UNIT V

INTRODUCTION TO INTERNATIONAL TRADE

FINANCE
 Topics
• Balance of payment
Current and capital items
Disequilibrium and rectification
• Components of IFS(International financial
systems)
Forex market
IMF & IMS
Exchange rate determination
Capital account convertibility
 What Is The
Balance Of Payments?
❖ A country’s balance of payments accounts keep track
of the payments to and receipts from other countries
for a particular time period.
❖ It is a statistical statement that systematically
summarizes for a specific time period, the economic
transactions of an economy with the rest of the world.
❖ Balance of payments accounting uses double entry
bookkeeping
❖ There are two main accounts
1. The current account records transfers of goods and
services or financial assets between the home country
and the rest of the world.
2. The capital account records one time changes in the
stock of assets.
Components of BOP
Suppose for the year 2018 the value of exported
goods from India is Rs. 60 lakhs and the value of
imported items to India is 90 lakhs, Whether
India has a trade deficit or trade surplus for the
year 2018?
 Components of BOP.
• Current Account
• Capital Account
1. The current account records transactions that pertain to goods,
services, and income, receipts and payments.
❖ current account deficit - a country imports more than it
exports
❖ current account surplus – a country exports more than it
imports

2. Capital Account: It consist of Short term and long term capital transactions.
Capital Outflow represent debit and capital inflow represent credit.
For ex, if an American firm invests $100
million in India, Where should we record in
the balance of payment?
Balance of Payment Disequilibrium
 OR
BOP deficit indicates that a country’s
imports are more than its exports.
OR
when a country’s export is
more than its import, its BOP
is said to be in surplus.
 Causes of Disequilibrium(Balance of
payment)
• Economic Factors
• Political Factors
• Social Factors
Measures or rectification in Balance of
payment
• Export promotion
• Import
• Reducing inflation
• Exchange control
• Devaluation of domestic currency
• Depreciation
Components of International Financial Environment
• International financial environment is totally different from
domestic financial environment. International financial
management is subject to several external forces, like

❖ Foreign exchange market,

❖ Currency convertibility,
❖ International monitory system,
❖ Balance of payments, and
❖ International financial markets.
Components of International Financial Environment
• International financial environment is totally different from
domestic financial environment. International financial
management is subject to several external forces, like

❖ Foreign exchange market,

❖ Currency convertibility,
❖ International monitory system,
❖ Balance of payments, and
❖ International financial markets.
1) Foreign Exchange Market
• Foreign exchange market is the market in which money denominated in one currency is
bought and sold with money denominated in another currency.

• It is an over the counter market, because there is no single physical or electronic market
place or an organized exchange with a central trade clearing mechanism where traders
meet and exchange currencies.

• It spans the globe, with prices moving and currencies trading somewhere every hour of
every business day. World’s major trading starts each morning in Sydney and Tokyo, and
ends up in the San Francisco and Los-Angeles.

• The foreign exchange market consists of two tiers: the inter bank market or wholesale
market, and retail market or client market.

• The participants in the wholesale market are commercial banks, investment banks,
corporations and central banks, and brokers who trade on their own account.

• On the other hand, the retail market comprises of travelers, and tourists who exchange
one currency for another in the form of currency notes or traveler cheques.
Terms and concepts related to foreign exchange market:
Exposure and Risk:
• EXPOSURE: Financial exposure is the amount an investor
stands to lose in an investment. For example, the financial
exposure involved in purchasing a car would be the initial
investment amount minus the insured portion.

• RISK: Risk often refers to the chance an outcome or

investment's actual gains will differ from an expected
outcome or return.
• Risk includes the possibility of losing some or all of an original
investment.
• For example, if an individual holds a substantial amount of stock in a single
company, they have a high financial exposure to that company's performance.
Two distinct strategies used in financial
markets to manage risk
Hedging:
• Hedging is an insurance-like investment that protects you from risks of any
potential losses of your finances.

Hedging is typically undertaken by individuals, businesses, or investors who have an

existing exposure to a particular risk, such as price fluctuations, currency
exchange rate movements, or interest rate changes.

