1. Foreign Exchange PREPARED BY UMAIR

2. Introduction to Foreign Exchange In simple words we can say that: Foreign Exchange means the currency of other countries. Not technically it means foreign currency. In other words: It may be thought of as the means of which mutual indebtedness of the nation is paid of. According to Encyclopedia Britannica: The system by which commercial nations discharge their debts to each other 3. Introduction to Foreign Exchange According to Hartley Whither A mechanism by which international indebtedness is settled between one country and another. According to H.E. Evitt: The means and methods by which rights of wealth expressed in terms of the currency of one country are converted into rights to wealth in terms of the currency of another country are known as foreign exchange. 4. Foreign Exchange Market Definitions: It is a market in which the currencies of different countries are traded against each other, just like the trading of goods and services in an ordinary market. In foreign exchange market it is one countries money that in exchanged for another countries money. 5. Foreign Exchange Market Definitions: In words of Kindlebeger: Foreign exchange market is a place where foreign money is bought and sold. 6. Need of Foreign Exchange Market Money is essential for the smooth running of every modern economy. Every govt. has her own authorized currency. However, the currency of a particular country is acceptable only in the geographical boundaries of that particular country. So if you purchase wheat form USA, you are bound to make payment in US$. 7. Features of Foreign Exchange Market: Foreign exchange market resembles very mush to our usual markets. 1. Medium of Exchange is $: 2. Sensitivity: 8. 1. Medium of Exchange is $. Every market has a medium of exchange which is also legal tender prevailing in that country. You can trade with the help of rupee in any market situated anywhere in Pakistan. Similarly one can purchase any commodity against pound form any market situated in UK. 9. 2. Sensitivity: Foreign exchange market can be called the most sensitive market. It has its effects on the whole capital market of the country and variety of factors have their direct effects in the working of this market. 10. Function of Foreign Exchange Market The most important function of the foreign exchange market is the determination of exchange rate. 1. Determination of Exchange Rate: Exchange rate are determined in the foreign exchange market. Demand Side: (a) Pak Exports: (b) Capital Inflows: (c) Reserve Currency: 11. (a) Pak Exports: One important reason for the demand of Pak rupee in international foreign exchange market is our exports. This demand comes form those people who wish to purchase our exported goods. 12. (b) Capital Inflows: The Second source comprises those people, firms who wish to purchase Pakistans assets. In order to buy any asset in Pakistan, they first have to convert their currencies in rupees. So capital inflows are accompanied by the demand for local currency. 13. (c) Reserve Currency: Government often hold and accumulate foreign exchange reserves. Just as we people hold savings account. The government of some countries say "Turkey may decide to increase her holdings of Rupees. Then in this case she will be demanding rupees. 14. Supply Side: (a)Imports: (b)Capital Outflows: (c)Reserve Currency: 15. (a) Imports: The main source of supply of rupee is the imports to Pakistan. Suppose I wish to purchase a Japanese radio. Then I will be supplying rupees and purchasing Japanese Yens. 16. (b) Capital Outflows: Capital outflows will also result in the supply of rupees. For instance, a Pakistani citizen may with to purchase assets in UAE. Now the will be supplying rupees to purchase Dirham. 17. (c) Reserve Currency: Also if a country holding rupees as foreign exchange reserves may decide that they offer poor return and that it should sell these rupees to buy any other currency. In this case, such a country will be supplying rupees. 18. The Shape of Demand Curve for Rupees. The demand for rupees in terms of any other currency say can be shown by a negatively sloped demand curve. Now why the demand curve for rupees in negatively slopped? The answer is as follows. The demand in rupee arise from our exports. 19. The Shape of Demand Curve for Rupees. The Supply curve for rupees is positively sloped. The reason for this is as follows. When the rupee falls in value, rupee price of all the important goods rises. It takes more rupees to purchase a single . So Pakistani citizen will buy less / fewer imported goods and will supply less rupees. 20. Aggregate Demand & Supply: The sum total of all the sources of demand give us aggregate demand for rupees. AD is the aggregate demand for rupees. AS is the aggregate supply of rupees. 21. II. Transfer Function: The foreign exchange market transfers the purchasing power between countries. If at same level of exchange rate and general price level, a currency has more purchasing power at home then aboard, then the people will try to accumulate local currency to take advantage of local cheaper goods. 22. III. Credit Function: This refers to the working of foreign exchange bills. By this, the exchange market provides credit to the debtors or importers. During an international trade, the exporters can draw the bill of exchange on importers. On acceptance of this bill of exchange. The exporters can get the payment at the time of maturity of the bill or they can also discount them. 23. Factors Influencing Foreign Exchange Foreign exchange market is a very sensitive market so are the foreign exchange rates. A variety of factors have their direct influence on foreign exchange market and the exchange rates which are determined in these markets. Following are some of the important factors which have their direct influence on exchange rates. 