FOREIGN EXCHANGE AND BOP

  

Unit 2

 FOREIGN EXCHANGE & BALANCE OF PAYMENTS 

 Introduction to Forex,

Forex (FX) refers to the global electronic marketplace for trading international currencies and currency derivatives. It has no central physical location, yet the forex market is the largest, most liquid market in the world by trading volume, with trillions of dollars changing hands every day. Most of the trading is done through banks, brokers, and financial institutions.

Forex exists so that large amounts of one currency can be exchanged for the equivalent value in another currency at the current market rate.

Foreign exchange market 

• The foreign exchange market is a decentralized worldwide market.It does not have a single market place or an organized exchange, electronic or physical like a stock exchange

 • The participants in the foreign exchange market include central banks, commercial banks, brokers etc. 

• The central banks monitor market movements and sentiments and intervene according to government policy. 

• The function of buying and selling of foreign currencies in India is performed by authorized dealers / money changers appointed by the RBI. 

• The foreign exchange department of the major banks are linked across the world on a 24 hour basis. 

• Major commercial centers are London, Amsterdam, Frankfurt, Milan, Paris, New York, Toronto, Bahrain, Tokyo, Hong Kong and Singapore.

Structure of the Forex Market

The FE market consists of two tiers:

 1. The retail market in foreign exchange is the market in which travellers and tourists exchange one currency for another in the form of currency notes or travellers’ cheques. 

2. The wholesale market is often called the inter-bank market

Participants of Forex market/Foreign exchange market

1.Individuals and firms : These are the exporters and importers, international portfolio investors, MNCs, tourists and others who use foreign exchange market to facilitate the execution of commercial or investment transactions.

2.. Dealers/Brokers/Arbitrageurs and Speculators 

Dealers are basically involved in buying currencies when they are low and selling them when they are high.

Exchange brokers/ Brokers: Are not authorized to take a position on the market. Their job is to find a buyer and a seller for the same amount for the given currencies. Their remuneration is in the form of brokerage.

Arbitrageurs make gains by discovering price discrepancies that allow them to buy cheap and sell dear. Their operations are risk-free, in a free and open market, the scope for currency arbitrage tends to be low and it is, by and large, accessible only to dealer banks. 

Speculators buy and sell currencies solely to profit from anticipated changes in exchange rates, without engaging in other sorts of business dealings for which foreign exchange is essential. Speculators and arbitragers trade in the foreign exchange market in their own way trying to make profit through normal and speculative operations.

2. Central banks and treasuries 

Central banks and treasuries use the foreign exchange market for the purposes of buying and selling country’s foreign exchange reserves. They also aim at influencing the value of their own currencies in accordance with the priorities of the national economic planning

3. Commercial Banks 

Commercial banks are intermediaries between seekers and suppliers of currency. The role of banks is to enable their clients to change one currency into another. Also, they operate on these markets to make a profit through speculation and the process of arbitrage. 

Commercial banks also participate on behalf of corporates who trade with other corporates based out of different countries 

5) Foreign Exchange Brokers : These are the commission agents who bring together suppliers and buyers of foreign currency. They specialize in certain currency although they deal in all major foreign currencies s

Types of transactions & settlement dates

Settlement of a transaction takes place by transfers of deposits between the two parties. The day on which these transfers are effected is called the settlement date or the value date. To effect the transfers, banks in the countries of the two currencies involved, must be open for business. The relevant countries are called settlement locations. The locations of the two banks involved in the trade are dealing locations, which need not be the same as settlement locations.

Thus a London bank can sell Swiss francs against US$ to a Paris bank. Settlement locations maybe New York & Geneva, while dealing locations are London & Paris. The transaction can be settled only on a day on which both the US & Swiss banks are open.

Features & Objectives of Foreign Exchange(Forex) Market

Features of Foreign exchange market

1.High liquidity-This is the most prominent  feature of the market as it means that trades can be executed at any time. With high liquidity also comes ease of entry and exit in a market which traders also find very important.. This is possible because of the markets size and its geographical spread. 

2.Lower trading Cost-The foreign exchange market features low trading costs because it does not have restrictive barriers to entry or high fees placed on transacting by brokers. With very small percentages being charged for transactions, participants can utilise more of their money in trades 

3.Market transparency-The foreign  exchange market features high information efficiency. With transactions on the.market being recorded electronically and information updated very quickly across the market it is considered to be both very efficient and transparent. 

