01 Global financial system

The global financial system (GFS) is a financial system consisting of institutions and
regulations that act on the international level, as opposed to those that act on a national or
regional level. The main players are the global institutions, such as International
Monetary Fund and Bank for International Settlements, national agencies and
government departments, e.g., central banks and finance ministries, and private
institutions acting on the global scale.

1.1 International institutions

The most prominent international institutions are the IMF, the World Bank and the WTO:

• The International Monetary Fund keeps account of international balance of

payments accounts of member states. The IMF acts as a lender of last resort for
members in financial distress, e.g., currency crisis, problems meeting balance of
payment when in deficit and debt default. Membership is based on quotas, or the
amount of money a country provides to the fund relative to the size of its role in
the international trading system.
• The World Bank aims to provide funding, take up credit risk or offer favorable
terms to development projects mostly in developing countries that couldn't be
obtained by the private sector. The other multilateral development banks and
other international financial institutions also play specific regional or functional
roles.
• The World Trade Organization settles trade disputes and negotiates international
trade agreements in its rounds of talks

Government institutions

Governments act in various ways as actors in the GFS: they pass the laws and regulations
for financial markets and set the tax burden for private players, e.g., banks, funds and
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exchanges. They also participate actively through discretionary spending. They are
closely tied to central banks that issue government debt, set interest rates and deposit
requirements, and intervene in the foreign exchange market.

Private participants

Players acting in the stock-, bond-, foreign exchange-, derivatives- and commodities-
markets and investment banking are

 Commercial banks
 Pension funds
 Hedge funds and private equity

02 Managing foreign exchange

02.1. How do central banks manage exchange rates?

Foreign exchange market and management of exchange rate of a country’s currency are
two key areas that influence the economic well-being of the general public. The exchange
rate of a country’s currency is the value of its money for international trade in goods,
services and finance and, therefore, it is part and parcel of the monetary condition of a
country. Therefore, the central banks being the monetary authorities have been given
discretionary powers under the relevant statutes to decide appropriate foreign exchange
policies along with its monetary, financial and economic development policies. In
macroeconomic perspective, foreign exchange policies are instrumental in mobilization
of foreign savings and capital to fill the domestic resource gap and expand investments.
Various public views are often expressed as to how the central banks should decide
exchange rate policies and what factors should be taken into consideration. Therefore,
this article is intended to educate the public on the background how the central banks
manage or regulate exchange rates and foreign exchange markets.

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2.2 Why exchange rates?

An exchange rate is a price of a currency stated in units of another currency, i.e., Rs 108 a
US Dollar (US $), US$ 1.5 a Euro or Chinese Yuan 7 a US$. The exchange rate between
two currencies can be stated in two ways, domestic currency price of foreign currency or
foreign currency price of domestic currency, i.e., Rs. 108 a US$ or US$ 0.01 a Rupee.

Exchange rates exist because countries have to exchange their national currencies with
foreign currencies to engage in trade and financial transactions with other countries. For
example, when a Sri Lankan garment manufacturer exports garments to a buyer in US,
Sri Lankan exporter receives the payment for his export in US$. Therefore, if the Sri
Lankan exporter is to use his US$ income in Sri Lanka, he has to sell his US$ proceeds to
a bank for Sri Lanka Rupees. Similarly, Sri Lankan importers have to buy currencies of
the exporting countries for payments to suppliers in those countries. Accordingly, any
foreign receipts to a country involve supply of foreign currencies (or foreign exchange) in
exchange for domestic currency. On the other hand, any payments to foreign countries
involve purchase (demand for) of foreign currencies by paying in the domestic currency.
In addition, certain authorized parties undertake dealings (buying and selling) in foreign
currencies seeking various kinds of financial gain. Since international transactions are
conducted in major foreign currencies such as US$, Sterling Pounds, Yen and Euro,
market participants and policymakers are concerned about the exchange rates of such
major currencies. In Sri Lanka, the Central Bank

(CBSL) monitors mainly the exchange rate for US$ as the Base Exchange rate in the
foreign exchange market. However, CBSL has designated several foreign currencies for
international transactions by the public through banks.

