FM 3103 – International Finance Management

Unit III
International Financial System
LEARNING OUTCOMES:
Q.1. International Financial System: Concept, Evolution, Importance of
Study and Recent Changes.
Answer:
In finance, the financial system is the system that allows the transfer of money between savers
(and investors) and borrowers. A financial system can operate on a global, regional or firm
specific level.

–A firm’s financial system is the set of implemented procedures that tracks financial activities
of the company.
– On a regional Scale, the financial system is the system that enables lenders and borrowers to
exchange funds.
– The global/international financial system is basically a broader regional system that
encompasses all financial institutions, borrowers and lenders within the global economy.

Or

The financial system refers to set of complex and interconnected components consisting
specialized and non-specialized financial institutions, organized and unorganized financial
markets, financial instruments and financial services. The aim of the financial system is to
facilitate the circulation of funds in an economy.

It is concerned about money, credit, and finance. Money refers to the medium of exchange or
mode of payment. Credit refers to the amount of debt which is returned along with the interest.
And the finance refers to the monetary resources comprising the own funds and debts of the
state, company or a person.

According to Prasanna Chandra: the  financial system  consisting of a variety of

institution, markets, and the instruments which are related in a systematic manner and
provide the principal means by which savings are transformed into instruments.

According to Amit Chaudhary,

“Financial system is the integrated form of financial institutions, financial markets, financial
securities, and financial services which aim is to circulate the funds in an economy for economic
growth.”

According to Dhanilal,
“Financial system is the set of interrelated and interconnected components consisting of financial
institutions, markets, and securities.”
INTERNATIONAL FINANCE:
International Finance is an important part of financial economics. It mainly discusses the issues
related with monetary interactions of at least two or more countries. International finance is
concerned with subjects such as exchange rates of currencies, monetary systems of the world,
foreign direct investment (FDI), and other important issues associated with international
financial management.

Like international trade and business, international finance exists due to the fact that
economic activities of businesses, governments, and organizations get affected by the existence
of nations. It is a known fact that countries often borrow and lend from each other. In such
trades, many countries use their own currencies. Therefore, we must understand how the
currencies compare with each other. Moreover, we should also have a good understanding of
how these goods are paid for and what is the determining factor of the prices that the
currencies trade at.

Note − The World Bank, the International Finance Corporation (IFC), the International
Monetary Fund (IMF), and the National Bureau of Economic Research (NBER) are some of
the notable international finance organizations.

International trade is one of the most important factors of growth and prosperity of
participating economies. Its importance has got magnified many times due to globalization.
Moreover, the resurgence of the US from being the biggest international creditor to become the
largest international debtor is an important issue. These issues are a part of international
macroeconomics, which is popularly known as international finance.

Importance of International Finance

International finance plays a critical role in international trade and inter-economy exchange of
goods and services. It is important for a number of reasons, the most notable ones are listed
here −
 International finance is an important tool to find the exchange rates, compare inflation
rates, get an idea about investing in international debt securities, ascertain the economic
status of other countries and judge the foreign markets.
 Exchange rates are very important in international finance, as they let us determine the
relative values of currencies. International finance helps in calculating these rates.
 Various economic factors help in making international investment decisions. Economic
factors of economies help in determining whether or not investors’ money is safe with
foreign debt securities.
 Utilizing IFRS is an important factor for many stages of international finance. Financial
statements made by the countries that have adopted IFRS are similar. It helps many
countries to follow similar reporting systems.
 IFRS system, which is a part of international finance, also helps in saving money by
following the rules of reporting on a single accounting standard.
  International finance has grown in stature due to globalization. It helps understand the
basics of all international organizations and keeps the balance intact among them.
 An international finance system maintains peace among the nations. Without a solid
finance measure, all nations would work for their self-interest. International finance
helps in keeping that issue at bay.
 International finance organizations, such as IMF, the World Bank, etc., provide a
mediators’ role in managing international finance disputes.

The very existence of an international financial system means that there are possibilities of
international financial crises. This is where the study of international finance becomes very
important. To know about the international financial crises, we have to understand the nature
of the international financial system.

Without international finance, chances of conflicts and thereby, a resultant mess, is apparent.
International finance helps keep international issues in a disciplined state.

INTERNATIONAL FINANCIAL SYSTEM:-

International Financial System refers to financial institutions and financial markets/facilitators
of international trade, financial instruments (to minimize risk exposures), rules regulations,
principles and procedures of international trade.

The Global Financial System (GFS) is the financial system consisting of institutions and
regulators that act on the international level, as opposed to those that act on a national or
regional level. The main players are the global institutions such as International Monetary Fund,
and Bank for International Settlements, National Agencies and Govt. Departments, e.g. Central
Banks and Finance Ministries, Private Institutions acting on the global scale, e.g., banks and
hedge funds, and regional institutions, e.g. the Euro Zone.

Evolution of International Financial System:

Not found

Importance of International Financial System:

INTERNATIONAL FINANCE
International finance is a branch of financial economics that deals with the monetary
interactions that occur between two or more countries. This section is concerned with topics
that include foreign direct investment and currency exchange rates. It also involves issues
pertaining to financial management, such as political and foreign exchange risk that comes with
managing multinational corporations.
 
Importance of International finance
International finance plays a critical role in international trade and inter-economy exchange of
goods and services. It is important for a number of reasons, the most notable ones are listed
here −
 International finance is an important tool to find the exchange rates, compare inflation
rates, get an idea about investing in international debt securities, ascertain the economic
status of other countries and judge the foreign markets.
 Exchange rates are very important in international finance, as they let us determine the
relative values of currencies. International finance helps in calculating these rates.
 Various economic factors help in making international investment decisions. Economic
factors of economies help in determining whether or not investors’ money is safe with
foreign debt securities.
 Utilizing IFRS is an important factor for many stages of international finance. Financial
statements made by the countries that have adopted IFRS are similar. It helps many
countries to follow similar reporting systems.
 IFRS system, which is a part of international finance, also helps in saving money by
following the rules of reporting on a single accounting standard.
 International finance has grown in stature due to globalization. It helps understand the
basics of all international organizations and keeps the balance intact among them.
 An international finance system maintains peace among the nations. Without a solid
finance measure, all nations would work for their self-interest. International finance
helps in keeping that issue at bay.
 International finance organizations, such as IMF, the World Bank, etc., provide a
mediators’ role in managing international finance disputes.

Alternatively,
International finance plays a pivotal role in the international trade and in the sphere of exchange
of goods and services among the nations
 
The following points highlight the importance of international finance.
1. International finance helps in calculating exchange rates of various currencies of nations and
the relative worth of each and every nation in terms thereof.
2. It helps in comparing the inflation rates and getting an idea about investing in international
debt securities.
3. It helps in ascertaining the economic status of the various countries and in judging the foreign
market.
4. International Financial Reporting System (IFRS) facilitates comparison of financial
statements made by various countries.
5. It helps in understanding the basics of international organizations and maintaining the
balance among them.
6. International finance organizations such as IMF, World Bank etc. mediate and resolve
financial disputes among member nations.
The very existence of an international financial system means that there are possibilities of
international financial crises. This is where the study of international finance becomes very
important. To know about the international financial crises, we have to understand the nature
of the international financial system.
Without international finance, chances of conflicts and thereby, a resultant mess, is apparent.
International finance helps keep international issues in a disciplined state.

Best Answer/Reference,
Significance of studying International Finance:
International Finance is related to business decisions such as asset selection, resource allocation
and financial management.
1. For Business Firms:
Every firm faces the four important decision-making areas in financial management.
These are:
i. Investment decision
ii. Financing decision
iii. Working capital management decision
iv. Dividend decision.

