Fundamentals of International Finance
Meaning and Scope
International finance, sometimes known as international macroeconomics, is
the study of monetary interactions between two or more countries, focusing on
areas of investment and trade.
It involves different currencies, governance systems, interest rates, taxation
rules and most importantly political factors.
External economy being an important contributor of GDP is dependent on
international finance.
Trade is the cause and effect of international relations. So it is the precursor of
economic linkages between 2 countries. Following commerce, finance follows
suit to support and enhance trade.
The populations of different countries are increasing. So is the aspirations of
nations. The demand for employment is ever increasing both in the developed
and developing world.
This is increasing the pressure on natural resources. Commercial logic to earn
more profit is causing nations to form trade blocs, striving to get bigger markets
for their domestic companies.
E.g CPEC corridor , built by China has accorded almost all construction
contracts to Chinese companies and Pakistan is paying for that.
The developed nations have developed sound economic systems. There is
generation of surplus wealth. This requires places for investments.
To match the need for finance in developing countries (for funding economic
growth), they channelize the investments to developing countries.
International trade is arguably the most important influencer of global prosperity
and growth.
But there are worries related to the fact the United States has shifted from being
the largest international creditor, to becoming the world's largest international
debtor.
It absorbing excess amounts of funding from organizations and countries on a
global basis. This may affect international finance in unforeseen ways.
Importance
• It is important while determining the exchange rates of the country. This can be
done against the commodity or against the common currency.
• It plays a crucial role in investing in foreign debt securities to have a clear idea
about the market.
• The transaction between countries can be significant in assessing the economic
conditions of the other country.
• The arbitrage in tax, risk, and price can be used to book good profits while
transacting in international trade.
• Exporters and importers can plan their logistics, orders, etc taking the overall
costing in view and thereby price their products accordingly.
• Traders can buy or sell currencies as per their profitability.
• Investors may have a broader horizon of investment and interchange markets
when economic changes affect different markets differently. Overseas mutual
funds are a case in point.
Balance of Payments (BoP)
The balance of payments (BOP), also known as the balance of international
payments, is a statement of all transactions made between entities
in one country and the rest of the world over a defined period, such as a quarter
or a year.
It summarizes all transactions that a country's individuals, companies, and
government bodies complete with individuals, companies, and government
bodies outside the country.
The balance of payments includes both the current account and capital
account.
• The current account includes a nation's net trade in goods and services, its net
earnings on cross-border investments, and its net transfer payments. The
current account includes transactions in goods, services, investment
income, and transfers. The current account is included in calculations of
national output
It also includes receipts from engineering, tourism, transportation, business
services, stocks, and royalties from patents and copyrights.
Trading in goods between countries are referred to as visible items and
import/export of services (banking, information technology etc) are referred to
as invisible items.
Unilateral transfers refer to money sent as gifts or donations to residents of
foreign countries.
The capital account consists of a nation's transactions in financial instruments
and central bank reserves. The capital account also includes the flow of taxes,
purchase and sale of fixed assets etc by migrants moving out/into a different
country. The deficit or surplus in the current account is managed through the
finance from the capital account and vice versa.
There are 3 major elements of a capital account:
• Loans and borrowings – It includes all types of loans from both the private and
public sectors located in foreign countries.
• Investments – These are funds invested in the corporate stocks by non-
residents.
• Foreign exchange reserves – Foreign exchange reserves held by the central
bank of a country to monitor and control the exchange rate does impact the
capital account.
A country’s BOP is vital for the following reasons:
• The BOP of a country reveals its financial and economic status.
• A BOP statement can be used as an indicator to determine whether the
country’s currency value is appreciating or depreciating.
• The BOP statement helps the Government to decide on fiscal and trade
policies.
• It provides important information to analyze and understand the economic
dealings of a country with other countries.
By studying its BOP statement and its components closely, one would be able
to identify trends that may be beneficial or harmful to the economy of the county
and thus, then take appropriate measures.
BoP Deficit
If a country exports an item (a current account transaction), it effectively imports
foreign capital when that item is paid for (a capital account transaction). If a
country cannot fund its imports through exports of capital, it must do so by
running down its reserves.
This situation is often referred to as a balance of payments deficit. Its causes
are :
1. High imports due to developing nations’ growth; inflation in domestic country
makes foreign goods cheaper; weaker currencies;
2. Political and economical instability leading to outward flow of funds from
capital markets
3. Demand for foreign goods and services in quest for a sophisticated life.
Effects :
1. Government borrowing 2. Flow of funds from multilateral agencies 3. More
opening up of economy for exports and technology imports 4. Inflationary trend.
