The Basics of Foreign Trade and Exchange
Growing Trade, Shrinking World
Americans drive cars made in Germany, use VCR’s made in Japan and wear clothing made in China. Japanese watch American movies, Egyptians drink American cola and Swedes jog in American running shoes. The world economy is more integrated than ever before.
What is international trade?
International trade shapes our everyday lives and the world we live in. Nearly every time we make a purchase we are participating in the global economy. Products and their components come to our store shelves from all over the world.
| International trade is the system by which countries exchange goods and services. Countries trade with each other to obtain things that are better quality, less expensive or simply different from what is produced at home. |
Goods and services that a country buys from another country are called imports, and goods and services that are sold to other countries are called exports. Trade mostly takes place between companies. However, governments and individuals frequently buy and sell goods internationally.
World Trade is Diverse
Most international trade consists of the purchase and sale of industrial equipment, consumer goods, oil and agricultural products. Services such as banking, insurance, transportation, telecommunications, engineering and tourism accounted for one-fifth of world exports in 2000.
WORLD EXPORTS ARE UP SHARPLY
Since the end of World War II, there has been a rapid increase in international trade.
More information on world trade statistics.
Trade: Important for economic well being
With the increase in volume, trade has become very important to the economic well-being of many countries. In early 1960s, the United States bought less than $1 billion of foreign cars and parts. By 2001, this figure had increased to more than $189 billion.
Financial ties between United States and the rest of the world have grown significantly over time:
| Foreign direct investment is the amount of money individuals invest in companies, assets and real estate of another country. |
The cost of international transportation and communication has fallen drastically, resulting in greater integration among the economies of the world. Because of this interdependence, economic trends and conditions in one country can strongly affect prices, wages, employment and production in other countries. Events in Tokyo, London and Mexico City have a direct effect on the everyday life of people in the U.S., just as the impact of events in New York, Washington and Chicago is felt around the globe.
If stocks on the New York Stock Exchange plummet in value, the news is transmitted instantly worldwide, and stock prices all over the world might change. This means that countries have to work together more closely and rely on each other for prosperity.
For data on FDI in the U.S.
Trade: Why do it?
International trade occurs because individuals, businesses and governments in one country want to buy goods and services produced in another country.
Benefits of Trade
Specialization and Its Benefits
To become wealthier, countries want to use their resources—land, labor, capital and entrepreneurship—in the most efficient manner. However, there are differences among countries in the quantity, quality and cost of these resources. The advantages that a country may have, vary:
Instead of trying to produce everything by themselves, countries often concentrate on producing things that they can produce most efficiently. They then trade those for other goods and services. In doing so, both the country and the world become wealthier. Learn more about the theory of specialization and trade.
|
Two economies, Cottonland and Woodland, have the same resources and produce both cloth and furniture. |
|
|
Cottonland
|
Woodland
|
|
Since Cottonland is more efficient in cloth production, it can double its cloth output to 16 bales a day by transferring all its resources to that industry. By doing so Cottonland will eliminate the furniture industry. However, it can trade the surplus cloth for furniture. Similarly, Woodland can direct all its resources to the production of furniture and produce 16 pieces of furniture. Although its cloth industry will suffer it can trade the surplus pieces of furniture for cloth bales. Through specialization and trade, the supply of goods in both economies increases, which brings the prices down, making them more affordable. |
|
Trade also provides a wider variety of goods to consumers: cars from Japan, salmon from Scandinavia, bananas from South America, are just a few.
Most industrialized countries can produce just about anything they want. For instance, the U.S.:
|
è |
such reallocation of resources makes no economic sense. |
|
è |
the resources that are directed towards the tropical fruit industry could be used more efficiently elsewhere. |
|
è |
countries achieve greater total wealth by devoting resources to their most productive industries. |
Law of Comparative Advantage
Even if a country can produce everything more efficiently than another country, there is still scope for trade. A country can maximize its wealth by putting its resources into its most competitive industries, regardless of whether other countries are more competitive in those industries. This is called the law of comparative advantage.
|
Suppose Cottonland produces both cloth and furniture better than Woodland: |
||
|
Bales of cloth per day |
Cottonland 10 |
Woodland 2 |
| Cottonland has an absolute advantage—is more efficient—in the production of both cloth and furniture. However to achieve greater wealth, each country should specialize in the item in which it enjoys greatest advantage among all the products it produces—comparative advantage. | ||
| In terms of opportunity cost, or the cost of not transferring resources, Cottonland is twice as efficient in producing cloth as furniture. | ||
Cottonland Woodland |
Opportunity
Cost 1 piece of furniture = 2 bales of cloth 1 piece of furniture = 2/3 bales of cloth |
|
| Since Woodland’s opportunity cost for
producing furniture is less than Cottonland’s, it makes economic sense for
Woodland to focus on furniture. Cottonland should continue producing cloth and trade for Woodland’s furniture. Whereas, Woodland should concentrate on furniture and trade it for cloth with Cottonland. Channeling resources into the most productive enterprise in each country will result in more products to trade. |
||
Benefits of Diversification
Even though it makes economic sense to allocate resources to the most productive industries, no country wants to rely on only a few products. This makes the country vulnerable to changes in the world economy, such as recession, new trade laws and treaties, and new technologies.
