International Answers….
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Q1. What is India’s export promotion p romotion policy? Answer: The Export Promotion Councils are non-profit organizations registered under the Indian Companies Act or the Societies Registration Act, as the case may be. They are supported by financial assistance from the Government of India. Role The main role of the EPCs is to project India's image abroad as a reliable supplier of high quality goods and services. In particular, the EPCs encourage and monitor the observance of international standards and specifications by exporters. The EPCs keep abreast of the trends and opportunities in international markets for good goods s and and servi service ces s and and assi assist st thei theirr memb member ers s in taki taking ng adva advant ntag age e of such such opportunities in order to expand and diversify exports. Functions The major functions of the EPCs are as follows: 1. To provide provide commercially commercially useful useful informati information on and assistance assistance to their their members members in developing and increasing their exports 2. To offer offer professio professional nal advice advice to their their members members in areas areas such as technolo technology gy upgradation, quality and design improvement, standards and specifications, product development and innovation etc. 3. To organize organize visits visits of delegations delegations of its members members abroad abroad to explore explore overseas overseas market opportunities. 4. To organize organize participati participation on in trade fairs, fairs, exhibiti exhibitions ons and buyer-selle buyer-sellerr meets in India and abroad. 5. To prom promot ote e int interac eracti tion on betw betwe een the expor xporti tin ng comm commun unit ity y and and the Government both at the Central and State levels
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6. To build build a statistica statisticall base and and provide provide data on the the exports exports and imports imports of the the country, exports and imports of their members, as well as other relevant international trade data.
Q2. What’re the objectives of the international monetary system?
(a) What challenges are faced by the countries in the present situation? (b) What’re the possible remedies? Answer: IMF) is the intergovernmental organization that The International Monetary Fund (IMF) oversees the global financial system by following the macroeconomic policies of its member countries; in particular those with an impact on exchange rate and the balance of payments. Its objectives are to stabilize international exchange rates and facilitate development through the encouragement of liberalizing economic policies in other countries as a condition of loans, debt relief, and aid. It also offers loans with varying levels of conditionality, mainly to poorer countries. The International Monetary Fund was conceived in July 1944 originally with 45 members and came into existence in December 1945 when 29 countries signed the agreement, with a goal to stabilize exchange rates and assist the reconstruction of the world's international payment system. Countries contributed to a pool which coul could d be borro borrowe wed d from from,, on a temp tempora orary ry basi basis, s, by coun countr trie ies s with with paym payment ent imbalances. The IMF was important when it was first created because it helped the world stabilize the economic system. (a) What challenges are faced by the countries in the present situation? Two criticisms from economists have been that financial aid is always bound to socalled "Conditionalit "Conditionalities", ies", including Structural Adjustment Programs (SAP). It is claimed that conditionalities retard social stability and hence inhibit the stated goals of the IMF, while Structural Adjustment Programs lead to an increase in poverty in recipient countries. The IMF someti sometimes mes advocat advocates es "auster "austerity ity program programmes mes," ," increas increasing ing taxes taxes even even when the economy is weak, in order to generate government revenue and bring budgets closer to a balance, thus reducing budget deficits. Countries are often advised to lower their corporate tax rate. 2 | Page
Argentina, which had been considered by the IMF to be a model country in its compliance to policy proposals by the Bretton Woods institutions, experienced a catastrophic economic crisis in 2001, which some believe to have been caused by IMF-induced budget restrictions
Impact on people’s access to food in developing countries. Impact on Public Health Impact on Environment (b) What’re the possible remedies? The delay in the IMF's response to any crisis, and the fact that it tends to only respond to them (or even create them) rather than prevent them, has led many economists to argue for reform. In 2006, an IMF reform agenda called the Medium Term Strategy was widely endorsed by the institution's member countries. The agenda includes changes in IMF governance to enhance the role of developing countries in the institution's decision-making process and steps to deepen the effectiveness of its core mandate, which is known as economic surveillance or helping member countries adopt macroeconomic policies that will sustain global growth and reduce poverty. On June 15, 2007, the Executive Board of the IMF adopted the 2007 Decision on Bilateral Surveillance, a landmark measure that replaced a 30-year-old decision of the Fund's member countries on how the IMF should analyze economic outcomes at the country level.
