History of Foreign Exchange Markets


Introduction

Foreign Exchange market is popularly known as the Forex markets.
It refers to buying currency of one country while selling currency of another country. A forex transaction is shift of funds from one country and currency to another.

It existed throughout ages, since the time of babylonians. With time, conversion developments took place which gave rise to the formal system of forex. Britain’s currency was the benchmark for most of the 17th, 18th and 19th centuries because of its navy and commercial interests. However, today most currencies are compared to the USD and Euro.

The foreign exchange market in India started in earnest less than three decades ago when in 1978 the government allowed banks to trade foreign exchange with one another. Today over 70% of the trading in foreign exchange continues to take place in the inter-bank market. The market consists of authorised dealers (mostly banks) who transact currency among themselves and come out “square” or without exposure at the end of the trading day.

The trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI), a self regulatory association of dealers. Since 2001, clearing and settlement functions in the foreign exchange market are largely carried out by the Clearing Corporation of India Limited (CCIL) that handles transactions of approximately 3.5 billion US dollars a day, about 80% of the total transactions.

The liberalisation process has significantly boosted the foreign exchange market in the country by allowing both banks and corporations greater flexibility in holding and trading foreign currencies. The Sodhani Committee set up in 1994 recommended greater freedom to participating banks, allowing them to fix their own trading limits, interest rates on FCNR deposits and the use of derivative products.

Here is useful introduction video to watch

Video credit alpari.academy

aMNCs and their impact on Forex Markets

MNCs are defined as firms that engage in some form of international business. MNCs are giant enterprises with HQ’s located in one country and variety of business operations/international offices in different countries.

  • MNCs have centralised ownership and control.
  • They have huge resources.

Indian MNCs — Tata, Infosys and Aditya Birla stories are well known.

Some other emerging or less known companies are:

  • Bharat forge — 2nd largest forging company in the world.
  • Ranbaxy — Amongst world’s top 10 generic pharma companies.
  • Asian paints amongst world’s top 10 decorative paint companies.

Reason for growth of Indian MNCs -

  • They have low cost and high quality products and services.
  • India has large pool of Intelligent professionals.
  • Government policies favourable for growth. However, lately business giants are of the opinion that new policies are making it difficult for MNCs to function.

Indian MNCs FDI abroad takes place in a lot of ways-

  • Backward Integration — Many Indian Co’s have acquired Resource rich upstream companies
  • Marketing — For IT and Pharma co’s
  • Energy Security — ONGC
  • Forward Integration — Reliance and USNL buying underground telephone cable networks at attractive prices from co’s in Bankruptcy.
  • Business Strategy — Tata buying tetley tea, Daewoo’s unit in south Korea, etc. Mahindra’s improving tractor units by buying tractor co’s abroad as a growth strategy. This improves the balance of payments and strengthens the INR against many currencies.

This video will explore the different determinants of exchange rates, focusing on the markets for Swiss francs in Europe and the market for Euros in Switzerland.

Factors affecting demand and supply of a currency

Demand & Supply of foreign currency vis-a-vis home currency depends and gets influenced by:

Balance of Payments (BOP): Higher/ surplus in current A/c and capital A/c indicates a stronger currency.

Inflation: It also depends on the global trends/external factors like oil prices and internal factors like elections, rainfalls, etc. A higher inflation level tends to weaken the currency.

Interest rate: Capital moves to place/countries where the interest rate is higher. Higher interest rate means higher capital flows.

Capital Flows: The higher the capital flow, the stronger the currency gets compared to the foreign currencies.

Political factors — The FDI depends on political stability. Slow down leads to weakening of the home currency.

Speculation — Genuine forex trade is just about 10%. Rest all is speculative flow ( hedge funds, investment banks). Hence speculators can influence forex rates.

Market Sentiments: It is an important aspect as if the market sentiments are on a high/ buying side, the home currency does well as that shows sign of progress.

Government policies: Recent approval for 100% FDI in multi brand retail, 49% in aviation and 49% in insurance are signs of better policy formations. They assure a strong rupee and a better road ahead.

Some facts about exchange rate system

The transition in the systems have been in the following order:

  1. Barter: Barter had lack of transferability, divisibility was an issue, perishable commodities/goods and unfair pricing.
  2. Commodity Money: It was difficult to store.
  3. Coins and paper money.

First paper banknotes appeared in China. However they were discontinued in 15th century.

Fiat Money: It is money whose face value is greater than the intrinsic value(value of the paper, had it not been a currency note). Fiat means by order.

Gold standard:

A monetary system in which the standard economic unit of account is based on a fixed quantity of gold. The video below explains the gold standard.

