International Payment Mechanism

International Payment Mechanism

Mechanism available for settlement of International Transactions Through international payment domestic currency of one country is converted into the currency of another country through foreign exchange market. Three major form of international money are 1) Gold 2) Foreign Reserve currencies 3) SDR Special Drawing Rights

Instruments of External Payments

1. Foreign Bills of Exchange: It is a customary form of making international payments. A written request or an order form between two transacting parties. 2. Cheques and Bank Drafts

3. Telegraphic Transfers: Transferred by cable or telax

4. Mail Transfer:

Foreign Exchange Market

Is a market in which currencies of different countries are bought & sold by individuals, firms, banks & brokers
Control & regulate to ensure it works in orderly fashion. Lenders of last resort. Prevents violent fluctuations in Ex rate
Facilitators of foreign currency to Banks Help in striking deals on a commission basis They do not buy or sell themselves.

Central Banks Brokers

Commercial Banks Exporters, Importers, Tourists, Investors, Immigrants

Providers of foreign currency to users Quote daily buying & selling rates Manage the demand & supply for a currency
Actual users. They are the buyers & sellers of foreign currencies

Function of Foreign Exchange Market?

FE market is a market in which foreign Exchange transactions take place 1) Transfer of Purchasing Power: Transfer funds from one country to another for facilitating international trade and capital movement. 2) Provision of Credit: Growth of Foreign Trade 3) Minimising Risk: - Hedging

The FE Markets
It classified on the basis of nature of Transaction

FE Market

Spot Market

Forward Market

The Markets

Spot Markets

When buyers & sellers of a currency settle their transaction within 2 days of the deal it is called spot transaction Spot sale & purchase makes it spot market And the rate is spot rate For all practical purposes spot rate is the prevailing exchange rate

Forward Markets

When buyers & sellers enter an agreement to buy & sell a foreign currency after 90 days of the deal it is called forward transaction Sale & purchase transaction after 90 days makes it forward market And the settled rate is forward rate

The Transactions
Hedging

Is settling the exchange rate in advance for a future transaction with a view to avoiding loss that might arise due to exchange depreciation in future
It is essentially covering risk arising out of exchange rate fluctuations

The exporter is assured of the value of his exports at the current exchange rate An importer secures his interest against possible increases in cost of imports due to exchange rate fluctuations

The Transactions
Arbitrage

Is an act of simultaneous purchase & sale of different currencies in two or more exchange markets
The objective is to make profit taking advantage of exchange rate differentials in various markets It equates the foreign exchange rates in all major foreign exchange markets It leads to transfer of foreign exchange from the markets where rate is low to the markets where the rate is high It works as a stabilising factor in foreign exchange markets As it equates demand for foreign exchange with its supply

The Transactions
Speculations

Is an act of buying & selling currency under uncertain conditions with a view to make profits Speculators Buy a currency when its weak and sell when its strong If they expect rate to decrease they may sell forward at the current rate and buy spot when they need currency for delivery And If they expect rate to increase they may buy forward at the current rate and then sell spot immediately. It has both effects Stabilizing if speculators buy when its cheap and sell when its dear. Destabilizing if they sell when rate is cheap expecting it decrease more and buy if rates are rising expecting them rise further

What is Foreign Exchange Rate?

Price of one currency in terms of another currency. It is rate at which one currency is exchanged for another

Determination of Exchange Rate

Exchange Rate is determined by demand and supply of Foreign Exchange

The Equilibrium Exchange Rate

D R = 44 Exchange Rate (Rs / $) Excess Supply S

R = 42

R= 40 Excess Demand D S O Q Quantity of Dollars

Determination of Exchange Rate

Appreciation of a currency: Is a increase in the value in terms of another foreign currency For EX: Rs 43 = $ 1 Rs 42 = $1

Strengthening / Appreciation of Indian Rupee Depreciation of Dollar

Depreciation of a Currency: Is a decrease in the value in terms of another foreign currency For EX: Rs 43 = $ 1 Rs 44 = $1

Weakening / Depreciation of Indian Rupee Appreciation of Dollar

Devaluation: One time lowering of value of its currency in terms of foreign exchange occasionally by a country Revaluation: If the country raises the value of its currency in terms of foreign currency

Determination of Exchange Rate

Demand for Foreign Exchange ( US Dollar)

The Indian individuals, firms or Govt who import goods from the USA Indians travellers and Students Indians who want to invest in equity , shares and bonds of US Indian firms who want to invest in physical assets in US

When Dollar Depreciates / Rupee Appreciate

Import becomes cheaper Demand (Import) increases More demand of Dollar

When Dollar Appreciates / Rupee Depreciate

Import becomes expensive Demand (Import) decreases Less demand of dollar

Therefore lower price of dollar, greater quantity is demanded for imports Higher price of dollar, smaller quantity is demanded for imports.

