PPP THEORY

John Wheatley-1802 and William Blake in 1810. Improved by Ricardo and presentable form by Gustav Cassel.

Absolute version:

Assumptions-

• There is free trade
• No transport Cost
• No transaction cost
• Pool of commodities are used in all countries

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Relative version:

R1= OER X Domestic Price Index (in base period)/Domestic price index (in current period) X Foreign price index (in current period) /foreign price index (in base period)

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Suppose price index in India has gone up to 400 and in US has gone up to 200 then

$1= 20X100/200 X 400/100

$1= 20X1/2 X4

$1=Rs40

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Criticisms:

1. Difficult to measure purchasing power
2. Neglects cost of transportation
3. Neglects quality of goods
4. Assumes given rate
5. Exchange rate influences price level
6. Only long term determination
7. Considers prices in domestic market
8. Ignores capital movements
9. It is narrow
10. Partial
11. Does not consider trade in invisibles

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BALANCE OF AYMENTS THEORY

Assumptions:

• Free trade
• Perfect Competition
• Equilibrium Exchange Rate

Criticisms

• Wrong Assumptions
• Overlooks impact of changes in Exchange rate on BOP
• Neglects Impact of changes in domestic prices on BOP
• Equilibrium in Exchange rate when there is equilibrium in BOP

Causes for Changes in Exchange Rates

• BOP position
• Domestic Inflation
• Interest Rates
• Money Supply
• National Income
• Monetary Policy
• Speculative Activities
• Capital Movements
• Political Factors
• Resource Discoveries

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Fixed and Flexible Exchange Rate

Fixed Rate:

Arguments For

• Promotes Trade
• Encourage Investment
• Correct Disequilibrium
• No Speculation
• No capital Flight
• Prevent competitive Depreciation
• Facilitate long range plan

Arguments Against:

• Transmission of economic disturbances
• Need for Exchange controls
• Not suitable for long-run
• Doesn’t reflect Cost-price relation
• Difficult to adjust BOP
• Not permanently fixed

Flexible Exchange Rate

Meaning

Arguments For-

• Smooth adjustment in BOP
• Independent Economic policies
• No need for Exchange and trade controls
• Greater Liquidity

• Better confidence
• Cost- price Relation
• Simple system

Arguments Against

• Uncertainty
• Speculation
• Inflationary Effect
• Adverse effect on trade
• Competitive Exchange Depreciation

Foreign Exchange Market

Meaning: Foreign exchange market refers to market where conversion (buying & selling) of domestic currency into foreign currency takes place. It is an established network of buyers and sellers through which the currency of one country is converted into currency of another country.

According to Paul Enzig “FE is the system or process of converting one national currency into another, and of transferring money from one country to another”

Participants:

According to Ellsworth “Foreign exchange market comprises of all those institutions and individuals who buy and sell foreign exchange which may be defined as foreign money or any liquid claim on foreign money”

• Corporates
• Commercial Banks
• Exchange Brokers
• Central Bank and Treasury Authorities
• Traders
• Investors
• Investment Funds or Banks

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Functions of foreign exchange market

1. Transfer Function
2. Credit
1. Export Credit
2. Import Credit

c) Hedging

d) Conversion of currencies

e) Facilitate capital flows

Concepts of Exchange Rate

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• Spot Rate & Forward Rate
• Buying & Selling Rate
• Single and Multiple Rate
• Fixed and Flexible Rate
• Market Rate & Equilibrium Rate
• Cross Rate
• Long Rate
• Tel Quel Rate

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Instruments of Credit Traded

• Telegraphic Transfer
• Mail Transfer
• Bank Drafts
• Cheques
• Bill of Exchange
• Letter of Credit

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FEDAI

Formed In August 1959

Functions:

1. Frame rules
2. Train Bank Personnel
3. Accredit Brokers
4. Advising and assisting members in settling issues
5. Represent members
6. Announce rates Co-ordinate with RBI
7. Circulate information
8. Act as clearing house for exchange information