Firms with a presence in different factor and product markets have to grapple with complex
issues unique to their operations. Decisions regarding where to set up a new plant (investment
decision), in the capital structure and where to raise finances (financing decision), how much
cash to hold, which currency to choose for denominating receivables and payables, the sources
of short-term funds (working capital management decisions) and whether to pay dividend or not
(dividend decision) are routine areas in financial management, for which standard evaluation
techniques and management methods exist.

However, in the globalized scenario, each decision acquires layers of complexity as it needs to
be taken in the context of differences between countries in their political and judicial systems,
economic conditions and financial infrastructure.

Will policies with regard to foreign investment be subjected to sudden and violent change? How
safe are assets held in other countries? Firms with several overseas affiliates are confronted with
the most complex web of problems, since value maximizing decisions have to be made for the
group as a whole rather than just for the parent company, or for each of its subsidiaries.
International Finance is often discussed from the perspective of the MNC because it has to
contend with political risk and exchange rate risk in numerous countries on a daily basis.

i. Investment Decision:
When an MNC decides to set up or acquire an affiliate overseas, it conducts a financial
evaluation. A capital budgeting proposal is evaluated in accordance with accepted measures
such as the Net Present Value (NPV) and the Internal Rate of Return (IRR). But an overseas
capital budgeting proposal involves exchange rate forecasting, political risk assessment and tax
planning.
Differences in corporate tax rates between countries, availability of subsidies in the host
country, and displacement of profits from exports must be accommodated into the framework of
the overseas capital budgeting evaluation process.

ii. Financing Decision:

Once the location is chosen, the next question is how and from where the money needed for the
project would be raised. This is essentially related to the capital structure. Will the affiliate have
the same capital structure as that of the parent, or will it be allowed to decide on the capital
structure? What are the factors that govern the composition of a global capital structure, and
how are they different from those within a single country?
What are the various sources of short-term, medium-term and long-term funds? What is the
distinction between Global Depository Receipts (GDRs) and American Depository Receipts
(ADRs)? How will future convergence of accounting standards affect reporting requirements?
Is the dividend income of overseas holders of ADRs and GDRs affected by the issuer’s home
country currency appreciation? Does two-way fungibility reduce arbitrage profits when the
domestic currency appreciates?
What are the regulatory restrictions in the MNCs home country and in the host country and how
will they affect the overall cost of capital? Therefore, managers require a thorough
understanding of the nature, structure and functioning of overseas financial markets, the degree
of financial integration, and an overview of the regulatory restrictions that are in place.
In 1992, Indian companies were permitted to borrow money at market-determined rates from
overseas under annually announced external commercial borrowing (ECB) limits. The quantum
of ECBs has risen both in terms of volume and the number of corporate opting for them as a
source of finance.

Companies compare ECB costs with the cost of domestic borrowing:

a. What are the rules and regulations governing ECBs?
b. Some ECBs are raised in the euro currency market. What is the euro currency market and
what type of instruments are issued?
c. Are listing norms and disclosure requirements as stringent as in the domestic market?
d. Can a foreign currency loan be repaid in some other currency? Can interest payments be
made in one currency and principal repayment in another?
e. What are the methods by which a company can protect itself against adverse movements in
exchange rates during the term of the overseas borrowing?
f. What is LIBOR and how is it computed? Can a company protect itself against rising interest
in a LIBOR-based loan, and if so how?
g. If a firm takes a LIBOR-based loan, can it subsequently swap this loan for a fixed interest
loan? What then are swaps?
Thus, the functioning of the euro-currency market, its rules and regulations, movements of
LIBOR, the operation of the overseas call money market and its impact on the interest burden
on Indian corporates, and the activities in the swap market, began to be closely studied.

iii. Working Capital Decision:

An MNC’s numerous inter-affiliate transactions affect tax collections in the respective host
countries, and offer opportunities to the parent company to reduce conversion costs. Suppose an
MNC has three affiliates A, B, and C, located in different countries. A located in Thailand
sources raw materials from Indonesian affiliate B, and sells the finished product to Malaysian
affiliate C.
What is the rate at which the affiliates price the products? This is related to a concept called
Transfer Pricing. Several countries have enacted Transfer Pricing rules for intra- group
transactions. It is important for the affiliates and the parent MNC to be aware of the Transfer
Pricing regimes in each country and the degree of latitude they offer in cross-border inter-
affiliate pricing decisions.

A related question is that of cash management. A firm’s cash holdings are attributed to the
transaction motive, precautionary motive and speculative motive respectively. This money may
be deployed in the money market and converted to cash as and when required. How much
autonomy will the parent give its affiliates with respect to cash management? It involves an
assessment of the direction of movement of exchange rates and its impact on funds required by
affiliates. Globalization, exchange rate volatility and financial and technological innovations
have converted cash management into a part of the treasury management function—exchange
rate forecasting is as important as funds procurement and deployment.

iv. Dividend Decision:

An MNC is entitled to receive dividend from its wholly owned overseas subsidiary, and on its
equity holding in an overseas firm. What are the dividend tax regulations in MNC’s home and
the host countries? Is dividend tax imposed on the company declaring it, as well as in the hands
of the recipient? In some countries, such as the USA, dividend is taxed in the hands of the
parent company only when it is brought into the US. So, the parent company may choose not to
have the dividend remitted.

Does the host country have dividend remittance restrictions? If so, the affiliate, in consultation
with the parent MNC, may choose to transmit the un-remittable dividend through legitimate but
indirect routes. One of the most common methods is through under-invoicing and over-
invoicing between affiliates or between the parent and the affiliate. The mode of transmission
depends on whether there are any business dealings between the associate concerns and/or the
parent.
This method also serves the objective of moving funds from a country with a higher corporate
tax structure to one with a lower tax rate. The result is that the affiliate located in the country
with the higher corporate tax structure ends up with a lower tax burden. But governments have
woken up to these modes of transmission and have brought in Transfer Pricing regulations.
Accounting Decision:
Consolidated financial statements for the whole group are prepared at the end of each
accounting year. This necessitates conversion of the profit and loss statement and the balance
sheet of each affiliate into the parent company’s home currency.

For this purpose, the following points should be noted:

1. Internationally accepted methods with respect to conversion
2. Differences in the methods and the impact on the profit and loss of the parent
3. The degree of harmonization of accounting standards
4. The periodicity and transparency in reporting, stringency of accounting standards, the
accounting treatment of cross-border financial leases, derivatives contracts, provisioning for
foreign exchange losses and use of Economic Value Added (EVA)

International Finance and Domestic Firms:

Import and export orders inevitably bring the foreign exchange market and exchange rate
movements into the forefront of the decision-making process. The firm will have to monitor
changes in import and export rules and regulations, understand the documentation involved the
agencies that finance foreign trade and the types of non-financial assistance available from
agencies within and outside the country. It must also be conversant with mechanisms to hedge
its exchange rate risk.

2. For Investors:
Exchange rate movements affect returns from overseas security holdings. That is, the expected
return on the security is not the sole factor that determines the investor’s ‘buy’ decision.
Exchange rate risk is equally important, and it has to be factored into the decision-making
process.
Foreign portfolio investments (and foreign institutional investors) move between overseas
markets in search of investments that offer a higher return. Returns in a foreign currency get
neutralized by adverse exchange rate movements. Of course, the reverse can hold, and favorable
exchange rate movements can magnify the portfolio return. It is important to be able to forecast
the likely exchange rate at the end of the holding period. Exchange rate forecasting plays a
significant role in portfolio destination.

Speculators play an important role in the foreign exchange market by imparting liquidity.
Their ability to make a profit rests on their constant following of exchange rate movements, and
accurate assessment of the impact on exchange rates of policy pronouncements, geopolitical
maneuvers, interest rate movements and economic growth. Foreign exchange markets are
extremely sensitive to new information, which is almost instantaneously factored into currency
pricing.
This underscores both the inherent fragility of the foreign exchange market and the
interdependence of financial markets across the globe. Individuals are also concerned with
exchange rate movements in their capacity as depositors and investors. When they are free to
move their deposits between countries, they compare interest rates, and factor in the effect of
exchange rates on their holdings.
3. For Central Banks:
Central banks are investors too, and are concerned with the gyrations of exchange rates in that
capacity. Since the RBI holds a portion of its foreign exchange reserves in the form of US
Treasury Bills, dollar depreciation affects the rupee value of its portfolio.

