Thakur Institute of Management Studies and

Research, Mumbai.

Course : Diploma (2008-09)

Semester : II
Marks : 100
Subject : International Finance
Faculty : Prof. Akshay Damani
FCA,MBA,Mcom,SET

References:

Books:
International Financial Management – Sharan
International Financial Markets – H R Machiragn
International Financial Management – V K BHalla
International Financial Management – Sathye, Rose and Allen
International Finance:

Chapter Name / Topic

1 Balance of Payments (part 1 and 2)
(Structure and Equilibrium) – Case studies and Problems
2 Foreign Exchange Markets
3 Mechanics of Foreign Exchange Markets
4 Economic Unions and Trade agreements
5 India’s Foreign Trade – Promotion & Control
Chapter 1:

Balance of Payments:

Introduction: All the economies in the world carry out various transactions with each
other, which bear an economic value. For instance, goods sold by Italy to France for
cash payments or services rendered by a British resident to Russian resident and in
return received goods of same value. Also there can be one sided transactions like gift
received by an Indian resident from a foreigner. All these transactions are exactly in the
same spirit, as they would have been carried out by two residents or companies of the
same country. Then what so special about these transactions? Why these transactions
are worth studying in a special context? One obvious reason is the difference of
currency. The two persons in above transactions are capable of transacting in different
currencies. Hence to complete the trade, they will have to refer to the Foreign Exchange
Reserves of the respective countries. To appreciate such transactions, which involve
foreign exchange (Forex) i.e. foreign currency, the government should have sound
position in Forex reserves. It can be explicitly known even to the government if and only
if it maintains separate accounts for such transactions.

THE BALANCE OF PAYMENTS (B0P):

BoP is a standard double entry accounting record to capture all the transactions of an
economy with Rest of the World (RoW). It is a regular double entry accounting statement
of economic transactions between the residents of a country and the nonresidents. For
our reference it may be enough to interpret ‘nonresidents’ as ‘residents of foreign
countries’. The term ‘economic transactions’ denotes any transaction wherein something
of economic value is provided by one party to another.
Balance of payments is a record of payments and receipts of the country. Hence in strict
sense it is a calculation of Balance of Payments and Receipts.

COMPONENTS OF THE BALANCE OF PAYMENTS:

As it is evident, balance of payment is a collection of accounts of all such eligible
transactions, which shall have bearing on the Forex position of the economy. This SoP,
the collection of accounts is conventionally grouped into three main accounts with
subdivisions in each.

The three major accounts in the BoP are:

(A) The Current account.
(B) The Capital account.
(C) The Reserve account.
Table LI shows the general structure of Balance of Payments of the Government of
India. Items under ‘A refer to the current account, ‘B’ to the capital account and C’, D’,
‘H’ (marked by) collectively refer to reserve account movements.
We shall discuss components of Balance of Payments in detail in following paragraphs.

TABLE 1.1—COMPONENTS OF BALANCE OF PAYMENTS

Term Credit Debit Net
(A) Current Account
(I) Merchandise
(I) Private
(II) Government
(ii) Non-monetary Gold Movement
(iii) Invisibles
(I) Travel
(II) Transportation
(In) insurance
(Iv) Investment Income
(v) Government not elsewhere classified
vi) Miscellaneous
vii) Transfer Payments— official and Private

Total Current Account (I + II + Iii)

(B) Capital Account

(I) Private
(I)Long Term
01) Short Tern,
(2) Banking
(3) Official
(I) Loans
(ii) Amortization
(iii) Miscellaneous
Total Capital Account (I+ 2 + 3)
(C) IMF
(0) SDR Allocation
(E)(B+C+O)
(F)(A+E)
(GJ Errors
(H) Reserves and Monetary Gold

Note: C, V’, ‘H’ (marked by) collectively refer to Reserve Account.

(Source, Balance of Payments Compilation Manual RBI.).

THE CURRENT ACCOUNT:

Current Account includes all trade transactions (Export-Import) of tangible goods and
also of services. It also includes transactions of gift and of income derived on foreign
investments. Current Account transactions have effect in income statement of the
respective entities. - -

Current account includes all trade transactions of tangible goods and of services It also
includes transactions of gift and of income derived on foreign investments. Current
account transactions have effect in income statement of the respective entities.

Goods: Transfer of tangible goods

Non monetary gold movements: held by RBI as a part of international reserves. Gold
that is traded.

Invisibles: Trade in services. Transportation, travel of tourists, Insurance, Bops, Kops,

etc.

Non-services: Transfer payments from people working abroad. Remittances.

CAPITAL account: Private sector capital flows: Loans received by private entities in India
from NRIs, Investment by foreigners in shares of Indian companies, repayment of loans
to residents by non-residents, etc.

Banking capital: This covers changes in assets and liabilities of commercial banks. This
includes government banks, private banks as well as co-operative banks that are
authorized to deal in foreign exchange. Assets are the balances held by foreign
branches of Indian banks and liabilities are deposits balances held by foreign banks in
India. Increase in asset is Debit and increase in liability is credit and vice –versa

Official Capital Flows: this includes transactions of government of India and RBI that
affect foreign financial assets and liabilities of Government of India.

The Resaves account: 2 accounts namely: IMF, SDR and Reserves and Monetary Gold
are collectively called as the Reserve account.

The Balance of Payments always balances: Consider a domestic situation where a

person earns Rs. 15000 as his salary for a month. His expenses for that month are
16000. there is an imbalance of Rs. 1000. he has 2 options, either to take a loan or
incur expenses on credit and repay in future. Another possibility is use his
savings/reserves.

However ultimately the account balances. The same logic applies to the BoP.

Class exercise:

1) The following BoP information is available for a particular economy.

Decline in foreign exchange reserves 500

Long term capital inflows (net) 600

Merchandise exports 2000

Export of services 3000

Import of services 2500

Determine BOP balance

2) The following BoP information is available for a particular economy.

