MBA BOOK international banking

International Banking

MBA Second Year
(International Business)
Paper No. 2.6

School of Distance Education

Bharathiar University, Coimbatore - 641 046


Authors: Dr M Ram Mohan Rao and G V S Sekhar
Copyright © 2008, Bharathiar University
All Rights Reserved
Produced and Printed
by
EXCEL BOOKS PRIVATE LIMITED
A-45, Naraina, Phase-I,
New Delhi-110028
for
SCHOOL OF DISTANCE EDUCATION
Bharathiar University
Coimbatore-641046


CONTENTS

Page No.

UNIT I
Lesson 1

International Monetary System

Lesson 2

Exchange Regimes

7
17
UNIT II

Lesson 3

Multinational Banking

25

Lesson 4

Eurocurrency Market

34

Lesson 5

Eurodollar Markets

44
UNIT III

Lesson 6

Multinationalisation of Banking

55

Lesson 7

Organisational Features of Multinational Banking

62

UNIT IV
Lesson 8

International Financing by Multinational Banks

73

Lesson 9

Letters of Credit

87
UNIT V

Lesson 10

International Network for Settlements

109

Lesson 11

International Financial Institutions

118

Model Question Paper

135


INTERNATIONAL BANKING
SYLLABUS
UNIT I
Introduction to International monetary system - International gold standard –fixed
exchange regime - Flexible Exchange regime – Present system in IMS.
UNIT II
Multinational banking: Introduction to Multinational Banking - the Eurodollar and
Euro currency Markets. Instruments of euro currency markets.
UNIT III
Multinational Banking: the multinationalisation of banking – organisational features of
multinational banking - Problems in Multinational Banking.
UNIT IV
International Financing by Multinational banks - Equity Financing - Bond Financing Bank Financing, Direct Loans, Parallel Loans. Unterwiting Facilities. Interest rates for
Money market Instruments. Letter of credits and its operations.
UNIT V
International networks for settlements - SWIFT - CHIPS-CHAPS-FEDFIRE.
International Financial Institutions - IMF-IBRD-IFC-IDA-MIGA-ADB-ACU.

5
International
Monetary System

UNIT 1

UNIT I


6
International Banking


7
International
Monetary System

LESSON

1
INTERNATIONAL MONETARY SYSTEM
CONTENTS
1.0

Aims and Objectives

1.1

Introduction

1.2

International Monetary System

1.3

System of Bretton Woods (1944-71)
1.3.1

Main Characteristics of Bretton Woods System

1.4

International Monetary System Since 1971

1.5

International Monetary Fund

1.6

International Bank for Reconstruction and Development

1.7

Late Bretton Woods System

1.8

Structural Changes Underpinning the Decline of International
Monetary Management

1.9

1.8.1

Return to Convertibility

1.8.2

Growth of International Currency Markets

1.8.3

Decline of U.S. Monetary Influence

"Floating" Bretton Woods (1968-72)

1.10

The "Nixon Shock"

1.11

The Gold Standard
1.11.1

Gold Specie Standard

1.11.2

Gold Bullion Standard

1.12

Let us Sum up

1.13

Lesson End Activity

1.14

Keywords

1.15

Questions for Discussion

1.16

Suggested Readings

1.0 AIMS AND OBJECTIVES
After studying this lesson, you should be able to understand:
z

The international monetary system and new forms of monetary interdependence

z

Growth of international currency market and gold standards

1.1 INTRODUCTION
International monetary system addresses itself to provide mechanisms to solve the
problems of liquidity and foreign exchange transactions. Since these cannot be solved
by any nation in isolation, it is desirable that all interacting nations agree to a certain
modus operandi to find solutions to common problems. Adequate finances are to be
arranged (particularly for less developed/developing countries) so that international
transactions take place smoothly. In the context of international trade, the problems


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International Banking

that crop up relate to: (i) liquidity, (ii) adjustment, and (iii) stability. Liquidity is
necessary to finance the transactions that are done on cash basis. Adjustment is
needed to bridge the gap that emanates because of imbalance between demand and
supply at existing exchange rates. Similarly, stability is necessary with intent to limit
the degree of uncertainty in international business decisions.

1.2 INTERNATIONAL MONETARY SYSTEM
Gold Exchange Standard was the first major step towards the establishment of an
international monetary system. This system was put into effect in 1850. The
participants were the UK, France, Germany and the USA. In this system, each
currency was linked to a weight of gold. The system was institutionalized at the
Conference of Genes in 1922. Since gold was convertible into currencies of the major
developed countries, central banks of different countries either held gold or the

currency of these developed countries.