Q3. What’re the different exchange rate systems in the world? Highlight its advantages & disadvantages. Answer: Exchange rates are determined by demand and supply. But governments can influence those exchange rates in various ways. The extent and nature of government involvement in currency markets define alternative systems of exchange rates. In this section we will examine some common systems and explore some of their macroeconomic implications. There are three broad categories of exchange rate systems. In one system, exchange rates are set purely by private market forces with no government 3 | Page
involvement. Values change constantly as the demand for and supply of currencies fluctuate. In another system, currency values are allowed to change, but governments participate in currency markets in an effort to influence those values. Finally, governments may seek to fix the values of their currencies, either through participation in the market or through regulatory policy.
Free-Floating Systems In a free-floating exchange rate system, governments and central banks do not participate in the market for foreign exchange. The relationship between governments and central banks on the one hand and currency markets on the other is much the same as the typical relationship between these institutions and stock markets. Governments may regulate stock markets to prevent fraud, but stock values themselves are left to float in the market. The U.S. government, for example, does not intervene in the stock market to influence stock prices. The concept of a completely free-floating exchange rate system is a theoretical one. In practice, all governments or central banks intervene in currency markets in an effort to influence exchange rates. Some countries, such as the United States, intervene to only a small degree, so that the notion of a free-floating exchange rate system comes close to what actually exists in the United States. A free-floating system has the advantage of being self-regulating. There is no need for government intervention if the exchange rate is left to the market. Market forces also restrain large swings in demand or supply. Suppose, for example, that a dramatic shift in world preferences led to a sharply increased demand for goods and services produced in Canada. This would increase the demand for Canadian dollars, raise Canada’s exchange rate, and make Canadian goods and services more expensive for foreigners to buy. Some of the impact of the swing in foreign demand would thus be absorbed in a rising exchange rate. In effect, a free-floating exchange rate acts as a buffer to insulate an economy from the impact of international events. The primary difficulty with free-floating exchange rates lies in their unpredictability. Contracts between buyers and sellers in different countries must not only reckon with possible changes in prices and other factors during the lives of those contracts, they must also consider the possibility of exchange rate changes. An agreement by a U.S. distributor to purchase a certain quantity of Canadian lumber each year, for example, will be affected by the possibility that the exchange rate between the Canadian dollar and the U.S. dollar will change while the contract is in 4 | Page
effect. Fluctuating exchange rates make international transactions riskier and thus increase the cost of doing business with other countries. Managed Float Systems Governments and central banks often seek to increase or decrease their exchange rates by buying or selling their own currencies. Exchange rates are still free to float, but governments try to influence their values. Government or central bank participation in a floating exchange rate system is called a managed float. Countries that have a floating exchange rate system intervene from time to time in the currency market in an effort to raise or lower the price of their own currency. Typically, the purpose of such intervention is to prevent sudden large swings in the value of a nation’s currency. Such intervention is likely to have only a small impact, if any, on exchange rates. Roughly $1.5 trillion worth of currencies changes hands every day in the world market; it is difficult for any one agency—even an agency the size of the U.S. government or the Fed—to force significant changes in exchange rates. Still, governments or central banks can sometimes influence their exchange rates. Suppose the price of a country’s currency is rising very rapidly. The country’s government or central bank might seek to hold off further increases in order to prevent a major reduction in net exports. An announcement that a further increase in its exchange rate is unacceptable, followed by sales of that country’s currency by the central bank in order to bring its exchange rate down, can sometimes convince other participants in the currency market that the exchange rate will not rise further. That change in expectations could reduce demand for and increase supply of the currency, thus achieving the goal of holding the exchange rate down. Fixed Exchange Rates In a fixed exchange rate system, the exchange rate between two currencies is set by government policy. There are several mechanisms through which fixed exchange rates may be maintained. Whatever the system for maintaining these rates, however, all fixed exchange rate systems share some important features. A Commodity Standard In a commodity standard system, countries fix the value of their respective currencies relative to a certain commodity or group of commodities. With each currency’s value fixed in terms of the commodity, currencies are fixed relative to one another. 5 | Page