4.Dynamic market-The foreign exchange market is considered dynamic because it provides a myriad of opportunities to earn a profit. The foreign currency market provides opportunities to make profit based on the market value of a particular currency going up or down. This feature of the foreign exchange market is one of the key reasons the market is so large.

5.Strong market trends-Forex trader makes money by getting accurate market data and then analyzing the direction the markets takes.

6..Operates 24 hours-There is trading going on within the foreign currency market at any given time as there is always a need for its services.

Theories of foreign exchange rate determination

1. Mint Par Theory

Mint par indicates the parity of mints or coins. It means that the rate of  exchange depends upon the quality of the contents of currencies. It is the  exact equivalent of the standard coins of one country expressed in terms of  standard coins of another country having the same metallic standards the  equivalent being determined by a comparison of the quantity and fineness of  the metal contained in standard coins as fixed by law. A nation’s currency is  said to be fully on the gold standard if the Government:

2. Purchasing Power Parity Theory

This theory was developed after the break down of the gold standard post  World War I. The equilibrium rate of foreign exchange between two  inconvertible currencies in determined by the ratio between their purchasing  powers. Before the first World War, all the major countries of Europe were on  the gold standard. The rate of exchange used to be governed by gold points. But  after the I World War, all the countries abandoned the gold standard and adopted  in convertible paper currency standards in its place. The rate of foreign exchange  tends to be stabilized at a point at which there is equality between the respective  purchasing powers of the 2 countries.

3. Balance of Payments Theory

According to this  theory, an adverse balance of payment lead to the fall or depreciation of the rate  of foreign exchange while a  favourable  balance of payments, by strengthening  the foreign exchange, causes an appreciation of the rate of foreign exchange.  When the balance of payment is adverse it indicates a situation in which a  demand for foreign exchange exceeds its supply at a given rate of exchange  consequently, its price in terms of domestic currency must rise i.e., the external  value of the domestic currency must depreciate. Conversely, if the balance of  payment is  favourable  it means that there is a greater demand for domestic  currency in the foreign exchange market that can be met by the available supply  at any given rate of foreign exchange. Consequently, the price of domestic  currency in terms of foreign currency rises i.e., the rate of exchange moves in  favor  of home currency, a unit of home currency begins to command larger  units of the foreign currency than before.

Balance of Payment theory, also known as the Demand and Supply  theory, holds that the  foreign exchange rate, under free market conditions is determined by the  conditions of demand and supply in the foreign exchange market.  According to this theory, the price of a commodity that is , exchange rate  is determined just like the price of any commodity is determined by the free play  of the force of demand and supply.

Components of Balance of Payment

The balance of payments includes three essential components that measure income, trade, ownership of assets and transactions of a country. The current account, financial account and capital account are the three primary elements  Here's a description of each:

1.Current account

The current account indicates the country’s economic activity. The current account is divided into four main components, which record the transactions of a country's capital markets, industries, services, and governments. The four components are:

1. Balance of trade in goods. Tangible items are recorded here.
2. Balance of trade in services. Intangible items like tourism are recorded here.
3. Net income flows (primary income flows). Wages and investment income are examples of what would be included in this section.
4. Net current account transfers (secondary income flows). Government transfers to the United Nations (UN) or European Union (EU) would be recorded here.

2.Capital account

The capital account is usually the smallest component of the balance of payment, and it tracks all the financial processes that don't affect a country's production, income or savings. If a nation starts a transaction like a transfer of copyrights, trademarks or cross-border payments on insurance premiums, it records this occurrence in the capital account. Since many economic and financial activities nations participate in typically have direct effects on income, savings and production, transactions within the capital account can be rare.

3.Financial account

The financial account shows the monetary movements into and out of the country.

The financial account is split into three main parts:

1. Direct investment. This records the net investments from abroad.
2. Portfolio investment. This records financial flows such as the purchasing of bonds.
3. Other investments. This records other financial investments such as loans.

