International payment

International Payment Mechanism

International Payment Mechanism

Mechanism available for settlement of International Transactions

Through international payment domestic currency of one country is converted into the currency of another country through foreign exchange market.

Three major form of international money are

1) Gold

2) Foreign Reserve currencies

3) SDR – Special Drawing Rights

Instruments of External Payments

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

2. Cheques and Bank Drafts

3. Telegraphic Transfers:Transferred by cable or telax

4. Mail Transfer:

Foreign Exchange MarketIs a market in which currencies of different countries are bought & sold

by individuals, firms, banks & brokers

Actual users. They are the buyers & sellers of foreign

currencies

Providers of foreign currency to usersQuote daily buying & selling rates

Manage the demand & supply for a currency

Facilitators of foreign currency to BanksHelp in striking deals on a commission basis

They do not buy or sell themselves.

Control & regulate to ensure it works in orderly fashion. Lenders of last resort.Prevents violent fluctuations in Ex rate

Function of Foreign Exchange Market?

FE market is a market in which foreign Exchange transactions take place

1) Transfer of Purchasing Power:

Transfer funds from one country to another for facilitating

international trade and capital movement.

2) Provision of Credit:

Growth of Foreign Trade

3) Minimising Risk: - “ Hedging”

The FE Markets

It classified on the basis of nature of Transaction

The Markets

Spot Markets When buyers & sellers of a currency settle their transaction

within 2 days of the deal – it is called spot transaction Spot sale & purchase – makes it spot market And the rate – is spot rate For all practical purposes – spot rate is the prevailing exchange

rate

Forward Markets When buyers & sellers enter an agreement to buy & sell a

foreign currency after 90 days of the deal – it is called forward transaction

Sale & purchase transaction after 90 days – makes it forward market

And the settled rate – is forward rate

The Transactions

Hedging

Is settling the exchange rate in advance for a future transaction with a view to avoiding loss that might arise due to exchange depreciation in future

It is essentially covering risk arising out of exchange rate fluctuations

The exporter is assured of the value of his exports at the current exchange rate

An importer secures his interest against possible increases in cost of imports due to exchange rate fluctuations

The Transactions

Arbitrage

Is an act of simultaneous purchase & sale of different currencies in two or more exchange markets

The objective is to make profit – taking advantage of exchange rate differentials in various markets

It equates the foreign exchange rates in all major foreign exchange markets It leads to transfer of foreign exchange from the markets where

rate is low to the markets where the rate is high

It works as a stabilising factor in foreign exchange markets As it equates demand for foreign exchange with its supply

The Transactions

Speculations

Is an act of buying & selling currency under uncertain conditions with a view to make profits

Speculators Buy a currency when its weak and sell when its strong If they expect rate to decrease – they may sell forward at the

current rate and buy spot when they need currency for delivery And If they expect rate to increase – they may buy forward at the

current rate and then sell spot immediately.

It has both effects Stabilizing – if speculators buy when its cheap and sell when its

dear. Destabilizing – if they sell when rate is cheap expecting it decrease

more and buy if rates are rising expecting them rise further

What is Foreign Exchange Rate?

Price of one currency in terms of another currency.

It is rate at which one currency is exchanged for another

Determination of Exchange Rate

Exchange Rate is determined by demand

and supply of Foreign Exchange

The Equilibrium Exchange Rate

D

D

S

R = 42

R’ = 44

R”= 40

Quantity of Dollars

O Q

E

SExcess Supply

Excess Demand

Exchange Rate (Rs / $)


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

Rs 42 = $1

Strengthening / Appreciation of Indian Rupee Depreciation of Dollar

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

Rs 44 = $1

Weakening / Depreciation of Indian Rupee Appreciation of Dollar

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

Revaluation: If the country raises the value of its currency in terms of foreign currency


Demand for Foreign Exchange ( US Dollar)

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

When Dollar Depreciates / Rupee Appreciate Import becomes cheaper Demand (Import) increases More demand of Dollar

When Dollar Appreciates / Rupee Depreciate Import becomes expensive Demand (Import) decreases Less demand of dollar

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


Supply of Foreign Exchange ( US Dollar )

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

When Dollar Appreciates / Rupee Depreciate Indian exports cheaper Increase in exports More supply of dollars

When Dollar Depreciates / Rupee Appreciate Indian goods become expensive Decrease in exports Less supply of dollar


Fixed Exchange Rate

When the Govt agrees to maintain the convertibility of the

currency.