BoP comprises of current account and capital account.
While the current account deals mainly with import and export of goods and
services, the capital account is made up of cross-border movement of capital
by way of investments and loans.
Current account convertibility refers to the freedom to convert your rupees into
other internationally accepted currencies and vice versa without any restrictions
whenever you make payments.
Similarly, capital account convertibility means the freedom to conduct
investment transactions without any constraints. Typically, it would mean no
restrictions on the amount of rupees you can convert into foreign currency to
enable you, an Indian resident, to acquire any foreign asset
India had been following a cautious approach in currency convertibility and
presently has partial capital account convertibility. There are restrictions on
foreign investments. Inward FDI is allowed in most sectors, and outbound FDI
by Indian incorporated entities is allowed as a multiple of their net worth.
Inward inflows and outflows of the foreign and domestic capital, which are prone
to volatility, can lead to excessive appreciation/depreciation of their currency
and impact the monetary and financial stability as was witnessed in South East
Asian crisis of 1997.
Excessive appreciation hurts exports while excessive depreciation makes
imports expensive and worsens current account deficit.
S S Tarapore committee report suggests transparent fiscal consolidation is
necessary to reduce the chances of a currency crisis.
An Indian investor looking to park money overseas or an NRI wanting to invest
in Indian assets, full convertibility on capital account may give you a greater
opportunity to diversify investments and reduce geographical risk. Note that
cross-border investments are allowed even now under RBI’s Liberalised
Remittance Scheme but within the overall limit of $250000.
Currency Convertibility in India
Current Account refers to the forex transactions involving trade of goods and services
while Capital account refers to the forex transactions without any corresponding
exchange of goods/ services eg borrowing & lendings, remittances, etc
The term convertibility of a currency indicates that it can be freely converted into any
other currency. Convertibility can also be identified as the removal of quantitative
restrictions on trade and payments on current account. Convertibility establishes a
system where the market place determines the rate of exchange through the free
interplay of demand and supply forces.
Government of India introduced the partial convertibility of rupee from March 1. 1992.
Since 1994, Indian rupee has been made fully convertible in current account
transactions.
Under this system, which remained in operation for a period of one year, 60 per cent
of the exchange earnings were convertible in rupees at market determined exchange
rate and the remaining 40 per cent earnings were convertible in rupees at the officially
determined exchange rate.
Current account convertibility is the next phase for attaining full convertibility of rupee.
Current account convertibility relates to the removal of restrictions on payments
relating to the international exchange of goods, services and factor incomes, while
capital account convertibility refers to a similar liberalization of a country’s capital
transactions such as loans and investment, both short term and long term.
Developments towards capital account convertibility
(a) Capital account convertibility exists for foreign investors and Non-Resident Indians
(NRIs) for undertaking direct and portfolio investment in India.
(b) Indian investment abroad up to US $ 4 million is eligible for automatic approval by
the RBI subject to certain conditions.
(c) In September 1995, the RBI appointed a special committee to process all
applications involving Indian direct foreign investment abroad beyond US $ 4 million
or those not qualifying for fast track clearance.
INTERNATIONAL MONETARY SYSTEMS
GOLD STANDARD
Traditionally gold has been an important yardstick for measure of wealth
internationally.
The international gold standard emerged in 1871 following its adoption by Germany.
By 1900, the majority of the developed nations were linked to the gold standard.
The gold standard is a monetary system where a country's currency or paper money
has a value directly linked to gold. Countries agreed to convert paper money into a
fixed amount of gold. A country that uses the gold standard sets a fixed price for gold
and buys and sells gold at that price.
For example, if the U.S. sets the price of gold at $500 an ounce, the value of the dollar
would be 1/500th of an ounce of gold.
The appeal of a gold standard is that it arrests control of the issuance of money out of
the hands of imperfect human beings. With the physical quantity of gold acting as a
limit to that issuance, a society can follow a simple rule to avoid the evils of inflation.
Also in times of deflation it was supposed to help promote a stable monetary
environment in which full employment can be achieved.
From 1871 to 1914, the gold standard was at its pinnacle. During this period, near-ideal
political conditions existed in the world. Governments worked very well together to
make the system work, but this all changed forever with the outbreak of the Great War
in 1914.
With World War I, political alliances changed, international indebtedness increased and
government finances deteriorated. This created a lack of confidence in the gold standard
that only exacerbated economic difficulties. It became increasingly apparent that the
world needed something more flexible on which to base its global economy.