Speculation:
• Speculation refers to the act of conducting a financial transaction that has
substantial risk of losing value but also holds the expectation of a significant
gain or other major value
Speculation is undertaken by traders or investors who do not necessarily have an existing
exposure but believe they can accurately predict future price movements based on
their analysis or market views.
 Hedging Example
• Imagine you own a small bakery in India, and you use wheat flour as a key
ingredient in your products like cake, snacks etc. Your primary concern is the cost
of wheat flour, which can be subject to price fluctuations due to factors like weather
conditions, crop yields, and market demand. You anticipate that the price of wheat
flour may rise significantly over the next six months due to unfavorable weather
conditions affecting wheat production in India.
Hedging Strategy:
• To protect your bakery from the potential increase in the cost of wheat flour, you decide to
implement a hedging strategy using a financial instrument known as a futures contract.
Initial Situation:
• Current Wheat Flour Price: ₹25 per kilogram
• Anticipated Wheat Flour Price in Six Months: Potentially ₹30 per kilogram
• Flour Consumption Rate: 100 kilograms per month

Hedging Steps:
• You decide to enter into a futures contract to buy 100 kilograms of wheat flour per month at
the current market price for delivery in six months. The futures contract is priced at ₹25 per
kilogram, which matches the current price.
 Speculation example
• Imagine a metropolitan area known for its booming technology industry, which has
been attracting a substantial number of high-paying jobs and skilled professionals
over the years. Prior to the COVID-19 pandemic, this region was experiencing
significant population growth and increased demand for housing.
• Real Estate Speculation Strategy:
• An individual investor named Dinesh had the potential for further appreciation in
property values in this tech-centric city and decided to engage in real estate speculation.

• Initial Situation:
• Current Property Prices in the City: $400,000 for a single-family home
• Anticipated Property Price Appreciation: Dinesh expected property prices to increase by
10% annually due to ongoing job growth and demand in the tech sector.

• Speculation Steps:
Dinesh purchased a single-family home for $400,000, financing it with a mortgage.
His primary motivation was to profit from the expected appreciation in property values over
the next few years, fueled by the influx of tech professionals and economic growth.
• During the COVID-19 pandemic, many
metropolitan areas, including those with
thriving technology industries, experienced
significant shifts and challenges in their real
estate markets.
2) Currency Convertibility
• Foreign exchange market assumes that currencies of
various countries are freely convertible into other
currencies.

• But this assumption is not true, because many

countries restrict the residents and non-residents to
convert the local currency into foreign currency,
which makes international business more difficult.

• Many international business firms use “counter

trade” practices to overcome the problem that arises
due to currency convertibility restrictions.
3) International Monetary System
• Any country needs to have its own monetary system and an
authority to maintain order in the system, and facilitate trade
and investment.

• India has its own monetary policy, and the Reserve Bank of
India (RBI) administers it.

• The same is the case with world, its needs a monetary system
to promote trade and investment across the countries.

