Section II Inter-Bank Market and FOREX Dealing
Section III Trade Finance—Letters of Credit
Section IV Trade Finance—Financing Indian Exporters
Section V Foreign Currency Loan
Central banks do not deal with customers who have international banking requirements. Therefore, commercial banks have been authorized as dealers to undertake foreign exchange transactions. Since it would be extremely difficult for a person to search for an individual who has foreign currency for supply or sale, foreign exchange market has been developed by designating certain banks as authorized dealers (AD). Banks normally classify their international banking operations into the following two segments:
The transactions pertaining to the first segment are carried out through select branches of the bank that have foreign exchange facility. At the same time, banks trade with each other in different currencies in the inter-bank market in order to square-up their positions undertaken for their customers in branches. One has to get a clear idea about the basic terms used in the foreign exchange market, in order to understand the international banking operations.
Exchange rate is the price of one currency in terms of another. The rate varies from time to time depending upon the supply of and demand for foreign exchange (FOREX) in the inter-bank market, which is based on the transactions in the merchant segment. The exchange rate of a currency appreciates if the general demand for that currency at any moment exceeds the current supply. It is worth noting that the exchange rates of active currencies fluctuate every four seconds.
You would have come across the data on buying and selling exchange rates in newspapers and televisions. The selling rate is the rate at which the banks sell a foreign currency against the local currency. The buying rate is the rate at which banks buy a foreign currency against the local currency. The margin between the selling and buying rates constitutes the exchange profit for the bank.
Foreign exchange market can be defined as an over-the-counter market in which retail individuals, business firms and banks purchase and sell FOREX. The transactions include sale and purchase of currencies, demand drafts (DD), cheques, transfer of money from one country to another and can be through telegraphic transfer (TT), mail transfer (MT), etc. Banks form the cream in the market and quote the rates to the customers as ‘price makers’. The characteristic features of the FOREX market are as follows:
While undertaking transactions with their retail and corporate clients, banks use the following modes for inward/ outward FOREX remittances:
Types of Rates There are different types of exchange rates. These are briefly discussed as follows:
A specimen quotation from a bank would look like this1:
The authorized dealers (banks) have to apply the relevant rate depending on the nature of transactions. Some of them can be illustrated as follows:
TT-selling rate: For (1) outward remittance in foreign currency (TT, MT or DD), (2) cancellation of purchase, e.g., bill purchased earlier is returned unpaid, (3) a forward purchase contract cancelled and (4) import documents received directly by the importer.
Bill-selling rate: For transactions involving transfer of proceeds of import bills (except for [4] above). Even if proceeds of import bills are to be remitted in foreign currency by way of TT, MT or DD, the rate to be applied is the bill selling rate and not the TT-selling rate.
TT-buying rates: For (1) clean inward remittance (TT, MT or DD for which the cover amount has already been credited to NOSTRO account of the bank abroad), (2) conversion of proceeds of instruments sent on collection basis, (3) cancellation of earlier outward remittance (TT, MT or DD, etc.) and (4) cancellation of forward sale contract. Generally, if the NOSTRO account has been credited, the TT-buying rate is applied.
Bill-buying rate: For the purchase/discounting of export bills.
There are two ways of quoting exchange rates—direct and indirect.
The direct quotation method is used in most countries for dealings between banks and their customers. In the case of a forward transaction, the purchase or sale is agreed, but will take place at some time in the future, thereby fixing the rate for a future exchange of currencies.
A FOREX transaction is a contract to buy or sell a quantity of one currency in exchange for another at a specified time for delivery and settlement and at a specified price or rate of exchange. The FOREX market consist of FOREX dealing rooms within commercial banks where trading takes place by computer and telephone for their customers. Despite its lack of a physical centre, the FOREX market is still a market in the sense that it is a system for bringing buyers and sellers together and for supplying information about prices and trading activity to participants. The FOREX dealers responsible for setting the prices at which their banks will exchange currencies must have access to the latest prices in the market.