As the gold supply continued to fall behind the growth of the global economy, the
British pound sterling and U.S. dollar became the global reserve currencies. Smaller
countries began holding more of these currencies instead of gold.
The stock market crash of 1929 was only one of the world's post-war difficulties. The
pound and the French franc were horribly misaligned with other currencies; war debts
and repatriations were still stifling Germany; commodity prices were collapsing; and
banks were overextended. The GREAT DEPRESSION sets in.
In 1931, the gold standard in England was suspended. Then, in 1934, the U.S.
government revalued gold from $20.67/oz to $35/oz, raising the amount of paper
money it took to buy one ounce to help improve its economy.
This higher price for gold increased the conversion of gold into U.S. dollars, effectively
allowing the U.S. to corner the gold market. 1939 saw record production of gold, thus
bringing down its value. WWII sets in.
As World War II was coming to an end, the leading Western powers met to develop the
alternative to gold standard at Bretton Woods , New Hampshire, USA.
BRETTON WOODS SYSTEM
The Bretton Woods Agreement was negotiated in July 1944 by 730 delegates from 44
countries at the United Nations Monetary and Financial Conference held in Bretton
Woods, New Hampshire.
All of the countries in the Bretton Woods System agreed to a fixed peg against the U.S.
dollar with diversions of only 1% allowed. Countries were required to monitor and
maintain their currency pegs which they achieved primarily by using their currency to
buy or sell U.S. dollars as needed.
The Bretton Woods System, therefore, minimized international currency exchange rate
volatility which helped international trade relations. More stability in foreign currency
exchange was also a factor for the successful support of loans and grants internationally
from the World Bank.
It wasn't until 1958 that the Bretton Woods System became fully functional. Once
implemented, its provisions called for the U.S. dollar to be pegged to the value of gold.
Moreover, all other currencies in the system were then pegged to the U.S. dollar’s value.
The exchange rate applied at the time set the price of gold at $35 an ounce.
As a consequence of Bretton Woods conference, 2 institutions were born : IMF and
World Bank
The purpose of the IMF was to monitor exchange rates and identify nations that needed
global monetary support. The World Bank, initially called the International Bank for
Reconstruction and Development, was established to manage funds available for
providing assistance to countries that had been physically and financially devastated by
World War II
In 1970s the oil shock came. In 1971, concerned that the US gold supply was no longer
adequate to cover the number of dollars in circulation, President Richard M. Nixon
devalued the U.S. dollar relative to gold.
After a run on gold reserve, he declared a temporary suspension of the dollar’s
convertibility into gold.
By 1973 the Bretton Woods System had collapsed. Countries were then free to choose
any exchange arrangement for their currency, except pegging its value to the price of
gold.
They could, for example, link its value to another country's currency, or a basket of
currencies, or simply let it float freely and allow market forces to determine its value
relative to other countries' currencies.
Although the system collapsed, but it had a significant importance in shaping global
economy, trade and development of infrastructure of countries. International Monetary
Fund and World Bank functions today and are the lifelines of many developing nations.
India has vastly benefitted from the soft loans and asistances, grants of WB that has led
to improvement in basic living conditions, poverty alleviation and education of the
poor.
IMF has been a key trigger to economic liberalization , benefits of which are felt even
today.
EUROPEAN MONETARY SYSTEM
The European Monetary System (EMS) refers to an arrangement established in 1979,
whereby members of the European Economic Community (EEC), now called European
Union (EU) agreed to link their currencies to encourage monetary stability in Europe.
The EMS aimed to create a stable exchange rate for easier trade and cooperation among
European countries through an Exchange Rate Mechanism (ERM). The ERM was
based on the European Currency Unit (ECU) – a currency unit composed of a basket of
12 European currencies weighted by GDP.
The European Monetary System mainly relied upon the ECU and the existing exchange
rate mechanism. The exchange rate fluctuations of member countries’ currencies were
limited to 2.25% from the fixed central point, which was determined by the European
Economic Community.
The European Monetary System aimed to achieve various macroeconomic goals: 1.
Encouraging trade within Europe 2. Exchange rate stability among trading members
3. Controlled inflation within Europe
Benefits : 1. Stability of exchange rates 2. Trade liberalization and easy movement of
goods. 3. Control over inflation. 4. Common market 5. Political and economic unity
However the EMS suffered from several limitations : 1. Fixed exchange rates and 2,
Common monetary and economic policy. Different countries had different resources
and pace of growth also varied. The main focus was development and hence the policy
rates were kept low.