2.3 What determines the exchange rates?

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Exchange Rates are determined by supply and demand side factors. For example,
increased demand for sterling will cause an appreciation in the Sterling exchange rate.
These are some of the most significant factors in exchange rate determination:

1. Interest Rates.

2. Relative inflation Rates.

3. Balance of Payments.

4. Speculative buying.

5. Public debt

6. Political stability and economic performance

2.4 Why exchange rates are important?

The changes in exchange rates will have both favorable and unfavorable impacts on
economic activities and living standard of the public because of the largely globalised
trade and finance involving exchange of currencies. In general, appreciation of a
country’s currency will have the following effects whereas depreciation will have the
opposite effects.

• Lowering the domestic prices of imports because the cost of imports in domestic
currency will be less due to higher value of the domestic currency, i.e., to pay for
any given foreign price of imports will require less units of domestic currency. As
a result, inflation will be lower depending on the extent of the imports in the
domestic consumption and production activities.
• Country’s outstanding foreign debt equivalent of domestic currency will be lower
and, therefore, burden on foreign debt repayment will less.
• One unfavorable effect will be that the lower import prices will encourage imports
and worsen the country’s trade balance (net position between exports and
imports).
• Another unfavorable effect will be that exporters will be discouraged by reduction
in their income in domestic currency which will adversely affect the export
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 industries. However, if domestic inflation will be lower due to reduced import
prices, there will be higher foreign demand for exports which will off-set the
initial reduction in exporters’ income.

However, there is no any acceptable economic model to determine whether appreciation

or depreciation is better for a country since each will have both favorable and unfavorable
effects in the short run and in the long run, depending on the economic conditions and
priorities prevailing at times. Therefore, the policymakers tend to adopt from time to time
certain policies to permit the currency to depreciate or appreciate depending on the
economic policy priorities. If the country has a foreign reserves problem and needs to
encourage exports while discouraging imports, it is conventional to adopt a policy to
permit the currency depreciation. Such policies include exchange rate determination
system permitted and specific measures introduced from time to time within the
permitted exchange rate system.

2.5 Direct foreign exchange

The foreign exchange market is where currency trading takes place. FX transactions
typically involve one party purchasing a quantity of one currency in exchange for paying
a quantity of another.

Today FX market is one of the largest and most liquid financial markets in the world, and
includes trading between large banks, central banks, currency speculators, corporations,
governments, and other institutions. The average daily volume in the global foreign
exchange and related markets is continuously growing. Traditional daily turnover was
reported to be over US$ 3.2 trillion in April 2007 by the Bank for International
Settlements. Since then, the market has continued to grow.

The purpose of FX market is to facilitate trade and investment. The need for a foreign
exchange market arises because of the presence of multifarious international currencies
such as US Dollar, Pound Sterling, etc, and the need for trading in such currencies. The
foreign exchange market is unique because of its trading volumes,

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The extreme liquidity of the market,

  The large number of, and variety of, traders in the market,
  Its geographical dispersion,
  Its long trading hours: 24 hours a day except on weekends
  The variety of factors that affect exchange rates.
  The low margins of profit compared with other markets of fixed
income  The use of leverage

2.6 Market participants

 Banks

 Commercial companies

 Central banks

 Hedge funds as speculators

 Investment management firms

 Retail foreign exchange brokers

01 retail foreign exchange brokers

02 market makers.

 Other

2.7 Financial instruments

 Spot

A spot transaction is a two-day delivery transaction, as opposed to the futures contracts,

which are usually three months. This trade represents a “direct exchange” between two

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currencies, has the shortest time frame, involves cash rather than a contract; and interest
is not included in the agreed-upon transaction. The data for this study come from the spot
market. Spot transactions have the second largest turnover by volume after Swap
transactions among all FX transactions in the Global FX market.

 Forward

One way to deal with the Foreign exchange risk is to engage in a forward transaction. In
this transaction, money does not actually change hands until some agreed upon future
date. A buyer and seller agree on an exchange rate for any date in the future, and the
transaction occurs on that date, regardless of what the market rates are then. The duration
of the trade can be a few days, months or years.

 Future

Foreign currency futures are exchange traded forward transactions with standard contract
sizes and maturity dates. Futures are standardized and are usually traded on an exchange
created for this purpose. The average contract length is roughly 3 months. Futures
contracts are usually inclusive of any interest amounts.

 Swap

The most common type of forward transaction is the currency swap. In a swap, two
parties exchange currencies for a certain length of time and agree to reverse the
transaction at a later date. These are not standardized contracts and are not traded through
an exchange.