1.3 SYSTEM OF BRETTON WOODS (1944-71)
The Bretton Woods system of monetary management established the rules for
commercial and financial relations among the world's major industrial states. The
Bretton Woods system was the first example of a fully negotiated monetary order
intended to govern monetary relations among independent nation-states. Preparing to
rebuild the international economic system as World War II was still raging, 730
delegates from all 44 Allied nations gathered at the Mount Washington Hotel in
Bretton Woods, New Hampshire for the United Nations Monetary and Financial
Conference. The delegates deliberated upon and signed the Bretton Woods
Agreements during the first three weeks of July 1944. In the year 1946, the
International Bank for Reconstruction and Development (IBRD) and the International
Monetary Fund (IMF) were established.

1.3.1 Main Characteristics of Bretton Woods System
z

Fixed rates in terms of gold (i.e. a system of gold standard), but only the US dollar
was convertible into gold as the USA ensured convertibility of dollars into gold at
international level.

z

A procedure for mutual international credits.

z

Creation of International Monetary Fund (IMF) to supervise and ensure smooth
functioning of the system. Countries were expected to pursue the economic and

monetary policies in a manner so that fluctuations of currency remained within a
permitted margin of + or - 1 per cent. That is, the central bank at every country
had to intervene to buy or sell foreign exchange, depending on the need.

z

Devaluations or reevaluations of more than 5 per cent had to be done with the
permission of the IMF. This measure was necessary to avoid chain & valuations
like the ones which occurred before the Second World War.
Check Your Progress 1
1. What do you understand by international gold exchange standard?
……………………………………………………………………………….
……………………………………………………………………………….
2. What is Bretton Woods System?
……………………………………………………………………………….
……………………………………………………………………………….


1.4 INTERNATIONAL MONETARY SYSTEM
SINCE 1971
On 15 August 1971, President Nixon of the USA suspended the system of
convertibility of gold and dollar. For some time, the system of fixed-rates with an
adjustment margin of + or –2.5 per cent was tried but did not work. Finally, the fixed
rate system was abandoned and the floating rate system came into effect. In December
1971, the Smithsonian Agreement was signed at Washington; its major features were:
z

devaluation of the dollar and revaluation of other currencies; gold passed from
$ 35 per ounce to $ 38;

z

new fluctuation margins: changing from ± 1 per cent to ± 2.25 per cent;

z

non-convertibility of the dollar.

In 1973, another devaluation of the dollar took place. Petrol shock added to the
international monetary crisis. Exchange rates became volatile.
In 1976, Jamaica Agreements were signed focusing on the:
z

Legalization of the floating exchange rate;

z

Demonetization of gold as the currency of reserves.

Thus, the part of quota which was hitherto required to be deposited in gold could be
deposited in foreign exchange. At the same time, the IMP sold one-third of its gold
reserves. In 1977 and 1978, in the wake of inflation in the USA, the dollar further
depreciated. The Federal Reserve practiced a strict monetary policy. Between 1980
and 1985, the dollar appreciated but at the same time the American BOP situation
deteriorated.

1.5 INTERNATIONAL MONETARY FUND
IMF was established on December 27, 1945, when the 29 participating countries at the
conference of Bretton Woods signed its Articles of Agreement, the IMF was to be the
keeper of the rules and the main instrument of public international management. The

Fund commenced its financial operations on March 1, 1947. IMF approval was
necessary for any change in exchange rates in excess of 10%. It advised countries on
policies affecting the monetary system.

1.6 INTERNATIONAL BANK FOR
RECONSTRUCTION AND DEVELOPMENT
The International Bank for Reconstruction and Development (IBRD) — now the most
important agency of the World Bank Group. The IBRD had an authorized
capitalization of $10 billion and was expected to make loans of its own funds to
underwrite private loans and to issue securities to raise new funds to make possible a
speedy postwar recovery. The IBRD was to be a specialized agency of the United
Nations charged with making loans for economic development purposes. In 1956, the
World Bank created the International Finance Corporation and in 1960 it created the
International Development Association (IDA). Both have been controversial. Critics
of the IDA argue that it was designed to head off a broader based system headed by
the United Nations, and that the IDA lends without consideration for the effectiveness
of the program. Critics also point out that the pressure to keep developing economies
"open" has led to their having difficulties obtaining funds through ordinary channels,
and a continual cycle of asset buy up by foreign investors and capital flight by locals.
Defenders of the IDA pointed to its ability to make large loans for agricultural
programs which aided the "Green Revolution" of the 1960s, and its functioning to

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Monetary System


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stabilize and occasionally subsidize Third World governments, particularly in Latin
America.
Check Your Progress 2
Match the following:
1. Gold Exchange Standard