International Finance and Banks:

Commercial banks play an active role in foreign exchange markets all over the world. They
lubricate the working of the foreign exchange market in a country, and often serve as the link
between the foreign exchange market at home and in other countries. They buy, sell and hold
various foreign currencies on behalf of their clients (corporate and non-corporate), and offer
two-way quotes in multiple currencies. These quotes are extremely competitive. Since the rates
change on a daily basis, banks are keen observers of the market and the effect of demand and
supply imbalances on exchange rates.

Sometimes, a commercial bank may be asked to buy or sell foreign exchange on behalf of the
central bank. Banks conduct proprietary trades and usually hold several foreign currencies as
part of their asset holdings. They have to be able to take a call on exchange rate movements. In
many countries around the world, commercial banks are the only entities that offer foreign
exchange risk management solutions to corporate clients.

When a country’s financial market lacks a currency derivatives exchange, corporate clients have
no alternative but to depend entirely on OTC contracts with a bank as the counter-party.
International banks offer and/ or participate in the syndicated foreign exchange loan market.
Banks arrange and provide foreign exchange loans to corporate clients, and sovereign loans to
governments, underwrite the corporate issue of securities in the euro currency and international
bond markets, and participate extensively in international trade transactions.

4. For Regulators:
The flow of capital between countries is impeded by capital controls. The removal of capital
controls requires careful sequencing and must be preceded by ‘the creation of institutional
structures ensuring the stability of the financial system’. The fewer the controls on capital
movement, the greater is the financial openness of an economy, and the better the chances that
domestic financial market will get integrated with financial markets in other countries.
In other words, capital account convertibility (or capital account liberalization) is viewed as the
predecessor to financial integration. Developed countries are characterized by open financial
systems, in contrast to the financial markets of many developing countries.

The benefits of financial openness include higher inflows of private capital in the form of FDI
and FII. Since capital inflows are associated with development, employment generation, and
growth, they are much sought after. But continuing inflows cause domestic currency
appreciation. This affects the country’s export competitiveness. A decline in exports has an
adverse effect on Balance of Trade.
The second and more serious effect of capital inflows is that the money supply within a country
increases. Price rise makes domestic goods more expensive in world markets, and acts as a
deterrent to exports. The balance of trade deteriorates further. A rise in inflation also affects
market expectations.

What can the central bank do? It can let these forces play themselves out. But more often than
not, it is galvanized into action. Monetary policy is revisited, interest rates are re-adjusted, steps
are taken to arrest domestic currency appreciation, and management of foreign exchange
reserves is re-assessed. The responses vary with time, but currency appreciation due to capital
inflows evokes prompt and timely action by market regulators and governments.
One of the biggest dangers of regulation is that there is a need for continuous fine-tuning, and
there is no guarantee that it will always work. The central bank’s efforts to stabilize the
domestic currency’s value can be stymied by factors beyond its control—such as hot money
flows, and interest rate changes in other countries.

Financial openness gives frightening speed to money entering and leaving an economy. It also
increases the ferocity of the financial crisis, as the domestic currency is susceptible to sudden
and large appreciation and depreciation. Regulators watch the foreign exchange market, ready
to intervene but unsure whether their efforts will yield the expected results.
These are some of the fascinating contradictions that make International Finance a dynamic
discipline that changes in accordance with market needs. Since International Finance is
concerned with the structure and functioning of the foreign exchange market, it follows that its
importance grows in tandem with the rise of cross-border movements of money.

The issues discussed above are by no means an exhaustive list of the reasons why knowledge of
International Finance is so crucial. But it does give the reader an idea of how essential it is to
develop an understanding of foreign exchange markets, international financial markets,
domestic financial markets, the linkages between both, and the array of institutional and
regulatory structures that shape the movement of funds between countries.

Some of the recent and emerging trends in

International Financial System are as below:
 
1. Countries are Re-balancing Their Import Export Trade
This trend is visible in the way countries like China are trying to balance their import and export
trade. The country’s fast growth in the last decade was fueled by its major dependence on its
import and export trade. The country is known for large amounts of export of inexpensive goods
all over the globe. This happened at a large scale which was not sustainable. Now China is
importing goods in exchange for investment. It is now focusing on producing everything they
need for domestic use. This puts the countries that relied on Chinese investment in a spot as they
struggle to find comparable markets for their products. In addition, the tariffs imposed on China
by the US and EU have slowed down its trade and have provided benefits to domestic
manufacturers.
 
2. There is New Found Cooperation Among Countries
There is a growing need for cooperation in trade among many countries. Countries are getting
involved in treaties and international organizations in a way that is mutually beneficial to all the
member countries. For example, the significant growth of the data economy has led to
businesses realizing the need of cross border data transfer. Hence, large scale multinational
corporations have eased up on their data transfer related restrictions. This helps the organizations
to share online resources for trading, export and for collecting relevant data from around the
world.
 
3. There Exists Growth in Export Opportunities in India and South America
India and many countries in South America such as Brazil, Chile, El Salvador and Peru have
been expanding their economic opportunities. India is a growing market for US exporters. It
purchases precious metals and diamonds, machinery, optical equipment and agricultural
products from the USA. Brazil imports aircraft, machinery, petroleum products and electronics
from the USA. These countries have a strong and growing economy as well as an ever-
expanding middle-class segment who is eager to purchase premium merchandise.
 
There is a Rising Popularity of Euro Markets
Euro market is a financial market that deals with euro-currencies. It consists of banks outside the
country from where the currencies originate. Euro banks are a popular choice for many
multinational corporations for their financial plans because they are free from any regulation and
they have the ability to expand a stock of money and credit outside the control of national
authorities.

There is a Visible Emergence of Multinational Corporations from Emerging Economies

In 2006, it was observed that out of the 100 big multinational corporations of the world, 22 of
them came from emerging economies. This figure has been on an increase and big multinational
corporations from the developing or transitional economies are playing a significant role in
world economics.
 
4. There is an Increase in Cross Border Mergers and Acquisition Based Activities
Due to the rise in the level of foreign direct investment (FDI), there has been a spike in mergers
and acquisitions (M&A) within the financial domain across the globe. The acquisition of ABN-
AMRO by the consortium of Royal Bank of Scotland, Fortis and Santander was one of the
largest deals in the history of the banking industry.
 
5. There is a Deregulation of the Financial Markets
The world is witnessing an internationalization of money and the capital markets. Countries like
the USA and many European countries offer free financial markets to investors. Singapore and
Hongkong have also emerged as strong financial markets. This has led to the creation of a
worldwide banking structure.
 
As organizations are going global, there is an increased interest in international finance for
investors and global business owners. And, they can make the most of their presence in the
international finance market by being aware of the latest trends in this field.

Recent Developments in Global Financial Markets

are:
Global financial markets witnessed turbulent conditions during 2007-08 as the crisis in the US
sub-prime mortgage market deepened and spilled over to markets for other assets. Concerns
about slowdown in the real economy propelled a broad-based re-pricing of growth risk by the
end of the year.

In the wake of the persistent uncertainties about the US sub-prime mortgage market and other
credit markets exposures, liquidity demand surged. To ease liquidity conditions, major central
banks continued to inject liquidity in a more collaborative manner.
Elevated inflationary pressures in many economies reflected historical peaks in crude oil prices.
Share prices in advanced economies fell, while those in emerging market economies (EMEs),
which had shown some resilience, declined sharply from January
2008. Long-term government bond yields in advanced economies softened, reflecting flight to
safety by investors and easing of monetary policy in the US. In the currency markets, the US
dollar depreciated against major currencies.