This created large imbalances. Germany was developing fast and was facing inflation
owing to the inability to raise interest rates. In 1992, Germany raised its interest rates
to combat inflation – it placed upward pressure on the exchange rates of member
countries at a time when they needed low interest rates and higher exports, resulting in
a crisis.
It continued functioning under the Maastricht Treaty, which was signed in 1992 and
laid the foundation for the European Union.
After several rounds of discussions, EMS and its exchange rate system were replaced
by the adoption of the Euro and the formation of the European Central Bank (ECB),
which has authority over the EU’s monetary policy.
SMITHSONOAN AGREEMENT
The Smithsonian Agreement was an agreement signed by 10 top industrialized
countries in 1971to regulate international payment and exchange at that moment.
The agreement made an amendment to the fixed exchange rates stipulated in the 1944
Bretton Woods Agreement. When the Smithsonian Agreement was signed in 1971, it
created a new standard to the U.S dollar in which the currencies of the other nine
countries that signed the agreement were pegged to the U.S dollar.
The 10 countries that signed the Smithsonian Agreement were; Netherlands, Japan,
Belgium, Sweden, France, Canada, Germany, Italy, the United Kingdom, and the
United States. The Smithsonian Agreement was signed by a group of ten countries
popularly called G10.
As contained in the agreement, the currencies of the above countries are allowed to
fluctuate against the US dollar by 2.25%.
The Smithsonian Agreement only lasted for 15 months because as of 1973, most major
currencies had changed from a fixed rate to a floating exchange rate just like the US
dollar.
SDR
SDR holdings is one of the components of the FER of a country. IMF makes the general
SDR allocation to its members in proportion to their existing quotas in the Fund. The
Board of Governors of the IMF had approved a general allocation of about SDR 456
billion on August 2, 2021 (effective from August 23, 2021) of which the share of India
is SDR 12.57 billion.
As per RBI circular dated 01.09.2021, International Monetary Fund (IMF) has made
an allocation of Special Drawing Rights (SDR) 12.57 billion (equivalent to around USD
17.86 billion at the latest exchange rate) to India on August 23, 2021.
The total SDR holdings of India stands at SDR 13.66 billion (equivalent to around USD
19.41 billion at the latest exchange rate) as on August 23, 2021.
This increase in SDR holdings will be reflected in the Foreign Exchange Reserves
(FER) data that shall be published for the week ended August 27, 2021
FIXED EXCHANGE RATE SYSTEM
Merits of Fixed Exchange Rate System:
1. Exchange Rate Stability: It is necessary for orderly development of the international
economy and rapid growth of world trade. It helps exporters in pricing their products
for foreign customers as the uncertainty is removed. Similarly the uncertainty attached
with the imports help policy makers in predicting growth and inflation. This puts the
BoP under control.
2. Promotes Capital Movements: The cross border flow of funds are not subject to
volatility and capital appreciation. It removes uncertainties about capital loss on
account of changes in exchange rate. Since foreign investment is an important source
of economic growth, the fixed exchange rate system would promote rapid economic
growth of the developing countries.
3. Prevents Speculation in foreign exchange market: Currency speculators who bet on
small intraday movements will be eliminated, resulting in better price discovery and
transparency based on trade and capital movement.
4. Control over inflation. Fixed exchange rates can serve as an anchor. Inflation will
cause balance of payments deficits and losses in reserves. Hence the authorities will
have to take counter measures to stop inflation. Fixed exchange rates should therefore
impose a discipline on governments and stop them from pursuing inflationary policies
which are out of time with the rest of the world.
5. Promotes economic integration of the world : It facilitates communication, trade and
free movement of finance between different regions of a country.
6. Promotes growth of capital markets: Owing to minimum volatility capital flow is
smooth and returns become predictable.
DEMERITS
1. Unequal growth and inflation as the exchange rates are administered and not market
driven.
2. No recognition for superior goods or services provided by a country as the demand
for the currency is not recognized.
3. Pressure on Central Banks to buy or sell currency reserves to maintain a fixed price.
So inefficiency creeps in. There is no incentive to produce a better import substitute.
TYPES OF FIXED EXCHANGE RATE SYSTEMS
Hard peg currencies : In a hard peg exchange rate policy, the government chooses an
exchange rate. A central bank can intervene in exchange markets in two ways. It can
raise or lower interest rates to make the currency stronger or weaker. It also can directly
purchase or sell its currency in foreign exchange markets.
A hard peg exchange rate policy will reduce exchange rate fluctuations, but means that
a country must focus its monetary policy on the exchange rate, not on fighting recession
or controlling inflation.