Role:

4. Foreign Exchange Department of a Bank

Organisation and Functions:

Organisation:

1. Dealer’s Section: Compute and advise exchange rates
• Calculating rates and advising
• Looking after foreign accounts
• Controlling exchange position

ii. Foreign Remittance Section

• Arrange for issue of TC, Drafts in FCs
• Encashment foreign currency notes
• Encashment of foreign drafts and TCs

iii. Import Section

• Opening LOC and pay for imports
• Making arrangement for inward bills sent by foreign banks for collection

iv. Export Section:

• Looking after export letter of credit
• Provide financial assistance
• Issue of bank certificates
• Acting as agent for collection

v. Statistics Section:

• Collecting sale and purchase figures from various departments and prepare periodical statements

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Functions:

1. Purchase and sale of foreign Currencies
2. Dealing in Bills of exchange
3. Issue of LOC
4. Providing Credit Facilities
1. Export Credit
2. Import Credit

5. Advisory functions

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Correspondent Banking

Correspondent bank is a “financial institution that provides services on behalf of another … financial institution”

Services under correspondent relationship:

• Collection of bills, cheques etc
• Issue of DD, MT, TT & TC
• Arrange for reimbursement on LOC issued by the bank
• Confirming and amending LOC
• Sale and purchase of foreign currencies
• Guaranteeing loan and OD
• Furnishing information on credit worthiness & market report

Foreign Currency Accounts:

• Nostro Account (our account with you)
• Vostro Account (Your account with us)
• Loro Account (their account with you)

Handling of NRI Accounts

Types of NRI accounts

• Non-resident Ordinary rupee (NRO) account: Accounts of persons who were residing in India but left for abroad permanently or for indefinite period are NRO accounts. The accounts can be SB,RD, CA or FD
• No –resident external rupee account (NRE): opened by NRI, opened in Indian rupee in the form of RD, FD, SB, CA and are convertible.

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• Foreign Currency Non-resident (FCNR)Accounts:

Held in FDs, accounts are held in defined currencies lie US or Australian or Canadian dollars, EURO, Yen, Pound.

• Non resident non -repatriable Rupee Deposit (NRNR)- Placement of rupee funds received from abroad. Can be in FD or Cash certificates
• Resident Foreign Currency (RFC) account: Can be in SB or FD. Opened by returning Indians in US dollar, Euro or pound.

Facilities Available:

• Attractive interest rates
• Freedom of transfer from one branch to another.
• Interest earned is exempted fro income tax
• Funds can be freely used for local payments
• Funds can be invested in immovable properties
• Can be invested without prior permission from RBI
• Reptriation of balance
• Returning Indians can open NRI accounts in convertible currencies

Ready Exchange Rates

The Merchant business agreed and executed on the same day is ready transaction.

Merchant Rate: the basis is interbank rate.

Exchange Margin: TT buy (0.025- 0.0085) bill buy and TT sell (0.125 to 0.15%) bill selling (.175 to 0.2%)

Fineness of quotation nearest multiples of 0.0025

Buying Rates: TT buying rate- indicates the rate at which bank converts inward remittances into INR. It is the rate applied when it doesn’t involves any delay in realisation of foreign exchange.

Format:

Bill Buying Rate: Applied when foreign bill is purchased

In case of sight bill, the transit period could be 15-25 days.

Selling Rate:

TT selling: do not involve handling of documents

Bill selling; Applied when transactions involve handling of documents

Ready rates for non-trading transactions

i) Issue and encashment of Foreign TCs

ii) Exchange Rates for foreign currency

Fully convertible currencies calculated on the basis of TCs

Purchase rate= TC buying rate- 0.5%

Selling rate= TC selling rate+ 0.5%

iii) Exchange rate for clean instruments:

Encashment of DD/ MT/TT /personal cheques/ money orders

Current TT buying rate- exchange margin of 0.125% interest will be recovered separately

TT buying rate+ exchange margin interest seperately

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