International

Business

Mrs. Rama Mishra

Assistant Professor

Globalization of Economic Activities

It means that national economies rely on international trade in overall economic activity.

World trade expanded faster than world output in the last 50 years by a significant margin due to rapid technological change and continuing liberalization of trade and investment.

Technological innovation led to the increase of productivity, and the advances in transport technology brought people and enterprises closer together so that the boundary of tradable goods and services has been greatly extended.

These activities have led to more and more

International Business (IB)

International Business refers to Business across countries.

It relates to transactions involving more than one countries.

It focuses on global resources, opportunities to buy/sell world wide.

It may defined as the business activity that involves transfers of

• Goods • Services • Resources • Knowledge • Skills • Information

across national boundaries with a view of satisfying the needs of Individuals, Organization and Government.

Nature of International Business

• It involves more than one country. • The size of the international business is large.

• It includes transfer of knowledge, skills, people,

capital and technology etc.

• International markets have more potential than domestic markets.

• It impact over economic, social and political life

throughout the world.

• It involves different modes of business such as Licensing, FDI etc.

Need for International Business

• International business:

– causes the flow of ideas, services, and capital across the world

– offers consumers new choices

– permits the acquisition of a wider of products

– facilitates the mobility of labor, capital, and technology

– provides challenging employment opportunities

– reallocates resources, makes preferential choices, and shifts activities to a global level

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Importance of IB

A) To achieve higher rate of profits:

When the domestic markets do not promise a higher rate of profits, business firms search for foreign markets that holds promise for higher rate of return

E.g.-Apple earned $730million from foreign markets and earned $620 million domestically (US market)

B) To explore opportunities in Untapped virgin Markets

IB provides the chance of exploring & exploiting the potential markets which are untapped so far.

E.g.- The entry of Coca-Cola to China in the late 1970s is used as an example of exploiting a virgin market.

These markets provide opportunity of selling the product at a higher price than in domestic markets

E.g.- Bata sells shoes in the UK at Rs.8000/- which price is around Rs.1200/- in India

C) To dispose Surplus Production & Revenue

Some of the domestic companies expanded their production capacities more than the domestic demand. These company thus dispose there surplus in foreign developed or developing companies.

E.g.- Toyota of Japan sells its produced vehicles (cars) in US, Asian and European markets

D)Limited Home Market

Due to smaller size of market, less population or low PPP companies have to enter in host country market

E.g.- ITC entered in European market due to low PPP of Indians with regard to the high quality cigarettes

E) Political Stability

Political stability doesn’t simply means the continuation of the same party in power, it means the continuation of the same policies of the Govt. for a longer period of time

Business firms prefer to enter the politically stable countries.

F) Availability of technology

It acts as pulling factor for business firms

African, US and European companies in recent years depended on Indian companies for software products & services through BPO & IT services

E.g.- Growing IT companies in India such as Wipro BPO, Tech Mahindra, Mahindra- Satyam, WNS….

G) Availability of Quality Human Resource at lower Cost

Companies of developed countries can have experts

and professionals at a less cost in developing countries.

E.g.- The cost of professionals in India is 10 to 15 times less compared to US & European labor markets.

H) Severe competition in the Home Country

The weak companies which are not able to face cut throat competition in the domestic market started entering in the foreign markets

G) Others……

To earn Forex

To diversify risk

Optimum utilization of cheap & natural resources

From the Government view:

Earning valuable foreign exchange

Diplomatic relations

Core competency of nations

Investment for infrastructure

Foreign trade policy and targets

WTO and international agencies

Scope in International Business

Domestic

International

Multinational

Company

Company

Company

(Phillips, Toyota,

(Export firm)

Nokia, IBM, Tata)

Global Company Transnational

Company

(Harley, Dr Reddy’s

(Procter & Gamble (P&G),

Lab, Ranbaxy)

Coca Cola, Wal Mart)

Cont……

• Domestic Company-It operates within the national

and political boundaries.

• International Company- It focuses on domestic

practices, but extends the wings to foreign countries.

• Multinational Company(MNC)- Adopts different

strategies for different markets (country)

• Global Company- either produce in one country

and market globally or produce globally and market

domestically.

• Transnational Company(TNC)- It produces,

markets, invest and operates across the world.

International Financial management

• International Financial Management is a well known term in today’s world and it is also known as international finance. It means financial management in an international business environment.

• It is different because of different currency of

different countries, dissimilar political situations, imperfect markets, diversified opportunity sets.

• International Financial Management came into

being when the countries of the world started opening their doors for each other.

• This phenomenon is well known with the name of “Globalization”.

Importance of IFM

Economic Interdependence

It means that in today’s world, no nation exists in economic isolation;

All aspects of a nation’s economy-its industry, service sectors, levels of income and employment, living standard are linked to the economics of its trading partners.

This linkage takes the form of international movements of goods and services, labor, business enterprise, investment funds, and technology.

Importance of IFM

International Competition

To withstand competition a corporation must lower its product cost through reducing cost of capital and sourcing inputs where those are cheaper.

Consequence of Increased Openness

Even the company that is not international in nature have to compete with corporations that could arrange capital at cheaper cost and produce goods where cost of production is lower.

How International FM Differ from the Domestic?

Challenges in International Financial Management

Foreign exchange risk

– IFM deals with exchange risk. Appreciation or devaluation of a currency may have an adverse effect on a company’s product pricing, input cost and financial state of affairs.

Political risk

– An unexpected overturn of the government may jeopardize existing negotiated contract. On the other hand expropriation of assets by the host government could ruin company’s investment.

Diverse Economic Environment

– The credit and BoP conditions may be totally different from what they are domestically. Anticipate day-to-day financial management challenges when operating internationally

Banking Regulations

• Unlike financial management in a single country, global financial management must deal with many other banking institutions that have rules and policy of their own.

• Some multilateral development banks, such as the

International Monetary Fund and World Bank, have been set up to regulate international economic affairs in emerging economies and typically give conditions to various countries and their banks.

Market Imperfections

• The world markets are highly imperfect due to legal restrictions on exchange of goods, Services and people.

Recent changes in IFM

• International Financial markets have experienced many changes during the last two decades.

• Technological advances in computers and

telecommunications, along with the globalization of banking and commerce, have led to deregulation, and this has increased competition throughout the world.

• The result is a much more efficient, internationally

linked market, but one that is far more complex than existed a few years ago.

• Emerging market countries had managed their policies

in order to avoid highly indebted positions and financial traps, they are integrated to the global system in a segmented mode.

• Large amounts of capital move quickly around the world in response to changes in interest and exchange rates.

• Financial and currency crises in emergent

market economies are increasingly frequent and intense.

Methods of International Business

Methods of International Business

• Exporting • Licensing & Franchising • Turnkey Contracts • Joint ventures • Mergers & Acquisition • Direct Investment

International Business Methods

There are several methods by which firms can conduct international business.

• International trade is a relatively conservative approach involving exporting and/or importing.

– The internet facilitates international trade by

enabling firms to advertise and manage orders through their websites.

• Licensing allows a firm to provide its technology in exchange for fees or some other benefits.

• Franchising obligates a firm to provide a

specialized sales or service strategy, support assistance, and possibly an initial investment in the franchise in exchange for periodic fees.

• Firms may also penetrate foreign markets by engaging in a joint venture (joint ownership and operation) with firms that reside in those markets.

• Acquisitions of existing operations in foreign

countries allow firms to quickly gain control over foreign operations as well as a share of the foreign market.

• Firms can also penetrate foreign markets by establishing new foreign subsidiaries.

• In general, any method of conducting business

that requires a direct investment in foreign operations is referred to as a foreign direct investment (FDI).

• The optimal international business method may

depend on the characteristics of the MNC.

Licensing

• A licensing agreement specifies the nature of the relationship between the licensor (owner of IP) and the licensee (the user).

• High technology firms routinely license their patents and know-how to foreign companies. Intel has licensed the right to a new process for manufacturing computer chips to a chip manufacturer in Germany.

• Warner licenses images from the Harry Potter books and movies to companies worldwide. Disney licenses the right to use its cartoon characters in the production of shirts and hats to clothing manufacturers in Hong Kong. Disney also licenses its trademark names and logos to manufacturers of apparel, toys, and watches for sale worldwide.