For centuries, the values of many currencies were fixed relative to gold. Suppose, for example, that the price of gold were fixed at $20 per ounce in the United States. This would mean that the government of the United States was committed to exchanging 1 ounce of gold to anyone who handed over $20. (That was the case in the United States—and $20 was roughly the price—up to 1933.) Now suppose that the exchange rate between the British pound and gold was £5 per ounce of gold. With £5 and $20 both trading for 1 ounce of gold, £1 would exchange for $4. No one would pay more than $4 for £1, because $4 could always be exchanged for 1/5 ounce of gold, and that gold could be exchanged for £1. And no one would sell £1 for less than $4, because the owner of £1 could always exchange it for 1/5 ounce of gold, which could be exchanged for $4. In practice, actual currency values could vary slightly from the levels implied by their commodity values because of the costs involved in exchanging currencies for gold, but these variations are slight. Under the gold standard, the quantity of money was regulated by the quantity of gold in a country. If, for example, the United States guaranteed to exchange dollars for gold at the rate of $20 per ounce, it could not issue more money than it could back up with the gold it owned. The gold standard was a self-regulating system. Suppose that at the fixed exchange rate implied by the gold standard, the supply of a country’s currency exceeded the demand. That would imply that spending flowing out of the country exceeded spending flowing in. As residents supplied their currency to make foreign purchases, foreigners acquiring that currency could redeem it for gold, since countries guaranteed to exchange gold for their currencies at a fixed rate. Gold would thus flow out of the country running a deficit. Given an obligation to exchange the country’s currency for gold, a reduction in a country’s gold holdings would force it to reduce its money supply. That would reduce aggregate demand in the country, lowering income and the price level. But both of those events would increase net exports in the country, eliminating the deficit in the balance of payments. Balance would be achieved, but at the cost of a recession. A country with a surplus in its balance of payments would experience an inflow of gold. That would boost its money supply and increase aggregate demand. That, in turn, would generate higher prices and higher real GDP. Those events would reduce net exports and correct the surplus in the balance of payments, but again at the cost of changes in the domestic economy. Because of this tendency for imbalances in a country’s balance of payments to be corrected only through changes in the entire economy, nations began abandoning the gold standard in the 1930s. That was the period of the Great Depression, during which world trade virtually was ground to a halt. World War II made the shipment of goods an extremely risky proposition, so trade remained minimal 6 | Page
during the war. As the war was coming to an end, representatives of the United States and its allies met in 1944 at Bretton Woods, New Hampshire, to fashion a new mechanism through which international trade could be financed after the war. The system was to be one of fixed exchange rates, but with much less emphasis on gold as a backing for the system.
Q4. Discuss the evolution of India’s rupee exchange rate system Answer: The rupee was historically linked i.e. pegged to the pound sterling. Earlier, during British regime and till late sixties, most of India’s trade transactions were dominated to pound sterling. Under Bretton Woods system, as a member of IMF Indian declared its par value of rupee in terms of gold. The corresponding rupee sterling rate was fixed 1 GBP = RS 18. When Bretton Woods system bore down in August 1971, the rupee was de-linked from US $ and the exchange rate was fixed at 1 US $ = Rs 7.50. Reserve bank of India, however, remained pound sterling as the currency of intervention. The US $ and rupee pegging was used to arrive at rupee-sterling parity. After Smithsonian Agreement in December 1971, the rupee was de-linked from US $ and again linked to pound sterling. This parity was maintained with a band of 2.25%. Due to poor fundamental pound got depreciated by 20%, which cause rupee to depreciate. To be not dependent on the single currency, pound sterling on September 25, 1975 rupee was de-linked from pound sterling and was linked to basket of currencies, the currencies includes as well as their relative weights were kept secret so that speculators don’t get a wind of the direction of the movement of exchange rate of rupee. From January 1, 1984 the sterling rate schedule was abolished. The interest element, which was hitherto in built the exchange rate, was also de-linked. The interest was to be recovered from the customers separately. This not only allowed transparency in the exchange rate quotations but also was in tune with international practice in this regard. FEDAI issued guidelines for calculation of merchant rates. The liquidity crunch in 1990 and 1991 on forex front only hastened the process. On March 1, 1992 Reserve Bank of India announced a new system of exchange rates known as Liberalized Exchange Rate Management System. 7 | Page
LERMS was to make balance of payment sustainable on ongoing basis allowing market force to play a greater role in determining exchange rate of rupee. Under LERMS, the rupee become convertible for all approved external transactions. The exporters of goods and services and those who received remittances from abroad were allowed to sell bulk of their forex receipts. Similarly, those who need foreign exchange to import and travel abroad were to buy foreign exchange from marketdetermined rate.