24. Factors Influencing Foreign Exchange 1. Changes in Price Levels 2. Capital Movement: 3. Speculations: 4. Exports and Imports: 5. Structural Changes: 6. Political Stability: 7. Exploration of Natural Reserves: 8. Influence of Bank Rates: 9. Stock Exchange Influence: 25. 1. Changes in price Levels: Price level of a country plays a significant role in determining the trends of exchange rate. Take the case of 2 countries Pakistan and England. If the price level in Pakistan rises due to inflation, this means that our goods have now become more expensive. 26. 2. Capital Movement: Capital movements across borders of countries exert strong influences over exchange rates. In a country where capital is flying in at a high rate, the currency appreciate. On the other hand, the currency of the country form where the capital flies out, depreciates also, if any country attracts investments form aboard then the currency of the country will appreciate. 27. 3. Speculations: Uncertainty about future exchange rate induces people to speculate about them. This also influences exchange rates. If foreigners expect rupee to appreciate, they will rush to buy Pakistani assets, and goods that are denominated in rupees. This will increase the current demand for rupees and hence rupees will appreciate. 28. 4. Exports and Imports: Volume of exports and imports of a country also produce significant changes on exchange rates. If exports of country are higher than its imports, then this means that demand for the currency of this country is also high. 29. 5. Structural Changes: Structural changes refer to the changes and improvement in the state of technology, innovations, inventions of new products and new ways of producing old products. All these advancements lead to the change in the pattern of comparative advantage. Innovations and advancements results in the productions of new and improved products which attracts thousands of new customers. 30. 6. Political Stability: Political stability, sound infrastructure, security, uncertainty about future ---- and these factors play significant role in the determination of exchange rate. If there is political stability in a country, returns are healthy, future is predictable then such country attracts investments from all over the world. 31. 7. Exploration of natural Reserves: When a country explores more neural resources, it takes a further step towards self sufficiency and independence which means less reliance on others. This also effects exchange rates. For instance assume that Pakistan fulfills 75% of its total petrol consumptions demand from outside and only 25% is produced locally. 32. 8. Influence of Bank Rates: The banking operations and variations in the bank rates also influence exchange rates. If bank rate is high, borrowing will be expensive and funds form outside the country will flow in to earn high return. This will lead to the appreciation of currency. 33. 9. Stock Exchange Influence: Working and status of stock exchange markets also influence exchange rates. If in a country, there is an active capital market and healthy business of stocks, shares, debentures is going on then funds will flow in to take advantage of these factors. 34. Conclusion: These are the factors which normally effect exchange rates. In real world, the situation is not so simple. Besides these, many other apparently irrelevant factors can also produce serious effects on the exchange rate. 35. Exchange Rate System There are basically two types of exchange rate system. Fixed exchange rate system and floating exchange rate system. These are explain below. 1. Fixed Exchange Rate System: 2. Floating Exchange Rate System: 36. 1. Fixed Exchange Rate System: Meaning & History: Under the fixed exchange rate system, the exchange rate is fixed. But it is not absolutely fixed, rather fixation of rate means that it is only allowed to fluctuate between some limits. The fixed exchange rate system was adopted by majority of countries of world (except the Communist block) after world war II. The decision was taken in the Bretton Woods conference of 1944 and it was supported by international monetary fund. 37. Advantages of Fixed Exchange System: Following are the advantages of this system. It ensures better control over the exchange rates. It allows more powers to central bank so that it can exert considerable influence of BOP (Balance of Payment) or other macro economic variables. It provides the hedge against unnecessary depreciation of currency. It eradicates the speculative business to a great extend. 38. disadvantages of Fixed Exchange System: Following are the advantages of this system. First of all it reduce the central bank liquidity. This is because central bank always has to hold huge gold and exchange reserves just for the buying selling of home currency in home market. The system does not give any method of changing the rate once fixed initially. The need to change the rate arises in response the fundamental disequilibrium in country's balance of payments. 39. Conclusion: The system remained in force in major part of the world after the world war II. However afterwards the instability arises due to the major reason that this system had reduced the worlds liquidity. After the sterling devaluation in 1967, many leading economists of world started advocating for flowing rate system. 40. 