my own notes for MCom sem II.doc

Economics of Global Trade & Finance(M.Com Part-I/ Sem.-II) Asst. Porf. Vikas W.Ubale

M.Com (part-I/Sem.II)

Economics of Global Trade & Finance

MODULE -

FOREIGN TRADE MULTIPLIER

Q. 1] What is Foreign Trade Multiplier? Discuss its international repercussions (Apr -09, Oct -09, Apr – 10, Oct – 10, Apr – 11, April – 12)

Ans: The original idea of Foreign Trade Multiplier was given by R. F. Kahn, this multiplier was Employment Multiplier, which studies the effect of changes in employment on changes in income.

( ΔY = ke • ΔE ), where ΔY stands for change in income, ke stands for Employment multiplier and ΔE stands for initial change in Employment. This was used by Lord Keynes for his idea of Investment Multiplier. The concept of foreign trade multiplier was given by Mr. Leighton, which is also called as Export Multiplier.

The foreign trade multiplier can be explained as follows:

If the exports of the country increase, inorder to meet the foreign demand, they will engage more factors to increase the production. This will raise the income of the producers. This process will continue and the national income increases by the value of the multiplier. The value of the multiplier depends on the value of the marginal propensity to save and the marginal propensity to import, there being an inverse relation between the two propensities and the export multiplier.

The formula for calculation of the Foreign Trade Multiplier can be explained as follows:

The national income in an open Economy is

Y = {C + I + G + (X-M)}, where Y = National Income, C = Nation’s Consumption, I = Nations Investment, G = Government’s Expenditure, X = Exports and M = Imports)

Since, Government doesn’t strictly follow the rules of economics its involvement can be ignored.

Y = C + I + (X – M)

Y – C = I + X – M

S = I + X – M ( S = Y – C, Savings = Income – Consumption)

S + M = I + X

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Thus, at equilibrium Savings + Imports is equal to Investment + Exports

However, there are leakages and they leave national income. Thus when,

a. S + M > I + X (Contraction takes place)

b. S + M < I + X (Expansion takes place)

And hence, when we introduce the change then the equation will be as follows:

ΔS + ΔM = ΔI + ΔX

The marginal propensity to saving i.e. ΔS/ΔY determines change in savings which is designated as S while the marginal propensity to import determines the change in imports i.e. ΔM/ΔY, hence the new formula would be as follows:

(S + M)/ΔY = ΔI + ΔX

ΔY = M (ΔI + ΔX)

The foreign trade multiplier is a function of Marginal Propensity to Save plus Marginal Propensity to Import Let Foreign Trade Multiplier be Kf

Kf = f(S +M)

Where, f stands for functional relationship S stands for Marginal Propensity to Save M stands for Marginal Propensity to Import There is an inverse relationship between S + M and Kf , smaller the S + M greater will be the Kf. Conversely greater the S + M smaller will be Kf. Hence the formula for income propagation through foreign trade multiplier will be as follows:

ΔY = M (ΔI + ΔX)

Kf = M M M

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Place for diagram.

International Repercussions

A country’s exports or imports affect the national income of the other country, affects the pattern of foreign trade and national income of the first country. This is known as foreign repercussion or the backward effect. The smaller the country in relation to the other trading partner, the negligible is the foreign repercussion. But the foreign repercussions will be high in the case of large country because a change in the national income of such a country will have significant foreign repercussions.

In case there are 2 large countries A and B, where A’s imports are B’s exports and vice versa. An increase in A’s domestic investment will cause a multiplier to increase in its income. This causes an increase in the imports of A from B, which leads to an increase in income of B. Now with the increase in the income of B, its imports will increase from A, which will induce a second round increase in A’s income and so on

Implications of International Repercussions

1. The foreign repercussion effects suggest a mechanism for the transmission of income variations of disturbances between trading countries. It implies that a boon or slump in one country has repercussions on the incomes of other countries.

2. The policy implications of the repercussions effects suggest that export promotion policies raise national income in the trading partners at a lower rate than by an increase in domestic investment. The export promotion measures raise national income via the simple foreign trade multiplier, whereas increase in domestic investments policies raises national income many times in multiplier rounds via the repercussion effects

3. The repercussion effects also suggest that since the backwash effects ultimately dwindles to nothing, automatic income changes cannot eliminate completely the current account BOP deficit or surplus produced by an automatic disturbance.

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Q. 2] Explain with the help of “Foreign trade multiplier the relationship between the income changes and balance of payments” (Oct – 11)

Q. 3] Explain Internal and external balance in terms of IS-LM and BP schedules (Apr -09)

Ans: To explain the Internal and External balance, it needs to be understood that LM curve represents monetary policy, IS curve represents fiscal policy and the BP curve represents those combinations of interest rate and national income that produce BOP equilibrium. Any increase in income will increase imports and increase the BOP deficit by increasing the current account deficit. On the other hand an increase in the interest rate will attract foreign investments and there will be capital inflow there by increasing the capital account surplus. Any point above and to the left of the BP curve represents surplus in BOP and a point below and the right of the BP curve shows a BOP deficit. The way expenditure changing monetary and fiscal policies affect BOP disequilibrium are discussed below.

Expenditure Changing Monetary Policy: Expenditure changing monetary policy affects the money supply and interest rates. A contraction in monetary policy leads to BOP surplus and an expansionary monetary policy to a BOP deficit.

Expenditure Reducing & Increasing Monetary Policy:

To reduce the expenditure the money supply is reduced, which increases the interest rate thereby reducing investment and output. The reduction in investment and output, in turn, reduces income and aggregate demand for imported goods. There is also a reduction in the domestic price level which may lead to switching of expenditure from foreign to domestic goods. Consequently, the country’s imports are reduced and exports are increased. Thus the current account trade becomes surplus. Simultaneously, there is a reduced outflow of short-term capital with reduction in imports and further creating a surplus in BOP. On the other hand, rise in domestic interest rates increase the inflow of capital, thereby leading to a full surplus in BOP. In case of Expenditure Increasing Monetary Policy this will be just the opposite of the above. This can be explained with the help of diagram.

Place for diagrams

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LM, I and BO is in equilibrium at point ‘E’, when there is expenditure reducing policy adopted then the original LM shifts to LM1 and the new equilibrium is at E1. Since, E1 is on the left of the BOP, there is a surplus BOP. The interest rate increases from OR to OR1, which generates a capital account surplus with capital inflow. On the other hand the income reduces from OY to OY1 and hence will tend to generate a current account surplus because of the reduction in imports. Thus a contractionary monetary policy leads to BOP surplus. Similarly a expansionary monetary policy leads to BOP deficit. If the monetary authority increases the money supply, the LM curve shifts downwards and the new equilibrium point is at E2. Since E2 is on the right of BOP, there is a deficit in BOP. The interest rate falls from OR to OR2 which leads to capital account deficit with less capital flow. On the other hand the income rises from OY to OY2 and thus leading to a current account deficit due to increase in imports. Thus expansionary leads to BOP Deficit.

Expenditure Changing Fiscal Policy:

By changing government expenditure or/and taxation, the expansionary fiscal policy tends to increase government expenditure or/and reduce taxes. On the other hand contractionary fiscal policy relates to cut in government expenditure or/and increase in taxes.

Expenditure Increasing Fiscal Policy:

If the government follows a expansionary fiscal policy i.e. increase its expenditure and reduces the taxes. As a result, the IS curve shifts upwards to the left as the IS1 curve which cuts the LM curve at E1. This new equilibrium shows increase in interest rate to OR1 and rise in income to OY1. The increase in interest rate leads to capital inflow thereby creating short run BOP surplus on capital account. On the other hand, the rise in income increases imports thereby leading to BOP deficit on current account. The net overall effect on the BOP will depend upon the elasticity of the BP curve. If the BP curve is elastic, then the equilibrium point E1 is above and to the left of the curve BP, there will be overall BOP surplus in an expansionary fiscal policy. In case the BP curve is less elastic as shown in BP1 curve, the equilibrium point E1 being below and to the right of BP1 curve, there will be overall BOP deficit.

Expenditure Reducing Fiscal Policy:

If the government follows a contractionary fiscal policy i.e. reduce its expenditure and in the mean time increase the tax, which leads to capital outflow and thus deficit of to capital account. The income level also falls, which reduces imports, thereby leading to current account deficit. Thus the BOP falls.

In case the government follows a expansionary fiscal policy, then the capital account is in surplus, income level rises leading to increase in imports and there by leading to a BOP deficit on current account. Thus BOP moves in to a surplus.