Q7. FDI vs. FII Both FDI and FII are related to investment in a foreign country. FDI or Foreign Direct Investment is an investment that a parent company makes in a foreign country. On the contrary, FII or Foreign Institutional Investor is an investment made by an investor in the markets of a foreign nation. In FII, the companies only need to get registered in the stock exchange to make investments. But FDI is quite different from it as they invest in a foreign nation. The Foreign Institutional Investor is also known as hot money as the investors have the liberty to sell it and take it back. But in Foreign Direct Investment, this is not possible. In simple words, FII can enter the stock market easily and also withdraw from it easily. But FDI cannot enter and exit that easily. This difference is what makes nations to choose FDI more than then FIIs. FDI is more preferred to the FII as they are considered to be the most beneficial kind of foreign investment for the whole economy. Foreign Direct Investment only targets a specific enterprise. It aims to increase the enterprises capacity or productivity or change its management control. In an FDI, the capital inflow is translated into additional production. The FII investment flows only into the secondary market. It helps in increasing capital availability in general rather than enhancing the capital of a specific enterprise. The Foreign Direct Investment is considered to be more stable than Foreign Institutional Investor. FDI not only brings in capital but also helps in good governance practices and better management skills and even technology transfer. Though the Foreign Institutional Investor helps in promoting good governance and improving accounting, it does not come out with any other benefits of the FDI. While the FDI flows into the primary market, the FII flows into secondary market. While FIIs are short-term investments, the FDI's are long term. 8 | Page
Summary 1. FDI is an investment that a parent company makes in a foreign country. On the contrary, FII is an investment made by an investor in the markets of a foreign nation. 2. FII can enter the stock market easily and also withdraw from it easily. But FDI cannot enter and exit that easily. 3. Foreign Direct Investment targets a specific enterprise. The FII increasing capital availability in general. 4. The Foreign Direct Investment is considered to be more stable than Foreign Institutional Investor
Q8. International Free Trade Agreement (FTA) Answer: Free trade agreements (FTAs) are generally made between two countries. Many governments, throughout the world have either signed FTA, or are negotiating or contemplating new bilateral free trade and investment agreements. The agreements are like stepping stones towards international integration into a global free market economy. There is another way to ensure that governments implement the liberalization, privatization and deregulation measures of the corporate globalization agenda. It is assumed that free trade and the removal of regulations on investment will head to economic growth reducing poverty and increasing standards of living and generating employment opportunity. Past evidences show that these kinds of agreements allow transnational corporations (TNCs) more freedom to exploit workers shaping the national and 9 | Page
global economy to suit their interests. In simple terms it removes all restrictions on businesses. FTAs severely constrain future governments in their policy options and help to lock in existing economic reforms which may have been imposed by the IMF, World Bank or Asean Development Bank, or pursued by national governments of their own volition. It works towards removing all restrictions on businesses as other free trade and investment agreements perform. FTAs are sometimes of narrow range in their dealing of traded goods. You can note the US-Cambodia bilateral textile trade agreement which was extended in January 2002 for a further 3 years. India and Sri Lanka signed a free trade agreement in December 1998 with India agreeing to a phase out of tariffs on a wide range of Sri Lankan goods within 3 years, while Sri Lanka agreed to remove tariffs on Indian goods over eight years. One of its objectives which were stated was to contribute, by the removal of barriers to bilateral trade "to the harmonious development and expansion of world trade". Other FTAs are much more comprehensive and cover other issues including services and investment. These agreements generally take existing WTO agreements as their benchmark. They often strive to even go further than what is set out in the WTO rules.
Q.10 Functions of IMF With its near-global membership of 187 countries, the IMF is uniquely placed to help member governments take advantage of the opportunities—and manage the challenges—posed by globalization and economic development more generally. The IMF tracks global economic trends and performance, alerts its member countries when it sees problems on the horizon, provides a forum for policy dialogue, and passes on know-how to governments on how to tackle economic difficulties. The IMF provides policy advice and financing to members in economic difficulties and also works with developing nations to help them achieve macroeconomic stability and reduce poverty.
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Marked by massive movements of capital and abrupt shifts in comparative advantage, globalization affects countries' policy choices in many areas, including labor, trade, and tax policies. Helping a country benefit from globalization while avoiding potential downsides is an important task for the IMF. The global economic crisis has highlighted just how interconnected countries have become in today’s world economy. Key IMF activities The IMF supports its membership by providing •
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policy advice to governments and central banks based on analysis of economic trends and cross-country experiences; research, statistics, forecasts, and analysis based on tracking of global, regional, and individual economies and markets;
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loans to help countries overcome economic difficulties;
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concessional loans to help fight poverty in developing countries; and
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Technical assistance and training management of their economies.
