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Module-1:Environment of International Financial Management: Introduction-

Multinational Enterprise and MNC financial management- Foreign
Exchange Market- Determination of Exchange Rates – International
Monetary System- Balance of Payments and International Economic
Linkages- Parity Conditions.

 Environment International Financial Environment

International financial environment is totally different from domestic financial environment. International
financial management is subject to several external forces, like foreign exchange market, currency convertibility,
international monitory system, balance of payments, and international financial markets.

1. Foreign Exchange Market

Foreign exchange market is the market in which money denominated in one currency is bought and sold with
money denominated in another currency. It is an overthe counter market, because there is no single physical or
electronic market place or an organized exchange with a central trade clearing mechanism where traders meet
and exchange currencies. It spans the globe, with prices moving and currencies trading somewhere every hour of
every business day. World’s major trading starts each morning in Sydney and Tokyo, and ends up in the San
Francisco and Los-Angeles.

The foreign exchange market consists of two tiers: the inter bank market or wholesale market, and retail market
or client market. The participants in the wholesale market are commercial banks, investment banks, corporations
and central banks, and brokers who trade on their own account. On the other hand, the retail market comprises of
travelers, and tourists who exchange one currency for another in the form of currency notes or traveler cheques.

2. Currency Convertibility
Foreign exchange market assumes that currencies of various countries are freely convertible into other
currencies. But this assumption is not true, because many countries restrict the residents and non-residents to
convert the local currency into foreign currency, which makes international business more difficult. Many
international business firms use “counter trade” practices to overcome the problem that arises due to currency
convertibility restrictions.

3. International Monetary System

Any country needs to have its own monetary system and an authority to maintain order in the system, and
facilitate trade and investment. India has its own monetary policy, and the Reserve Bank of India (RBI)
administers it. The same is the case with world, its needs a monetary system to promote trade and investment
across the countries. International monetary system exists since 1944. The International Monetary Fund (IMF)
and the World Bank have been maintaining order in the international monetary system and general economic
development respectively.

4. International Financial Markets

International financial market born in mid-fifties and gradually grown in size and scope. International financial
markets comprises of international banks, Eurocurrency market, Eurobond market, and international stock
market. International banks play a crucial role in financing international business by acting as both commercial
banks and investment banks. Most international banking is undertaken through reciprocal correspondent
relationships between banks located in different countries. But now a days large bank have internationalized their
operations they have their own overseas operations so as to improve their ability to compete internationally.
Eurocurrency market originally called as Eurodollar market, which helps to deposit surplus cash efficiently and
conveniently, and it helps to raise short-term bank loans to finance corporate working capital needs, including
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imports and exports. Eurobond market helps to MNCs to raise long-term debt by issuing bonds. International
bonds are typically classified as either foreign bonds or eurobonds. A foreign bond is issued by a borrower
foreign to the country where the bond is placed. On the other hand Eurobonds are sold in countries other than the
country represented by the currency denominating them.

5. Balance of Payments
International trade and other international transactions result in a flow of funds between countries. All
transactions relating to the flow of goods, services and funds across national boundaries are recorded in the
balance of payments of the countries concerned.

Balance of payments (BoPs) is systematic statement that systematically summarizes, for a specified period of
time, the monetary transactions of an economy with the rest of the world. Put in simple words, the balance of
payments of a country is a systematic record of all transactions between the ‘residents’ of a country and the rest of
the world. The balance of payments includes both visible and invisible transactions. It presents a classified record
of:

All receipts on account of goods exported, services rendered and capital received by ‘residents’ and
Payments made by then on account of goods imported and services received from the capital transferred to
‘non-residents’ or ‘foreigners’.
Thus the transactions include the exports and imports (by individuals, firms and government agencies) of goods
and services, income flows, capital flows and gifts and similar one-sided transfer of payments. A rule of thumb
that aids in understanding the BOP is to “follow the cash flow”. Balance of payments for a country is the sum of
the Current Account, the Capital Account, and the change in Official Reserves.

 Introduction-

We know that international business activity has been in existence for hundreds of years. More than two
hundred years back. Adam Smith wrote in his famous title. "Wealth of Nations" that if a foreign country can
supply us with a commodity Cheaper than we ourselves can make it, better buy it of them with some part of
the produce of our own in which we have some advantage, The period after the World War II has seen a
phenomenal growth in exchange of goods between nations. During this period. There has been a systematic
effort to facilitate the free flow of goods and services across national boundaries. Rapid economic growth in
the Western countries owed much to the relatively free flow of goods and services. Now, other countries
have joined in this process and growth of international trade continues unabated. Pros and cons of this
development are debated in different fora all the time. Even disputes arise between nations. To resolve
disputes and make further progress on free flow, the bodies like World Trade Organisation (WTO) have come
into existence. Despite the difficulties and road blocks. Integration of the world economy is moving forward.
Fast means of communication have made the world a small village. No single nation can remain aloof today,
without having to transact with others. Exchange of goods, services, financial resources. Technology and
manpower (albeit to a limited extent) is the reality of today's economic system. The world trade has in fact
grown at a pace much faster than the world output. For several countries, the growth has been described as
export oriented growth since the share of exports in their GDP is significantly high.

Even in case of India, the period after 1951 has been one of liberalization and integration with the world
economy. The country followed, for very long time. The policy of import substitution and self-reliance. In Net,
in the past, there used to be some sort of merit associated with the dictum, "import and perish". Now there is
implied virtue in the dictum. "export and prosper". Now many countries like India,

feel the need for increasing their share in international exchange of goods, services capital and technology. Some of the
important steps taken over the period of last years can be summarized as follows:

a) establishment of unified market determined exchange rate;

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b) introduction of current account convertibility and phased introduction of capital account convertibility, which will lead
to full convertibility in due course;
c) reduction in import duties;
d) liberalization of portfolio and foreign direct investment;

Over a period very large size business organisations have developed. Big multinational corporations (MNCs) have
production and sales activities spread in many countries. About one thousand big multinationals are stated to be owning
about half of the assets of the world economic system. Fast development of international movement of goods and
investment was not possible without corresponding development or Financial system. They had to go hand-in-hand. A
sophisticated and well networked banking system and various financial products in the form of risk management tools and
insurance are necessary to allow the momentum of growth to continue. The arrangements are needed to tide over short-term
imbalances as and when they occur in any country or any part of the world.

The process of integration of the world economy has witnessed the creation of a very dynamic international financial
market. A new field of finance namely financial engineering, has come into existence. The financial market of today offers
a large variety of financial products for investment, speculation and risk management. The financial market with innovative
products presents vast opportunities as well as unprecedented risks. Therefore, understanding operations in this market is a
must for any finance manager, particularly the one dealing with international operations. Now, more and more companies
are venturing into international operations in one form or another. Some may be doing only exports, others may be doing
both exports and imports and still others may be doing exports, imports and investments. In order to be effective in
managing the expanding cross-border activities, finance managers are required to have a good command on working of the
financial markets, underlying which are sophisticated financial products. Theoretical basis for these products has to be
clearly understood. The market dynamics of many of these products is such that a risk management product can turn into a
big risk itself, if not understood properly or not dealt with due care.

