CHAPTER FIFTEEN

International Banking—Foreign Exchange and Trade Finance

CHAPTER STRUCTURE

Section I Basic Concepts

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

Chapter Summary

Test Your Understanding

KEY TAKEAWAYS FROM THE CHAPTER

• Learn the concept and terms pertaining to international banking.
• Understand the practical aspects of foreign exchange operations.
• Know the basics of exchange rates and foreign exchange markets in India.
• Understand basics of letters of credit.
• Understand various aspects of trade finance.

IntroductIon

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:

• When the dealing is between a bank and a merchant (could be importer, exporter, individuals).
• When the dealing is between banks (inter-bank segment). ‘Forex Dealing Room’ is a part of this segment.

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.

SECTION I

BASIc concEPtS

Exchange Rates

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.

FOREX Market

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:

• 24-hour open-market (inter-bank segment, because of the time difference between countries)
• World-wide market: No single location and no geographical constraint
• Large capital and trade flows

Transfer Systems

While undertaking transactions with their retail and corporate clients, banks use the following modes for inward/ outward FOREX remittances:

• Telegraphic transfer (TT): Banks transfer funds from one country to another by way of instructions through Telex. With the advent of software ‘SWIFT’ (Society for Worldwide Inter-bank Financial Telecommunication), most banks use SWIFT for international fund transfer. The payments are made the very next day by the banks.
• Mail transfer (MT): A mail transfer is an agreement between two banks in writing, to pay to the beneficiary the sum mentioned therein. This can be issued to the correspondent bank/branch abroad and normally being sent by post. MT is not as quick as TT, but it is a cheaper mode.
• Demand draft (DD): A foreign DD is a written order issued by a bank on another bank (correspondent) or its own branch in a different country.

Types of Rates There are different types of exchange rates. These are briefly discussed as follows:

1. TT (Buying)
2. TT (Selling)
3. Bill (Buying)
4. Bill (Selling)
5. Currency (Buying)
6. Currency (Selling)
7. Traveller’s Cheque (TC-Buying and Selling)

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.

Direct and Indirect Quotations

There are two ways of quoting exchange rates—direct and indirect.

• For direct quotation, the value of one unit of the foreign currency is expressed in terms of the domestic currency. For example, in the United States, the rate for the euro against dollar might be stated as $1.0571 per euro.
• For indirect quotation, a foreign currency’s value is expressed in terms of one unit of domestic currency. For example, in UK, the sterling/euro rate could be quoted as euro 1.4875 per one pound sterling.

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.

Functioning of Foreign Exchange Market

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:

• Trade transactions: This is a transaction between a bank and a non-bank customer where the customer wishes to buy or sell a quantity of currency to complete a trading transaction or occasionally, speculates for profit by anticipating future charges in the exchange rates.
• Inter-bank transactions: This is a transaction where two banks trade currencies between themselves.

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.

SECTION II

IntEr-BAnK mArKEt And forEX dEALInG

FOREX Dealing Room Operations

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:

1. Front office
2. Mid office
3. Bank office

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.

Spot, Forward, Cash, TOM Rates in an Inter-Bank Market

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.

• It is a binding agreement to buy or sell a specific quantity of one currency in exchange for another.
• The rate of exchange is fixed when the contract is made.
• The contract is for delivery of the currency, at an agreed future time, either a specific date or any time between two specific dates, depending on the contract terms.

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.

Bid and offer Rates

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.

Foreign Exchange Market

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.

SECTION III

trAdE fInAncE—LEttErS of crEdIt

Financing International Trade Through Letters of Credit

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.

The different parties involved in an import transaction with a LC can be the following:

• Applicant: Normally, an applicant is the buyer of the goods or the importer who approaches the bank for opening the LC.
• Issuing bank or opening bank: The bank which issues the LC, i.e., the bank which opens the LC and undertakes to make the payment.
• Beneficiary (Exporter): A beneficiary is the seller of the goods, who has to receive the payment from the applicant. An LC is issued in the seller’s favour in order to enable him or his agent to obtain payment on submission of the stipulated documents.
• Advising bank: An advising bank is one which advises the LC to the beneficiary, thereby assuring the genuineness of the LC. It is normally situated in the country/place of the beneficiary. The advising bank could also be the beneficiary’s bank.
• Confirming bank: A confirming bank is one which adds guarantee to the LC opened by another bank, thereby undertaking the responsibility of payment/negotiation/acceptance under the credit, in addition to that of the issuing bank. LC confirmation is not mandatory and is desirable in some cases where the parties and the banks are not internationally reputed. For example, sometimes, the seller abroad may not be aware of the standing of the LC opening bank and, hence, may ask for the credit to be guaranteed for payment by a bank in his own country against presentation of documents without recourse.
• Reimbursing bank: This is the bank which is authorized to honour the reimbursement claim in the settlement of negotiation/acceptance or payment lodged with it by the paying, negotiating or accepting bank. It is normally the bank with which the issuing bank has an account from which payment is to be made (NOSTRO account).

