Module 7

Foreign Exchange Market

Concept
• Foreign exchange is the system or process of converting one national
currency into another, and of transferring money from one country to
another (Paul Einzig)
• Foreign exchange is used to refer to foreign currencies
• But in a broader sense, it includes, foreign currency and drafts,
travellers’ cheques, letters of credit, bills of exchange etc. drawn in a
national currency, but payable in any foreign currency
• FOREX market is where foreign exchange transactions take place
• In other words, a market in which national currencies are bought and
sold against one another
• FOREX is the result of international trading of goods and services
Functions
A foreign exchange market performs three important functions
1. Transfer of purchasing power
• Primary function, by transferring purchasing power from one
country to another
• International clearing function
• FOREX market facilitates international liquidity
• Facilitates international trade and capital movements
2. Provision of credit
• Growth of international trade depends on the extent of credit
facilities
• Credit facility is available to exporters and importers
• Exporters may get pre-shipment and post-shipment credit
3. Provision of hedging facilities
• Provides mechanism for exporters and importers to guard
themselves against losses arising fluctuations in exchange rates
• This facility is provided by agreeing an exchange rate on a future
date
• Forward exchange rate regime is generally followed in this regard
Methods of International Payments
International payments are effected through five methods
1. Telegraphic transfer

2. Mail transfer

3. Cheques and Bank drafts

4. Foreign bills of exchange

5. Documentary (reimbursement) credit

Fixed and Flexible Exchange rate
• Fixed exchange rate a system of exchange rate where the countries
keep their currencies at a fixed or pegged rate.
• The exchange rate is changed only at infrequent intervals when the
economic situation forces them to do so.
• Also called pegged or stable exchange rate
• The exchange rate is officially determined
• This system broke down in early 1970s
Arguments for Fixed Exchange rate system
Necessary for orderly growth of foreign trade, avoiding uncertainties
Prevent continuous depreciation
Attracts foreign investment and prevents capital flight
Eliminates speculation in foreign exchange market
Facilitates international borrowings
a.Under flexible exchange rate system, exchange rates are freely
by the inter-play of demand and supply mechanism
b.This is due to variations in BoPs
c. There is no official intervention in the foreign exchange market
d.Also called floating or unstable exchange rate
e.Flexible exchange rate system is theoretically sound
Arguments against flexible exchange rate system
• Flexible exchange rate system presents a situation of instability,
creating uncertainty and confusion
• The market uncertainties make it impossible for exporters and
importers to certain about prices and thereby will have dampening
effect on foreign trade
• There will be widespread speculation in the foreign exchange market,
and which will have a destabilizing effect
• The system of flexible exchange rate gives an inflationary bias to an
economy, due to persistent depreciation
Determinants of E-R
Two important theories :
• Purchasing power parity theory
• BoP theory OR demand & supply theory
Purchasing Power Parity (PPP) theory
• Propounded by Gustav Cassel (1920)
• States that the E-R between one currency and another is in
equilibrium when their domestic purchasing powers at that rate
of exchange are equivalent.
• To Cassel “the E-R between two currencies must stand
essentially on the quotient of the internal purchasing powers of
these currencies”
• Based on the purchasing powers of respective currencies in their
domestic economies; this is called PPP
• In short, a bundle of goods should cost the same in one country and the
other, once the exchange rate is taken into account
• For eg; a particular bundle of goods in India costs Rs. 48/- and the same
in USA costs $1/-, then the E-R will be in equilibrium if it is $1 = Rs. 48.
• A change in the purchasing power of currencies will be reflected in their
E-Rs
• The index number of prices may be made use of to determine the PPP