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This can be explained using the below diagram:

At the equilibrium point E, OR is the interest rate and OY is the national income, since the government is adopting contractionary fiscal policy, then the IS curve shifts downwards to the left to IS2 cutting the LM curve at E2. There is a fall in interest rate to OR2, which leads to an outflow of capital and to capital account deficit. Income also falls to OY2 which reduces the imports, thereby leading to a current account deficit. Thus the overall effect is a BOP deficit, since E2 is below and to the right of the BP curve.

However, the effects will also depend upon the slope of the BP curve. In the mentioned case BP curve is elastic. If the BP curve is less elastic such as the BP1 curve in the figures, the BOP would be surplus as point E2 is above and to the left of the BP1 curve.

Q. 4] Explain the Trade – off between internal and external trade balances (Oct – 10, Oct – 11)

Ans: The trade off between external and internal balances indicate the balance of indebtedness. The balance of indebtedness is a stock convept . It gives the position of investment of ca country or in country over the entire period or a long period. It gives the international investment position in terms of external and internal balances.

When a country borrows or lends internationally, it will have short-run disequilibrium in its balance of payments, as these loans are usually for a short period or even if they are for long duration, they are repayable later on; hence the position will be automatically corrected and poses no serious problem. As such a disequilibrium may also emerge if a country’s imports exceed its exports in a given year. This will be a temporary one once in a way, because later on the country will be in a position to correct it easily by creating the required credit surplus by exporting more to offset the decicit. But even this type of disequilibrium in the balance of payments is not justified, because it may pave the way for a long – term disequilibrium. When such disequilibrium occurs year after year over a long period, it becomes chronic and may seriously affect the country’s economy and its international economic relations. A persistent deficit will tend to deplete its foreign exchange and the country may not be able to raise any more loans from foreigners.

A huge population and its high rate of growth in poor countries also have adversely affected their balance of payment position, it is easy to see that an increase in population increases the need of these countries for imports and decreases the capacity to export.

Another reason for a surplus or deficit in balance of payments may arise out of international borrowing and investment. A country may tend to have an adverse balance when it borrows heavily from another country, while the leading country will tend to have favorable balance, and a deficit balance when the loan is repaid.

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The balance of international indebtedness improves when country registers a net capital outflow whether private or government. Its net credit position is enhanced and its net debtor position is reduced.

The settlement of balance of payment account influences the balance of indebtedness. When deficits are settled by reducing reserves in foreign countries or by increasing the reserves of other countries in the country, the effect is that net investment credit side is reduced. It also means the net investment of foreign countries is increased. Thus, a deficit in the balance of payment will reduce the net creditor position or increase the net debt position.

However, only if a net capital outflow is accompanied by an equal, combined positive balance on current, unilateral transfer and gold accounts will it serve to improve a country’s balance of international indebtedness. Only if the payments deficit is settled wholly or in part by an export of gold will the balance of international indebtedness be changed in its favour.

To know the latest position of investment, the present market values can be taken into account, but then in this case the figures will not tally if the balance of indebtedness is prepared from the past accounts of balance of payments. When deficit are financed by loss of reserves, the balance of indebtedness remains unchanged. Balance of indebtedness can also be prepared for a short period of time or for a long period of time. The long-term investment position is of less immediate importance. Long – term investments are unlikely to be withdrawn on short notice and tend to respond more to long-range, basic economic considerations. The long term investment position is of significance in determining the international flows of interest and dividend payments, which appear in the current account of the balance of payment.

Q. 5] Discuss how a country use monetary and fiscal policy for internal and external stability (Apr -10)

Q. 6] Explain the Monetary – Fiscal policy mix in converting the disequilibrium in Balance of Payments (Apr – 11)

Ans: The BOP deficit can be bridged by strict fiscal and monetary discipline in order to control aggregate demand within the economy. So long as the fiscal deficit is under control, the BOP situation does not deteriorate.

Any disequilibrium in the balance of payments when it persists continuously is certainly undesirable because of its disastrous effects on the country’s economy and orderly world trade. Thus one of the basic problems of international economic policy is restoring ‘even balance’ to a country whose balance of payments is seriously and persistently in surplus or in deficit, since both are bad for normal internal economic operations and international economic relations. Especially a deficit or adverse balance of payments is more harmful to a country’s economic growth and is therefore to be corrected sooner than later. For obvious reasons, an adverse balance of payments has to be corrected by encouraging exports and/or discouraging imports.

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Role of Monetary and Fiscal policies

The various measures that may be used for correcting an adverse balance of payments are of two kinds:

Monetary Policies:

a. Deflation

b. Exchange Depreciation

c. Devaluation

d. Exchange Control

Fiscal Policies:

a. Tariffs – import duties

b. Import quotas

c. Export promotion policies & programmes

Monetary measures usually have two edged effects in improving the balance of payments position. They boost up exports as well as check or curtail imports. Monetary measures however function indirectly. Non-monetary measures, on the other hand are directly effective. But they work one way only. Tariffs and quotas for instance, tend to restrict only imports. Export promotion measures, on the other hand, enhance exports only.

Fiscal measures are considered more effective, significant and are normally applicable than monetary measures in correcting the adverse balance of payments. Fixing of import quotas and tariffs to check imports and launching upon export promotion programmes in perhaps the best solution of correcting the

disequilibrium in the balance of payments. Devaluation of currency may be resorted to only under abnormal conditions.

Q. 7] Discuss Mundell – Fleming model (Oct – 09, April – 12)

Ans: Robert A. Mundell and Fleming J. Marcus introduced Mundell-Fleming model, is an extension of IS-LM-BOP Model.

Mundell and Fleming have extended the IS, LM model to incorporate external balance by way of incorporating BOP Schedule.

IS schedule represents investment and saving schedule LM represents Demand for and Supply of money schedule BOP represents Balance of Payments schedule.

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The intersection between IS and LM schedules determine internal balance which is shown by the Point E at which rate of interest is OR and National Income is OY, since the point E is lying on the left side of BOP, it shows that the economy is running a balance of payment into surplus.

Under these circumstances if the economy would like to achieve both internal and external balance then it have four options.

Option 1: Place for diagrams

Diagram (a) shows appreciation in the foreign exchange rate such that BP curve shifts upward and passes through equilibrium point E and intersects IS and LM curves. As such the internal balance and the external balance are achieved.


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Diagram (b) shows the central bank pursuing the expansionary monetary policy by lowering down the rate of interest such that LM schedule shifts to the right and passes through IS and BOP schedules thus at the point of intersection i.e. E1 once again internal balance and external balance are achieved.


Diagram (c) shows that the government switches over to the expansionary fiscal policy such that the IS curve shifts to the right upward and passes through the intersecting point E1 as such once again internal and external balances are attained.


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Diagram (d) shows the role of monetary and fiscal policy when there is a perfect capital mobility i.e. BOP curve is a horizontal straight line going parallel to X axis. Initial equilibrium is at E at which IS and LM schedules intersect each other with BP schedule given. When the central bank follows expansionary monetary policy which shifts the LM schedule to the right leading to LM schedule. When the government follows expansionary fiscal policy the IS schedule. With the BP schedule given IS1 and LM1 schedules intersect at the point E1 leading to establishing internal and external balance at a higher level with the national income increasing from OY to OY1.

Asst.prof. Vikas W. Ubale

MODULE -

FOREIGN EXCHANGE MARKET

Q. 1] Define the term Foreign Exchange.

Ans: Foreign exchange simply means foreign money. It can be defined as the mechanism through which payments are effected between two or more countries having different currencies. It not only includes foreign money but also near money instruments denominated in foreign currency.

Definition:

The Foreign Exchange Regulation Act 1973 defines foreign exchange as follows:

“Foreign exchange means foreign currency & includes:

all deposits, credits & balances payable in any foreign currency & any draft, travelers cheques, letters of credit & bill of exchange, expressed or drawn in Indian currency but payable in any foreign currency;

any instrument payable, at the option of drawee or holder thereof or any other party there to, either in Indian currency or in foreign currency or partly in one & partly in the other”.

It is clear from the above definition that ‘foreign exchange’ refers to foreign money including currency notes, cheques, bills of exchange, bank balances & deposits in foreign currencies.

Q. 2] State & explain in brief the instruments which are used for international payments

Ans: The instruments which are used for International Payments are as follows:

1) Foreign Bill of Exchange

2) Bank Draft

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3) Mail Transfer

4) Telegraphic Transfer

5) Letter of Credit

1) Foreign Bill of Exchange: It can be defined as a negotiable credit instrument with an unconditional order in writing drawn by a drawer addressed to the drawee to pay a sum of money on demand to the payee or to the undersigned at a future date for the held transaction. The participants are as follows:

a. Drawer: The exporter of goods, drawing the bill of exchange to send a written order to the drawee for making the payment at a future date

b. Drawee: The importer of goods, receiving the bill of exchange & acknowledging to making the payment

c. Payee : The person receiving the payment, he can be a person whom the drawer indicates the Drawee to make the payment to. The Drawer & Payee can be same.