Increase in foreign exchange reserves 500

Short term capital outflow (net) 1000

Merchandise exports 1900

Merchandise imports 1700

Export of services 3100

Import of services 1500

Determine BOP balance

Q3 the following data pertains to the BoP for a country for the year 2000

Government loans from abroad 30

Government loans to abroad 60

Direct investment abroad 58

FDI in India 191

Foreign short term loans investment in India 60

Short term loans and investments abroad 451

Private remittance to abroad (transfers) 85

Private remittances from abroad (transfers) 211

Determine BOP balance

Q4) the following Bop information is available:

Increase in foreign exchange reserves 450

Short term capital outflow (net) 1200

Merchandise exports 2000

Merchandise imports 1500

Export of services 2700

Import of services 2200

Determine long term capital account only.

India's Balance of
Payments (2008-09)
India's foreign exchange reserves stand at $252.97 billion as on April 10, 2009

BALANCE OF PAYMENT

Widening trade deficit

India’s trade deficit on a balance of payments (Bop) basis has widened

significantly by 52.04 percent to $ 105.33 26 billion in the nine months (April-
December) of fiscal year* 2008-09 from $ 68.28 billion in the comparable period in
previous fiscal. The widening trade deficit is attributed to significant growth in
imports. During the nine-month period (April-December, 2008) imports were up
30.60 percent to $ 238.86 billion from $ 182.89 percent in the comparable period
in fiscal 2007-08.This is revealed in a report of the country’s central banking
authority Reserve Bank of India (RBI) on India's Balance of Payments
Developments during the Third Quarter (April-December 2008) of fiscal
2008-09.

The key features of India’s BoP that emerged at the end of Q3 of fiscal 2008-09
were: the key features of India’s BoP that emerged in April-December 2008 were:
(I) widening of trade deficit led by high growth in imports and slowdown in exports,
(ii) increase in invisibles surplus, led by remittances from overseas Indians and
software services exports, which financed about 65 per cent of trade deficit, (iii)
higher current account deficit due to large trade deficit, (iv) lower net capital flows
mainly led by large net outflows under portfolio investment and large repayments
under short-term trade credit, and (v) sharp decline in reserves.

Major Items of India's balance of Payments (April-December, 2008)

(In $ million)

April-December (2008-09) April-December (2007-08)

(P) (PR)
Exports 133,527 113,614
Imports 238,864 182,894
Trade Balance -105,337 -69280
Invisibles, net 68,868 53772
Current Account Balance -36,469 -15508
Capital Account* 16,089 82,682
Change in Reserves#
(+ indicates increase;- 20,380 -67,174
indicates decrease)

Including errors & omissions; # On Bop basis excluding valuation; P: Preliminary,

PR: Partially revised. R: revised
SOURCE: Reserve Bank of India Report

Invisibles
Both invisibles receipts and payments recorded negative growth, though marginal,
during Q3 of 2008-09 reflecting the impact of global economic slowdown.

(ii) Invisibles receipts registered a marginal decline of 0.6 per cent in Q3 of 2008-
09 (as against an increase of 33.2 per cent in Q3 of 2007-08) on account of a
decline in travel, transportation and insurance receipts in the services category
and private transfers and investment income receipts. Overall services exports,
however, witnessed a marginal increase of 0.5 per cent during the quarter
(compared with a higher growth of 33.4 per cent in Q3 of 2007-08) due to
increase in software exports.

Private transfer receipts declined marginally during Q3 of 2008-09. Software

services receipts, on the other hand, increased by 11.8 per cent during the
quarter.

(iv) Invisibles payments also recorded a marginal negative growth of 2.1 per cent
during Q3 of 2008-09 mainly led by sharp decline in payments under travel,
software and business services account. There was also a marginal decline in
payments under investment income in the form of interest payments and
dividends.

(v) With the decline in invisibles payments higher than the receipts, the net
invisibles (invisibles receipts minus invisibles payments) rose moderately to US$
21.7 billion in Q3 of 2008-09. At this level, net invisibles surplus financed 59.7 per
cent of trade deficit in Q3 of 2008-09 (82.6 per cent in Q3 of 2007-08).

Current Account Deficit

On account of large trade deficit and with moderate increase in net invisibles, the
current account deficit rose sharply to US$ 14.6 billion in Q3 of 2008-09 (US$ 4.5
billion in Q3 of 2007-08). This level of CAD was the highest quarterly deficit since
1990.

Capital Account and Reserves

Capital account balance turned negative showing outflows of US$ 3.7 billion
during the Q3 of 2008-09 (net inflows at US$ 31.0 billion during Q3 of 2007-08) for
the first time since Q1 of 1998-99 mainly due to net outflows under portfolio
investment, banking capital and short-term trade credit.

(ii) The gross capital inflows to India during Q3 of 2008-09 amounted to US$ 70.0
billion (US$ 127.3 billion in Q3 of 2007-08) as against gross outflows from India at
US$ 73.6 billion (US$ 96.3 billion in Q3 of 2007-08). Other components of the
capital account which recorded a fall during the quarter were inflows and outflows
under foreign direct investment and external commercial borrowings, while inflows
under short-term trade credit also declined during the quarter.

(iii) Net FDI flows (net inward FDI minus net outward FDI) amounted to US$ 0.8
billion in Q3 of 2008-09 (US$ 2.0 billion in Q3 of 2007-08). Net inward FDI stood
at US$ 6.7 billion during Q3 of 2008-09 (US$ 7.9 billion in Q3 of 2007-08). Net
outward FDI remained buoyant at US$ 5.9 billion in Q3 of 2008-09 (US$ 5.8 billion
in Q3 of 2007-08).

(iv) Portfolio investment primarily comprising foreign institutional investors’ (FIIs)

investments and American Depository Receipts (ADRs)/Global Depository
Receipts (GDRs) continued to witness net outflows at US$ 5.8 billion in Q3 of
2008-09 (as against net inflows of US$ 14.9 billion in Q3 of 2007-08). Outflows
under portfolio investment were led by large sales of equities by FIIs in the Indian
stock market and slowdown in net inflows under ADRs/GDRs due to drying-up of
liquidity in the overseas market. Another feature observed in the context of
portfolio flows was that not only net flows remained negative but both inflows as
well as outflows reduced sharply during the quarter.