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Franchising

• Franchising is an advanced form of licensing in which the focal firm (the “franchisor”) allows an entrepreneur (the “franchisee”) the right to use an entire business system in exchange for compensation.

• As with licensing, an explicit contract defines the terms of the relationship.

• McDonald’s, Subway, Hertz, and FedEx are well-established international franchisors.

• Franchising is very common in international retailing: Benetton, Body Shop, Yves Rocher, Marks & Spencer, etc.

International Business: Strategy, 40

Management, and the New

Joint Venture

• The term ‘Joint Venture’ applies to those strategic alliances where there is equity participation from both the foreign entrant and the local collaborator. The equity participation can be of different ratios, ranging from a minority stake, equal stake to a controlling stake or a more predominant majority stake.

• As in India, the government has policies which prevent

foreign companies from having full ownership in certain industries. In such cases, foreign companies end up having to enter into joint venture to take advantage of the low cost of manufacturing and the large size of the markets.

Turnkey Contracting

• Turnkey contracting refers to an arrangement where the focal firm or a consortium of firms plan, finance, organize, manage, and implement all phases of a project abroad and then hand it over to a foreign country after training local personnel.

• Contractors are firms in construction, engineering, design, and architectural services. Typically, a major facility (e.g., a nuclear power plant or a subway system) is built, put into operation, and then handed over to the project sponsor, often a national government.

• Involves construction, installation, and training, and may include follow-up contractual services, such as testing and operational support.

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Examples of Turnkey Projects

• Among the most popular turnkey projects are extensions and upgrades to metro systems, such as bridges, roadways, and railways.

• Turnkey projects are also used to construct airports, harbors, refineries, and hospitals.

• One of the world's largest publicly-funded turnkey projects is in Delhi, India. The $2.3 billion project was commissioned by Delhi Metro to build roads and tunnels that run through the city’s central business district. The turnkey consortium includes local firms and Skanska AB, one of the world’s largest construction firms, based in Sweden.

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Meaning of FDI

• Foreign direct investment (FDI) in its classic form is defined as a company from one country making a physical investment into building a factory in another country. It is the establishment of an enterprise by a foreigner.

• It is the movement of capital across national frontiers in

a manner that grants the investor control over the acquired asset

February 16 47

• Its definition can be extended to include investments made to acquire lasting interest in enterprises operating outside of the economy of the investor.

• The FDI relationship consists of a parent enterprise and

a foreign affiliate which together form an international business or a multinational corporation (MNC).

• In order to qualify as FDI the investment must afford

the parent enterprise control over its foreign affiliate.

February 16 48

Merger

• Merger refers to a situation when two or more existing firms combine together and form a new

entity. Either a new company may be incorporated

for this purpose or one existing company (generally a

bigger one) survives and another existing company

(which is smaller) is merged into it. Laws in India use

the term amalgamation for merger. It is done in two

ways – Merger through absorption – Merger through consolidation

Types of Merger

Horizontal Vertical

merger merger

Co Conglo-

generic merate Merger

merger

Horizontal merger

• A merger is horizontal if it involves the joining together of two companies which are producing essentially the same products or services which compete directly with each other

Vertical merger

• It is a merger which takes place upon the combination of two companies which are operating in the same industry but at different stages of production or distribution system.

• If a company takes over its supplier/producers of

raw material, then it may result in backward integration of its activities

• Ex: Merger of Reliance Petro Chemicals Ltd with

Reliance Industries Ltd is a Back ward Integration

Co generic Merger

• In this merger the acquirer and target companies are related through basic technologies, production processes or markets.

• The acquired company represents an extension of

product line, market participants or technologies of the acquiring companies.

• An example of a this merger is Citigroup's acquisition

of Travelers Insurance. While both were in the financial services industry, they had different product lines.

Conglomerate merger

• These mergers involve firms engaged in unrelated type of business activities i.e. the business of two companies are not related to each other neither horizontally nor vertically.

• Ex: The Torrent group has acquired Ahmadabad

Electric Company and Surat Electric Company in order to diversify the risk of its existing line of pharmaceuticals business.

Acquisition

• Acquisition refers to the acquiring of ownership right in the property and asset without any combination of

companies. Thus in acquisition two or more

companies may remain independent, separate legal

entity, but there may be change in control of

companies

Theories of International

Business

Theories of International Business

Why are firms motivated to expand their business internationally?

Theory of Comparative Advantage

– Specialization by countries can increase production efficiency.

Imperfect Markets Theory

– The markets for the various resources used in production are “imperfect.”

Theories of International Business

Theory of Mercantilism

Absolute Cost advantage Theory

Comparative Cost Theory

Product Life Cycle Theory

Absolute Cost Advantage Theory

Adam Smith states that

“1.Certain goods can be produced cheaply in some countries than in other countries.

2. Every country should specialize in producing those goods which it can produce at less cost.

3. It should exchange these goods with other goods which other countries can produce at less cost

- Here both nations would gain from trade”.

Absolute cost advantage Theory

(Continued)

Assumption:

◦ There are no barriers to international trade ◦ Factors of production are not mobile across

countries ◦ No transportation cost is involved in trade between

countries ◦ labour is the only cost of production ◦ lower labour-hours per unit of production means

lower production costs and higher productivity of labour.

For Example:

North has an absolute advantage in the production of cloth.

South has an absolute advantage in the production of grain.

It follows that: If North produces cloth and South produces grain, and an exchange

ratio can be arranged, both the countries will benefit from trade (Export & Import).

Theory of comparative Cost Advantage (Continued)

Assumption:

• labour is the only cost of production • There is a perfect Market • There is full employments in both countries • There is no change in the supply of labour • Technology remains same • There are no transport cost

• No transportation cost is involved in trade

between countries

Theory of comparative advantage (Continued)

• North has an absolute advantage in the production of both cloth and grain but the relative costs differ (i.e. gains from trade).

• In North, one unit of cloth costs 50/100 hours of grain. • In South, one unit of cloth costs 100/100 hours of grain.

It follows that:

• If North can import more than a half unit of grain for one unit of cloth, it will gain from trade.

• If South can import one unit of cloth for less than one unit of grain, it will also gain from trade.

• Under the circumstance presented in the above example, both countries can benefit from trade.

Product Life cycle Theory

• The product life-cycle theory is an economic theory that was developed by Raymond Vernon in response to the failure of the Heckscher-Ohlin model to explain the observed pattern of international trade.

• The theory suggests that early in a product's life-cycle all the

parts and labor associated with that product come from the area in which it was invented. After the product becomes adopted and used in the world markets, production gradually moves away from the point of origin.

Why are firms motivated to expand their business internationally?

Product Cycle Theory

– As a firm matures, it may recognize additional opportunities outside its home country.

Stages in a PLC

• There are five stages in a product's life cycle: • Introduction • Growths • Maturity • Decline

The International Product Life Cycle

Introduction

and Growth

Stages:

MNC Manufactures Product in Developed Countries; Exports to Developing Countries

Sales

Early Late Decline

Maturity: Maturity

MNC Moves Developing Developing Country

Production to Country Markets Remain Viable

Developing Competitor

Target Markets for

Country; Begins Exports Product

MNC; MNC Home

Importing to To MNC Home

Country Market Is

Home Country Country;

Competes Diminishing

with MNC

Imports

Time

The International Product Life Cycle

Firm creates product to accommodate local demand.

a. Firm differentiates

product from competitors and/or expands product line in foreign country.

Firm exports product to accommodate foreign demand.

or

b. Firm’s foreign business declines as

its competitive advantages are eliminated.

Firm

establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs.

