Importance of foreign currency in times of global growth

When goods are traded across borders, the selling and the buying firms usually pay or receive among in a currency of their choice. Not only firms but also governments borrow foreign currency internationally. When such trade or borrowings take place, a number of currencies are at play. For this complicated process to work out smoothly there exists a market which enables the participants to buy or sell currencies in a manner that they can convert the outflows and inflows into the currency of their choice. In other words, Foreign Exchange is a means of exchanging two currencies of two different countries at a rate determined by these very market forces. At present, the foreign currency market is a market valued at over 5 trillion per day, making it the biggest market in the world, in terms of liquidity.

With more than 40 per cent of transactions taking place in the capital London itself, the United Kingdom in 2019 had by far the largest Over the Counter (OTC) foreign exchange market. The average daily turnover was an approximate 3.6 trillion US dollars. A bulk of this was through numerous kinds of foreign exchange derivatives. Meanwhile currency swaps were the most common foreign exchange instrument traded. Standard spot transactions, where two currencies are exchanged at an agreed price within two days and without a contact, only accounted for 1.1 trillion US dollars of the total average daily turnover.

What is the Foreign Exchange Market?

The Foreign Exchange Market is global and trading of currencies takes place all over the world. Also known as the forex market, this is the market where exchange rates are determined. Exchange rates are the mechanisms by which world currencies are tied together in the global marketplace, providing the price of one currency in terms of another. There are basically two ways of trading currencies bilaterally over the counter and electronically, and an exchange rate is a price, specifically the relative price of two currencies.

An exchange rate is another price in the economy. When exchange rates are priced, the denominator refers specifically to one unit of a currency. Although the exchange rate is just a price, it is an important one. The exchange rate plays a crucial role in the economy since it has a direct impact on imports, exports, & cross-border investments. However, the exchange rate also has an indirect impact on certain economic variables, such as the domestic prices of goods and services or wages in a country.

Just like in other markets, the price of a currency is determined by demand and supply. The exchange rate of a particular country is determined by the interaction of the demand for this currency and the corresponding supply of the foreign currency.

Currency markets are the largest of all financial markets in the world. A typical transaction in USD is about 10 million. In the triennial survey conducted by the Bank of International Settlements (BIS) in April 2019, it was estimated that the average daily volume of trading on the foreign exchange market -spot, forward, and swap- was close to USD 6.6 trillion –a 29% increase, compared to April 2013, see Exhibit I.1 below. The daily average volume is about ten times the daily volume of all the world’s equity markets and sixty times the U.S. daily GDP. The exchange market’s daily turnover is also equal to 40% of the combined reserves of all central banks of IMF member states.

Why is Foreign Exchange needed?

We live in the age of globalization. We live in a world where many goods and services are exchanged across various countries and continents, and all of this happens for money. This money takes the form of a particular currency. But one currency is different in value to another currency, as currencies differ from country to country. This is why foreign currency plays an important role in international trade and business. In the absence of foreign currency, the world would have no means to determine the value of goods and services which are imported or exported by countries all over the world. Without this exchange of goods and services, the possibility to trade, much of today’s capitalist processes would come to a standstill. Businesses which rely on resources of other countries would be in trouble. There would also be critical issues for travelers to purchase or sell while in a foreign country.

What are currency fluctuations?

Currency fluctuations are a natural result of most major economies’ use of variable exchange rates. Exchange rates are influenced by a variety of factors, such as a country’s economic performance, inflation expectations, interest rate differentials, capital flows, and so on. The strength or weakness of the underlying economy usually determines the exchange rate of a currency. As such, a currency’s value can fluctuate from one moment to the next.

Risks in foreign exchange markets

The biggest risk is exchange rate volatility, or excessive variations in the rate at which one currency is changed into another. If volatility is too high, it will cause instability in the foreign exchange market, affecting the value of individual institutions’ foreign currency assets and liabilities. In the foreign exchange market, derivative products such as swaps, options, and forwards are available to help reduce the risk of exchange rate volatility. The following are the different types of transactions that can be made in the foreign exchange market.

(i) Cash basis

Immediate delivery of purchases/sales of a foreign currency on the same day. (ii) Tom basis

Delivery of purchases/sales of a foreign currency the next business day.

(iii) Spot basis

Delivery of purchases/sales of a foreign currency within two business days.

(iv) Forward basis

Purchase/sale of a foreign currency at a price specified now with the delivery and settlement at some future date exceeding two business days.

Since 2001, Sri Lanka has had a floating exchange rate system, which allows the exchange rate to be adjusted independently according to market forces of demand and supply. However, there may be market interventions aimed at reducing excessive volatility in the currency rate. The CBSL prescribes maximum net open position (NOP) limits for LCBS and closely monitors the activities in the domestic foreign exchange market to ensure an orderly functioning of the market.

The danger that a domestic investor’s foreign currency holdings would lose purchasing power when converted back to the local currency is known as foreign exchange rate risk. How can we quantify the impact of exchange rate fluctuations on the pricing of international assets and liabilities? A simple mathematical relation links the rates of returns measured in the local currency of the foreign asset with those in the home country, or domestic, currency.

Impact on economy

Foreign capital tends to flow towards countries with stable currencies, strong governments, and active economies. To attract cash from overseas investors, a country requires a somewhat stable currency. Otherwise, the threat of currency depreciation-induced exchange rate losses may dissuade foreign investors.

Foreign direct investment (FDI), in which foreign investors buy, sell, and trade securities in the recipient market, and foreign portfolio investment, in which foreign investors buy, sell, and trade securities in the recipient market, are the two types of capital flows. For developing economies like China and India, FDI is a key source of funding.