(v) Net External Commercial Borrowings (ECBs) remained lower at US$ 3.9 billion
in Q3 of 2008-09 (US$ 6.2 billion in Q3 of 2007-08) due to drying up of liquidity
abroad and increased cost of borrowings.

(vi) Short-term trade credit to India witnessed a net outflow of US$ 3.1 billion (as
against inflows of US$ 4.1 billion in Q3 of 2007-08) mainly due to lower
disbursements reflecting tightness in the overseas market and increased
repayments as roll over was difficult.

(vii) There was a turnaround in the inflows under the non-resident Indian (NRI)
deposits to US$ 1.0 billion during Q3 of 2008-09 (outflow of US$ 0.9 billion during
Q3 of 2007-08) responding to the hike in ceiling interest rates on NRI deposits.

(viii) The foreign exchange reserves on BoP basis (i.e., excluding valuation)
declined sharply by US$ 17.9 billion in Q3 of 2008-09 as against an accretion of
reserves of US$ 26.7 billion in Q3 of 2007-08. The decline in the reserves was
due to widening of current account deficit combined with outflows under the
capital account. The largest decline in reserves on a BoP basis during any one
quarter in earlier years at US$ 4.7 billion was observed in the Q3 of 2005-06.
Even during the balance of payments crisis of the early 1990s, a decline of US$
1.5 billion was seen in the third quarter (October-December 1990), while a decline
of US$ 1.1 billion was observed during April-June 1991.

Balance of Payments (BoP) for April- December, 2008

Merchandise Trade (April-December, 2008)

(i) On a BoP basis, India’s merchandise exports posted a growth of 17.5 percent
during April-December 2008 (21.9 percent in the corresponding period of the
previous year).

(ii) According to the commodity-wise data available for April-November 2008 from
the DGCI&S, the exports of engineering goods and petroleum products showed
high growth, while growth in textile products, ores and minerals, and gems and
jewellery registered sharp slowdown. The exports of marine products, raw cotton,
iron ore and handicrafts declined during the period.

(iii) Import payments, on a BoP basis, remained higher and recorded a growth of
30.6 percent during April-December 2008 as compared with 28.3 percent in the
corresponding period of the previous year.
 (iv) According to the DGCI&S data, while oil imports recorded a significant growth
of 43.3 percent in April-December 2008 (24 percent in the corresponding period of
the previous year), growth in non-oil imports slowed down to 25 percent from 29.3
percent in the corresponding period of the previous year. In absolute terms, oil
imports accounted for about 34.7 percent of total imports during April-December
2008 (31.7 percent in the corresponding period of the previous year).

(v) According to the DGCI&S data, out of the total increase in imports of $ 52.8
billion in April-December 2008 over the corresponding period of the previous year,
oil imports contributed an increase of $ 23.6 billion (44.6 percent as against 28.4
percent in April-December 2007), while non-oil imports contributed an increase of
$ 29.2 billion (55.4 percent as against 71.6 percent in April-December 2007).

(vi) According to the commodity-wise DGCI&S data available for April-November

2008, the items under non-oil imports which showed a high growth were fertilizers,
paper and paper products, manufactures of metals, project goods, export related
items like pearls, precious and semi-precious stones, chemicals, and coal, coke
and briquettes, while imports of items like pulses, electronic goods, and gold and
silver declined.

(vii) The sharp increase in oil imports reflected the impact of the increase in oil
price of the Indian basket of international crude (a mix of Oman, Dubai and Brent
varieties), which had increased to an average of $ 132.5 per barrel in July 2008,
but came down subsequently to an average of $ 40.6 per barrel in December
2008. The average oil prices were higher at $ 95.5 per barrel in April-December
2008 as compared with an average of $ 74.7 per barrel in the corresponding
period of the previous year

INDIA’s cumulative value of exports for the period April- February, 2009 stood at $
156597 million (Rs.705231 crore) as against $ 145878 million (Rs.586233 crore)
registering a growth of 7.3 percent in Dollar terms and 20.3 percent in Rupee terms
over the same period last year. Imports during April-February 2009 were valued at $
271687 million registering the growth of 19.1 percent and in Rupee terms it stood at
Rs. 1223213 signifying a growth of 33.4 percent.

EXPORTS & IMPORTS (April-February, FY 2008-09)

In $ Million In Rs Crore
Exports including re-exports
2007-2008 145878 586233
2008-09 156597 705231
Growth 2008-09/2007-
7.3 20.3
2008 (percent)
Imports
2007-08 228081 917179
2008-09 271687 1223213
Growth 2008-09/2007-
19.1 33.4
2008 (percent)
Trade Balance
2007-08 -82203 -330946
2008-09 -115090 -517982

Figures for 2007-08 are the latest revised whereas figures for 2008-09 are
provisional

The trade deficit for April- February, 2009 was estimated at $ 115090 million which
was higher than the deficit at $ 82203 million during comparable period of fiscal
2007-08.

Source: Federal Ministry of Commerce, Government of India

Trade Deficit

i) On a BoP basis, the merchandise trade deficit widened sharply to US$ 105.3
billion during April-December 2008 from US$ 69.3 billion in April-December 2007 on
account of higher growth in imports coupled with the slowdown in exports

Invisibles

Invisible Receipts
i) Invisibles receipts witnessed a lower growth of 18.8 percent during April-
December 2008 (30.1 percent in the corresponding period of the previous year)
mainly due to slow pace of growth in travel, business services and investment
income receipts.

(ii) Travel receipts at $ 8.2 billion during April-December 2008 rose moderately by
6.2 percent (26.2 percent in April-December 2007) reflecting slowdown in tourist
arrivals in the country.

viii) Private transfers are mainly in the form of (i) Inward remittances from Indian
workers abroad for family maintenance, (ii) Local withdrawal from NRI Rupee
deposits, (iii) Gold and silver brought through passenger baggage, and (iv)
Personal gifts/donations to charitable/religious institutions.