Hard pegs usually go hand in hand with sound fiscal and structural policies and low
inflation.
Soft Peg currencies : A soft peg describes the type of exchange rate regime applied to
a currency to keep its value stable against a reserve currency or a basket of currencies.
In a soft peg exchange rate policy, the foreign exchange market usually determines a
country’s exchange rate, but the government sometimes intervenes to strengthen or
weaken it.
The main difference between soft and hard pegged currencies is that the soft peg
systems provide a limited degree of monetary policy flexibility to allow governments
and central banks to deal with economic shocks.
Soft peg currencies include the Chinese yuan, an interesting soft peg currency as it is
softly pegged to the U.S. dollar while also being a reserve currency, the Venezuelan
bolivar and the Hong Kong dollar (which are both pegged to the U.S. dollar).
FLOATING EXCHANGE RATE SYSTEMS
Merits :
1. Automatic stabilization. BoP deficit is counterbalanced by currency depreciation and
vice versa. Eg. if a country suffers from a deficit in the balance of payments then, other
things being equal, the country’s currency should depreciate. This would make the
country’s exports cheaper, thus increasing demand, while at the same time making
imports expensive and decreasing demand. The balance of payments equilibrium would
therefore be restored. On the contrary, a balance of payments surplus would be
automatically eliminated through a change in the exchange rate.
2. Internal policy freedom for governments : a floating exchange rate allows a
government to pursue internal policy objectives such as full employment growth in the
absence of demand-pull inflation without external constraints (such as debt burden or
shortage of foreign exchange).
3. Inflation control is automatic as higher import prices prevents imports and cheaper
exports reduces fund flow.
4. Reduces pressure on forex reserves of Central Banks.
5. Demand for a currency represents demand for superior lifestyle and goods. This is a
recognition for a country’s growth and investment potential. This provides an incentive
to maintain that.
Demerits :
1. BoP deficits in case of developing countries rises due to costly commodity prices
(oil, metals, etc).
2. Source of domestic inflation, as import of essentials raises prices in the domestic
currency.
3. Flight of capital drastically influences currency.
4. Cheaper exports from a developing country can make the domestic industry
uncompetitive in a developed country creating employment generation issues and
political turmoil.
5. Volatility gives rise to uncertainty and source of speculation which distorts market
forces.
TYPES OF FLOATING EXCHANGE RATE SYSTEMS
In countries that allow their exchange rates to float, the central banks intervene (through
purchases or sales of foreign currency in exchange for local currency) mostly to limit
short-term exchange rate fluctuations. However, in a few countries (for example, New
Zealand, Sweden, Iceland, the United States, and those in the euro area), the central
banks almost never intervene to manage the exchange rates.
Managed float : The value of the currency is kept in a range against another currency
(or against a basket of currencies) by central bank intervention. Many developing
nations seek to protect their domestic industries and trade by using a managed float
where the central bank intervenes to guide the currency.
The frequency of such intervention varies. For example, the Reserve Bank of India
closely manages the rupee within a very narrow currency band while the Monetary
Authority of Singapore allows the local dollar to fluctuate more freely in an undisclosed
band.
Market uncertainties are tackled by central banks to prevent exchange rates influencing
inflation. The central banks of both Turkey and Indonesia intervened openly numerous
times in 2014 and 2015 to combat currency weakness caused by instability in emerging
markets worldwide.
Some central banks prefer not to publicly acknowledge when they intervene in the currency
markets; for example, Bank Negara Malaysia was widely rumored to have intervened to
support the Malaysian Ringgit during the same period, but the central bank has not
acknowledged the intervention
A managed float system isn't considered to be a true floating exchange rate because,
theoretically, true floating rate systems do not allow for intervention. However, the
most famous show-down between a speculator and a central bank took place in
September 1992, when George Soros forced the Bank of England to take the pound out
of the ERM. The pound theoretically floats freely, but the Bank of England spent
billions on an unsuccessful attempt to defend the currency.
Free float exchange rate : A free floating exchange rate, sometimes referred to as
clean or pure float, is a flexible exchange rate system solely determined by market
forces of demand and supply of foreign and domestic currency, where government
intervention is totally inexistent. It allows countries to retain their monetary
independence, which basically means they can focus on the internal aspects of their
economy, and control inflation and unemployment.
While the system provides independence, promotes open market and low requirement
of maintaining reserves, the disadvantages are that it creates uncertainty, resource
allocation becomes skewed and lack of discipline.