December 27, 1945

2. IMF

1946

3. International Bank for Reconstruction and Development

1960

4. International Development Association

1850

1.7 LATE BRETTON WOODS SYSTEM
After the end of World War II, the U.S. held $26 billion in gold reserves, of an
estimated total of $40 billion (approx 65%). As world trade increased rapidly through
the 1950s, the size of the gold base increased by only a few percent. In 1958, the U.S.
balance of payments swung negative. The first U.S. response to the crisis was in the
late 1950s when the Eisenhower administration placed import quotas on oil and other
restrictions on trade outflows. More drastic measures were proposed, but not acted on.
However, with a mounting recession that began in 1959, this response alone was not
sustainable. In 1960, with Kennedy's election, a decade-long effort to maintain the
Bretton Woods System at the $35/ounce price was begun. The design of the Bretton

Woods System was that nations could only enforce gold convertibility on the anchor
currency—the United States’ dollar. Gold convertibility enforcement was not
required, but instead, allowed. Nations could forgo converting dollars to gold, and
instead hold dollars. Rather than full convertibility, it provided a fixed price for sales
between central banks. However, there was still an open gold market, 80% of which
was traded through London, which issued a morning "gold fix," which was the price
of gold on the open market. For the Bretton Woods system to remain workable, it
would either have to alter the peg of the dollar to gold, or it would have to maintain
the free market price for gold near the $35 per ounce official price. The greater the
gap between free market gold prices and central bank gold prices, the greater the
temptation to deal with internal economic issues by buying gold at the Bretton Woods
price and selling it on the open market.
However, keeping the dollar was still more desirable than holding gold because of the
dollar's ability to earn interest. In 1960 Robert Triffin noticed that holding dollars was
more valuable than gold was because constant U.S. balance of payments deficits
helped to keep the system liquid and fuel economic growth. What would later come to
be known as Triffin's Dilemma was predicted when Triffin noted that if the U.S. failed
to keep running deficits the system would lose its liquidity, not be able to keep up
with the world's economic growth, and, thus, bring the system to a halt. But incurring
such payment deficits also meant that, over time, the deficits would erode confidence
in the dollar as the reserve currency created instability.
The first effort was the creation of the "London Gold Pool." The theory behind the
pool was that spikes in the free market price of gold, set by the "morning gold fix" in
London, could be controlled by having a pool of gold to sell on the open market that
would then be recovered when the price of gold dropped. Gold's price spiked in
response to events such as the Cuban Missile Crisis, and other smaller events, to as
high as $40/ounce. The Kennedy administration drafted a radical change of the tax
system in order to spur more productive capacity, and thus encourage exports. This
culminated with his tax cut program of 1963, designed to maintain the $35 peg.

Check Your Progress 3
Describe, in brief, the following:
1. Triffin’s dilemma
……………………………………………………………………………….
……………………………………………………………………………….
2. London Gold Pool
……………………………………………………………………………….
……………………………………………………………………………….

1.8 STRUCTURAL CHANGES UNDERPINNING THE
DECLINE OF INTERNATIONAL MONETARY
MANAGEMENT
1.8.1 Return to Convertibility
In the 1960s and 70s, important structural changes eventually led to the breakdown of
international monetary management. One change was the development of a high level
of monetary interdependence. The stage was set for monetary interdependence by the
return to convertibility of the Western European currencies at the end of 1958 and of
the Japanese yen in 1964. Convertibility facilitated the vast expansion of international
financial transactions, which deepened monetary interdependence.

1.8.2 Growth of International Currency Markets
Another aspect of the internationalization of banking has been the emergence of
international banking consortia. Since 1964 various banks had formed international
syndicates, and by 1971 over three quarters of the world's largest banks had become
shareholders in such syndicates. Multinational banks can and do make huge
international transfers of capital not only for investment purposes but also for hedging
and speculating against exchange rate fluctuations.
These new forms of monetary interdependence made possible huge capital flows.
During the Bretton Woods era countries were reluctant to alter exchange rates

formally even in cases of structural disequilibria. Because such changes had a direct
impact on certain domestic economic groups, they came to be seen as political risks
for leaders. As a result official exchange rates often became unrealistic in market
terms, providing a virtually risk-free temptation for speculators. They could move
from a weak to a strong currency hoping to reap profits when a revaluation occurred.
If, however, monetary authorities managed to avoid revaluation, they could return to
other currencies with no loss. The combination of risk-free speculation with the
availability of huge sums was highly destabilizing.

1.8.3. Decline of U.S. Monetary Influence
A second structural change that undermined monetary management was the decline of
U.S. hegemony. The U.S. was no longer the dominant economic power it had been for
more than two decades. By the mid-1960s, the E.E.C. and Japan had become
international economic powers in their own right. With total reserves exceeding those
of the U.S., with higher levels of growth and trade, and with per capita income
approaching that of the U.S., Europe and Japan were narrowing the gap between
themselves and the United States. The shift toward a more pluralistic distribution of
economic power led to increasing dissatisfaction with the privileged role of the U.S.