2) Bank Draft: It can be defined as an order of a bank on its branch or any other bank to pay a sum of money to the bearer of the bank draft on demand.

3) Mail Transfer: The transfer of money from one bank account to another bank account of the same bank at two different places through post office by mailing the post card

4) Telegraphic Transfer: A telegraphic order of a bank to its branch or to correspondent bank to pay a sum of money to a person concerned. The amount needs to be deposited in one bank account & then telegraphic transfer can be used to transfer the money to the concerned person’s bank account.

5) Letter of Credit: It is an authorization letter issued by a bank of the importer for specified money. The importer imports the goods & sends LOC to the exporter, the exporter gets the money on presenting the LOC to his bank & the money is transferred by the importers bank to the exporters bank.

Q. 3] Only Exporters & Importers are the main participants in the Foreign Exchange Market – Examine

Ans: The foreign exchange market facilitates the monetary transactions of foreign trade. It can be defined as a mechanism through which foreign currency can be bought & sold. It comprises of buyers & sellers & also includes the intermediaries through which the buyers & sellers of foreign exchange are brought together.

The participants of the Foreign Exchange Market include:

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1) Customers

2) Commercial Banks

3) Central Banks

4) Bill Brokers

5) Discount Houses

6) Acceptable Houses

1) Customers: It mainly comprises of importers & exporters. They participate in the foreign exchange market through bank services

2) Commercial Banks: They are supposed to be the most active players in the foreign exchange. Since banks have wide network of branches all over the world, they can transact the foreign exchange business smoothly, quickly & efficiently. They act as intermediaries for the importers & exporters. Being an active player, they also achieve their objectives of Profitability & risk bearing using foreign exchange market.

3) Central Banks: They are the main players in the foreign exchange market. One of the main functions of the central Banks in the world is to maintain the external value of the domestic currency using foreign exchange rate systems like:

a. Fixed exchange rate system

b. Floating exchange rate system

4) Bill Brokers: Their function is to bring buyers and sellers together to settle the foreign exchange transaction, for which they charge a brokerage.

5) Discount Houses: They discount the foreign bill of exchange put forwarded by an exporter and finance’s him before the maturity of the foreign bill of exchange. London Discount Houses are an example of Discount Houses in London international money market.

6) Acceptable Houses: They lend their name and acknowledge the responsibility to make the payment of the foreign exchange bill to the payee on behalf of the drawee, as they are financially well to do firms and with a glaring reputation in the foreign exchange world.

Q. 4] What are the functions of the foreign exchange market?

Ans: The following three are the main functions of the foreign exchange market:

1) Transfer Function

2) Credit Function

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3) Hedging Function

4) Determination of Exchange rate

1) Transfer Function: The main function of foreign exchange market is the transfer of funds i.e. purchasing power from one nation or currency to another. It is also called as money changing function of a foreign exchange market. It is mainly commercial banks which operate as clearing houses for Forex demanded & supplied in the course of foreign transactions.

2) Credit Function: Foreign exchange market also performs the function of financing trade. It is called credit function. Exporters require credit when the goods are in transit. The exporters usually allow ninety days to the importers to pay. After shipment the exporters can immediately get credit from commercial banks, which in turn collect payment from importers. Thus forex market permits time to the importers in making payment on the one hand & permit instant payment to the exporters on the other.

3) Hedging Function: To hedge means to shoulder risk. Under the system of fluctuating exchange rates importers & exporters are exposed to exchange risk. Importers are worried that the foreign currency many appreciate in future & they will have to pay more in local currency. Exporters are also worried that foreign currency may depreciate & they might receive less in local currency. Foreign exchange market provides hedging facilities to protect importers & exporters against the exchange risk. It is the function of the foreign exchange market to enter into forward contract to sell the foreign exchange at a predetermined rate.

4) Determination of exchange rate: The most important function of foreign exchange market, however, is determination of exchange rate. Exchange rate is basically the price of one currency expressed in terms of another currency. Under the system of market determined exchange rate, demand from all buyers of forex & supply from all sellers of forex determines the rate of exchange.

Q. 5] Distinguish between spot and forward exchange market

Ans: Sport Exchange Forward Exchange

1)S. It is the day to day rate of exchange which is charged on the delivery of goods on spot.

1)F. A forward contract is an agreement between the seller of forex & the buyer of forex, the seller agrees to deliver a specified amount of forex at some future date, the buyer agrees to pay in other currency at the future date.

2) S.In actual practice the settlement takes place within two days in most of the forex market

2)F. It may be one month forward, 3 months forward, 6 months forward etc.

3)S. The buyer of forex has to pay immediately on the spot the amount in other currency.

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3)F. The payment depends upon the contract date

4)S. The exchange rate is the rate which is prevailing at the time of trade, hence known as spot rate

4) F.The rate is agreed upon at the time of signing the forward contract but delivery / payment is made at some date in future.

Q. 6] What do you understand by Arbitrage?

Ans: Arbitrage means the simultaneous buying and selling of foreign currencies with the intension of making profit. When the prices of some product - a commodity, security or currency — differ in two different markets, one can make risk tree profit by buying the product in the low price market & simultaneously selling it in the high price market, this process is called as Arbitraging. The person engaged in arbitrage activity is known as the arbitrageur. Arbitrage can take place in any commodity, security or currency if there are price differences. Arbitrage results into price equalization as the price goes up in the low price market & falls in high price market. The arbitrageurs play an important role in removing price discrepancies & bringing about price equalization. Arbitrage is thus a very short term temporary phenomenon.

Currency Arbitrage: In forex market currency arbitrage takes place when the exchange rate between two currencies differs in two different markets. The Currency arbitrage is of two kinds viz. two way arbitrage (also known as two point arbitrage) & three-way arbitrage (also known as three point of triangular arbitrage)

Interest Arbitrage: - There is a close interrelationship between exchange rates, interest rates. It revolves around the theory of interest arbitrage. The theory of interest arbitrage slates that interest rates for comparable short term investments in different countries & currencies must differ by the same proportion as the spot rate differs from the forward exchange rate. In other words, the annualized percentage difference between interest rates must be equal to the annualized percentage difference between the spot rate & forward rate.

EXCHANGE RATE SYSTEMS

Q. 7] Define Foreign Exchange Rate

Ans: Exchange rate is the rate at which one country’s currency is exchanged against the other country’s currency. It is expressed as the number of units of local currency per unit of foreign currency. For example, $ 1 = Rs. 54/- In other words, it is the price of foreign exchange expressed in terms of local currency.

Q. 8] Explain how demand for and supply of foreign exchange determine the Foreign Exchange Rate

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Ans: As per BOP theory there are twin market which determine the Exchange Rate. It can be explained as follows:

The demand for foreign currency is represented in the diagram. On the X axis it represents the quantity of England’s ounds (£) demanded by US and on the Y axis the exchange rate is shown. The demand curve being a downward sloping curve from left to right, it’s clearly seen that when the exchange rate is $2 = £ , the total quantity demanded by US is £1,000. As the exchange rate falls to $1.5 = £1, the demand for Pounds (£) increase to £1,500.

The foreign currency is demanded because of the following reasons:

a. Import of goods

b. Import of services

c. Unilateral Payments (donations, gifts, etc.)

d. Miscellaneous (repayment of debts, purchase of assets in foreign countries, direct foreign investments etc.)

place for diagrams

The supply of foreign currency is represented in the diagram. On the X axis it represents the quantity of England’s ounds (£) supplied and on the Y axis the exchange rate is shown. The supply curve being an upward curve from left to right, it can be seen that when the exchange rate is $1.5 = £1, the total quantity supplied by England is £1,000. As the exchange rate falls to $2 = £1, the supply of Pounds (£) increase to £1,500.

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The main reasons of increase in supply of foreign exchanges are as follows:

a. Export of goods

b. Exports of services

c. Unilateral receipts (donations, gifts, grants received)

d. Miscellaneous (FDI, Foreign Portfolio Investment, repayments of debt taken by other countries etc.)

With the intersection of Demand curve and Supply curve, we can determine the Foreign Exchange rate as shown in the following diagram:

F.E.R = f(Df. Sf)

F.E.R. stands for Foreign Exchange Rate

f stands for functional relationship

Df stands for Demand of Foreign Exchange

Sf stands for Supply of Foreign Exchange

M.Com MORE CLASSES

Economics of Global Trade & Finance Your partner in studies

The demand curve and the supply curve intersect each other at ‘E’. Hence the equilibrium FOREX rate is $2 = £1. If the exchange rate decreases to $2.5 = £1, then the supply will increase to point b, however, at that decrease the demand for Forex will fall from E to point a, showing the increase in price of Pounds (£) and demand for Pounds falling. Also if the exchange rate increase to $1.5 = £1, then the supply falls to point c, however in the mean time the demand for Pounds (£) increases showing the fall in price leading to a rise in demand and fall in supply.