A country that relies too heavily on one product is especially susceptible to market forces. If demand suddenly drops or if a cheaper alternative becomes available, the economy of that country could be damaged.
Many Middle East countries that are largely dependent on their oil exports see their economic fortunes rise and fall in tandem with the oil market.
The degree to which countries specialize is influenced by that country’s terms of trade—i.e. the relative prices of a country’s imports and exports. It is most advantageous to have declining import prices compared with the prices of exports. Exchange rates and productivity differences affect the terms of trade more than any other factors.
By developing a diversified economy, a country can make sure that even if some industries are suffering, other, more competitive industries will keep the economy relatively healthy. The United States is competitive in finance, entertainment, aerospace, industrial equipment, pharmaceuticals and communications, among others.
Competitiveness
Competitiveness is used to describe the relative productivity of companies and industries. If one company can produce better products at lower prices than another, it is said to be more competitive. This is a matter of concern for governments, since it is difficult for uncompetitive industries to survive.
In the long run, competitiveness depends on:
Natural resources are predetermined and must be used efficiently, but a country’s infrastructure and its workers’ skills have to be developed over time. The ability of a society to do this effectively determines whether it can remain competitive in the global economy.
Economies of Scale
The law of comparative advantage says that a country can become more competitive by directing its resources to its most efficient industries. This enables a country to achieve economies of scale—increasing its output in a particular industry so that its costs per unit decrease. Such lower-cost goods are more in demand in international markets.
Certain industries that require heavy research and development or capital expenditures cannot be competitive unless they can spread the costs over many units. If a sophisticated weapons industry knows that it has access to foreign markets and could export, it may increase the scale of its manufacturing operations and become more efficient and competitive in the international markets.
Other factors affecting a country’s trade competitiveness can be complex.
|
Knowledge-Intensive Products Contributed to a U.S. Export Boom From 1986 to 2001 there was an enormous boom in U.S. exports, especially in manufactured goods. Exports went up from $227 billion to $731 billion. One of the driving forces behind the increase in exports was the success of U.S. companies in selling "knowledge-intensive" manufactured goods to other industrialized countries. The value of knowledge-intensive products depends on the skills that went into producing them, rather than the actual cost of the components. For example, while producing a new compact disc, the expenses of paying the artist, advertising, marketing and legal and other fees far outweigh the actual cost of the physical disc. Production of such knowledge-intensive goods relies more on a well-educated and skilled workforce than on natural resources. A number of products fit this description, from computer software to custom-built aircraft engine parts. Such products are produced for specific market niches and substitutes are not easy to come by. These knowledge-intensive products are becoming a major force in international trade and a source of wealth for economies well positioned to compete in those markets. |
More data on U.S. exports.
Free Trade vs. Protectionism
All governments regulate foreign trade. The extent to which they do so is a matter of great controversy and debate. The news is full of reports of various groups protesting about:
Free trade proponents stand for an open trading system with few limitations and little government involvement. Advocates of protectionism believe that governments must take action to regulate trade and subsidize industries to protect their domestic economy.
Although the amount of government involvement in trade varies from country to country and product to product, overall barriers to trade have been lowered since World War II. All governments practice protectionism to some extent. The debate is over how many, or how few, such measures should be used to reach the country’s long-term macroeconomic goals.
Completely free trade would:
If cars can be produced more efficiently in another country and consumers are free to buy them from anywhere, the domestic auto industry will lose business and may ask for government protection by limiting imports of lower-cost cars.
Arguments for protection
There are many arguments forwarded by advocates of protectionism:
Methods of Protection
Governments use a variety of tools to manage their countries’ international trade positions.
Learn more about tariffs.
|
Suppose there is a U.S company and a foreign company producing widgets: |
|
| U.S.- made widget Foreign-made widget |
Cost to produce $1.00 $0.75 |
| The American widget factory will find it difficult to stay competitive under this scenario. Now, if the U.S. were to impose a tariff of 60 percent: | |
| U.S.-made widget Foreign-made widget |
New cost to U.S consumers $1.00 $1.20 = [(0.75x.60)+0.75] |
|
If consumers base their purchases only on price, the demand for the foreign widget would fall and the U.S. widget industry would prosper. If no tariff were imposed, as under free trade, Americans would have saved money by buying the cheaper foreign widget. The U.S. widget industry would either have to become more efficient in order to compete with the less expensive imported products or face extinction. Tariffs need not push the price of an import above the price of its domestic counterpart. They should be just high enough to reduce the price differential between the import and the domestic good. Tariffs are usually levied as a percentage of the value of the import, although sometimes a flat rate may be charged. |
|
With tariffs, it is the importing country that stands to gain through increases in the tax revenue. However, in case of quantitative restraints, the exporting country gains as the price of the imported good rises.
Both import quotas and voluntary restraints thwart the functioning of the free market. The quantity of goods remains constant while the price changes, instead of demand and supply determining both quantity and price.
For example, the United States subsidizes the sugar and dairy industries, among others.