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dollar as the international currency. As in effect the world's central banker, the U.S.,
through its deficit, determined the level of international liquidity. In an increasingly
interdependent world, U.S. policy greatly influenced economic conditions in Europe

and Japan. In addition, as long as other countries were willing to hold dollars, the U.S.
could carry out massive foreign expenditures for political purposes—military
activities and foreign aid—without the threat of balance-of-payments constraints.
Dissatisfaction with the political implications of the dollar system was increased by
détente between the U.S. and the Soviet Union. The Soviet threat had been an
important force in cementing the Western capitalist monetary system. The U.S.
political and security umbrella helped make American economic domination palatable
for Europe and Japan, which had been economically exhausted by the war. As gross
domestic production grew in European countries, trade grew. When common security
tensions lessened, this loosened the transatlantic dependence on defense concerns, and
allowed latent economic tensions to surface.

1.9 "FLOATING" BRETTON WOODS (1968-72)
By 1968, the attempt to defend the dollar at a fixed peg of $35/ounce, the policy of the
Eisenhower, Kennedy and Johnson administrations, had become increasingly
untenable. Gold outflows from the U.S. accelerated, and despite gaining assurances
from Germany and other nations to hold gold, the profligate fiscal spending of the
Johnson administration had transformed the "dollar shortage" of the 1940s and 1950s
into a dollar glut by the 1960s. In 1967, the IMF agreed in Rio de Janeiro to replace
the tranche division set up in 1946. Special Drawing Rights were set as equal to one
U.S. dollar, but were not usable for transactions other than between banks and the
IMF. Nations were required to accept holding Special Drawing Rights (SDRs) equal
to three times their allotment, and interest would be charged, or credited, to each
nation based on their SDR holding. The original interest rate was 1.5%.
The intent of the SDR system was to prevent nations from buying pegged gold and
selling it at the higher free market price, and give nations a reason to hold dollars by
crediting interest, at the same time setting a clear limit to the amount of dollars which
could be held. The essential conflict was that the American role as military defender
of the capitalist world's economic system was recognized, but not given a specific
monetary value. In effect, other nations "purchased" American defense policy by

taking a loss in holding dollars. They were only willing to do this as long as they
supported U.S. military policy, because of the Vietnam War and other unpopular
actions, the pro-U.S. consensus began to evaporate. The SDR agreement, in effect,
monetized the value of this relationship, but did not create a market for it.
The use of SDRs as "paper gold" seemed to offer a way to balance the system, turning
the IMF, rather than the U.S., into the world's central banker. The US tightened
controls over foreign investment and currency, including mandatory investment
controls in 1968. In 1970, U.S. President Richard Nixon lifted import quotas on oil in
an attempt to reduce energy costs; instead, however, this exacerbated dollar flight, and
created pressure from petro-dollars now linked to gas-euros resulting the 1963 energy
transition from coal to gas with the creation of the Dutch Gasunie. Still, the U.S.
continued to draw down reserves. In 1971 it had a reserve deficit of $56 Billion
dollars; as well, it had depleted most of its non-gold reserves and had only 22% gold
coverage of foreign reserves. In short, the dollar was tremendously overvalued with
respect to gold.


Check Your Progress 4
1. What do you understand by Special Drawing Rights (SDRs)?
……………………………………………………………………………….
……………………………………………………………………………….
2. What was the intent behind the creation of SDRs?
……………………………………………………………………………….
……………………………………………………………………………….

1.10 THE "NIXON SHOCK"
By the early 1970s, as the Vietnam War accelerated inflation, the United States as a
whole began running a trade deficit (for the first time in the twentieth century). The
crucial turning point was 1970, which saw U.S. gold coverage deteriorate from 55%
to 22%. This, in the view of neoclassical economists, represented the point where

holders of the dollar had lost faith in the ability of the U.S. to cut budget and trade
deficits. In 1971 more and more dollars were being printed in Washington, then being
pumped overseas, to pay for government expenditure on the military and social
programs. In the first six months of 1971, assets for $22 billion fled the U.S. In
response, on August 15, 1971, Nixon unilaterally imposed 90-day wage and price
controls, a 10% import surcharge, and most importantly "closed the gold window,"
making the dollar inconvertible to gold directly, except on the open market.
Unusually, this decision was made without consulting members of the international
monetary system or even his own State Department, and was soon dubbed the "Nixon
Shock".
The surcharge was dropped in December 1971 as part of a general revaluation of
major currencies, which were henceforth allowed 2.25% devaluations from the agreed
exchange rate. But even the more flexible official rates could not be defended against
the speculators. By March 1976, all the major currencies were floating—in other
words, exchange rates were no longer the principal method used by governments to
administer monetary policy.