Q. 9] Explain the different Exchange Rate systems in brief

Ans: Broadly speaking there are two different types of Exchange Rate Systems:

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Place for diagram

a. Fixed Exchange Rate System

b. Flexible Exchange Rate System

a. Fixed Exchange Rate System: As the name suggests under this exchange rate system, the countries agree to keep their currencies at a fixed or pegged exchange rate. Since the values of the currencies were pegged against gold, it was also called as Gold Standard Exchange Rate system. This system prevailed till the First World War period. It had

3 different versions as follows:

i) Gold Specie Standard – consisted of gold coins with fixed gold content

ii) Gold Bullion Standard – consisted of paper currency fully backed by gold and were convertible into gold

iii) Gold Exchange Standard – in this domestic currency of the country concerned is linked with the paper currency of another country which is fully convertible into gold

It used to function on the basis of Mint Parity Theory i.e. gold parity. For example, if $100 were backed by 50 grams of gold and Rs. 100/- were backed by 10 grams of gold then the exchange rate would be 1$ = Rs. 5/- as $100 backing was equal to Rs. 500/- backing. Automatic stability of exchange rate and automatic equilibrium in BOP were the merits of gold standard.

b. Flexible Exchange Rate System: This system came into existence when the world switched over to inconvertible paper currency standard. In this the exchange rate is determined freely by the twin market fares of demand for and supply of foreign exchange in the foreign exchange market. The exchange rate fluctuates as per the fluctuations in the demand for and supply of foreign exchange. To understand this, it’s very important to understand the Purchasing Power Parity Theory. There are 2 versions of PPP Theory, which are as follows:

i) Absolute Version

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ii) Relative Version

Q. 10] Explain the Mint Parity Theory

Ans: Under the Mint Parity Theory, it is assumed that the currencies of the two trading or participating countries must be on the same mono-metallic standard i.e. gold or silver. The exchange rate would be determined on the basis of the metallic content of the two currencies i.e. the value of the each gold currency depends upon the gold contained by the respective currencies.

For example: if $100 were backed by 50 grams of gold & Rs. 100/- were backed by 10 grams o gold then the exchange rate would be 1$ = Rs. 5/- as $100 backing was equal to Rs. 500/- backing.

Under this theory the foreign exchange rate fixed was allowed to fluctuate within very narrow limits called the gold export point and gold import points. The points were determined on the basis of transport, handling, loading, unloading, shipment of gold insurance etc.

Place for diagram

On the X axis the demand for and supply of Gold Dollar are shown while along Y axis foreign exchange rate between Gold Dollar and Gold Rupee is shown. D shows the demand for Gold Dollar and S curve shows the supply of Gold Dollar. R shows the Mint Parity i.e. fixed exchange rate between Gold Dollar and Gold Rupee. R1 shows Gold Export Points and R2 shows the Gold Import points. These are to and fro fluctuations in the fixed exchange rate which remain within the very narrow limit

Q. 11] Explain the cases in favour and against of Fixed exchange rate

Ans: The Fixed exchange rate operated successfully under the strict rules, the following are the advantages/in favour of Fixed Exchange Rate system

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a) Stability

This system ensured stability, certainty and confidence in promoting international trade. The trading partners knew how much they are going to receive or how much they are supposed to pay as the rate is fixed.

b) Long term investment

This system paved the way for long term investments which facilitates growth of capital market.

c) No danger of speculation

There is no danger of speculation i.e. in future there will be no ups and downs in the foreign exchange rate.

d) Internal stability

It leads to internal economic stabilization.

e) Underdeveloped countries

The lender and the borrower know how much they are going to receive and how much they are supposed to get, since developing countries depend heavily on foreign loans and foreign capital. The stable exchange rate promotes international lending and thus helps Underdeveloped countries.

f) Small countries

Small countries like Belgium and Denmark foreign trade plays a very important role in their national income. Stable exchange rate system becomes the right policy of such countries

g) Growth of Money and Capital Market

This system is very much essential for the up to date growth of international money and capital market.

The Fixed exchange rate system is defective in following ways:

a) High Government interference

The fixed exchange rate is determined by the government and not by the market forces and hence it is ill suited for the economic and political conditions of the country as per Milton Friedman

Q. 12] Explain the cases in favour and against of Flexible exchange rate

Ans: Flexible Exchange Rate system has the following advantages:

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a) Twin Market Forces

Flexible exchange rate system works on twin market forces of demand for foreign exchange and supply of foreign exchange in the foreign exchange market. Hence it represents the general theory of value

b) Government Policies

In this system government of the countries are free to pursue their own fiscal and monetary policies

c) Adjustment of BOP

It serves as an instrument of adjustment in the balance of payment

d) Solution for Disequilibrium

It helps to solve the problem of disequilibrium in the balance of payment

e) Less dependency of Forex reserve

It relieves the country’s dependency on foreign exchange reserves

f) Effective functioning of Forex market

This system paves the way for the effective functioning of foreign exchange market

Q. 13] What is Managed Flexibility?

Ans: Management Flexibility means the flexibility of foreign exchange is controlled. The system of managed flexibility is between the two extreme situations of foreign exchange rate system.

a) The fixed exchange rate system

b) The flexible exchange rate system

OR is the equilibrium rate, when the foreign exchange rate fluctuates around the equilibrium foreign exchange rate then the central bank intervenes in to the foreign exchange market. When the demand for foreign exchange rate rises the central bank releases its foreign exchange reserve and sells the foreign exchange into the market to tide over the increased demand for foreign exchange. Conversely when the supply of foreign exchange rises it buys the foreign exchange from the market. Thus the central bank keeps the fluctuations in the foreign exchange rate within limit.

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Place for Diagram

The managed flexibility can be of three types:

a) Adjustable Peg system

b) Crawling Peg system

c) Managed Floating

a) Adjustable Peg system:

Once the country has made its choice of either currency or basket of currencies, the exchange rate is pegged to the chosen item. Under fixed exchange rate system, govt. attempts to maintain this fixed value over a long period of time. The govt. may like to maintain it fixed forever & may insist that it will never change the fixed rate. However, in reality, it is not possible to maintain exchange rate fixed forever. Whether govt. likes it or not, circumstances force govt. to change the exchange rate. In the case of ‘fundamental’ disequilibrium in BO , the govt. is forced to adjust the external value of its local currency in terms of other currencies. This approach is known as ‘adjustable peg’. The adjustable peg system is also described as maximum devaluation system, because the country waits for a long time trying to hold exchange rate fixed, then undertakes a sudden big devaluation of currency. As the old peg or fixed exchange rate becomes non-feasible the country moves on to a new peg or new equilibrium rate. The Bretton woods system of fixed exchange rate was actually a system of adjustable peg. IMF allowed the member countries to devalue their currency in case of ‘fundamental’ disequilibrium in their balance of payments.

b) The system of crawling peg:

The system is also known as trotting peg or gliding parity. It is another variety of managed flexibility. Here it is believed that sudden devaluation is bad & therefore should be avoided. A country should not wait for an unduly long period of time until all its forex reserves are exhausted. The theory of gliding parity advocates that the country should keep on adjusting its exchange rate to new demand & supply conditions in forex market. The exchange rate should be

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adjusted at frequent intervals, for example, once a month or once a fortnight. It is a system of minimum devaluation, also known as the system of crawling peg or trotting peg. While the adjustable peg system is closer to fixed exchange rate policy, the crawling peg system is closer to flexible exchange rate policy. Under the crawling peg system exchange rate is changed often according to a set of indicators or to the judgment of the monetary authority.

c) Managed Floating:

Under managed floating, exchange rate is basically determined by free market forces of demand & supply in the forex market, but govt. intervenes in forex market to influence the market determined exchange rate. Thus, the float is not ‘clean’. It becomes ‘dirty’ by government intervention. Of course, the degree of government intervention differs from country to country & from time to time.

Under the managed floating exchange rate system, the nation’s monetary authorities are entrusted with the responsibility of intervening in forex market to smooth out short-run fluctuations without attempting to affect the long term trend in exchange rates. Any short run excess demand for forex can be met with supply of forex from the reserves. It would moderate the tendency of the local currency to depreciate. Any short run excess supply of forex in the market can be absorbed in to forex reserves thereby moderating the tendency of local currency to appreciate. Thus, central bank can stabilize short run fluctuating in exchange rates by using forex reserves. This is known as the policy of leaning against the wind. As per the managed flexibility the forex rate is allowed to fluctuate but within limit.

