Unit 1: Foreign Exchange and Foreign Trade

Foreign Exchange (Forex)

Foreign Exchange (Forex) refers to foreign currencies and the system used to buy and sell currencies of different countries. Example: If you’re going from India 🇮🇳 to the USA 🇺🇸, you need US Dollars (USD). You go to a bank or forex shop and exchange your Indian Rupees (INR) for US Dollars. That’s foreign exchange.

Foreign Trade

Foreign Trade means buying and selling goods and services between countries. It’s also called International Trade.

➤ Types

• Import: Buying goods/services from another country (e.g., India buys oil from Saudi Arabia).
• Export: Selling goods/services to another country (e.g., India sells spices to the UK).

Exchange Rate

The exchange rate is the value of one country’s currency in terms of another country’s currency. Example: If 1 USD = ₹83, then to buy 1 US dollar, you need 83 Indian rupees.

Exchange rates keep changing due to supply & demand, government policies, etc.

Foreign Exchange as Stock

Foreign exchange as stock means the total foreign currency held by a country at a particular time, often in reserves with the central bank (like RBI).

It includes:

• Foreign currency
• Gold reserves
• Special Drawing Rights (SDRs)
• IMF reserve position

➤ Example: India’s Forex Reserve includes US dollars, Euros, Gold, etc. It helps in maintaining international payment capacity.

Balance of Payments (BoP)

The Balance of Payments is a record of all financial transactions (money in and out) made by a country with the rest of the world over a specific time (usually 1 year).

➤ It has two main parts

BoP Accounting

BoP Accounting means recording all international transactions in a proper format, using double-entry bookkeeping.

Each transaction is entered as:

• A credit (money coming into the country)
• A debit (money going out of the country)

➤ BoP Equation

In theory, BoP should always balance. But in practice, differences arise due to misreporting or data lag, so Errors & Omissions are added.

Components Explained

Important Note:

BoP must always balance in accounting terms:

If there's a surplus or deficit in one part (like Current Account), it's balanced by changes in others (like Financial Account or Forex reserves). Example: Let’s say

• Current Account = –$20B (deficit)
• Financial Account = +$25B (inflow)
• Capital Account = +$1B
• Errors & Omissions = –$1B

Then,

That means there's a $5 billion surplus, increasing foreign exchange reserves.

Simple Example of BoP

Let’s say India does the following in a year

• Total Credits = $100M + $20M + $50M = $170M
• Total Debits = $80M + $30M = $110M
• BoP Surplus = $170M - $110M = $60M

So, India has a BoP surplus of $60 million.

Summary Table

Balance of Payments (BoP)

BoP is a financial statement that records all international transactions made by a country with the rest of the world over a specific period (usually a year).

It includes three main accounts:

• Current Account
• Capital Account
• Official Reserve Account

Also, transactions are recorded as:

• Credit (Money coming in)
• Debit (Money going out)

Current Account

• Trade in Goods (Visible items): Exports & Imports
• Trade in Services (Invisible items): Tourism, banking, IT services
• Income: Salaries, dividends, interest
• Current Transfers: Gifts, remittances, foreign aid (non-investment)

📌 Example

Capital Account

• Capital Transfers: Debt forgiveness, migrant transfers
• Sale/Purchase of Non-Produced, Non-Financial Assets: Patents, copyrights, etc.

📌 Note: This is a small component of BoP in most countries.

Financial Account (Often clubbed with Capital Account)

• Foreign Direct Investment (FDI)
• Foreign Portfolio Investment (FPI)
• Loans and borrowings (External debt)
• Bank deposits and currency flows

📌 Example

Official Reserve Account

This records changes in the foreign currency reserves (Forex) held by the central bank (like RBI). If there's a BoP deficit or surplus, it’s adjusted using this account.

📌 Example

Debit and Credit Entries (BoP Accounting Rule)

Summary Table

International Exchange Systems

An international exchange system is the method used by countries to determine the value of their currency in terms of another country's currency in the global market.

There are two main types of exchange rate systems:

• Fixed Exchange Rate System
• Floating Exchange Rate System

Fixed Exchange Rate System

In a Fixed Exchange Rate System, the government or central bank (like RBI) fixes the value of its currency against another major currency (like the US Dollar or gold). The exchange rate does not change freely based on market forces.

How does it work?

The central bank buys or sells foreign currency in the market to maintain the fixed rate. It uses foreign exchange reserves to control the value.

📌 Example: Before 1991, India had a fixed exchange rate system where 1 USD was fixed at a certain value in INR. Some Gulf countries like Saudi Arabia still peg their currency to the US Dollar.

Advantages

• Stability in international prices
• Promotes foreign trade and investment

Disadvantages

• Requires large foreign exchange reserves
• Difficult to maintain during economic crisis

Floating Exchange Rate System

In a Floating Exchange Rate System, the value of the currency is determined by market forces — supply and demand in the foreign exchange market. The rate keeps changing daily depending on market conditions.

How does it work?

• No fixed rate is set by the government.
• The exchange rate fluctuates freely.
• Central banks may intervene slightly (called Managed Float) to reduce volatility.

