Trade Currency
International trade refers to trade between the residents of two different countries. Each country functions as a sovereign state with its own set of regulations and currency. The difference in the nationality of the exporter and the importer presents certain peculiar problems in the conduct of international trade and settlement of the transactions arising there from. Important among such problems are:
Different countries have different monetary units
Restrictions imposed by countries on import and export of goods.
Restrictions imposed by nations on payments from and into their countries
Differences in legal practices in different countries.
The existence of national monetary units poses a problem in the settlement of international transactions.
The conversion of currencies is done by banks who deal in foreign exchange. These banks maintain stocks of foreign currencies in the form of balances with banks abroad.
II. EXCHANGE RATE
The rate at which one currency is converted into another currency is the rate of exchange between the currencies concerned. The rate of exchange for a currency is known from the quotation in the foreign exchange market. The banks operating at a financial centre and dealing in foreign exchange, the rates in the foreign exchange market. As in any commodity or stock market the rates in the foreign exchange market are determined by the interaction of the forces of demand for and supply of the commodity dealt in foreign exchange. Since the demand and supply are affected by a number of factors both fundamental and transitory the rates keep on changing frequently and violently too.
The exchange rate between currencies in currencies in a foreign exchange market is affected by a number of factors. The extent to which these fluctuations are allowed is vastly dependent on the monetary systems adopted by the countries concerned.
When countries were under gold standard the value of currency of a country was fixed as the value of gold of definite weight and fineness. The exchange rate between the currencies was determined on the relative value of gold content of currencies concerned.
III. FIXED EXCHANGE RATES
Fixed exchange rates refer to the system under the gold standard where the rate of exchange tends to stabilize around the mint par value. Any large variation of the rate of exchange from the mint par value would entail flow of gold into or from the country. This would have the effect of bringing the exchange rate back to the mint par value.
The present day situation where gold standard no longer exists, fixed rates of exchange refer to maintenance of external value of the currency at a predetermined level. Whenever the exchange rate differs from this level it is corrected through official intervention. For example when International Monetary Fund was instituted every member country was required to declare the value of the currency in terms of gold and US dollars. The actual market rates were allowed to fluctuate only within a narrow band of margin from this level.
The par value system was abolished with the second amendment to the articles of international monetary fund. Still the system of fixed rates continues in many countries in the form of pegging their currencies to a major currency. For instance countries like Chile, Egypt, Iraq and Pakistan have pegged the value of their currencies to US dollar. That is, the values of these national currencies are fixed in terms of US dollar and are allowed to vary in the exchange markets only within a narrow band.
If the exports of the country exceed imports the demand for the local currency in the exchange market will rise. This will raise the value of the currency in the market. Where the increase in value is beyond the support point the central bank of the country intervenes in the market to sell local currency and thus the foreign exchange reserves of the country increase. The sale of local currency in the market leads to increase in money supply in the country causing inflation. Revaluation may be resorted to allow for more imports and contain inflation.
IV. FLOATING/FLEXIBLE EXCHANGE RATES
Free or floating rates refer to the system where the exchange rates are determined by the conditions of demand for and supply of foreign exchange in the market. The rates are free to fluctuate according to the changes in demand and supply forces with no restrictions on buying and selling of foreign currencies in the exchange market.
Flexible rates of exchange refer to the system where the exchange rate is forced but is subject to frequent adjustments depending upon the market conditions. Thus it is not free or floating rate with cent per cent flexibility but is any system providing for adjustments as and when required.
However in practice, often the above difference is ignored and both the terms are used interchangeably. The term managed float or dirty float is used to refer to the system where the central bank intervenes only where the market forces cause violent fluctuations to bring some order in the market.
Under floating rates no par value is declared and the central bank does not intervene in the market. Any disparity in the balance of payments is adjusted through the changes rate that takes place automatically in the market. Because the central bank does not intervene in the market there is no change in the exchange reserves of the country.
A lively debate on the advisability of adopting fixed or floating rates of exchange has always been engaging the attention of economists. Forceful agreements have been put forward in favour of both systems.
V. CASE FOR FIXED RATES
Promotion of international trade. Stable exchange rates encourage international trade by providing certainty and confidence. Exporters and importers know in advance how much they will receive or they will have to pay in terms of home currency.
Promotion of international investment. Stable exchange rates promote international investments which are essential for economic development and progress of the underdeveloped countries. Lenders on long term would be prompted to invest in other countries only when the return in terms of home currency is ensured by stable exchange rates.
Facility of long range planning. Firms and the government can draw out long range plans and work towards economic stability and prosperity easily under conditions of stable exchange rates. The stable exchange rates provide the necessary framework for drafting out such plans. Under flexible exchange rates the frequent changes in exchange rates would render determination of the outlay of the plans difficult because with every change in exchange rates the outlay would vary.
Development of currency areas. Proper functioning of regional arrangements like sterling area or dollar area would be facilitated with the stable exchange rates. In such arrangements, if flexible rates prevail especially for the major currency like pound sterling or dollar with which the other currencies are linked it will have serious repercussions on many other currencies.
Prevention of speculation. Stable exchange rates avoid the dangerous possibilities of speculation and thus help in orderly growth of international markets.
Small open economies. It is argued that flexible rates will not work for small open economies. Such economies may be depending upon imports to a large extent for many of its consumption goods.
Inflation. Under the fixed rate system where rates are strictly on gold or dollar standard there was need for the central bank to keep a close watch on the money supply and keep the inflation under control.
Terms of trade. Many countries maintain their currencies pegged through trade and exchange controls at a level higher than that would prevail in a free market. The introduction of flexible rate system would substantially deteriorate their terms of trade.
Competitive exchange depreciation. Under the flexible exchange rate system there is a possibility of countries engaging in competitive depreciation of their currencies in order to capture world markets. Such unhealthy practices are eliminated in the case of stable exchange rates.
VI. CASE FOR FLEXIBLE RATES
A strong case for flexible exchange rates is made by refuting many of the arguments made in favour of fixed exchange rates. In addition flexible exchange rates offer other advantages also.
Adjustment of balance of payments
Better confidence
Better liquidity
Gains from free trade
Independence of policy
Cost price relationship
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