 Multinational Enterprise and MNC financial management

A multinational corporation (MNC) or enterprise (MNE),is a corporation or an enterprise that manages

production or delivers services in more than one country. It can also be referred to as aninternational
corporation. The International Labour Organisation (ILO) has defined an MNC as a corporation that has its
management headquarters in one country, known as the home country, and operates in several other
countries, known as host countries.

The Dutch East India Company was the first multinational corporation in the world and the first company to
issue stock. It was also arguably the world's first megacorporation, possessing quasi-governmental powers,
including the ability to wage war, negotiate treaties, coin money, and establish colonies.

The first modern multinational corporation is generally thought to be the East India Company. Many
corporations have offices, branches or manufacturing plants in different countries from where their original
and main headquarters is located.

Some multinational corporations are very big, with budgets that exceed some nations' GDPs Multinational
corporations can have a powerful influence in local economies, and even the worls economy, and play an
important role in international relations and globalisation.

There are different types of multinational companies, such as;

a) Raw-Material Seekers: Raw-material seekers were the earliest multinationals and their aim was to exploit
the raw materials that could be found overseas. The modern-day counterparts of these firms, the
multinational oil and mining companies such as British Petroleum, Exxon Mobil, International Nickel, etc.,

b) Market Seekers: The market seeker is the archetype of the modern multinational firm that goes overseas to
produce and sell in foreign markets. Examples include IBM, Toyota, Unilever, Coca-cola.
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c) Cost Minimizers: Cost minimizers are a fairly recent category of firms doing business internationally. These
firms seek out and invest in lower-cost production sites overseas (for example, Hong Kong, Malaysia, Taiwan,
and India) to remain cost competitive both at home and abroad.

STEPS IN INTERNATIONALIZATION

Stage 1. Domestic Company-

Domestic company limits its operations,mission and vision to the national political boundaries. This companies
focuses its view in the domestic market opportunities, domestic suppliers, domestic financial companies,
domestic customers, etc.

the domestic company never thinks of growing globally. If it grows, beyond its present capacity, the company
selects the diversification strategy of entering into new domestic markets, new products, technology, etc. The
demotic company does not select the strategy of expansion penetrating into the international markets.

Stage 2. International Company-

Some of the companies which grow beyond their production or domestic marketing capacities,think of
internationalizing their operations.These companies believe that the practices adopted in domestic business, the
people and products of domestic business, the people and products of domestic company are superior to those of
other countries. The Focuses of these companies is domestic but extends the wings to the foreign countries.

The International company holds the marketing mix constantly and extends the operations to new countries. Thus,
the international company extends the domestic country marketing mix and business model and practices to
foreign countries.

Stage 3. Multinational Company-

Sooner or later, the international companies learn that the extension strategy (that is extending the domestic
product, price and promotion to foreign markets) will not work.

This stage of multinational company is also referred to as multi-domestic. Multi-domestic company formulates
different strategies for different markets; thus, the orientation shifts from ethnocentric to polycentric orientation
the offices/branches/subsidiaries of a multinational company work like domestic company in each country where
they operate with distant policies and strategies suitable to the country concerned. Thus, they operate like a
domestic company of the country concerned in each of their markets.

Stage 4. Global Company-

A global company is the one, which has either global marketing strategy or a global strategy. Global company
either produces in home country and focuses on marketing these products globally, or produces the products
globally and focuses on marketing these products domestically.

Stage 5. Transnational Company-

Transnational company products, markets, invests and operates across the world. It is an integrated global
enterprise that links global markets at profit. There is no pure transnational corporation. However, most of the
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transnational companies satisfy many of the characteristics of a global corporation. For example, Coca-Cola,
Pepsi-Cola, etc.

Intenational Financial Management:

The main objective of international financial management is to maximise shareholder wealth. This would
require making sound investment and financing decisions that would result in adding value to the firm. One of
the main reasons for focusing on shareholder wealth is that the companies who do not do so may be taken
over by others. If the shareholder wealth is maximized or, in other words, if share price is made to go up
hostile takeover becomes difficult and costly.

Traditionally financial management is separated into two basic functions.

First Function:The first is concerned with acquisition of funds, also known as financing decision. This
function involves generating funds from internal as well as external sources. The effort is to get funds at the
lowest cost possible.

Second Function: The second, that is, investment decision is concerned with deployment of the acquired
funds in a manner so as to maximize shareholder wealth. Other decisions relate to dividend payment, working
capital and capital structure etc. In addition, risk management involves both financing and investment
decision.

Challenges faced by international financial manager:

(i)To understand the interrelationship between environmental changes and corporate response. For example, how
will the credit conditions be impacted by stock market crash? How will defaults by some debtor countries affect
funding ability in the international capital market?

(ii)To understand the development and use of new instruments such as options, forwards futures and swaps for
effective management.

(iii)To develop ways to minimize risks through internal and external techniques.

(iv)To take a balanced view of successes and failures, treating them as experiences to learn from. Decisions such
as taking loan in a currency that has started appreciating fast, taking a fixed rate financing when rates have started
going down will have an adverse impact and impel finance manager to contain the damage to the extent possible.

International financial management Involves:

International financial management will involve the study of :

(a) Exchange rate and currency markets,

(b) Theory and practice of estimating future exchange rate,
(c) Various risks such as political/country risk, exchange rate risk and interest rate risk,
(d) Various risk management techniques,
(e) Cost of capital and capital budgeting in international context,
(f) Working capital management,
(g) Balance of payment, and
(h) International financial institutions etc.
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 Foreign Exchange Market-

Definition: The Foreign Exchange Market is a market where the buyers and sellers are involved in the
sale and purchase of foreign currencies. In other words, a market where the currencies of different countries
are bought and sold is called a foreign exchange market.

At the bottom of a pyramid are the actual buyers and sellers of the foreign currencies- exporters,
importers, tourist, investors, and immigrants. They are actual users of the currencies and approach
commercial banks to buy it.

The commercial banks are the second most important organ of the foreign exchange market. The banks
dealing in foreign exchange play a role of “market makers”, in the sense that they quote on a daily basis
the foreign exchange rates for buying and selling of the foreign currencies. Also, they function as clearing
houses, thereby helping in wiping out the difference between the demand for and the supply of currencies.
These banks buy the currencies from the brokers and sell it to the buyers.

The third layer of a pyramid constitutes the foreign exchange brokers. These brokers function as a link
between the central bank and the commercial banks and also between the actual buyers and commercial
banks. They are the major source of market information. These are the persons who do not themselves buy
the foreign currency, but rather strike a deal between the buyer and the seller on a commission basis.

The central bank of any country is the apex body in the organization of the exchange market. They work
as the lender of the last resort and the custodian of foreign exchange of the country. The central bank has
the power to regulate and control the foreign exchange market so as to assure that it works in the orderly
fashion. One of the major functions of the central bank is to prevent the aggressive fluctuations in the
foreign exchange market, if necessary, by direct intervention. Intervention in the form of selling the
currency when it is overvalued and buying it when it tends to be undervalued.
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Functions of Foreign Exchange Market:

The following are the main functions of foreign exchange market, which are actually
the outcome of its working:

1)Transfer Function: The basic and the most visible function of foreign exchange market is the
transfer of funds (foreign currency) from one country to another for the settlement of payments. It
basically includes the conversion of one currency to another, wherein the role of FOREX is to transfer the
purchasing power from one country to another.
For example, If the exporter of India import goods from the USA and the payment is to be made in
dollars, then the conversion of the rupee to the dollar will be facilitated by FOREX. The transfer function
is performed through a use of credit instruments, such as bank drafts, bills of foreign exchange, and
telephone transfers.