 Option

A foreign exchange option is a derivative where the owner has the right but not the
obligation to exchange money denominated in one currency into another currency at a
pre-agreed exchange rate on a specified date. The FX options market is the deepest,
largest and liquid market for options of any kind in the world.

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2.8 Main currencies used in foreign exchange:

 The U.S. Dollar

The United States dollar is the world's main currency. All currencies are generally quoted
in U.S. dollar terms. Under conditions of international economic and political unrest, the
U.S. dollar has been the main safe-haven currency, which was proven particularly well
during the Southeast Asian crisis of 1997-1998.

 The Euro €

The euro is the official currency of 16 out of 27 member states of the European Union
(EU). The states, known collectively as the Euro zone

The currency is also used in five further countries and territories with formal agreements
and six other countries without such agreements. Hence it is the single currency for over
327 million Europeans.

The euro was introduced to world financial markets as an accounting currency on 1

January 1999, replacing the former European Currency Unit (ECU) at a ratio of 1:1.
Physical coins and banknotes entered circulation on 1 January 2002.

 The Japanese Yen

The Japanese yen is the third most traded currency in the world; it has a much smaller
international presence than the U.S. dollar or the euro. The yen is very liquid around the
world, practically around the clock. The natural demand to trade the yen concentrated
mostly among the Japanese keiretsu, the economic and financial conglomerates.

 The British Pound

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The pound is the currency of the united kingdom .The currency is heavily traded against
the euro and the U.S. dollar, but has a spotty presence against other currencies.

Sterling is currently the third-largest reserve currency, after the US dollar and the euro.[3]
The pound sterling is the fourth-most-traded currency in the foreign exchange market
after the US dollar, the euro, and the Japanese yen.[4]

 The Swiss Franc

The Swiss franc is the only currency of a major European country that belongs neither to
the European Monetary Union nor to the G-7 countries. Although the Swiss economy is
relatively small, the Swiss franc is one of the four major currencies, closely resembling
the strength and quality of the Swiss economy and finance.

Typically, it is believed that the Swiss franc is a stable currency. Actually, from a foreign
exchange point of view, the Swiss franc closely resembles the patterns of the euro, but
lacks its liquidity. As the demand for it exceeds supply, the Swiss franc can be more
volatile than the euro.

03 Bills of Exchange

The most common and yet most complex form of negotiable instrument used for business
transactions is known as the draft, or the bill of exchange. A bill of exchange can be used
for payment, credit, or security in a financial transaction. The term comes from the
English and is defined as an unconditional order in writing that is addressed by one
person to another and signed by the person giving it. In a bill of exchange transaction, a
person, or the drawer, agrees to pay to another, also known as the drawer , a sum of
money at a given date, usually three months ahead. In principle, the bill of exchange
operates much a like a postdated check in that it can be endorsed for payment to the
bearer or any other person named other than the drawer.

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If the person accepts the bill of exchange by signing his name, or his name with the word
"accepted," across the face of the paper, he is called an acceptor. The person to whom a
bill is transferred by the acceptor's endorsement is called the endorsee. Any person in
possession of a bill, whether as payee, endorsee, or bearer, is termed a holder. The basic
rule applying to bills of exchange is that any signature appearing on a bill obligates the
signer to pay the specified amount drawn on the bill.

The bill of exchange then must be accepted or "endorsed" by an accepting house, an

institution that deals exclusively with bills of exchange, such as a bank, or a trader. Once
the bill is accepted, the drawee does not have to wait for the bill to mature before
receiving his funds. If he so chooses, the drawee can also sell the bill on the money
market for a small discount.

A bill of exchange can also be passed beyond the drawer, drawee, and creditor. For the
purposes of payment or borrowing, the creditor may transfer the bill of exchange to a
fourth party, who in turn may pass it on and on through endorsement or signature of the
transferor. Endorsement transfers the rights of the endorser to the new holder and also
creates a liability of the endorser for payment of the amount of the draft if the drawee
does not meet payment when the draft is due. A failure to pay a draft must be more or
less formally recognized, and the draft holder may claim payment from any endorser
whose signature appears on the instrument.

3.1 Characteristics of Bills of exchange

 incorporation,
 literality,
 abstraction,
 Autonomy.

