Foreign Exchange Market and Exchange Rate Determination 117

Foreign exchange market is a mechanism where various national

FOREIGN EXCHA\ currencies are purchased or sold like any other commodity. Demand
for and supply of foreign exchange determines its price, that is,
foreign exchange rate. When we say, ? 75 is the price of a dollar, it is
the foreign exchange rate or the price of dollar expressed in terms
of rupees. Here the US dollar ($) is the vehicle currency in which
exchange rate is quoted in India. Vehicle currency is an
internationally accepted currency. It is a standard currency used in
DETE foreign exchange market.
A foreign exchange market can either be completely free or
restricted. Restrictions vary from country to country. In India, full
convertibility is allowed only on current account and not on capital
account. Even under free exchange market or floating exchange rate,
12.1 Foreign Exchange Market the Government intervenes whenever there is wide fluctuation in
12.2 Participants in Foreign Exchange Market exchange rate. Such intervention is essential to avoid negative effects
of unstable exchange rate.
12.3 Functions of Foreign Exchange Market
12.4 Foreign Exchange Rate
12.5 Demand For Foreign Exchange
12.6 Supply of Foreign Exchange
12.7 Determination of Exchange Rate The main participants in the foreign exchange market are (i) retail
clients (ii) commercial banks (iii) foreign exchange dealers, (iv)
12.8 Changes in Exchange Rate foreign exchange brokers and other authorised agents. The central
12.9 Factors Responsible for Change in Exchange Rate banks too participate in this market as per its policy decisions. Let
us briefly explain the main participants in the foreign exchange
market.
Retail Clients : These comprise people, international investors,
multinational corporations and others who need foreign exchange.
Retail clients deal through commercial banks and authorised agents.

which Commercial Banks : They carry out buy and sell orders from their
Foreign excha within
mar^et is an organisational setting buy and sei retail clients and of their own account. They deal with other
individuals bn^
foreign currencies
8overnments and banksmarket in
{ar fhe largest and liquid
commercial banks and also through foreign exchange brokers.

wnr; “ round the doc Foreign Exchange Dealers : Banks, investment firms and brokers
world. It is a mar^et which operates HongKong/ 1 1
•° sing1 function as dealers.
due to time zone when it is morning in a
evening in jq Y y \L Foreign exchange market is not A foreign exchange dealer is a firm or individual that buys foreign
Physical place.
 IIS International Economics (T y /j
exchange from one party and sells to another party
in Or
profit. The spread between bid (buy) and ask (sell) price
. Eoreign Exchange Market and Exchange Rate Determination U9
difference between buy and sell price (spread) earns
him n is' %
A dealer is often a commercial company or bank, or Profit
anoth
like an investment management firm. Foreign exchange emity The wholesale market is also called the interbank market.
also be brokers and agents working for these entities d I Commercial banks, business corporations and central banks are the
carry out speculation or/ and retail trading. Th
also main participants in this segment of the market. The size of
transaction in the market is very large. The dealers here are highly
A forex dealer handles foreign exchange investment oppon professional and are the primary price makers, ft is big players like
by exchanging one currency for another. h
Cities multinational banks that exert a lot of influence in the market and
are mainly responsible for determining the exchange rate.
A foreign exchange dealer's work is exciting as well as
a dealer one should have enough knowledge of forex
riskv T In the retail market travellers, tourists and people who are in need
mathematics and economics, analytical skill and quickmark •
° of foreign exchange for permitted small transactions, exchange one
making abilities. IS10n dJ currency for another. The retail market is a secondary price
maker.
Brokers act as middlemen between the price makers.
Foreign Exchange Brokers : Each foreign exchange market They
information to the banks about the prices at which there provide
has some authorised brokers. Brokers act as intermediaries Cenh- are buyers
buyers and sellers, mainly the banks. Commercial banks prefer betwee* and sellers of a pair of currencies. Most of the banks
ones deal through brokers who purchase and sell onexcept the major
brokers as banks could obtain the most favourable quotations the Brokers possess more information and better
behalf of others.
them. from knowledge of market.
The price takers in the foreign exchange
They are the currency sellers or currency retailers. They market are those who buy
constitutea the foreign exchange which they require and
small percentage among the dealers, that is, around 2 percent. sell what they earn at
the price determined by the primary price
Their makers.
importance is increasing as more and more individuals enter the
foreign exchange trading. These small traders who also get in INDIAN FOREIGN EXCHANGE
MARKET
speculation to earn profit, require the help of brokers. It is made up of three tiers. In
the first, the dealings take place
Central Banks : Under the floating exchange rate the central bank between Reserve Bank of India and
of a country normally does not interfere in the exchange market. comprising mainly commercial banks. Authorised
In
dealers (ADs)
the second tier the ADs
deal with each other and in the
Since 1973 however most of the central banks frequently intervened third the ADs deal with their
corporate customers. The retail
to buy and sell their currencies in an attempt to influence the rate at In this segment there are market mainly caters to the tourists.
which their currencies are traded. Being the monetary authority of money changers who deal in foreign
the country, Central Bank of each country is the custodian of foreign |
currencies.
exchange reserves which it uses to balance the balance of payments. ,
In the process it draws down its foreign exchange reserves or adds 12.3
to them. FUNCTIONS OF FOREIGN EXCHANGE
The above groups are the sources from where demand and supph 1 market
forces generate which in turn help determine the foreign I 1
exchange rate. Transfer of purchasing power:
I International trade involves
different currencies. Indians require
purchasing power in the
 International Economics (T.Y.B 4 .
120 121
of u S. dollars ($) to purchase goods and setvi
and Exchange Rate Determination
,
^country.
h
Similarly residents of other country ° foreign Exchange Market
residents who wish to purchase the country's goods and
tin any other acceptable currency fot pu^.1
lnd“" currency or Foreign exchange
ting in India. market helps t
*"
foreign
us to the concept of exchange rate between
services. This bringsThe rate of exchange
currencies. of a currency is its price in
peo^. differentanother
S power (currencies) between the
and credit For the purp
terms of
currency, or a group of other currencies. The rate of
exchange of a currency is a measure of its external value that
2. Provision of credit instruments
W measures its purchasing power in terms of foreign goods and
fcrrinc credit, credit instruments are used. These ar/ important variable through which a country's
services. It is an with
toSm of telegraphic transfer foreign exchange bill,
etc instruments with time
period i.e. a bi 1 of foreign dt^
exch,^
interdependence
evaluated.
the global economy can be measured and

^90 days can be discounted before the due date.