International Product Life Cycle, continued

• The Product Introduction Stage

• New products are manufactured, produced and consumed in the developed (inventing) countries

International Product Life Cycle, continued

• The Growth Stage Increasing competition and rapid product adoption

Marketed primarily in developed countries

Product is exported to developing countries

International Product Life Cycle, continued

• The Maturity Stage Product is adopted by most target consumers

Sales are leveling off

Profits decline due to intense competition

Manufacturing operations move to developing countries to take advantage of cheap labor

New competitors: firms from developing countries

International Product Life Cycle, continued

• The Decline Stage

Products are rapidly losing ground to new technologies and product alternatives

Decrease in sales and profits

Product lifecycle is extended through sales to consumers in developing countries

Balance Of Payment

STRUCTURE OF BALANCE OF

PAYMENTS

The Balance of Payments of a country is mainly divided into two types of accounts – (1) Current Account (2) Capital Account. (1) Current Account – The current account of a country’s balance of payments consists of all transactions related to trade in goods, services, income and unilateral transfers . The current account includes following items Merchandise Exports & Imports – Merchandise exports and

imports are the most important items in the current account. In general, it covers a significant portion of total transactions recorded in the BOP of a country. Generally, exports are calculated on free on board (f.o.b.) basis which means that the costs of transportation, insurance, etc. are excluded. Generally, imports are calculated on carriage, insurance and freight (c.i.f.) basis which means that costs of transportation, insurance and freight are included.

(b) Invisible Exports & Imports - Invisible exports & imports also known as service exports & imports are another important component of current account. Important invisible items would include – travel, insurance, transportation, investment income in the form of profits, dividends, etc. and Government not included elsewhere.

(c) Unilateral Transfers – Unilateral transfers or

transfer payments are the third important component of current account. Unilateral transfers include gifts, grants, etc. either received from abroad (credits) or given abroad. (debits). They are one sided transactions, without a quid pro quo that has a measurable value. The unilateral transfers could be official or private.

(2) Capital Account - The capital account of a country consists of its transactions in financial assets in the form of short term and long term lending and borrowing and private and official investments. In other words, the capital account shows international flow of loans and investments, and represents a change in the country’s foreign assets and liabilities. The capital account mainly consists of –

a) Borrowing from & Lending to Foreign Countries –

Borrowing from foreign countries are credit entries because they are receipts from foreign countries. Lending to foreign countries are debit entries because they are payments to foreign countries. This borrowing or lending could be of short term i.e. up to one year or long term i.e. more than one year. Borrowing from & lending to foreign countries could be also called as net sale of assets to foreigners and net purchases of assets from foreigners.

b) Direct Investment & Portfolio Investment –

Direct investment is investment in enterprises located in one country but effectively controlled by residents of another country. As a rule, direct investment takes the form of investment in branches and subsidiaries by parent companies located in another country. Portfolio investment refers to purchases of foreign securities that do not carry any claim on control or ownership of foreign enterprises.

In brief, borrowing from foreign countries and direct & portfolio investment by foreign countries represent capital inflows. On the other hand, lending to foreign countries and direct & portfolio investment in foreign countries represent capital outflows.

(3) Other Components - Apart from the above two main accounts, BOP of a country also includes some other entries like –

(a) Transactions with IMF, (b) SDR allocations, (c) Errors & Omissions and (d) Official settlements / Reserve account

Overall Balance of Payments

• It is the sum of the balance of current account and capital account (including errors & omissions ). In some countries, overall balance is also called as official settlement balance. The overall balance of payments may either balance, or have a surplus, or have a deficit.

• In general it can be said that -

If the overall surplus in the BOP was caused by current account surpluses but not capital account surpluses, then the surplus may be a good sign for the country.

If the overall deficit in the BOP was caused by current account deficit

rather than capital account deficits, then the deficit may be considered as a bad sign for the reporting country. Thus, not only the extent but location of overall surplus or deficit is important.

It is to be noted that different nations use different measures of the overall balance of payments surplus or deficit. Some compare the net increase in their official reserves with the net rise in a wide definition of liquid foreign claims against the country. Others simply measure the change in official reserves alone.

Importance of Balance of Payments

A study of BOP is important because –

• It serves as an indicator of the changing international economic or financial position of a country.

• It helps in formulation of a country’s monetary, fiscal and trade policies.

• It helps in determining the influence of foreign trade & transactions on the level of national income of a country.

• It is useful to banks, firms, financial institutions and individuals which are directly or indirectly involved in international trade and finance.

• It is an economic barometer of nation’s progress vis-à-vis rest of the world.

Agencies that facilitates

International Flow

• The International Monetary Fund (IMF) • The credit union for its member countries. Because it helps member

countries with balance of payment problems, most notably those with significant trade deficits.

• The World Bank Group • provides developing countries with low-cost loans and in some cases,

free grants to assist them with their health care, education, social services and infrastructure needs. There are three key agencies within the World Bank Group discussed as follows:

• Three key agencies of the World Bank Group • The international finance corporation

Multilateral Invest Guarantee Agency International Development Association

• The World Trade Organization • settles international trade disputes between and among

member countries.

Functions of IMF

Review & monitor national & global economic and financial developments

Advice member countries on their economic policies

Lend them hard currencies to support their policies

Provide temporarily assistance to tide over balance of payment deficits.

Offer a wide range of technical assistance and training

Work on Banking supervision for improving regulatory standards

Conduct research and publish reports

WORLD BANK

• President :-

• Established :-

• Membership :-

• Affiliates :-

• Headquarters :-

• Staff :-

Robert B. Zoellick July 1,1944

187 countries (as on

31st Jan 2011)

IFC, IDA, MIGA Washington, DC

about 10000 all over

the world

FUNCTIONS

• To assist in the reconstruction and development of economy of its member countries

• To promote private foreign investment • To promote the long range balanced

growth of international trade • To arrange the loans or guarantees by it

in relation to international loans through other channels

Background

• Along with world bank and IMF, General (GATTAgreementtoWTO)onTariffs and Trade(GATT) was set

up after 2nd World War to undertake the process of post war construction of the global economy in 1947 signed by 23 countries.

• India was one of the founder member of GATT. • The main purpose of GATT was to ensure

competition in commodity trade by removal of trade barriers.

• It was neither an organisation nor a court of justice; it was merely a legal agreement so it could not enforce its decision.

• The Eight round of GATT negotiation (Uruguay Round) gave birth to the World Trade Organization in April 1994.

History

• 1947 GATT is drawn to record the results of trade negotiations between 23 countries. Enters (provisionally) in force on January 1 1948

• 1950 US administration abandons efforts to seek congressional support for the International Trade Organization

• 1949-1956 First four rounds of tariff negotiations • 1962 Derogations to the GATT rules in the areas of cotton

and fibers were negotiated. Later to evolve in to the Multifibre agreements

• 1964-67 Kennedy Round. UNCTAD is created to press for trade measures to favor the developing countries

• 1973-1979 The Tokyo round. Multifibre agreement negotiated in1974 to restrict export growth, and extended several times thereafter

• 1986-1994 Uruguay Round of negotiations. • April 15 1994: The Marrakech protocol signed, establishing

the creation of the World Trade Organization

World Trade Organization (WTO)

• The WTO agreement was signed by 104 member nations of GATT and it came into force

from January 1st 1995. • It is essentially an extension of GATT. • It is a permanent international

institution designed to play the role of Watchdog of International Trade.

• The present membership of WTO is 160 countries (as on June 2014).

Features of WTO

• It is global in its membership with 160 member countries.

• Unlike the GATT, the WTOs approach is rule- based and

time-bound. • The agreements under the WTO are permanent

and binding to the member countries. • The WTO is a huge organisational body with a

large secretariat. • All its members enjoys equal voting rights,

irrespective of type and volume of trade. • It has an automatic dispute settlement system. • It has a wide coverage of not only trade but also service.

Objectives of WTO

• To eliminate discriminatory treatment in international trade relations

• To develop an integrated, viable and durable

multilateral trading system • Raise the standard of living in member countries by

ensuring full employment • To promote sustainable development in member countries

by the optimal use of resource • Help developing countries to get a share in the growth

of international trade • To reduce tariff and other trade barriers among

member countries • To ensure linkages between trade and environmental policies

Functions of the WTO

The major functions of the WTO are as follows:

1. To lay-down a substantive code of conduct aiming at reducing trade barriers including tariffs and eliminating discrimination in international trade relations.

2. To provide the institutional framework for the administration of the substantive code which encompasses a spectrum of norms governing the conduct of member countries in the arena of global trade.

3. To provide an integrated structure of the administration, thus, to facilitate the implementation, administration and fulfillment of the objectives of the WTO Agreement and other Multilateral Trade Agreements.