(iv) Private transfer receipts, comprising mainly remittances from Indians working
overseas, increased to $ 36.9 billion in April-December 2008 from $ 29.3 billion in
the corresponding period of the previous year. Private transfer receipts constituted
14.4 percent of current receipts in April-December 2008 (13.5 percent in the
corresponding period of the previous year).

(vii) Under Private transfers, the inward remittances for family maintenance
accounted for about 50.4 percent of the total private transfer receipts, while local
withdrawals accounted for about 44 percent in April-December 2008 as against
49.7 per cent and 43.3 per cent, respectively, in April-December 2007.

viii) Software receipts at US$ 34.6 billion showed a steady growth of 26 per cent in
April-December 2008. The NASSCOM has projected a growth rate of 16-17 per
cent during 2008-09 with a target of software services export revenues at around $
47 billion for the financial year.
(ix) Miscellaneous receipts, excluding software exports, stood at $ 22.4 billion in
April-December 2008 ($ 20.6 billion in April-December 2007).

(x) The key components of the business services receipts and payments were
mainly the trade related services, business and management consultancy services,
architectural, engineering and other technical services, and services relating to
maintenance of offices abroad. These reflect the underlying momentum in trade of
professional and technology related services. While receipts under trade related
and business and management consultancy services increased, the receipts under
architectural, engineering, and other technical services declined during April-
December 2008.

(xi) Investment income receipts amounted to $ 10.3 billion in April-December 2008

as compared with $ 9.3 billion in April-December 2007.

Inflows & Outflows from NRI Deposits and Local Withdrawals

(In $ million)

Inflows Outflows Local Withdrawals

2006-07 (R) 19914 15593 13208
2007-08 (PR) 29401 29222 18919
April-December
18,683 19614 12669
2007 (PR)
April-December
27760 25645 16236
2007 (PR)

P: Preliminary, PR: Partially revised. R: Revised

SOURCE: Reserve Bank of India Report, 2009

Invisible Payments
(i) Like invisibles receipts, invisibles payments also showed a lower growth of 8.7
percent in April-December 2008 (13.2 percent in April-December 2007) mainly on
account of slowdown in payments relating to travel, software services and a number
of business and professional services.

(ii) Travel payments growth remained lower at 5.9 percent during April-December
2008 (31.1 percent in April-December 2007) reflecting a sharp reduction in
outbound travels. According to the International Transport Association, international
passenger volumes increased marginally by 1.6 percent in 2008 led by a 1.5
percent decline for Asia-Pacific region.

(iii) Investment income payments, reflecting mainly the interest payments on

commercial borrowings, external assistance and non-resident deposits, and
reinvested earnings of the foreign direct investment (FDI) enterprises operating in
India declined marginally to $ 13.3 billion in April-December 2008 ($ 13.5 billion in
the corresponding period of the previous year) mainly due to decline in interest
payments on NRI deposits and reinvested earnings of FDI companies in India

Invisibles Balance
(i) Net invisibles (invisibles receipts minus invisibles payments) stood higher at $
68.9 billion during April-December 2008 ($ 53.8 billion during April-December 2007)
mainly led by receipts under private transfers and software services. At this level,
the invisibles surplus financed about 65.4 percent of trade deficit during April-
December 2008 as against 77.6 percent during April-December 2007.

Current Account Deficit

(i) Despite higher net invisibles surplus, the large trade deficit mainly on account of
higher growth in imports coupled with slowdown in export growth in the third quarter
led to higher current account deficit at $ 36.5 billion in April-December 2008 ($ 15.5
billion during April-December 2007)

Capital Account

(i)The gross capital inflows to India during April-December 2008 decreased to $

246.4 billion ($ 291.8 billion in April-December 2007) as against an increase in
outflows to $ 231.1 billion ($ 209.8 billion in April-December 2007)

(ii) Net capital flows, however, at $15.3 billion in April-December 2008 remained
much lower as compared with $ 82.0 billion in April-December 2007. Under net
capital flows, all the major components except FDI and NRI deposits, showed
decline during April-December 2008 from their level in the corresponding period of
the previous year. The decline was sharp in the case of portfolio flows and short-
term trade credits to India.

(iii) Net inward FDI into India remained buoyant at $ 27.4 billion during April-
December 2008 ($ 20.0 billion in April-December 2007) reflecting relatively better
investment climate in India and the continuing liberalization measures to attract FDI.
During April-December 2008, FDI was channeled mainly into manufacturing (21.4
percent) followed by financial services (14.1 percent) and communication services
(12 percent).

(iv) Net outward FDI from India continued to remain high at $ 12.0 billion during
April-December 2008 even in the current economic situation. However, it was
marginally lower than that of $ 13.1 billion invested during April-December 2007.
Due to large inward FDI, the net FDI (inward FDI minus outward FDI) was higher at
$ 15.4 billion in April-December 2008 as compared with $ 6.9 billion in April-
December 2007.

(v) Portfolio investment comprising mainly foreign institutional investors (FIIs)

investments and American depository receipts (ADRs)/global depository receipts
(GDRs) witnessed large net outflows of $ 11.3 billion during April-December 2008
(net inflows of $ 33.3 billion in April-December 2007) due to large sales of equities
by FIIs in the Indian stock market reflecting bearish market conditions and
slowdown in the global economy. The inflows under ADRs/ GDRs slowed down to $
1.1 billion in April-December 2008 ($ 8.4 billion in April-December 2007).

vi) Net external commercial borrowings (ECBs) inflow slowed down to $ 7.1 billion
in April-December 2008 ($ 17.4 billion in April-December 2007) mainly due to tight
liquidity conditions in the overseas markets.
 (vii) Banking capital (net), including NRI deposits, turned marginally negative to $
0.1 billion during April-December 2008 as against net inflows of $ 5.9 billion during
April-December 2007. Among the components of banking capital, NRI deposits
witnessed a net inflow of $ 2.1 billion in April-December 2008, a turnaround from
net outflow of $ 0.9 billion in April-December 2007.