The pricing behaviour has begun to mirror the strains of the ongoing economic recession and
prices have been decidedly volatile given the environment of heightened uncertainty.
Pressure on credit market persists in the wake of recession in many economies and subdued
corporate performance, which has given rise to the expectation of possible increase in defaults.
During the fourth quarter of 2008-09, the equity valuations generally remained low on account
of concerns stemming from the weak financial and economic outlook.

Money Markets:
The policies initiated by central banks and the guarantees offered by governments assuaged to
an extent the funding pressures that were evident in the international financial markets during
September and October 2008. The spreads between Libor and overnight index swaps (OIS)
have been gradually narrowing.
In the UK, however, bank funding markets came under renewed pressure. The Sterling Libor-
OIS spreads slightly widened and the inter-bank term lending remained subdued during late
January and February 2009.
The benchmark credit default swap (CDS) indices have shown significant spread volatility since
end-November 2008 up to the fourth quarter of 2008-09. Investment grade spreads, however,
mostly performed better than the lower-rated borrowers.
For instance, between end-November 2008 and end- February 2009, the US five-year CDX
high yield index spread had risen by 148 basis points, while the investment grade spreads
registered a decline of 28 basis points.
The same pattern was exhibited by the European CDS indices. As problems persist in the
banking sector internationally and recessionary conditions have become widespread, it is
expected that default rates will increase. Risk tolerance in the market is low and lower-rated
spreads are expected to see increased volatility. In March
2009, the Federal Reserve approved the application of the ICE Trust to become a member of the
Federal Reserve System. The ICE trust would provide central counterparty services for CDS
contracts conducted by its participants.

Under the arrangement, the ICE Trust would work towards reducing the risk associated with the
trading and settlement of CDS transactions by assuming counterparty credit risk and enforcing
participation standards and margin requirements.

As spreads continued to be affected by financial market concerns, in January 2009, the

authorities in the UK announced a further broad-based package for rescue of the financial
institutions in the country. Additional support measures were announced by other European
countries as well.

However, as concerns mounted over the fiscal implications of the support packages and the
depressed risk appetite, spreads on sovereign CDS rose during the first three months of 2009.
Recent measures taken by the governments and central banks do seem to be having a favourable
impact on certain segments of the money and credit markets, which had faced severe
disruptions during the acute phase of the crisis in the third quarter of 2008-09.
For instance, the US government’s announcement in November 2008 and the subsequent
initiation of a programme for purchase of up to US$ 100 billion of direct obligations of housing
related government-sponsored enterprises and up to US$ 500 billion of mortgage backed
securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae has helped in reducing
spreads on agency debt and the conditions for high-quality borrowers in the primary residential
mortgage market recovered to an extent.

In March 2009, the Federal Open Market Committee also announced plans to purchase an
additional US$ 750 billion of agency MBS and invest an additional US$ 100 billion in agency
debt. The Committee also announced that it would buy up to US$ 300 billion of longer-term
Treasury securities over the next six months to help improve conditions in private credit
markets.

The Federal Reserve launched the Term-Asset Backed Securities Loan Facility (TALF) on
March 3, 2009 in an attempt to unfreeze markets for securities backed by loans.
Spreads in the areas where the programme is focused – pooled credit card, auto, student and
small business Voarvs – narrowed during the first two months of 2009 in anticipation of TALF
and narrowed considerably in March with the launch of the programme. The first tranche of
funding under TALF was settled on March 25, 2009.
The banking sector in the US and Europe continued to show further signs of problems, despite
the massive injection of capital by the government and from private sources since late 2007.
Notable instances of governments picking up or hiking their stakes in financial entities during
the fourth quarter of 2008-09 include the German government taking a 25 per cent stake in the
merged entity of Commerz Bank and Dresdner Bank, the US authorities’ investment of US $ 20
billion in Bank of America through a preferred equity stake and the UK government
restructuring its investment in the Royal Bank of Scotland.
The UK authorities continued to announce a series of measures during the fourth quarter of
2008-09 for enabling sufficient credit flow to households and businesses.
These measures include capping the losses on banks’ holdings of risky assets, state guarantees
to facilitate bank funding and purchase of commercial paper, corporate bonds and other
securities to enhance credit availability in the economy.

In March 2009, the Bank of England embarked upon a policy of credit/quantitative easing
entailing the purchase of £ 75 billion worth of conventional gilts and notified private sector
assets in the secondary market, in a bid to support the flow of corporate credit. The UK
programme has resulted in significantly lower yields for the gilts, which the Bank has agreed to
buy.
Corporate bond yields have also fallen. By the first week of April 2009, £ 26 billion of asset
purchases had been made and it is expected that the programme will be completed in another
two months.
In April 2009, the Bank of Japan announced that it would offer credit-worthy commercial banks
subordinated loans worth up to VI trillion to smoothen financial intermediation in the country.

Short-term Interest Rates:

The easing of short-term interest rates in advanced economies persisted in the fourth quarter of
2008-09, as policy rates continued to be cut with inflation concerns disappearing and the
recession in most advanced economies turning out to be deeper and more protracted than was
earlier estimated.

The US federal funds rate remains in the range of 0.0-0.25 per cent set in mid-December 2008.
The Bank of England affected a 50 basis point cut in policy rates-in each of the three months of
the fourth quarter of 2008-09. As of March 5, 2009, the official bank rate was at an all-time low
of 0.5 per cent.

The ECB has reduced its policy rates by 300 basis points since October 2008, the rate for main
refinancing operations thus stands reduced to 1.25 per cent. The softening of interest rates was
broad-based and across the spectrum, as emerging economies also saw frequent cuts in policy
rates and liquidity injections by the authorities.
Countries that effected cuts in policy rates during the fourth quarter of 2008-09 include Turkey
(cumulative reduction of 725 basis points since October 2008), South Africa (cumulative
reduction of 250 basis points since October 2008) and South Korea (cumulative reduction of
300 basis points since October 2008).
The policy rate cuts by the Czech Republic, Peru, Sri Lanka, Chile, Egypt, Canada, Poland,
Malaysia, New Zealand, Iceland and Brazil, during the fourth quarter of 2008-09, ranged from
50 basis points to 600 basis points.
Government Bond Yields:
There has been much volatility in the government bond yields because even as most advanced
economies are facing a recession, concerns have mounted over the increased borrowing
requirements of the governments. This contributed to the increase in the 10-year government
bond yields in some advanced countries during the fourth quarter of 2008-09.
The 10-year government bond yield in the US increased by 72 basis points between December
29, 2008 and April 8, 2009. During the same period, yields on 10-year government papers
increased by 34 basis points in the Euro area, 20 basis points in Japan and 15 basis points in the
UK.

Foreign Exchange Markets:

The international financial markets witnessed extreme dislocations in the period immediately
following the collapse of the Lehman Brothers in mid-September 2008.
The volatility in the markets, which peaked by end-2008, moderated somewhat in 2009. Due to
the unwinding of carry trade positions and low risk appetite, the yen appreciated against most
other currencies, including the US dollar during 2008-09.
However, beginning mid- February 2009 up to mid-April 2009, the yen has generally
depreciated against the US dollar.
Although, the foreign exchange swap spreads have begun to soften, the foreign exchange
markets remained strained for most countries during the first quarter of 2009.
The Bank of Mexico had to directly intervene in the foreign-exchange markets for the first time
in more than a decade in February 2009 because of the severity of the impact of the crisis on its
currency trading.
Four eastern European central banks (of Romania, Hungary, Poland and the Czech Republic)
announced that they would make co-ordinated effort to bolster their currencies as the sharp
depreciations experienced by their respective currencies were not in line with the economic
fundamentals.