Arguments for Free Trade
The debate about how free a trading system should be is an old one, with positions and arguments evolving over time. U.S. free-trade advocates typically argue that consumers benefit from freer trade and forward many reasons in support of their theory:
Measures of Trade
Balance of trade and balance of payments are two of the statistics most widely used to measure a country’s international trade position.
|
Balance of trade is the difference between a nation’s exports and imports of both goods and services. Balance of payments gives a complete summary of all economic transactions that involve money flowing into or from a country. |
Exports are the value of goods and services sold abroad over any specific period of time.
Imports are the value of goods and services purchased from foreign countries over a specific period of time.
A "favorable" balance of trade, or trade surplus, occurs when exports exceed imports. A "negative" balance, or trade deficit, occurs when the imports surpass exports.
From the mid-1970s through 2001, the United States ran persistent trade deficits. Economists disagree as to what effect these deficits had on the economy, but they allowed:
The balance of trade alone does not give the whole picture. The detailed record of all economic transactions between a country and the rest of the world is called the balance of payments. This includes trade in:
The balance of payments is separated into two main accounts:
If you buy an automobile made by a factory in Germany, the transaction will be recorded in the current account. However, if you buy the automobile factory or stock in the automobile factory, the transaction will be a part of the capital account.
|
Table 1: U.S. International Transactions, 2001
(Billions of dollars) |
||
|
Current account
Capital Account
|
Credits
1,298.3 720.8
4.9 895.5 6.1 |
Debits
1,147.4
434.7
|
| Source: U.S. Department of Commerce, Bureau of Economic Analysis, U.S. International Transactions Accounts Data. Totals may differ due to rounding. | ||
Every international transaction automatically enters the balance of payments twice, once as a credit and once as a debit, resulting in two equal and opposite entries. A transaction that involves money flowing into the country is recorded as a balance of payment credit and anything that draws money out of the country is a balance of payment debit.
For example, if you buy a camera from a Japanese company, XYZ Inc., and pay by check, your purchase results in the following two entries in the balance of payments statements:
| Credit | Debit | |
| Current account Camera purchase (U.S. import) |
$1,000 |
|
|
Capital account |
$1,000 |
Your payment to buy a good (the camera) from a foreign company is recorded as a debit in the U.S. current account. Let’s say XYZ Inc. deposits the check in their account at ABC Bank in New York. This means, XYZ Inc. has purchased, and ABC Bank has sold, a U.S. asset (a bank deposit) worth $1,000—and the transaction will appear as a credit in the U.S. capital account.
This system of double-entry bookkeeping tries to ensure that the current and capital accounts are balanced. However, due to accounting conventions and differences in the recorded values of transactions, this does not always happen. Accounting for these differences, called statistical discrepancies, makes possible the following fundamental identity of the balance of payment accounts:
| Current account + Capital account + Statistical discrepancy = 0 |
CURRENT ACCOUNT
The current account consists of four sub accounts:
| Table 2: Calculating the balance on the current account (Refer to Table 1 above) |
|||
| Current Account: | Billions of dollars | ||
+ + |
Exports Imports Net unilateral transfers (inflows minus outflows) |
(-) (-) |
1,298.3 1,665.3 00050.5 |
| Balance on current account | (-) | $417.5 (1) | |
CAPITAL ACCOUNT
The capital account measures the difference between sales of assets to foreigners and purchases of assets located abroad.
|
Table 3: Calculating the balance on the capital account
(Refer to Table 1 above) |
|||
|
Capital Account: |
Billions of dollars
|
||
| Purchase of assets abroad (U.S. owned assets abroad) | (-) |
439.6
|
|
| + | Sales of assets to foreigners (foreign-owned assets in U.S.) |
895.5
|
|
| Balance on the capital account | $455.9 (2) | ||
BALANCE OF PAYMENT DEFICIT AND SURPLUS
In theory, the current account should balance with the capital account. The sum of the balance of payments statements should be zero. Therefore, when a country buys more goods and services than it sells (a current account deficit), it must finance the difference by borrowing, or by selling more capital assets than it buys (a capital account surplus). A persistent current account deficit amounts to exchanging capital assets for goods and services. Large trade deficits mean that a country is borrowing from abroad and it appears as an inflow of foreign capital in the balance of payments.
The accounts do not exactly offset each other, due to statistical discrepancies, accounting conventions, and exchange rate movements that change the recorded value of transactions.
|
Calculating Statistical Discrepancy on the Balance
of Payment Accounts If (1) and (2) are not equal, the difference (with the sign changed) is attributed to statistical discrepancies.
Thus statistical discrepancies were (-) $38.4 billion for 2001. |
2001 U.S. BALANCE OF PAYMENTS
In 2001, the U.S imported goods and services worth $1,352 billion, while its exports were only $1,004 billion. And with net unilateral transfers of $50.5 billion, the deficit on the current account amounted to $417 billion. To cover this deficit, the United States required a capital inflow of the same amount. That means net borrowings or net sales of assets to foreigners of the same magnitude.