• International monetary system exists since 1944. The

International Monetary Fund (IMF) and the World Bank have
been maintaining order in the international monetary system
and general economic development respectively.
HISTORY OF INTERNATIONAL MONETARY
SYSTEM/ EVOLUTION OF IMS
• There have been four phases/ stages in the evolution of the
international monetary system:
• Gold Standard (1875-1914)
• Inter-war period (1915-1944)
• Bretton Woods system (1945-1972)
• Present International Monetary system
(1972-present)
1) GOLD STANDARD
• The gold standard is a monetary system in which each country
fixed the value of its currency in terms of gold. The exchange
rate is determined accordingly.
• Let’s say- 1 ounce of gold = 20 pounds (fixed by the UK) and 1
ounce of gold = 10 dollars (fixed by the US).
• Hence, the dollar-pound exchange rate will be 20 pounds = 10
dollars or 1 pound = 0.5 dollars
• The Gold standard created a fixed exchange rate system.
• There was a free convertibility between gold and national
currencies.
2) INTER-WAR PERIOD
• After the world war started in 1914, the gold standard was
abandoned.
• Countries began to depreciate their currencies to be able to export
more. It was a period of fluctuating exchange rates and competitive
devaluation.
3) BRETTON WOODS SYSTEM
• In the early 1940s, the United States and the United Kingdom began
discussions to rebuild the world economy after the destruction of
two world wars. Their goal was to create a fixed exchange rate
system without the gold standard.
• The new International Monetary System was established in 1944 in a
conference organized by the United Nations in a town named
Bretton Woods in New Hampshire (USA).
• The conference is officially known as United Nations Monetary and
Financial Conference. It was attended by 44 countries.
• The conference also led to the creation of International Monetary Fund (IMF),
World Bank and GATT.
4) PRESENT INTERNATIONAL MONETARY SYSTEM
• The Bretton Woods system collapsed in 1971. The United
States had to stop the convertibility to gold due to high
inflation and trade deficit in the economy.
• Inflation led to an increase in the price of gold. Hence, the US
could not maintain the fixed value of 35 dollars to 1 ounce of
gold.
• In 1973, the world moved to flexible exchange rate system.
• In 1976, the countries met in Jamaica to formalize the new
system.
• Floating exchange rate system means that the exchange rate
of a currency is determined by the market forces of demand
and supply.
International Financial Institutions: International Monetary Fund (IMF)
Origin
• The IMF is an International monetary institution/ supranational financial institution
established by 45 nations under the Bretton Woods Agreement of 1944.

• OBJECTIVE: Such an institution was necessary to avoid repetition of the disastrous economic
policies that had contributed to Great depression of 1930’s.

• The principal aim was to avoid the economic mistakes of the 1920s and 1930s. It started
functioning from March 1, 1947. In June, 1996, the Fund had 181 members.

• The IMF was established to promote economic and financial co-operation among its
members in order to facilitate the expansion and balanced growth of world trade.

• It performs the activities like/ OBJECTIVES:

a) monitoring national, global and regional economic developments and advising member
countries on their economic policies (surveillance);

b) lending member currencies to support policy programme designed to correct BOP problems;

C) offering technical assistance in its areas of expertise as well as training for government and
central bank officials.
Functions
• To fulfill the above objectives, The IMF performs the following functions:

• The Fund gives short term loans to its members so that they may correct their
temporary balance of payments disequilibrium.

• The Fund is regarded “as the guardian of good conduct” in the sphere of balance of
payments.

• It aims at reducing tariffs and other trade restrictions by the member countries.

• also renders technical advice to its members on monetary and fiscal policies.

• It conducts research studies and publishes them in IMF staff papers, Finance and
Development, etc.

• It provides technical experts to member countries having BOP difficulties and other
problems.
Organization and Structure
• The Second Amendment of the Articles of Agreement made important changes in
the organization and structure of the Fund.

• As such, the structure of the IMF consists of a Board of governors, an Executive

Board, a Managing Director, a council and a staff with its headquarters in
Washington, U.S.A.

• There are ad hoc and standing committees appointed by the Board of Governors
and the Executive Board.

• There is also an Interim Committee appointed by the Board of Governors.

• The Board of Governors and the Executive Board are decision making organs of the
Fund.

• The Board of Governors is at the top in the structure of the Fund. It is composed of
one Governor and one alternate Governor appointed by each member.
• The alternate Governor can participate in the meeting of the Board but has the
power to vote only in the absence of the Governor.
• The Board of Governor which has now 24 members meets annually in which details of the
Fund activities for the previous year are presented. The annual meeting also takes few
decisions with regards to the policies of Fund.

• The Executive Board has 21 members at present. Five Executive Directors are appointed by
the five members (USA, UK, Germany, France and Japan) having the largest quotas

• There is a Managing Director of the Fund who is elected by the Executive Directors.

• The Executive Board is the most powerful organ of the Fund and exercise vast powers
conferred on it by the Articles of Agreement and delegated to by the Board of Governors. So
its power relates to all Fund activities, including its regulatory, supervisory and financial
activities.