2)Credit Function: FOREX provides a short-term credit to the importers so as to facilitate the smooth
flow of goods and services from country to country. An importer can use credit to finance the foreign
purchases. Such as an Indian company wants to purchase the machinery from the USA, can pay for the
purchase by issuing a bill of exchange in the foreign exchange market, essentially with a three-month
maturity.

3)Hedging Function: The third function of a foreign exchange market is to hedge foreign exchange
risks. The parties to the foreign exchange are often afraid of the fluctuations in the exchange rates, i.e., the
price of one currency in terms of another. The change in the exchange rate may result in a gain or loss to
the party concerned.
Thus, due to this reason the FOREX provides the services for hedging the anticipated or actual
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claims/liabilities in exchange for the forward contracts. A forward contract is usually a three month
contract to buy or sell the foreign exchange for another currency at a fixed date in the future at a price
agreed upon today. Thus, no money is exchanged at the time of the contract.
There are several dealers in the foreign exchange markets, the most important amongst them are the
banks. The banks have their branches in different countries through which the foreign exchange is
facilitated, such service of a bank are called as Exchange Banks.

Types of Foreign Exchange Market

Broadly, the foreign exchange market is classified into two categories on the basis of the nature of
transactions. These are:

1)Spot Market: A spot market is the immediate delivery market, representing that segment of the
foreign exchange market wherein the transactions (sale and purchase) of currency are settled within two
days of the deal. That is, when the seller and buyer close their deal for currency within two days of the
deal, is called as Spot Transaction.
Thus, a spot market constitutes the spot sale and purchase of foreign exchange. The rate at which the
transaction is settled is called a Spot Exchange Rate. It is the prevailing exchange rate in the market.

2)Forward Market: The forward exchange market refers to the transactions – sale and purchase of
foreign exchange at some specified date in the future, usually after 90 days of the deal. That is, when the
buyer and seller enter into a contract for the sale and purchase of foreign currency after 90 days of the deal
at a fixed exchange rate agreed upon now, is called a Forward Transaction.
Thus, the forward market constitutes the forward transactions in foreign exchange. The exchange rate at
which the buyers or sellers settle the transactions in the forward market is called a Forward Exchange
Rate.

Thus, the spot and forward markets are the important kinds of foreign exchange market that often helps in
stabilizing the foreign exchange rate.
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Types of Foreign Exchange Transactions

Definition: The Foreign Exchange Transactions refers to the sale and purchase of foreign currencies.
Simply, the foreign exchange transaction is an agreement of exchange of currencies of one country for
another at an agreed exchange rate on a definite date.

1.Spot Transaction: The spot transaction is when the buyer and seller of different currencies settle their
payments within the two days of the deal. It is the fastest way to exchange the currencies. Here, the currencies are
exchanged over a two-day period, which means no contract is signed between the countries. The exchange rate at
which the currencies are exchanged is called the Spot Exchange Rate. This rate is often the prevailing exchange
rate. The market in which the spot sale and purchase of currencies is facilitated is called as a Spot Market.

2.)Forward Transaction: A forward transaction is a future transaction where the buyer and seller enter into
an agreement of sale and purchase of currency after 90 days of the deal at a fixed exchange rate on a definite date
in the future. The rate at which the currency is exchanged is called a Forward Exchange Rate. The market in
which the deals for the sale and purchase of currency at some future date is made is called a Forward Market.

3.Future Transaction: The future transactions are also the forward transactions and deals with the contracts
in the same manner as that of normal forward transactions. But however, the transactions made in a future contract
differs from the transaction made in the forward contract on the following grounds:

 The forward contracts can be customized on the client’s request, while the future contracts
are standardized such as the features, date, and the size of the contracts is standardized.
 The future contracts can only be traded on the organized exchanges, while the forward contracts can
be traded anywhere depending on the client’s convenience.
 No margin is required in case of the forward contracts, while the margins are required of all the
participants and an initial margin is kept as collateral so as to establish the future position.

4.Swap Transactions: The Swap Transactions involve a simultaneous borrowing and lending of two
different currencies between two investors. Here one investor borrows the currency and lends another currency to
the second investor. The obligation to repay the currencies is used as collateral, and the amount is repaid at
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a forward rate. The swap contracts allow the investors to utilize the funds in the currency held by him/her to pay
off the obligations denominated in a different currency without suffering a foreign exchange risk.

5.Option Transactions: The foreign exchange option gives an investor the right, but not the obligation to
exchange the currency in one denomination to another at an agreed exchange rate on a pre-defined date. An option
to buy the currency is called as a Call Option, while the option to sell the currency is called as a Put Option.

Thus, the Foreign exchange transaction involves the conversion of a currency of one country into the currency of
another country for the settlement of payments.

Foreign Exchange Rate Determination

Foreign Exchange Rate is the amount of domestic currency that must be paid in order to get a unit of foreign
currency. According to Purchasing Power Parity theory, the foreign exchange rate is determined by the relative
purchasing powers of the two currencies.

Example: If a Mac Donald Burger costs $20 in the USA and Re 100 in India, then the exchange rate between India
and the USA will be (100/20=5), 1 $ = 5 Re.

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

Within the country, transactions are, then, simple and straight-forward. But if the Indian shawlmaker decides to go
abroad, he must exchange Indian rupee into Jap yen or dollar or pound or euro. To facilitate this exchange form,
banking institutions appear. Indian shawlmaker will then go to a bank for foreign currencies.

The bank will then quote the day’s exchange rate—the rate at which Indian rupee will be exchanged for foreign
currencies. Thus, foreign currencies are needed for the conduct of international trade. In a foreign exchange market
comprising commercial banks, foreign exchange brokers and authorised dealers and the monetary authority (i.e., the
RBI), one currency is converted into another currency.

A (foreign) exchange rate is the rate at which one currency is exchanged for another. Thus, an exchange rate can be
regarded as the price of one currency in terms of another. An exchange rate is a ratio between two monies.

If 5 UK pounds or 5 US dollars buy Indian goods worth Rs. 400 and Rs. 250 then pound-rupee or
dollar-rupee exchange rate becomes Rs. 80 = £1 or Rs. 50 = $1, respectively.

Exchange rate is usually quoted in terms of rupees per unit of foreign currencies. Thus, an exchange rate indicates
external purcha-sing power of money.

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

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

Now two pertinent questions that usually arise in the foreign exchange market are to be answered now. First, how is
the equilibrium exchange rate determined, and secondly, why does exchange rate move up and down?

There are two methods of foreign exchange rate determination.

 One method falls under the classical gold standard mechanism and
 another method falls under the classical paper currency system.

Note:Today, gold standard mechanism does not operate since no standard monetary unit is now
exchanged for gold. All countries now have paper currencies not convertible to gold.

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

Four ways to determine the rate of foreign exchange are:

(a) Demand for foreign exchange (currency)

(b) Supply of foreign exchange
(c) Determination of exchange rate
(d) Change in Exchange Rate!

Expressed graphically the Intersection of demand and the supply curves determines the equilibrium exchange
rate and equilibrium quantity of foreign currency. This is called equilibrium in foreign exchange market).