In the same period, the capital account registered an increase of $439 billion in U.S assets located abroad and a $895 billion increase in foreign assets held in the U.S. giving us a surplus balance of $456 billion.
The difference, of approximately $39 billion, was attributed to statistical discrepancy, leaving a zero balance in the balance of payment statement.
More information on the U.S foreign trade statistics may be accessed on the Department of Commerce, Bureau of Economic Analysis web site.
BALANCE OF PAYMENTS AND INTEREST RATES
The balance of payments is influenced by many factors, including the financial and economic climate of other countries. If the U.S banks are offering higher interest rates for deposits than banks abroad, foreign funds will flow into the United States. Conversely, if interest rates are higher abroad, U.S. investors will choose to invest their money abroad.
|
Interest rate in U.S. |
Interest rate abroad |
Fund flows |
U.S.Capital Account |
|
Statistics Can Have Different Interpretations Interpretations of trade statistics sometimes can differ sharply, depending on the questions being asked. The U.S. trade deficit has been viewed as good, bad, irrelevant, overstated, understated and illusory. For example, a company that exports goods to the United States will view the deficit as a sign of a healthy U.S market. On the other hand, a U.S. based trade union may consider the deficit a sign that domestic industries are unable to compete in the world markets. In a global economy that is measured in trillions of dollars, not every transaction is going to be reported accurately. Statistics for many types of transactions rely heavily on estimates made by statisticians, and even the best estimates are sometimes incorrect. This can produce a skewed measurement of what is actually happening in the economy. Measuring imports and exports Imports: U.S. importers file tax documents with the U.S. Customs Service describing the type and value of imported goods. These reports are processed and tabulated to arrive at the overall level of U.S. imports. Inaccurate reports, delays in processing data, and smuggling can affect their value. Exports: There is no tax on exports, so to collect information, the U.S. Department of Commerce developed a form called the Shippers’ Export Declaration (SED) form, which is filled out when goods are sent overseas. These are tallied to arrive at export totals. Access more data on U.S. trade. The Bretton Woods Agreements Act of 1945 requires the publication of balance of payments information. The statistics are generally reliable although the collection process is often difficult, especially in case of data on travel, services, direct foreign investment and financial transactions. Sometimes it is difficult to classify a good as an import or an export. Trade is usually tabulated on the basis of national origin rather than national ownership. If a product is shipped from the U.S. to Germany, it is considered a U.S. export and a German import. It makes no difference whether a foreign company owns the U.S. factory or if it is a U.S. firm in Germany that imports the product. If a U.S. company owns a plant in Brazil and sells a product to a Japanese company in Canada, the transaction is recorded as a Canadian import and a Brazilian export. It is also difficult to assign a value to goods. To compare the exports of two countries in a given year, it is necessary to convert the figures into the same currency. However, there can be distortions due to:
Changes in trade statistics do not necessarily signify changes in a nation’s trading patterns; the change may merely result from a change in the way the data is presented. |
Foreign Currency Exchange
Foreign Exchange Market: What is it?
To buy foreign goods or services, or to invest in other countries, companies and individuals may need to first buy the currency of the country with which they are doing business. Generally, exporters prefer to be paid in their country’s currency or in U.S. dollars, which are accepted all over the world.
When Canadians buy oil from Saudi Arabia they may pay in U.S. dollars and not in Canadian dollars or Saudi dinars, even though the United States is not involved in the transaction.
The foreign exchange market, or the "FX" market, is where the buying and selling of different currencies takes place. The price of one currency in terms of another is called an exchange rate.
The market itself is actually a worldwide network of traders, connected by telephone lines and computer screens—there is no central headquarters. There are three main centers of trading, which handle the majority of all FX transactions—United Kingdom, United States, and Japan.
Transactions in Singapore, Switzerland, Hong Kong, Germany, France and Australia account for most of the remaining transactions in the market. Trading goes on 24 hours a day: at 8 a.m. the exchange market is first opening in London, while the trading day is ending in Singapore and Hong Kong. At 1 p.m. in London, the New York market opens for business and later in the afternoon the traders in San Francisco can also conduct business. As the market closes in San Francisco, the Singapore and Hong Kong markets are starting their day.
The FX market is fast paced, volatile and enormous—it is the largest market in the world. In 2001 on average, an estimated $1,210 billion was traded each day—roughly equivalent to every person in the world trading $195 each day.
More statistics on the foreign exchange market.
Foreign Exchange Market Participants
There are four types of market participants—banks, brokers, customers, and central banks.
With more than $1.2 trillion changing hands every day, the activity of these participants affects the value of every dollar, pound, yen or euro.
The participants in the FX market trade for a variety of reasons:
Foreign Exchange Rates
Most common contact with foreign exchange occurs when we travel or buy things in other countries.
| Suppose a U.S. tourist travelling in London wants to buy a sweater. Price tag is 100 pounds. | ||
| Current exchange rate | Price of sweater in dollars | |
| $1.45 to £1 $1.30 to £1 $1.60 to £1 |
Pound falls Pound rises |
100 x 1.45 = $145.00 100 x 1.30 = $130.00 100 x 1.60 = $160.00 |
| Thus, small changes in exchange rates may not seem significant. But when billions of dollars are traded, even a hundredth of a percentage point change in exchange rates becomes important. | ||
|
Stronger US |
|
è
è |
Cost of purchasing foreign goods falls Does not help firms that produce for exports |
|
Weaker U.S. |
|
è
è |
Helps firms that rely on exports Demand for imports falls
|
It would seem logical that if the dollar weakens, the trade balance will improve, as exports would rise. However, this does not always happen. U.S. trade balance usually worsens for a few months.
