Definition It is a system under which commercial nations pay off their debts.
It can be defined as the system of foreign bills of exchange under which foreign payments are made.
Black and Daniel define it as:
“The term foreign exchange refers to funds available for use in international transactions and may include foreign currency, deposits in foreign banks, and other liquid, short term financial claims payable in foreign currencies”.
FACTORS OF FOREIGN EXCHANGE
Foreign exchange always involves two elements:
- Mechanism of foreign payments
- Determination of exchange rate
Mechanism of Foreign Payments: A third party always exists in the settlement of transactions between importer and exporter. This third party is either a bank or a discounting house. These two institutions play an important role in the foreign trade as under:
- The local bank appoints its representatives posted in banks in foreign countries through whom foreign payments are cleared.
- The local bank maintains in foreign countries its own branches which are used in settling transactions relating to foreign exchange.
- Some banks establish independent banks in foreign countries. These banks offer services to importers, exporters, and government and help them in foreign banks purchase foreign exchange in the local market in order to supply the exchange to the importer.
Determination of Exchange Rate: Foreign exchange rate is determined in the following methods.
1. Rate fixed by the Government: The government fixes its currency rate in terms of foreign currency. The rate remains fixed and stable over a long period of time. In the determination, the state keeps in view market forces, demand for local and foreign goods, and dictates of the World Bank and IMF.
2. Free Float: In this method the government leaves its currency in the open market where it (currency) finds its genuine place. Market forces like demand and supply; push the currency at a certain level which becomes its rate. The rate of exchange will be high if the currency has a good demand abroad and will be at low level if the demand is poor.
3. Dirty Float: It is the mixture of the above two methods. The government uses its discretion upto a certain level and the rest is left to open market forces in the determination of exchange rate.
FACTORS OF EXCHANGE RATE
The following parameters play a vital role in the fixation of exchange rate.
- Business Conditions
- Influence of stock exchange
- Banking influence
- Currency position
- Role of the World Bank
- Foreign loans
- Planned use of incomes
Business Conditions: Business conditions are the result of production, business cycle, employment, balance of payment, balance of trade, inflation, and government policies. If business conditions are poor, the rate of exchange will fall, and vice versa.
Influence of Stock Exchange: The function of stock exchange include buying and selling of stocks, shares and bonds, offering investment opportunities, and mobilization of capital. The stock exchange is the index of a country’s economy. Inflow of foreign currency on the stock exchange that is foreign buying of shares and securities pushes the foreign exchange rate high.
Banking Influence: The use of bank drafts, travellers cheques, letter of credit, bills of exchange, and plastic money (credit cards) has a bearing on the rate of exchange. Their incoming raises and outgoing drops the rate of exchange.
Bank rate also affects the rate of exchange. The rate is the ratio at which a central bank rediscounts bills of exchange presented by commercial banks. High bank rate may attract foreign exchange throwing a good impact on the exchange rate.
Currency Position: If currency notes are over-issued the inflow of foreign investment will stop. Consequently, the demand for local currency will fall resulting in the drop of the exchange rate. Deficit financing and subsidies also weaken the currency.
Speculation: Speculation in currencies and gold greatly affects the local currency. Speculative buying of a currency may indicate the possibility of the increase in its value compared with other currencies. Speculative buying of gold, on the other hand, portends the expected fall in the value of a country’s currency.
Role of World Bank: Monetary systems all over the world have fallen under the purview of the World Bank and International Monetary Funds (IMF). All borrowing counties have to follow the dictates of the IMF in the determination of the exchange rate for their currencies and other monetary policies.
Foreign Loans: Foreign loans go a long way in strengthening local currency. However, if these loans are not properly utilized and spent on non development work the local currency does not become strong, and the government finds itself in a difficult situation when due date for the repayment of the loan falls.