Exchange Rate Forecasting

Both the cost of an MNC’s operations and the revenue it receives from operations are affected by exchange rate movements. An MNC’s forecasts of exchange rate movements can influence its managerial decisions 

Why Firms Forecast Exchange Rates 

Hedging decision. - Multinational corporations constantly face the decision of whether to hedge future payables and receivables in foreign currencies. Whether or not a firm hedges may be determined by its forecasts of foreign currency values. EXAMPLE Laredo Co., based in the United States, plans to pay for clothing imported from Mexico in 90 days. If the forecasted value of the peso in 90 days is sufficiently below the 90-day forward rate, then the MNC may decide not to hedge. Forecasting may enable the firm to make a decision that will increase its cash flows.

Short-term investment decision: Corporations sometimes have a substantial amount of excess cash available for a short time period. Large deposits can be established in several currencies. The ideal currency for deposits will (1) exhibit a high interest rate and (2) strengthen in value over the investment period. EXAMPLE Lafayette Co. has excess cash and considers depositing the cash into a British bank account. If the British pound appreciates against the dollar by the end of the deposit period when pounds will be withdrawn and exchanged for U.S. dollars, more dollars will be received. Thus the firm can use forecasts of the pound’s exchange rate when determining whether to invest the short-term cash in a British versus a U.S. account.

Capital budgeting decision: When an MNC assesses whether to invest funds in a foreign project, the firm takes into account that the project may periodically require the exchange of currencies. The capital budgeting analysis can be completed only when all estimated cash flows are measured in the MNC’s local currency. EXAMPLE Evansville Co. wants to determine whether to establish a subsidiary in Thailand. The earnings to be generated by the proposed subsidiary in Thailand would need to be periodically converted into dollars to be remitted to the U.S. parent. The capital budgeting process requires estimates of future dollar cash flows to be received by the U.S. parent. These dollar cash flows depend on the forecasted exchange rate of Thailand’s currency (the baht) against the dollar over time. Accurate forecasts of currency values will improve the accuracy of the estimated cash flows and therefore enhance the MNC’s decision making Foreign Exchange & Balance of Payment Why Firms Forecast Exchange Rates Earnings assessment : An MNC’s decision about whether a foreign subsidiary should reinvest earnings in a foreign country or instead remit those earnings back to the parent may be influenced by exchange rate forecasts. If a strong foreign currency is expected to weaken substantially against the MNC’s home country currency, then the parent may prefer to expedite the remittance of subsidiary earnings before the foreign currency weakens

Forecasting Techniques

 The numerous methods available for forecasting exchange rates can be categorized into four general groups: (1) technical, (2) fundamental, (3) market-based, and (4) mixed. Foreign Exchange & Balance of Payment Forecasting Techniques -Technical Forecasting Technical forecasting involves the use of historical exchange rate data to predict future values. There may be a trend of successive daily exchange rate adjustments in the same direction, which could lead to a continuation of that trend. Alternatively, there may be some technical indication that a correction in the exchange rate is likely, which would result in a forecast that the exchange rate will reverse its direction. Foreign Exchange & Balance of Payment Forecasting Techniques -Technical Forecasting Tomorrow Kansas Co. must pay 10 million Mexican pesos for supplies that it recently received from Mexico. Today, the peso has appreciated by 3 percent against the dollar. Based on an analysis of historical time series, Kansas has determined that whenever the peso appreciates against the dollar by more than 1 percent, it experiences a reversal of about 60 percent of that change on the following day. Given this forecast, Kansas Co. decides that it will make its payment tomorrow instead of today so that it can benefit from the expected depreciation of the peso. Foreign Exchange & Balance of Payment Forecasting Techniques -Technical Forecasting Technical forecasting is sometimes cited as the main technique used by investors who speculate in the foreign exchange market, especially when their investment is for a very short time period. Foreign Exchange & Balance of Payment Forecasting Techniques -Technical Forecasting Limitations: • Multinational corporations make only limited use of technical forecasting because it typically focuses on the near future, which is not that helpful for developing corporate policies. • Most technical forecasts apply to very short-term periods (e.g., one day) because patterns in exchange rate movements may be more predictable over such periods. • Because such patterns are likely less reliable for forecasting longterm movements (e.g., over a quarter, a year, or five years), technical forecasts are less useful for forecasting exchange rates in the distant future. Foreign Exchange & Balance of Payment Forecasting Techniques -Technical Forecasting Thus technical forecasting may not be suitable for firms that require a long-range forecast of exchange rates. Furthermore, a technical forecasting model that has worked well in one particular period may not work well in another period. Unless historical trends in exchange rate movements can be identified, examination of past movements will not be useful for indicating future movements. I Foreign Exchange & Balance of Payment Forecasting Techniques -Fundamental Forecasting Fundamental forecasting is based on fundamental relationships between economic variables (such as inflation, income level, and interest rates) and exchange rates.