provision enables to obtain credit from the commercial
Such8
bank,
or authorised agents. 12.5 DEMAND FOR FOREIGN EXCHANGE
3. Coverage of risk: Exporters
and importers may cover th
in the exchange rate throu h The demand for foreign exchange in a country is determined by a
possible risk due to a future changeforward complex set of factors that are influenced by the country's level of
forward exchange market. "Theto exchangeexchange marker development, growth rate, international trade and government
where buyers and sellers agree currencies at some
policies. Some of the important factors that generate demand for
specified date in the future." Hedging operation helps
foreign exchange are:
speculators, exporters and importers to cover the risk.
1. Import of goods: This is the most important factor generating
licensed by the RBI can
In India foreign exchange market agencies demand for foreign exchange in a country. Most countries
They are :
only deal in foreign exchange transactions. import goods to meet domestic demand and to take advantage
are the commercial banks of cost differences with other countries. Countries trade in
1. Authorised Dealers (ADs) : They capital, intermediate and consumer goods. With the lowering
authorised by the RBI to undertake transactions in foreign of trade barriers in the last few decades, there has been very
exchange. significant increase in import of goods, particularly by emerging
agents, department economies, resulting in increased demand for foreign exchange.
2. Money changers : Well established travel The price of imports and the demand for foreign exchange are
stores, hoteliers are permitted to buy and sell
foreign currency.
inversely related. Elasticity of demand for imports has a
significant impact on the demand for foreign exchange for this
purpose. If the demand for a country's major merchandise
imports is price and income inelastic then the demand for
foreign exchange is likely to be consistently high.
n emational trade requires exchange of currencies between multiple
In order have a better understanding ol 2. Import of services: Along with goods, countries import services.
ra ing partners. with the Import of services by many countries has increased manifolds
in ernational trade, it is necessary to be familiar
of one after the creation of the WTO and the development of
international payments system. What should be the value question communication technology. Services that are imported by
rrency in terms of another has always been a challenging nations include tourism, transport, banking and insurance,
for economists and policymakers. communication, education, professional services.
residents but also b
try s currency is used not only by its
 122 International Economics (T.Yq
3. Unilateral payments: These are payments from one Exchange Market and Exchange Rate
another that do not correspond to the purchase Of C°Untry t0 Determination 123
service or asset. These include donations, gifts, ren^8^ demand curve like an ordinary demand
wards from left to right and shows an
curve is sloping
(returning of incomes
investing and creditor
like profits,
countries),
dividends, i
remittances sent b to ^^en the price of foreign exchange in
^^andisfordemanded. More
inverse relationship
domestic currency and the
^’gn
foreign^ rate
workers working in the reporting country,
assistance given by the government of a country?*1 0
^^unt is
Per °t foreign currency, OQ
demanded at a lower price.
countries. °ther
4. Export of capital: Capital leaves a country in various 12 6 SUPPL* OF FOREIGN EXCHANGE
resuming in demand for foreign exchange. Repayment fornis
of
purchase of assets by residents and government in debts F reign currencies enter a country through
countries, investments in financial assets m fore.gn forei services, capital inflows, exports of goods and
unilateral receipts, all together
foreign direct investments and lendmg to foreign countries, ly of foreign exchange in the
domestic generates
generate demand for foreign exchange.
nationals, ail of the important factors that generate exchange market. Some
supply for foreign exchange
are:
5. Future expectations: Since almost everywhere, the
exchange rates are market determined, they change foreign Export of goods: Merchandise or
1
goods exports
changes in demand and supply. Hedgers demand with major source of supply of foreign
exchange.
constitute a
Supply of foreign
foreign
currencies in order to protect themselves from risk arising
exchange is influent u, o
’
of the exported goods. The
j v wiuuie or exports and the prices
of exchange rate fluctuations, while speculators demand out elasticity of demand for and supply
foreign of a country's exports
exchange to make profit by selling the currencies at a higher significantly
exchange earned from exports. If influence the foreign
rate in the future. Both these activities generate demand for major exports is relatively the demand for a country's
foreign exchange on the basis of future expectations. the supply of foreign inelastic in foreign countries, then
be large. Example, oil
exchange from merchandise exports will
The total demand for foreign exchange is inversely related to its exporting countries. If demand for
is relatively elastic, then exports
price, that is, the exchange rate. with a fall in price of
will be significant rise in exports, there
of foreign exchange in foreign exchange earnings
the country will be large. and supply
2 Export of
services: With increase in trade
countries have been in services, many
exchanges from this source.earning large part of their foreign
this regard. Exports of India is a significant example
services are a major factor in
supply of foreign exchange generating
in the exchange markets.
3. Unilateral
receipts: These include receipts
to another
without corresponding sale of anyfrom one country
asset. These include good, service or
donations, gifts, aid received
residents
j
by the
Demand for Foreign Exchange (Df) (in US $) | repatriationsand the government, as well
of incomes like profits, as receipts of
Fig. 12.1 I
abroad, and remittances
I countries. sent
dividends and interest from
by nationals working in
foreign
 224 International Economics (T.Y.b a
i n • "
4. Import of capital: Capital inflows into a country ge } foreign Exchange Market and Exchange Rale
supply of foreign exchange. Such inflows take due to Determination
borrowings, foreign direct investments and foreign pOrXr,?aI
ext^0 125

investments. There has been significant increase in

f
0||« RATE
capital flows from developed to emerging economies ln e |2.3 the exchange rate is
process of the current phase of globalistaion. Such determined at E, where demand
of capital cause frequent changes in the exchange rates. movem^ alK upply curves for foreign exchange
etluibbrium exchange rate when demand for intersect.
of capital is highly influenced by government policies. P°n In^ is equ ।to supply - OR1 and OR2are not
the
OR is the
the foreign exchange
D > S i.e. R2M > equilibrium exchange
5. Future expectations: Just like demand for foreign
supply of foreign exchange is also influenced by exchan r3nS> R P- Exchange rate R1 and R2N.
R2
Similarly
are not
at OR1
;e
S > D i.e.
expectations. When speculators begin to sell foreign fut^ hange rates. At the Rj and
prevailing rate to moveR2 exchange rates
stable
there
or equilibrium
will be pressure
current
in order to make profits, the supply of foreign exchange rate i.e. towards point E.
towards the equilibrium
ris* exchange
lowering the value of the foreign currency. Speculation
motivated by future price expectation. i

The total supply of foreign exchange is directly related to its prjCe

that is, the exchange rate.

From the above analysis it

Supply of Foreign Exchange (Sf) (in USS) any other price is is understood that
exchange rate, like
determined by demand and supply
Fig. 12.2 foreign exchange market. forces in the
result in a change in Any change in demand
the exchange rate. and supply will
Supply from all these sources add up to the aggregate supply of
foreign exchange. The total supply, like the supply of any other The exchange rate
determined by the market forces
commodity, is directly related to the price i.e. the foreign exchange as these forces change in the market. The would change
rate. The diagram above shows the (bid) or sell (ask) the primary price makers buy
relationship between rate of currencies in the market and the
foreign exchange and its supply. The supply curve of foreign continuously change rates
in a free market
exchange like any other supply curve, slopes upwards. supply. depending on demand and
The primary
dealers quote two-way prices
and are ready to deal on
126
International Economics (T.Y.B a • ct.
seU. A bank quotes its rate foreign Exchange Market and Exchange Rate Determination 127
either side, that is, to buy and in demand and supply curves have brought a
following manner. Shifts inexchange rate, that is, rupees offered per change in the
foreign dollar. When supply
INR/USD 70.50bid/ 70.75 ask of dollar increased, dollar became cheap bringing down the exchange
the units of rupee (INR) the dea|er ,
rate per dollar, that is from R to Ro. The equilibrium exchange rate
The above quote expresses the dollar that is his bid (buvin ' went up from R to R, when the demand curve shifted to the right
ready to pay (70.50) while buying from D t° indicating an increase in demand for dollars. The shifts
The ask selling) price
price for one US dollar (USD). one dollar for those (70.75) in demand and supply of foreign exchange (dollars) are the result
at which he is willing to sell who Want ' of changes in underlying factors that affect demand and supply. At
purchase it. In the transaction there
is a spread between bid and J p rupee is stronger, that is, less rupees
are offered per dollar.
a profit of < 0.25 on a transaction of Whereas R: rupee has become
price enabling the dealer earn
at weaker or depreciated, that is,
rupees are required to purchase one dollar. more
one dollar.