(viii) Gross disbursement of short-term trade credit stood at $ 31.4 billion during
April-December 2008 ($ 32.2 billion in April-December 2007). Repayments of short-
term trade credit were high at $ 30.8 billion during April-December 2008 (as
compared with $ 21.5 billion during April-December 2007) due to some problems in
rollover observed during the third quarter. Net short-term trade credit stood at $ 0.5
billion (inclusive of suppliers’ credit up to 180 days) during April-December 2008 as
compared with $ 10.7 billion during the same period of the previous year.

(ix) Other capital includes leads and lags in exports, funds held abroad, advances
received pending for issue of shares under FDI and other capital not included
elsewhere (n.i.e.). Other capital recorded net inflows of $ 1.9 billion in April-
December 2008.

Variation in Reserves

(i) The decline in foreign exchange reserves on BoP basis (i.e., excluding valuation)
was $ 20.4 billion in April-December 2008 (as against accretion to reserves of $
67.2 billion in April-December 2007). Taking into account the valuation loss, foreign
exchange reserves recorded a decline of $ 53.8 billion during April-December 2008
(as against an accretion to reserves of $ 76.1 billion in April-December 2007).

(ii) At the end of December 2008, outstanding foreign exchange reserves stood at $
256.0 billion.

Reconciliation of import data

(i) During April-December 2008, based on the records of the DGCI&S imports data
and the BoP merchandise imports, the difference between the two data sets works
out to about $ 14.4 billion

Source: (indiaonestop.com)
Chapter 2:

Exchange Rate Regimes:

Definition:
Rate at which one currency may be converted into another. Also called rate of
exchange or foreign exchange rate or currency exchange rate.
(investorwords.com)

Floating and Fixed Exchange Rate Systems

There are two basic systems that can be used to determine the exchange rate between
one country’s currency and another’s; a floating exchange rate system and a fixed
exchange rate system.

Under a floating exchange rate system, the value of a country’s currency is determined
by the supply and demand for that currency in exchange for another in a private market
operated by major international banks.

In contrast, in a fixed exchange rate system a country’s government announces, or

decrees, what its currency will be worth in terms of “something else” and also sets up the
“rules of exchange.” The “something else” to which a currency value is set and the “rules
of exchange” determines the type of fixed exchange rate system, of which there are
many. For example, if the government sets its currency value in terms of a fixed weight
of gold then we have a gold standard. If the currency value is set to a fixed amount of
another country’s currency, then it is a reserve currency standard.

As we review several ways in which a fixed exchange rate system can work, we will
highlight some of the advantages and disadvantages of the system. In anticipation, it is
worth noting that one key advantage of fixed exchange rates is the elimination of
exchange rate risk, which can greatly enhance international trade and investment. A
second key advantage is the discipline a fixed exchange rate system imposes on a
country’s monetary authority, likely to result in a much lower inflation rate.

1. Gold Standard
 2. Reserve Currency Standard
3. Gold Exchange Standard
4. Other Fixed Exchange Rate Variations

(Surannovic, S., (2005), International Finance Theory and Policy)

Bretton woods system:

Nations attempted to revive the gold standard following World War I, but it collapsed
entirely during the Great Depression of the 1930s. Some economists said adherence to
the gold standard had prevented monetary authorities from expanding the money supply
rapidly enough to revive economic activity. In any event, representatives of most of the
world's leading nations met at Bretton Woods, New Hampshire, in 1944 to create a new
international monetary system. Because the United States at the time accounted for over
half of the world's manufacturing capacity and held most of the world's gold, the leaders
decided to tie world currencies to the dollar, which, in turn, they agreed should be
convertible into gold at $35 per ounce.

Under the Bretton Woods system, central banks of countries other than the United
States were given the task of maintaining fixed exchange rates between their currencies
and the dollar. They did this by intervening in foreign exchange markets. If a country's
currency was too high relative to the dollar, its central bank would sell its currency in
exchange for dollars, driving down the value of its currency. Conversely, if the value of a
country's money was too low, the country would buy its own currency, thereby driving up
the price.

The Bretton Woods system lasted until 1971. By that time, inflation in the United States
and a growing American trade deficit were undermining the value of the dollar.
Americans urged Germany and Japan, both of which had favorable payments balances,
to appreciate their currencies. But those nations were reluctant to take that step, since
raising the value of their currencies would increases prices for their goods and hurt their
exports. Finally, the United States abandoned the fixed value of the dollar and allowed it
to "float" -- that is, to fluctuate against other currencies. The dollar promptly fell. World
leaders sought to revive the Bretton Woods system with the so-called Smithsonian
Agreement in 1971, but the effort failed. By 1973, the United States and other nations
agreed to allow exchange rates to float.

Economists call the resulting system a "managed float regime," meaning that even
though exchange rates for most currencies float, central banks still intervene to prevent
sharp changes. As in 1971, countries with large trade surpluses often sell their own
currencies in an effort to prevent them from appreciating (and thereby hurting exports).
By the same token, countries with large deficits often buy their own currencies in order to
prevent depreciation, which raises domestic prices. But there are limits to what can be
accomplished through intervention, especially for countries with large trade deficits.
Eventually, a country that intervenes to support its currency may deplete its international
reserves, making it unable to continue buttressing the currency and potentially leaving it
unable to meet its international obligations.

(U.S. Department of State,About.com:Economics.com)

Freely Floating Exchange Rate Systems:

Exchange Rate Systems That Affect Market Behavior

Since an exchange operates in different types of exchange rate systems, it is

fundamental to understand what these are. There are four main types of these exchange
rate systems where an exchange rate can operate. Here is a description of the different
types of exchange rate systems.

Fixed Exchange Rates System

It is true that every government will be interested in its currency's performance. A

country's currency performance affects other markets in the economy. The exchange
rate of that currency also becomes a reflection of economic performance, political
conditions, and the general mood of a country's economy.

In this exchange rate system a government would exercise control over the exchange
rate. Thus inducing or maintaining that country's exchange rate to a narrowed-down
price range. Policies will be passed or direct-action (in the form of investments etc.) will
be used to keep the exchange rate pegged at the desired range.

This exchange rate system has certain advantages. Exporters and importers have a
more stable profitability. Normally there would be less speculation in this exchange rate
system. This helps the import/export firms ensure that their sales would remain robust
whatever the exchange rate is. The inflation rate would be kept to a minimum. And a
steady price would attract more trade and investment.