2. Floating Exchange Rate System: The idea behind this is simple. In case the disequilibrium occurs and there is either an upward or downward pressure on the exchange rate, it is allowed to float freely. Central bank does not intervene in the foreign exchange market to buy or sell local currency. The theory says that once an equilibrium is altered, the forces of market i.e., demand and supply will come into play and a new equilibrium will be soon found. 41. Advantages of Floating Exchange Rate System: The major advantage is that it has increased the worlds liquidity. Central banks are no longer required to hold huge gold and exchange reserves for the foreign exchange market operations and hence these reserves can be used in other productive areas. In this system, the exchange rate management is automatically done by the market, so it is argued that government can focus her attention on domestic policies. 42. Disadvantages of Floating Exchange Rate System: This system gives rise to massive speculation as the rates are not controlled by any central authority the speculators work freely in such system. Another disadvantage is that traders feel problem under such system, as rates are constantly changing. For this reason, forward exchange rates are widely used by traders under such system. This system is also dangerous in the aspect that it can rob the economic policies of the government. Further as in this system, there is no intervention from any central authority, there is a risk of collapse of the currency. 43. Kinds of Exchange rates: Rate of exchange depends not only on actual worth of currencies but also on ongoing circumstances and events. It also depends on nature of transaction for which rate is being calculated. 1. Spot Rate: 2. Forward Rate: 3. Selling / Buying Rate: 4. Inter Bank Rate: 5. Official Rate: 44. 1. Spot Rate: It means the rate at the spot or at he moment. If you go to any currency dealer and ask him the exchange rate, he will give you the spot rate. 45. 2. Forward Rate: Forward rates are related to future deliveries or transactions. They in fact provide hedge against anticipated devaluation to importer, Suppose Mr. A has entered into a trade deal whereby Mr. X in America will sent him 100 cars in 3 months Mr. A knows that in case devaluation occur in future 3 months, he will have to pay more rupee and his cost of purchase will rise. 46. 3. Selling / Buying Rate: Selling rate is one at which currency dealers sell the foreign exchange. Buying rate is one at which they are willing to buy foreign exchange. Normally the selling rate is little bit higher than buying rate, for example if the buying rate is Rs. 60.25 per dollar then the selling rate will might be about 60.45. 47. 4. Inter Bank Rate: It is the rate at which central bank and commercial banks sell and buy foreign exchange in the inter bank market. 48. 5. Official Rate: It is the rate which is issued by the central bank and at which all trade dealings take place. 49. Instruments of Making Foreign Payments We know that currency of our country is not a legal tenders in other countries and hence it will no be accepted abroad in discharge of debts and obligations. All importers face this problem that their exporter in other countries require payments in their homeland currency. 50. Instruments of Making Foreign Payments 1. Letter of Credit 2. Bill of Exchange 3. Cable Transfer, Mail Transfer 4. Travellers Cheque: 5. Foreign Bank Draft: 6. International Money Order: 51. 1. Letter of Credit: A letter of credit or LC as it is often called is most widely used instrument that ensures maximum safety and reliability. In words of Pritchard. A letter of credit is a commitment on the part of buyers banks to pay or accept drafts drawn upon it, provided drafts do not exceed a specified amount. 52. 2. Bill of Exchange: A bill of exchange is just like a post dated cheques. The only difference is that a bill of exchange can be discounted at the bank but a post dated cheque cant be discounted. A bill of exchange is an order from the drawer to the drawee to pay a certain sum of money on demand or on certain specified date. 53. 3. Cable Transfer, Mail Transfer: Cable transfer and mail transfer are traditionally used instruments for making payments abroad. Banks have been sending messages to other banks in other countries through mail or cable since long. Cable transfer involves a telegraphic order while written messages are sent via mail in mail transfer. 54. 4. Travellers Cheque: Travellers cheques are commonly called TCs. The basic purpose is to ensure safety in transmission of cash. However they are also used as instrument of foreign payment. In actual a TC is an order drawn by a bank in its own branch to pay the sum of money (as determined by the value of TCs) on demand to the purchaser of TCs. 55. 5. Foreign Bank Draft: Foreign bank drafts work in same way as the ordinary bank drafts. In actual, it is an order drawn by a bank on its branch in foreign country to pay a certain amount of money on demand to the bearer of draft or to the order of the bearer. 56. 6. International Money Order: International money order also works in the same way as a local money order. It is widely used by the people working aboard to send money to homeland. 57. Exchange Control Meaning: Broadly speaking the Exchange Control refers to those action which a government of a country adopt to effect exchange rates. Objective of Exchange Control: Exchange controls are basically implemented to safe guard the interest of whole of the economy. Their basic aim is to maintain the exchange value of the local currency, but they also help in curing other economic and fiscal ills. 58. Exchange Control 1. Stabilization of Exchange Rate: 2. Foreign Payment: 3. Protectionism: 4. Balance of Payment 5. Safeguarding Foreign Exchange Reserve. 