12.8 CHANGES IN EXCHANGE RATE 12.9 FACTORS RESPONSIBLE FOR CHANGE

IN EXCHANGE RATE
by the intersection of
The equilibrium exchange rate is determined
demand for and supply of foreign exchange. andthis point the
At
1 Inflation : Relative inflation rates of the two
demand is equal to supply. However the demand supply curves
the exchange rate. Between India and USA;
countries influence
let us say, the
an
may shift either to the right or to the left indicating increase or exchange rate is^70 = lUS$ina given year. In
the rate of exchange the
decrease in demand and supply. Accordingly year if the rate of inflation is higher in India than subsequent
USA, Indian
would also change. Figure 12.4 explains the above mentioned goods and services will be costlier compared
to USA, where
changes. inflation rate is lower. There will be less
goods and services from USA, thus demand for Indian
dollars, whereas USA's rate of inflation reducing the supply of
be more demand from India for USA's being low, there will
goods and services. The
situation results in more demand for
time less supply. Increased demand
dollars and at the same
with the given supply or
decrease in supply of dollars, make the dollar
12.4 the exchange rate has gone costlier. In Figure
? 70 to 72. An opposite
up from R to Rlz let us say from
scenario would make the dollar
cheaper.
2 Interest Rates : A higher rate of interest in India
foreign money to India to take will attract
advantage of interest
differentials. Larger inflow of, say, dollar or euro would increase
their supply and make them
cheaper against the rupee.
However, it should be noted that
-
Source : A.C. Shapiro Multinational Financial Managemen
f ,P differential in real interest rate, that isinvestors consider the
nominal rate of interest
minus rate of inflation.
and 41.
128
International Economics (T. Y.B.4 .
3. Economic Growth : Higher economic growth rate foreign Exchange Market and Exchange
foreign capital to that country. China which enjoyedattr Rale
Determination
economic growth attracted more foreign
high^ 7‘ Write short notes .
za\ Functions of foreign 129
*
others. India which enjoys a better growth rateinvestment tha
than many othj*
exchange market
participants in foreign
countries has experienced its rupee appreciating in recent exchange market
from 48.395 in 2002-03 to 44.411 in October 2010. yea^
in June 2013, exchange rate per US $ crossed 60.00. On Howeve'
28, 2013 rupee-dollar exchange rate was ? 68.85 = 1 US $AuguSf
reflected weak economic situation of India. Subsequently which A Choose the correct option and
—
exchange rate settled around ? 65 $ 1. At present (October
2020) the exchange rate has crossed ? 75 = $1. Similarly
1. A
(a) Fiat
currency is an rewrite the
internationally
(b)
statement •
accepted currency
with poor economic performance experience foreign capital
countries (c) Hard Vehicle
(d)
moving out thus making the domestic currency weaker. 2 Which of the following entities is Reserve
retail clients in the foreign not included in
4. Political and Other Factors : Political instability coupled with I (a) Commercial banks
exchange market?
the definition of
(b) Individuals
poor economic performance alongwith other factors like social (c) MNCs
(d) Tourists
unrest make people demand less of that country's currency. 3. In the wholesale market for
primary price makers. foreign exchange, the
Whereas those countries which enjoy a positive economic, social are the
and political environment find their currencies are more in (a) banks
(b) retail clients
demand. (c) central bank
(d) dealers
4 The market in the foreign
The above discussed factors influence the demand and supply of a price maker. exchange market is the
secondary
particular country's currency, thus rendering it strong or weak. (a) forward
Besides these factors, future expectations by the market participants (c) retail
(b) spot
about foreign exchange market / rate, leading to speculation would 5. Which of the following is (d) wholesale
not a function of the
also bring in a change in exchange rate. market? foreign exchange
(a) Determining interest
rate
(b) Transferring
purchasing power between different
(c) Risk coverage countries
- (d) Provision of credit
6. Which of the
What is a foreign exchange market ? Who are its participants ? following is true for the equilibrium rate of
(a) There is no excess exchange?
2. What are the functions of a foreign exchange market ? (b) There is excess demand for and supply of foreign exchange
3. Who are the participants in foreign exchange market. Bring out their demand for, but no excess supply of foreign
role. exchange
(c) There is no
4. What is rate of exchange ? How is it determined ? excess supply of, but there is
excess demand for
foreign exchange
5. Discuss demand for and supply of foreign exchange. (d) There is
6. Explain the determination of foreign exchange rate and
factors 7- If the excess demand for and excess supply of foreign exchange
demand for a country's major merchandise imports
responsible for its change. inelastic, then is price
(a) The
(b) The
demand for foreign exchange is likely to be consistently low
demand for foreign exchange will not be affected by elasticity
 International Economics (T.Y.B.a . SEfy 131
130
exchange is likely to be consistently
(c) The demand for foreign hi
(d) The demand for foreign exchange is likely to be consistently |08h
increase the supply of foreign excha
8. Which of the following will
in a country?
(a) A reduction in exports
(b) A rise in import of goods
(c) A rise in unilateral payments
EXCHANGE RATE -II
(d) A rise in receipts of capital
exchange rises, with no change in its
9. When the demand for foreign
supply/ then
will depreciate against the foreign
(a) The domestic currency
currency
(b) The domestic currency
will appreciate against the foreign 13.1 Managed Flexibility
currency 13.2 Swap Market
(c) The foreign currency
will depreciate against the domestic
currency 13.3 Components of Foreign Exchange Reserves
constant
remain luxouuu
will renuuii
(d) The exchange rate win
country, assuming that interest rate in the
10. A high interest rate in the same, will
foreign country remains the
currency in the home market
(a) Reduce the supply of foreign
(b) Increase the supply of foreign
currency in the home market 13.1 MANAGED FLEXIBILITY
foreign currency in the home market
(c) Increase the demand for
(d) None of the above Most countries followed the Dollar standard of Bretton Wood, which
constant, if a country's unilateral payments is also known as gold exchange standard from 1947 to 1971.
11. Other things being currency in terms of the domestic Between
increase, the value of the foreign 1971 to 1973, several attempts were made by the advanced
countries
currency will to save the Bretton Wood system. In 1973, however,
(b) fall the system
(a) rise collapsed and most of the IMF countries started
(d) become zero floating their
(c) remain the same currencies. As majority of the IMF member countries found that a
12. complete floating system may not suit them, hence opted for
(b) Export of services managed flexible system.
(a) Export of goods
(d) Import of capital
(c) Export of capital Under the managed flexible exchange rate system,
13. generates supply for foreign exchange. is the exchange rate
(a) Unilateral payments (b) Export of capital allowed to be determined by the market forces but the monetary
(d) Unilateral receipts authority (RBI in India) and/or the government has
(c) Import of services
- --
Ans.: (1) (b), (2) (a), (3)-- - - -
(d), (4) (c), (5) -
(a), (6) (a), -
(7) (c),-(8) (d), intervene in the foreign exchange
a right to
market inorder to prevent the
- -
(9) (a), (10) (b), (11) (a), (12) (c), (13) (d)
exchange rate from fluctuating beyond a point. In other
exchange rate is not allowed to become volatile words the
'domestic economy. and disturb the
232 International Economics (T.Y.B.A.:
SE^
The exchange rate determined by the market forces
flexible, that is, to appreciate or depreciate upto a limitremains resource allocation between the domestic and 133
considered safe by the authorities. Beyond this limit the
which i Undervaluation leads to inflationary external sectors.
will intervene and control the exchange rate to remain within authorities overvaluation brings in higher pressure, while
rates of unemployment.
the in the exchange rate in either Changes
and affects investment decisions.direction
limit. brings in uncertainty
The disturbances
activities caused by changes in the in economic
Exchange Rate Intervention kept under control if the authorities exchange rate can thus be
necessary changes in the exchange intervene and bring in the
It is defined as a sale or purchase of foreign currency by monetary rate.
authorities with the aim of changing the exchange rate of their own 3. To smoothen the economic adjustment
surplus or deficit in the balance of process : A persistent
currency vis-a-vis one or more currencies. In the seventies of the payments lead to
last century, an overwhelming number of countries which switched the exchange rate to correct the changes in
are larger, then the consequent disequilibrium. If the changes
to a flexible regime have followed a managed exchange rate system disturbances in
In most of these countries central banks intervened in the foreign
economic activities require adjustments the domestic
levels etc. If adjustments required in employment, price
exchange markets to minimise the fluctuation in exchange rate. In becomes painful in its effects.
are of higher
case of the developing countries where the foreign exchange magnitude, it
disturbances and the effects. AnIntervention can reduce such
markets are thin and narrow, central banks' "leaning against wind" vicious circle of depreciation economy may be caught in a
intervention policy is to check erratic fluctuation in the exchange which in turn leads to furtherleading to price and wage rises
rate of its currency. wage-price spiral. Interventiondepreciation i.e. depreciation¬
down or avoid the spiral. by the authorities
may slow
Reasons for Central Bank's Intervention
Intervention is also preferred by
of protection or correction like
many economists to other
1. Ability to produce a more appropriate rate : The government tariffs, subsidies, methods
or monetary authorities may be in a better position to gather controls etc. Most of these exchange rate
permanent and cause more
methods have the tendency
all the relevant information than the market. The market may damage to become
to the economy by
have the wrong perception and may find it difficult to use the wrong exchange rate. producing
information to determine the appropriate rate of exchange. The Many countries
authorities are in a better position than the market in predicting of flexible
have taken precautions to
exchange rate check the negative effects
by not
the future course of policies and their implications for the account. At
the same time by allowing convertibility in the capital
exchange rate. For example, if there is an expected increase in rate, they
attempt adopting managed flexible
money supply, the authorities would know the extent of it and I flexible and to have the advantages exchange
accordingly plan the intervention to influence the exchange rate. fixed exchange rate systems. associated with both
In the absence of intervention, the market may indulge in
Types of
speculation due to its inability to have accurate information. Intervention
2. To mitigate costs of overvalued or undervalued exchange |Under managed
rates: Exchange rates which deviate from the real exchange rates (Central Bank) flexible exchange rate, the
requires to monetary authority
(in relation to purchasing power parity) lead to distortion in rate ^om
extreme intervene to prevent foreign
fluctuations. The Central Bank's (RBIexchange
lnlervention are of two in India)
types: (i) Unsterilised and (ii)
Sterilised.
 134 International Economics (T.Y.B.A.:
Under the unsterilised intervention, the central bank purchases
ExcMiXi’Kale-H
sells foreign exchange (currency) in order to maintain the desir^
Or Central banks require sufficient
amount of r «5
level of exchange rate. For this purpose, a central bank requires t0
serves tointervene in
(September 2021)
the market.
India fo r8” ^nge (forex >
maintain enough reserves of foreign exchange.
Foreign exchange transaction of a Central Bank (RBI), through
purchase and sale of foreign currency (dollars / euros) leads to the
$640 billion US dollars
finance ministry, is sufficient to intervene
in the foreign exchange market.
wh
7 ^”
'“^csabout
7 when necessary
according <o the
as and