Let us assume that there are two countries—India and USA—and the exchange rate of their currencies, viz.,
rupee and dollar are to be determined. Presently there is floating or flexible exchange regime in both India and
USA. Therefore, the value of currency of each country in terms of the other currency depends upon the demand
for and supply of their currencies.

(a) Demand for foreign exchange (currency):

Demand for foreign exchange is caused (i) to purchase abroad goods and services by domestic residents, (ii) to
purchase assets abroad, (iii) to send gifts abroad, (iv) to invest directly in shops, factories abroad, (v) to undertake
foreign tours, (vi) to make payment of international trade, etc. The demand for dollars varies inversely with rupee
price of dollar, i.e., higher the price, the lower is the demand. The demand curve in Fig. 10.1 is downward sloping
because there is inverse relationship between foreign exchange rate and its demand.

(b) Supply of foreign exchange:

Supply of foreign exchange monies

(i) when foreigners purchase home country’s (say, India’s) goods and services through our exports

(ii) when foreigners make direct investment in bonds and equity shares of home country

(iii) when speculation causes inflow of foreign exchange

(iv) when foreign tourists come to home country

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The supply curve is upward sloping (vide Fig. 10.1) because there is direct relationship between foreign exchange
rate and its supply.

(c) Determination of exchange rate:

This is determined at a point where demand for and supply of foreign exchange are equal. Graphically,
intersection of demand and supply curves determines the equilibrium exchange rate of foreign currency. At any
particular time, the rate of foreign exchange must be such at which quantity demanded of foreign currency is
equal to quantity supplied of that currency. It is proved with the help of the following diagram. The price on the
vertical axis is stated in terms of domestic currency (i.e., how many rupees for one US dollar).

The horizontal axis measures quantity demanded or supplied of foreign exchange (i.e., dollars). In this figure,
demand curve is downward sloping which shows that less foreign exchange is demanded when exchange rate
increases (i.e., inverse relationship). The reason is that rise in the price of foreign exchange (dollar) increases the
rupee cost of foreign goods which makes them more expensive. The result is fall in imports and demand for
foreign exchange.

The supply curve is upward sloping which implies that supply of foreign exchange increases as the exchange rate
increases (i.e., direct relationship). Home country’s goods (here Indian goods) become cheaper to foreigners
because rupee is depreciating in value.

As a result, demand for Indian goods increases. Thus, our exports should increase as the exchange rate increases.
This will bring greater supply of foreign exchange. Hence, the supply of foreign exchange increases as the
exchange rate increases which proves the slope of supply curve.

In the Fig. 10.1, demand curve and supply curve of dollars intersect each other at point E which implies that at
exchange rate of OR (QE), quantity demanded and supplied are equal (both being equal to OQ). Hence,
equilibrium exchange rate is OR and equilibrium quantity is OQ.

(d) Change in Exchange Rate:

Suppose, exchange rate is 1 dollar = Rs 50. An increase in India’s demand for US dollars, supply remaining the
same, will cause the demand curve DD shift to D’D’. The resulting intersection will be at a higher exchange rate,
i.e., exchange rate (price of dollar in terms of rupees) will rise from OR to OR, (say, 1 dollar = 52 rupees). It
shows depreciation of Indian currency (rupees) because more rupees (say, 52 instead of 50) are required to buy 1
US dollar. Thus, depreciation of currency means a fall in the price of home currency.

Likewise, an increase in supply of US dollar will cause supply curve SS shift to S’S’ and as a result exchange rate
will fall from OR to OR2. It indicates appreciation of Indian currency (rupees) because cost of US dollar in terms
of rupees has now fallen, say, 1 dollar = Rs 48, i.e., less rupees are required to buy 1 US dollar or now Rs 48
instead of Rs 50 can buy 1 dollar. Thus, appreciation of currency means ‘a rise in the price of home currency’.
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In a system of flexible exchange rate, the exchange rate of a currency (like price of a good) is freely determined by
forces of market demand and supply of foreign exchange.

Demand-Supply Approach of Foreign Exchange:Or, BOP Theory of Foreign Exchange Rate Determination:

Demand for Foreign Exchange:

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

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

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

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

Supply of Foreign Exchange:

In a similar fashion, we can determine the supply of foreign exchange. Supply of foreign currency comes from
receipts for its exports. If the foreign nationals and firms intend to purchase Indian goods or buy Indian assets or give
grants to the Government of India, the supply of foreign exchange is generated. In other words, what the Indian
exports (both goods and invisibles) to the rest of the world is the source of foreign exchange. To be more specific, all
the transactions that appear on the credit side of the BOP account are the sources of supply of foreign exchange.
 14

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

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

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

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

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

The exchange rate that we have determined is called a floating or ‘flexible exchange’ rate. (Under this
exchange rate system, the government does not intervene in the foreign exchange market.) A floating
exchange rate, by definition, results in an equilibrium rate of exchange that will move up and down
according to a change in demand and supply forces. The process by which currencies float up and down
following a change in demand or a change in supply forces is thus illustrated in Fig. 6.7.
 15

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

Similarly, if the supply curve shifts from SS1 to SS2 as shown in Fig. 6.8, the new exchange rate thus determined
would be OP2. If Indian goods are exported more following an increase in national income of the USA, the
supply curve would then shift rightward. Consequently, dollar depreciates and rupee appreciates. New exchange
rate is settled at that point where the new supply curve SS2 intersects the demand curve at E2.

This is the balance of payments theory of exchange rate determination. Wherever govern-ment does not
intervene in the market, a floating or a flexible exchange rate prevails. Such a system may not necessarily be
ideal since frequent changes in demand and supply forces cause frequent as well as violent changes in the
exchange rate. Consequently, an air of uncertainty in trade and business would prevail.

Such uncertainty may be damaging for the smooth flow of trade. To prevent this awkward situation,
government intervenes in the foreign exchange rate. It may keep the exchange rate fixed. This exchange rate is
called a ‘fixed exchange’ rate system where both the demand and supply forces are manipulated or calibrated
by the central bank in such a way that the exchange rate is kept pegged at the old level.
 16

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

Purchasing Power Parity Theory:

Introduction to Purchasing Power Parity Theory:

The Purchasing Power Parity Theory has been popularized during the inter-war period by GAUSTAV
CASSEL, the Swedish Economist.

According to this theory, rates of exchange between two countries are determined by relative price level.

The actual rate of exchange must be such that the same amount of purchasing power, when exchanged at that
rate, must buy the same amount of goods and services in both the countries.

For Example, if by spending Rs. 60/- we can buy an amount of goods in India as we can buy with £1 in
England the rate of exchange between England and India will be Rs. 60/- to £1. This is easily seen if we reflect
on the fact that the price paid in a foreign currency is ultimately a price for foreign commodities, a price which
must stand in a certain relation to the prices of commodities on the home market. Thus, we arrive at the
conclusion that the rate of exchange between two currencies must stand essentially on the quotient of the
internal purchasing powers of these currencies.

Definition:

“The rate of exchange determined in relation to price-levels is known the Purchasing Power Parity”.

This is a norm round which actual rates of exchange will vary. So long as the relationship between two
price-levels remains unchanged, the rates of exchange will tend towards the parity. But it should be noted that
this parity is not a fixed par like gold points. It is a moving par-changing with changes in price-levels.