Incorporation
Incorporation means that the obligation is incorporated in the instrument. In other words,
who owns the document owns the right, meaning that it is enough to be the legitimate
holder upon a continuous series of endorsements to have the right to claim and receive
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payment. This is so important because the good faith holder of the bill prevails over a
previous holder that unfairly lost its possession
Literality
Literality means that the existence and content of the obligation is defined by the
document. This is another dimension of incorporation of the credit in the bill. But it goes
further to justify the protection of the good faith holder in terms that several defects of
will cannot be opposed to him, thus making circulation easier.

Abstraction
Abstraction means that the causal or underlying business is separated from the bill of
exchange. In fact, the defects of the causal or underlying transaction cannot be opposed to
subsequent good faith holders of the bill. However, in case they are in bad faith those
defenses can be opposed to them.

Autonomy
Autonomy means that exceptions of the causal transaction cannot be opposed to
subsequent holders in good faith (appraised at the moment of acquisition of the bill, and
that the legitimate holder of the bill has an autonomous right, and therefore a previous
holder that unfairly lost its possession cannot oppose to the legitimate holder the
illegitimacy of the prior holder of the bill who has transmitted the bill to him. In this
context, gross negligence means bad faith, for example, in case the holder gets the bill
from someone well known to be a thief or an indigent person.

04 Forfeiting

Forfeiting and factoring are services in international market given to an exporter or seller.
Its main objective is to provide smooth cash flow to the sellers. The basic difference
between the forfeiting and factoring is that forfeiting is a long term receivables (over 90
days up to 5 years) while factoring is short termed receivables (within 90 days) and is
more related to receivables against commodity sales.

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Definition of Forfeiting

The terms forfeiting is originated from a old French word ‘forfeit’, which means to
surrender ones right on something to someone else. In international trade, forfeiting may
be defined as the purchasing of an exporter’s receivables at a discount price by paying
cash. By buying these receivables, the forfeiter frees the exporter from credit and the risk
of not receiving the payment from the importer.

4.1 How forfeiting Works in International Trade

The exporter and importer negotiate according to the proposed export sales contract.
Then the exporter approaches the forfeiter to ascertain the terms of forfeiting. After
collecting the details about the importer, and other necessary documents, forfeiter
estimates risk involved in it and then quotes the discount rate.
The exporter then quotes a contract price to the overseas buyer by loading the discount
rate and commitment fee on the sales price of the goods to be exported and sign a
contract with the forfeiter. Export takes place against documents guaranteed by the
importer’s bank and discounts the bill with the forfeiter and presents the same to the
importer for payment on due date.

4.2 Documentary Requirements

In case of Indian exporters availing forfeiting facility, the forfeiting transaction is to be

reflected in the following documents associated with an export transaction in the manner
suggested below:

• Invoice: Forfeiting discount, commitment fees, etc. needs not be shown separately
instead, these could be built into the FOB price, stated on the invoice.

• Shipping Bill and GR form: Details of the forfeiting costs are to be included along
with the other details, such FOB price, commission insurance, normally included
in the "Analysis of Export Value "on the shipping bill. The claim for duty
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 drawback, if any is to be certified only with reference to the FOB value of the
exports stated on the shipping bill.

The forfeiting typically involves the following cost element

1. Commitment fee, payable by the exporter to the forfeiter ‘for latter’s’

commitment to execute a specific forfeiting transaction at a firm discount rate
within a specified time.

2. Discount fee, interest payable by the exporter for the entire period of credit
involved and deducted by the forfeiter from the amount paid to the exporter
against the avulsed promissory notes or bills of exchange.

4.3 Benefits to Exporter

 100 per cent financing: Without recourse and not occupying exporter's credit line
That is to say once the exporter obtains the financed fund, he will be exempted
from the responsibility to repay the debt.

 Improved cash flow: Receivables become current cash inflow and it is beneficial
to the exporters to improve financial status and liquidation ability so as to
heighten further the funds raising capability.

 Reduced administration cost: By using forfeiting, the exporter will spare from the
management of the receivables. The relative costs, as a result, are reduced greatly.

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  Advance tax refund: Through forfeiting the exporter can make the verification of
export and get tax refund in advance just after financing.
 Risk reduction: forfeiting business enables the exporter to transfer vary risk
resulted from deferred payments, such as interest rate risk, currency risk, credit
risk, and political risk to the forfeiting bank.

 Increased trade opportunity: With forfeiting, the export is able to grant credit to
his buyers freely, and thus, be more competitive in the market.