increase or decrease in the supply of domestic currency. Accordingly 13.2 SWAP MARKET
it may increase or decrease the level of inflation. en the Centra]
Bank (RBI) attempts to insulate or neutralise the effects of foreign
A foreign exchange swap (Fx Swap)
exchange market intervention through use
of monetary p0|i(.y
instruments it is called sterilised intervention.
^mbined with a forward refers toac„
repurchase of the
'
of the single transaction. Spot
are executed simultaneously fortransaction and ^7"^ “ part
Purchase of foreign currency, in order to prevent
of domestic currency, results in an increase
the appreciation
m the quantity of
the sale of government
as foreign exchange risk free
the same
amount
collaterised borrowing
'™saction
domestic currency. This can be neutralised by Participant in swap market are “‘a ana
and
lending
securities through open market operations, which reduces the financial
multinational companies institutional institutions «.»•
money in circulation. Central Bank can also make use of Cash
Reserve Ration (CRR) when an increase in CRR reduces the ability Short-dated Fx swaps include overnight mds^ufato"”5'
investors
of commercial banks to create credit, thus reducing money supply. against tomorrow (Tom) Tom-next (T/N) fo/Ml
a
SWap
the next day spot-next (S/N). A swap A swan.
Similarly sale of foreign currency brings down the quantity of money day spot-week (S/W). A starting
in circulation.
To counter-check this effect, that is, to inject more money in
^^next swap starting sroHTspot agairata^we^
To illustrate the swap market
k circulation, the Central Bank can make use of open market operation
Mumbai receives $ 1 million operation - suppose City bank
I whereby it resorts to purchase of government securities. Also at the after three months. Meantime payment to-day which it requires in
same time, CRR can be reduced to enable commercial banks advance
City bank would swap it withCity bank wants to invest it in it
more loans to the public.
transaction or dual. The swap Deutsch bank as a part of a
euros.
The foreign exchange market intervention by the Central Bank to basis) is the difference rate (usually expressed single
between the spot and on a yearly
maintain a desirable or appropriate rate of exchange is inevitable
InFx swap, two different forward rates.
under the 'managed float' exchange rate regime. By doing so it tries time periods are
to achieve the objectives of its intervention as stated above. as leg 1and leg 2. involved - they are referred
Since the adoption of managed float in 1990, the RBI has intervened Leg1 is the initial date. The first
in foreign exchange market whenever necessary to check the spot rate. The parties swap
leg is a transaction at a
amounts of the same value prevailing
volatility in the external value of the rupee. Since 2011, till date respective currencies at the spot
exchange rate has depreciated from 60 to 75. The rupee also initial date. rate - that is exchange in their
rate at the
appreciated frequently, though marginally, during this period.
Whenever the change is in a wide range, the RBI has sold US $ t J- Dominic
Salvatore : International
check the volatility. Edition (Reprint 2021), P. 415. -
Economics Trade and Finance,
Eleventh

j
 136 International Economics (T.Y.B.A.: SE^
Leg 2 is the maturity date. It is the transaction at the pre-deterny
-
Exchange Rate II
forward rate at maturity. The parties swap amounts again,
each party receives the currency if loaned and returns the curr
So'?cd 5. Reserve position (tranche) with
contributed in gold. - 25% of the quota
it borrowed . The following chart explains the transaction. Special Drawing Rights (SDRs)
6.

Party A ] Party A Need for Forex

/ r
Spot Currency A
Forward 1. It is the first line of defence in
Currency A Rate Currency g case of economic
Rate economic slowdown. emergency or
[ Party B | | Party tT 2. Helps stabilise foreign
exchange rate.
3. Promotes international
Fig. 13-1 : Transaction of Currencies confidence in promoting
trade and foreign investment.
international
Fx swaps are useful for borrowing amounts without taking provides good
Outa
cross-border loan. It also eliminates foreign exchange risk by lo^
4. international image or strength.
in the forward rate, making the future payment known. 5. Buffer against foreign
exchange volatility.
In India, the RBI conducts sell/ buy swap, for dollar ($) billions to Forex is built up by the surplus
halt the depreciation/appreciation of the Rupee. are usually in the form of trade inflow of foreign exchange.
other type of inflow of surplus, foreign They
unilateral receipts.
foreign investment or
assets/ currencies in the any
13.3 COMPONENTS form
India had forex reserves of
RESERVES ranks 4th in the world in $ 642.453 billion in September
terms of forex reserves. 2021. It
Foreign exchange reserves (Forex) is regarded as the BOX 13.1
of a country. health meter
The components of forex are : Special Drawing
Rights (SDR)
The SDR is an
Foreign exchange assets - They are mainly in
foreign currencies, to supplementinternational reserve asset created
the by
not money in the official reserves of its member IMF in 1969
the standard currencies such as i
USA dollars ($), British pound
(£), euro (€) and yen (¥). goods and classical sense, as they countries. It is
cannot
2. Gold reserves reserve assetservices. It is called "paper
like gold. The gold"
be used to buy
as it performs as
IMF sets the value currency code for
3. Bonds of selected governments has no physical of XDR in terms of US SDR is XDR. The
such as USA and EU.
to member form. It is only a book dollars every day. It
4. Deposits of foreign commercial countries on the basis of entry. SDRs are
banks. its original quota. allocated ।
'
138 International Economics (T.Y.B.A.: 139

Till August 2, 2021, a total of SDR 660.7 billion, equivalenT? REVIEW QUESTIONS
about US $ 943 billion have been allocated.
gxpla*n meaning ar|d operation of managed flexible exchange rate.
The value of the SDR is based on a basket of five currencies - 1.
the
US Dollar, the Euro, the Chinese renminbi, the Japanese yen an j Why does monetary authority intervene to manage the exchange rate ?
2.
British pound sterling. The SDR basket is reviewed every fjVc 3.
Explain meaning and operation of foreign exchange swap.
years. The next review is delayed to July 31, 2022. The new basket 4. What are the components of foreign exchange reserves ? Why does a
country require forex ?
will become effective on August 1, 2022.
The SDR is neither a currency nor a claim on IMF. It is a potential OBJECTIVE QUESTIONS
claim on the freely useable currencies of IMF members. SDRs
can be exchanged for members' currencies.
A Choose the correct option and rewrite the statement :
Participating members and prescribed holders can buy and sell . Many IMF members opted for managed flexible exchange rate after
SDRs in the voluntary market. Besides the participating (a) 1973 (b) 1990
members, IMF has the authority to prescribe other institutions (c) 2008
or organisations (institutions that perform the functions of the 2 In sterilised intervention, the central bank of a country neutralises the
central bank for more than one member). As of end January, impact of changes in exchange rate on domestic money supply through
2021, there were15 organisations approved as prescribed holders' (a) monetary measures
(b) surplus budget
An IMF member country (with SDR facility) that requires foreign
(c) increasing budgetary deficit
currency may sell its SDRs to another member country in
3 Forex swap is undertaken by executing spot and forward transactions
exchange for their currency. To sell SDRs, a country must find a
(a) independently (b) simultaneously
willing party to buy them. The IMF acts as an intermediary in
their voluntary exchange. (c) both (a) and (b)
4. Swap operation avoids
The IMF has the authority under the designation mechanism to (a) exchange rate volatility (b) profit
ask member countries with strong foreign exchange reserves to (c) risk
purchase XDR from those with weak reserves. The XDRs can be 5. Which of the following is not a part of forex reserves ?
exchanged only for standard currencies, that is US dollars, euros, (a) Gold (b) SDRs
Japanese yen, UK pounds. Interest is paid to the members that (c) Deposits in the world bank
have sold XDRs. - - - - -
Ans.: (1) (a), (2) (a), (3) (b), (4) (c), (5) (c)
A member country will receive interest on SDRs acquired over
and above its quota. Similarly a member has to pay interest if its
SDRs are less than the allotted quota. This happens when a
member uses its SDRs to acquire foreign exchange against SDRs.
 141