1.11 THE GOLD STANDARD
The development of the foreign exchange market in its present form can be traced
back to around the mid- 1850s. Around that time, bimetallism (using gold and silver)
gradually gave way to monetary system using gold alone. The history of the foreign
exchange market was a story that virtually ran parallel to the history of the US
currency. The US dollar was established in April 1792 under the Mint Act of the US.
Its supremacy in international finance can be traced to the post- Great Depression days
and the introduction of the fixed foreign exchange rate system. It was at that the US
dollar was set to be made freely convertible to gold at the fixed rate of $35 to a troy
ounce. The main characteristic of the Gold Standard was that it was based on the
system of fixed exchange rates, exchange rates parities being set against gold as the
reference value. Two main types operated under the Gold standard are Gold Specie
Standard and the Gold Bullion Standard.

1.11.1 Gold Specie Standard
For the Gold specie standard to work efficiently, four main conditions had to be
operating. They are as follows:
1. The central bank of the country concerned had to back the currency, promising to
buy or sell the metal in unrestricted amount at the price fixed;

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International Banking

2. Extending this reasoning, a person who possessed gold could approach the state
mint and have the right to have coin struck from gold, whatever the amount;
3. By the same reasoning, he could also melt the gold as and when he wished to
do so;
4. Gold could be freely imported and exported.
Under the arrangement described above, the face value of gold and the value of the
coins struck were thus always the same. Obviously, the supply of gold determined the
liquidity and consequently its value.

1.11.2 Gold Bullion Standard
Under this the metal was not the medium of exchange. Rather, the medium of
exchange (coin or currency) was backed by gold as the reserve asset. A country thus
could have more money in circulation than the actual quantity of gold that it held in
the state mint to with the central bank. Depending on the credibility of the currency in
circulation, the monetary authorities could print more paper currency than the amount

of gold held as physical asset or currency equivalent.

1.12 LET US SUM UP
Over the period, the international monetary system has undergone a significant
evolution. The Bretton Woods system put into effect in 1944 has had to be abandoned.
Subsequently, the monetary role of gold has, been reduced, which is no longer used as
a means of settlement with the IMF. The far reaching changes that took place in East
Europe at the end of 1980s have led to the creation of several new currencies. Besides,
adoption of the system of market economy by a large majority of countries the world
over has had important repercussions on the international financial scene.

1.13 LESSON END ACTIVITY
Go through the recent developments in the international currency market and position
of Dollar in terms of other currencies.

1.14 KEYWORDS
ADB: Asian Development Bank.
Balance of Trade: The difference between the value of exports and import of
merchandise.
Blocked Currency: A currency that is not convertible/transferable across the broader
due to exchange control.
IBRD: International Bank of Reconstruction and Development.
IMF: International Monetary Fund.

1.15 QUESTIONS FOR DISCUSSION
1. Recapitulate the historic developments which led to floating exchange rate
system.
2. What do you know about gold standard? Why did it fail?
3. How did the US / position of the balance of payments influence the whole
International monetary system under the Bretton Woods system?

4. How does exchange rate stability affect international trade?
5. Is a floating rate system more inflationary than a fixed rate system?


6. What is the difference between devaluation and depreciation?
7. Write an essay on International Monetary System.

Check Your Progress: Model Answers
CYP 1
1. Gold Exchange Standard was the first major step towards the establishment
of an international monetary system. This system was put into effect in
1850. The participants were the UK, France, Germany and the USA. In this
system, each currency was linked to a weight of gold. The system was
institutionalized at the Conference of Genes in 1922. Since gold was
convertible into currencies of the major developed countries, central banks
of different countries either held gold or the currency of these developed
countries.
2. Bretton Woods system was the first example of a fully negotiated monetary
order intended to govern monetary relations among independent
nation-states.
CYP 2
1. 1850
2. December 27, 1945
3. 1946
4. 1850
CYP 3
1. In 1960 Robert Triffin noticed that holding dollars was more valuable than
gold was because constant U.S. balance of payments deficits helped to keep
the system liquid and fuel economic growth. What would later come to be
known as Triffin's Dilemma was predicted when Triffin noted that if the

U.S. failed to keep running deficits the system would lose its liquidity, not
be able to keep up with the world's economic growth, and, thus, bring the
system to a halt. But incurring such payment deficits also meant that, over
time, the deficits would erode confidence in the dollar as the reserve
currency created instability.
2. The theory behind the pool was that spikes in the free market price of gold,
set by the "morning gold fix" in London, could be controlled by having a
pool of gold to sell on the open market that would then be recovered when
the price of gold dropped.
CYP 4
1. In 1967, the IMF agreed in Rio de Janeiro to replace the tranche division
set up in 1946. Special Drawing Rights were set as equal to one U.S. dollar,
but were not usable for transactions other than between banks and the IMF.
Nations were required to accept holding Special Drawing Rights (SDRs)
equal to three times their allotment, and interest would be charged, or
credited, to each nation based on their SDR holding. The original interest
rate was 1.5%.
2. The intent of the SDR system was to prevent nations from buying pegged
gold and selling it at the higher free market price, and give nations a reason
to hold dollars by crediting interest, at the same time setting a clear limit to
the amount of dollars which could be held.