How Purchasing Power Parity Theory is Determined?

It should be noted that the purchasing power parity theory is determined by comparing general price-levels and
not the price-levels of internationally traded goods. Prices of exports and imports must remain at the same level
in every country (barring of course, cost of transport) tariffs etc. Moreover, they are often the result of changes
in exchange rates. Hence, it is easy to verify the theory by comparing wholesale standards.

The prestige and the so-called verifications of the theory from a comparison of the existing wholesale index
numbers were due to the fact that the latter were overloaded with internationally traded goods. But parties
should be “measured only by general index figures representing so far as possible the whole mass of
commodities marketed in the country.”

The theory is an explanation of monetary adjustment and states that if the essential condition of international
trade remains unchanged, foreign exchange rates will reflect those price-changes. But the conditions of
international trade never remain the same. In particular, the barter terms of trade are constantly changing owing
to changes in the demand for foreign goods, changes in the conditions of supply of exported goods, changes in
the volume of foreign loans, changes in the costs of transport and in every item in the invisible balance of trade.
 17

Further, we should take the case of a country which borrows from another. The increased supply of the foreign
currency in the first country’s foreign exchange market will raise the value of the own currency in terms of the
currency of the lending country. This change in the exchange rates will not always be reflected in suitable
changes in the price-levels of the two countries.

If the barter terms of the trade change, the relationships between the price-levels of the different countries will
change, and parties determined by comparing the former price-level relationship will fail to reflect changes in
exchange-rates. The theory may thus be true only under circumstances when the terms of trade do not change.

Fluctuations of the Rates of Exchange and its Causes:

The Rates of Exchange fluctuate above and below the mint par. What are the causes which influence the
movements of the rates of exchange? They may be grouped under two main heads: the demand and supply of
foreign currency, and the currency conditions. The demand and supply of foreign currency arises from three
sources.

They are:

(1) Trade conditions,

(2) Stock Exchange influences, and

(3) Banking influences.

1. Trade Conditions:

The demand and supply of foreign currency are dependent primarily on the volume of exports and imports.
When exports are greater than imports, foreigners owe to us a greater sum than we owe to them. The rate of
exchange moves in our favour. On the other-hand when imports are greater than exports, the demand for
foreign currency is greater than the supply and the rate will fall. Among exports and imports we must include
not only goods but the invisible items, because these also give rise to the demand for and the supply of foreign
currency.

2. Stock Exchange Influences:

Stock exchange influences include the payment of loans, interest and re-payment of loans, the purchase of sale
of foreign securities by home investors or of home securities by foreign investors. When a country gives loans
to another the loans have to be transferred into the foreign currency. Its demand for foreign currency increases,
and the rate of the exchange moves against it.

In the same way when home investors buy foreign securities or home securities are sold by foreigners the rate
falls. But when loans are being repaid or when foreigners buy domestic securities, the demand for home
currency or their part rises and the rate of exchange rises.

3. Banking Influences:

Banking influences include the purchase and sale of banker’s drafts, traveller’s letters of credit, arbitrage
Operations etc. when a bank issues a draft or a letter of credit etc. on a foreign branch, the demand for foreign
currency rises and the rate of exchange falls. Bank Rate is also an important influence on the rates of exchange.
 18

When it is high i.e., in relation to other countries, foreigners will send funds to that country to earn the high rate
of interest. The demand for home currency rises and the rate of exchange moves up. The opposite will happen
when the bank rate is lowered.

The second group of factors which influence the Exchange Rate is:

(a) Currency Conditions:

The conditions of currency in a country also exercise important influence on the rates of exchange. If there is a
rumor that the currency will depreciate due to an over issue of paper money, the demand for that currency will
fall off, since no-body wants to transfer his funds into a currency whose purchasing power is likely to
depreciate the rate of exchange will, therefore, rise and may jump up to abnormally high figures if there is a
“flight from the foreign currency” i.e., if foreigners not liking to invest their funds to their home currency,
hasten to transfer them to foreign countries where purchasing power is more stable.

Similarly, when the currency of one country is based on silver and another on gold, the rates of exchange will
depend on the gold price of silver.

Besides these there are:

(a) The political conditions,

(b) The growth of speculative sentiment etc. which will affect the rate.

Limits to Fluctuations in Exchange Rates:

When both the countries are on gold standard the actual rates of exchange will fluctuate around the mint par of
exchange within limits fixed by the gold points. The mint par is determined with reference to the value of the
amount of pure gold in the coins of each country. The rate of exchange is said to be at par when it is the same
as the mint par. The rate of exchange will fluctuate above and below the mint par. The limits to the fluctuations
in the rates of exchange are fixed under gold standard by the gold or specie points.

The actual gold export point is determined by adding the shipping expenses etc. to the mint par. Similarly, the
gold import point is found by subtracting the shipping expenses from the par. So long as the price of bills is
within the gold points, merchants will buy bills in order to make payments to foreign countries. But if the price
of bills is higher than the gold export point, they will send gold instead of sending bills.

Similarly, when the rate of exchange touches the import point, gold will be imported. Unlike the mint par
which is stable so long as the gold contents and the fineness of the coins are not changed, gold points are
variable according as the cost of freight, insurance etc. increase or decrease.

Favourable and Unfavorable Rates:

A country is said to have favourable exchange when the rate of exchange is near the gold import point; it has
unfavorable exchange where the rate is near gold export point. When we have imported more and exported less
we shall have to pay the foreigners for the imports by sending gold or other funds. The exchange is said to be
unfavorable. Conversely, when our exports are greater than our imports foreigners must pay us by sending gold.
The exchange is then said to be favourable.
 19

Limits under Paper Currency Standard:

When both the countries are on inconver-tible paper currency there are no gold points. The mint par is replaced
by the purchasing power, Parity, determined with reference to the price-levels of the two countries. Unlike the
mint par the purchasing power parity is a moving par, changing in response to every change in the prices.
Though there is a part of exchange, there is however, no limit to the fluctuations in the rates of exchange. The
latter will fluctuate in accordance with every change in the demand and supply of foreign currency.

Interest Rate Parity (IRP) Theory

Interest Rate Parity (IPR) theory is used to analyze the relationship between at the spot rate and a corresponding
forward (future) rate of currencies.

The IPR theory states interest rate differentials between two different currencies will be reflected in the
premium or discount for the forward exchange rate on the foreign currency if there is no arbitrage - the activity
of buying shares or currency in one financial market and selling it at a profit in another.

The theory further states size of the forward premium or discount on a foreign currency should be equal to the
interest rate differentials between the countries in comparison.

Examples

For our illustration purpose consider investing € 1000 for 1 year.We'll consider two investment cases viz:

Case I: Domestic Investment

In the U.S.A., consider the spot exchange rate of $1.2245/€ 1.

So we can exchange our € 1000 @ $1.2245 = $1224.50

Now we can invest $1224.50 @ 3.0% for 1 year which yields $1261.79 at the end of the year.
 20

Case II: Foreign Investment

Likewise we can invest € 1000 in a foreign European market, say at the rate of 5.0% for 1 year

But we buy forward 1 year to lock in the future exchange rate at

$1.20025/€ 1 since we need to convert our € 1000 back to the domestic currency, i.e. the U.S. Dollar.