I ^asthe
Vs Foreign Trade
Fo^nnAid & Marshall plan after World War II. During the time of
,

C^reign aid in the form of money, food and medicine.

may be
jisaster' was ajso extended to promote trade by building trade
Eoreign SUch as infrastructure, training and so on. Aid to
of foreign aid to the
FOREIGN AID VS related ^solute poverty is a common feature
14 FOREIGN TRADE
OF FOREIGN AID
14.2 TYPES
in the form of different sources or types. They may be :
Aid may be
: Aid from one country to another.
14.1 Meaning 1. Bilateral Bank, Asian
: International institutions like World
14.2 Types of Foreign Aid Multilateral
2. Development Bank, collect resources from donor or member
14.3 Case for Foreign Aid extend the aid to other needy countries.
countries and
Case Against Foreign Aid
in the form of donations or charity, as
14.4 is
Voluntary Aid : It is
14.5 Foreign Trade during covid-19.
the case of aid given
14.6 Case for Foreign Trade with conditions. For example a donor
Aid : Aid given
14.7 Case Against Foreign Trade 4 Tied may link the aid to promote its own export to aid
country
14.8 Conclusion receiving country.
given to undertake projects in the areas of
: Aid
5. Project Aid education and health care.
infrastructure,
machinery,
Military Aid : It may in the form of military
14.1 MEANING 6. associated requirements.
equipment and other
out that China's aid to Pakistan, Sri Lanka
7. Political : It is pointed
Foreign aid is the voluntary transfer of resources from one country
in the South-East Asian region is politically
and other countries
to another. It may be in the form of loans, grants, donations, goods receiving countries will remain
and services. Foreign aid given in currency may be a soft aid that is, motivated, with the aim that aid become a super power
It also has an agenda to
in the home currency of the recipient or hard aid, that is, in foreign indebted to it. like India. Aid extended by USA
exchange such as dollars, euro, etc. It may take any form of assistance and dominate other countries
has political interest or agenda. As, Mr. Henry
which one country voluntarily gives to the other. Foreign aid may to Pakistan of USA put it, "America
Foreign Secretary
be to promote economic development, to meet the challenges of Kissinger, former or permanent enemies but
natural calamity or disaster like covid-19. It may be conditional or does not have permanent
friends
unconditional. It may be to rebuild war-devastated economies as permanent interest".
 142 International Economics (T.Y.B.A ‘ Trade
SEfy Aid Vs Foreign
Foreign aid would enable the public authorities
14.3 CASE FOR FOREIGN AID requirements.
countries to supply these public goods.
of the poor
Developing
correct disequilibrium in balance of payment: to promote
All the countries are not equally endowed with natural To goods and services
The advanced and rich countries are fortunate to have resources 6 need to improve many
countries development. They include capital goods, technology,
resources hence more income and higher standard of living.more economic inputs, whereas their exports are not in much
rest of the world, comparatively have less resources, thus suffer The intermediate to imports
a few exceptions. This leads exchange
from demand with
poverty, unemployment and other related problems. It is exports, creating a gap (deficit) in foreign
therefore
argued that the rich should help the poor on the following grounds. outstripping Foreign bridge the gap
aid helps
receipts and payments.
1. Moral obligation : Many of the rich countries were : The world is increasingly reeling under
colonial Natural calamities which manifests in the form of floods,
masters of many Asian, African and Latin American 7 problems
countries.
It is further pointed out that they exploited the colonies and environmental Besides there are earthquakes in many countries
drought, etc. heavy suffering. Diseases like malaria, dengue
left them poor. For example cases like England and India and in suffering
other British colonies, France and some of the African countries which result of the type of covid-19, bring a lot of beyond
and so on. Hence, it is the moral obligation of the erstwhile and the pandemic
human lives. Poor
countries may find it
resources, to
and loss of and physical
master to compensate the earlier colonies. in terms of human
their capacity, the rich countries becomes almost
Foreign aid from
2. To bridge resource gap : Development requires investment. In tackle them.the
money terms there should be enough savings to invest for using essential in context.
the natural resources. Unfortunately the poor countries have AID
FOREIGN
14.4 CASE AGAINST
low income hence less saving and less investment. These
countries suffer from vicious circle of poverty. Foreign aid is
of huge
required to break this vicious circle. including India are recipients
Many developing
countries however, have not been upto
results,
foreign aid. The below.
3. To eradicate poverty and unemployment : Foreign aid is
required to invest in industries and agriculture, thereby create
amounts Hence there is case against foreign aid as stated
of
the mark. requires many
more employment, provide income and reduce poverty, absorbing capacity : Investment labour force,
specially absolute poverty. 1. Limited in the form of
trained
complimentary inputs facilities and so on.Such
infrastructure
4. Aid to promote trade : International trade requires industry related
services,
Joseph Stilitz1 are particularly small.
to
infrastructure facilities and trained personnel. Aid is required capacities, according aid received may not
use: Foreign
to overcome these constraints. may be used
2. Wasteful and unproductive
and for the right purposes. It
the recipient
5. To provide public goods : In the poor countries, due to market be used productively of the government of
buildings,
failure, public goods in the form of education, health care, roads, political agenda administrative
to meet types of and
street lights, parks and so on is in very limited supply. In other country. Huge and palatial worship, huge monuments
words, market would not provide the above mentioned public structures/ places of
religious
goods as they require more investment with hardly any profit.
It is therefore the responsibility of the government to meet these Laureate, 2001
American Economist, Nobel
L Joseph Stiglitz :
 J45
Vs ForeignTrade
144 International Economics (T.Y.B.A.:
SEM^I) foreign Aid statement and initiated many measures
the above
so on. It has been remarked that, "India has Rolls argeed with the situation.At the ground level or what is called
administration on a bullock cart economy". In most ROyCe
of to improvecorruption', however, is not any better.
developing countries the feudal nature of the economic the the 'retail uncorrupt
political system continues even under democracy, and of aid depends on its
huge amounts of unproductive expenditure.
involving The effectivenessMost of the aid receiving countries
are not
implementation. quality.
Donors may exploit the poor countries : Aid given by knownfor this positive
3. other
countries or international institutions may come with conditions
TRADE
14.5 FOREIGN
which may be unfavourable to the recipient countries. When
aid comes in the form of Foreign Direct Investment (FDI) by
the multinational companies, they may not adhere to the local the export and import of goods and services
refers to some neo¬
conditions such as environmental safety, labour laws and so Foreign tradecountries. Classical economists and alsoits
the out benefits.
on. It may lead to intra-industry trade between the industries between economist argued for free trade pointing have comparative
established by the investor company with the unfavourable classical that the developing countries
considered whereas advanced countries
conditions to the host countries. They primary goods They
advantage in producing in producing manufactures.
4. To gain political influence : Donor countries may have a hidden the comparative advantageas a market for the manufactures of
have developing countries suppliers of
political agenda to pursue while granting aid. USA's aid to found the countries and the developing countries asWorld Trade
Pakistan and China's aid to its neighbouring countries are the advanced specially the raw1995, materials.
examples in this context. primary goods, in in place of erstwhile
Organisation (WTO)
established of liberal
5. Develops psychology of dependency : A country receiving aid on tariffs and trade also a promoter
General Agreement
most of the time may continue to depend on that country rather
than putting efforts to become self sufficient without aid. It is trade.
pointed out, such countries are likely to develop the psychology
of dependency. As the saying goes, it is more appropriate "not 14,6 CASE FOR
FOREIGN TRADE
give a poor man fish to eat but rather teach him how to catch free trade. We must
fish". out for and against It is liberal
Arguments are pointed form, hardly existed.
that free trade in its true trade.
6. Misuse of the aid for political purpose : Countries ruled by understand is usually termed as free
dictators or autocrats may use the aid to further their own trade which 11 - Please refer these
political agenda. Aid to Pakistan from USA is cited as an (Chapter 1, 10 and advantages of
In the earlier chapters and
the importance trade. They are:
example in this regard.
chapters), we have discussed or a case for
the arguments
7. Corruption : Corruption is a historical and world wide trade. We list below and development.
phenomenon. India usually ranks among the highly corrupt It promotes growth