These and other relevant definitions can be found under Article 2 of UCP 600.

Flowchart Depicting a Typical Import Transaction with Letter of Credit

Types of LC

Banks issue several types of LC to suit the need of their trading clients. The most common types are briefly introduced as follows:

• Irrevocable LC: This is a basic form of LC, most commonly used in foreign trade. An irrevocable LC cannot be revoked or amended without the consent of all parties thereto. Under UCP, all LCs are deemed irrevocable.
• A confirmed LC is confirmed/guaranteed by a bank other than the issuing bank.
• An unconfirmed LC is one where the advising bank or another bank forwards the LC to the exporter without adding its own undertaking to make payment or accepting responsibility for payment on due date, but confirming the LC’s authenticity
• Revolving LC: Under the terms and conditions of a revolving LC, the amount under the revolving LC can revolve in relation to time or value. This type of LC provides for delivery of goods in installments and at intervals. Such a credit would stipulate certain ceiling amount in addition to the date of expiry.
• Deferred payment LC: This type of LC allows the issuing bank to make the payment to the beneficiary in installments. The timing and the amount of these installments are predetermined. The buyer accepts the documents and agrees to pay the issuing bank on a fixed maturity date. Thus, the buyer gets an extended period for payment.
• Transferable LC: In some cases, the seller or beneficiary may not be the actual producer of the goods. In such cases, the seller (exporter) may request the buyer (importer) to open a transferable irrevocable LC. On receipt of the same, he will instruct his bank to transfer the credit in favour of the actual third party supplier. The other features of this type of LC are (a) at the request of the (first) beneficiary, it may be made available in whole or in part to another (second) beneficiary and (b) a credit may be transferred in part to more than one second beneficiary.
• Back to back LC: This is a variant of the transferable LC. In this case, instead of transferring the original LC to the third party supplier, the exporter uses the LC as security to establish a second LC issued by the advising bank in favour of the third party supplier. In other words, when an inland LC is opened by a bank in the exporter’s country backed by the security of another LC (original LC by importer), it is known as ‘back to Back credit’. This is useful for merchant exporters.

  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.

• Anticipatory LC: It provides for payment to beneficiary at the preshipment stage. Under this type of LC, a ‘red clause’ LC (it is called so because the referred clause is normally incorporated in red ink) provides for payment up to processing and packing goods for shipment, while a ‘green clause’ LC provides for payment up to point of loading for shipment.
• Standby LC: We have seen the use of bank guarantees in the earlier chapters on bank lending. Standby LCs are used in lieu of bank guarantees in some countries, e.g., the USA. They are secondary payment mechanisms used as support where an alternate, less secure method of payment has been agreed upon. They can be used to guarantee financial payments (like a financial guarantee) or guarantee performance (as in performance guarantee). The ICC rules for operating standby LCs are UCP600 and ISP98 International Standby Practices.

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:

• Documents against payment: Documents are released to the importer only against payment. These are also known as a ‘sight collection’ or ‘cash against documents’ (CAD), and correspond to cash.
• Documents against acceptance: Documents are released to the importer only against the acceptance of a draft. They are also known as a ‘term collection’, and correspond to ‘credit sales’.

SECTION IV

trAdE fInAncE—fInAncInG EXPortErS

The Export Credit Scheme

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.

Features of Packing Credit in Local 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.

1. The PC availed against an LC/order will be adjusted by the bank from out of the proceeds of the export made against that LC/order. The bank makes an endorsement in the original LC/order to prevent the exporter from availing a PC with another bank, while allowing the credit.
2. Running account facility: This is a facility granted to exporters with good track record to avail PC without lodging an LC/order. The borrower will have to produce the LC/order to the bank within a reasonable time. The liquidation of PCs outstanding in the running account is done on a ‘first in first out’ basis.
3. A PC can be given for a period not exceeding 360 days.
4. This type of credit is generally granted at a concessional rate of interest. If the credit is not adjusted within 180 days, the concession could be withdrawn.
5. Refinance can be available by banks from the RBI against the PC granted to the exporters, up to a period not exceeding 180 days.
6. PC is available for both cash exports and deemed exports. In cash exports, goods are exported outside the country and the full value is realized within the prescribed period.