CONVERTIBILITY OF A CURRENCY

Q. 1] Define Currency Convertibility

Ans: A convertible currency is one which can be converted into foreign currencies and can be used freely for payment against import of goods and services.

Q. 2] Distinguish between Partial Convertibility and Full Convertibility of the currency

Ans: Partial Convertibility Full Convertibility

1)P. It is the day to day rate of exchange which is charged on the delivery of goods on spot.

1)F. A forward contract is an agreement between the seller of forex & the buyer of forex, the seller agrees to deliver a specified amount of forex at some future date, the buyer agrees to pay in other currency at the future date.

2) P.In actual practice the settlement takes place within two days in most of the forex market

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2) F.It may be one month forward, 3 months forward, 6 months forward etc.

3)P. The buyer of forex has to pay immediately on the spot the amount in other currency.

3) F.The payment depends upon the contract date

4) P.The exchange rate is the rate which is prevailing at the time of trade, hence known as spot rate

4)F. The rate is agreed upon at the time of signing the forward contract but delivery / payment is made at some date in future.

Q. 3] Write notes on Prerequisites and Merits of currency convertibility

Ans: The Prerequisites for making the currency convertibility a grand success are as follows:

1) Domestic stability of an economy

2) Adequate stock of foreign exchange reserves

3) When foreign exchange reserves are not adequate then the imports should be restricted in a country and should import only essential commodities

4) Current Account position of balance of payment should be comfortable

5) Conducive and appropriate industrial and investment policies

6) Development planning should be export oriented such that incentives should be given for the promotion of exports

The merits of convertibility are as follows:

1) It encourages exports by increasing profitability of exports

2) It leads to import substitution and export promotion

3) It gives incentive to Non-Resident Indians to remit funds

4) Before convertibility Hawala Market remains very active to the remittance of funds now after convertibility remittance of funds gets done through proper channel

5) It assigns real value to the currency

Q. 4] Explain the term Foreign Exchange Reserve

Ans: The term foreign exchange reserve is associated with the system of international payments of a country. It is a part and parcel of international liquidity.

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International liquidity a broader concept refers to generally accepted means of international payments available to a country for the settlement of international transactions, it consists of two elements

a. Owned reserves

b. Borrowing facilities

Of these two elements the foreign exchange reserves constitute only Owned reserves. It consists of the following:

a. Official holding of gold

b. Foreign exchanges like US dollars, Pound sterling and other strong or reserve currencies of the world countries.

c. Special Drawing Rights (SDRs)

d. Reserve Position in IMF

Q. 5] Write a note on the Reserve position in IMF

Ans: The reserve position of IMF can be had from each member country’s contribution to IMF, in terms of fixed quota. Each member country’s quota is fixed on the following grounds:

a) 2% of national income

b) 5% of gold and dollar reserves

c) 10% of average annual imports

d) 10% of maximum variation in annual exports

e) The sum of (a), (b), (c) and (d) increased by the percentage ratios of average annual exports of national income

The quotas of all member countries taken together determine the major financial resources of the fund. Each member country is required to subscribe its quota partly in gold and partly in 25% of its quota or 10% of its gold stock and US Dollar holdings, whichever is less. The portion of subscription paid in nations currency is deposited in nations central bank on behalf of IMF.

Quotas of selected member countries of IMF:

As on December 31, 1972 in million US

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Country

USA UK Germany France Japan Canada Italy India

Quota 6700 2800 1600 1500 1200 1100 1000940

Gold Sub 1672 700 400 375 300 275 250162

1 SDR = 0.888671 gram of fine gold

Source: IMF International Financial Statistics Feb. 1973

(For latest info: http://www.imf.org/external/np/sec/memdir/members.aspx)

Q. 6] Explain importance of SDR’s

Ans: To cater to the growing need of international liquidity to finance the balance of payments deficits and other international financial obligations, SDR (Special Drawing Rights) were introduced.

SDR is an international reserve asset created by IMF by taking into account the global need to supplement the existing reserves and thus to alleviate the problem of international liquidity.

The SDR is a created deposit of the IMF. It confers on the holder the right to obtain its defined equivalent in foreign exchange from other member countries of IMF. It is only a book entry in the Special Drawings Account of the IMF. The allocation of DRs takes the form of credit entry in the DR’s Account of the Fund.

The features of DR’s are as follows:

a) There is no need to furnish any adequate collateral security when the SDRs are issued to any member country.

b) It can be freely used by the creditor country to meet its balance of payment details.

c) It doesnot require prior approval of IMF for using a SDR and also the member country need not adopt any specific economic policy for the same

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d) A participant member country having a need to use SDRs toward balance of payments deficit can approach a designated member of the fund for the supply of the required foreign exchange.

e) The fund designates members to provide the foreign exchange in exchange for SDRs on the basis of strength of their balance of payments and reserve position.

The importance of SDRs are as follows:

a) To obtain currency in transactions through agreement with other members, without any requirement for balance of payment deficit.

b) For swap arrangements

c) In forward operations

d) To make loans of SDRs

e) To settle financial obligations

f) As security for the performance of financial obligations in either of the two ways:

a. Members may pledge SDRs which is recoded in a special register kept in the IMF

b. SDRs may be used by members as security against performance of obligation

The SDR is known as paper gold as it is substituted for gold as the most important international monetary asset. The main objective of IMF behind the issue of SDTs is to provide adequate reserves to member countries to facilitate the expansion and the growth of international trade. The allocation of SDRs supplements the exiting international reserves. It also reduces the dependency of the member participating countries on US dollar as the international means of payments.

The value of SDR is determined on the basis of a basket of five currencies vis the US dollar, the Deutsch Mark, the French Franc, the Japanese Yen and the British Pound Sterling.

Q. 7] Define Exchange Risk

Ans: Exchange Risk can be defined as the rate at which a currency is exchanged for another country may be uncertain volatile and the amount that an exporter receives in domestic currency or an importer has to pay in terms of domestic currency will be unpredictable and uncertain. Similarly, if funds are transmitted from one country to another, the amounts to be set or to be received will not be certain, if exchange rates are not fixed. But in the present global economy, free market forces operate to determine the exchange rates depending upon the supply and demand for the currency. This will lead to fluctuating rates, which may result in profits or losses to the holders of foreign currency.

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Q. 8] What are the types of exchange risks

Ans: The different types of exchange risks are as follows:

a) Credit risk of customer: Credit rating by international banks and international credit rating agencies will help reducing this risk

b) Country risk: This is slightly different from currency risk and arises out of the policies of economic and political nature and their external payments position and their export earnings to service the foreign creditors, convertibility or otherwise of their currencies etc.

c) Currently risk: This risk arises out of the volatility or otherwise of the currency and its strength or weakness in terms of other currencies and interest rates and relative degrees of inflation in the respective countries which influence the exchange rates. It also depends on the hot money flows and speculative short term flows as between countries which will destabilize the exchange rates.

d) Market risk: Risk of commodities, their quality and change of government policies of taxation etc., are borne by the exporters. It will thus be seen that some risks cannot be avoided or passed on by the exporters and in fact many more risks are to be borne by the importers than by the exporters.

Q. 9] State the financial instruments used by the foreign exchange market to link it globally

Ans: The financial instruments used by the foreign exchange market to link it globally are as follows:

1. Spot: In spot transaction the trade represents a “direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the agreed upon transaction

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

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

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

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

6. Exchange Traded fund: Exchange – traded funds are open ended investment companies that can be traded at any time throughout the course of the day.

7. Speculation: Speculation have a stabilizing influence on the market and perform the important function of providing a market for hedgers and transferring risk from those people who don’t wish to bear it, to those who do. Large hedge funds and other well capitalized “position traders” are the main professional speculators.

Asst. Prof. Vikas Ubale

MODULE –

CURRENCY MARKET

Q. 1] Explain the important features of Euro-Currency Market. What are the factors that contributed to its growth? (A-09, O-09, A-10, O-10, A-11)

Ans: Euro-currency market is an international financial market specializing in the borrowing and lending of currencies outside their countries of issue Euro currency market is primarily a post war phenomena and came to be known as Euro dollar market. Thus the Euro dollar market is more broadly called the Euro currency market as it also includes currencies other than the dollars such as Pounds, Francs, Yen. However, the Euro dollar portion of the Euro currency is the dominant one. But a Euro currency system is not necessarily is located in Europe, it extends far beyond its original European location with centers open for business at almost any time in the middle east and south east asia, as well as Canada and Japan, however its origin is in Europe.

