International Monetary System & Foreign Exchange Market An efficient International Monetary System is a necessary pre condition for the smooth functioning & expansion of International business. (i)Pre- Bretton Woods Period Until World War- I & beyond major Industrialized nations of the world traded under, a fixed exchange system, Gold Standard.

Under this system, each nation defined its currency in terms of gold. ‘Money’ issued by member countries had to be backed by reserves of gold. Gold would act as an automatic adjustment, flowing in & out of countries & automatic altering the gold reserves of that country if imbalances in trade occur.

Exchange rate$ 200/10grms of gold between nations Rs. 2000/10grms of gold $ 0.1/ Re or 1 $ = Rs. 10 = =

Under the Gold Standard, Money Supply was directly linked to the stock of Monetary Gold. Gold Standard could not with stand abnormal periods like war & depression.

The Bretton Woods System ( ) The govts. of 44 allied nations gathered together in Bretton Woods, New Hampshire in 1944 to plan for the post war international monetary system. For the new Monetary System to be stable & sustainable :- It Should be able to provide sufficient liquidity to countries during periods of crisis. (stable exchange rates)

Any new system had to have facilities for the extension of credit for countries to defend their currency values. (multilateral credit mechanism) The Bretton woods agreement called for : Fixed exchange rates between member countries termed as “adjustable Peg”.

The establishment of a fund of gold & currencies available to members for stabilization of their respective currencies (the IMF) The establishment of a bank that would provide funding for long-run development projects World Bank.

The international monetary system that existed from 1947 to 1971 is generally known as the par value system or pegged exchange rate system. Under this system, each member country of the IMF was required to define the value of its currency in terms of gold or the US dollar & to maintain (to peg) the market value of its currency within +1% _

Value of dollar was $ 35 per ounce gold. US promised that all US $ in the hands of central banks would be redeemed in gold, upon demand, at a fixed price of $35 per ounce.

Break Down of the Bretton Woods System & Emergence of Managed Floating – Floating Exchange Rate 1973 Since March 1973, the world’s major currencies have floated in value versus each other.

Bretton Woods System failed because the governments all over the world were unable to maintain their parity under the gold or Dollar system since it required reserve assets. An expansion in trade required increase in international liquidity. The persistent & burgeoning BOP deficit of the US & the huge accumulation of the dollar outside the US led to the breakdown of the par value (US liabilities rose to $68 billion) Central Bank of Germany alone held enough dollar to exhaust entire gold of US.

Foreign Exchange Markets became hectic in early 1971, and Central banks, with the strongest currencies, had to buy massive amounts of dollar in order to maintain exchange rates at the official par value (+1%). So, the Central Banks became increasingly reluctant to continue the stabilization procedure. Speculators & MNCs became very eager to unload dollars & to acquire other currencies.

IMF’s par value system officially ended on 15, Aug President Nixon withdrew US’s commitment to buy & sell per ounce, thus abrogating the IMF agreement. The collapse of the agreement resulted in a floating exchange rate. Monetary authorities have not been allowing their currency values to be determined solely by demand & supply, but have been intervening from time to time to keep the exchange rate within desired rates – Managed float.

Indian rupees was pegged to a basket of five currencies for its rate determination. These currencies are $, ξ, Franc,Yen & Deutch mark. The breakdown of the ‘par value system’ led to floating of major currencies. Different exchange rate systems prevail today.

Former Governor RBI, Bimal Jalan, observes that the debate on appropriate policies relating to FE markets centers around : - Exchange rates should be flexible & not fixed or pegged.

Countries should be able to intervene or manage exchange rates – to act at least to some degree – if movements are believed to destabilize in the short run. Reserves should be sufficient to take care of fluctuations in capital flows & liquidity at risk.

EMS, ECU & EURO EEC (European Economic Community) established a common exchange rate system. In 1979 New arrangement EMS (European Monetary System) was introduced – stability of fixed exchange rates among themselves & having flexibility in exchange rates with the rest of the world. EMS – is a system of fixed but adjustable exchange rates. Each currency had a central rate expressed in terms of European Currency Unit(ECU).

The ECU consisted of a basket of fixed amounts of currencies of the common market countries. The central rates determined a grid of bilateral central rates with fluctuations margin of +2.5% Intervention by the participating central banks kept the exchange rates of Their currencies within the margins in EMS currencies.

Intervention in other currencies (US) was allowed & had been undertaken on a substantial scale. The grid of bilateral central rates & intervention limits was supplemented by the “divergence indicator”, which showed the movement of the exchange rate of each EMS currency against the (weighted) average movement of others

If a currency crossed a “threshold of divergence”, this led to a presumption that the authorities concerned would correct the situation by taking adequate measures. ECU is central of EMS. It served as a unit of a account for exchange rate mechanism & for the operations in both the intervention & the credit mechanism.

Central banks participating in the exchange rate mechanism of the EMS received an initial supply of ECUs at the start of the EMS, against the deposit of 20% of both their gold holdings & gross US reserves with the European Monetary Cooperation Fund. To finance interventions in EMS currencies, there were mutual credit lines among the central banks (a very short term financing facility)

In EMS, adjustments of central rates were “Subject to mutual agreement” By a common procedure which comprised all countries participating in The exchange rate Mechanism & Commission. An agreement was concluded at Maastricht Summit(1991) by EC leaders on the requirements & time table for EMU & for the move to common European Monetary Policy. It specified 3 stages transition to EMU (European Monetary Union).