4. To ensure the implementation of the substantive code. 5. To act as a forum for the negotiation of further trade liberalisation. 6. To cooperate with the IMF and WB and its associates for establishing

a coherence in trade policy-making. 7. To settle the trade-related disputes.

Difference between GATT and WTO

Basis GATT WTO

Year of 1948 1995

creation

Purpose To strengthen international To govern GATT and international

trade trade practices.

Framework No permanent structure or Has a permanent structure with a

framework. permanent framework

Trade in goods; trade in services

Scope Trade in goods only and trade-related aspects of

intellectual property rights.

Dispute Has a permanent appellate Disputes are resolved faster as

body to review findings and settlement system has a select time

resolution

settle disputes. frame

Structure of WTO

A) The Ministerial Conference (MC): It is

the highest level consisting of representative members. It has authority to take decision in any matter for World trade. It meets at least once in every two years

B) The General Council (GC): It discharges

functions of MC during interval between two meetings of MC. The GC meets as and when necessary. It has its own rules and procedure.

C) Dispute Settlement Body (DSB): It is

empowered to establish panels, exercise surveillance for compliance with rules and regulations and authorize measures in case of non-implementation of recommendations

WTO Agreements

1. Agreement on Agriculture (AOA) 2. General Agreement on Trade in

Services(GATS) 3. Agreement on Trade

Related Investment Measures (TRIMs)

4. Agreement on Trade Related Intellectual Properties (TRIPs)

5. Agreement on Trade in Textiles and clothing (Multi Fiber Arrangements-MFA)

Foreign Exchange Market

1. Definition of Foreign Exchange

Markets

Foreign exchange markets are markets on which individuals, firms and banks buy and sell foreign currencies:

– foreign exchange trading occurs with the help of the

telecommunication net between buyers and sellers of foreign exchange that are located all over the world

– a single international foreign exchange market

for every single currency

– foreign exchange trading takes place at least in some of the world financial centers in every moment

(d) The FX market is almost a 24 hour market.

(e) The major foreign exchange trading

centers are in – London, New York, and Tokyo ---60% – Zurich, Singapore, and Hong Kong --- 20%

(f) Foreign exchange market in India is

totally structured, well regulated both by RBI and also by voluntary association (FEDAI)

(g) Only dealers authorized by RBI can undertake foreign exchange transactions.

The Currency Market

Where money denominated in one currency is bought and sold with money denominated in another currency.

International Trade and Capital Transactions:

• facilitated with the ability to transfer purchasing power between countries.

Location

1. OTC-type: no specific location 2. Most trades by phone, telex, or SWIFT

SWIFT: Society for Worldwide Interbank Financial Telecommunications

Functions of a foreign exchange market

• The following are the important functions of a foreign exchange market:

• To transfer finance, purchasing power from one nation to another. Such transfer is affected through foreign bills or remittances made through telegraphic transfer. (Transfer Function).

• To provide credit for international trade. (Credit Function).

• To make provision for hedging facilities, i.e., to facilitate buying and selling spot or forward foreign exchange. (Hedging Function).

Transfer Function The basic function of the foreign exchange market is to facilitate the conversion of one currency into another, i.e., to accomplish transfers of purchasing power between two countries. This transfer of purchasing power is effected through a variety of credit instruments, such as telegraphic transfers, bank draft and foreign bills.

In performing the transfer function, the foreign exchange market carries out payments internationally by clearing debts in both directions simultaneously, analogous to domestic clearings.

2. Credit Function • Another function of the foreign exchange

market is to provide credit, both national and international, to promote foreign trade. Obviously, when foreign bills of exchange are used in international payments, a credit for about 3 months, till their maturity, is required.

Hedging Function A third function of the foreign exchange market is to hedge foreign exchange risks. Hedging means the avoidance of a foreign exchange risk. In a free exchange market when exchange rate, i. e., the price of one currency in terms of another currency, change, there may be a gain or loss to the party concerned.

Under this condition, a person or a firm undertakes a great exchange risk if there are huge amounts of net claims or net liabilities which are to be met in foreign money.

Exchange risk as such should be avoided or reduced. For this the exchange market provides facilities for hedging anticipated or actual claims or liabilities through forward contracts in exchange.

Kinds of Foreign Exchange Markets

• Foreign exchange markets are classified on the basis of whether the foreign exchange transactions are spot or forward accordingly, there are two kinds of foreign exchange markets: Spot Market, Forward Market

(i) Spot Market • Spot market refers to the market in which the receipts

and payments are made immediately. Generally, a time of two business days is permitted to settle the transaction. Spot market is of daily nature and deals only in spot transactions of foreign exchange (not in future transactions). The rate of exchange, which prevails in the spot market, is termed as spot exchange rate or current rate of exchange.

• The term ‘spot transaction’ is a bit misleading. In fact, spot transaction should mean a transaction, which is carried out ‘on the spot’ (i.e., immediately). However, a two day margin is allowed as it takes two days for payments made through cheques to be cleared.

Forward Market Forward market refers to the market in which sale and purchase of foreign currency is settled on a specified future date at a rate agreed upon today. The exchange rate quoted in forward transactions is known as the forward exchange rate. Generally, most of the international transactions are signed on one date and completed on a later date. Forward exchange rate becomes useful for both the parties involved in the transaction. Forward Contract is made for two reasons:

(a) To minimize the risk of loss due to adverse changes in the exchange rate (through hedging);

(b) To make profit (through speculation).

The components of the Indian Foreign Exchange Market

• A. Retail Market

In this segment end-users of foreign currencies (individuals, exporters, importers, travellers and tourists) approach AD’s for their requirements. AD’s provide committed rates for such transactions. These rates are called ‘Merchant Rates’. Total turnover and individual transaction size is very small i.e. transactions are customized in terms of amount and maturity. Transactions here are governed by the Exchange Control Regulations of RBI. Tariffs and commissions are maintained as per FEDAI. Brokers are not allowed.

B. Wholesale Market

1. This market is also called interbank market. It includes transactions between AD’s as also between AD’s and the RBI.

2. Transactions are conducted in standard market lot and volume is large; they are carried at interbank rates. The rates are determined in this market.

3. A large part of transactions are undertaken through approved/authorized brokers.

4. They are governed by guidelines from RBI and FEDIA

Participants in the Foreign Exchange

Market

Participants at 2 Levels

1. Wholesale Level (95%) - major banks 2. Retail Level (business customers)

Two Types of Currency Markets 1. Spot Market:

- Immediate transaction

- recorded by 2nd

business day 2. Forward Market:

- transactions take place at a specified future date

Participants by Market

• Spot Market a. Commercial banks b. Brokers c. customers of commercial and central banks

• Forward Market • arbitrageurs • traders • hedgers • speculators

Size of Foreign Exchange Market

Transactions

• The biggest share of all financial markets in the world

Capital Account Convertibility (CAC)

• The first step in the direction of CAC was taken in 1997 by constituting a committee headed by the Deputy Governor of RBI.

• Its recommendations could not be implements

because of South East Asia crisis, currency failures in Brazil and Russia and air strikes on the US on 11.09.01.

• A second committee was appointed thereafter and

its recommendations are to be implemented by RBI. • Meanwhile RBI has progressively allowed

greater freedom in capital transactions.

• Individual investors are permitted to invest up to US $100,000 in international securities.

• Individuals are allowed to open non-interest

bearing accounts in specified manner. • RBI has allowed Indian corporate entities to

raise resources and invest overseas in larger quantities.