The US dollar, generally, appreciated against most of the currencies as the US investors were
liquidating their positions in overseas equity and bond markets and repatriating the money back
to the US. Notwithstanding the deepening of the financial crisis and weakness in economic
activity in the US, the flight to safety considerations helped strengthen the US dollar.

During 2008-09, the US dollar appreciated against most major currencies including the euro and
the pound sterling. The US dollar, however, depreciated against the Japanese yen, as a result of
unwinding of carry trades.
Amongst Asian currencies also, the US dollar appreciated against Korean won, Thai baht,
Malaysian ringgit, Indonesian rupiah and Indian rupee but depreciated against Chinese yuan. As
on April 14, 2009, however, the US dollar depreciated against most major currencies, except the
euro and the Japanese yen, over end-March 2009 levels.

Equity Markets:
The year 2008-09 continued to be a dismal year for the stock markets. As a reflection of the
economic and financial market outlook, the year was characterised by depressed equity
valuations.
Equity price indices in most advanced economies were relatively flat during July and August
2008, but caught on the downward spiral subsequently, which continued into the first two
months of 2009.
Consequently, price/earnings ratios in most markets across the world followed a downward
trend. They remained at or close to all-time low levels for most regions during the fourth
quarter of 2008-09. Though the decline in equity valuations was broad-based across all sectors,
financial institutions, particularly in Japan, were the worst sufferers.
The volatility in the markets in the fourth quarter was compounded by the lack of detailed
information about government rescue packages.
The equity markets saw a slight recovery in most countries/regions since mid-March 2009,
helped further by the US government announcing the details of the public-private investment
programme aimed at repairing balance sheets of financial institutions.

Derivative Markets :
In the second half of 2008, the financial crisis resulted in a decline in the total notional amounts
outstanding of over-the-counter (OTC) derivatives to $592 trillion at end-year, an indication of
reduced market activity. Foreign exchange and interest rate derivatives markets both recorded
their first significant contractions.
Against a background of severely strained credit markets and efforts to improve multilateral
netting of offsetting contracts, credit default swap (CDS) markets continued to contract, with
outstanding amounts decreasing by more than 25%. Facing significant price drops, outstanding
commodity and equity derivatives also declined notably.
Despite the drop in amounts outstanding, significant price movements resulted in notably higher
gross market values, which increased to $34 trillion at end-2008. Gross market values, which
measure the cost of replacing all existing contracts, can be used to capture derivatives related
exposures.

The higher market values were also reflected in gross replacement costs after taking into
account bilateral netting agreements, also referred to as gross credit exposures, which grew by
nearly one third to $5 trillion.

The market for interest rate derivatives contracted for the first time in the second half of 2008,
with notional amounts outstanding of these instruments falling to $419 trillion. Nonetheless,
declining interest rates resulted in almost a doubling of the gross market value.
The gross market value of interest rate swaps, by far the largest market segment, reached $17
trillion. The most significant increase took place in the US dollar swap market, where the gross
market value nearly tripled.

Amounts outstanding of CDS contracts fell to $42 trillion against a background of severely
strained credit markets and increased multilateral netting of offsetting positions by market
participants. This was a continuation of the developments which began in the first half of 2008.
Single-name contracts outstanding declined to $26 trillion while multi-name contracts,
including CDS indices and CDS index tranches, saw a more pronounced decrease to $16
trillion. The composition of market activity across counterparties also changed in the second
half of 2008.

Outstanding contracts between dealers and other financial institutions as well as between
dealers and non-financial institutions saw large declines relative to the inter-dealer market.
Despite the lower outstanding amounts, the gross market value of CDS contracts also increased
significantly as a result of the credit market turmoil.

Notional amounts outstanding of foreign exchange derivatives decreased to $50 trillion, while
their gross market value rose to $4 trillion. The dollar and the euro remained the most important
vehicle currencies, followed by the yen and the pound sterling.

Amounts outstanding of commodity derivatives fell by two thirds to $4.4 trillion. The continued
declines in commodity prices during the second half of 2008 also had a substance impact on the
gross market value of commodity contracts, which fell to $1.0 trillion.
Outstanding equity derivatives decreased to $6 trillion, well below the levels seen in recent
years and a notable change of pace from the increase in the first half of 2008. Reflecting lower
outstanding positions and significantly lower equity prices, the gross market values of
outstanding equity derivatives saw only a moderate decline.

Exchange-traded Derivatives:
The first quarter of 2009 saw a continued but limited decline of activity on the international
derivatives exchanges. Total turnover based on notional amounts decreased further, to $367
trillion from $380 trillion in the previous quarter. Consistent with a gradual return of risk
appetite, however, trading activity on a monthly basis did start to increase towards the end of
the quarter.

Overall turnover in interest rate derivatives remained largely unchanged at $324 trillion
compared to the previous quarter. The moderate change in overall turnover nonetheless; reflects
differences across regions, with turnover in North America declining notably relative to the
previous quarter, while European turnover increased.
In contrast to interest derivatives markets, equity derivatives turnover fell for all contract types
and all major currencies, including the euro. Against a background of negative economic
growth and Uncertainty about growth recovery, activity in equity index derivatives declined
significantly to $38 trillion.

Foreign change derivatives turnover also continued to slide. The decrease in activity among the
main currencies was most pronounced for the yen and US dollar segments. Turnover in
Australian and New Zealand dollar futures, possibly driven by renewed interest in FX carry
trades, increased substantially relative to the previous quarter.

Q.2. International Financial System and Developing Countries.

 Or
Role/Impact of International Financial System in Developing Countries.
Answer:

Q.3. Theories of International Trade.

Answer:
What Is International Trade?
International trade theories are simply different theories to explain international trade. Trade is
the concept of exchanging goods and services between two people or entities. International
trade is then the concept of this exchange between people or entities in two different countries.
People or entities trade because they believe that they benefit from the exchange. They may
need or want the goods or services. While at the surface, this many sound very simple, there is a
great deal of theory, policy, and business strategy that constitutes international trade.
In this section, you’ll learn about the different trade theories that have evolved over the past
century and which are most relevant today. Additionally, you’ll explore the factors that impact
international trade and how businesses and governments use these factors to their respective
benefits to promote their interests.

With time, economists have established theories that explain global trade. These theories
explain what exactly happens in International Trade. There are 6 economic theories under
International Trade Law which are classified in four: (I) Mercantilist Theory of trade (II)
Classical Theory of trade (III) Modern Theory of trade (IV) New Theories of trade. Both of
these categories, classical and modern, consist of several international theories.

Theories:
1. Mercantilism
This theory was popular in the 16th and 18th Century. During that time the wealth of the
nation only consisted of gold or other kinds of precious metals so the theorists suggested
that the countries should start accumulating gold and other kinds of metals more and
more. The European Nations started doing so. Mercantilists, during this period stated that
all these precious stones denoted the wealth of a nation, they believed that a country will
strengthen only if the nation imports less and exports more. They said that this is the
favorable balance of trade and that this will help a nation to progress more.

Mercantilism thrived during the 1500's because there was a rise in new nation-states and
the rulers of these states wanted to strengthen their nations. The only way to do so was by
increasing exports and trade, because of which these rulers were able to collect more
capital for their nations. These rulers encouraged exports by putting limitations on
imports. This approach is called “protectionism” and it is still used today.

Though, Mercantilism is one the most old-fashioned theory, it still remains a part of
contemporary thinking. Countries like China, Taiwan, Japan, etcetera still favor
Protectionism. Almost every country, has implemented protectionist policy in one way or
another, to protect their economy. Countries that are export oriented prefer protectionist
 policies as it favors them. Import restrictions lead to higher prices of good and services.
Free-trade benefits everyone, whereas, mercantilism's protectionist policies only profit
select industries.
 