Factors That Influence Exchange Rates

1.Relative Inflation Rates

Changes in relative inflation rates can affect international trade activity, which influences the demand for and supply of currencies and therefore affects exchange rates. (Assume that both British and U.S. firms sell goods that can serve as substitutes for each other.) The sudden jump in U.S. inflation should cause some U.S. consumers to buy more British products instead of U.S. products. At any given exchange rate, there would be an increase in the U.S. demand for British goods, which represents an increase in the U.S. demand for British pounds. In addition, the jump in U.S. inflation should reduce the British desire for U.S. goods and thereby reduce the supply of pounds for sale at any given exchange rate.

These market reactions are illustrated in the graph. At the previous equilibrium exchange rate of $1.55, there will now be a shortage of pounds in the foreign exchange market. The increased U.S. demand for pounds and the reduced supply of pounds for sale together place upward pressure on the value of the pound. According to the graph, the new equilibrium value is $1.57. If British inflation increased (rather than U.S. inflation), the opposite dynamic would prevail

Relative Inflation Rates Assume there is a sudden and substantial increase in British inflation while U.S. inflation remains low. (1) How is the demand schedule for pounds affected? (2) How is the supply schedule of pounds for sale affected? (3) Will the new equilibrium value of the pound increase, decrease, or remain unchanged? Given the described circumstances, the answers are as follows: (1) The demand schedule for pounds should shift inward. (2) The supply schedule of pounds for sale should shift outward. (3) The new equilibrium value of the pound will decrease. Of course, the actual amount by which the pound’s value will decrease depends on the magnitude of the shifts.

2.Relative Interest Rates

Changes in relative interest rates affect investment in foreign securities, which influences the demand for and supply of currencies and thus affects the equilibrium exchange rate. EXAMPLE Assume that U.S. and British interest rates are initially equal but then U.S. interest rates rise while British rates remain constant. U.S. investors will likely reduce their demand for pounds, because U.S. rates are now more attractive than British rates. Because U.S. rates now look more attractive to British investors with excess cash, the supply of pounds for sale by British investors should increase as they establish more bank deposits in the United States.

In response to this inward shift in the demand for pounds and outward shift in the supply of pounds for sale, the equilibrium exchange rate should decrease. These movements are represented graphically. If U.S. interest rates decreased relative to British interest rates, then the opposite shifts would be expected.

3. Relative Income Levels

A third factor affecting exchange rates is relative income levels. Because income can affect the amount of imports demanded, it can also affect exchange rates. EXAMPLE Assume that the U.S. income level rises substantially while the British income level remains unchanged. Consider the impact of this scenario on (1) the demand schedule for pounds, (2) the supply schedule of pounds for sale, and (3) the equilibrium exchange rate.

1st, the demand schedule for pounds will shift outward, reflecting the increase in U.S. income and attendant increased demand for British goods. 2nd, the supply schedule of pounds for sale is not expected to change. Hence the equilibrium exchange rate of the pound should rise

4. Government Controls 

A fourth factor affecting exchange rates is government controls. The governments of foreign countries can influence the equilibrium exchange rate in the following ways: (1) imposing foreign exchange barriers; (2) imposing foreign trade barriers; (3) intervening (buying and selling currencies) in the foreign exchange markets; and (4) Affecting macro variables such as inflation, interest rates, and income level

Recall the example in which U.S. interest rates rose relative to British interest rates. The expected reaction was an increase in the British supply of pounds for sale to obtain more U.S. dollars (in order to capitalize on high U.S. money market yields). However, if the British government placed a heavy tax on interest income earned from foreign investments, such taxation would likely discourage the exchange of pounds for dollars.

5. Expectations 

A fifth factor affecting exchange rates is market expectations of future exchange rates. Like other financial markets, foreign exchange markets react to any news that may have a future effect. News of a potential surge in U.S. inflation may cause currency traders to sell dollars because they anticipate a future decline in the dollar’s value. This response places immediate downward pressure on the dollar

i.Impact of Favorable Expectations - 

Many institutional investors (such as commercial banks and insurance companies) take currency positions based on anticipated interest rate movements in various countries. 