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International monetary systems are sets of internationally agreed rules, conventions and supporting institutions that facilitate international trade, cross border investment and generally the reallocation of capital between nation states. They provide means of payment acceptable between buyers and sellers of different nationality, including deferred payment. To operate successfully, they need to inspire confidence, to provide sufficient liquidity for fluctuating levels of trade and to provide means by which global imbalances can be corrected. The systems can grow organically as the collective result of numerous individual agreements between international economic actors spread over several decades. Role of IMF in IMS 1. Combating poverty in low income countries 2. Providing a forum for discussion and consultation among member countries 3. Increase global supply of international reserves. 4. Supervising the adjustable peg system. 11 | P a g e
Q11. Main Functions of World Bank The World Bank is an international financial institution that provides loans to developing countries for capital programmes. The World Bank proclaims a goal of reducing poverty. By law, all of its decisions must be guided by a commitment to promote foreign investment, international trade and facilitate capital investment. World Bank- its Objectives and Functions The International Bank for Reconstruction and Development (IBRD), commonly known as World Bank, was result of the Bretton Woods Conference. The main objectives behind setting up this international organization were to aid the task of reconstruction of the war-affected economies of Europe and assist in the development of the underdeveloped nations of the world. For the first few years, the World Bank remained preoccupied with the task of restoring war-torn nations in Europe. Having achieved success in accomplishing this task by late 1950s, the World Bank turned its attention to the development of underdeveloped nations. Over the time, additional organizations have been set up under the umbrella of the World Bank. As of today, the World Bank is a group of five international organizations responsible for providing finance to different countries. As mentioned earlier, the World Bank is entrusted with the task of economic growth and widening of the scope of international trade. During its initial years of inception, it placed more emphasis on developing infrastructure facilities like energy, transportation and others. No doubt all this has benefited the under-developed nations too, but the results were not found to be very satisfactory due to poor administrative structure, lack of institutional framework and non-availability of skilled labor in these countries. Realizing these problems, the World Bank later decided to divert resources to bring about industrial and agricultural development in these countries. Assistance is extended to different countries for raising cash crops so that their incomes rise and they may export the same for earning foreign exchange. The bank has also been providing resources for education, sanitation, health care and small scale enterprises. Today, the services provided by the World Bank have increased manifold. The World Bank is no longer confined to simply providing financial assistance for infrastructure development, agriculture, industry, health and sanitation. It is rather significantly involved in areas like removal of rural poverty through raising productivity, increasing income of the rural poor, providing technical support, and initiating research and cooperative ventures. The group and its affiliates headquartered in Washington DC catering to various financial needs are listed below on World Bank and its affiliates. World Bank and its Affiliates
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Institution International Bank for Reconstruction and Development (IBRD) 1945 International Financial Corporation (IFC) 1956 International Development Association (IDA) 1960 Multilateral Investment Guarantee Agency (MIGA) 1988 International Centre for Settlement of Investment Disputes (ICSID) 1966
Q.12 Explain how India has benefitted from World bank’s lending programme. The World Bank Program in India To support India in achieving its long-term vision of a country free of poverty and exclusion, the World Bank Group’s Country Strategy for India for FY 2009-2012 (CAS) is closely aligned with the objectives outlined in the country's Eleventh Plan. World Bank lending to India has diverged from initial plans spelt out in the Country Strategy due to the impact of the global financial crisis, the World Bank’s efforts to refocus, realign and consolidate the India program, and the increased demand from the Government for more financing. In FY10, the World Bank lent a record $9.2 billion to India, compared to $2.3 billion in FY09. Fourteen new projects were added in FY10, and the project pipeline has grown in light of increased demand from the Government of India. The average size of requested projects has increased. And, the volume of Bank lending has shifted further towards infrastructure, the delivery of essential social services, and increasing engagement on urban issues and agriculture. World Bank lending to India is organized around the following key challenges: 1. Achieving Rapid and Inclusive Growth India’s integration into the global economy has been accompanied by impressive economic growth that has brought significant economic and social benefits to the country. Nevertheless, disparities in income and human development are on the rise. A large section of the population - especially the poor, Scheduled Castes, Scheduled Tribes, Other Backward Classes, minorities and women - lack access to the resources and opportunities needed to reap the benefits of economic growth. To assist the government in achieving rapid inclusive growth, the World Bank is supporting activities which address both cyclical and structural impediments to growth, as well as the constraints to making growth inclusive: 13 | P a g e
2. Ensuring Development is Sustainable India’s remarkable economic growth has been clouded by a degrading environment. The country is also very vulnerable to climate change on account of its high levels of population density, poverty, stressed ecological systems, and a substantial dependence on natural resources of much of India’s population. The following areas will thus require long-term vision and urgent action: •
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Protecting India’s fragile environment - air, water, forests and bio-diversity in the face of the rising pressures created by economic success Adapting to climate change and the growing scarcity of water Coping with accelerating urbanization through governance and environmental management
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Improving energy efficiency and ensuring adequate energy supplies
The World Bank is in the process of articulating a vision for an environmentally sustainable future for India (India 2030), and has projects in the pipeline to support the National Ganga River Basin Authority and industrial pollution management. 3. Increasing the Effectiveness of Service Delivery Most public programs suffer from varying degrees of ineffectiveness, poor targeting, and wastage of resources. In the current economic climate, India will have to dramatically improve the impact of every rupee spent. The World Bank is working with the Government of India to improve the delivery of key public services through systemic governance and institutional reforms of public sector service providers, decentralization of responsibilities, promoting effective systems of transparency and accountability, effective monitoring of service delivery, and expanding the role of non-state service providers.