• The Interim Committee (now IMFC-International Monetary & Financial Committee)) was
established in October 1974 to advice the Board of Governors on supervising the
management and adaptation of the international monetary in order to avoid disturbances
that might threaten it. It currently has 22 members.

• The Development Committee was also established in October 1974 and consists of 22
members. It advices and reports to the Board of Governors on all aspects of the transfer of
real resources to developing countries and makes suggestions for their implementation.
4) International Financial Markets
• International financial market born in mid-fifties and gradually grown in size and scope.

• International financial markets comprises of international banks, Eurocurrency market, Eurobond

market, and international stock market.

• International banks play a crucial role in financing international business by acting as both
commercial banks and investment banks.

• Most international banking is undertaken through reciprocal correspondent relationships

between banks located in different countries. But now a days large bank have internationalized
their operations they have their own overseas operations so as to improve their ability to
compete internationally.

• International bonds are typically classified as either foreign bonds or eurobonds.

• A foreign bond is issued by a foreign borrower to the country where the bond is placed. An
example of a foreign bond is a bond denominated in US dollars issued by a German company in
the United States.

• Foreign bonds bear distinct “street” names by which they are recognized as being traded in a
particular country. Examples of foreign bonds are: Yankee bonds traded in the United States,
Bulldog bonds traded in the United Kingdom, Samurai bonds traded in Japan, and Matador bonds
traded in Spain.
• On the other hand Eurobonds are sold in countries
other than the country represented by the currency
denominating them.
• An example of a Eurobond is a bond denominated in
US dollars issued by a US firm and placed in
European and/or Asian countries
EXCHANGE RATE DETERMINATION:
• Foreign Exchange Rate is the amount of domestic currency
that must be paid in order to get a unit of foreign currency.
• According to Purchasing Power Parity theory, the foreign
exchange rate is determined by the relative purchasing
powers of the two currencies.

• Example: If a McDonald’s Burger costs $20 in the USA and Re

100 in India,
What will be the exchange rate between India and the USA ?
 Types of Exchange Rate

• Nominal Exchange rate

It is the rate at which one country's currency
can be exchanged for another country's
currency. It represents the relative price of
two currencies in the foreign exchange
market.
It is also influenced by factors such as
interest rates, inflation, and speculative
demand for currencies.
• Example, If the exchange rate between the
U.S. dollar (USD) and the euro (EUR) is 1
USD = 0.95 EUR, this is a nominal
exchange rate. It tells you how many
euros you can get for one U.S. dollar.
• 1 United States Dollar equals=83.16 Indian
Rupee
 Real Exchange rate
• The real exchange rate, on the other hand,
adjusts the nominal exchange rate for
differences in price levels (inflation)
between two countries. It represents the
relative purchasing power of two currencies
and tells you how much of one country's
goods and services can be exchanged for
those of another country.
• The formula for the real exchange rate is as
follows:
• Real Exchange Rate = (Nominal Exchange
Rate x Domestic Price Level) / Foreign Price
Level
 Example
• Let's assume that India's nominal exchange rate with
the U.S. dollar is 1 USD = 75 Indian Rupees (INR).
Now, consider that India's domestic price level is
relatively low compared to the United States due to
lower inflation and production costs.
• Real Exchange Rate = (Nominal Exchange Rate x
Domestic Price Level) / Foreign Price Level
• If India's domestic price level is much lower than that of
the United States, the real exchange rate would be
favorable for Indian exports. This means that Indian
goods and services are relatively cheaper for U.S.
consumers when adjusted for the price level. As a
result, Indian exporters may find it easier to sell
their products in the U.S. market, potentially
boosting India's exports.
 Other types of Exchange Rate Regimes
• Fixed Exchange rate
• Floating Exchange rate
• Managed Floating
Fixed Exchange Rate
Under this system, there is complete government intervention in the
foreign exchange markets.
The government or central bank determines the official exchange rate
by linking the exchange rate to the price of gold or major
currencies like US dollar.
If due to any reason, the exchange rate fluctuates, government
intervenes and make sure that equilibrium pre-determined level is
maintained.
The only merit of fixed exchange rate system is that it assures the
stability of exchange rate. It prevents both currency appreciation
and depreciation.
• The many disadvantages of such a system are: It puts a heavy
burden on governments to maintain exchange rate. This
especially happens during the time of deficits, as the
governments need to infuse a lot of money to maintain
exchange rate.
Example 1: The gold standard was a historical example of
a fixed exchange rate system. Under the gold
standard, the value of a country's currency was
directly tied to a specific amount of gold. For instance,
the U.S. dollar was fixed at $20.67 per ounce of gold.