The Govt acting through the central bank agrees to buy and

sell as much currency as it is needed.

Countries keep there currency at a fixed rate and change their

value only at infrequent intervals – when the economic situation

forces them to do so.

Maintaining Fixed Rates - Demand For Rupee Increases

D

D

S

R = 0.025

R’ = 0.026

Quantity of Rupees

O Q

E

S

Exc

ha

ng

e R

ate

(R

e /

$)

Demand increase

That is demand for IndianGoods & Services has risen

Rupee appreciates vs $

To get it back to its originalrate Supply has to increase

RBI – prints more money &Sells them in exchange for $

Foreign Exchange ReservesIncreases

D1

D1

Maintaining Fixed Rates - Demand For Rupee Decreases

D

D

S

R = 0.025

R”= 0.024

Quantity of Rupees

O Q

E

S

Less Demand

Exc

ha

ng

e R

ate

(R

e /

$)

Demand reduces

Rupee depreciates vs $

To get it back to its originalrate Supply has to decrease

RBI – buys Rupees in exchange for $

Foreign Exchange ReservesReduces

Arguments for Fixed Exchange Rate

It provides development and growth of Foreign Trade. It provides stability in foreign exchange market and reduces risk

and uncertainty. It prevents depreciation of currency for the countries (developing) which

faces persistent problem of deficit in BOP. Smooth flow of International capital as investors are interested in a

country having stable currency. Eliminates the possibility of speculations. Necessary for the growth of international money and capital market Encourages Globalisation or integration of the world economy

Demerits of Fixed Exchange Rate

Countries with persistent deficit / surplus in BOP have long term

disequilibrium.

Deficit in BOP cannot always be corrected by a regular drawing form the

foreign exchange and sale of gold.

Borrowing money from IMF could lead to devaluation

Which leads to inflation

Surplus in BOP could also lead to inflation

Flexible Exchange Rate The rate of exchange is allowed to be freely determined by

interaction between demand and supply of foreign exchange

in the foreign exchange market.

Under this the first impact of BOP is on the Exchange Rate.

Surplus:

Excess demand for country’s currency and exchange rate will rise.

Deficit: Excess supply of the country’s currency and exchange rate will fall.

Factors effecting Demand and Supply

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

Maintaining Flexible Rates - Increase in Supply

D

D

S

R

R’

Quantity of US Dollars

O Q

E

S

Exc

ha

ng

e R

ate

(R

e /

$)

Increase USA Income

That is demand for IndianGoods & Services has risen

Increase in Supply of $Supply curve shift to S’S’

Rupee appreciates vs $

Dollar Depreciate

New Exchange Rate at E1

E1

S’

S’

Maintaining Flexible Rates - Increase in Demand

D

D

S

R

R’

Quantity of US Dollars

O Q

E

S

Exc

ha

ng

e R

ate

(R

e /

$)

Increase in India Income

Increase in Demand for US Exports

Increase in Demand of $Demand curve shift to D’D’

Rupee depreciates vs $

Dollar appreciate

New Exchange Rate at E1

E1

D’

D’

Q1

Arguments for Flexible Exchange Rate

It automatically deals with the BOP problem.

During Deficit: External value falls , discourages import and

encourages export. It provides freedom in respect of domestic economic policies.

It is not necessary for economies to depend upon exchange rate for planning there domestic economic policy.

Its self adjusting and Govt intervention are not required. You can predict the exchange rate It gives a true picture of the strength of the currency in foreign exchange

market

Which system should a country adopt?

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

Education

International payment