Q.14 What’re the ways in which India can reduce BOP A balance of payments (BOP) sheet is an accounting record of all monetary transactions between a country and the rest of the world. These transactions include payments for the country's exports and imports of goods, services, and 14 | P a g e
financial capital, as well as financial transfers. The BOP summarizes international transactions for a specific period, usually a year, and is prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as negative or deficit items. When all components of the BOP sheet are included it must sum to zero with no overall surplus or deficit. For example, if a country is importing more than it exports, its trade balance will be in deficit, but the shortfall will have to be counter balanced in other ways – such as by funds earned from its foreign investments, by running down reserves or by receiving loans from other countries. Expressed with the IMF definition, the BOP identity can be written:
Measures to improve balance of payments in India Reduce domestic Consumption. Domestic consumption in India is proving resilient as rest of world slips into recession. This is causing imports to rise faster than exports. Reducing consumer spending would reduce imports, but, it may be deemed inappropriate as economic growth may be more important than balance of payments. Encourage depreciation of Rupee. Depreciation in the Rupee would make Indian exports more competitive and imports more expensive. The problem is that with a global recession many other countries will want to help their exporters through encouraging a weaker currency. Structural improvements. Long term supply side policies aimed at increasing the competitiveness of exports should help improve the balance of payments for India. However, they will take a long time to work.
Q16. Why is US-$ a Global Currency? 15 | P a g e
In the foreign exchange market and international finance, a world currency, supranational currency, or global currency refers to a currency in which the vast majority of international transactions take place and which serves as the world's primary reserve currency. In March 2009, as a result of the global economic crisis, China and Russia have pressed for urgent consideration of a global currency. A UN panel of expert economists has proposed replacing the current US dollar-based system by greatly expanding the IMF's SDRs or Special Drawing Rights. Currencies have many forms depending on several properties: type of issuance, type of issuer and type of backing. The particular configuration of those properties leads to different types of money. The pros and cons of a currency are strongly influenced by the type proposed. Consider, for example, the properties of a complementary currency. U. S. Dollar In the period following the Bretton Woods Conference of 1944, exchange rates around the world were pegged against the United States dollar, which could be exchanged for a fixed amount of gold. This reinforced the dominance of the US dollar as a global currency. Since the collapse of the fixed exchange rate regime and the gold standard and the institution of floating exchange rates following the Smithsonian Agreement in 1971, most currencies around the world have no longer been pegged against the United States dollar. However, as the United States remained the world's preeminent economic superpower, most international transactions continued to be conducted with the United States dollar and it has remained the de facto world currency. Only two serious challengers to the status of the United States dollar as a world currency have arisen. During the 1980s, the Japanese yen became increasingly used as an international currency, but that usage diminished with the Japanese recession in the 1990s. More recently, the euro has increasingly competed with the United States dollar in international finance. Since the mid-20th century, the de facto world currency has been the United States dollar. According to Robert Gilpin in Global Political Economy: Understanding the International Economic Order (2001): "Somewhere between 40 and 60 percent of international financial transactions are denominated in dollars. For decades the dollar has also been the world's principal reserve currency; in 1996, the dollar accounted for approximately two-thirds of the world's foreign exchange reserves" (255). Many of the world's currencies are pegged against the dollar. Some countries, such as Ecuador, El Salvador, and Panama, have gone even further and 16 | P a g e
eliminated their own currency in favor of the United States dollar. The dollar continues to dominate global currency reserves, with 63.9% held in dollars, as compared to 26.5% held in Euros
Q19. What is forward market rate? The forward exchange market is a market for contracts that ensure the future delivery of a foreign currency at a specified exchange rate. The price of a forward contract is known as the forward rate. Forward rates Forward rates are usually negotiated for delivery one month, three months, or one year after the date of the contract's creation. They usually differ from the spot rate and from each other. What determines the forward rate? If there is no government intervention on the value of a currency, the forward market will be governed by supply and demand. In such a case it is possible that the forward rate provides information on the future spot rate, but ultimately uncertain. What is certain is that the forward rates reflect the expectations forward market participants have on the changes of the spot rate during the specified interval. If the forward rate and the spot rate are the same, forward market participants do not expect much change in the price of a currency over the given period of time.
