Chpt 1 Introduction to International Finance (1)

7/29/2019 Chpt 1 Introduction to International Finance (1)

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Discuss in detail the BOP theory? What arethe components of BOP?

Discuss the exchange rate system based ongold? What are the advantages anddisadvantages of gold standard?

Discuss Bretton woods Agreement.

Explain fixed and floating exchange ratesystems in detail.

What is Capital Account Convertibility?Discuss CAC in India.


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Need to study international finance: asdifferent countries transact with each otherwith different currencies.

Therefore there is need for an intermediary tocarry out such transactions with ForeignExchange Reserves.

The transactions involving foreign exchangeare carried out by countries under two majorheadings i.e. current transactions and capitaltransactions.


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Records all the business transactions of thecountry with the rest of the world

It is a record of payments and receipts Economic transactions take place between

residents and non residents

A favorable BOP exists when more paymentsare coming in than going out


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Current Account: I. Merchandise II. Non-Monetary Gold Movement III. Invisibles

Capital Account: I. Private II. Banking III.Official i.e. government

Reserve Account: I. IMF II. SDR AllocationIII. Reserves and Monetary Gold


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The transactions related to the income statementof the country are recorded under currentaccount

Merchandise: Export and import of tangible goodsexcept gold

Non Monetary gold : Export and import of gold byall the organizations and individuals except RBI

Invisibles: Export and import of services such astravel, transportation, insurance etc. Interest,dividends, and profits


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Transactions related to balance sheet arerecorded here

Loans, investments, equity, bonds, term loans,assets etc.

Banking transactions include banking deposits

and loans


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Forex reserves of RBI,

Gold stock with RBI,

Contributions of IMF, and SDRs by IMF


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Double entry system Either surplus or deficit in the current or capital

account

Final adjustment takes place by increasing orreducing the forex reserves

Government has to borrow or reduce reserves Forex transactions which take place as a part of

regular business are called as transactions abovethe line or autonomous transactions Government trigger certain transactions called as

accommodating transactions


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Accommodating transactions initiated bygovernment

Imbalances in the autonomous flows areadjusted with SDRs, forex reserves ormonetary gold

Thus reserves account also called as officialsettlement account


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System based on value of gold and the goldheld by monetary authority

Three gold standards adopted since 1700 The gold specie

Gold exchange

Gold bullion


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Actual gold coins were in circulation

Along with gold coins, silver coins and coins of

other metals were also in circulation Fixed conversion ratio e.g. 5 silver coins = 1

gold coin

Value of gold coin was equal to the value ofgold content in it

Government used gold to mint coins or someother metals like silver to mint coins


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E.g. in U.S., the four base units were cents,dime, dollar and eagle

Out of these, cent, dime and dollar were madeup of silver and expressed in terms of eagle

Eagle was made up of gold

1 Eagle (Gold) = 10 dollar (silver) 1 Dollar (Silver) = 10 Dimes (Silver)

1 Dime (Silver) = 10 Cents (Silver)


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Monetary authority held stock of gold andactual gold was not in circulation

Currency in circulation was paper currency Paper currency has a promise written on it by

the monetary authorities

The paper currency was easily convertible intogold

Currency was fixed with the gold


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E.g. U.S. Introduced paper currency in 1862along with the eagle in circulation

1 dollar was exchangeable with 1 dollar coin 1 dollar was equal to 1.5 gms of gold

1925 Gold bullion standard was introduced

by British government which lasted till 1931 1873 Germany 2790 marks = 1 kg of gold

1876 Spain 31 Pesetas = 9 Gms of gold


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In exchange standard if one currency is worthof X gms of gold and other currency Y gms ofgold then, exchange ratio is the ratio of X to Y

It was called mint par exchange

Exchange rate was calculated based on therelative content of gold

E.g. 1 troy ounce of gold = $ 20.646 1 troy ounce of gold = 4.252

Thus $/ = $20.646/ 4.252 = 4.856$/


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Under this system, currency is exchangeablefor another currency

The currency with which it was fixed wascalled reserve currency

Some of the currencies were fixed with pound

while some of those were pegged with dollar E.g. Rupee was fixed with pound while

Mexican peso, Japanese Yen were pegged withdollar


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Monetary discipline: the monetary authoritiesmust have sufficient stock of gold

Anti-inflationary system: the money supply wascontrolled by the amount of gold

Exchange rates were stable: Exchange rates wereone currency in terms of other currency which inturn was gold quantity represented by eachcurrency

Exchange rates were predictable: Changes in thegold parity was possible with discussion amongthe governments so


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It imposes rigid discipline on the govts asgovts always have to maintain certain stock of

gold Govt has to make compromises with respect to

economic growth as this policy was antiinflationary and some inflation is necessaryfor healthy growth of the economy

When inflation is controlled it is accompaniedby unemployment and low growth


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In case of war or natural calamities, goldparity cant be maintained

Free trade of gold with all the countries mayresult in permanent loss of gold

Free convertibility of notes to gold wasunpredictable liability


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Government should not change the gold parity

Government should be able to convert

unlimited amount of paper currency into gold There should be free flow of gold from one

country to another

Government should issue exactly sameamount of notes as the amount of gold intreasury


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By the end of world war most of the countriessuspended gold standard as they did not have

enough money to pay for their war investment The wars forced the monetary authorities to

print more money than it was supported bythe gold

Countries printed more paper money than theGDP i. e. goods and services resulting ininflation and decline in the value of currency