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Monetary System


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International Banking

1.16 SUGGESTED READINGS
C. Jeevanadam, Foreign Exchange Management.
International Finance, Levi
Ian H. Giddy, Global Financial Markets.
Rupnaryan Bose, Fundamentals of International Banking, Macmillan India Ltd.
Vyuptakesh Sharan, International Financial Management, Prentice Hall of India.
ICFAI University Press, International Banking.
B.K. Chauduri, O. P. Agrarwal, A Textbook of Foreign Trade and Foreign Exchange,
Himalaya Publishing House.


17
Exchange Regimes

LESSON

2
EXCHANGE REGIMES
CONTENTS
2.0

Aims and Objectives

2.1

Introduction

2.2

Types of Regimes

2.2.1 Float

2.3

2.2.2

Pegged float

2.2.3

Fixed

Regime of Fixed Exchange Rates
2.3.1 Advantages and Disadvantages of the Fixed Rate System

2.4

Regime of Floating Exchange Rates
2.4.1 Advantages and Disadvantages of the Floating Rate System

2.5

Maintaining a Fixed Exchange Rate

2.6

Let us Sum up

2.7

Lesson End Activity

2.8

Keywords

2.9

Questions for Discussion

2.10

Suggested Readings

2.0 AIMS AND OBJECTIVES
After studying this lesson, you should be able to understand:
z

The different types of exchange rates and their significance

z

Significance of the exchange rates

2.1 INTRODUCTION
The exchange rate regime is the way a country manages its currency in respect to
foreign currencies and the foreign exchange market. It is closely related to monetary
policy and the two are generally dependent on many of the same factors. The basic
types are a floating exchange rate, where the market dictates the movements of the
exchange rate, a pegged float, where the central bank keeps the rate from deviating

too far from a target band or value, and the fixed exchange rate, which ties the
currency to another currency, mostly more widespread currencies such as the U.S.
dollar or the euro.
The IMF classifies exchange rate regimes in four categories:
z
regime of fixed exchange rates;
z
regime of free floating exchange rates;
z
regime of managed floating rates;
z
regime of limited flexibility.


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2.2 TYPES OF REGIMES
2.2.1 Float
Floating rates are the most common exchange rate regime today. For example, the
dollar, euro, yen, and British pound all float. However, since central banks frequently
intervene to avoid excessive appreciation/depreciation, these regimes are often called
managed float or a dirty float.

2.2.2 Pegged float
Here, the currency is pegged to some band or value, either fixed or periodically
adjusted. Pegged floats are:
z

Crawling bands: The rate is allowed to fluctuate in a band around a central value,

which is adjusted periodically. This is done at a preannounced rate or in a
controlled way following economic indicators.

z

Crawling pegs: Here, the rate itself is fixed, and adjusted as above.

z

Pegged with horizontal bands: The currency is allowed to fluctuate in a fixed
band (bigger than 1%) around a central rate.

2.2.3 Fixed
Fixed rates are those that have direct convertibility towards another currency. In case
of a separate currency, also known as a currency board arrangement, the domestic
currency is backed one to one by foreign reserves. A pegged currency with very small
bands (<1%) and countries that have adopted another country's currency and
abandoned its own also fall under this category. Mai, a foretold economist from
France would disagree to this statement, but many economists will go on to prove that
he has misunderstood.
Fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange
rate regime wherein a currency's value is matched to the value of another single
currency or to a basket of other currencies, or to another measure of value, such as
gold. As the reference value rises and falls, so does the currency pegged to it. In
addition, fixed exchange rates deprive governments of the use of an independent
domestic monetary policy to achieve internal stability. A former president of the
Federal Reserve Bank of New York described fixed currencies as follows:
"Fixing the value of the domestic currency relative to that of a low-inflation
country is one approach central banks have used to pursue price stability. The
advantage of an exchange rate target is its clarity, which makes it easily

understood by the public. In practice, it obliges the central bank to limit
money creation to levels comparable to those of the country to whose
currency it is pegged. When credibly maintained, an exchange rate target can
lower inflation expectations to the level prevailing in the anchor country.
Experiences with fixed exchange rates, however, point to a number of
drawbacks. A country that fixes its exchange rate surrenders control of its
domestic monetary policy."
In certain situations, fixed exchange rates may be preferable for their greater stability.
For example, the Asian financial crisis was improved by the fixed exchange rate of the
Chinese renminbi, and the IMF and the World Bank now acknowledge that Malaysia's
adoption of a peg to the US dollar in the aftermath of the same crisis was highly
successful. Following the devastation of World War II, the Bretton Woods system
allowed Western Europe to have fixed exchange rates until 1970 with the US dollar.
Yet others argue that the fixed exchange rates (implemented well before the crisis)
had become so immovable that it had masked valuable information needed for a