6. Watch Eye on Capital Movements. 7. Forming Cartels 8. Under Valuation: 9. Over Valuation: 10. Source of Income 59. 1. Stabilization of Exchange Rate: The basic object is to stabilize and maintain exchange rate. Such controls help the central bank to maintain exchange rates without spending precious reserves on buying and selling of local currency. 60. 2. Foreign Payment: Exchange controls are exercised with the intention to accumulate enough funds for making foreign payments. 61. 3. Protectionism: Exchange controls are an important tool of protectionism policies. They are used to protect and flourish the home industry against foreign competitive firms. 62. 4. Balance of Payment Exchange controls are used to turn the balance of payments favorable by reducing BOP deficit. Exchange control policy may be aimed at increasing inflows and reducing outflows. 63. 5. Safeguarding Foreign Exchange Reserve: Government hold foreign exchange reserves, just as we people hold bank deposits and saving certificates. Such foreign exchange reserves are of vital importance for the government. 64. 6. Watch Eye on Capital Movements: Capital flights in and out of the country are of vital importance. Sometimes the economic situation is such that the returns are not healthy and future is non- predictable. 65. 7. Forming Cartels: Exchange controls can be used mutually by group of countries to form cartels for their mutual benefits. Under cartels, the group of some countries gain economic advantages at the expense of others. 66. 8. Under Valuation: It means to fix a rate, lower then it would be in a free floating exchange system. The basic aim for under valuation is the protection of local industry and favour of local exporters. 67. 9. Over Valuation: This is appreciation i.e., the exchange rate is fixed over and above its normal level. This policy is adopted in following cases. When a country has a massive foreign debt an appreciation will lessen the burden of debt. When supply of local currency is extraordinary higher than its demand. When country is facing high inflation. When the BOP shows extremely unfavorable situations. 68. 10. Source of Income: Exchange controls are also source of income for the government. Since during exchange controls, the government directly retains the foreign exchange and as foreign exchange is directly sold by government so difference between buying and selling rate goes to the government as income. 69. Methods of Exchange Control The basic theory of exchange control is that the government orders to all exports and foreign exchange dealers, brokers etc. to surrender all their foreign exchange directly to the central bank. Different method of exchange control are as follows: 70. Methods of Exchange Control 1. Exchange Pegging 2. Exchange Equalization Account 3. Multiple Exchange Rate: 4. Quota Systems: 5. Block Accounts 6. Clearing Agreements: 7. Barter Trade/ Compensation Agreement: 8. Stand Still Agreement / Rescheduling 9. Payment Agreements. 71. 1. Exchange Pegging It means to peg (fix) the exchange rate over or under the equilibrium rate. In case it is over valued i.e., over the equilibrium level it is called pegging up. 72. 2. Exchange Equalization Account It is a fund which is set up by the central authority. Once equilibrium has been disturb then, the reserves of this fund are used to restore exchange rate. 73. 3. Multiple Exchange Rate: Under this system as the name suggest, different rates are prescribed by central bank for trading with different countries. Rates also differ for trade of different commodities. 74. 4. Quota Systems: Quota systems are the part of import policy. They are used to ration fixed amount of foreign exchange among import of various items. Quota system besides acting as an exchange control also help to check import of invalid and luxurious goods. 75. 5. Block Accounts: Block account technique varies form ordinary blocking to the complete freezing of foreign exchange accounts (this is what Pakistani government did after test of nuclear devices). 76. 6. Clearing Agreements: Clearing agreements are used to improve the liquidity of national trade. Under such agreements central banks of two countries negotiate with each other a suitable exchange rate for a particular future period. 77. 7. Barter Trade / Compensation Agreement: Although barter came to an end with the invention of money yet it is used sometimes in international trade. Under compensation agreements the trading countries simultaneously trade in equal value of goods i.e., they import and export goods of same value thus no need of change of currency arises. 78. 8. Stand still Agreement / Rescheduling: Stand still agreements or re-scheduling means altering the schedule of payment of loans. Debtor country may negotiate with the creditor country to repay debts in easy installments after some time in future. 79. 9. Payment Agreements: Under payment agreements the debtor country enter into a settlement with the creditor country whereby the creditor country agrees to have more and more imports form debtor country. On the other hand, debtor country tends to have minimum imports from creditor country. This also help in clearing BOP deficits. 80. Summing Up: These are different exchange controls which are applied form time to time by different countries to maintain their exchange rates in favorable area and to turn BOP favorable. In the modern world, the highly developed countries have restricted developing countries form practicing any strong protectionism policies (Pakistan also as member of WTO is unable to impose extra tariffs on imports).