countries. It's rank, in the case of doing business, though 1. Engine of growth - output.
market for surplus
improved, is not yet upto the mark.
2.L Vent for surplus -
Provides
saving and investment,
more
Former Prime Minister Late Mr. Rajiv Gandhi stated that out increases
of one rupee spent by 3. Promotes innovations, economic welfare.
the government only 15 paise of the
ne it reaches the beneficiary. production and enhances
The present government too
 147
246
4.
International Economics (T.Y.B.A.:
Increases efficiency in production, promotes
competiti()n
Foreigrowth
^A^VsForeiresulted
has^lTrnde
dualism
in a dual-economy. Another negative effect
where people engaged in export sector
enables international transfer of technology. is the socialpaid, enjoyed better living and provide better
Creative destruction, that is, outdated technology and
are better to their children. Foreign capital, technology and
5.
of production will be discarded and replaced by new methods
education are confined to the export sector and nospread effect
and more dynamic methods of production.
technology know-how
rest of the economy.
to the
and HansSinger
in Terms of Trade: Raul Prebish
6. New and dynamic enterprises will enter the market with
their /ji)Deterioration the
and their
terms of trade of developing countries Singer
positive contribution. had studied which are popularly known as ’Prebish
conclusions that the less developed countries suffer from
Thesis’ statein terms of trade. Though there is no definite trend
14.7 CASE AGAINST FOREIGN TRADE deteriorationterms of trade, they fluctuate and very often turn
of adverse developing countries. Some of the important reasons
Trade does not benefit all the participants equally. While the against the for the unfavourable terms of trade are :
put forward
advanced countries benefit, the poor/ developing countries face a
Elasticity of Demand : The demand of developing
number of constraints thereby reducing the benefits. (a) Low as income
exports has a low price as well
countries' prices do not induce the advanced countries
Developing countries are not benefiting from the trade as pointed elasticity. Low in
out by classical and other economists who support the free/ liberal more of poor countries goods. An increase
to purchase countries also does not increase
trade. income of the advanced Availability of
countries exports.
Adverse effects of trade on developing countries are pointed out by their demand for poor and the very nature of goods
many economists, as stated below. numerousbysubstitutes
developing countries are the major causes
exported the
Failure of Engine of Growth : The free trade proponents and then- for the weak demand. have
supporters believed strongly in the doctrine of international trade Substitutes : Advanced countries
acting as an engine of growth, The critics, however, had doubts in (b) Use of Synthetic and developing substitutes for
in discovering
succeeded of poor
the positive effects of trade on developing countries. The cotton and many other such exports price.
rubber, jute,
in demand as well
as
comparative advantage theory being a static theory, its contribution leading to decline
to economic development - which is a dynamic process - was countries Technological
doubtful. Even if the effects are applicable to a dynamic situation, in Raw Material Content : has
(c) Decline production of manufacturers
they need not be positive. Ragnar Nurkse, Gunnar Myrdal, Raul improvement in the material content. Better economic
raw
resulted in reduced also brought down input-requirement
Prebish, Hans Singer, Jagdish N. Bhagwati are some of the leading
economist who had pointed out the failure of the engine in use of raw material
promoting economic growth of less developing countries via of these items in the
production.
international trade. Their main arguments are : : The development process
Goods their
(d) Need for Capital poor countries has increased
(i) Lopsided Growth : Ragnar Nurkse argued that trade has led initiated by almost all the and capital goods. Prices of these
to the growth of export sector i.e. minerals, raw materials and
demand for manufactures increased due to increase in
other exportable commercial crops but the rest of the economy
goods have
continuously
remained backward and underdeveloped. Such lopsided
 148 International Economics (T. Y.B.A.: Trade
demand and higher cost of production. SEM-V/) foreign^‘d Vs Foreign
and social dualism widens the inequality of income
increase in wages has prevented the prices of Continuous Economic
the country.
from declining inspite of technological these goods within
improvement. immiserizing Growth : Trade may promote growth through
(e) Balance of Payment Problem : Prof. Hicks points /v) effects A country's production possibility frontier
its 'spread
the developing countries being in balance of out that
payment
' may be shifted outward due to tapping and utilisation of new
of better technology, all of which are due to the
problem try to restore the equilibrium
by accepting resources, use
of trade. Inspite of the advantages and growth
unfavourable terms of trade. Poor countries try to the expansion
more by offering their exports at a lower price. earn achieved, a country may not be better off if it experiences
The
trade. gain in the form of growth is lost
(0 Protectionism : It is not only the commodity terms of
adverse terms ofterms of trade - a situation which economist
trad due to adverse
expressed in price ratios are not favourable but the Bhagwati calls 'Immiserizing Growth'.
terms of trade are also not in favour of developing
income J. N.
countries. In commodities both primary and some non¬ have seen the case for as well as against international trade.
We of the world trade takes place between the advanced
primary where the developing countries have a clear Major portion
and they have certainly benefited out of it. The developing
comparative advantage and thus the cost and price countries trade is faced with numerous problems. Their export are
advantage, they could not turn the income terms of trade countries
increasing at a rate which is sufficient to provide the required
in their favour. Their export earnings could not increase not to accelerate the growth. The actual gain for the poor
•big push' As
even at a lower price due to numerous Non Tariff Barriers
from the trade has become a debatable proposition.
(NTBs) imposed by the advanced countries. Though the countries has net positive benefits it is better to have trade than
tariffs have been lowered substantially under GATT long as trade trade and their effects on growth have
at all. The gains of
(W.T.O.), the loopholes or exemption provided by the not have it for more liberal trade. The
GATT (W.T.O.) have enabled rich countries protect the
encouraged the W.T.O. to negotiateraised a serious question about
world economic situation has
very industries in which the developing countries had or current willingness of the developed countries to throw open
have been acquiring comparative advantage. Historically the ability and
liberal trade.
it is evident that advanced countries have been strong their borders for free or
supporters of free trade only when it suits them.
(iii) Cultural impoverishment : Due to the domination of the poor 14.8 CONCLUSION
countries by the advanced countries, craftsmen in the
trade and foreign aid have the capacity to improve
developing countries could not continue their profession of skill Both foreign It is not so much the
intensive crafts against the capital intensive large scale of poor economies.
economic conditions foreign aid but the quality and effective
production of similar items. Most of them have become vs
arguments of foreign trade two channels. Advanced countries,
industrial or agricultural labourers and those who could not, use of resources from theseOrganisation of Economic Co-operation
became jobless. Gunnar Myrdal terms such a situation as specially the members of the promised to grant aid upto 0.7
have
cultural impoverishment. and Development (OECD) the aid, less than 0.4 percent of
(iv) Widening Inequality : Trade not only widens the development percent of their GDP but extended
gap and therefore the income gap between the countries but their GDP.
within the country also it accentuates the income inequality.
 151
i§0 International Economics (T.Yb a Foreign Trade
• ct
Aid Vs
It should be kept in mind that foreign aid cannot correct n eradicate absolute poverty
-
wrongs that is - social, economic and political that exist ‘ the all the above country to
recipient countries. A country's economic development
depends upon its own people, their sincere participation and suit
ulti^ 5.
may help the recipient
m
A’d end on unproductive investment
(a) sp on luxurious administrative infrastructure
planning. Trade and aid support compliment the proces^
economic development but cannot supplant the recipient count5
°f
C
spend on political agenda
ries
sincere and genuine efforts. all the above
form international trade are
Benefits
6. without obligation to all the citizens
REVIEW QUESTIONS zb\
M distributed equally
distrivu^-

1. Explain the meaning and types of foreign aid.

£Developing
both (a) and (b)
countries may not benefit from international
trade due to
7. z adverse terms of trade
Discuss the case for and against foreign aid.
2.
3. Analyse the case for and against foreign trade. $' high elasticity of demand
for their exports

<a>' w <a>
4. Write short notes on :
(a) Types of foreign aid Ans.: (V - W'
m w - <«' ® - <d>' ®
(b) Case for foreign aid
(c) Case against foreign aid
(d) Argument for trade
(e) Case against foreign trade.