2. Absolute Cost Advantage
This theory was developed by Adam Smith, he was the father of Modern Economics.
This theory came out as a strong reaction against the protectionist mercantilist views on
international trade. Adam Smith supported the necessity of free trade as the only
assurance for expansion of trade. He said that a country should only produce those
products in which they have an absolute advantage. According to Smith, free trade
promoted international division of labour. By specialization and division of labour
producers with different absolute advantages can always gain over producing in
remoteness. He emphasised on producing what a country specializes in so that it can
produce more at a lower cost than other countries. This theory says that a country should
export a product in which it has a cost advantage.

Adam's theory specified that a country's prosperity should not be premeditated by how
much gold and other precious metals it has, but rather by the living standards of its
citizens.
 
3. Comparative Cost Advantage Theory
The comparative cost theory was first given by David Ricardo. It was later polished by J.
S. Mill, Marshall, Taussig and others. Ricardo said absolute advantage is not necessary.
He also said a country will produce where there is comparative advantage.
The theory suggests that each country should concentrate in the production of those
products in which it has the utmost advantage or the least disadvantage. Hence, a state
will export those supplies in which it has the most benefit and import those supplies in
which it has the least drawback.
Comparative advantage arises when a country is not able to yield a commodity more
competently than another country; however, it has the resources to manufacture that
commodity more proficiently than it does other commodities.
 
4. Hecksher 0hlin Theory (H-0 Theory)
Smith and Ricardo's theories didn't help the countries figure out which products would
give better returns to the country. In 1900s, two economists, Eli Hecksher and Bertil
Ohlin, fixated on how a country could profit by making goods that utilized factors that
were in abundance in the country. They found out that the factors that were in abundance
in relation to the demand would be cheaper and that the factors in great demand
comparatively to its supply would be more expensive.

The H-0 Theory is also known as the Modern Theory or the General Equilibrium Theory.
This theory focused on factor endowments and factor prices as the most important
determinants of international trade. The H - 0 is divided in two theorems: The H - 0
theorem, and the Factor Price Equalization Theorem. The H - 0 theorem predicts the
 pattern of trade while the factor-price equalization theorem deals with the effect of
international trade on factor prices. H - 0 theorem is further divided in two parts: factor
intensity and factor abundance. Factor Abundance can be explained in terms of physical
units and relative factor prices. Physical units include capital and labor, whereas, relative
factor price includes the adjoining expenses like rent, labor cost, etcetera. On the other
hand, factor intensity means capital, labor or technology, etcetera, any factor that a
country has.
 
5. National Competitive Theory or Porter's diamond
The diamond theory was given by Micheal Porter. This theory states that the qualities of
the home country are vital for the triumph of a corporation. This theory was given its
name because it is in the shape of a diamond. It describes the factors that influence the
success of an organization. There are Six Model Factors in this theory which are also
known as the determinants.

The following are the determinants:

a. Factor Condition;
b. Demand Conditions;
c. Related and Supporting Industries;
d. Firm Strategy, Structure, and Rivalry;
e. Chance; and
f. Government.
 
6. Product Life Cycle Theory
This theory was developed by Raymond Vernon in the Mid 1960's, he was a Harvard
Business School professor. This theory was developed after the failure of Hecksher
Ohlin's Theory. The theory, detailed that a product goes through various stages in the
course of its progress. These stages are: (1) new product stage, (2) maturing product
stage, and (3) standardized product stage. This theory assumed that the production of a
new product would take place in the nation where it was innovated.
In the 1960's this was a very useful theory. At that time, United States of America was
dominating the whole globe in terms of manufacturing after the World War II.

Stage I: New Product

The stage begins with introducing a new product in the market. A corporation will begin from
developing a new good. The market for which will be small and sales will be comparatively
low. Vernon assumed that innovation or invention of products will mostly be done in developed
nations, because of the economy of the nation. To balance the effect of less sales, corporations
would keep the manufacturing local. As the sales would increase, the corporations would start
to export the goods to different nations in order to increase the revenue and sales.

Stage II: Mature Product Stage

The product enters this stage when it has established demand in developed nations. The
manufacturer, would need to open manufacturing plants in each nation where the product has
demand. Due to local production, labour costs and export costs will decline which will in result
reduce the per unit cost and increase the revenue.

This stage may include product development. Demand for the product will continue to rise in
this stage. demand can also be expected from less developed nations. Local competition with
other cooperation's will begin.

Stage III: Standardized Product Stage

In this stage exports to nations various developed and under developed nations will begin.
Foreign product competition will reach its peak due to which the product will start losing its
market. The demand in the nation from where the product originated will start declining and
eventually diminishes as a new product grabs the attention of the people. The market for the
product is now completely finished.

Then, the cycle of a new product begins.

Conclusion:
The theories discussed above have aided economists, government and industries to comprehend
trade internationally in a healthier way.

The mercantilists view dominated in the 17th and 18th century. Mercantilists held that trade is
not free and its main was to achieve surplus. However, they failed to address various issues.
Adam Smith opposed the Mercantilist Theory and highlighted the importance of free trade in
increasing the prosperity of nations. Smith's theory was criticized by David Ricardo and others.
According to Ricardo, each nation should focus in the production of those goods that yield the
most. Heckscher - 0hlin explained the basis trading in respect to factor endowments. Vernon's
theory scrutinized the effect of technical changes on the pattern of international trade.

The Mercantalists theory, Cost Adavantage and Comparative Advantage theory assumed only
two commodities, factors and countries, and the rest of the factors as constant. On the other
hand, the New theories that consists of Product Life Theory and Porter's Diamond are based on
more explainable assumptions, that talked about changes in factors. Therefore, the new theories
are better at explaining the pattern of world trade today.

Q.4. International Financial Market and its Instruments.

Answer:
PDF

Q.5. Capital Account Convertibility.

Answer:
In India the Capital Account Convertibility means “the freedom to convert the local financial
assets into foreign financial assets and vice-versa at a market determined rate of exchange. It
is associated with the changes of ownership in foreign/domestic financial assets and
liabilities and embodies the creation and liquidation of claims on, or by the rest of the
world”.

Convertibility facilitates conversion of any currency into rupee or in any currency freely. In
simple words rupee can be freely convertible into any foreign currency for acquisition of assets
like shares, properties, and assets abroad. Banks can also accept deposits in any currency.

The Capital Account convertibility being linked with the monetary and economic policy is
regulated by the Reserve Bank of India Convertibility is mainly related to Foreign Exchange
transactions which are mostly government by the foreign exchange management Act 1999.

Section 2(i) defines a current account transaction as a transaction and without prejudice
to the generality of the foregoing such transaction includes:
1. Payments due in connection with foreign trade, other current business, services, and short
term banking and credit facilities in the ordinary course of business.
2. Payments due as interest on loans and as net income from investments.
3. Remittances for living expenses of parents, spouse and children residing abroad.
4. Expenses in connection with foreign travel, education and medical care of parents, spouse
and children.

For the current account transactions any one can sell or draw foreign exchange to or from any
authorized person. However the Regulatory body may restrict current account transactions/limit
of transactions in case of need and keeping in view the public interest.

Taking everything into account and liberalized economic policies adopted by the government of
India is fully convertible on the current account which means all payments and receipts
concerning trade and services (export/import payments/receipts) are free from forex regulations.

One can make payment in any currency to other parts of world for goods/services purchased but
not for capital creation. So if you want to pay your supplier $ 100 million for import of raw
material you can do it freely. RBI will not come in the way of making such huge payment as it
is a payment on the current account. But in case of buying any immoveable property like
investment in real estate exceeding the cost of $ 100000/- the permission of RBI is required.
Acquiring an immoveable property tantamount to creation of capital asset and RBI has fixed an
upper limit for such transactions. Like wise no foreign national can invest in real estate in India
without the prior permission of the RBI.