So € 1000 @ of 5.0% for 1 year = € 1051.27

Then we can convert € 1051.27 @ $1.20025 = $1261.79

Thus, in the absence of arbitrage, the Return on Investment (RoI) is same regardless of our choice of
investment method.

There are two types of IRP.

1. Covered Interest Rate Parity (CIRP)

Covered Interest Rate theory states that exchange rate forward premiums (discounts) offset interest rate
differentials between two sovereigns.

In another words, covered interest rate theory holds that interest rate differentials between two countries are
offset by the spot/forward currency premiums as otherwise investors could earn a pure arbitrage profit.

Covered Interest Rate Examples

Assume Google Inc., the U.S. based multi-national company, needs to pay it's European employees in Euro in a
month's time.

Google Inc. can achieve this in several ways viz:

Buy Euro forward 30 days to lock in the exchange rate. Then Google can invest in dollars for 30 days until it
must convert dollars to Euro in a month. This is called covering because now Google Inc. has no exchange rate
fluctuation risk.

Convert dollars to Euro today at spot exchange rate. Invest Euro in a European bond (in Euro) for 30 days
(equivalently loan out Euro for 30 days) then pay it's obligation in Euro at the end of the month.

Under this model Google Inc. is sure of the interest rate that it will earn, so it may convert fewer dollars to Euro
today as it's Euro will grow via interest earned.

This is also called covering because by converting dollars to Euro at the spot, the risk of exchange rate
fluctuation is eliminated.

2. Uncovered Interest Rate Parity (UIP)

Uncovered Interest Rate theory states that expected appreciation (depreciation) of a currency is offset by lower
(higher) interest.

Uncovered Interest Rate Example

In the above example of covered interest rate, the other method that Google Inc. can implement is:
 21

Google Inc. can also invest the money in dollars today and change it for Euro at the end of the month.

This method is uncovered because the exchange rate risks persist in this transaction.

Covered Interest Rate Vs. Uncovered Interest Rate

Recent empirical research has identified that uncovered interest rate parity does not hold, although violations
are not as large as previously thought and seems to be currency rather than time horizon dependent.

In contrast, covered interest rate parity is well established in recent decades amongst the OECD economies for
short-term instruments. Any apparent deviations are credited to transaction costs.

Implications of Interest Rate Parity Theory

If IRP theory holds then arbitrage in not possible. No matter whether an investor invests in domestic country or
foreign country, the rate of return will be the same as if an investor invested in the home country when
measured in domestic currency.

If domestic interest rates are less than foreign interest rates, foreign currency must trade at a forward discount
to offset any benefit of higher interest rates in foreign country to prevent arbitrage.

If foreign currency does not trade at a forward discount or if the forward discount is not large enough to offset
the interest rate advantage of foreign country, arbitrage opportunity exists for domestic investors. So domestic
investors can benefit by investing in the foreign market.

If domestic interest rates are more than foreign interest rates, foreign currency must trade at a forward premium
to offset any benefit of higher interest rates in domestic country to prevent arbitrage.

If foreign currency does not trade at a forward premium or if the forward premium is not large enough to offset
the interest rate advantage of domestic country, arbitrage opportunity exists for foreign investors. So foreign
investors can benefit by investing in the domestic market.

Limitations of Interest Rate Parity Model

In recent years the interest rate parity model has shown little proof of working.

In many cases, countries with higher interest rates often experience it's currency appreciate due to higher
demands and higher yields and has nothing to do with risk-less arbitrage.
 22

Forces Behind Exchange Rate Determination

Foreign Exchange is a price of one country currency in relation to other country currency, which like the price of any
other commodity is determined by the demand and supply factors. The demand and supply of the foreign exchange
rate come from the residents of the respective countries.

Demand for Foreign Exchange (Foreign Money goes Supply of Foreign Exchange (Foreign
out) Money Comes in)

The source of foreign currency available to

Foreign Currency is needed to carry out transactions in
the domestic country are foreigners
foreign countries or for the purchase of foreign goods
purchasing our goods and services
and services (IMPORTS).
(Exports).

Foreign currency is needed to invest in foreign country Foreigners investing in Indian Stock
assets/shares/bonds etc. markets, Assets, Bonds etc. (FPIs and FDIs)

Foreign currency is needed to make transfer payments. Transfer payments. Example: Indian
Example: Indian Parents sending Money to his/her working in the USA, sending money to
son/daughter studying in the USA. his/her old aged parents.

Indians holding money in overseas Banks Foreigners holding assets in Indian Banks.

Indians Travelling abroad for Tourism Purpose. Foreigners travelling to India.

 23

 The DD curve represents the demand for foreign exchange by India. The SS curve represents the supply
of foreign exchange to India.
 The point where both DD and SS curves intersect is the point of equilibrium. At this point demand for
foreign exchange is exactly equal to the supply of foreign exchange.
 At equilibrium point E0, the exchange rate is 1 $ equal to 5 Re.
 In normal day to day functioning of markets, the exchange rate may fluctuate. If at any point in time, the
exchange rate is at E1, then the demand for foreign exchange falls short of supply of foreign exchange, as a
result at this point Indians are demanding less foreign currency due to which Re will appreciate vis-à-vis
foreign currency. The appreciation mainly occurs due to a favourable balance of payment situation (Surplus).
 By the same token at point E2, demand for foreign exchange is greater than the supply of foreign
exchange, at this point Indians are demanding excess foreign exchange than what the foreigners are willing to
supply, as a result, at E2 Re will depreciate vis-à-vis foreign currency. The depreciation mainly occurs due to
the unfavourable balance of payments situation(Deficits).

Types of Exchange Rate Regimes

Fixed Exchange Rate versus Floating Exchange Rate

Fixed Exchange Rate Floating Exchange Rate

Under this system, the market is allowed
Under this system, there is complete government
to determine the value of exchange rate
intervention in the foreign exchange markets.
freely.
The government or central bank determines the official
The exchange rate is determined by the
exchange rate by linking exchange rate to the price of
forces of demand and supply.
gold or major currencies like US dollar.
If due to any reason exchange rate
If due to any reason, the exchange rate fluctuates,
fluctuates, the government never
government intervenes and make sure that equilibrium
intervenes and allows the market to
pre-determined level is maintained.
function and determine the true value of
 24

exchange rate.
The only merit of fixed exchange rate system is that it The only demerit of floating exchange
assures the stability of exchange rate. It prevents both rate system is that exchange rate
currency appreciation and depreciation. fluctuates a lot on day to day basis.
The advantages of such a system are: the
exchange rate is determined in
The many disadvantages of such a system are: It puts a well-functioning foreign exchange
heavy burden on governments to maintain exchange markets with no government interference.
rate. This especially happens during the time of deficits, The exchange rate reflects the true value
as the governments need to infuse a lot of money to of the domestic currency which helps in
maintain exchange rate. establishing the trust among foreign
The foreign investors avoid investing in such countries investor.
as they fear to lose their investments because they
believe that exchange rate does not reflect the true A country can easily access funds/ loans
value of the economy. from IMF and other international
institutions if the exchange rate is market
determined.

 Managed Floating Exchange rate

Manage Floating exchange rate lies in between of the two extremes of fixed and floating exchange rate. Under
such a system, the exchange is allowed to move freely and determined by the forces of the market (Demand and
Supply). But when a difficult situation arises, the central banks of the country can intervene to stabilise the
exchange rate.