4.4 Problem areas in forfeiting

 There is, presently, no legal framework to protect the banker or forfeiter except
the existing covers for the risks involved in any foreign transactions.

 Data available on credit rating agencies or importer or foreign country is not

sufficient. Even exam bank does not cover high-risk countries like Nigeria.

 High country and political risks dissuade the services of factoring and banking to
many clients.

 Government agencies and public sector undertakings (PSUs) neither promptly

make payments nor pay interest on delayed payments.. The assignment of book
debts attracts heavy stamp duty and this has to be waived.

 Legislation is required to make assignment under factoring have priority over

other assignments.

 There should be some provisions in law to exempt factoring organization from

the provisions of money lending legislations.

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  The order 37 of Civil procedure code should be amended to clarify that factor
debts can be recovered by resorting to

05 Letters of Credit

Letters of credit accomplish their purpose by substituting the credit of the bank for that of
the customer, for the purpose of facilitating trade. There are basically two types:
commercial and standby. The commercial letter of credit is the primary payment
mechanism for a transaction, whereas the standby letter of credit is a secondary payment
mechanism.

Commercial Letter of Credit

Commercial letters of credit have been used for centuries to facilitate payment in
international trade. Their use will continue to increase as the global economy evolves.

Letters of credit used in international transactions are governed by the International

Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The
general provisions and definitions of the International Chamber of Commerce are binding
on all parties. Domestic collections in the United States are governed by the Uniform
Commercial Code.

A commercial letter of credit is a contractual agreement between banks, known as the

issuing bank, on behalf of one of its customers, authorizing another bank, known as the
advising or confirming bank, to make payment to the beneficiary. The issuing bank, on
the request of its customer, opens the letter of credit. The issuing bank makes a
commitment to honor drawings made under the credit. The beneficiary is normally the
provider of goods and/or services. Essentially, the issuing bank replaces the bank's
customer as the payee.

5.1 Elements of a Letter of Credit

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 • A payment undertaking given by a bank (issuing bank)
• On behalf of a buyer (applicant)
• To pay a seller (beneficiary) for a given amount of money
• On presentation of specified documents representing the supply of goods
• Within specified time limits
• Documents must conform to terms and conditions set out in the letter of credit
• Documents to be presented at a specified place

Beneficiary
The beneficiary is entitled to payment as long as he can provide the documentary
evidence required by the letter of credit. The letter of credit is a distinct and separate
transaction from the contract on which it is based. All parties deal in documents and not
in goods.

Issuing Bank
The issuing bank's liability to pay and to be reimbursed from its customer becomes
absolute upon the completion of the terms and conditions of the letter of credit.

The issuing banks' role is to provide a guarantee to the seller that if compliant documents
are presented, the bank will pay the seller the amount due and to examine the documents,
and only pay if these documents comply with the terms and conditions set out in the letter
of credit.

Advising Bank
An advising bank, usually a foreign correspondent bank of the issuing bank will advise
the beneficiary. Generally, the beneficiary would want to use a local bank to insure that
the letter of credit is valid. In addition, the advising bank would be responsible for
sending the documents to the issuing bank. The advising bank has no other obligation
under the letter of credit. If the issuing bank does not pay the beneficiary, the advising
bank is not obligated to pay.

Confirming Bank
The correspondent bank may confirm the letter of credit for the beneficiary. At the
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request of the issuing bank, the correspondent obligates itself to insure payment under the
letter of credit. The confirming bank would not confirm the credit until it evaluated the
country and bank where the letter of credit originates. The confirming bank is usually the
advising bank.

06 Factoring

In finance factoring, a business will sell off its accounts receivable, which are the
invoices that the company has coming in, at a discounted rate. By doing this, the
organization or business is able to obtain cash, or capital, that is readily available to them
rather than waiting for the accounts receivable to actually come in to them. In many
situations, this helps to keep the organization afloat and helps them to pay debts they may
have.

There are several differences between finance factoring and a business loan that may be
obtained from a bank, for example. First, when considering this type of finance, the value
of the receivables is the ultimate important number. This is in contrast to the credit
worthiness of the business, which is what would happen in a business loan. Secondly,
another area the two differ is that the factoring does not offer a loan to the business.
Rather, it is more of a purchase of an asset that the business has.