OBJECTIVE
— —
QUESTIONS ... -

A Choose the correct option and rewrite the statement :

1. Foreign aid may be in the forms of
(a) money (b) goods and services
(c) technology (d) all the above
2. Multilateral aid comes from
(a) a rich country (b) international institutions
(c) aid for multiple projects
3. Colonial masters have a obligation to offer aid to their erstwhile
colonies.
(a) political (b) moral
(c) economical
Aid helps the poor countries to
(a) bridge saving-investment
(resource) gap
(b) finance deficit in balance of
payment deficit
 152
(FDI) & Multinational Corporations (MNCs) 153
Dtr ct Investment
•
foreW
A FOREIGN DIRECT INVESTMENT (FDI)
FOREIGN DIRECT
15 INVESTMENT (FDI)
AND
15'! introduction
ital inflows thatoffinance
any country's deficit can take several
capital inflows include bond finance, bank
^Different types
MULTINATIONAL forms-
Ho
fending, foreign direct investment and foreign
investment. In this chapter we consider foreign direct
CORPORATIONS fnvestment (FDI).
(MNCs)
15.2 THE CONCEPT
Direct Investment (FDI) occurs when a firm based in one
Foreign or a factory in a second country or
country builds a new plant
that it
an existing one. The central element of FDI is thus,
A. FOREIGN DIRECT INVESTMENT (FDI) purchases of capital, skills, knowledge, etc.; and
consists of a package
15.1 Introduction tends to be industry specific.
15.2 The Concept investments are real investments in factories, capital goods,
Direct both capital and management are
15.3 The Motivation land, and inventories where
involved, and the investor retains control
over the use of the invested
15.4 The Role and Merits
In fact, a distinguishing feature of FDI is the exercise of
capital. enterprise located in one country
decision making in an
15.5 Demerits (Cost) control over
B. MULTINATIONAL CORPORATIONS (MNCs) by investors located in another.
forms :
15.6 Introduction FDI can take any one of the following
owned by foreign residents starts a subsidiary
15.7 Definition (i) A firm largely
15.8 Role/ Advantages firm or factory located domestically,
expands a subsidiary
15.9 Disadvantages (ii) A firm largely owned by foreign residents
firm or factory located domestically,
 154 International Economics
(T.Y.B.A.;
residents takes SE^ Vj)
(1 1)1) ^Multinational
* «,m largely owned by foreign Ihrcct Itivcslmcnl orpora lions (MN(
X
(
H domestic firm by purchasing a majority control '
o 155

of the
st^' THE MOTIVATION
FDl thus includes cross border mergers and
acquisitions.
sum up the structure or types of
— -■

We may accordmg^y
imalv
because the investing enterprise has some advantage.
the following diagram in r g FDl h0Ws .
in
cnl occurs technology or management, which it wishes to
„prhaps exploit
foreign markets, or
perhaps in technology or management, which
Ei
.. wishes to exploit in foreign markets, or perhaps some disadvantage
to eliminate.
it wishes
industry specific. Industry specific investments take
ppi is typically
two important forms: horizontal and vertical integration.
wish to integrate horizontally by opening new
Large corporations
in various parts of the world. This is often done in a
subsidiariesway: one or several existing competing firms in the host
predatory
country are simply bought up by a large international rival. In the
process competition is often reduced.
Vertical integration is also a strong motive for direct investment.
For example, there are few companies that refine and fabricate
Fig. 15.1 : Types of FDl copper. It is not surprising that they have sought control over copper
mines by vertically integrating backwards in the production process.
Source: UNCTAD (2000) Thus, one obvious reason for vertical integration is a desire to reduce
Although direct investments may be made by individuals or risk.
partnerships, most FDl is undertaken by enterprises, and the larger Historically, firms have engaged in FDl to achieve one or more of
part of that by multinational enterprises/corporations,1 could the following objectives:
not
come into existence without there having been FDl in the first place.
However, their importance is as major providers of FDl, often using (i) To obtain control of a needed raw material and thus ensure an
capital which has been raised in the capital markets of the country unlimited supply at the lowest possible cost. Firms have
in which they are investing rather than in the capital market invested across national borders to gain access to national
of their
home country. resources. For example, U.S. oil companies have invested
heavily in Middle Eastern countries, because they hold a large
Foreign direct investments are usually undertaken by MNCs engaged proportion of the world's petroleum reserves.
in manufacturing, resource extraction or
services. Direct investments
are now as important as portfolio (ii) Avoid tariffs and other restrictions that nations impose on
investments as channels or forms
of international private capital
flows. imports. Firms invest across borders to gain secure access to
foreign markets. In many cases tariff and non-tariff barriers
make it difficult for firms to export into important markets. By

Corporations or TNCs^ C°rPorat'ons' a^so known as Transnational

 International Economics (T.Y.b a . c
***** Direct Investment (FDI) & Multinational
__ Corporations (MNCs) 157
investing inside the country, firms can jump over such b • —
and produce and sell in the local market. Forexample j5 4 THE ROLE and merits
1980s and 1990s Japanese automobile MNCs such as
Nissan and Honda, built production facilities in the U SQ°ta' . makers and academi« contend that foreign direct
response to VERs (Voluntary Export Restraints) that li in nV P^(FDI)
automobile imports into the U.S. Vestment
1
untry’5 development
can have important positive
effort. In addition to
effects on a host
the direct capital
rnancing it supplies,
FDI can be a source of valuable technology
(iii) Many large corporations (usually in monopolistic a a while fostering linkages with local firms, which can
oligopolistic markets) often have some unique producti nd know-how
help jumpstart an economy. Based on these arguments,
knowledge or managerial skill that could easily and profitably
utilised abroad and over which the corporation wants to retain
kJ •Idustrialised and developing countries have offered incentives to
direct control. This involves horizontal integration, or the
^courage foreign direct investments in their economies.