Features of Euro-Currency Market

1. International Market: Euro currency market has emerged as the most important channel for mobilizing and deploying funds on an international scale. By its very nature for eg: the euro currency market is outside the direct control of any national monetary policy “It is aptly said that the dollar deposits in London are outside US control because they are in London, and out British

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control because they are in dollars.” The growth of market owes a great deal to the fact that it is outside the control of any national authority.

2. Short term Money Market: the deposits in this market range in maturity from one day to several months and interest is paid on all of them,. Although some Euro currency deposits have a maturity of over one year. Euro currency deposits are predominantly a short term instruments. Euro currency market is a credit market – a market in dollar bank loans- and as an important assessor to the Euro bond market. Euro dollar loans are generally for short periods i.e 3months or less. Euro bonds being employed for long term loans. The Euro bonds developed out of the euro currency market to [provide longer term loans than was usual with euro dollar. These bonds are usually issued by a consortium of banks and issuing houses.

3. Wholesale market: It’s a whole sale market in the sense that the Euro dollar is a currency dealt in only large units. The size of individual transaction is usually above $1million dollar.

4. Highly competitive: Euro currency market is sensible market.Its efficiency and competitiveness are reflected in its growth and expansion. The resiliency of the euro dollar market is reflected in the responsiveness of the supply of an demand for funds to the changes in the interest rates.

Factors that contributed to the growth of euro currency market:

1. Suez crisis:- The restrictions placed upon sterling credit facilities for financing trades which did not touch the britishers during the Suez crisis in 1957 provided a stimulus for the growth of euro dollar market. The British banks in search of an alternative way to meet the demand for credit on the part of the traders in this sphere easily found a good substitute in dollars.

There was already available a pool of US Dollars held by residence outside the US.

2. Exchange controls and currency convertibility:-The general relaxation of exchange control the stability in the exchange market and the resumptions of currency convertibility in western Europe in 1958 provided an added impetus to the growth of the Euro Dollar market. In a convertible currency system, some countries are as a rule in surplus and others indeficiate. The money market in the surplus country being liquid, short term funds flow to the euro market, attracted by the higher rate of interest .On the other hand, credit flows from the euro market to the deficit countries where the money market is right. The relaxation of exchange controls not only enabled the holder of the dollar claims to retain them rather than surrendering the dollar to the exchange control authorities, but also increased the demand for US dollars as they could be freely converted into domestic currency to finance domestic economic activity

3. Political Factors: The cold war between US and the communist countries also contributed to the growth of the euro market. Due to the fear of blocking or seizure of deposits by the US in the

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event of hostilities, the Russian and the east European banks sought to place their dollar balances with European banks especially British and French rather than with banks in the US.

4. Balance of Payment deficits of the US: The large and persistent deficit in the BOP of the US meant an increasing flow of the US dollars to those countries who had surplus with the US. The US has had a deficit in International payments every year since 1950, except in 1957 since 1958 the deficit assumed alarming proportions. This is one of the most important factors responsible for the rapid growth of Euro Dollar market.

5. Innovative Banking: The advent of innovative banking spearheaded by the American banks in Europe and the willingness of the banks in the market to operate on a narrow ‘spread’ also encouraged the growth of Euro market.

6. Supply of Petro dollars: the flow of petro dollars facilitated by the tremendous increase in the O EC’s oil revenue following the hikes in the Oil prices since 1973 has been a significant source of growth of the Euro dollar market. Oil price rise in 1973 which was followed by frequent escalations and the resultant huge current account surplus of the OPEC who came to place their funds in the Euro currency market proved to be an unprecedented boon. The OPEC surplus rose from US $64b. in 1974 to $120b. in 1980 with a corresponding availability of large funds to the Euro currency markets providing burgeoning liquidity to the International banks operating in the market.

Q. 2] What is meant by currency area? Discuss the emerging trends in currency area (O-09, O-10, O-11)

Ans: Currency areas refer to a group of countries, whose currencies are permanently linked through a fixed exchange rate system among themselves. The currencies of member countries are linked with the currencies of the non-member countries on the basis of flexible exchange rate system. Currency area may be linked through a common currency such as the Euro of the EC countries. Currency area is a territory or region in which one monetary unit of a currency circulates with fixed rate and its is integrated through trade and factor movements. The currencies of member countries may be linked with non-member countries may be linked with non-member countries on a flexible exchange rate system. The membership of an OCA may involve benefits and costs. A country joining the OCA or economic unions gains greater monitory efficiency under a fixed exchange rate as compared to a flexible exchange rate with a nonmember country,. The monetary efficiency gain will be all the more higher if such factors as labour and capital can move freely between the country joining the OCA and its other members. The EU also known European Economic Community, is a successful example of a currency area. The first step towards this direction was the establishment of a band of exchange rate fluctuations known as the snake in the tunnel in 1972. This arrangement continued after the collapse of the Bretton Wood system in 1973, with the participating EEC counties jointly floating relative to the rest of the world. It was simply an arrangement but not the integration or

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coordination of monetary and fiscal policies of the union. Member countries moved out of this arrangement with the change in circumstances.

With the formation of EMS (European Monetary System) in 1979 official transactions with the union, the ECU (European Currency Units) came into use. The EMS worked well because members were free to peg their exchange rate bands to the new ‘snake’. The Maastricht Agreement of 99 was ratified by all members by the end of 1993. The Euro, common currency of EEC came into existence on 1st January 1999 and the EEC became the EU. The importance of Euro Currency Market in the international economy has increased over whelming. Its future is linked with the future of world economy as a whole. Indeed, development of the market has been so much amazingly rapid that it has now become the focus of considerable controversy. Its size, rapid growth and freedom from national regulations have attracted interest in its Macro Economic implications and its impact of its policies of individual countries. It will continue to play a major role in the world economy scene so long as worlds international transactions or the integration of world economy proceeds as smoothly as they have in the past. The important role of the EC market in the international lending is well brought out by the fact that of the total international bond issue and placements more than one half was in the Euro dollar issues and placements. It is obvious that the sound development of the world economy cannot be maintained without the smooth functioning of the Euro Currency Market.

The development of currency market indicates the extent of monetary interdependence of the economies of the world. The degree of its development is such that for the proper management and monitoring of the world economy, effective coordination between the monetary and other policies of the major countries of the world is essential. Agreements of some form of coordinated surveillance and official intervention in the currency market may well prove the beginning of laying the foundation of further cooperation in coordinating economic policies of the countries of the world. Until there is some consensus agreement among the concerned the countries regarding the overall role of euro currency market as an international capital market there is, little chance of progressing in the direction of formulating specific regulatory measures for the markets.

The positive effects of currency markets are in the form of increased international capital mobility, integration of capital markets, reducing interest differentials among nations and help in financing balance of payment deficits. The flows of Euro dollars have some adverse effects also. According to Milton Friedman, “the Euro dollar market has almost surely raised the worlds nominal money supply (expressed in dollar equivalent) and has this made the world price level (expressed in dollar equivalent) higher than otherwise it would be”. This has obviously created difficulty in monetary regulation by different countries.

Q. 3] Explain Euro – currency and Euro – equity Capital (O-11)

Ans: For Euro – Currency refer to Q.12 & 13

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Euro – equity Market: Euro-issue is an issue where the securities are issued in a currency of the country of issue and the securities are sold internationally to corporate and private investors in different countries. A Euro – issue is different from a foreign issue where the issuer is not incorporated in the country in which the securities are being issued, but the securities are denominated in the currency of the country of issue and are aimed at domestic investors in the country where the issue is made. Euro securities are transferable securities which are to be underwritten and distributed by a syndicate.

The major benefit that a Euro issue provides to the issuer company is the ability to raise funds at a lower cost. Average coupon rates on convertible bonds of five year maturity in the Euro market are 2.5% to 4% as against the domestic long term interest rate of 14% or more. The cost of 8% to 14%, thus providing a mechanism for raising equity at a cost which is lower than the cost of making a rights issue. Also, a Euro issue can be priced at par or even at a slight premium depending on the market conditions. Besides these benefits, issuer companies which can enlarge the market for its shares through greater exposure and at the same time, enhance its image in the international markets. International listings can provide increased liquidity for the securities, thus making them more attractive to buyers. From an investor’s angle, a Euro issue provides them a simple means to diversify their portfolio globally, and have access to foreign markets which were closed to foreign investment until now.

Q. 4] Explain Euro Currency, Euro Equity and Euro bond Markets (A-12)

Ans: Currency Market refers to the mechanism through which payments of global trade are settled. It is the system of materializing global trade and financial transactions in international institutions and Commercial Banks realized the need for a common currency to settle international trade transactions.