The J–curve explains why the trade position does not improve soon after the weakening of a currency. Most import/export orders are taken months in advance. Immediately after a currency’s value drops, the volume of imports remains about the same, but the prices in terms of the home currency rise. On the other hand, the value of the domestic exports remains the same, and the difference in values worsens the trade balance until the imports and exports adjust to the new exchange rates.
Exchange rates are an important consideration when making international investment decisions. The money invested overseas incurs an exchange rate risk.
When an investor decides to "cash out," or bring his money home, any gains could be magnified or wiped out depending on the change in the exchange rates in the interim. Thus, changes in exchange rates can have many repercussions on an economy:
Determination of Foreign Exchange Rates
Exchange rates respond directly to all sorts of events, both tangible and psychological—
At the heart of this complex market are the same forces of demand and supply that determine the prices of goods and services in any free market. If at any given rate, the demand for a currency is greater than its supply, its price will rise. If supply exceeds demand, the price will fall.
The supply of a nation’s currency is influenced by that nation’s monetary authority, (usually its central bank), consistent with the amount of spending taking place in the economy. Government and central banks closely monitor economic activity to keep money supply at a level appropriate to achieve their economic goals.
| Too much money è inflation è value of money declines è prices rise |
| Too little money è sluggish economic growth è rising unemployment |
Monetary authorities must decide whether economic conditions call for a larger or smaller increase in the money supply.
Sources for currency demand on the FX market:
Foreign Currency Trading
|
"Yoshi, it’s Maria in New York. May I have a price on twenty cable."
|
Yoshi it’s Maria in New York. I am interested in either buying or selling 20 million British pounds." |
|
"Sure. One seventy-five, twenty-thirty."
|
"Sure I will buy them from you at 1.7520 dollars to each pound or sell them to you at 1.7530 dollars to each pound." |
|
"Mine twenty."
|
"I’d like to buy them from you at 1.7530 dollars to each pound." |
|
"All right. At 1.7530, I sell you twenty million pounds."
|
"All right. I sell you 20 million pounds at 1.7530 dollars per pound." |
|
"Done."
|
"The deal is confirmed at 1.7530." |
|
"What do you think about the Japanese yen? It’s up 100 pips."
|
"Is there any information you can share with me about the fact that the Japanese yen has risen one-one hundredth of a yen against the U.S. dollar in the past hour?" |
|
"I saw that. A few German banks have been buying steadily all day…."
|
"Yes, German banks have been buying the Japanese yen all day, causing the price to rise a little…." |
Traders in the foreign exchange market make thousands of trades daily, buying and selling currencies while exchanging market information. The $1.2 trillion that is traded everyday may be used for varied purposes:
In the volatile FX market, traders constantly try to predict the behavior of other market participants. If they correctly anticipate their opponents’ strategies, they can act first and beat the competition.
Traders make money by purchasing currency and selling it later at a higher price, or, anticipating the market is heading down, selling at a high price and buying back at a lower price later.
| Trader purchases a lot of currency | è | long on the currency (e.g. long dollar, long yen) |
| Trader sells a lot of a currency | è | short on the currency (e.g. short sterling) |
To predict the movements of currencies, traders often try to determine whether the currency’s price reflects its fundamental value in terms of current economic conditions. Examining inflation, interest rates, and the relative strength of the country’s economy helps them make a determination.
| Currency underpriced | è | price will go up |
| Currency overpriced | è | price will go down |
CURRENCY TRADING BETWEEN BANKS
Banks are a major force in the FX market and employ a large number of traders.
Trading between banks is done in two ways—through a broker or directly with
each other.
Brokers: If a U.S. bank trades with another bank, a FX broker may be used as an intermediary. The broker arranges the transaction, matching the buyer and seller without ever taking a position and charges a commission to both the buyer and seller. About a third of transactions are arranged in this way.
Direct: Mostly banks deal with each other directly. A trader "makes a market" for another by quoting a two-way price i.e. he is willing to buy or sell the currency. The difference between the two price quotes (the spread) is usually no more than 10 pips, or hundredths, of a currency unit.
Most currencies are quoted in terms of how many units of that currency would equal $1. However, the British pound, New Zealand dollar, Australian dollar, Irish punt and the Euro are quoted in terms of how many U.S. dollars would equal one unit of those currencies.
The currencies of the world’s large, industrialized economies, or hard currencies, are always in demand and are actively traded. In terms of trading volumes, the FX market is dominated by four currencies: the U.S. dollar, the euro, the Japanese yen and the British pound. Together these account for over 80 percent of the market.