There is a third way in which finance factoring is different from a business loan. That is
the structure of it. Whereas with a business loan involves just two parties, the bank and
the borrower, the factoring system involves three parties. This includes the receivable
clients, the business owner and the company that purchases the receivables

In finance factoring, the business will sell their receivables to a third party who pays the
business a fraction of what those receivables are worth. The customers of the business
then pay the receivables to the third party at full price. In this transaction, any defaulting
on the behalf of the receivables is not dealt with by the business any longer.

There are many situations in which finance factoring becomes an important part of the
business and therefore is used often.
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6.1 How factoring can benefit your business

• Factoring is competitively priced compared to overdrafts and business loans

• You have more working capital to put back into your business
• The facility grows with your business so there is no need to keep increasing your
overdraft or take out additional loans
• You’ll know when you’ll be paid, which helps you manage your cash flow
• You can react more quickly to market opportunities
• The Factor can manage your sales ledger and protect you from bad debts

6.2 What are the main features of Factoring?

• Up to 90% of the value of your invoices can be advanced by the next working day
• Flexible finance – Factor some or all of your sales ledger
• The Factoring company can take over management of your sales ledger
• The facility is easy to set up through Simply Business

07 International financial markets

In economics, typically, the term market means the aggregate of possible buyers and
sellers of a thing and the transactions between them.

The term "market" is sometimes used for what are more strictly exchanges, organizations
that facilitate the trade in financial securities, e.g., a stock exchange or commodity
exchange. This may be a physical location or an electronic system. Much trading of
stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an
exchange, while any two companies or people, for whatever reason, may agree to sell
stock from the one to the other without using an exchange.

Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade
on a stock exchange, and people are building electronic systems for these as well, similar
to stock exchanges.

Financial markets can be domestic or they can be international.

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7.1 Types of financial markets

The financial markets can be divided into different subtypes:

• Capital markets which consist of:

o Stock markets, which provide financing through the issuance of shares or

common stock, and enable the subsequent trading thereof.

o Bond markets, which provide financing through the issuance of bonds, and
enable the subsequent trading thereof.

• Commodity markets, which facilitate the trading of commodities.

• Money markets, which provide short term debt financing and investment.

• Derivatives markets, which provide instruments for the management of financial

risk.

o Futures markets, which provide standardized forward contracts for trading

products at some future date; see also forward market.

• Insurance markets, which facilitate the redistribution of various risks.

• Foreign exchange markets, which facilitate the trading of foreign exchange.

The capital markets consist of primary markets and secondary markets. Newly formed
(issued) securities are bought or sold in primary markets. Secondary markets allow
investors to sell securities that they hold or buy existing securities.

7.2 What is their purpose?

Without financial markets, borrowers would have difficulty finding lenders themselves.
Intermediaries such as banks help in this process. Banks take deposits from those who
have money to save. They can then lend money from this pool of deposited money to
those who seek to borrow. Banks popularly lend money in the form of loans and
mortgages.

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More complex transactions than a simple bank deposit require markets where lenders and
their agents can meet borrowers and their agents, and where existing borrowing or
lending commitments can be sold on to other parties. A good example of a financial
market is a stock exchange. A company can raise money by selling shares to investors
and its existing shares can be bought or sold.

7.3 Financial market participants

There are four main participants

1. The Central Bank

The Central Bank is the federal government's bank and has the following roles in the
financial market:
a) is the lender of last resort?
b) Oversees and conducts monetary policy.
c) Preserves the value of the dollar.

2. Deposit Intermediaries

Deposit intermediaries include the following institutions:

a) Banks
b) Credit Unions
c) Mortgage and loan companies.
d) Mortgage and loan agencies.

3. Contractual savings intermediaries

Contractual savings intermediaries are in the form of the following:

a) Life insurance companies.
b) Pension funds.
c) Property and casualty insurance companies
d) Government pension plans.

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4. Investment intermediaries

Investment intermediaries include:

a) Mutual funds companies,
b) Investment dealers.
c) Consumer loan companies.
d) Business finance companies.

08 What is Foreign Direct Investment (FDI)

According to the IMF and OECD definitions, direct investment reflects the aim of
obtaining a lasting interest by a resident entity of one economy (direct investor) in an
enterprise that is resident in another economy (the direct investment enterprise). The
“lasting interest” implies the existence of a long-term relationship between the direct
investor and the direct investment enterprise and a significant degree of influence on the
management of the latter.