Euro currency market is an international financial market specializing in the borrowing and lending of currencies outside their countries of issue, The prefix “Euro” thus refers to external indicating that the market is not a constituent of the domestic financial system and is thus free from the domestic banking regulation.

The Euro-currency market is primarily a post war phenomenon and came to be known as Euro-dollar market. Thus the Euro-dollar market is, more broadly called the Euro-currency market as it also includes currencies other than the dollars such as pounds, Francs, Yen. However, the euro-dollar portion of the Euro-currency is the dominant one. But a Euro-currency system is not necessarily located in Europe, it extends far beyond its original European location with centers open for business at almost any time in the Middle East and South East Asia as well as Canada and Japan. However its origin is in Europe.

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Constituents of Euro Currency Market

1. Euro Currency: Funds in the Euro Currency market are funded by banks in the form of loans and Merchant Bankers help in the loan syndication. To play in the international capital market the major things that are important are the choice of currency and the choice of financial instrument and in the selection of these, only the merchant bankers skills, expertise, experience and resource position is reflected. There are lot of new instruments which came into existence and choice has to be made to economies the cost and quick availability of funds depending on the need profile of the user.

2. Euro Equity: With liberalization having opened the floodgates of overseas market, more companies are moving towards the mobilization of funds from the international market in the form of Euro issues- GDRs. This would in turn lead to Merchant bankers to be fully conversant to deal in Euro issues. However, there are some barriers which are restricting the growth of the euro-equity market. The heavy cost and time involved in reaching the investors, difficulty for investors in making the decision to invest in a particular currency, standardizing of various systems, complications of various regulations in other nations etc. are some of the reasons. These could be overcome once the Merchant Bankers develop expertise in these areas

3. Euro Bond: Merchant Bankers can enter into the international bond market as lead managers. There are various centers which provide technical facilities and depending upon the borrowers’ country of origin, funds requirement, location of stock exchange. All Eurobonds are required to be listed on one or more stock exchange for easy trading. To enter the areas of international market, the Merchant Banker has to follow the two steps namely to participate in international groupings and association with other merchant Banks operating in International Market.

Q. 5] What are the characteristics of the Euro-currency Markets (A-12)

Ans: The important characteristics of the currency market are as follows:

1. International Market: Currency market has emerged as the most important channel for mobilizing and deploying funds on an international scale.

2. Short-term Money Market: The deposits in this market range in maturity from one day to several months and interest is paid on all of them. Although some Euro-currency deposits have a maturity of over one year. Euro-currency deposits are predominantly a short-term instrument. Euro-currency market is a credit market – a market in dollar bank loans and as an important accessory to the Eurobond market. Euro-dollar loans are generally for short periods – three months or less. Euro-bonds being employed for longer term loans. The Euro-bonds developed out of the Euro-currency market to provide longer term loans than was usual with Euro-dollars. These bonds are usually issued by a consortium of banks and issuing houses.

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3. Wholesale market: The Euro-currency market is a wholesale market in the sense that the Euro dollar is a currency dealt in only large units. The size of an individual transaction is usually above $1 million

4. Highly Competitive: Euro-currency market is sensible market. Its efficiency and competitiveness are reflected in its growth and expansion. The resiliency of the Euro dollar market is reflected in the responsiveness of the supply of and demand for funds to the changes in the interest rates.

Asst. Prof. Vikas W. Ubale

MODULE-

EMERGING ISSUES IN GLOBAL TRADE

Q. 1] Write a note on Tariff’s

Ans: Tariffs refers to the duties or taxes which are imposed on internationally traded commodities when these goods cross the national boundries.

Classification of Tariff’s: place for T diagram

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Q. 2] What are the effects of Tariffs?

Ans: The following are the effects of Tariffs:

1. Price Effect

2. Protective Effect

3. Revenue Effect

4. Consumption Effect

5. Income and Employment Effect

6. Transfer Effect or Redistribution Effect

7. Terms of Trade Effect 8. Balance of Payment Effect

Q. 3] What do you mean by Non-Tariff Barriers? Explain them briefly (April 09)

Ans: Non – tariff barriers are in the form of quantity restrictions such as quotas, import licensing, counselor formalities trading blocks, state trading, export obligation exchange control etc.

Tariffs are not very effective in under developed countries. Their problems are different from the problems faced by the developed countries. The problem before the developed countries is to maintain the already attained high rate of economic growth while the problem before the undeveloped countries is to accelerate the rate of economic growth. Hence, NTB’s can be divided into two categories – NTB’s for Developing countries (for preventing foreign exchange outflows or those which result from the chosen strategy of economic development) and NTB’s for Developed countries (for protecting domestic industries which have lost international competitiveness and/or which are politically sensitive for governments of these countries)

The measures which are used other than tariffs to restrict imports collectively are referred as non-tariff barriers. These are direct measures of import restrictions. These can be further divided

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into two forms (a) those NTB’s which restrict imports directly (b) those which restrict imports by encouraging domestic production.

The following are the types of import quotas:

1. Tariff Quota: In this case, imports of commodity up to certain amount, is permitted under a low rate of tariff duty. Any further increase in imports beyond the given quantity is charged at a higher rate of import duty. Thus, it’s a combination of tariff as well as quota.

2. Unilateral Quota: A Quota which is fixed without negotiation with the foreign trading partner is called Unilateral Quota. There are two types of Unilateral Quota (a) Global Quota (b) Allocated Quota.

Under Global Quota a fixed amount of goods can be imported from any country. Under Allocated Global Quota a fixed amount of goods to be imported is rigidly fixed and the exporting country is also fixed and hence there is also a fear of creation of monopoly.

3. Bilateral Quota: Bilateral quota implies negotiation between both the trading countries regarding the fixing of quota of the commodity to be imported. An importing country levies bilateral quota in consultation with the exporting country.

4. Mixing Quota: Mixing quota combines the features of the domestic raw materials and the imported spare parts from the exporting country. The assembling takes place in the domestic country. Mixing Quota is advisable in order to boost up domestic production. It also saves precious and scarce foreign exchange.

5. Import Licensing: Import licensing is import quota regulatory system. Under this system the prospective imports would be required to obtain import license from the authority and this exerts a better control over imports.

1. Foreign Exchange Restrictions: Exchange control measures are used by many developed nations to regulate their imports and keep their balance of payments in controllable limits. In this the importer has to ensure that adequate foreign exchange would be made available to him for the import of goods by obtaining a clearance from the exchange control authorities of the country before concluding the contract with the supplier.

2. Technical and Administrative Regulations: In this the importing country specifies certain standards on the imported commodities and which they must satisfy before their import is permitted. It may be like a standard on technical production, technical specification etc. It can also be administrative restrictions such as adherence to certain documentary procedure which are to be adopted to regulate imports. These technical and administrative measures impede the free flow of trade to a large extent.

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3. Consular Formalities: In this along with shipping documents it must accompany the consular documents such as certificate of origin, certified invoices, import certificates etc. In case the documentation is faulty or not drawn in the language of importing country, heavy penalties are imposed and also fees charged on these documentations are quite heavy.

4. State Trading: Separate state agencies are setup for each class of products. These agencies carry on the international trade strictly according to the government policies. A few other countries of the world follow state trading in a restricted sense to achieve certain desired results especially where bulk imports are needed and government wants to maintain price stability. For eg. Some articles, as decided by the government, are imported only through State Trading Corporation (STC), similarly exports of raw materials such as iron ore, mica etc. are canalized only through Minerals and Metals Trading Corporation (MMTC).

5. Preferential Arrangement: In multilateral trading system, a few member countries agree to a small advantageous group for their mutual benefit. The member countries of the group negotiate and arrive at a settlement of preferential tariff rate to carry on trade amongst them. These rates are much lower than ordinary tariff rates and applicable only to the member nations of the small group. Such type of preferential arrangements is outside the purview of the WTO.

Q. 4] Discuss the process and progress of globalization in India and China(April 09, Oct 09)

Ans: Most of the global economies have chose to turn their economic systems towards the market economy and global economy. These countries include Eastern European countries, Vietnam, Peru, Mexico, Brazil, India, Ethiopia, Morocco, Chile, Spain, Cuba etc. India had observed these developments in the global economies and responded favourably to these changes in 1991.

Sequence of reforms in china:

The First Phase (1978-1993) Economic reforms in China began with reforms in agricultural and rural development

1978 : Dismantled the Rural people‟s Communes and allotted land reforms on long-term contract, with right of inheritance. Adopted „Dual Track ricing Mechanism‟, under which agents were permitted to sell part of the produce in the open market.

