourable which will reinforce the expansionary effectof lower interest rate on domestic spending, thusmaking the monetary policy more effective.



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(vi) The system of flexible exchange rates eliminatesthe need for official foreign exchange reserves, ifindividual governments do not employ stabilisationfunds to influence the rate. It thus solves the problemof international liquidty automatically.

Prof. Nurkse remarks: "Fluctuating exchange ratescause constant shifts of domestic factors of productionbetween export and home-market industries, shiftswhich may be disturbing and wasteful.



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EXCHANGE CONTROL

Objective of Exchange Control

The chief objective of exchange control by

a country is to restore equilibrium in itspayments. If a country finds that itsbalance of trade has been persistentlyunfavourable, then it must do something

to set it right. The balance of paymentsmust ultimately be made to balance.


M h d f E h


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Methods of ExchangeControl

There are as many as 41 different methods ofexchange control. Broadly speaking, thesemethods may be classified into two types:direct and indirect methods. Direct methodsconsist mainly of intervention, restriction andexchange clearing agreements. Indirectmethods of exchange control consist ofquantitative restrictions on internationaltrade and interest rate changes to influencethe rate of exchange.


Direct Methods


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Direct Methods

(a) Intervention: For an effective control of foreignexchange rates and foreign exchange market, the

government should have a central authority - thecentral bank - which should have complete powerto control and regulate foreign exchange market.Anyone wanting foreign exchange should purchase

it only from the central authority and from no othersource. Likewise, anyone wanting to sell foreignexchange should sell it only to the centralauthority. The buying and selling of foreignexchange by a single authority shall enable the

latter to adjust demand and supply of foreignexchange according to the needs of the country.



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Government Intervention: In the foreign exchangemarket, it takes the form of "pegging-up" or "peggingdown" the currency of the country to a chosen rate ofexchange. The pegging operations take the shape ofbuying and selling of the home currency either by theGovernment or by the central bank of the countryexchange for the foreign currency In the foreignexchange market Intervention of the Government In theforeign exchange market has the effect of influencing

the forces of demand and supply of foreign exchange.Besides in order to carry on intervention, theauthorities must have reserves of both local and foreigncurrencies. If that is not possible, the Government willeither have to resort to the alternative method of directexchange control, via" restriction, or the Governmentwill fail in their purpose of controlling the rate ofexchange.



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(b) Restriction: A more powerful weapon ofexchange control has been devised in

exchange restriction. Exchange restrictionrefers to the policy by which the Governmentrestricts the supply of its currency cominginto the exchange market.

Exchange restriction was first adopted byGermany in 1931, where non-compliance ofcurrency regulation was punishable withdeath. During the Second World War, many

other countries followed the Germanexample.


( ) E h Cl i A


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(c) Exchange Clearing Agreements.Exchange clearing is a method of exchangecontrol, which was practiced during the

Depression of 1930's. Under it, twocountries engaged in trade pay to theirrespective central banks the amountspayable to their respective foreign

creditors.However. the exchange clearingagreements suffer from an importantdefect, that there is a possibility of

economic exploitation of a weakercountry by a powerful country.


I di t M th d f


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Indirect Method ofExchange Control

Restriction of Imports by the use of tariffs leads tothe decline of the demand for foreign currencyand exports are increased, the rate of exchangewill go up in favor of the country imposing importrestrictions. In this sense, import duties and otherquantitative restrictions may have an effect onthe rate of exchange but an import duty, imposedspecifically to protect local industries against

foreign competition cannot be properly called amethod of exchange control since the mainobjective is to restrict imports.



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Exchange Rate in India

As part of economic reforms, partial convertibilityof the rupee on current account was introduced inMarch 1992. under this Liberalised Exchange RateManagement System (LERMS), 60% of all receiptsunder current transactions (merchandise exportsand invisible receipts) could be converted at thefree market exchange rate quoted by authoriseddealers. For he remaining 40% the rate is theofficial rate fixed by the RBI. Full convertibility of

the Rupee on trade account was introduced bythe 1993 -94 budget.



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With regard to Capital Account convertibility(CAC), the Tara pore Committee which submittedits report on 30 May 1997 laid down a 3- yearroadmap (1999 2000). However the movetowards CAC has been tardy. Further, the South

East Asian economic crisis has created a greatdeal of scepticism about CAC

Since the 1980s the RBI has been experimentingwith a managed float, pegging the rupee to dollar

and pound sterling alternatively depending onwhich was going down, to guard against theappreciation of the rupee that would adverselyaffect the countrys exports.


F i E h d


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Foreign Exchange andManagement Act (FEMA)

Effective from Jan. 1, 2000, enacted to facilitate externaltrade and payments and to promote orderly developmentand maintenance of Forex market. It empowers thegovernment to impose restrictions on dealings in foreignexchange and foreign security, payments to and receipts

from any person outside India. It also imposes restrictionson persons residents in India on acquiring, holding orowning foreign exchange security and immovableproperty abroad and on transfer of foreign exchange orsecurity abroad. RBI plays a decisive role in theadministration of FEMA.

foreign exchange systems

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