Section 2(e) of the Foreign Exchange Management Act, 1999 defines a Capital Account
Transaction as a transaction which alters the assets or liabilities, including contingent
liabilities, outside India of persons resident in India or assets or liabilities in India, and includes
transactions referred to in subsection (3) of Section 6. Transactions under the capital account
are restricted and controlled by a number of regulations.
For example Foreign Exchange Management (Permissible capital account transactions)
Regulations 2000 and FEMA Act do not permit capital account transactions without obtaining
specific permission from the Reserve Bank of India.

The system appears paradoxical as all capital account transactions are prohibited, unless
specifically permitted. In case of current account transactions the fact is otherwise true that all
current transactions are permitted unless specifically prohibited.

Investment in certain sectors – Foreign investment in India in any company, firm or

proprietary concern engaged or proposing to engage in the following activities is
completely prohibited:
i. Chit Funds,
ii. Nidhi Company,
iii. Agricultural or Plantation activities,
iv. Real Estate Business, and 
v. Trading in transferable Development Rights.

However there is very little difference in current and capital account transactions in certain
unspecified and undefined cases and is matter of further consideration for more clearly.
However a difference between the two type of transactions i.e. current account transactions and
capital account transactions can be understood by a very simple example.
If an Indian needs some foreign exchange for paying his fees for study abroad or wishes to visit
his relatives settled abroad he can get foreign currency exchanged from any approved money-
changer or from any bank. It is treated as Current Account Transaction.

But if any Indian citizen wants to import some heavy equipment, plant or machinery or wants to
invest abroad and the amount involved is big it will be treated as a capital account transaction
for which he shall be required to obtain the permission of Reserve Bank of India.

As per monetary policy of any country with regard to capital account convertibility to ensure
ability to accept such transactions where local financial assets are transacted into foreign
financial assets freely and at the same time also at the foreign exchange rate of interest
prevailing in the market.

Convertibility of capital or current account depends how sound is the position of balance of
payments with any country which solely depend how much foreign exchange reserve any
country possesses.

Time is not for ahead in 1990es our country was depleted of foreign currency reserves so that
an Indian citizen wishing to visit abroad was eligible for foreign exchange currency of only $
2000/- only hardly sufficient to survive on a foreign land even for two days. During those days
it was not possible to think about even partial convertibility of rupee. But the regulatory
authorities were cautious enough to improve the situation.
Forget the days of FERA 1947 when it was just like impossible to import an item for personal
use costing as low as $10/- for which RBI’s approval was required. Some changes were made in
FERA in 1973 and latterly FEMA 2000 shifted its focus from conservation of foreign exchange
to facilitating trade and payments.

With the result India has adopted current account convertibility for export and import of goods
and services but in case of capital account convertibility it is only partially allowed. Upper limit
has been fixed by the RBI and beyond that limit permission of RBI is required.

When we are talking about full convertibility on capital account we should be able to
understand the difference between full and the fuller convertibility. The difference between full
and fuller convertibility leaves much to be desired. As is well known, in the scenario of global
recession there is always a chance of relatively unstable and volatile economic situation before
any country and in view of this fact any country needs controls over capital flow.

In case of current account India is fully convertible but in case of creating capital assets outside
India that too on credit basis it accounts for creation of capital liability on the country and
adversely affects the balance of payment account of the country and it is for this reason that
certain limits have been prescribed.

In case fuller convertibility is allowed there shall be no restrictions of any kind and the national
economy and monetary policy shall also be adversely affected. There is glaring examples of
what happened to the economy of several nations where fuller convertibility was permitted.
For example some countries in east Asia where some Foreign financial institutions had invested
in real estate by miss utilising short term funds for long term investments and with the result
which destabilized the entire economy of these countries. In view of this very fact the fuller
(complete) convertibility on capital accounts is still under consideration of the government of
India. Because it would mean no restrictions without any question.

But developing countries like India (now declared as developed country by the president of
USA Mr. Barak Obama.) may face foreign exchange problems in keeping the sufficient foreign
exchange reserves to maintain stability of trade balance and stability of its economy. With the
increase in foreign exchange reserves the stipulated restrictions shall go on removing gradually.
Till date the capital account convertibility remains a major question for the government to
decide whether full rather fuller convertibility on capital account shall or not be in the larger
interest of the economy of our country, particularly when there are glaring examples of many
countries which allowed full capital convertibility.

Objectives of Full Capital Account Convertibility:

1. Economic Growth:
The Introduction of FCAC will help in the economic development of the country through
capital investment in the country. This leads to employment generation in the country,
infrastructure development, global competition etc.
2. Improvement in Financial Sector:
There would be improvement in the financial sector as huge capital flow into the system, which
will help the companies to perform better. It will boost liquidity into the system.

3. Diversification of Investment:
It will also help in the diversification of Investment by ordinary people, wherein they can invest
abroad without any restriction and diversify their portfolio.

Special Topics:
Q.A. Find out the similarities and distinction between International
Financial System and Indian Financial System.
Or
International Financial System Vs. Indian Financial System
Answer:
https://byjus.com/govt-exams/indian-financial-system/

Q. (B). Basic Concept of Financial System.

Introduction
The economic expansion of any country depends upon the existence of a well-ordered financial
system. It helps in the creation of wealth by linking savings with the investment. The
financial system is an organized and regulated structure where an exchange of funds takes place
between the lender and the borrower. It supplies the necessary financial inputs for the production of
goods and services, in turn, promote the well-being and standard of living of people in the country.

Meaning & Concept:

A financial system is a network of financial institutions, financial markets, financial

instruments, and financial services that facilitate money transfer. This system includes
end users of saver, arbitrator, device, and money. The level of economic development
depends largely on the basis and it facilitates the economy of the prevailing financial
system. Proper circulation of funds is necessary for the economic development of the
country.
The financial system refers to set of complex and interconnected components
consisting specialized and non-specialized financial institutions, organized and
unorganized financial markets, financial instruments and financial services. The aim
of the financial system is to facilitate the circulation of funds in an economy.

It is concerned about money, credit, and finance. Money refers to the medium of
exchange or mode of payment. Credit refers to the amount of debt which is returned
along with the interest. And the finance refers to the monetary resources comprising
the own funds and debts of the state, company or a person.

The efficient financial system and sustainable economic growth are corollaries. The
financial system mobilizes the savings and channelizes them into productive activity
and thus influences the pace of economic development. Economic growth is
hampered for want of an effective financial system. Broadly speaking, financial
system deals with three inter-related and interdependent variables, i.e., money,
credit, and finance.

Definition of the financial system

According to Prasanna Chandra: the financial system consisting of a variety of institution, markets,

and the instruments which are related in a systematic manner and provide the principal means by
which savings are transformed into instruments.

According to Amit Chaudhary,

“Financial system is the integrated form of financial institutions, financial markets, financial
securities, and financial services which aim is to circulate the funds in an economy for economic
growth.”

According to Dhanilal,

“Financial system is the set of interrelated and interconnected components consisting of financial
institutions, markets, and securities.”

The financial system provides channels to transfer funds from individuals and groups
who have saved money to individuals and group who want to borrow money. Saver
(refer to the lender) are suppliers of funds to borrowers in return with promises of
repayment of even more funds in the future.

Significance of the Financial System:

1.    To attain economic development, financial systems are important since they induce people to
save by offering attractive interest rate. These savings are then channelized by lending to various
business concerns which are involved in production and distribution.

2.    It helps in monitor corporate performance

3.    It links savers and investors. This process is known as capital formation

4.    It helps in lowering the transaction cost and increase returns which will motivate people to save
more

5.    It helps government in deciding monetary policy

Constituents of the Financial System:

1.    Financial institutions:  it is a corporation affianced in the business of dealing with financial
and monetary matters such as deposit, loans, investments and currency exchange. They are
providing various services to the economic development with the help of issuing financial instruments.
They are further divided into banking institutions and non-banking institutions.

a)    Banking institutions: they are the key part of economic development. They play a vital role in the
field of savings and investment of money from the public and lending to business concerns. 

b)    Non-banking institutions: they are the entities and the institutions that provide certain bank-like
and financial services but do not have banking license. E.g. IFCI, IDBI, LIC.