The important FOREX dealing centres in the world, each operating within a specified time zone, are in London, New York and Tokyo. Historically, London has been the major centre for FOREX trading. There are two types of FOREX transaction:
Banks buy and sell huge quantities of foreign currencies. They also accept currency deposits and lend in foreign currency. Banks are subjected to exposure if they sell more or less of a currency than they buy. Most of the FOREX deals are transacted between banks. This is partly to hedge their exposures to customer business. Banks, these days, maintain accounts in foreign currencies with different banks for international fund transfer and settlement (NOSTRO account). For example, Corporation Bank maintains NOSTRO account in US dollar with Bank of America and in GBP with Barclays Bank.
In the early days of the FOREX market, transactions were purely trade or investment-related and there was little dealing between banks operating in the FOREX markets. But now, the exchange rates in major currencies such as, dollar/yen, euro/dollar and sterling/dollar have become increasingly volatile as the volume of FOREX transactions has increased. With the advent of electronic trading mechanism, a bank can eliminate its exposure instantly with another bank and lock in a profit. In addition to trade-related transactions, there are speculative transactions in the forward market. These are outright gambles on future exchange rate movements, conducted by bank dealers, investment managers and brokers or by companies.
FOREX dealing room of a bank occupies an important place since the strategic international banking transactions are carried out by the ‘dealers’ engaged in trading of currencies. International banking division, particularly the officers designated as ‘dealers’ enter into positions—purely selling and buying FOREX—to minimize profit because of the fluctuations in exchange rates. The inter-bank market operates on a professional basis with the integrity of the dealers.
Dealing room is the nodal point for all the FOREX activity of a bank. Most of the banks classify the organizational structure of dealing room into three segments, which are as follows:
The front office, which forms the main hub of the operations, consists of the dealing room made up for inter-bank and corporate desks. While the inter-bank desk engages in management of exposures arising on account of transactions from branches by trading with other banks, the corporate desk quotes the exchange rates for merchant transactions emanating from branches. The mid-office shall be responsible for administration of the risk management policy of the bank. The bank office is responsible for a follow-up of every transaction entered into by the bank till it reaches its logical end, i.e., settlement of currencies. The bank office functions include maintenance of parallel exchange position, cross checking the deal entered into by dealers, settlement data and so on.
The FOREX dealing rooms of banks are connected through electronic network. The rate quotations are always available on the screen meant for trading currencies. A discussion between the dealers of different banks, sitting in Mumbai, London, Singapore and Dubai takes place and in the same way, an ‘Internet chat’ takes place between people sitting at different locations. The conversations would go something like this:
Bank A: | Hi Hi Bank A Here Spot USD/GBP please, 2,000 |
Bank B: | Hi there, 1.6945/53 |
Bank A: | OK at 45 yours 2,000 |
Bank B: | Agreed. I buy USD 2,000 at 1.6945 value spot My USD to my account with my New York City Where your GBP please |
Bank A: | My GBP to my account with my London Barclays Bi Bi |
Heavy responsibility rests on the FOREX dealers of a bank. The dealers meet before the work starts and arrive at tentative conclusions valid for the day. They are supposed to concentrate on the market rates by maintaining contacts with other banks.
When a dealer buys or sells foreign currency, the bank gets into a position and if the purchases are more than the sales in a given day, it is said to be in an overbought/long/plus position. If the sales are more than the purchases, it is said to be in an oversold/shot/minus position. That is, an excess of assets over liabilities is called an overbought position and excess of liabilities over assets results into a short/oversold position.
A FOREX transaction to buy or sell currency can be broadly categorized as a spot transaction or a forward transaction. A spot transaction is a contract to buy or sell a quantity of a foreign currency for immediate settlement or value. The exchange rate for such a transaction is known as spot rate.
There could also be cash and TOM-based dealings in the inter-bank market. The settlement date (value date) in the case of spot transaction would be on the second working day, that for cash on the same day and for TOM— the next day; and forward means any day beyond the spot.
Every forward contract has three main elements.
However, a spot transaction in the merchant segment of the FOREX market refers to conversion and remittance of money on the same day from one country to another. Anything beyond the spot is known as forward.