Features of Pre-Shipment Credit in Foreign Currency (PCFC)

The following are the features of PCFC:

1. The foreign currency loans (FCL) granted to exporters by the banks are known as PCFC. The salient features of PCFC are similar to rupee export credit. However, PCFC is available only for cash exports in foreign currencies. The facility will be made available in one of the convertible currencies—USD, GBP, JPY and Euro.
2. The lending rate to the exporter, under the current guidelines, should not exceed 200 bps above LIBOR (London interbank offered rate)/EUROLIBOR/EURIBOR⁴ Even though the interest rate is less in PCFC, compared to that of PC in rupees, exporters may not prefer PCFC when they expect a fall in the value of rupees. For example, if rupee depreciates against US dollar subsequent to availing of PCFC, say, from 1 USD = ₹43 to ₹48, the exporter will not get the benefit of such depreciation as the export proceeds in US dollar will be adjusted against the PC which is already accounted in dollar. The exporter will get the benefit of depreciation, if PC was availed of in rupees, as the bank will convert the export proceeds in dollar to rupee @ 1 US dollar = ₹48 for adjusting the PC outstanding and crediting the balance to the party’s account.
3. For lending under the PCFC scheme, banks can use the foreign currency balances available with them, in exchange earners foreign currency (EEFC) account/resident foreign currency (RFC) accounts, foreign currency non-resident (FCNR) account, foreign currency borrowings, etc.
4. PCFCs can be maintained as running accounts.
5. PCFC is self-liquidating in nature and is liquidated by purchasing/discounting of related bills.
6. Refinance from the RBI is not available to banks against PCFC.

Post-Shipment Finance

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.

1. Negotiation (i.e., payment of export bill and documents under LC)
2. Purchase (i.e., providing finance against export documents without LC, covered by drafts drawn ‘at sight’ at spot bill buying rate)
3. Discount of export bill under confirmed order/export contracts (i.e., providing finance against export documents covered by drafts without LC, drawn ‘on usance’ at the usance bill buying rate)
4. Advances against export bills sent on collection basis

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.

SECTION V

forEIGn currEncy LoAn (fcL)

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.

Features of Foreign Currency Loans

The following are the features of FCL:

1. The FCL can be extended for a period ranging between 6 months and 3 years normally. Banks are free to determine the tenor.
2. Purpose: The FCL can be extended for meeting working capital/capital expenditure needs of the clients subject to precautions taken by banks relating to prudential norms, credit discipline and credit monitoring. Banks do not offer FCL as personal loans and loans for purchase of consumer durables. The loans can be used for many other purposes, including expansion projects or diversifying into another sector. There are many cases where private educational institutes and hospitals have borrowed money as FCL for 2 or 3 years for their requirements like constructing new buildings, etc.
3. Loans would be denominated in foreign currency irrespective of the fact whether the loan is utilized in foreign currency for payment of imports or in rupee for domestic expenditure. Repayment can be made by remitting rupee or foreign currency. Exporters can repay the loan in foreign currency or by way of proceeds of export bills, if they so desire.
4. Banks are free to decide the interest rate on FCL. Most of the banks have adopted a system where interest rates are linked to prevailing LIBOR plus margin. In FCL, there is exchange risk factor due to possible depreciation of rupee against foreign currency at the time of repayment, say after 6 months or 3 years.
5. FCLs are available at a lower interest rate. When depreciation is not anticipated, forward booking can be avoided and thus forward premium is saved. In such cases, FCLs will be a cheaper source of financing.
6. There is no maximum ceiling on FCL.
7. A customer can repay loans even before the due date, if he desires, by paying a nominal penalty.

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.

CHAPTER SUMMARY

• The volume in the FOREX has witnessed a surge in the recent years because of rapid growth in foreign trade and foreign investment. Although multinational banks have got an edge in this segment, small banks are also trying to capture their own market share in the FOREX business. Since the exchange rate is becoming increasingly volatile, banks have been permitted to offer FOREX derivative products like options, swaps and forward rate agreement to their customers.
• The FOREX market in India comprises of the spot and derivatives markets. Although the OTC derivatives instruments dominate the derivatives markets in the form of forwards, rupee and cross currency swaps and options, the introduction of exchange traded currency futures in October 2008 has gained rapid popularity.
• Financing international trade is an important function of a commercial bank. Banks extend trade finance products through their selected branches located in towns, designated as ‘FOREX’ specialised branches. With the increase in the volume of foreign trade, many banks have identified ‘trade finance’ as a focus area.
• LCs are the important financing tools for firms involved in trade, especially international business and trade. A bank agrees to open LCs on behalf of creditworthy customers alone. The bank, on behalf of the customer or trader, and for a fee, promises through the LC, to pay the purchase price to a seller (or the seller’s bank) if the stipulated and highly detailed conditions are fulfilled.