There are mainly three sub categories under managed floating exchange rate:

1. Adjusted Peg System: In this system, a country should try to hold on to a fixed exchange rate system for
as long as it can, i.e. until the country’s foreign exchange reserves got exhausted. Once the country’s foreign
exchange reserves got exhausted, the country should undergo devaluation of currency and move to another
equilibrium exchange rate.
2. Crawling Peg System: In this system, a country keeps on adjusting its exchange rate to new demand and
supply conditions. The system requires that instead of devaluing currency at the time of crisis, a country should
follow regular checks at the exchange rate and when require must undertake small devaluations.
3. Clean Floating: In the clean float system, the exchange rate is determined by market forces of demand
and supply. The exchange rate appreciates or depreciates as per market forces and with no government
intervention. It is identical to floating exchange rate.
4. Dirty Floating: In the dirty float system, the exchange rate is to a very large extent is determined by the
market forces of demand and supply (so far identical to clean floating), but occasionally the central banks of the
countries intervene in foreign exchange markets to smoothen or remove excessive fluctuations from the foreign
exchange markets.

 International Monetary System:

Introduction:

The term, international monetary system, refers to the institutions, norms and the entire environment that
facilitate the settlement of international payments. We can take a simple example here. Suppose you have to pay
for the import invoiced in US dollar; You will go to your banker to get US dollars for rupees. If you are an
exporter getting euro, you will go to your banker to convert euros into rupees. This is nothing but the exchange of
currencies. There are many other cases where currency is exchanged.
 25

Whenever one currency is exchanged for the other, a basic question arises as to how many units of a currency
would be foregone to fetch one unit of the other currency. This is the question of the relationship between value of
two currencies exchanged. In common terminology, it is known as the exchange rate. Exchange rate thus plays
a vital role in the settlement of international payments and so any arrangement in this context forms the subject
matter of the international monetary system.

Besides the exchange rate arrangement, it is the ability of a country to pay that lies at the root of the settlement of
international payments. The ability to pay is interpreted in terms of liquidity. A country should have the desired
liquidity to make international payments. A country's liquidity is necessarily tagged with the international
liquidity. It is the International Monetary Fund (IMF) whose main concern is to maintain and improve
international liquidity. Thus any discussion of the IMF's role in maintaining international liquidity too forms the
subject-matter of the international monetary system.

EXCHANGE RATE ARRANGEMENT

The nature of exchange rate arrangement has undergone changes over past couple of centuries. There was a time
when costly metal was' used as medium of international exchange of commodities under a specific arrangement,
known as commodity specie standard, It was followed by gold standard that was a more sophisticated version of the
exchange rate arrangement and that had set rules. It enjoyed merits, but at the same time, there were some limitations to that
system that led to its suspension for some time and subsequently to its abandonment. The abandonment of the gold standard
led to upheavals in the exchange rates and then to check it, the-IMF was established. These different regimes are explained
below:

Commodity Specie Standard

Under the commodity specie standard, the value of the commodities was expressed in terms of gold and silver coins that
were used for the settlement of international payments. There was a fixed ratio between the gold coin and the silver coin. It
was known as the mint ratio. For example, the mint ratio was 15.5: 1 between silver and gold coins in France during the
early nineteenth century.

In many cases, coins were full-bodied coins meaning that the value of the metal used in the coin was the same as its face
value, In other cases, there were debased coins with greater face value than the value of the metal used in them.

Gold Standard

Although pound had been minted of gold as far back as in the 17'x' century, gold standard originated in England in 1816
when gold became the official tender. By 1870s, gold standard stood widely accepted among countries and it reigned with
full fervour till the outbreak of the Great War in 1914.

Forms

Gold standard had three forms; One was the gold specie standard in which coins were minted of gold. The paper currency
could be converted into gold on demand. The price of gold was fixed under law. The second form was the gold bullion
standard with no compulsion to mint gold coins, Paper currency was not convertible into gold on demand; rather gold bars
could be bought from the central bank at fixed rates. The third was the gold exchange standard with no compulsion to mint
gold coins, nor the exchange of paper currency into gold either on demand or through purchase of gold bars. The currency
being on gold exchange standard was convertible into the currency being on the gold specie standard and the latter was
convertible into gold, For example, rouble could be exchanged for gold via British pound.

Whatever the form might be, there was no restriction on the inter-country flow of gold, The central bank of a gold-specie/
gold bullion standard country did have 100 per cent backing of gold behind its currency.

Broad Rules

The broad rules of the gold standard were manifest in automatic mechanism for;

1. Fixed exchange rates

2. Adjustment in the balance of payments
3. Domestic price stability
 26

The exchange rate depended upon the content of gold in different currencies. In practice, one ounce of gold was then valued
at £ 4.24 and the same weight of gold with similar fineness was valued at $ 20.67. Naturally, one pound was exchanged for
$ 20.67 14.24 or $ 4.87. This rate was known as mint parity or mint exchange rate. The actual exchange rate remained
close to mint parity because free flow of gold between two countries helped avoid any major deviation. Suppose the value
of dollar depreciated to $ 5.25/£, the arbitraguer would buy one ounce of gold in the United
States for $ 20.67 and sell it in the United Kingdom for £ 4.24 and then they could exchange the pound for dollar in the
foreign exchange market for $ 5.25 x 4.24 = $ 22.26. This brought them a profit of $ 22.26 - 20.67 = $ 1.59. The process of
arbitrage continued till the original parity was reestablished. It may be noted that this process involved transaction cost or
transportation cost of gold that might not help equate the actual exchange rate to mint parity. But the difference from the
mint parity was limited to only that amount.
27
 28

 Balance of Payments and International Economic Linkages- Parity Conditions.

A. Balance of Payments
B. The International Flow of Goods, Services, and Capital
C. Current Account Deficit

A.Balance of payments (“BOP”) – an accounting statement that summarizes all of the economic transactions
between residents of the home country and residents of all other countries.
Current Account – reflects the net flow of
Goods and services (balance of trade);
Income (interest, dividends, and compensation); and
Unilateral transfers (pensions, remittances, and other transfers for which no services were rendered).
Capital Account – reflects capital transfers that offset transactions undertaken without exchange in fixed assets or in their
financing.
Financial Account – reflects net purchases of financial assets:
Portfolio investments – financial assets with maturity > one year
Direct investments – financial assets for which management control is exerted (at least 10% equity ownership)
Changes in reserve assets held by official monetary institutions
Double-entry accounting ensures that the sum of all transactions is zero.
A “statistical discrepancy” line is included to offset non-zero balances.

Basic BOP statement

Category Debit (-) Credit (+)

Current Account

Goods (export/import) -$xxx $xxx

Services (export/import) -$xxx $xxx

Income (receipts/payments) -$xxx $xxx

Unilateral transfers -$xxx

Capital Account

Capital transfers -$xxx $xxx

 29

Financial Account

Portfolio investment (in U.S./overseas) -$xxx $xxx

Direct investment (in U.S./overseas) -$xxx $xxx

Government investment (in U.S./overseas) -$xxx $xxx

Changes in reserve assets -$xxx $xxx

Surplus/Deficit

Statistical Discrepancy

 BOP definitions
Basic balance – includes transactions that are fundamental to the economic health of a currency.
Net liquidity balance – measures change in private domestic borrowing or lending required to keep payments
balanced without adjusting official reserves.
Official reserve transactions balance – measures the adjustment required in official reserves to achieve BOP
equilibrium.