market to function properly. That is, the currencies did not represent their true market
value. This masking of information created volatility which encouraged speculators to
"attack" the pegged currencies and as a response these countries attempt to defend
their currency rather than allow it to devalue. These economists also believe that had
these countries instituted floating exchange rates, as opposed to fixed exchange rates,
they may very well have avoided the volatility that caused the Asian financial crisis.
Countries like Malaysia adopted increased capital controls believing that the volatility
of capital was the result of technology and globalization, rather than fallacious
macroeconomic policies which resulted not in better stability and growth in the
aftermath of the crisis but sustained pain and stagnation.
Countries adopting a fixed exchange rate must exercise careful and strict adherence to
policy imperatives, and keep a degree of confidence of the capital markets in the
management of such a regime, or otherwise the peg can fail. Such was the case of

Argentina, where unchecked state spending and international economic shocks
disbalanced the system and ended up forcing an extremely damaging devaluation (see
Argentine Currency Board, Argentine economic crisis, and the Mexican peso crisis).
On the opposite extreme, China's fixed exchange rate with the US dollar until 2005
led to China's rapid accumulation of foreign reserves, placing an appreciating pressure
on the Chinese Yuan.
Check Your Progress 1
Define the following:
1. Pegged with horizontal bands.
……………………………………………………………………………….
……………………………………………………………………………….
2. Dirty float.
……………………………………………………………………………….
……………………………………………………………………………….
3. Fixed Exchange Rate.
……………………………………………………………………………….
……………………………………………………………………………….

2.3 REGIME OF FIXED EXCHANGE RATES
In this system, a currency is pegged to a foreign currency, with fixed parity. The rates
are maintained constant or they may fluctuate 'within a narrow range, when a currency
tends towards crossing over the limits, governments intervene to keep it within the
band. A country pegs its currency to the currency of the country in which the major
foreign transactions are carried out. Some countries peg their currencies to SDR. The
currencies to which many other currencies pegged are: US dollar (24 currencies),
French franc (14 currencies), SDR (4 currencies).

2.3.1 Advantages and Disadvantages of the Fixed Rate System
The major advantage of this system is that it provides stability to international trade.
Commercial transactions take place without any worry about exchange rate risk

problem. An exporter would know how much he is going to receive on the due date
and the importer would know how much he would be paying.

19
Exchange Regimes


20
International Banking

The disadvantage of the system is speculation. For example, a speculation anticipating
devaluation of the pound sterling will buy US dollars at fall so as to sell them when
devaluation of the pound takes place on a future date.

2.4 REGIME OF FLOATING EXCHANGE RATES
In the regime of floating exchange rates, adjustment takes place OJ the market as a
function of free play of demand and supply. Yet, sometime:
Table 2.1: Regime of Fixed Rates
Pegged to a single
currency
US dollar
Angola
Bannuda
Argentina
Bahamas
Belize

Pegged to a basket
French franc
Benin

Burkina Faso
Cameroon
Comores
Cote d'Ivire

Dijibouti
Dominican
Republic
Ethiopia

Gabon
Guinea
Mali
Niger

Granada

Central African
Republic

Iraq

Lesotho (South
African Rand)

Senegal
Chad
Togo

SDR

Libya
Myanmar
Rwanda
Seychelles
-

Other than SDR
Algeria
Bangladesh
Botswana
Burundi
Chypre

-

Fiji
Hungary
Solomon Island
Jordan
Kuwait

Namibia (South African
Rand)
Swaziland (South
African
Rand)

Liberia

Lithuania

Marshal Island
Micronesia
Nigeria
Oman
Panama
Saint-Kitts
Saint-Vincent
Saint-Lucie
Surinam
Syria
Yemen

Other currency
Azerbaijan
(Ruoble)
Bhutan
(Indian Rupee)
Estonia
(Deutschmark)
Kiribati
(Australian dollar)

Malta
Morocco

Mauritius
Nepal
New Papua
Guinea
Tanzania

Thailand
Tonga
Vanuatu
Zimbabwe

Source: Report of IMF, 1994.

2.4.1 Advantages and Disadvantages of the Floating Rate System
With this system, possibility of speculation is reduced because the central bank is not
responsible to ensure as to what future rate should be. A speculator is exposed to
greater risk, and therefore, will indulge in it less often. Further, the central bank of the
country is not required to maintain large reserves to defend the currency.
The disadvantage is that since one is not in a position to anticipate with any degree of
accuracy as to what is going to happen in future, a trader (exporter or importer) is
continuously exposed to a difficult situation of probable loss. An exporter is worried
about depreciation of the currency in which he would receive his amount whereas an


importer is concerned about appreciation of the currency in which his imports are
invoiced. As a result, one has to take recourse to different techniques of exchange rate
risk management.