production of a differentiate product that is also produced in Though there are several merits to FDI, there remains a basic
the home country of the MNC. question often unanswered question. Namely, why the residents of
from other countries and themselves
one country do not borrow
(iv) MNCs make cross border investments to improve the efficiency make real investments in
their own country rather than accept direct
of their operations. These types of investments account for a investments from other countries. After all the residents of a country
substantial and rapidly increasing share of cross border may be more familiar with local conditions, and thus be at a
investment. competitive advantage with respect to foreign investors. The
(v) To take advantage of various government subsidies to encourage
answers to this question account for the role, and thus the benefits
FDI. or merits of FDI.
(i) FW provides capitai. FDI brings a bundle of resources to the host
(vi) To enter a foreign oligopolistic market so as to share in the profits. country that can make a positive contribution to the host
(vii) To pu rchase a promising foreign Jinn to avoid its future competition country's welfare by facilitating higher investment to achieve
and possible loss in export markets. growth targets. The foreign investor also bears the risk of
investment.
(viii) To eani higher returns due to higher growth rates abroad, and more
favourable tax treatment, and/or greater availability of (ii) FDI removes Balance of Paymen ts constrain ts. The inflow of foreign
infrastructure. exchange resources removes the constraints of foreign exchange
resources.
(ix) To diversify risks.
(iii) FDI can transfer savings from one country to another.
(x) Only large foreign MNCs can obtain the necessary financing to
enter the market. (iv) FDI does not raise the host country's external indebtedness, because
MNCs invest by creating domestic affiliates. Of the many ways
(xi) If transportation costs are sufficiently high then they may make in which savings can be transferred from one country to another,
the expansion of production in domestic plants (of the MNC) FDI may be the most stable and least burdensome for the
and the export of that increased production less profitable. recipient countries. FDI does not create liabilities of loans which
corporations or the government have to repay.
 158 International Economics (T.Y.B.A.:
SEm u, inve9ttnent & Multinational Corporations
,(Vx MNCs transfer technology to host countries. Since foreign Direct (MNCs) 159
Seible assets that are often based to specialised
MNCs conlrol1 A 7 External benefits: It is often argued that MNCs confer
benefits
e investments they make in host countries can often knowled on the host country such as training the local labour in more
Ms knowledge being transferred to indigenous firms.
lead8,' sophisticated techniques or demonstrating the gains that can
^hnoloKy transfers can generate significant positive Such be made by different management practices. Such benefits can
^th
X wider implications for development. Positive externality
externalities
when economic actors in the host country that are
be labelled as external if they are costless to those learning them,
and become available and usable in the rest of the economy.
diXtlv involved in the transfer of technology from an MNCnot
to
,
(X Consumers benefit from increased choice and better quality of
services.
Qoods and
a teal affiliate also benefit from this transaction.
(vi) MNCs transfer managerial and marketing expertise to ho (xiii) FDI also promotes higher wages. Relatively skilled jobs receive
countries. Greater experience at managing large firms allow wages.
higher
MNC personnel to organise production and coordinate the
activities of multiple enterprises more efficiently than host
country managers. This knowledge is applied to the host 15>5 DEMERITS (COSTS)
country affiliates, allowing them to operate more efficiently as
well. Indigenous managers in these affiliates learn these The special merits of FDI and particularly the kinds of incentives
management practices and can then apply them to indigenous offered to foreign firms in practice have begun to be questioned.
firms. In this way managerial expertise is transferred from the Fuelling this debate is that empirical evidence for FDI generating
MNC to the host country. positive spillovers for host countries is ambiguous at both the micro
and macro levels.
(vii) MNCs can enable host country producers to gain access to
marketing networks. When direct investments are made as part (i) While FDI brings a bundle of resources into host countries,
of a global production strategy, local affiliates of the MNC and foreign ownership means that there is no guarantee that these
the domestic firms that supply these affiliates become integrated resources will be used in a way that the host country considers
into a global marketing chain. This opens up export advantageous; or that the resources will be used in a manner
opportunities that are otherwise unavailable to indigenous consistent with the host countries economic objectives.
producers. (ii) Foreign managers retain control over;
(viii) Governments gain from the revenue earned from the taxation of (a) how much capital and technology is actually transferred
profits of foreign-owned companies. to the host country,
(ix) FDI provides increased employment. Employment is created (b) how the resources they bring will be combined with local
through direct employment opportunities and also through inputs, and
backward and forward linkages.
(x) FDI generates a competitive environment in the host country. (c) how the revenues generated by the local affiliate will be
Domestic enterprises are compelled to compete with the foreign used.
corporates and in their efficiency and quality of products and (iii) Foreign control can diminish the contribution that FDI makes
services. to the host country economy and lead to resource allocations
 International Economics (T.Y b
160 a & Multinational Corporations (MNCs)
^irect Invesbnent 161
that are substantially different from the economic ac "
the host country government.
gench
of retain control over
to host
its technology, but then transfer this
country
technology firms. The transfer of managerial
expertise may be limited also,
(iv) Managerial decisions made in reference to the MNC n because MNCs are often reluctant
objectives can reduce the contribution that FDI makes s host-country residents into top-level
t0 hire managerial
the
host country. MNC decisions can reduce rather than inc° positions.
the amount of funds available to investment in the host
Such practices reduce the availability of local funds to fin
cou^^ , H) MNCs decisions about how to use the revenues generated by
may bear no
ance their affiliates relationship to the host country
new projects. For instance; government'scare
economic objectives. In a world in which
little about the type of economic activity that
governments within
(a) MNCs sometimes borrow on the host country Capit their
market instead of bringing capital from their home country is conducted borders, this would be of little
When they do that, MNC investment crowds out domestic
consequence. But when governments use a wide variety of
investment, that is, by using scarce domestic savings, policy instruments to try to promote certain types of economic
the activity, whether this is manufacturing in a developing country
MNC prevents domestic firms and individuals from
making investments. or high technology industries in an advanced industrialised
country, foreign control of these revenues can pose serious
(b) MNCs also often earn rents on their products and repatriate obstacles to government policy.
most of their earnings.
(viii) If the revenues generated by the local affiliate are sufficient to
(c) In addition, MNCs usually charge the host country affiliate finance additional investment, decisions about whether this
licensing fees or royalties for the technology that is being investment will be made in the host country or somewhere else,
transferred, and these fees represent a transfer of funds and if in the host country then in which sector, are made by the
from the host country to the MNC. MNC rather than by the government. In short, MNC control
over the resources generated by their affiliates makes it difficult
(v) MNCs often require the local affiliate to purchase inputs from for governments to channel resources toward the economic
other subsidiaries of the same corporation. These internal activities they are trying to encourage.
transactions take place at prices that are determined by the MNC
(ix) One aspect of control is that the MNC may require then-
parent, a practice known as transfer pricing. Since these
subsidiaries to operate policies which are inefficient and/or
transactions are internal to the MNC, the parent can set the
cause distortions in local markets. For example, policies which
prices at whatever level best suits its global strategy. When the
place restrictions on exports to avoid competition from other
parent overcharges an affiliate for the goods it imports from
subsidiaries in other countries.
affiliates based in other countries and under-prices the same
affiliates exports, revenues are transferred from the local affiliate (x) MNCs may suppress R&D within the subsidiary so that research
to the MNC parent. is concentrated in the home country of the MNC.
(vi) MNCs also tightly control technology and managerial positions, (xi) Given their international status and ability to shift taxable
in some cases limiting the transfer of both. One of the principal income, MNCs often circumvent national domestic policies. For
reasons for MNC investment arises from the desire to maintain example, their ability to avoid restrictions on credit or on foreign
control over intangible assets. Given that it is hard to understand
why an MNC would make a large fixed investment in order to
exchange transactions by transferring money internally.
 International Economics (T.Y.B.A
762
.
_
MNCmavy also lobby the government of the host
(xii) An MN
(o pursue policies favourable cou
• sr*,

forflX"
mNCs are
(FD,) Corporation,(MNCs)
now officially designated by the United Nations as
163

•°teSs to the
Thus, political and economic exploitation MN/'
occur. J^nsnational corporations" or TNCs.

ma’or Amer'can, Japanese or West

yearly a'1 Examples include Nike,a,?,
Wal-Mart,
gutopean. Coca-Cola, PepsiCo, Procter and AOL, Toshiba, Honda
Gamble, IBM, etc.
and BMW,
of foreign investments could have limited effect 15.8 ROLE/ ADVANTAGES OF MNCS/ TNCS
growth inan economy. "The gradge against what in
S
fhis'Tbility town as the ‘enclave’ type of development, is duehas
of primary products from mines, wells and
to i Direct employment. The 100 largest TNCs provided
Stations to slip out of a country without leaving much ofa
trace in the rest of the economy.
’
employment to 14 3 million persons at home and abroad.
Though this represents only around 3 per cent of the world's
labour force, employment in TNCs accounts for nearly 10 per
cent of the world's employees.
B. MULTINATIONAL CORPORATIONS (MNCS) 7 Indirect employment: TNCs also contribute indirectly to
employment generation in developing countries through
backward linkages such as the purchasing of raw materials,
parts and components from sub-contractors and external
15.6 INTRODUCTION suppliers.
3. FDI: The top 100 TNCs control about one-third of the world
Multinational Corporations or MNCs have been playing a dominant foreign direct investment (FDI). More than 40 per cent of MNCs
role globally and have been integrating the world economy. assets are located outside their home countries. MNCs provide
However, their role and contribution to the process of growth and investment that does not have to be financed by local savings,
development of less developed regions are of controversial. MNCs which can be used for building other assets in the country .
have therefore evoked passions of an extreme nationalistic variety
across the political spectrum. 4. Technology: MNC capital brings with it up-to-date technology
which should be hard to develop domestically or even transfer
to home-owned firms. Besides the technology may not be
15.7 DEFINITION commercially available.
5. Higher income: MNCs provide higher paying jobs than might
A multinational corporation is a corporation that has its facilities be available to local inhabitants and thus raise the standard of
and other assets in at least one country other than its home country.
living.
Such companies have offices and/ or factories in different countries
and usually have a centralized head office where they co-ordinate 6. Foreign networking and access to foreign markets: MNCs
global management. Very large multinationals have budgets that enable foreign networking by linking the local economy with
exceed those of many small countries. the world economy in ways that would be hard to accomplish
by firms of purely local origin.