Video credit Learn Liberty
  1. Gold Specie — In this system, actual gold coins/ coins with fixed content of gold were in Circulation. This system ended with the world war I.
  2. Gold bullion — Monetary authorities hold stock of gold. Paper note is in circulation. On these notes is a written promise of monetary authorities that if you demand on submission of this note, they would give you specified quantity of gold. It means currency is pegged with gold. Here, the currency-to-bullion ratio I.e. Gold quantity per note was fixed. It ended with the Great depression of 1920s.
  3. Gold Exchange Standard- Currency is pegged with the other currency. The other currency was either in the form of gold coin itself or paper notes with promise to give gold on submission by monetary authority of that country. Hence, here rupee is in ‘ Gold exchange’ and gold is in gold bullion standard.

Bretton Woods System:

The video below explains the Bretton Woods System which was introduced to rectify the existing problems in the currency markets.

Video credit University of Shed

In 1944, representatives from around 40 countries met at Bretton woods, a town in New Hampshire State of the USA. It was the result of this meet that two Supra-national institutions were formed:

  • World Bank (With an American head)
  • International Monetary Fund(IMF) with an European head.

It was a Modified Version of gold exchange standard.

Main features -

  1. USA undertook to convert USD into gold at a fixed rate I.e. 35USD/ Ounce (1 ounce is 28.35 gms)
  2. Other currencies had to maintain a 1% variation in this parity(+ or -).

Bretton Wood system collapsed in 1973, and officially in 1978. US lost its role as anchor of the world. The Smithsonian Agreement of 1971 after several attempts couldn’t find solution to the problem explained by Prof. Triffin. Let’s take a look at the Triffin’s Paradox or Triffin’s Dilemma.

Prof. Robert Triffin pointed out the reason of failure of Bretton woods system and as a result this is known as “Triffin Paradox”.

  • The system was dependent on USD as the key currency.
  • As a result, other countries had to keep USD reserves to carry out international trade.
  • US had to virtually supply unlimited dollars ( Run BOP deficits) Deficit got higher which caused inflationary worries which countries started doubting the capability of the USD conversion into Gold.
  • Soon, it was evident that US did not have enough gold to honor its commitment of conversion of gold. USD was made the International reserve currency.
  • To ensure International liquidity, the USA was forced to run deficits in their BOP’s, otherwise world inflation would have been caused. ( Dollar would end up being weak and unwanted).
Bretton Woods Story

Currency Convertibility

Current A/c convertibility: Freedom to convert or switch from 1 currency to another to ‘Buy or Sell goods and services’. E.g. For travel, import of goods, royalties, etc.

Capital A/c convertibility: Freedom to convert or switch from 1 currency to another in order to buy capital assets such as bonds, shares and property.

LERMS: It stands for ‘ Liberalised Exchange Rate Management System.’

  • It was put in place in March 1992 following recommendations of the Rangarajan Committee to move towards the market-determined exchange rate.
  • It initially involved a dual exchange rate system.
  • All forex receipts on current A/c transactions were required to be surrendered to the Authorised dealers(AD) in full.

The proceeds of the transactions — 40 percent is converted at RBI’s official rate and the remainder 60 percent at the market rate quoted by the AD’s.

LERMS was replaced by unified exchange rate system in march 1993 (All forex receipts were converted at market determined rates). Unification of Exchange Rate of Indian Rupee helped in achieving current A/c convertibility in 1994.

Conclusion

Currency markets present a good investment opportunity. However, investors should participate only after a thorough understanding of how they work. In options, the risk is lower because the loss is limited to the premium paid. But investors need to know how puts and calls work and whether the premium being paid for an option is feasible. It’s advisable to take a course on forex derivatives offered by currency exchanges and associations.

One has to be clued in to global developments, trends in world trade as well as economic indicators of different countries. These include GDP growth, fiscal and monetary policies, inflows and outflows of the currency, local stock market performance and interest rates.

The currency derivatives market is highly leveraged. In the stock futures market, a 20% margin gains a five-fold leverage. In forex futures, the margin payable is just 3%, so the leverage is 33 times. This means that even a 1% change can wipe out a third of the investment. However, the Indian currency markets are well-regulated and there is almost no counter-party risk. Investors should start small and gradually invest more.

Liberalisation has transformed India’s external sector and a direct beneficiary of this has been the foreign exchange market in India. From a foreign exchange-starved, control-ridden economy, India has moved on to a position of $300 billion plus in international reserves with a confident rupee and drastically reduced foreign exchange control. As foreign trade and cross-border capital flows continue to grow, and the country moves towards capital account convertibility, the foreign exchange market is poised to play an even greater role in the economy, but is unlikely to be completely free of RBI interventions any time soon.

Currency vs. Money
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