2.5 MAINTAINING A FIXED EXCHANGE RATE
Typically, a government wanting to maintain a fixed exchange rate does so by either
buying or selling its own currency on the open market. This is one reason
governments maintain reserves of foreign currencies. If the exchange rate drifts too far
below the desired rate, the government buys its own currency off the market using its
reserves. This places greater demand on the market and pushes up the price of the
currency. If the exchange rate drifts too far above the desired rate, the opposite
measures are taken. Another, less used means of maintaining a fixed exchange rate is

by simply making it illegal to trade currency at any other rate. This is difficult to
enforce and often leads to a black market in foreign currency. Nonetheless, some
countries are highly successful at using this method due to government monopolies
over all money conversion.
Check Your Progress 2
Match the following:
1. Fixed rates

1944

2. floating exchange rates

direct convertible

3. Bretton Woods system

1945

4. World War II

free play of demand and supply

2.6 LET US SUM UP
This lesson focuses on interest rate regimes and their features. The exchange rate
regime is the way a country manages its currency in respect to foreign currencies and
the foreign exchange market. It is closely related to monetary policy and the two are
generally dependent on many of the same factors. The basic types are a floating
exchange rate, where the market dictates the movements of the exchange rate, a
pegged float, where the central bank keeps the rate from deviating too far from a
target band or value, and the fixed exchange rate, which ties the currency to another

currency, mostly more widespread currencies such as the U.S. dollar or the euro.

2.7 LESSON END ACTIVITY
Discuss the prevailing trends in exchange rates.

2.8 KEYWORDS
Ask-Rate: The selling rate of currency.
Bid-ask spread: Difference between buying and selling rates of a currency expressed
as a percentage.
Exchange Rate: Rate for transaction between one currency and other currency.
IMS: International Monetary System.

2.9 QUESTIONS FOR DISCUSSION
1. Explain the features of exchange rate regimes.
2. What are the advantages and disadvantages of fixed exchange rate regime?
3. What are the advantages and disadvantages of floating exchange rate regime?

21
Exchange Regimes


22
International Banking

Check Your Progress: Model Answers
CYP 1
1. The currency is allowed to fluctuate in a fixed band (bigger than 1%)
around a central rate.
2. Floating rates are the most common exchange rate regime today. For
example, the dollar, euro, yen, and British pound all float. However, since

central
banks
frequently
intervene
to
avoid
excessive
appreciation/depreciation, these regimes are often called managed float or a
dirty float.
3. Fixed exchange rate, sometimes called a pegged exchange rate, is a type of
exchange rate regime wherein a currency's value is matched to the value of
another single currency or to a basket of other currencies, or to another
measure of value, such as gold.
CYP 2
1. direct convertible
2. free play of demand and supply
3. 1944
4. 1945

2.10 SUGGESTED READINGS
C. Jeevanadam, Foreign Exchange Management.
Levi, International Finance.
Ian H. Giddy, Global Financial Markets.
Rupnaryan Bose, Fundamentals of International Banking, Macmillan India Ltd.
Vyuptakesh Sharan, International Financial Management, Prentice Hall of India.
ICFAI University Press, International Banking.
B.K. Chauduri, O. P. Agrarwal, A Textbook of Foreign Trade and Foreign Exchange,
Himalaya Publishing House.

23
Multinational Banking

UNIT 1

UNIT II


24
International Banking


25
Multinational Banking

LESSON

3
MULTINATIONAL BANKING
CONTENTS
3.0

Aims and Objectives

3.1

Introduction

3.2

The Payment Mechanism
3.2.1

Settlement Systems

3.2.2

Settlement System in UK

3.2.3

Settlement System in France

3.2.4

Settlement System in Switzerland

3.2.5

Japanese Settlement System

3.3

Let us Sum up

3.4

Lesson End Activity

3.5

Keywords

3.6

Questions for Discussion

3.7

Suggested Readings

3.0 AIMS AND OBJECTIVES
After studying this lesson, you should be able to understand:
z

The world banking system

z

Revolution in world's money and capital markets

3.1 INTRODUCTION
The words Multinational banking and Multinational Banking are used synonymously
in the academic world. The world economy has witnessed in recent years a
phenomenal growth in financial transactions, surpassing that of transactions on goods
and services. It has been estimated that transnational operations on financial assets are
ten to fifteen times those on goods and services. Financial flows are likely to continue
to grow at a faster pace than output. And the banking system happens to be at the
centre of this increase in financial transactions. It has in particular assumed a leading
role not only in the financing of trade, but also in relatively new areas such as the

financing of projects, companies and states.
The solidity of the world banking system depends on the solidity and stability of
national economies. Economic growth will naturally have a positive influence on the
performance of the banking system; conversely, recession and inflation would affect
this performance negatively. Since mid '80s cross-country financial flows have
become a considerable mainstay of the world economy. This situation owes much to
four major developments; First, changes in the regulatory environment. These
changes have permitted the opening-up of domestic markets to competition from