In the case of a forward transaction, the purchase or sale is agreed; but will take place at some time in the future, thereby fixing the rate for a future exchange of currencies.
Exchange rates are commonly quoted by banks as two-way rates—the bid price and the offer price.
USD/EUR 0.9670/0.9682
USD/GBP 0.7121/0.7126
However, sometimes, the financial press shows the mid-point (average) of the bid and offer rates. The bid rate is the price at which the bank will buy base currency from a customer. In the case mentioned above, a bank will buy 1 USD against 0.9670 euro and 0.7121 pound sterling, respectively. The difference between the bid price and the offer price is called the spread.
Premium and Discount A currency is said to be at a premium, when it is costlier for a forward value date. In the case of direct quotes, the premium is added to the spot rate for both buying and selling to arrive at the forward rate. A currency is said to be at a discount when it is cheaper for a forward value date.
Pips and the Big Figure Exchange rates are usually quoted up to five figures by banks. The first three digits of the quote are the big figure.
Example:
In the above case, 0.95 is known as ‘big’ and 67 is called as ‘pip’.
The dealers often assume that everyone knows what the big figure is in major currencies at the time. Deals are often conducted without any mention of the big figure; only the pips are quoted.
Cross Rate It is an expression of the value of one foreign currency versus another foreign currency, neither of which is a domestic currency. For example,
Then, USD/INR = 45.6251
Here, you are required to calculate EUR/INR rate based on the information given above. EUR/INR rate, in this case, is called as the cross rate.
Volatility The exchange rate fluctuation is referred to as volatility. The turnover signifies the volume of business transacted during this period. It can be seen from the chart that although turnover has been increasing, the volatility in exchange rates is high.
Banks in India were first permitted to undertake intra day trading in FOREX in 1976. In the early 1990s, the exchange rate was pegged to a basket of currencies, which can be considered as the first step towards current account convertibility. In August 1994, current account convertibility was permitted.
Under current account convertibility, residents of India can make or receive foreign currency payments related to export and import trade, sundry remittances and gain access to foreign currency for education, travel, medical treatment, gifts and so on. On the other hand, when investments and borrowings in foreign currency are also freely permitted at market determined exchange rates, it is called capital account convertibility. This essentially means that anyone can move freely from local to foreign currency and back. Residents of India are even now subject to capital controls, even though a gradual process of liberalization has been initiated.
Though the FOREX market has seen a substantial increase in average daily turnover from the 1990s, the market is dominated by spot transactions. This, coupled with the global financial turmoil of 2007, resulted in increased volatility.
The exchange traded currency futures platform in India has been setting global benchmarks since its introduction. Apart from India, Brazil is the only country where the currency futures market has exhibited more liquidity than the OTC currency market.
The players in the FOREX markets are the ADs, FOREX brokers and individuals/corporate firms.
A letter of credit (LC) is an instrument for settling trade payments and is an arrangement of making payment against documents. Under this arrangement, a bank, at the request of a customer, undertakes to pay a third party by a given date, according to agreed stipulations and against presentation of documents, the counter-value of goods or services shipped. An LC is a commitment on the bank’s part to place an agreed sum at the seller’s disposal on behalf of the buyer under precisely defined conditions. The importer knows that the negotiating bank will not effect payment to the seller unless and until the latter tenders the documents strictly in accordance with the terms of the LC. The seller is assured of getting payment as long as he presents the documents as per LC terms to the negotiating bank.
Box 15.1 introduces ICC, uniform customs and practice (UCP) and their connection to the LC.
As trade between nations rapidly increased in the early part of the 20th century, conflicting laws governing LC among countries acted as a major barrier to trade expansion. In 1933, members of the ICC created the first uniform customs and practice for documentary credits (UCPDC), a set of rules that brought uniformity to documentary LC.
About the ICC (www.iccwbo.org)
About the UCP
UCP plays a pivotal role in the world of international business and trade finance. It is a set of standardized rules that was first put together in 1933 to facilitate international trade transactions. The UCP has since then gone through seven versions. The current version, UCP 600, came into force in July 2007.