Determination of Exchange Rate

Supply of Foreign Exchange ( US Dollar )

The Indian individuals, firms or Govt who export goods to USA Foreign travellers to India Americans who want to invest in equity, shares and bonds of India American firms who want to invest in physical assets Indians settled aboard send money home (Remittances)

When Dollar Appreciates / Rupee Depreciate Indian exports cheaper Increase in exports More supply of dollars
When Dollar Depreciates / Rupee Appreciate Indian goods become expensive Decrease in exports Less supply of dollar

Determination of Exchange Rate

Exchange Rate

Fixed

Flexible

Fixed Exchange Rate

When the Govt agrees to maintain the convertibility of the currency. The Govt acting through the central bank agrees to buy and sell as much currency as it is needed. Countries keep there currency at a fixed rate and change their value only at infrequent intervals when the economic situation forces them to do so.

Maintaining Fixed Rates - Demand For Rupee Increases

D1
D S

Demand increase That is demand for Indian Goods & Services has risen Rupee appreciates vs $
D1

R = 0.026
Exchange Rate (Re /$)

R = 0.025

To get it back to its original rate Supply has to increase

D S O Q Quantity of Rupees

RBI prints more money & Sells them in exchange for $

Foreign Exchange Reserves Increases

Maintaining Fixed Rates - Demand For Rupee Decreases

D S Exchange Rate (Re /$)

Demand reduces

Rupee depreciates vs $
R = 0.025 E

R= 0.024 Less Demand D S O Q Quantity of Rupees

To get it back to its original rate Supply has to decrease

RBI buys Rupees in exchange for $

Foreign Exchange Reserves Reduces

Arguments for Fixed Exchange Rate

It provides development and growth of Foreign Trade. It provides stability in foreign exchange market and reduces risk and uncertainty. It prevents depreciation of currency for the countries (developing) which faces persistent problem of deficit in BOP. Smooth flow of International capital as investors are interested in a country having stable currency. Eliminates the possibility of speculations. Necessary for the growth of international money and capital market Encourages Globalisation or integration of the world economy

Demerits of Fixed Exchange Rate

Countries with persistent deficit / surplus in BOP have long term disequilibrium. Deficit in BOP cannot always be corrected by a regular drawing form the foreign exchange and sale of gold.

Borrowing money from IMF could lead to devaluation

Which leads to inflation Surplus in BOP could also lead to inflation

Flexible Exchange Rate

The rate of exchange is allowed to be freely determined by interaction between demand and supply of foreign exchange in the foreign exchange market. Under this the first impact of BOP is on the Exchange Rate.

Surplus: Excess demand for countrys currency and exchange rate will rise. Deficit:
Excess supply of the countrys currency and exchange rate will fall.

Factors effecting Demand and Supply

Interest Rates Rate of Inflation Political or Military Unrest Domestic Financial Market Strong Domestic Economy Business Environment Stock Markets Economic data Balance of Trade Government budget deficits/surpluses Rumors

Maintaining Flexible Rates - Increase in Supply

Increase USA Income
D

S
Exchange Rate (Re /$)

That is demand for Indian Goods & Services has risen Increase in Supply of $ Supply curve shift to SS

R R

E1 Rupee appreciates vs $
D

S
O

S
Q Quantity of US Dollars

Dollar Depreciate New Exchange Rate at E1

Maintaining Flexible Rates - Increase in Demand

D D

Increase in India Income

S

E1
Exchange Rate (Re /$) R

Increase in Demand for US Exports Increase in Demand of $ Demand curve shift to DD Rupee depreciates vs $
D

Dollar appreciate
O Q Q1 Quantity of US Dollars

New Exchange Rate at E1

Arguments for Flexible Exchange Rate

It automatically deals with the BOP problem. During Deficit: External value falls , discourages import and encourages export. It provides freedom in respect of domestic economic policies. It is not necessary for economies to depend upon exchange rate for planning there domestic economic policy. Its self adjusting and Govt intervention are not required. You can predict the exchange rate It gives a true picture of the strength of the currency in foreign exchange market

Which system should a country adopt?

It depends upon The characteristics of the economy Values and view of a political nature