• Branches of Indian banks in SEZ’s are

permitted to accept deposits, grant loans in foreign currencies

Foreign Exchange Market and Insurance

Against Foreign Exchange Risk

– activities with which the foreign exchange market participants avoid exchange rate risk or activities with which they are closing their open foreign exchange position

– closed foreign exchange position:

• size of the assets in a certain currency is equal to the size of the liabilities in the same currency

• full insurance against exchange rate risk

with respect to this currency

Foreign Exchange Market and Insurance

Against Foreign Exchange Risk

– open foreign exchange position:

• long: net assets in a certain currency • short: net liabilities in a certain currency

– in the spot or forward foreign exchange market – standardized forward contracts and options

Foreign Exchange Markets and Conscious

Foreign Exchange Risk Acceptance

• activities in which economic agents consciously open their foreign exchange positions – long or short – hoping to get profits in all foreign exchange market segments

Economic Agents and Types of Activities

on Foreign Exchange Markets

• bank clients (individuals, firms, non-banking financial institutions): – all those groups of legal and physical persons

that need foreign currency in doing their commercial or investment business

• commercial banks:

the most important group of foreign exchange market participants

they buy and sell foreign currencies for their clients and trade for themselves

Economic Agents and Types of Activities

on Foreign Exchange Markets

• brokers:

– agents that connects dealers interested in buying and selling foreign exchange, but does not become an active client in the transaction

– they provide their client, the bank, with the information about the exchange rates at which banks are willing to buy or sell a particular currency

Economic Agents and Types of Activities

on Foreign Exchange Markets

• central banks:

foreign exchange market interventions are meant to influence the exchange rate of the domestic currency in a way that is beneficial for the domestic economy and, consequently, for the country

it does not necessarily have a profit, it can also have a loss

Economic Agents and Motivation for the Foreign Exchange Market Participation

• arbitragers:

– they want to earn a profit without taking any kind of risk (usually commercial banks): • try to profit from simultaneous exchange

rate differences in different markets

• making use of the interest rate differences that exist in national financial markets of two countries along with transactions on spot and forward foreign exchange market at the same time (covered interest parity)

Arbitrage

• Arbitrage is basically buying in one market and simultaneously selling in another, profiting from a temporary difference. This is considered riskless profit for the investor/trader.

• Here is an example of an arbitrage opportunity. Let's

say you are able to buy a toy doll for $15 in Tallahassee, Florida, but in Seattle, Washington, the doll is selling for $25. If you are able to buy the doll in Florida and sell it in the Seattle market, you can profit from the difference without any risk because the higher price of the doll in Seattle is guaranteed.

• If all markets were perfectly efficient, there would never be any arbitrage opportunities - but markets seldom remain perfect.

• It is important to note that even when markets have a discrepancy in pricing between two equal goods, there is not always an arbitrage opportunity.

• Transaction costs can turn a possible arbitrage situation into one that has no benefit to the potential arbitrager.

• Consider the scenario with the toy dolls above. It would cost you a certain amount per doll to get the dolls from Florida to Seattle. If it costs $11 per doll, the arbitrage opportunity has been erased.

Example of Arbitrage

• Anywhere you have a financial asset derived from something else, you have the possibility of pricing discrepancies. This would allow arbitrage. The FX futures market is one such example.

• Suppose we have the following quotes: – GBP/USD spot rate =1.45 – 12-month GBP/USD futures contract trades at 1.44 – 12-month interest on USD is 1.5% – 12-month interest on GBP is 3%

• A financial future is a contract to convert an amount of currency at a time in the future, at an agreed rate.

• Suppose the contract size is 1,000 units. If you buy one GBP/USD contract today, in 12-months time, you will receive £1,000 and give $1,440 in return.

• The arbitrageur thinks the price of the futures contract is too high. If he sells one contract, he will have to deliver GBP 1,000 in 12-months time, and in return will receive USD 1,440.

He does the following calculations:

• To deliver £1,000, the arbitrageur needs to deposit £970.45 now for 12-months @ 3%.

• He can borrow in US dollars the amount, $1407.15 at 1.5% interest. He can convert this to £970.45 at the spot rate. The cost of the deal is $1407.15 + $21.27, 12-months interest @ 1.5% ($1,428.41).

• The above deal would create a synthetic futures contract that would convert £1,000 to $1428.41 in 12-months time. The cost today is USD 1,428.41.

• From this, he knows that the 12-month futures price should really be 1.4284. The market quote is too high. He does the following trade:

• Sell one futures contract @ 1.44.

• Create the synthetic futures deal as above • At the end of 12-months, under the contract he

delivers the £1,000 and receives $1,440. Using the money, he pays back his loan of $1407.15, plus $21.27 interest. He makes a riskless profit of:

• USD 1,440 – USD 1,428.41 = USD 11.59 • Notice that the arbitrageur did not take any

market risk at all. There was no exchange rate risk, and there was no interest rate risk. The deal was independent of both and the trader knew the profit from the outset.

Cross-currency arbitrage

• With triangular arbitrage, the aim is to exploit discrepancies in the cross rates of different currency pairs.

• For example, suppose we have: – Broker A :

EUR/USD = 1.3000 GBP/USD = 1.6000

• This means we should have the cross rate: GBP/EUR = 1.6000 / 1.3000 = 1.2308

• Suppose Broker B quotes GBP/EUR at 1.2288. From the above the arbitrageur does the following trade:

• Buy 1.2288 EUR @ 1.300×1.2288 USD from Broker A Buy 1 GBP @ 1.2288 EUR from Broker B Sell 1 GBP @ 1.6 USD to Broker A His profit is 1.6 USD – 1.3 x 1.2288 USD = .00256 USD

• Of course, in reality the arbitrageur could have increased his deal sizes. If he trades standard lots, his profit would have been 100,000 .00256 or $256.

Process of Arbitrage

Economic Agents and Motivation for the Foreign Exchange Market Participation

• Hedgers and speculators:

hedgers do not want to take risk while participating in the market, they want to insure themselves against the exchange rate changes

speculators think they know what the future exchange rate of a particular currency will be, and they are willing to accept exchange rate risk with the goal of making profit

every foreign exchange market participant can behave either as a hedger or as a speculator in the context of a particular transaction

Types of transactions

1. Spot 2. Forward 3. Swap

1. Spot Foreign Exchange Transactions • almost immediate delivery of

foreign exchange

Outright Forward Transactions

buyer and seller establish the exchange rate at the time of the agreement, payment and delivery are not required until maturity

forward exchange rates:

1, 3, 6, 9 months, one year

Spot transaction

• An agreement on price today, with settlement usually two business days later.

• Settlement = actual delivery of currency for currency • In the case of the US dollar for the Canadian dollar

(or the Mexican peso), settlement is on the next day of the transaction.

\endash Forward Contract

An agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.

Forward transaction

◦ An agreement on price today for settlement at some date (called the “value date”) in the future (one or two weeks, or 1 ~ 12 months).

◦ Example

– Exxon has a scheduled payment of £25 million in 8 months and buys that amount of British pounds forward today. No money will change hands now.

3. Swap Transactions • simultaneous purchase and sale of a given

amount of foreign exchange for two different value dates: – “spot against forward” swaps:

Swap

• A sale (purchase) of a foreign currency with a simultaneous agreement to repurchase (resell) it at some date in the future.

• Usually in the inter-bank market • Example

– Citibank buys DM 2.5 million from Deutsch Bank for $1 million, with a simultaneous agreement to sell the DM back in 6 months for $1.05 million. $50,000 = swap rate.

FX transaction

• 65% of transactions: spot • 33% of transactions : swap

• 2% : (outright) forward

• Spot against forward • Tomorrow next • Forward-forward

Hedging

• The act of reducing exchange rate risk

Forward Rate Quotations

Two Methods:

a) Outright Rate: quoted to

commercial customers.

b) Swap Rate: quoted in the interbank market as a discount or premium.

Futures positions

• Futures are similar to forwards • First, futures positions require a margin deposit to be

posted and maintained daily. • If a loss is taken on the contract, the amount is debited

from the margin account after the close of trading. • In other words, these futures are cash settled and no

underlying instruments or principals are exchanged. • Secondly, all contract specifications such as expiration

time, face amount, and margins are determined by the exchange instead of by the individual trading parties.

Futures

• basic characteristics of futures: – the amount of the currency that is being traded – type of currency quotation – contract expiration – last day of trading with the contract – settlement day – margin requirements

• information about futures trading • futures usage:

– arbitrage between outright forward contract and futures

– rarely used as an insurance instrument (rigidity!)

Differences between Forward contracts and Futures contracts

• The daily cash flows take place on a futures contract. In a forward contract, no money will change hands until the contract expires.

• Because the time pattern of cash flow is different,

your opportunity cost is different.