Semi-Fixed Exchange Rate System

This system is pretty much like the fully fixed exchange rate system. In this exchange
rate system currencies are allowed to move but only within a specified permitted range.
Governments exercising this system would lend to economic policy making targeting the
exchange rate. Interest rates may also be set to meet the targeted exchange rate.

In this exchange rate system there would be varying levels of control over exchange
rates. There have been studies that show that in an economy of high capital mobility this
system is unstable.

It allowed a country or a government that has poor monetary policy to exercise

discretionary power overwhelmingly. Thus in cases like this, this exchange rate system
would not be beneficiary to a government's economic system.

Free Floating Exchange Rate System

In a free floating exchange rate system the forces of supply and demand solely
determine the value of the currency of a given country. Trade and capital flows directly
affect forex market movements.

In contrast to fixed exchange rates a free floating exchange rate system allows
exchange rates to move without the intervention from a national government. Market
forces determine exchange rate movement. Changes and movements in market supply
and demand cause changes in the value of currency.

Countries with large payments deficits may benefit from this system. This is due to the
fact that fluctuations provide an automatic adjustment.
It also allows the monetary authorities in governments certain flexibility in interest rate
determination. These would not be so concerned with influencing the exchange rate.

Managed Floating Exchange Rates System

This is the system that most governments would prefer. It is quite like a hybrid of the
floating exchange rate and the fixed rate system. The government has a bit of leverage
in this system. This system may also be a part of a fixed exchange rate system in a way.

Understanding how each system behaves and how they affect market movement would
help a trader regarding planning and trading. Given all these systems a trader would be
able to make profits whether a currency rate would either raise or drop depending on the
profit making decisions they make. (wallstreetforex.eu)

Dirty Float:

A system in which exchange rates are determined by supply and demand in the foreign
exchange market, but where governments buy and sell currencies in order to influence
the market. (answers.com)

Currency Devaluation and Revaluation:

Under a fixed exchange rate system, devaluation and revaluation are official changes in
the value of a countries currency relative to other currencies. Under a floating exchange
rate system, market forces generate changes in the value of the currency, known as
currency depreciation or appreciation. In a fixed exchange rate system, both
devaluation and revaluation can be conducted by policy makers, usually motivated by
market pressures.

Under a fixed exchange rate system, only a decision by a country’s government or

monetary authority can alter the official value of the currency. Governments do,
occasionally, take such measures, often in response to unusual market pressures.
Devaluation, the deliberate downward adjustments in the official exchange rate, reduces
the currency’s value; in contrast, a revaluation is an upward change in the currency’s
value.

Motives for Revaluation of currency

When countries revalue their currency -- that is effect an upward change in the
currency's value -- there are implications on both the capital and the current account. On
the current account, imports become cheaper (where revaluation has been undertaken)
and exports become more expensive. Cheaper imports will lower the cost of
imported raw materials, and overtime, even wages, which would allow exports to
be priced lower.

To what extent this happens depends on factors ranging from the import intensity of
exports and productivity changes effected by the exporter. The effect on the capital
account is for speculative investments to immediately unwind in the revaluing currency.
Dollars could flow from China to the yen, and other emerging Asian markets,
strengthening their currencies.

The longer-term anti-inflationary impact of a revaluation (via cheaper imports) makes for
lower interest rates. From a monetary point of view, this would induce an outflow of
resources from China to those currencies whose interest rate differential vis-à-vis
Chinese rates has gone up.

Lower interest rates could spur investment and attract more FDI, attracting inflows and
reinforcing the currency's tendency to harden.
In the case of China, it has been under pressure especially from the US to revalue, given
the huge trade deficit of $162bn, which the US runs with Beijing. Yuan appreciation will
mean that Chinese firms could lose their competitive edge and may have to brace for
lower margins. (aussiestockforums.com)

What is capital account convertibility?

There is no formal definition of capital account convertibility (CAC). The Tara pore
committee set up by the Reserve Bank of India (RBI) in 1997 to go into the issue of CAC
defined it as the freedom to convert local financial assets into foreign financial assets and
vice versa at market determined rates of exchange.
In simple language what this means is that CAC allows anyone to freely move from local
currency into foreign currency and back.

How is CAC different from current account convertibility?

Current account convertibility allows free inflows and outflows for all purposes other
than for capital purposes such as investments and loans. In other words, it allows
residents to make and receive trade-related payments — receive dollars (or any other
foreign currency) for export of goods and services and pay dollars for import of goods
and services, make sundry remittances, access foreign currency for travel, studies abroad,
medical treatment and gifts etc. In India, current account convertibility was established
with the acceptance of the obligations under Article VIII of the IMF’s Articles of
Agreement in August 1994.

Can CAC coexist with restrictions?

Contrary to general belief, CAC can coexist with restrictions other than on external
payments. It does not preclude the imposition of any monetary/fiscal measures relating to
forex transactions that may be warranted from a prudential point of view.

Why is CAC such an emotive issue?

CAC is widely regarded as one of the hallmarks of a developed economy. It is also seen
as a major comfort factor for overseas investors since they know that anytime they
change their mind they will be able to re-convert local currency back into foreign
currency and take out their money.
In a bid to attract foreign investment, many developing countries went in for CAC in the
80s not realising that free mobility of capital leaves countries open to both sudden and
huge inflows as well as outflows, both of which can be potentially destabilising. More
important, that unless you have the institutions, particularly financial institutions, capable
of dealing with such huge flows countries may just not be able to cope as was
demonstrated by the East Asian crisis of the late nineties.

Following the East Asian crisis, even the most ardent votaries of CAC in the World Bank
and the IMF realised that the dangers of going in for CAC without adequate preparation
could be catastrophic. Since then the received wisdom has been to move slowly but
cautiously towards CAC with priority being accorded to fiscal consolidation and financial
sector reform above all else.

In India, the Tarapore committee had laid down a three-year road-map ending 1999-2000
for CAC. It also cautioned that this time-frame could be speeded up or delayed depending
on the success achieved in establishing certain pre-conditions — primarily fiscal
consolidation, strengthening of the financial system and a low rate of inflation. With the
exception of the last, the other two pre-conditions have not yet been achieved.