Q20. Describe Letter of Credit Mechanism Letters of credit accomplish their purpose by substituting the credit of the bank for that of the customer, for the purpose of facilitating trade. There are basically two types: commercial and standby. The commercial letter of credit is the primary payment mechanism for a transaction, whereas the standby letter of credit is a secondary payment mechanism. Commercial Letter of Credit
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Commercial letters of credit have been used for centuries to facilitate payment in international trade. Their use will continue to increase as the global economy evolves. Letters of credit used in international transactions are governed by the International Chamber of Commerce Uniform Customs and Practice for Documentary Credits. The general provisions and definitions of the International Chamber of Commerce are binding on all parties. Domestic collections in the United States are governed by the Uniform Commercial Code. A commercial letter of credit is a contractual agreement between banks, known as the issuing bank, on behalf of one of its customers, authorizing another bank, known as the advising or confirming bank, to make payment to the beneficiary. The issuing bank, on the request of its customer, opens the letter of credit. The issuing bank makes a commitment to honor drawings made under the credit. The beneficiary is normally the provider of goods and/or services. Essentially, the issuing bank replaces the bank's customer as the payee. Elements of a Letter of Credit • •
A payment undertaking given by a bank (issuing bank) On behalf of a buyer (applicant)
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To pay a seller (beneficiary) for a given amount of money
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On presentation of specified documents representing the supply of goods
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Within specified time limits
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Documents must conform to terms and conditions set out in the letter of credit Documents to be presented at a specified place
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Buyer and seller agree to conduct business. The seller wants a letter of credit to guarantee payment. Buyer applies to his bank for a letter of credit in favor of the seller. Buyer's bank approves the credit risk of the buyer, issues and forwards the credit to its correspondent bank (advising or confirming). The correspondent bank is usually located in the same geographical location as the seller (beneficiary).
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Advising bank will authenticate the credit and forward the original credit to the seller (beneficiary). Seller (beneficiary) ships the goods, then verifies and develops the documentary requirements to support the letter of credit. Documentary requirements may vary greatly depending on the perceived risk involved in dealing with a particular company. Seller presents the required documents to the advising or confirming bank to be processed for payment. Advising or confirming bank examines the documents for compliance with the terms and conditions of the letter of credit. If the documents are correct, the advising or confirming bank will claim the funds by: o
Debiting the account of the issuing bank.
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Waiting until the issuing bank remits, after receiving the documents.
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Reimburse on another bank as required in the credit.
Advising or confirming bank will forward the documents to the issuing bank. Issuing bank will examine the documents for compliance. If they are in order, the issuing bank will debit the buyer's account. Issuing bank then forwards the documents to the buyer.
Q.21 Describe the features of Forex Market The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized over-the-counter financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. The primary purpose of the foreign exchange is to assist international trade and investment, by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business's income is in US dollars. It also supports speculation, and facilitates the carry trade, in which investors borrow low-yielding 19 | P a g e
currencies and lend (invest in) high-yielding currencies, and which (it has been claimed) may lead to loss of competitiveness in some countries. In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system. The foreign exchange market is unique because of • •
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its huge trading volume, leading to high liquidity; its geographical dispersion; its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday; the variety of factors that affect exchange rates; the low margins of relative profit compared with other markets of fixed income; and The use of leverage to enhance profit margins with respect to account size.