• similarities and differences between outright forward contract and futures: – both need to be executed unconditionally – they are usually established for at most one year

Characteristic Futures Outright Forward Contract

Size of the contracts standardized for a given currency depends on the individual needs of the

client

Location and trade at the stock exchange or at a given with the provision of agents, connected

activity location; actively traded in an among each other with the help of

organized market

telecommunications; not traded in an

organized market

Duration of the standardized, but at most a year depends on the individual needs of the

contract client , but not more than a year

Contract has to be yes yes

executed

Insurance and insurance explicitly required (margin insurance not required explicitly

Security of doing requirements); high security of doing (implicit insurance are affiliations of

Business with the business with the instrument two partners up till now); lower

Instrument security than futures

Trade regulation regulated with the stock exchange regulation not explicitly determined

rules

Options

• Options are a way of buying or selling a currency at a certain point in the future.

• An option is a contract which specifies the price

at which an amount of currency can be bought at a date in the future called the expiration date.

• Unlike forwards and futures, the owner of an

option does not have to go through with the transaction if he or she does not wish to do so.

Types of options

• The buyer of a call has the right but not the obligation to buy the underlying asset at the strike price on or before a specified date in the future.

• However, the seller has a potential obligation to sell the underlying

asset at the strike price on or before a specified date in the future if the holder of the option exercises his or her right.

• The buyer of a put has the right but not the obligation to sell the

underlying asset at the strike price on or before a specified date in the future.

• On the other hand, the seller of a put has a potential obligation to

buy the underlying asset at the strike price on or before a specified date in the future if the holder of the option exercises his/her right.

Options

• basic characteristics of options:

– financial instrument that gives the buyer the right, but not the obligation, to buy or sell a standardized amount of a foreign currency, that is traded, at a fixed price at a particular time, or until a particular time in the future

– call option and put option – American and European options – three different prices:

exercise/strike price cost, price or value of the option underlying or actual spot exchange rate

Options

• types of options trading: – in organized markets:

• standardized contracts with given strike prices,

standardized durations (1, 3, 6, 9, 12 months) and expirations

• only certain currencies, contract amounts

are standardized – over-the-counter trading:

• expiration date, strike price and contract amount

depend on the individual needs of the client • counterparty risk! • retail and interbank market

Options

• Usage of options:

– when the economic agent expects that the exchange rate trend of a particular currency could change drastically

– when the economic agent does not know

for sure that a certain foreign exchange flow will occur in the future

– advantages: • fixed option costs • options do not need to be executed

6. Quotations of Currencies on Foreign Exchange Markets

• Quotation of a currency tells us at what price is a financial mediator willing to buy or sell a certain currency

• Forex rate : The price of one currency quoted in terms of another currency.

Currency Quotations in Spot Foreign Exchange

Markets

European and American quotation

direct and indirect quotation (which currency is regarded as a domestic/basis currency)

European quotations

There are two types of quotations in the forex market. The American quotations and the European quotations.

The European quotations are quotes given as

“number of units of a currency per us dollar.

Example : JPY125.65/USD

INR48.75/USD

American quotations

The american quotations are quotes given as

“number of us dollars per unit of a currency”.

Example : USD0.8775/EUR, USD1.6542/GBP etc.

Direct quotes : in a country, direct quotes are those that give units of the home currency per unit of a foreign currency. For example : inr48.59/USD is a direct quote in India, USD 0.6385/CHF is a direct quote in.

INDIRECT QUOTES

Stated as number of units of a foreign currency per unit of home currency.

Thus, USD 0.04132/INR is a indirect quote in India and JPY 0.243/USD is an indirect quote in America.

CROSS RATES

Given the exchange rates of two countries, the exchange rate for a third country can also be found out.

USD 0.02339/BHATT , USD 0.02538 / INR.

What will be the INR to BHATT exchange rate ?

Solution for CROSS RATES

(i) COST OF ONE INR = 0.02538 USD (ii) COST OF ONE BHATT = 0.02339 USD

OR 0.02339 USD = 1 BHATT

OR 1 USD = 1 BHATT/0.02339 OR 0.02538 USD = 1 BHATT X 0.02538

0.02339

OR 1 INR = 1.085 BHATT

TELEGRAPHIC TRANSFER BUYING RATE

The banks quote a variety of exchange rates. One of them is the T T buying rate (T T stands for telegraphic transfer).

T T rates are applicable for clean inward or outward remittances where the banks undertake only the job of money transfer and do not have to perform any other function , such as handling documents.

As for example

you purchase from citi bank in New York a DD of 2000 USD, drawn on citi bank-Mumbai.

The New York bank will credit the Mumbai bank’s account immediately.

When you come back to mumbai and present the dd at citi bank – mumbai , the particular branch will pay you as per the tt – buying rate.

The rate at which the New York bank had sold the dd to you is the TT selling rate.

ANOTHER EXAMPLE COULD BE : An exporter assigns the bank the responsibility of collection of an export bill. The bank may pay to the exporter before the collection of the bill. Here also, while making the payment the bank will adopt the t t buying rate. (In this case there will be additional flat fees applicable).

BILL BUYING RATE

Exporters frequently draw bills of exchange on their foreign customers.

Then they sell these bills to an authorised dealer in foreign currency.

The authorised dealer buys the bill and then collects the payment from the importer.

BILL BUYING RATE

Since, there is delay between the ad paying the exporter and itself getting paid, various margins are subtracted from the base rate to compute the bill buying rate.

So, bill buying rate = the base rate minus exchange margin minus forward discount.

EXCHANGE MARGIN

N : The banks have to transmit or transit the cheques or bills it has received, in which, considerable amount of time and some money is spent.

In order to recover this along with profit the bank or ad charges exchange margin.

FORWARD MARGIN

Bills are of two kinds. Sight or demand bills require payment by the drawee on presentation. The delay involved in payment of such bills is the transit period.

Time or usage bills give time to the importer to settle the payment which means that the exporter has given credit to the importer. In such cases the delay is both because of transit and credit period.

In addition to the exchange margin to cover costs and profit the ad loads forward margin for an appropriate period to cover the delay due to credit.

BILL SELLING RATE

When an importer requests the bank to make payment to a foreign supplier, against a bill drawn on an importer, the bank has to handle documents related to the transaction.

For this, the bank loads another margin on the base rate to arrive at the bill selling rate.

Hence bill selling rate = base rate + exchange margin.

Economic and Monetary Union

(EMU)

• An economic and monetary union is a type of trade bloc which is composed of an economic union (common market and customs union) with a monetary union.

• European Economic and Monetary Union - EMU' The successor to the European Monetary System (EMS), the combination of European Union member states into a cohesive economic system, most notably represented with the adoption of the euro as the national currency of participating membersEconomic and Monetary Union (EMU) represents a major step in the integration of EU economies.

• It involves the coordination of economic and fiscal policies, a common monetary policy, and a common currency, the euro.

• Whilst all 28 EU Member States take part in the economic union, some countries have taken integration further and adopted the euro. Together, these countries make up the euro area.

• The decision to form an Economic and Monetary Union was taken by the European Council in the Dutch city of Maastricht in December 1991, and was later enshrined in the Treaty on European Union (the Maastricht Treaty). Economic and Monetary Union takes the EU one step further in its process of economic integration, which started in 1957 when it was founded.

• Economic integration brings the benefits of greater size, internal efficiency and robustness to the EU economy as a whole and to the economies of the individual Member States. This, in turn, offers opportunities for economic stability, higher growth and more employment – outcomes of direct benefit to EU citizens. I

• In practical terms, EMU means: • Coordination of economic policy-making

between Member States • Coordination of fiscal policies, notably

through limits on government debt and deficit • An independent monetary policy run by

the European Central Bank (ECB) • Single rules and supervision of financial

Institutions within the euro area • The single currency and the euro area

Economic governance under EMU

• Within EMU there is no single institution responsible for economic policy. Instead, the responsibility is divided between Member States and the EU institutions. The main actors in EMU are:

• The European Council – sets the main policy orientations • The Council of the EU (the 'Council') – coordinates EU

economic policy-making and decides whether a Member State may adopt the euro

• The 'Eurogroup' – coordinates policies of common interest for the euro-area Member States

• The Member States – set their national budgets within agreed limits for deficit and debt, and determine their own structural policies involving labour, pensions and capital markets

• The European Commission – monitors performance and compliance

• The European Central Bank (ECB) – sets monetary policy, with price stability as the primary objective and act as central supervisor of financial Institutions in the euro area

• The European Parliament - shares the job of formulating legislation with the Council, and subjects economic governance to democratic scrutiny in particular through the new Economic Dialogue

International Monetary System

Historical Review

Over the past 200+ years, the world has gone though major changes its global exchange rate environment.