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

Pd Where:
ER = Er x ER – equilibrium exchange rate
Pf Er – exchange rate in the reference period
Pd – domestic price index
Pf – foreign country’s price index
Critical evaluation
Merits
• Indicates the relationship between international price levels
• Explains the state of the trade of a country
Demerits
• It suffers from the limitations of price index
• The type of goods and services (commodity basket) in various countries
is not same
• The cost of international transport is ignored
• Ignored the effect of international capital on foreign exchange
• Only long term change is significant
Balance of payments (BoP) Theory (DD & SS, General Equilibrium
Theory)
• Holds that exchange rate of the currency of a country depends upon the demand
for and supply of foreign exchange.
• Thus according to the theory, E-R is determined just like the prices of any
commodity by the free play of the forces of dd & ss in the market
• If the demand for foreign exchange is higher than its supply, the price of foreign
currency will go up (appreciation).
• In case, the demand of foreign exchange is lesser than its supply, the price of
foreign exchange will decline (depreciation)
• The demand for foreign exchange comes from
the debit side of balance of payments.
• The debit items in the BoP are import of goods
and services and loans and investments made
abroad
• The supply of foreign exchange arises from the credit side of the BoP
• It is made up of the exports of goods and services and capital receipts.
• When the BoP is in equilibrium, the ss & dd for currencies are equal
• If the BoP of a country is in deficits (dd for foreign exchange > ss of foreign
exchange), the rate of foreign exchange declines.
• On the other hand, if the BoPs is in surplus (dd for foreign exchange < ss of
foreign exchange), the rate of exchange will go up.
• The domestic currency can purchase more amounts of foreign currencies
Evaluation
• An ideal theory as it gives importance to BoP in determining E-R
• E-R is the price of currencies in the foreign exchange market, hence DD &SS
mechanism is logical in the determination of E-R
• Indicates the possibility of correcting BoP, through adjusting exchange rates
Concept of Balance of Payment (BoP)
A systematic record of all economic transactions of a reporting
country with the rest of the world during a given period of time,
usually one year
BoP includes both visible (physical goods) and invisible (services)
items of trade
Balance of trade (BoT) is the difference between exports and imports
of merchandise items alone
Where as BoP comprises BoT plus exports and imports of services
The items included in the Bop are merchandise items of trade,
investment flow, service of banking insurance, banking, education,
tourism, transportation, communication, consultancy, expenses on
diplomatic arrangements, interest and dividend payments, NRE
deposits, unilateral payments etc.
 Hence, BoP represents a better picture of a country’s
economic and financial transactions with the rest of the world
BoPs are recorded in standard double-entry book-keeping
There are four components of BoPs
Current account
Capital account
Unilateral payment account
Official reserve asset account
Convertibility of Rupee
• Convertibility of a currency implies that a currency can be transferred into
another currency without any limitations or any control.
• Convertibility of currency can be related as the extent to which a country's
regulations allow free flow of money into and outside the country.
• A currency is said to be fully convertible, if it can be converted into some other
currency at the market price of that currency.
• Current account convertibility refers to currency convertibility required in the
case of transactions relating to exchange of goods and services, money transfers
and all those transactions that are classified in the current account.
• Capital account convertibility refers to convertibility required in the transactions
of capital flows that are classified under the capital account of BoP
• Similarly, an exporter had to surrender the foreign exchange to RBI
and get it converted at a rate pre-determined by RBI.
• Till 1990, one had to get permission from the Government or RBI to
procure foreign currency for any purpose.
• In 1991, India began to lift restrictions on its currency.
• A series of reforms were introduced to remove restrictions on current
account transactions including trade, interest payments and
remittances and capital transactions
• After liberalization 1991,as a first concrete step, the government
eased the movement of foreign currency on trade account (current
account)
• Presently, there is almost full convertibility on the
current account and partial convertibility on the
capital account.
• The government liberalized the flow of foreign exchange to include
items like amount of foreign currency that can be procured for
purposes like travel abroad, studying abroad, engaging the services
of foreign consultants etc.
• These relaxations coincided with the liberalization on the industry
and commerce
• There is also simultaneous relaxation on the restriction on the funds
that foreign investors can bring into India to invest in companies
and the stock market in the country (partial convertibility in the
capital account).
• Capital Account convertibility in its entirety would mean that any
individual, be it Indian or foreigner will be allowed to bring in any
amount of foreign currency into the country and take any amount of
foreign currency out of the country without any restriction.
• Indian companies were allowed to raise funds by way of equities
(shares) or debts.
• In 2000, the FOREX policy was further relaxed that allowed
companies to acquire other companies abroad without having to go
through series of getting permission on a case to case basis.
• Further, Indian debt based mutual funds were also allowed to invest in
AAA rated government /corporate bonds abroad.
• With India's FOREX reserves increasing steadily, it has slowly and
steadily removed restrictions on movement of capital on many counts.
Ref:
Cherunilam: International Business, 3rd edn
Cherunilam: Intl trade & Export Management