B.International Flow of Goods, Services, and Capital:

Macroeconomic accounting identities

 Link domestic spending and production to savings, consumption, and investment behavior, and thus to
Current Account and Financial Account balances.
 Manipulating accounting identities reveals the nature of the links between U.S. and world economies.

1. Domestic savings and investment and the Financial Account

2. Link between Current Account and Financial Account
3. Government budget deficits and the Current Account

International Flow of Goods, Services, and Capital: Savings and Investment and the Financial Account

 National income* is either spent or saved. Thus:

National Income = Consumption + Savings

Identity1:.National expenditures consist of consumption and investment. Thus:

Identity2:National Expenditures = Consumption + Investment

Identity3:National Income – National Expenditures = (consumption + savings) – (consumption +

investment) =Savings – Investment

If income > expenditures, then savings > investment, resulting in a capital surplus (excess savings).

Surplus capital is invested overseas.

 30

Thus, surplus capital becomes net foreign investment.

If positive, net foreign investment equals a Financial Account deficit.

Financial Account Debit (-) Credit (+)

Portfolio investment (in U.S./overseas) -$xxx $xxx
Direct investment (in U.S./overseas) -$xxx $xxx
Government investment (in U.S./overseas) -$xxx $xxx
Changes in reserve assets -$xxx $xxx
Balance -$xxx

National income consists of domestic goods and services and exports.

National expenditure consists of spending on domestic goods and services and imports.

Thus:

Identity4:National Income – National Expenditure =

(dom. goods/services + exports) – (dom. goods/services + imports) = Exports – Imports

Combining Identity .3 and Identity 4:

Identity 5: Savings – Investment = Exports – Imports

Thus, if savings > investment, net exports are positive and the Current Account will run a surplus.
 Because net foreign investment = savings - investment:
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Identity 6:Net Foreign Investment = Exports – Imports

 Thus, the Current Account balance = net capital outflow.

 If savings > investment, net foreign investment is positive and the Current Account will run a surplus.

 By Identity 6, the excess of goods and services bought over goods and services produced domestically
must be acquired through foreign trade and financed by an equal amount of borrowing from abroad.
 That is, if exports < imports, net foreign investment is negative.
When exports < imports, the Current Account will run a deficit.
When net foreign investment is negative, the Financial Account will run a surplus.
 Thus, the Current Account and Financial Account balances must exactly offset each other.
If income > expenditures, then exports > imports, resulting in a Current Account surplus.

 By Identity 5.6, the excess of goods and services bought over goods and services produced domestically
must be acquired through foreign trade and financed by an equal amount of borrowing from abroad.
 That is, if exports < imports, net foreign investment is negative.

 When exports < imports, the Current Account will run a deficit.
 When net foreign investment is negative, the Financial Account will run a surplus.

 Thus, the Current Account and Financial Account balances must exactly offset each other.Using identities to
assess the efficacy of solutions to improve the Current Account balance

Two conditions must be satisfied to reduce/increase a Current Account deficit/surplus:

 By Identify 5.3, raise income relative to expenditures; and

 Bv Identity 5.5, raise savings relative to investment.

However, a Current Account surplus is not necessarily a sign of economic health.

 Countries that provide good investment opportunities may run trade deficits (investment > savings).
 Countries that grow rapidly import more goods and services and may thus run trade deficits.
 Weak economies may reduce their imports, given a positive correlation of income with import consumption,
and may thus run trade surpluses.

The previous identities include government spending and taxation in national income and expenditures.

Differentiating government from household spending shows the effect of a government budget deficit on the
Current Account.

Identity 7:

National Expenditures =

Household Spending + Private Investment + Govt. Spending=

(National Income – Private Savings – Taxes)+ Private Investment + Govt. Spending

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By Identity 7, excess spending, or capital surplus is expressed as:

Identity 5.8:

National Expenditures – National Income =

Private Investment – Private Savings + Govt. Budget Deficit*

*Govt. budget deficit = taxes – govt. spending

Rearranging and combining Identity 5.4 and Identity 5.8 shows the impact of the government budget deficit on
the Current Account balance:

Identity 9:

Current Account Balance =

Private Savings Surplus – Govt. Budget Deficit

Thus, a country running a Current Account deficit is not saving enough to finance its private investment and
government budget deficit, and a country running a Current Account surplus has excess savings after financing
private investment and the government deficit.

C. Current Account Deficit 1

Responses to a Current Account deficit include currency devaluation, protectionism, and increasing savings.
 Devaluation
 An overvalued currency acts as a tax on exports and a subsidy to imports.
 Empirical review of currency devaluation and trade deficit
-1976-1980 – dollar depreciated as trade deficit first worsened and then improved.
-1980-1985 – dollar appreciated as trade deficit steadily worsened.
-1985-1987 – Dollar began depreciating while trade deficit rose steadily.
-2002 – Dollar began depreciating as trade deficit reached record levels

 Conventional explanations for disconnect between changes in currency value and changes in trade
deficit
 Lagged effects – time is needed for an exchange rate change to affect trade. Empirical review indicates
that changes in the dollar’s value explain less than 5% of the variation in the trade balance between 1970 and
2006.
 J-Curve theory – as currency depreciates, the trade deficit initially worsens and then improves over time.
Consistent with presence of lagged effects. Empirical review indicates that the trade deficit initially
worsened in 1985 but did not reach its 1985 level until four years later. Subsequent Current Account
improvements may have been due to budget deficit declines, rendering the J-curve theory inconclusive.
 The attractive investment climate in the 1980s caused investors to expand holdings of U.S. assets, which
bid up the value of the dollar such that Americans changed their assets for foreign goods and services,
causing a Financial Account surplus and Current Account deficit.
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Current Account Deficit 3

 Protectionism
 Tariffs increase the prices of imports, causing domestic consumers to opt for domestic substitutes.
 Quotas restrict supply of imports, thereby raising prices and causing domestic consumers to opt for
domestic substitutes.
 Protectionism thus results in increased domestic prices, erosion in purchasing power, and a decline in
living standards.
 Protectionism does not affect the trade balance, as other imports rise or exports fall.
 By Identity 5, as imports fall, exports will fall by an equal amount absent changes in saving or
investment.

 Increasing savings
 The prospect of receiving Social Security benefits may negatively affect saving habits.
 Increase tax-favored savings vehicles
 Switch from income tax to consumption tax
 Reduce the government budget deficit
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Module-2: Financing foreign operations- International financing and

International Financial Markets- Special Financing Vehicles-
Designing a global financing strategy.

2.1 Financing Foreign operations:

 Sources of Funds
 Internal
 Private Placement/Venture Capital
 Banks
 Insurance Companies
 Pension Funds
 Endowment Funds
 Capital Markets
 Governments
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Module- 3: MNC Investment- Analysis- International Portfolio Investment- foreign Direct Investment-
Capital budgeting for the MNC- The cost of capital for the foreign investments- management
of political risk- International Tax Planning
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Module- 4: Foreign Exchange Risk Management: Principles of Exposure Management- Working

capital management- internal and external techniques