Starting with the gold standard regime of the latter part of the 19

th century to today’s

somewhat “mixed system” we can identify there 3 distinct periods: – Gold Standard: 1816 - 1914 – Bretton Woods: 1945 - 1973 – Mixed System: 1973 – the present

International Monetary System

(h) The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates

(i) The system for establishing exchange rates has evolved over time. – From 1876 to 1913, each currency was convertible into

gold at a specified rate, as dictated by the gold standard. – This was followed by a period of instability, as World War

I began and the Great Depression followed. – The 1944 Bretton Woods Agreement called for

fixed currency exchange rates. – By 1971, the U.S. dollar appeared to be overvalued. The

Smithsonian Agreement devalued the U.S. dollar and widened the boundaries for exchange rate fluctuations.

Even then, governments still had difficulties maintaining exchange rates within the stated boundaries.

In 1973, the official boundaries for the more

widely traded currencies were eliminated and the

floating exchange rate system came into effect.

Gold Standard

3. The gold standard refers to a system in which countries peg currencies to gold and guarantee their convertibility

– the gold standard dates back to ancient times when gold coins

were a medium of exchange, unit of account, and store of value – payment for imports was made in gold or silver

4. Gold standard = the value of money is fixed relative to gold. 5. For example, suppose

– 1 unit of currency A = 1 ounce of gold – 1 unit of currency B = 2 ounce of gold

Then

EA/B = 2 1 = 2 = price of currency B in terms of currency A.

Gold Standard (cont’d)

• The gold standard leads all countries to the balance of payment equilibrium (i.e. BOP = 0).

• The system hit by shock will restore the equilibrium. • Long-run price stability because money supply

is restricted by gold supply. • the gold par value refers to the amount of a

currency needed to purchase one ounce of gold

Bretton Woods: A Pegged Regime

• In July of 1944, as World War II is coming to an end, all 44 allied countries meet in Bretton Woods, New Hampshire for the purpose of establishing a new international monetary system.

• At Bretton Woods, countries agree that fixed exchange rates were necessary for “restarting” world trade and global investment (both of which had fallen dramatically).

• It is also obvious that the US dollar would become the cornerstone of any new international monetary system.

• Key points of the Bretton Woods were: – Pegging the U.S. dollar to gold at $35 per ounce (with the USD

the only currency convertible into gold). – All other countries peg their currencies to the U.S. dollar.

• Their par values are set in relation to the U.S. dollar – a fixed exchange rate system was established – all currencies were fixed to gold, but only the U.S. dollar

was directly convertible to gold

– devaluations could not to be used for competitive purposes

– a country could not devalue its currency by more than 10% without IMF approval .

Bretton Woods System: 1944 - 1973

• In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system that would facilitate postwar economic growth

• Under the new agreement – a fixed exchange rate system was established – all currencies were fixed to gold, but only the U.S.

dollar was directly convertible to gold – devaluations could not to be used for

competitive purposes – a country could not devalue its currency by more than

10% without IMF approval

Bretton Woods Agreement

• 1. International Monetary Fund (IMF)

Purpose: To lend FX to any member whose supply of FX had become scarce. (To help the countries facing difficulty.

Lending would be conditional on the member’s pursuit of economic policies that IMF would think appropriate (IMF Conditionality).

Bretton Woods Agreement

• 2. The US dollar would be designed as a reserve currency, and other nations would maintain their FX reserves in the form of dollars.

• 3. Each country fixed its ex rate against the

dollar and the value of dollar is defined by the official gold price $35 per ounce (Gold Exchange Standard).

Bretton Woods Agreement

• 4. A Fund member could change its par value only with Fund approval and only if the country’s BOP was in “fundamental disequilibrium”.

• 5. Countries would have to make a payment

(subscription) of gold and currency to the IMF in order to become a member.

Decline and Fall of the Bretton Woods

System

• 1958-65: Private capital outflows from US • 1965-68: Johnson Administration

The bad US macroeconomic policy package caused considerable damage to the US economy and the int’l monetary system.

Decline of and Fall of BW system

• 1971: US CA deficit massive private purchase of

DM Bundesbank intervened in FX market by buying huge amount of dollars, then it gave up and allowed the DM to float.

• August 1, 1971: Nixon’s announcement – Stop to sell gold for dollars to foreign central banks

– 10% tax on all imports until revaluation of each

country’s currency against the dollars – Freeze on prices and wages.

Collapse of Bretton Woods

Devaluation pressures on US dollar after 20 years

– Lyndon Johnson policies

Vietnam war financing Welfare program financing

– Nixon ended gold convertibility of US dollar in 1971

– US dollar was devalued and dealers started

speculating against it for further devaluation – Bretton Woods fixed exchange rates abandoned in

January 1972

Jamaica Agreement 1976

Floating rates declared acceptable

Gold

abandoned as reserve asset;

– IMF returned gold reserves to members at current prices

– Proceeds placed in trust fund to help poor nations

– IMF quotas – member country contributions – increased; membership now 182 countries

– Less-develop, non-oil exporting countries given more access to IMF

IMF continued its role of helping countries cope with macroeconomic and exchange rate problems

Floating Exchange Rates: 1973 -

2. Speculative attacks on the pound and the lira 3. 1972: Britain allowed the pound to float. 4. 1972-73: speculators began selling dollars massively. 5. 1973: US devalued the dollar again ($42.22

per ounce of gold). 6. By March 1973 major currencies were all floating. 7. Managed float: central banks frequently intervene.

Choice of Exchange Rate Regimes

• Fixed or pegged ex rates would work like a gold standard.

• To keep their prices fixed, countries have to buy or

sell their currencies in FX market (FX market Intervention). Fixed exchange rates are government controlled.

• Floating (Flexible) ex rates the ex rates are

determined by the market forces of demand and supply.

• Floating exchange rates are market driven.

A variety of ex rate system

• Managed Floating: MA influences ex rates through active FX market intervention

• (Independently) Floating: the ex rate is market

determined. No FX intervention.

• Currency Board: A legislative commitment to exchange domestic currency for a specified foreign currency at a fixed ex rate.

A variety of ex rate system

• Fixed Peg: The ex rate is fixed against a major currency. Active intervention needed.

• Crawling Peg: The ex rate is adjusted periodically in small amounts at a fixed, preannounced rate.

• Dollarization: The dollar circulates as the legal tender.

• The term pegged exchange rate refers to setting a targeted value for a country’s foreign exchange, and it indicates the govt. has some ability to move the peg.

• Governments attempt to keep the value

fixed for relatively long periods of time to reduce trade uncertainties.

A crawling peg can be changed often (monthly, say) according to a set of indicators or the judgment of the country’s monetary authority. Indicators: – The difference of inflation rates – International reserve assets – Growth of the money supply

– The current actual market exchange rate relative to the central par value of the pegged rate

Choice of Peg or Float

Peg – Small size (GDP) – Open economy – Harmonious inflation rate – Concentrated trade

Float – Large size – Closed economy – Divergent inflation rate – Diversified trade

EXCHANGE RATE

FOREIGN EXCHANGE

• Popularly referred to as "FOREX" • The conversion of one country's currency

into that of another. • It is the minimum number of units of one

countries currency required to purchase one unit of the other countries currency.

WHY IT NEEDED???.....

• Different countries have different currencies with different values….

Example: India - Rupees America -Dollar China - Yuan

• When trade takes place…..

the persons of these countries have to convert their currencies to other countries currencies to make payments

• For this purpose the concept of foreign exchange come into operation.

• Under mechanism of international payments,

the currency of a country is converted in to the currency of another country through FOREIGN EXCHANGE MARKET.

• The effect of globalization and international

trade • Increased import and export

What Type of Exchange Rate

System Is In Practice Today?

• Various exchange rate regimes are followed today – 14% of IMF members follow a free float policy

– 26% of IMF members follow a managed

float system

– 22% of IMF members have no legal tender of their own. Ex. Euro Zone countries

– the remaining countries use less flexible systems

such as pegged arrangements, or adjustable pegs

What Type of Exchange Rate

System Is In Practice Today?