It is not always easy to find a market for all currencies. The demand for currencies of less developed countries, soft currencies, is a lot less than for the hard currencies. Weak demand internationally along with exchange controls may make these currencies difficult to convert.
Types of Transactions
There are different types of FX transactions:
Spot Transaction: How it works
This expresses only a potential interest in a deal, without the caller saying whether he wants to buy or sell.
By convention the payment is actually made two days later, but next day settlements are used as well. |
Although spot transactions are popular, they leave the currency buyer exposed to some potentially dangerous financial risks. Exchange rate fluctuations can effectively raise or lower prices and can be a financial planning ordeal for companies and individuals.
|
Exchange Risks in Spot Transactions Suppose a U.S. company orders machine tools from a company in Japan.
There is no guarantee that the rate will remain the same six months later.
Conversely, if the rate goes up to 140 yen to a dollar:
|
One alternative for a company is to pay for the foreign good right away to avoid the exchange rate risk. But no one wants to part with money any sooner than necessary—if the company does pay the money in advance, it loses six months’ interest and risks losing out on a favorable change in exchange rates.
In all of these transactions, market rates might change. However, the buyer and seller are locked into a contract at a fixed price that cannot be affected by any changes in the market rates. These tools allow the market participants to plan more safely, since they know in advance what their FX will cost. It also allows them to avoid an immediate outlay of cash.
|
Swap Transaction: How it works Suppose a U.S. company needs 15 million Japanese yen for a three-month investment in Japan.
|
For a price, a market participant can buy the right, but not the obligation, to buy or sell a currency at a fixed price on or before an agreed upon future date. The agreed upon price is called the strike price.
Depending on which—the option rate or the current market rate—is more favorable, the owner may exercise the option or let the option lapse, choosing instead to buy/sell currency in the market. This type of transaction allows the owner more flexibility than a swap or futures contract.
| Option to buy currency | è | Call option |
| Option to sell currency | è | Put option |
Get more information of different types of FX transactions.
|
Option: How it works Suppose a trader purchases a six-month call on one million euros at 0.88 U.S. dollars to a euro.
|
Floating and Fixed Exchange Rates
The FX market was not always quick to respond to changing events. For most of the 20th century, the exchange rates were fixed, or kept constant, according to the amount of gold for which they could be exchanged. This was called the gold-exchange standard.
|
Under this system, the value of all currencies was fixed in terms of how much gold for which they could be exchanged. For example, if one ounce of gold was worth 12 British pounds or 35 U.S. dollars, the exchange rate between dollars and pounds would remain constant at just under three to one. There were many advantages of the gold-exchange system:
This system was put in place in 1944, when the leaders of allied nations met at Bretton Woods, New Hampshire, to set up a stable economic structure out of the chaos of World War II. The U.S. dollar was fixed at $35 per ounce of gold and all other currencies were expressed in terms of dollars.
The Bretton Woods system began to weaken in the 1960s, when foreigners accumulated large amounts of U.S. dollars from post World War II aid and sales of their exports in the United States. There were concerns as to whether the U.S. had enough gold to redeem all the dollars. With reserves of gold falling steadily, the situation could not be sustained and the U.S. decided to abandon this system. In 1971, President Nixon announced that U.S. dollars would no longer be convertible into gold. By 1973, this action led to the system of floating exchange rates that exist today. Currently, currencies rise and fall in value according to the forces of demand and supply. After the abandonment of the gold-exchange standard, the foreign exchange market went from a relatively unimportant financial specialty to the forefront of international economics. |
Under another system, the gold standard, U.S. households and businesses could exchange their dollars for gold. This practice was abandoned in 1933 during the Great Depression to allow freer expansion of money supply. However, foreign governments were still able to exchange their dollars for gold until 1971, when the United States terminated the gold-exchange standard entirely.
Role of Central Banks
Despite the size and importance of the foreign exchange market, it remains largely unregulated. There is no international organization that supervises it, nor any institution that sets rules. However, since the advent of the flexible exchange rate system in 1973, governments and central banks, such as the Federal Reserve System in the United States, occasionally intervene to maintain stability in the FX market.
There is no standard definition of instability or a disorderly market—circumstance must be evaluated on a case-by-case basis. Sharp rapid fluctuations of exchange rates and traders’ reluctance to be ready to either buy or sell currencies (maintaining a "two-way" market) may be signs of disorderly market.
To restore stability, the central banks often work together. However, a country taking a conservative view on intervention would act only in response to unusual circumstances that require immediate action, like political unrest or natural disasters. Most monetary authorities would be less likely to intervene to counteract the fundamental forces that drive FX markets, such as trade patterns, interest rate differentials and capital flows.
Intervention
The U.S. Treasury has the overall responsibility for managing the U.S. government’s foreign currency holdings. It works closely with the Federal Reserve to regulate the dollar’s position in the FX markets. If the Treasury feels that there is a need to weaken or strengthen the dollar, it instructs the Federal Reserve Bank of New York to intervene in the FX market as Treasury’s agent.
The Federal Reserve Bank of New York buys dollars and sells foreign currency to support the value of the dollar. The Fed also sells dollars and buys foreign currency to try and exert downward pressure on the price of the dollar.