📌 Example: After 1991, India moved to a floating exchange rate system. Countries like USA, UK, Japan follow this system.

Advantages

• Automatically adjusts to economic conditions
• Less need for foreign reserves

Disadvantages

• High volatility in currency value
• Can hurt exports/imports due to uncertainty

Comparison Table

Example: Imagine you're running a shop

• In fixed system, you always sell 1 product for ₹100, no matter what.
• In floating system, the price of the product changes daily based on how many people want it and how many are available.

Exchange Rate Systems before IMF

These systems were used before the International Monetary Fund (IMF) was established in 1944-45 to bring stability in the international monetary system. Before IMF, countries followed Gold-based standards to determine exchange rates and the value of money. These systems linked currencies to gold—either directly or indirectly.

Let’s understand each one:

Gold Currency Standard (Gold Coin Standard)

• Under this system, actual gold coins were used as legal tender (money) for transactions.
• Paper money could also be exchanged freely for a fixed amount of gold.
• Currencies of different countries had a fixed gold content, so exchange rates were stable.

📌 Example: If 1 British Pound = 10 grams of gold and 1 US Dollar = 5 grams of gold, then 1 Pound = 2 Dollars (10 ÷ 5)

Key Features

• Gold coins circulated in the economy
• Full convertibility of paper currency into gold
• Exchange rates were fixed based on gold content

Pros

• Highly stable and trusted
• Encouraged international trade

Cons

• Not flexible during economic crises
• Required large gold reserves

Gold Bullion Standard

• In this system, gold coins were not used in daily transactions.
• Instead, people and countries could exchange currency notes for gold bars (bullion) at the central bank.
• A minimum gold transaction amount was required (e.g., 400 grams), so only large transactions involved gold.

📌 Example: A central bank would only exchange currency for gold bars, not for coins.

Key Features

• No gold coins in circulation
• Currency convertible into gold bars
• Mainly used by large investors, banks, or governments

Pros

• Reduced cost of minting coins
• Gold reserve usage more controlled

Cons

• Not useful for general public
• Still required significant gold backing

Gold Exchange Standard

Under this system, a country's currency was not directly backed by gold, but linked to another country’s currency, which was itself convertible into gold. Usually linked to a strong economy like the UK Pound or US Dollar.

📌 Example: India linked its rupee to the British Pound, which was backed by gold. So, indirectly, the rupee was connected to gold via the Pound.

Key Features

• Indirect gold backing (via another currency)
• Countries held foreign currencies as reserves instead of gold
• Encouraged use of foreign exchange reserves

Pros

• Cheaper to manage
• Suitable for countries with less gold

Cons

• Depended heavily on the stability of the anchor currency
• Not truly independent

Summary Table

In Simple Words

Exchange Rate Systems Under IMF

The International Monetary Fund (IMF) was established in 1944 at the Bretton Woods Conference to create a stable global monetary system. These systems evolved after World War II as the global economy sought stability in exchange rates through the IMF (International Monetary Fund).

Let’s understand the three major exchange rate systems under the IMF era:

Bretton Woods System (1944–1971)

A fixed exchange rate system created after World War II. Currencies were pegged to the US Dollar, and the US Dollar was pegged to gold at a fixed rate of $35 per ounce of gold.

How It Worked

• Each country fixed its currency’s value in terms of the US dollar.
• The US guaranteed convertibility of dollars into gold.
• IMF was created to provide financial help to countries facing temporary balance of payment issues.

📌 Example: If 1 USD = ₹7 (fixed), India would maintain that rate by buying/selling dollars in the market.

Pros

• Provided exchange rate stability
• Encouraged international trade and investment

Cons

• Countries needed large foreign exchange reserves
• Created pressure on the US to maintain dollar-gold convertibility

By 1971, the US suspended gold convertibility, ending the system.

The Smithsonian Agreement (1971–1973)

• A short-lived system created after Bretton Woods collapsed.
• Signed by 10 major developed countries in 1971 in Washington (Smithsonian Institution).
• It aimed to revise and adjust the fixed exchange rate system.

Key Features

• Devalued the US Dollar slightly (gold price raised to $38/ounce)
• Allowed currencies to fluctuate within ±2.25% around fixed par values
• Tried to restore stability without full return to gold standard

Why It Failed

• Still couldn’t stop market pressure and speculative attacks on currencies.
• Ended by 1973, leading to floating exchange rates.

Flexible Exchange Rate Regime (Since 1973–Present)

• Also called the Floating Exchange Rate System
• Currencies are determined by market forces — supply and demand in the foreign exchange market
• IMF accepted that member countries could choose flexible exchange rate systems

📌 Example: India follows a managed floating rate, where the RBI intervenes occasionally. USD, Euro, Pound — all float based on market trends.

Features

• No fixed rate
• Countries can let their currency float or intervene when needed (called managed float)

Pros

• Automatically adjusts to economic changes
• No need to maintain huge foreign reserves

Cons

• Exchange rate can be volatile
• Uncertainty in international trade and investment

Summary Table

In Simple Words