Q22. Rupee – Dollar Option The Indian derivative market has seen the rupee-dollar forward contracts for quite some time now. But the market was introduced to a new currency derivative on 7th July, 2003 — the rupee-dollar option contract. Options are relatively new instruments in the local financial market. Though cross-currency options have been available to corporate since January 1994, they have not yet become popular. For years, corporate have been accessing the foreign exchange market for dollarrupee forwards in order to hedge their exposures on exports, imports and loans. Forwards, therefore, have better understanding and acceptability with the corporate. As a result, the risk management decision for rupee-dollar exposures for all these years was mostly about whether to cover the risk by way of a forward contract or to leave it open. Now the corporate manager has the alternative to forward contracts in the form of rupee-options. But an option is a different animal altogether, and a novelty not only for the corporate, but also for Indian banks. In a forward contract, if a corporate hedges say, an import payment and the dollar depreciates by the payment date, the corporate cannot benefit from the dollar depreciation and has to pay at the 20 | P a g e
agreed exchange rate under the forward contract. Even though the rate paid may be close to the budgeted rate and, therefore, need not be viewed as a loss, an opportunity has nevertheless been lost. In contrast, if an option contract is used for the same payment, the importer will pay a premium upfront and secure the right to buy the dollars at say, the forward rate. An option contract with an exercise price equal to the forward rate is called an ‘at the money forward (ATMF)’. Now if the dollar depreciates, the importer is under no obligation to buy the dollars at the option contract rate. The importer will buy the cheaper dollars from the spot market. Does it mean that one is always better off hedging by way of options? Not necessarily so, because derivatives (forwards, options - the two basic families) are risk management tools and appropriate use of derivatives is the key to managing risks. For example, in the case of the importer discussed above, if the dollar had appreciated by the payment date instead of falling against the rupee, the importer would have felt better off (in retrospect though) with a forward contract. This is so because the option contract involved the payment of option premium. An option contract is like an insurance policy. In case of an insurance contract, the policyholder gets compensated in case of an eventuality like death, accident etc. However, no policyholder would want such an eventuality to happen. Be it car insurance or life insurance. One does not want to die just because one has an insurance policy on one’s life; instead, the benefits of living longer are greater income inflows, besides the joys of living. An option contract is not much different. For the buyer of the option, the benefit is most when the need to exercise the option does not arise. Take for example, the importer discussed earlier, whose payout would be minimized if the dollar depreciates, rather than on the dollar does appreciation and the importer have to use the call option on the dollar. When and how to use option contracts is a matter of risk management practice and corporate treasurers need to bear this in mind. They would need to see the premium paid upfront as an insurance against unfavorable currency movement and not as a cost. There is a general lack of understanding on how the currency options should be used. This results in the option premium being seen as a cost and therefore the demand for zero cost option structures in the Indian market. It needs to be understood that zero cost option structures do not come free. It comes at the cost of limiting the ’possible gain’ - the very reason for which one would like to use options. While the interbank market in rupee: dollar options is thin, a number of banks actively quote prices to their customers. The relatively low volatility in the rupeedollar exchange rate, compared to say the dollar-euro or dollar-yen, makes the rupee-dollar option prices attractive. In time, as more and more corporate 21 | P a g e
understand the use of options better; it has the potential as a risk management tool to emerge as a formidable alternative to forward contracts. Exchange rates keep adjusting to reflect the changes in economic environment for most developing countries, even though undue volatility in the exchange rates is not a comfortable scenario for the businesses. A two-way movement of the currency, which is a prerequisite for an efficient market in options, is already taking place, albeit in a limited way. After all, which exporter would have believed even a year back that the rupee would appreciate so dramatically? This helps in two ways. One, the pricing of options becomes viable. Option pricing is based on two way movement of the underlying - the rupee-dollar exchange rate. The writer/seller of the option will not find the business worthwhile if the market moves consistently only in one direction. In the absence of two-way movement of the underlying; is it a stock or a bond or a currency pair, the market liquidity suffers. Secondly, two-way movement of the currency will improve their understanding of the difference between forwards and options, and the need to use both derivatives at different times. While the banks offer a number of derivative structures based on options for the corporate, it is important that the user is conversant with such structures. Currency options, and in particular the rupee dollar options, are a new risk management tool for the Indian corporate treasury manager and therefore not many are expected to be familiar with options-based structure. It may therefore be useful to use plain vanilla options to begin with, for those who are new. This will be in the interest of the market that the participants understand the product that they are looking at. Treasury professionals, advisors and banks have an important role to play by explaining to corporate users and their management, the appropriate alternative strategies for using forward and option contracts, and the multitude of variants being sold by the banks. Unless options are used properly for risk management purposes by the corporate, the gains will not be seen and the market for options will not deepen.
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