  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).

• The trade finance functions of a bank can be broadly classified as:
  • Financing the importers
  • Financing the exporters
  • Pre-shipment finance
  • Post-shipment finance

TEST YOUR UNDERSTANDING

1. An exporter has a requirement of ₹2,40,000 to meet his expenditure at the pre-shipment stage. He has a choice of availing PC in Indian rupees or a PCFC in US dollar. He is planning to apply for a loan on 1 January. Assume that the exchange rate is ₹48 = 1 USD. He gets an offer from his bank for PCFC of USD 5,000 (equivalent of ₹2,40,000 for 6 months at LIBOR + 120 basis points (LIBOR on USD = 2.5 per cent) on 1 January. He has to pay 8.5 per cent interest rate, if he has to avail pre-shipment loan in Indian rupees.
   1. How much would he have to pay back, if he avails ₹2,40,000 as rupee loan?
   2. Calculate his repayment liability, if he goes for FCL, if exchange rate becomes 1USD = ₹50.
   3. State which one would be profitable for him.
   4. What would be his liability, if he gets a forward contract @ 1 USD = 49.50 for repayment?
2. USD = INR 48.79/83. Forward rates are quoted as one month 0.31/33. At what rate can you sell USD as an exporter? At what rate, can you buy USD as an importer?
3. Exchange rate of Swiz Franc against Indian rupees (CHF/INR) in the Inter-bank market is 26.8967/9235. An exporter requests bank to purchase a bill for CHF 3,50,000.
   1. What rate would the bank quote to the exporter, if the bank requires an exchange margin of 0.20 per cent?
   2. What would be the interest on export finance to be recovered from the exporter, if the transit period of the export bill is 25 days and the rate of interest is 8 per cent?
   3. What would be the rupee amount payable to the exporter?
4. An exporter based in UK submits a sight bill for US Dollar 20,000 for post-shipment finance in his bank. How much his bank will credit to his account, taking into account the following given particulars?

   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

5. An exporter in France has the requirement of EURO 5,000 to meet his expenditure at the pre-shipment stage. He has a choice of availing PC in EURO or a FCL in Japanese Yen. He is planning to apply for the loan on 1 January. Assume that the exchange rate is Euro 1 = 150 Yen. He gets an offer from his bank for FCL of 7,50,000 Yen (equivalent of Euro 5,000/–) for 1 year at LIBOR + 70 basis points (LIBOR on JPY + 0.20%) on 1 January. He has to pay 2.5% interest rate, if he has to avail pre-shipment loan in Euro. How much he has to pay back, if he avail Yen as loan, if the currency is stable? Calculate his repayment liability, if he goes for FCL if exchange rate becomes 1 Euro = JPY 144. State which one would be profitable for him? What would be his liability, if he gets a forward contract @ 1 Euro = JPY 149 for repayment?
6. Society for inter-bank worldwide financial telecommunication is known as_____.
   1. SFIWFT
   2. SIBWFT
   3. SWIFT
   4. none of these
7. _____make the price in the foreign exchange market.
   1. Importers
   2. Exporters
   3. Brokers
   4. Banks
   5. Central bank
8. A bank’s account in a foreign currency, with a bank in the said foreign country for international fund transfer and settlement is called as_____.
   1. TT
   2. NOSTRO
   3. premium
   4. forward
9. Importers do not prefer _____.
   1. advance payment
   2. documentation
   3. payment in Euro
10. Import LC is issued by an _____.
    1. exporter
    2. importer’s bank
    3. exporter’s bank
    4. advising bank

SELECT REFERENCES

1. Paul, Justin (2006). International Business. 4th ed. Delhi: Prentice Hall of India.
2. Apte, P. G. (2005). International Financial Management. New Delhi: Tata McGraw-Hill.
3. Paul and Aserkar (2009), Export-Import Management, Oxford University Press.

ENDNOTES

1. Rates quoted are 1 USD = _____ Indian Rupees and 1 Euro = ______ Indian Rupees.
2. RBI, 2009, Committee on financial sector assessment, Chapter 4, Table 4.5, page 203, accessed at www.rbi.org.in
3. For a full text of the RBI guidelines, please refer ‘Master circular on rupee and foreign currency export credit and customer service to exporters’ dated 1 July, 2009, accessed at www.rbi.org.in
4. RBI circular ‘Interest rates on export credit in foreign currency’ dated February 19, 2010, accessed at www.rbi.org.in. The circular also stipulates that where the pre-shipment credit in foreign currency is outstanding beyond 180 days, an additional interest of 200 bps over the existing rate would be applicable.