The transactions in the intervention are small compared to the total volume of trading in the FX market and these actions do not shift the balance of supply and demand immediately. Instead, intervention is used as a device to signal a desired exchange rate movement and affect the behavior of investors in the FX market.
The frequency of intervention in the FX markets by the U.S. monetary authorities has reduced tremendously over the last decade. The Federal Reserve Bank of New York intervened only once since 1995.
Central banks in other countries have similar concerns about their currencies and sometimes intervene in the FX markets as well. Usually, intervention operations are undertaken in coordination with other central banks.
Most of the Federal Reserve Bank of New York’s activities in the foreign exchange market are for far less dramatic purposes than to influence exchange rates. The New York Fed often intervenes in the FX market as an agent for other central banks and international organizations to execute transactions related to flows of international capital.
Learn more about the Federal Reserve Bank’s role in the FX market.
Some countries have special arrangements with other countries to help them keep their currencies stable. Many less developed countries have their soft currencies pegged to hard currencies, so their value rises and falls simultaneously with the stronger currency. Some peg, or target, their currency to a basket of hard currencies, the average of a group of selected currencies.
Countries that are part of the European Union (EU) had pegged their currencies to the euro. There were formulas set for converting from the euro to the currency of each member nation. However, since January 2002, all currencies that were part of the Economic and Monetary System of the EU ceased to exist.
Intervention in the FX market is not the only way monetary authorities can affect the value of their countries’ currencies. Central banks can also affect foreign exchange rates indirectly by influencing interest rates.
| Higher interest rates è | Value of currency goes up | è | Investors want to buy currency to invest at high rates |
|
German interest rate |
U.S. interest rate |
è | Demand for German mark goes up |
Concerns about Eurocurrency
An important side effect of the increase of international economic activity over the past few decades has been the creation and growth of the Eurocurrency market. This is the name given to any bank deposits in any country held in a different country’s currency, like U.S. dollars in a British bank. A great deal of foreign exchange market activity involves the transfer of Eurocurrency deposits.
Eurocurrency, especially eurodollars (approximately two-thirds of Eurocurrency are U.S. dollars) are a source of concern to central banks and regulators because they are "stateless money"—subject to very little regulation. Rules governing currency and bank deposits— such as taxes, restrictions on capital movements and exchange controls—do not apply to the currency in the Eurocurrency markets.
Banks around the world use the Eurocurrency market to move and store funds more profitably than they could in many countries. This poses a problem for countries attempting to regulate capital flows.
International trade and foreign exchange cannot be viewed as two separate economic processes. The two are intimately connected on many levels. Increased trade and investment has brought the FX markets to their present level. Together, trade and foreign exchange affect peoples’ living standards and livelihoods all over the world.
Working across Borders
Many large companies are "multinational" in that they have branches and subsidiaries all over the world. By some estimates, intra-firm trade, or trade between branches of the same company in different countries, accounts for 40 percent of U.S. exports.
Many companies buy and sell goods overseas and others form partnerships with foreign companies so that cooperation replaces competition. This has a profound effect on how companies operate in the global marketplace. Businesses around the world work side-by-side to produce and market products, thereby reducing the economic risks of global production and marketing.
|
For instance, there may be a running shoe company:
Multinational companies shift resources from one country to another to maximize profits and productivity. The running shoes may be sold all over the world. If a shoe is shipped from San Francisco to Indonesia, it is simply a U.S. export. However, if Indonesia imposes a tariff on the shoe, it harms more than just the U.S. exporter; all businesses around the world that were involved in the process are affected, including Indonesia’s own rubber exports. With globalization, it is increasingly difficult for governments to target trade policies effectively. |
To remain competitive, individuals, companies, and governments all must adapt to the changing global marketplace.
Business practices vary from country to country and may require new approaches to making profits. In the United States, a signed contract is considered all but sacrosanct; in the Far East, southern Europe and the Middle East, the spirit of the agreement can sometimes matter more than the letter.
The "get down to business" approach that the U.S. and German businesses usually favor may be considered brusque or harsh in Japan or Korea. Even small details of business behavior—whether or not to look someone in the eye, tone of voice, exchange of gifts—vary significantly from country to country.
International Organizations and Trade Issues
As trade becomes more and more important to economic well being, international organizations have been formed to facilitate cooperation on trade issues.
The World Trade Organization (WTO), established on January 1, 1995, is the only global international organization dealing with the rules of trade between nations. It was created by the Uruguay Round of negotiations over a 14-year period and has 144 member countries (as of January 2002).
At the heart of the WTO are the various agreements, negotiated and signed by the bulk of the world’s trading nations and ratified in their parliaments. These agreements cover a range of topics:
The goal of the WTO is to help producers of goods and services, exporters, and importers conduct their business. The agreements have three main objectives:
To learn more about the activities of the WTO.
Another organization, the International Monetary Fund (IMF), was founded at the United Nations Monetary and Financial Conference at Bretton Woods in 1944. The IMF is an international organization of 183 member countries, established to:
The purpose of the IMF has remained unchanged but its operations — which involve surveillance, financial assistance, and technical assistance — have developed to meet the changing needs of its member countries in an evolving world economy. Lean more about the IMF.