Direct investment involves both the initial transaction establishing the relationship
between the investor and the enterprise and all subsequent capital transactions between
them and among affiliated enterprises, both incorporated and unincorporated. It should be
noted that capital transactions which do not give rise to any settlement.

The fifth Edition of the IMF’s Balance of Payment Manual defines the owner of 10% or
more of a company’s capital as a direct investor. But the IMF recommends using this
percentage as the basic dividing line between direct investment and portfolio investment
in the form of shareholdings. Thus, when a non-resident who previously had no equity in
a resident enterprise purchases 10% or more of the shares of that enterprise from a
resident, the price of equity holdings acquired should be recorded as direct investment.
From this moment, any further capital transactions between these two companies should
be recorded as a direct investment. When a non-resident holds less than 10% of the shares
of an enterprise as portfolio investment, and subsequently acquires additional shares

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resulting in a direct investment (10% of more), only the purchase of additional shares is
recorded as direct investment in the Balance of Payments.

8.1 The case for free capital flows

Economists tend to favor the free flow of capital across national borders because it allows
capital to seek out the highest rate of return. Unrestricted capital flows may also offer
several other advantages, as noted by Feldstein (2000). First, international flows of
capital reduce the risk faced by owners of capital by allowing them to diversify their
lending and investment. Second, the global integration of capital markets can contribute
to the spread of best practices in corporate governance, accounting rules, and legal
traditions. Third, the global mobility of capital limits the ability of governments to pursue
bad policies.

In addition to these advantages, which in principle apply to all kinds of private capital
inflows?

• FDI allows the transfer of technology—particularly in the form of new varieties

of capital inputs—that cannot be achieved through financial investments or trade
in goods and services. FDI can also promote competition in the domestic input
market.

• Recipients of FDI often gain employee training in the course of operating the new
businesses, which contributes to human capital development in the host country.

• Profits generated by FDI contribute to corporate tax revenues in the host country.

Of course, countries often choose to forgo some of this revenue when they cut corporate
tax rates in an attempt to attract FDI from other locations. For instance, the sharp decline
in corporate tax revenues in some of the member countries of the Organization for
Economic Cooperation and Development (OECD) may be the result of such competition.

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Conclusion

The global financial system (GFS) is a financial system consisting of institutions and
regulations that act on the international level, as opposed to those that act on a national or
regional level.

Foreign exchange market and management of exchange rate of a country’s currency are
two key areas that influence the economic well-being of the general public. The exchange
rate of a country’s currency is the value of its money for international trade in goods,
services and finance and, therefore, it is part and parcel of the monetary condition of a
country. Central banks, private banks, hedge funds, Investment management firms, Retail
foreign exchange brokers are participate for foreign management. Dollars, Euro, Swiss
frank, yen, pounds are the main currencies exchange in foreign exchange market.

The most common and yet most complex form of negotiable instrument used for business
transactions is known as the draft, or the bill of exchange. A bill of exchange can be used
for payment, credit, or security in a financial transaction.

Forfeiting and factoring are services in international market given to an exporter or seller.
Its main objective is to provide smooth cash flow to the sellers.

Letters of credit accomplish their purpose by substituting the credit of the bank for that of
the customer, for the purpose of facilitating trade.

International financial market is the world largest market in the world. It include bond
market, stock market, capital market, derivatives markets, futures markets, insurance
markets and foreign exchange market.

According to the IMF and OECD definitions, direct investment reflects the aim of
obtaining a lasting interest by a resident entity of one economy (direct investor) in an
enterprise that is resident in another economy (the direct investment enterprise). The
“lasting interest” implies the existence of a long-term relationship between the direct
investor and the direct investment enterprise and a significant degree of influence on the
management of the latter.

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References

• Sunderam A.K, Black J.S, 1997, The International Business Environment, Pretice
hall of india, New Delhi.

• Keeth Monk, Go international, Mc grae hill

• Thakur D, Mishra SK, 1989, International Business, Deep and Deep publications,
New Delhi, India.

Website

• http://www.google.lk/search?
hl=en&safe=strict&q=strategies+for+foreign+direct+investment&btnG=Search&
meta=

• http://en.wikipedia.org/wiki/Global_financial_system

• http://www.cbsl.gov.lk/pics_n_docs/11_education/_docs/Articles_How_Centralba
nks%20manage%20exchange%20rates.pdf

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