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After the second world war US and UKauthorities started attempts to revive the

monetary system In 1944, 44 countries came together at

Bretton Woods in US

Two institutions were formed namely IMF andWorld Bank


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US was given the responsibility to convert USdollar into gold at a fixed exchange rate of $ 35per troy ounce (1 troy ounce = 31.10 grams)

Other countries agreed to maintain a fixedexchange rate with US

The governments of every country was supposeto maintain the exchange rate either by buyingdollars or selling dollars

The countries can also borrow from IMF in theform of SDRs for maintaining the exchange rate


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Thus when there is demand for home currencythe country will sell home currency in theinternational market and buy dollar and will

enjoy surplus in BOP Similarly when there is less demand for home

currency and more supply, the country would selldollar to buy home currency and will have deficit

in BOP If it is difficult to maintain the fixed exchange rate

then the country can adjust exchange rate in therange of +10% or -10%


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Robert Triffin An American Economist He stated that it is difficult for the country like US to

fulfill its domestic objectives if its currency is also

working as a reserve currency. 1) To provide liquidity under Bretton Woods, US hadto face deficit

People started speculating US dollar in the hope thatdollar will be overvalued

People started converting dollar into gold and takingit offshore

With less gold dollar was overvalued and there wasmore speculation


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2) To maintain confidence in US dollar, US hadto maintain current account surplus

This was the Triffins Dilemma US dollar toserve as an international currency wouldrequire huge supply of US dollar resulting inBOP deficit and such deficit would weaken the

US dollar further


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US found it difficult to run current account deficitand current account surplus at the same time

1) US government spending was rising as a resultof Vietnam war and to finance this deficitgovernment printed more dollars

2) Since there was heavy supply of US dollars in

the international markets, the non-reservecountries had to buy dollars to maintain theexchange rate. This resulted in current accountsurplus for the non-reserve countries


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3) Dollar started losing its value as the amountof dollars held by the non-reserve countries

exceeded the gold stock held by US treasury 4) There was an obvious threat that US would

run out of its gold stock

5) Due to this threat, all the countries startedconverting their dollars into gold

6) From 1948 till 1970 the gold stock with USfell from 67% to 16% of the world total


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7) The only option left with US was to devalue theUS dollar substantially

Dollar Standard: In 1968 US refused the dollar

conversion into gold. Due to this, either gold ordollar was allowed to be used for transactions.Thus, the period from1968 to 1973 is called asdollar standard

Nixon Shock: In 1971, President Nixon of USclosed the gold window ending convertibilitybetween dollar and gold. This was called as NixonShock


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In 1971, at Smithsonian institute US agreed toraise the price of gold from $ 35 to $ 38 per

troy ounce of gold This agreement was an incomplete solution as

it did not address the issues like dollarsunconditional convertibility to gold

After many attempts the system was finallycollapsed in 1978


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Exchange rate is fixed between one nationalcurrency and another currency of country of

industrial power Also called as hard peg

US dollar is frequently used for hard peg


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The banks can buy or sell currency at fixed price

It doesnt allow inflation because whenever there

is excess supply of domestic currency it will getabsorbed to protect the exchange rate and viceversa

To intervene it is necessary for the central banks

to hold inventory of foreign currency If there is continuous deficit in the BOP then the

country has to ultimately devalue its currency


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Advantages

Certainty of exchangerate

Inflation is controlled Smooth monetary

system

Prevents monetaryshocks

Disadvantages

Burden on exchangereserves

Country must havesufficient provision ofreserves

Fails to solve the BOP

disequilibrium


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Exchange rate is determined by the marketforces

Demand for foreign currency increases due toincrease in imports, investment abroad etc.

Supply of foreign currency increases due toincrease in exports, investment in domesticcountry etc.

Both demand and supply determine theexchange rate


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Monetary authorities continue intervention inspite of flexible exchange rate regime

Degree of intervention and period ofintervention can not be controlled

Sometimes the objective of intervention is tosmoothen short term fluctuations


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Often called as currency basket

Weighted average of few currencies is taken as

a value of the common currency Composition and weights depend on the

purpose of the currencies

Domestic currency is pegged with thatcommon currency

E.g. Euro


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Currency board is the monetary authoritywhich issues notes and coins

Domestic currency is anchored with theforeign currency

Anchor currency is strong internationallytraded currency

E.g. Hong Kong Dollar


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EU - A single currency which makes the tradeamong the countries easier

Adjustable Peg When the authorities declarea fixed exchange rate and if required changethe parity is called as adjustable peg


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Freedom to transact abroad

Freedom to convert one currency into another

without any restrictions There can be current account convertibility or

capital account convertibility or both


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Import and exports are recorded on currentaccount like buying and selling of goods and

services Freedom to transact for such purposes is

called as current account convertibility

Advantages Enhanced trade, bigger markets,access to cheaper goods

Threats to the domestic industry, possibilityof demand push inflation


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Freedom of currency conversion in relation tocapital transactions in terms of inflow and

outflow If domestic people are allowed to invest in the

foreign binds, shares, properties etc. orforeigners are allowed to invest in domestic

bonds, shares and properties then the countryhas capital account convertibility


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WTO

IMF

World Bank OECD

OPEC

SAARC ASIAN

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Chpt 1 Introduction to International Finance (1)

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