Exchange Rate Policies of IMF Members

Freely Floating Currencies by Country

or Region, IMF data, 2006

Albania

Congo, Dem. Rep. of

Indonesia

Uganda

Australia

Brazil

Canada

Chile

Iceland

Israel

Korea

Mexico

New Zealand

Norway

Philippines

Poland

South Africa

Sweden

Turkey

United Kingdom

Tanzania

Japan

Somalia

Switzerland

United States

Eurozone

Exchange Rate Regimes Today

• Currently, current exchange rate regimes fall along a spectrum as represented by national government involvement in affecting (managing) their currency’s exchange rate.

Very Little (if any) Involvement

Forex Market is Determining Exchange rate

Active

Involvement

Government is Managing or

Pegging Exchange rate

FOREIGN EXCHANGE MARKET

• Also called “FOREX” market. • It is the place were foreign moneys

were bought and sold. • It involves the buying of one currency and

selling of another currency simultaneously. • Exchange rates are determined here…. • Has no geographical boundaries…..

FOREIGN EXCHANGE RATE

• It is the rate at which one currency will be exchanged for another in foreign exchange.

• It is also regarded as the value of one

country’s currency in terms of another currency.

There are three basic types;

Fixed rate

Floating rate

Managed rate

FIXED EXCHANGE RATE

• It is the system of following a fixed rate for converting currencies.

• In this system, the government (or the central

bank acting on its behalf) intervenes in the currency market in order to keep the exchange rate close to a fixed target.

• It does not allow major fluctuations from the

central rate.

Advantages

It provide the stability of exchange rate.

Fixed rates provide greater certainty for exporters and importers.

Disadvantages

Too rigid to take care of major upheavals.

Need large reserves to defend the fixed exchange rate.

May cause destabilizing speculations; most currency crisis took place under a fixed exchange

system.

FLOATING/FLEXIBLE

EXCHANGE RATE

• Under the flexible exchange rate system, the rate of exchange is allowed to vary to suit the economic policies of the government.

• Flexible exchange rates are exchange rates,

which fluctuate according to market forces. • The value of the currency is determined solely

by the forces of demand and supply in the exchange market.(self correcting mechanism)

Advantages

Automatic adjustment for countries with a large balance of payments deficit.

Flexibility in determining interest rates

Allow countries to maintain independent economic policies.

Permit a smooth adjustment to external shocks.

Don't need to maintain large international reserves.

Disadvantages

Flexible exchange rates are highly unstable so that flows of foreign trade and investment may be discouraged.

They are inherently inflationary.

MANAGED EXCHANGE RATE

• Managed exchange rate systems permit the government to place some influence on an exchange rate that would otherwise be freely floating.

• Managed means the exchange rate system

has attributes of both systems. • Through such official interventions it is

possible to manage both fixed and floating exchange rates.

Simple Mechanism of Demand &

Supply

• As stated earlier exchange rate is determined by its the forces of supply and demand.

• Therefore, if for some reason people increase

their demand for a specific currency, then the price will rise provided that the supply remains stable.

• On the contrary, if the supply is increased the

price will decline and it is provided that the demand remains stable.

Purchasing Power Parity Theory (PPP Theory)

• Most widely accepted theory

“According to PPP theory, when exchange rates are of a fluctuating nature, the rate of exchange between two currencies in the long run will be fixed by their respective purchasing powers in their own nations.”

• i.e the price of a good that is charged in one country should be equal to the one charged for the same good in another country, being exchanged at the current rate.

4. This rule is also known as the law of one price. 5. It is an economic theory that estimates the

amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency's purchasing power.

The Balance of Payment Theory

• The balance of payments approach is another method that explains what the factors are that determine the supply and demand curves of a country’s currency.

• As it is known from macroeconomics, the balance of

payments is a method of recording all the international monetary transactions of a country during a specific period of time.

• The transactions recorded are divided into four

categories: the current account transactions, the capital account transactions, financial account and the central bank transaction.

CURRENT ACCOUNT

export and import of goods &services

CAPITAL ACCOUNT

Capital transfers

FINANCIAL TRANSFERS

Foreign direct investment

Portfolio investment

RESERVEBANK TRANSACTIONS

• According to the theory, a deficit in the balance of payments leads to fall or depreciation in the rate of exchange, while a surplus in the balance of payments strengthens the foreign exchange reserves, causing an appreciation in the price of home currency in terms of foreign currency. A deficit balance of payments of a country implies that demand for foreign exchange is exceeding its supply.

• As a result, the price of foreign money in terms of domestic currency must rise, i.e., the exchange rate of domestic currency must fall. On the other hand, a surplus in the balance of payments of the country implies a greater demand for home currency in a foreign country than the available supply. As a result, the price of home currency in terms of foreign money rises, i.e., the rate of exchange improves.

Arguments for Flexible Exchange Rates (cont.)

Depreciation leads

to higher demand

for and output of

domestic products

Reduction in aggregate demand

Fixed exchange

rates mean output

falls as much as

the initial fall in

aggregate demand

Arguments Against

Flexible Exchange Rates

1. Uncoordinated macroeconomic policies. 2. Speculation and volatility in the foreign exchange

market become worse, not better. Money market disturbances could me more disruptive.

3. Reduction of trade and international investment

caused by uncertainty about exchange rates. 4. Discipline: if central banks are tempted to enact

inflationary monetary policies, adherence to a fixed exchange rates may force them not to print so much money.

5. Illusion of greater monetary policy autonomy.

Copyright © 2006 Pearson Addison-Wesley. All rights 19-48 reserved.

Advantage of Flexible rates

• Each country can produce independent macroeconomic policies.

• Countries can choose different inflation rates.

Disadvantage of Flexible rates

• The system is subject to destabilizing speculation – Increase the variability of ex rates – Self-fulfilling prophecy – “evening out” swings in ex rates

Advantage of Fixed rates

• Stable ex rates • Each country’s inflation rate is “anchored” to

the inflation rate in the US. price stability

Disadvantage of Fixed rates

• A country cannot follow macroeconomic policies independent of those of other countries.

• To maintain the fixed rates, countries need

to share a common inflation experience.

Factors affecting foreign

exchange rates

1.Relative Inflation Rates

• when inflation increases there will be less demand for local goods (decreased supply of foreign currency) and more demand for foreign goods (increased demand for foreign currency).

• Changes in relative inflation between two

countries must cause a change in exchange rates • If domestic inflation rate is lower than that in

the foreign country, the domestic currency should be stronger than the foreign currency

Relative Inflation Rates, cont.

• Inflation rate is declining but still on a high levels that has a –ve impact on $/LE

Interest rates • Whenever there is an increase interest rates in

domestic market there will be increase investment funds causing a decrease in demand for foreign currency and an increase in supply of foreign currency.

• Fisher Effect—links inflation and interest rates R1 i

1 r 1

– nominal interest rate in a country is the real interest rate plus inflation

– Real interest rate should be the same in every country, the country with the higher interest rate should have higher inflation

Impact of interest rates, cont.

International Fisher Effect (IFE)— links interest rates and exchange rates, Interest-rate differential is a predictor of future changes in the spot exchange rate

currency of the country with the lower interest rate will strengthen in the future

CBE monthly avg dicount rates

10 10

11 11.5 11.5 11.5

9 9 9 9 9 9

Dec-07 Jan-08 Feb-08 Mar-08 Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08

3. International trade balance • The deficit in the international trade balance

is increasing with –ve impact on $/LE

International trade balances Y08

Jul/Aug Jul/Sep Jul/Oct Jul/Nov

-29,566

-47,543

-66,428

-82,485

LE mio

Foreign currency supply • Excepted decline in foreign currency

supply from: – Suez canal. – Tourism – Money transfer from gulf area.

• This decline will put more pressure on LE

5. Government budget deficit or surplus

The market usually react negatively to widening govt. budget deficits and positively to narrowing budget deficits. This will result in change in the value of countries currency.

6. Political conditions

Internal, regional and international political conditions and events can have a profound effect on currency market

7. Other factors affecting exchange rate movements

• Confidence—safe currencies considered attractive

• Technical factors – release of national statistics – seasonal demands for a currency

– slight strengthening of a currency

following a prolonged weakness