1979 : Special economic Zones (SEZs) set up in Shenzen, Zhuhai, Shantou, and Xiamen to attract FDI. Foreign players allowed to make own investment-production and marketing-decisions in these zones. Flexible labour laws introduced in these zones.

1984 : Free Trade Zones opened in 14 post cities along the North and South-Eastern coast and Hainan island

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1985 : State monopoly on purchase and marketing of grains, cotton etc. replaced by a system of contract purchase Agriculture products allowed to be bought and sold freely State subsidies on agricultural products totally withdrawn

1987 : Contract system introduced among all newly recruited workers in state owned enterprises

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1988 : Made Hainan island a separate province and a declared the whole island a Special economic Zone

1991 : Direct subsidies to exporters stopped

1993 : Central Bank of China given greater powers; influence of local governments over monetary and credit policies reduced The Second Phase 1994 : A single VAT of 17 per cent introduced in place of a host of indirect taxes. Share of national and local governments changed to 75:25

1995 : large scale privatisation of loss making SOEs. Lay-off begin 1996 : current account convertibility allowed and averaged customs duty reduced from 36 percent to 23.4 percent

1997 : Launched programme to convert large industrial enterprises into conglomerates while releasing others Bureaucracy streamlined to reduce the number of officials by half

1998 : Grain distribution system reformed, new channels for capital circulation opened, housing commercialised and a medicare programme introduced 1999 : Recapitalisation of national banks started by creating four asset management companies

2000 : Two government bonds issued to finance the government‟s infrastructure activities Private Individual Wholly Invested Enterprise Law brought into effect Individuals allowed to set up private companies and tap the capital market Indian industries does not have much to show its efforts towards globalization except its success in software projects. But Chinese consumer durable industry like Haier, Galantz, TCL and Konka are exporting to Asia and Europe with these phenomenal developments. China poses a threat to India not only in the Indian market, but also in the foreign markets

Economic Reforms in India

The First decade (1991-2001)

1991 : New Industrial policy announced Foreign investment up to 51% in select industries allowed PSU reserve list cut from 17 to 8 FIIs allowed to invest in market PSUs brought under SICA

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1992 : Steel industry decontrolled Wealth tax abolished Free pricing of IPOs allowed 100% private equity in core sectors like steel, telecom and power permitted Five year EXIM policy announced

1993 : Companies Act amended Rupee made convertible on trade account Excise duty simplified by merging special and basic duty

1994 : Private telcos allowed to compete with state owned COS Lending rates deregulated Automatic approval announced for foreign investment upto 51% Rupee made convertible on current account Drug industry delicensed

1995 : Modified carry forward trading system allowed Insurance regulatory body mooted

1996 :74% foreign equity in 9 industries, and 51% in16 more permitted

1997 : Coal sector privatised Maximum income tax rate cut to 30% and corporate tax to 35% Restrictions on import of 69 goods lifted New takeover code approved 1998 : New prudential norms for NBFCs notified FII investment in treasury bills cleared FDI norms under automatic route simplified Trading in derivatives by FILLs cleared Norms on foreign equity participation in airline sector overhauled 100% FDI in cigarettes allowed 74% foreign equity cap announced for TV software firms Up to 40% FDI in private

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banks allowed ISP policy frees tariffs, allows private gateways Insurance, patent reforms cleared

1999 : IT ministry launches a Rs. 100 cr VC fund for start ups IRDA (Insurance regulatory and development) bill passed Foreign Exchange Regulatory Act replaced by the Foreign Exchange Management Act Department of Disinvestment created to oversee privatisation of public sector enterprises Excise rate slab cut from 11 to 3-8%, 16% and 24%

2000 : VC cos. made exempt from income tax as well as dividend tax Rs. 150 cr. R and D fund set up Minimum daily requirement for maintaining cash reserve ratio balances slashed from 85 to 65% Inter-bank gold trading by banks allowed Scheduled commercial banks allowed to float insurance subsidiaries Special economic zones to be created with 100% foreign equity Quantitative Restrictions (QRs) on 714 tariff lines at the 8 digit level lifted Single window clearance for import of capital goods at a flat rate of 5% announced Indian industry has to meet the competition of Chinese industry. There are three options to India. They are:

- Collaboration with China by forming regional trade block on the lines of ASEAN.

- Collaborate with USA / Japan, acquire competencies and meet the competition.

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- Collaborate with some of the industries of other countries.

Globalisation has brought in new opportunities to India and China. Greater access to developed country markets and technology transfer hold out promise improved productivity and higher living standard.

1. Liberal Economy: Globalisation made India and China more economically liberal. These liberalization measures include scrapping of the industrial licensing regime, reduction in the number of areas reserved for the public sector, amendment of the Monopolies and the Restrictive Trade Practices act (MRTP), start of privatization etc.

2. GDP growth rates: GDP grew from 4.6% in 1990-91 to a peak level of 77.8% in 1996-97. A global comparison shows that India is the second fastest growing economy after China.

3. FDI: Over the past decade FDI flows into India has averaged around 0.5% of GDP against 5% for China, where as FDI inflows into China now exceeds US $50 billion annually. It is only US $4 billion in the case of India.

4. Agriculture: replicating the reforms model of China may not be possible for India at this moment, but certainly applying the insights from their experience is worth doing, which will certainly create an environment conducive to achieve the growth rate of 9% per annum in this decade.

Q. 5] What is strategic trade policy? Analyse its significance for developing countries (Oct 09, Oct – 10, April – 11)

Ans: Strategic Trade Policy refers to the system of government interference in foreign trade. The nature of government interference or trade policy has very broad implications – it has impact not only on the volume and composition of imports and exports but also on the pattern of investment and direction development, competitive conditions, cost conditions, entrepreneurial and business attitudes, consumption patterns etc. While the need for government interference in the trade, as in other sectors, of the developing countries is well recognized, there is no agreement on the type of trade strategy or the nature of the government interference in trade that is suitable for the developing countries.

The choice of the trade strategy is one of the most important economic policy decisions a developing country has to make because of its wide implications indicated above. The trade policy is only one of the elements of the macroeconomic policy mix – all the elements of the mix should be mutually supportive for the development strategy to be successful.

Under protectionism, the domestic industries are protected from the competition of foreign goods. The home industries are granted protection in any one or more of the following ways:

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1. Protective Duties: When the government, with a view to make the imports costly imposes duties on the imports of foreign goods, such duties are called Protective Duties. Such duties may be advalorem (on the value of imports) or specific (on the weight or measurement).

2. Commercial Prohibition: Sometimes, the government prohibits altogether the imports of certain commodities with a +

3. Quota System

4. License System

5. State Trading

6. Discriminatory Transport Charges

7. Devaluation

8. Exchange Control

Q. 6] Explain the impact of non-tariff barriers on import and export of developing countries (April – 10, Oct – 11, April – 12)

Ans: Non tariff distortions occur due to imposition of non – tariff barriers. The non – tariff barriers are in the form of quantitative restrictions such as quota, license, foreign exchange restrictions consular formalities, technical and administrative regulations. The following are some of the major non – tariff restrictions:

1. Exchange Permit: Exchange permits are very important to the exporters. In order to conserve scarce foreign exchange and to solve balance of payment difficulties, many countries have imposed restrictions on the use of their currency.

2. Quotas: Quotas are quantitative restrictions. Quotas involve a limitation either on the value or the quantity of a commodity that may be imported or exported from the country during specified period of time.

Import quota is a protectionist device under which only a fixed amount of goods and services may be imported. Import quotas are of two types (i) autonomous quotas fixed by law and (ii) agreed quotas, fixed by trade agreements between the countries

3. Consular Formalities: In many countries consular documents have to be obtained by the importers like import certificates, certificate of origin, certified consular invoices etc. Documentation fee payable by the importers is also quite high.

4. State Trading: In many socialist countries of the world, foreign trade is not only regulated but also exclusively handled by state enterprises. In such

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Economics of Global Trade & Finance Your partner in studies countries, the nature and extent of international trade is influenced by government policies.

5. Dumping: It is the process of selling goods abroad at a price lower than the selling price at the home market. It doesn’t imply selling at a loss, or selling at cost price; being charged from the home market. Such a dumping by its very nature is not a permanent feature of international trade. The producer does not have the intention to keep on selling the goods below the home price for all times to come.

Q. 7] Compare the process of liberalization and globalization in India and China (April – 11) or Analyse the process and effects of globalization of India and China (Oct – 11)

Ans: The Chinese adopted a path of embracing the process of globalization in late 970’s by liberalizing their economy. Today, China is about to enter the WTO with the status of a developed country.

Refer to Q. 4 for remaining part of the answer

Asst. Prof. Vikas W. Ubale

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my own notes for MCom sem II.doc

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