Stage 1 – Launched in July 1990, the free internal market of EC would be completed & obstacles to financial integration removed. Member countries to coordinate monetary & fiscal policy. Stage 2 – Began Jan 1994, worked towards a common Monetary Policy, establishment of the European Monetary Institute(EMI) which would develop a framework for closer coordinate of monetary policies that affect EMU area as a whole & establishment European Central Bank(ECB)

Stage 3 – Establishment of common currency, the Euro in The Euro was launched by 11 of 15 members of the union on Jan 01, 1999 The exchange rate € 1 = US $ 1.17 = ξ 0.70 = ¥ 133 Duetch Mark = 1.96 Rs.= 49 Britain, Denmark & Sweden opted out Greece could not satisfy eligibility Criteria (joined 2001) Deadline for withdrawing national currencies was July1, 2002.

In the beginning ‘Euro’ had 2 conversion rations. Internal – for participating currencies to be converted into Euro during transition – It was fixed. External – Exchange rates against currencies outside the Euroland – Market determined.

Monetary policy decisions for the Euro area are made by the European Central Bank (ECB) which along with National Central Bank of all EU members comprise - European System of Central Banks.

Benefits of Euro – Single Currency brings. Single interest rate. Eliminate currency risk. Give equity & bond markets the necessary. Scope & liquidity to attract big investors.

Consumers benefit – price transparency in Euro saves cost of hedging against exchange rate risk Companies – Ease of outsourcing, relocation of production bases, M&As, Transportation procedures & marketing etc.

Market Foreign Exchange F.M. Means – The process of converting one currency into another or Foreign Currencies.

Functions of F.E. Market Transfer of purchasing power (from currency to another or one country to another) Provision of credit (Exporters – Pre-shipment & imports post- shipment) Provision of Hedging facilities (covering of export risk)

Methods of Affecting International Payments 1.Transfer (Bank to Bank by Electronic or other way) 2.Cheques & Bank Drafts 3.Foreign Bills of Exchange is an unconditional order in writing, addressed by one person to another, requiring the person to whom it is addressed to pay a certain sum on demand

4.Documentary (or Reimbursement credit) 5.Opening by the importer of a credit in favor of exporter at a bank in exporter’s country. Import’s Bank Exporter’s Country Bank It informs the importer by L/C that it will pay the sum in exchange of BOE & shipping documents. Bill of loading to exporter

hedging on FE Market Spot & Forward Exchangescover the risks arising out of fluctuations in F.E. rates Delivered at a specified future date (on a price agreed upon in the contract) FE transactions are completed on the spot or immediately

Forward Exchange Rate At par – quoted equivalent to the spot rate at the time of making the contract. At premium – w.r.t. spot rate when one $ buys more units of another currency in the forward than in the spot market

At discount – w.r.t. spot rate when one dollar buys fewer rupees in the forward than the spot market. Premium & discount are expressed as a % deviation from the spot rate on a per annum basis.

Futures – Have standard features while a forward contract may be customized. Contract size & maturity dates are standardized Can be traded only on organized exchanges & traded competitively. An initial margin must be deposited into a collateral account to establish a futures position.

Options – While the forward or futures contract protects the purchaser of the contract from the adverse exchange rate movements, it eliminates the possibility of gaining a windfall profit from favorable exchange rate movements.

Option combines advantages of futures & spot. An option is a contract or financial instrument that gives holder the right, but not the obligation, to sell or buy a given quantity of an asset at a specified rate at a specified future date.

An option to buy the underlying asset is known as a call option and an option to sell the underlying asset is known as a put option. The buyer of the option is known as the long & the seller of an option is known as the writer of the option or the short. The price for the option is known as premium.

2 types of options – European &American Exercised only at the exercised at any time maturity or expiration during the contract. date of the contract

Swap Operation – Simultaneous sale of spot currency for the forward purchase of the same currency or the purchase of spot for the forward sale of the same currency. The spot is swapped against forward.

Arbitrage – is the simultaneous buying & selling of Foreign Currencies with the intention of making profits from the difference between the exchange rate prevailing at the same time in different markets.

Determination of Exchange Rates Purchasing Power Parity Theory – In the absence of govt. control exchange rate between two currencies is determined by the price levels in respective countries. Balance of Payments or the Demand & Supply Theory – F.E. under free market conditions is determined by the conditions of demand & supply in the F.E. market.

Exchange Control – is an important means of achieving certain national objective like an improvement in BOP position, restriction of essential imports, facilitation of import of priority items, control of outflow of capital & maintenance of external value of currency. Control is by exchange control authorityRBIFEDIA Legal ProvisionFERA 1973 & FEMA Daily buying & selling

Exchange Rate Systems : Fixed exchange rate Flexible exchange rate 1.Fixed exchange rate – Stable or pegged exchange rate 2. Flexible exchange rate – works on market mechanism Gold standard

Exchange rate & convertibility of rupee : After collapse of Bretton Woods systems in 1971, rupee was pegged to pound sterling for four years In 1935 was linked to 14 currencies & later to 5 currencies of India’s major trading partners till 1980s external payments crisis in 1991 (rupee was devalued by 18% in July 1991)

In 1992 rupee was partially convertible through LERMS 60% - Market rate 40% - Officially fixed rate Current account convertibility on trade account Capital account convertibility Devaluation Dual exchange rate