Since inception, the UCP has become the most successful private set of rules for trade ever developed. Now firmly established, the UCP remains an essential component in international trade. It establishes the conditions under which the majority of banks operate in documentary commercial credit transactions. The current version, UCP 600, has been officially endorsed by the UN commission on international trade law (UNCITRAL) in 2009. Where a credit is issued subject to UCP600, the credit will be interpreted in accordance with the entire set of 39 articles contained in UCP600.
About ‘documentary credits’—The letter of credit
A ‘documentary credit’—an agreed method of settlement in international trade—is one where the buyer’s bank pays the seller against presentation of ‘documents’, after ensuring compliance with conditions stipulated in the documentary credit.
A documentary credit is a conditional undertaking of payment given by a bank. It is a written conditional undertaking issued on behalf of the importer (applicant) by the issuing bank to the exporter of goods (beneficiary) to pay for the goods or services, provided the documents submitted conform strictly to the terms and conditions of the credit.
The advantages of settlement of payment through documentary credits accrue to both buyer and seller. The buyer is confident that payment will be made to the seller only if the documents strictly comply with the terms of credit as agreed to by the buyer and seller. The seller will ensure payment by complying with the terms and conditions of the credit.
Now the connection…
All documentary LC are subject to the provisions of UCP (currently UCP 600) issued by the ICC, wherever it is incorporated into the text of the credit as such. UCP600 does not automatically apply to a credit if the credit is silent as to which set of rules it is subjected to.
For example, a credit issued by SWIFT MT700 is not subject by default to the current UCP.
The different parties involved in an import transaction with a LC can be the following:
These and other relevant definitions can be found under Article 2 of UCP 600.
‘Incoterms’ can be expanded to international commercial terms. They are standard trade definitions most commonly used in international sales contracts.
ICC has updated the Incoterms rules six times since 1936, when the first version was introduced. ICC has introduced Incoterms 2010.
The scope of Incoterms rules is limited to matters relating to the rights and obligations of the parties to the contract of sale with respect to the delivery of goods sold, but excluding ‘intangibles’ like computer software.
Each Incoterms rule is referred to by a three-letter abbreviation. There are 13 Incoterms, which are given below. (The common abbreviation is followed by the expansion).
EXW (EX WORKS)
FCA (FREE CARRIER)
FAS (FREE ALONGSIDE SHIP)
FOB (FREE ON BOARD)
CFR (COST AND FREIGHT)
CIF (COST, INSURANCE AND FREIGHT)
CPT (CARRIAGE PAID TO)
CIP (CARRIAGE AND INSURANCE PAID TO)
DAF (DELIVERED AT FRONTIER)
DES (DELIVERED EX SHIP)
DEQ (DELIVERED EX QUAY)
DDU (DELIVERED DUTY UNPAID)
DDP (DELIVERED DUTY PAID)
Incoterms 2000 groups the above terms in four categories, denoted by the first letter of the three-letter abbreviations given above; for example, those abbreviations beginning with C are called the ‘C’ terms and so on. How are these terms helpful?
It can be seen that all terms list the buyers’ and sellers’ obligations. The listing helps the users to compare buyers’ and sellers’ respective obligations under each Incoterms rule. Subsequent revisions of Incoterms rules are adapted to contemporary commercial practice. The revisions also clearly indicate the loading and unloading requirements of both buyer and seller.
In order to illustrate, the explanation for the abbreviations seems to show a clear trend—the ‘D’ terms are the most risky to the seller or exporter, the ‘C’ terms, less risky and so on. Hence, in international trade, exporters would typically prefer refraining from dealing in trade terms that would hold the seller responsible for the import customs clearance and/ or payment of import customs duties and taxes and/or other costs and risks at the buyer’s end; for example, the trade terms DEQ (Delivered Ex Quay) and DDP (Delivered Duty Paid). This is understandable, since the charges and expenses at the buyer’s end may cost more to the seller than anticipated. The current revision of Incoterms rules specifies that under DEQ the buyer (and not the seller) is required to clear the goods for import and to pay for all formalities, duties, taxes and other charges upon import. This is a clear deviation from the previous stipulation under DEQ, which required the seller to arrange for import clearance.