EXAMPLE Investors may temporarily invest funds in Canada if they expect Canadian interest rates to increase, because this may cause further capital flows into Canada, which could place upward pressure on the CAD’s value. By investing in securities denominated in CAD based on expectations, investors can fully benefit from the rise in the CAD’s value because they will have purchased CAD before the change occurred. Although these investors face the obvious risk that their expectations may be wrong, the point is that expectations can influence exchange rates because they commonly motivate institutional investors to take foreign currency positions.

ii.Impact of Unfavorable Expectations : 

Just as speculators can place upward pressure on a currency’s value when they expect it to appreciate, they can place downward pressure on a currency when they expect it to depreciate. 

EXAMPLE During the 2010–2015 period, Greece experienced a major debt crisis because of concerns that it could not repay its existing debt. Some institutional investors expected that the Greece crisis might spread throughout the eurozone, which could cause a flow of funds out of the eurozone. There were also concerns that Greece would abandon the euro as its currency, which caused additional concerns to investors who had investments in euro-denominated securities. Consequently, many institutional investors liquidated their investments in the eurozone, exchanging their euros for other currencies in the forex market. Investors who owned euro-denominated securities attempted to liquidate their positions before the euro’s value declined. These conditions played a large part in the euro’s substantial depreciation during this period

Impact of exchange rate on BOP 

The exchange rate can have a significant impact on the balance of payment(BOP) of a country. Especially exchange rate has an impact on balance of payment (current account, capital account and financial account), inflation, interest rate, remittance, foreign direct investment, money supply, unemployment, tourism, government operations (public debt, budget deficit) and some of other macro-economic variables. 

1.Impact on Current Account

a)Exchange rate depreciation

If a country's currency depreciates, the exports become cheaper and more competitive, while imports become more expensive.This can lead to an improvement in the trade balance, as export increases and imports decreases. This in turn can lead to an improvement in the current account balance.

b)Exchange rate appreciation

If a country's currency appreciates, the exports become expensive and less competitive, while imports become cheaper.This can lead to deterioration in the trade balance, as export decrease and imports increase. This in turn can lead to a deterioration in the current account balance.

2.Impact on Capital Account

a)Exchange rate depreciation

If a country's currency depreciates,  it becomes cheaper for foreigners to invest in the country, which can lead to an increase in foreign investment inflows.This in turn can lead to an improvement in the capital account balance.

b)Exchange rate appreciation

If a country's currency appreciates, it becomes more expensive for foreigners to invest in the country, which can lead to a decrease in foreign investment inflows.This in turn can lead to a deterioration  in the capital account balance.

Remedial measures taken by Government & Regulatory Authorities in India

The government and regulatory authorities of India have implemented a range of remedial measures to address various issues in the financial sectors including

1.Banking Sector Reforms-The RBI has implemented a range of reforms to improve the functioning of banking sector including the introduction of prompt corrective action(PCA) framework, the implementation of Basel III norms and the recapitalisation of public sector banks.

2.Insolvency and bankruptcy code- The Insolvency and Bankruptcy code(IBC) was introduced in 2016 to provide a time-bound process for the resolution of insolvency issues, improve the recovery of bad loans and reduce the burden on courts.

3. SEBI Reforms-SEBI has implemented a range of reforms to improve transparency and investor protection in the securities market, including the introduction of electronic book building, the implementation of uniform know your customer(KYC)norms, and the mandatory de-materialization of securities.

4.Foreign investment Policies-The government has implemented various policies to attract foreign investment in the country, including liberalizing foreign direct investment(FDI)

norms in various sectors,simplifying procedures for investment, and introducing the Foreign Portfolio Investment (FPI)regime.

5. Digitalization of Financial services-The government and regulatory authorities have promoted the digitalization of financial services in India to increase financial inclusion, improve efficiency and reduce costs, initiatives like Pradhan Mantri Jan Dhan Yojana,the Unified Payments Interface(UPI) and the Bharat Bill Payment System have played a significant role in this regard.

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Syllabus for Unit 2: FOREIGN EXCHANGE & BALANCE OF PAYMENTS (14hrs) Introduction to Forex, Features & Objectives, Foreign Exchange Market, Intermediaries Theories of Foreign Exchange Rate Determination, Exchange Rate Forecasting, Impact of exchange rate on BOP - Remedial measures taken by Government & Regulatory Authorities in India