What is the position in India today?

Convertibility of capital for non-residents has been a basic tenet of India’s foreign
investment policy all along, subject of course to fairly cumbersome administrative
procedures. It is only residents — both individuals as well as corporates — who continue
to be subject to capital controls. However, as part of the liberalisation process the
government has over the years been relaxing these controls. Thus, a few years ago,
residents were allowed to invest through the mutual fund route and corporates to invest in
companies abroad but within fairly conservative limits.

Buoyed by the very comfortable build-up of Forex reserves, the strong GDP growth
figures for the last two quarters and the fact that progressive relaxations on current
account transactions have not lead to any flight of capital, on Friday the government
announced further relaxations on the kind and quantum of investments that can be made
by residents abroad. These relaxations are to be reviewed after six months and if the
experience is not adverse, we may see further liberalization and in the not-too-distant
future full CAC. (welcome-nri.com).
Chapter 3: Foreign Exchange Markets:

Features:
♦ Market where foreign currencies are traded
♦ Round the clock market
♦ Global market
♦ Large volume of transactions

Participants

♦ Individuals: tourists, migrants

♦ Firms: importers and exporters
♦ Banks: short position, long position, square position
♦ Governments/ monetary authorities: market intervention
♦ International agencies: lending
♦ Two tier market:
– First tier: ultimate customer and banker
– Second tier: between banks

Classification of participants
♦ Non-banking enteritis: business transactions and hedging
♦ Banks: foreign exchange dealers
♦ Arbitrageurs: profit seeking from variations in rates in different markets
♦ Speculators: profit seeking from movements in exchange rates

Types of markets
♦ Spot market
♦ Forward market
♦ Derivatives markets: currency futures and options

Spot market
 ♦ Currencies traded for immediate delivery at rates prevailing at the time of
transaction
♦ Actual delivery (electronic transfer) may take two working days
♦ Currency arbitrage: buying a currency at cheaper rate in one market and selling
at a higher rate in another market
– Two point arbitrage
– Triangular (three point) arbitrage – three currencies
♦ Currency speculation: buying and holding a currency for sale at a higher rate in
the near future
Forward market
♦ Contract for future delivery
♦ Hedging:
– Currencies are bought or sold for forward delivery
– Reduces foreign exchange risk
♦ Speculation:
– Reap profit from changes in exchange rates in future (difference between
forward rates and future spot rates)
♦ Arbitrage:
– Reaping profit from disparity between forward differential and interest rate
differential
Futures market
♦ It is a derivatives market
♦ Currency futures market is of recent origin (1972)
♦ Currencies can be bought and sold in the futures market
♦ Size and maturity of contracts are standardized
♦ Transactions made with the help of brokers through the clearing house
♦ Margin deposit and daily marking to the market
♦ Hedging: to reduce risk
♦ Futures may not provide a perfect hedge ( mismatch in size and maturity)
♦ Speculation: to reap short term profit

Types of Transaction:

Spot market finance - definition

Throughout different securities and commodities markets, a price that is good only at
a particular moment in time. In the foreign exchange market, the spot market
involves a straightforward trans-action in which one currency is directly exchanged
for another. A spot market is in contrast to the futures market or forward market, in
which the price refers to a certain time in the future. References to the spot market
are often found in the foreign exchange market. The terms cash market and spot
market are generally interchangeable (http://www.yourdictionary.com/finance/spot-
market)

Forward foreign exchange rate

The exchange rate available today to exchange currency at some specified date in the future.
Forward contracts:
Forward contract
A contract that specifies the price and quantity of an asset to be delivered on in the future.
Forward contracts are not standardized and are not traded on organized exchanges. (financial-
dictionary.thefreedictionary.com)

Forward premium/ discount:

= n day forward rate – spot rate x 365 x 100

 Spot rate n

Swap contracts:

Simultaneous purchase and sale of identical amounts of a currency at different value

dates. Swaps are transacted between two banks and a bank and a customer.

Example: one bank enters into an agreement with another bank to buy 1 million
Japanese Yen for US dollars in Spot market and also simultaneously agrees with the
same bank to sell 1 million Japanese Yen for US Dollars after 60 days. Exchange rates
for both the transactions are agreed at the time of contract. This is a swap deal.
(investopedia.com)

Uses of Swaps:
a) to take advantage of arbitrage opportunity
b) to correct mismatch in position
c) Banks use it as a cover for early delivery and cancellation or extension of
contracts.

Structure of Foreign exchange market:

a) Whole sale market : Sub divided into – giant transaction layer (large giant
commercial banks)and other transaction layer.(smaller commercial banks)
b) Retail market: - Central banks.

Forex quotations and Arbitrage:

Clearing house inter bank payment system (CHIPS)

SWIFT
FED WIRE

Bid And Ask Rate:

Bid rate: if the customer gives one US $ to the banker, banker is willing to pay
Rs. 49.0501 to him. This is bankers bid price for dollar in terms of Rupees.

Ask rate: If the customer desires to buy a US $ from the banker, he has to pay Rs.
48.2051 to the banker. The banker is ASKING for 48.2051 rupees per dollar.

Difference between the Bid and Ask rate is Spread.

Spread = Ask (sell) rate – Bid (buy rate) x 100

Ask (sell) rate

Qt) quotation for Us $ in Indian rupees is Rs. / $ 48.3004/3120. Caluculate percentage

spread.

Spread = (48.3120 – 48.3004)/48.3120 x 100

Types of Quote:

American quote
European quote
Direct quote
Indicative quote
Syndication:
What Does Syndicated Loan Mean?
A loan offered by a group of lenders (called a syndicate) who work together to provide funds for a
single borrower. The borrower could be a corporation, a large project, or a sovereignty (such as a
government). The loan may involve fixed amounts, a credit line, or a combination of the two.
Interest rates can be fixed for the term of the loan or floating based on a benchmark rate such as
the London Inter-bank Offered Rate (LIBOR).