The foreign investors avoid investing in such countries as they

fear to lose their investments because they believe that
exchange rate does not reflect the true value of the economy.
 Flexible Exchange Rate
Under this system, the market is allowed to determine the value of
exchange rate freely.
The exchange rate is determined by the forces of demand and supply.
If due to any reason exchange rate fluctuates, the government never
intervenes and allows the market to function and determine the true
value of exchange rate.
The only demerit of floating exchange rate system is that exchange rate
fluctuates a lot on day to day basis.
The advantages of such a system are: the exchange rate is determined in
well-functioning foreign exchange markets with no government
interference.
The exchange rate reflects the true value of the domestic currency which
helps in establishing the trust among foreign investor.
A country can easily access funds/ loans from IMF and other
international institutions if the exchange rate is market determined.
 Example
• For example:
• If the U.S. economy shows strong growth
and higher interest rates, there may be
increased demand for USD, causing the
exchange rate to rise (e.g., 1 USD = 0.90
EUR).
• Conversely, if the U.S. faces economic
challenges or lower interest rates, demand
for USD may decrease, causing the
exchange rate to fall (e.g., 1 USD = 0.80
EUR).
• Managed Floating Exchange rate
• Manage Floating exchange rate lies in between of
the two extremes of fixed and floating exchange
rate. Under such a system, the exchange is allowed
to move freely and determined by the forces of the
market (Demand and Supply). But when a difficult
situation arises, the central banks of the country can
intervene to stabilize the exchange rate.
• For example, if a country's currency is
appreciating rapidly and hurting export
competitiveness, the central bank may
intervene to slow down or reverse the
appreciation.
 Factors affecting Foreign Exchange Rate

• Interest Rates
• Inflation Rates
• Economic Indicators such as GDP
growth, employment data
• Political Stability
• Central Bank Policies
• Market Interventions
CAPITAL ACCOUNT CONVERTIBILITY:
• Capital account refers to expenditures and investments in hard
assets, physical premises, and factories as well as investments in
land and other capital-intensive items.

What is Capital Account Convertibility ?

• Capital Account Convertibility means that the currency of a country

can be converted into foreign exchange without any controls or
restrictions.
• In other words, Indians can convert their Rupees into Dollars or
Euros and Vice Versa without any restrictions placed on them. The
reason why it is called capital account convertibility is that the
conversion of domestic currencies into foreign currencies is
allowed in the capital account and not only the current account.
• Capital account convertibility is thus the freedom of foreign
investors to purchase Indian financial assets (shares, bonds
etc.) and that of the domestic citizens to purchase foreign
financial assets.
Status of capital account convertibility in India
• There is partial capital account convertibility in India. Though
tremendous capital account liberalization measures were
taken place since the launch of economic reforms,
introduction of full capital account convertibility is yet to be
implemented.
• In the case of current account there is full convertibility.
Altogether, there is the rupee is partially convertible.
CAPITAL ACCOUNT CONVERTIBILITY: Impact on Countries

• For instance, in India where the currency is partially convertible,

investors cannot liquidate their assets and leave the country
without approval.
• On the other hand, they can repatriate the money that they have
invested in the stock market, as was the case in recent months.
The effect of this is that many foreign companies do not hold
assets like buildings, premises, and other items that fall in the
capital account.
• They also tie up with local companies because in times of crisis,
they can exit the joint venture easily and get back their money
invested in the merged entity.
• As for other countries in South East Asia that were fully
convertible, the Asian financial crisis of 1997 was a wakeup call for
them as investors fled the country and capital flight accelerated
leading to a near collapse of the economies in the region with the
exception of Singapore.