A related organization, the World Bank, was founded in 1944 with the primary focus of helping the poorest people and the poorest countries. Its mission is to fight poverty for lasting results and to help people help themselves and their environment by providing resources, sharing knowledge, building capacity, and forging partnerships in the public and private sectors. Learn more about the World Bank.
The Bank for International Settlements (BIS) in Basel, Switzerland, is an international organization that fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability.
The BIS functions as:
The Basel Committee on International Banking Supervision, a committee of the BIS that consists of representatives of some of the world’s largest countries, meets to establish uniform financial and performance guidelines for commercial banks around the world. Learn more about the working of the BIS.
The Group of Seven, or G7, was created in 1975 with the objective of setting up a forum, at the highest decisional level and having formalities reduced to a minimum, in which to discuss important macroeconomic and monetary issues. The group was established with the intent of filling the gap created in the management of the monetary system following the breakdown of the Bretten Woods agreement in 1971.
The G-7 consists of the leaders of the United States, Germany, Japan, France, Great Britain, Canada, and Italy. The Birmingham Summit in 1998 marked Russia's official entry in the Group and the creation of the G8. Among other things the Group discusses
While economic issues still dominate the G8 meetings, discussions on environmental issues and arms control have been included in recent years. Learn more about G7.
A major change in the economic structures in recent years has been the creation of the European Union (EU). It is the result of a process of cooperation and integration that began in 1951 between six countries (Belgium, Germany, France, Italy, Luxembourg and the Netherlands).
After nearly fifty years, and four waves of accessions, the EU today has fifteen Member States.
One of the main objectives of the EU is to promote economic and social progress. Towards this end, Member States established the single market in 1993 and the single currency was launched in 1999. The completion of the EU’s internal "single market" boosted intra-EU trade, which represents two-thirds of the total EU Member States’ trade.
Suppliers of goods, services and investment from outside the EU have benefited from the single market program, just as much as people and companies within the EU. The EU has been busy consolidating its single market. Traders at home and overseas can market their goods in the EU based on one set of rules. The single market experience may include valuable elements for the multilateral system of the future. Learn more about the European common market.
Other nations have moved to build free-trade zones and common markets as well. Under the North American Free Trade Agreement (NAFTA), the United States, Canada and Mexico have agreed to eliminate barriers to trade and to facilitate the cross-border movement of goods and services. The agreement also aims to promote conditions of fair competition in the free trade area and to substantially increase investment opportunities. Learn more about NAFTA.
Many smaller "trade blocs" are developing all over the world, in North Africa, South East Asia, different parts of Latin America, Eastern Europe and the Middle East. Over the last 50 years more than 100 regional economic agreements have been created.
|
A trade bloc refers to a regional arrangement among countries that have established formal mechanisms for cooperation on trade issues. The term does not necessarily imply a protectionist stance with respect to nonmember countries, although it is sometimes used in this way. Trade blocs commonly include six types of arrangements: economic union, common market, customs union, free trade area, preferential arrangement, and regional cooperation organization. |
A possible problem is that competing trade blocs will adopt protectionist policies and slow worldwide economic growth by restricting trade among groups of nations. However, rapid proliferation of trade blocs and free-trade zones has occurred because countries want the benefits of increased trade that accompany lower trade barriers.
The WTO has created a committee to study regional groups and to assess whether they are consistent with WTO rules. The committee is also examining how regional arrangements might affect the multilateral trading system, and what kind of relationship they might have.
Useful Web Links
U.S. related:
U.S. Department of Treasury: Capital Movements Bulletin:
http://www.fms.treas.gov/bulletin/b21.pdf
U.S. Department of Commerce: Export Portal:
http://www.export.gov/docTSFrameset.html
White House: Economic Statistics Briefing Room:
http://www.whitehouse.gov/fsbr/international.html
Census Bureau: Foreign Trade Statistics:
http://www.census.gov/
http://www.census.gov/foreign-trade/www/
Bureau of Economic Analysis:
http://www.bea.doc.gov/bea/di1.htm
Federal Reserve Board: Research and Data:
http://www.federalreserve.gov/rnd.htm
Federal Reserve Board: Flow of Funds Data:
http://www.federalreserve.gov/releases/Z1/Current/Coded/coded.pdf
International Sites:
World Bank:
http://www.worldbank.org/
http://www1.worldbank.org/wbiep/trade/services_data.htm#Flows
Bank of International Settlements:
http://www.bis.org/
European Union:
http://europa.eu.int/index_en.htm
G-7 Home page:
http://www.g7-2001.org/en/frames_c.htm
OECD National Accounts:
http://www.oecd.org/std/nahome.htm
World Trade Organization:
http://www.wto.org/
http://www.wto.org/english/res_e/statis_e/technotes_e.htm
General Agreement on Trade and Tariff (GATT):
http://gatt.org/
North American Free Trade Agreement (NAFTA):
http://www.nafta-sec-alena.org/
International Monetary Fund:
http://www.imf.org/
International Finance Corporation:
http://www.ifc.org/