Typically there is a lead bank or underwriter of the loan, known as the "arranger", "agent", or
"lead lender". This lender may be putting up a proportionally bigger share of the loan, or perform
duties like dispersing cash flows amongst the other syndicate members and administrative tasks.

Also known as a "syndicated bank facility". (investopedia.com)

Futures and Options:

Futures and options represent two of the most common form of "Derivatives". Derivatives are financial
instruments that derive their value from an 'underlying'. The underlying can be a stock issued by a company,
a currency, Gold etc., The derivative instrument can be traded independently of the underlying asset.

The value of the derivative instrument changes according to the changes in the value of the underlying.

Derivatives are of two types -- exchange traded and over the counter.

Exchange traded derivatives, as the name signifies are traded through organized exchanges around the
world. These instruments can be bought and sold through these exchanges, just like the stock market.
Some of the common exchange traded derivative instruments are futures and options.

Over the counter (popularly known as OTC) derivatives are not traded through the exchanges. They are not
standardized and have varied features. Some of the popular OTC instruments are forwards, swaps,
swaptions etc.

Futures

A 'Future' is a contract to buy or sell the underlying asset for a specific price at a pre-determined time. If you
buy a futures contract, it means that you promise to pay the price of the asset at a specified time. If you sell
a future, you effectively make a promise to transfer the asset to the buyer of the future at a specified price at
a particular time. Every futures contract has the following features:

• Buyer
• Seller
• Price
• Expiry

Some of the most popular assets on which futures contracts are available are equity stocks, indices,
commodities and currency.

The difference between the price of the underlying asset in the spot market and the futures market is called
'Basis'. (As 'spot market' is a market for immediate delivery) The basis is usually negative, which means that
the price of the asset in the futures market is more than the price in the spot market. This is because of the
interest cost, storage cost, insurance premium etc., That is, if you buy the asset in the spot market, you will
be incurring all these expenses, which are not needed if you buy a futures contract. This condition of basis
being negative is called as 'Contango'.

Sometimes it is more profitable to hold the asset in physical form than in the form of futures. For eg: if you
hold equity shares in your account you will receive dividends, whereas if you hold equity futures you will not
be eligible for any dividend.

When these benefits overshadow the expenses associated with the holding of the asset, the basis becomes
positive (i.e., the price of the asset in the spot market is more than in the futures market). This condition is
called 'Backwardation'. Backwardation generally happens if the price of the asset is expected to fall.
It is common that, as the futures contract approaches maturity, the futures price and the spot price tend to
close in the gap between them i.e., the basis slowly becomes zero.

Options

Options contracts are instruments that give the holder of the instrument the right to buy or sell the underlying
asset at a predetermined price. An option can be a 'call' option or a 'put' option.

A call option gives the buyer, the right to buy the asset at a given price. This 'given price' is called 'strike
price'. It should be noted that while the holder of the call option has a right to demand sale of asset from the
seller, the seller has only the obligation and not the right. For e.g.: if the buyer wants to buy the asset, the
seller has to sell it. He does not have a right.

Similarly a 'put' option gives the buyer a right to sell the asset at the 'strike price' to the buyer. Here the
buyer has the right to sell and the seller has the obligation to buy.

So in any options contract, the right to exercise the option is vested with the buyer of the contract. The seller
of the contract has only the obligation and no right. As the seller of the contract bears the obligation, he is
paid a price called as 'premium'. Therefore the price that is paid for buying an option contract is called as
premium.

The buyer of a call option will not exercise his option (to buy) if, on expiry, the price of the asset in the spot
market is less than the strike price of the call. For e.g.: A bought a call at a strike price of Rs 500. On expiry
the price of the asset is Rs 450. A will not exercise his call. Because he can buy the same asset from the
market at Rs 450, rather than paying Rs 500 to the seller of the option.

The buyer of a put option will not exercise his option (to sell) if, on expiry, the price of the asset in the spot
market is more than the strike price of the call. For eg: B bought a put at a strike price of Rs 600. On expiry
the price of the asset is Rs 619. A will not exercise his put option. Because he can sell the same asset in the
market at Rs 619, rather than giving it to the seller of the put option for Rs. 600. (rediff.com)

Offshore banking:

An offshore bank is a bank located outside the country of residence of the depositor,
typically in a low tax jurisdiction (or tax haven) that provides financial and legal
advantages. These advantages typically include:

• greater privacy (see also bank secrecy, a principle born with the 1934 Swiss
Banking Act)
• low or no taxation (i.e. tax havens)
• easy access to deposits (at least in terms of regulation)
• protection against local political or financial instability

While the term originates from the Channel Islands being "offshore" from the United
Kingdom, and most offshore banks are located in island nations to this day, the term is
used figuratively to refer to such banks regardless of location, including Swiss banks and
those of other landlocked nations such as Luxembourg and Andorra.
(http://en.wikipedia.org/wiki/Offshore_bank. Accessed on 27.5.2009)

Mechanics of Foreign trade exchange market:

Contracts

Credits

Documentations
Risks in International Transactions:

Foreign exchange risk, Settlement risk, Counter party /Third party risk.

Types of Credit:

Important credit clauses

Procedure for establishing credit.

Chapter 4: Presentation on:

Economic Union and trade agreements:

International trade organization

General agreement on tariffs and trade

Uruguay round

North south divide and dialogue

European economic and community and integration 1992.

Impact of currency blocks on world trade

IMF

World Bank

WTO

Chapter 5:

Indias Foreign trade – promotion and control

Export Import bank of India

Export credit guarantee corporation (ECGC) – its functions, policy, management and
current operations

Foreign exchange control – FERA/FEMA

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27.5.09)
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%20of%20payments.htm
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7) http://www.investorwords.com/1806/exchange_rate.html
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http://internationalecon.com/Finance/Fch80/F80-1.php)
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http://economics.about.com/od/foreigntrade/a/bretton_woods.htm. Accessed date:
27.5.2009)
11) http://www.wallstreetforex.eu/exchange-rate-systems.html Accessed date: 27.5.2009)
12) http://www.welcome-nri.com/cac.htm Accessed date: 27.5.09