Similarly, importers prefer not to deal in EXW (Ex Works) or FAS (Free Alongside Ship), which would hold the buyer responsible for the export customs clearance, payment of export customs charges and taxes, and other costs and risks at the seller’s end. The current revision stipulates that under FAS, the seller ( and not the buyer) is required to clear the goods for export.
Banks issue several types of LC to suit the need of their trading clients. The most common types are briefly introduced as follows:
Many banks may be reluctant to issue back to back LC due to the level of risk to which they are exposed, whereas a transferable credit will not expose them to risk higher than that under the original credit.
It is important to note that all parties in the LC transaction deal with ‘documents’ and not with ‘goods’.
Documentary collections under the LC may be carried out in two different ways:
The export credit scheme to finance exporters was introduced in 1967. It is intended to facilitate exports through providing working capital finance to exporters at internationally competitive interest rates. Banks are permitted to decide appropriate rates of interest based on the current guidelines, borrower’s creditworthiness, risk perception and market practices.3
Pre-Shipment Finance Pre-shipment credit is a short-term working capital finance provided by a bank to an exporter enabling the latter to procure raw materials, to process/manufacture the goods, arrange for transport and warehouse and for shipment of the finished goods. Pre-shipment credit is usually extended as packing credit (PC). It is also granted as advance against incentives receivable from the government, advance against duty drawback and advance against cheques/drafts received as an advance payment. The exporter can avail the PC either in rupees or in a foreign currency.
Normally, banks extend PC to exporters on production of either an LC or a confirmed order. A confirmed order is a purchase order issued by a reputed foreign buyer to the exporter, mentioning the terms of purchase, such as the price, quality, quantity, the date within which the shipment is to be effected and so on.
The following are the features of PCFC:
Post-shipment credit is defined as any loan or advance granted by a bank to an exporter of goods/services from the date of extending the credit after the shipment of goods/services to the date of realization of the export proceeds. It is a working capital finance extended against the evidence of a shipping document for the purpose of financing the export receivables. Post-shipment finance is extended in the following manner.
After making the shipment, the exporter presents to his bank the set of export documents, such as bill of lading/ airway bill, invoice, bill of exchange, insurance policy, certificate of origin, inspection certificate, packing list, etc. The bank then verifies the documents and confirms that the shipment of goods is as per the terms of LC/confirmed order. Thereafter, the bank negotiates the bill (if against LC) or purchases (sight bills without LC)/discounts (usance bills without LC). The bill is drawn in foreign currency and the proceeds credited in rupees, to the exporter’s account, after adjusting the PC outstanding against it.
Companies prefer to borrow money in a currency where interest rate is low. For example, many multinational corporations all over the world have borrowed in Japanese yen and other low interest rate currencies for a relatively long period.
Till October 1996, the commercial banks in India were permitted to give FCL to exporters only by way of granting PCFC. In 1996, the RBI permitted banks in India to use FCNR (B) funds to extend foreign currency denominated loans to their resident constituents (including non-exporters) for meeting their term loan needs too.
The following are the features of FCL:
Example: A customer takes FCL of USD 50,000 for 6 months, at 2 per cent interest, when USD–INR Rate is 1 USD = ₹45. If the rate becomes 1 USD = 50 INR on the due date, then the customer will have to pay an amount equivalent to the principal and the interest at the rate of ₹50. In order to hedge the exchange rate risk, banks permit the borrower to have forward contract booked for repayment of the FCL, especially in respect of non-exporters. So, the effective cost of FCL will be LIBOR + margin + forward premium.
How are these conditions and rules stipulated? The most widely accepted ‘rules’ for LC business across the world are those drafted by the International Chamber of Commerce (ICC).
Inter-Bank US $1 = 0.75 GBP
Exchange margin to be taken by the bank = 0.15%
Transit period: 15 days (from the date of financing to the date of realization of export bill)
Interest rate: 3% per annum on GBP