2.    Financial market: it is a market which deals with various financial instruments such as
shares, debentures, bonds, etc. and financial services such as merchant banking, underwriting, etc.
They are further divided into 

a)    Capital market: institutional arrangement for borrowing medium and long term funds and which
provides facility for marketing and trading of securities. E.g. shares, debentures, bonds, etc. They are
then divided into:

 Primary market: where securities are offered for the first time for receiving the public subscription.

Secondary market: where pre-issued securities dealt between the investors.

b)    Money market: it is for short term funds, which deals in financial assets whose period of
maturity is up to 1 year. They are highly liquid and easily marketable. Eg treasury bill, commercial
paper etc

3.    Financial services: these services are provided by the finance industry. They are usually
customer focused. They study the needs of the customer in detail before deciding their financial
strategy, giving due regard to cost, liquidity, and maturity. Eg insurance company, credit rating facility,
etc

4.    Financial instruments: it is any contract that gives rise to a financial asset of one entity and
a financial liabilities or equity instruments to another entity. The various instruments are shares,
debentures, bonds in the capital market and Treasury bill, commercial paper, certificate of deposit,
repurchase agreement in the money market.

 Capital market     Money market

1.it is a market where lending and
1.It is a market where lending and   Borrowing takes place for medium   borrowing takes place for short-term
and long term.                                                                                       
up to 1 year.  
2. They deal in treasury
bills,  commercial bill, Deposit
2. They deal in equity, shares, debentures, bonds, preference shares etc                 
3. Capital markets are formal            3. The money market is informal
4. Due to less liquid nature and long  Maturity risk is comparatively 4. Due to more maturity is less
high maturity is less than 1 year, risk                                                     than Involved is low
5.The money term credit needs of
5. The capital market fulfills long term Credit needs of the business    the business
6. It increases the liquidity of funds in
6. It stabilizes the economy due to long  term savings                                   the        market
                          
7. The returns are high because of higher Duration 7. The returns are usually low
 

Remarks

The money market is usually accessed alongside the capital market. This money market is termed as
a good place to park funds that are needed in a shorter period. They provide a variety of functions for
individuals, corporates or government entities such as high liquidity. The company may want to invest
funds overnight and look to the money market to accomplish or to cover operating expenses or
working capital of any. Those individuals living on a fixed income often use the money market
because of the safety associated with these types of investment.

The capital market is a widely followed market. Their daily movements are analyzed for the general
economic conditions of the world markets. The institutions operating in the capital market access
them to raise capital for long term purposes such as for merger and acquisition or to expand the
business or capital projects.
#Functions of Financial System:

Functions and Role of the financial system, market are given below.

 Pooling of Funds.
 Capital Formation.
 Facilitates Payment.
 Provides Liquidity.
 Short and Long-Term Needs.
 Risk Function.
 Better Decisions.
 Finances Government Needs, and.
 Economic Development.

Now each one Functions of the financial system are discussing on brief:

Pooling of Funds:

In a financial system, the Savings of people are transferred from households to

business organizations. With these production increases and better goods are
manufactured, which increases the standard of living of people.

Capital Formation:

Business requires finance. These are made available through banks, households and
different financial institutions. They mobilize savings which leads to Capital
Formation.

Facilitates Payment:

The financial system offers convenient modes of payment for goods and services.
New methods of payments like credit cards, debit cards, cheques, etc. facilitate quick
and easy transactions.
Provides Liquidity:

In the financial system, liquidity means the ability to convert into cash. The financial
market provides the investors the opportunity to liquidate their investments, which
are in instruments like shares, debentures, bonds, etc. Price is determined on the
daily basis according to the operations of the market forces of demand and supply.

Short and Long-Term Needs:

The financial market takes into account the various needs of different individuals and
organizations. This facilitates optimum use of finances for productive purposes.

Risk Function:

The financial markets provide protection against life, health, and income risks. Risk
Management is an essential component of a growing economy.

Better Decisions:

Financial Markets provide information about the market and various financial assets.
This helps the investors to compare different investment options and choose the best
one. It helps in decision making in choosing portfolio allocations of their wealth.

Finances Government Needs:

The government needs a huge amount of money for the development of defense
infrastructure. It also requires finance for social welfare activities, public health,
education, etc. This is supplied to them by financial markets.

Economic Development:

India is a mixed economy. The Government intervenes in the financial system to

influence macroeconomic variables like interest rate or inflation. Thus, credits can be
made available to corporate at a cheaper rate. This leads to the economic
development of the nation.
#Main Functions of Financial System:

The functions of the financial system can be enumerated as follows:

 The financial system acts as an effective conduit for optimal allocation of

financial resources in an economy.
 It helps in establishing a link between savers and investors.
 The financial system allows ‘asset-liability change’. When they accept deposits
from customers, banks make claims against themselves, but they also make
assets when providing loans to customers.
 Economic resources (i.e., money) are transferred from one party to another
through the financial system.
 The financial system ensures the efficient functioning of the payment
mechanism in the economy. All transactions between buyers and sellers of
goods and services are easily affected due to the financial system.
 In the case of mutual funds, the financial system helps in risk change by
diversification.
 The financial system increases the liquidity of financial claims.
 The financial system helps in finding the prices of financial assets from the
 contact of buyers and sellers. For example, the value of the securities is
determined by capital market demand and supply forces.
 The financial system helps reduce the cost of transactions.

As discussed above, financial markets play an important role in economic

development through the role of capital allocation capital, supervising managers,
saving savings and promoting technological change among others. Economists had
thought that the development of the financial sector is an important element to
encourage financial growth.

Financial development can be defined as the ability to obtain information effectively

in the financial sector, implement contracts, facilitate transactions, and promote
special types of financial contracts, markets, and arbitrators. Should be at a lower
cost.

Financial development occurs when financial tools, markets, and intermediaries

improve on the basis of information, enforcement and transaction costs, and
therefore provide better financial services. Financial work or services can affect the
economy’s savings and investment decisions through capital accumulation and
technical innovation and therefore economic growth.

Capital accumulation can be modeled either through capital peripherals or capital

goods, which are produced using constant returns, but without the use of any
reproduction factors to stabilize static per-state growth.

Through capital accumulation, the steady growth rate in the work done by the
financial system affects the rate of capital formation. The financial system affects
capital accumulation either by either changing the savings rate or by reallocating the
savings between capital production levels. Through technological innovation, focus on
innovation of new production processes and inventions.

Because friction of the market and laws, rules and policies are quite different with the
economies and the times, the impact of financial development on development can
have different effects for the economy allocation and welfare in the economy.

Alternatively,

Meaning of Financial System

The financial system is a system that facilitates the movement of funds among people in
an economy. It is simply a means through which funds are exchanged between investors,
lenders, and borrowers. A financial system is composed of various elements like financial
institutions, financial intermediaries, financial markets, and financial instruments which
altogether facilitate the smooth transfer of funds.

This system exists at the regional, national, and international levels. It is an efficient tool
that helps in the economic development of a country by linking savings and investments
thereby leading to wealth creation. The financial system acquires money from people who
are keeping it idle and distributes it among those who use it for yielding income and
generates wealth in the country.

Financial system aims at the efficient allocation of financial resources by channelizing

funds between net savers and net spenders. The financial system has an efficient role in
minimizing the risk through diversification of funds among a large number of people. 
Advantages of Financial system
1. Provides Payment System: The financial system provides a payment mechanism for the smooth flow of funds
among peoples in an economy. Buyers and sellers of goods or services are able to perform transactions with
each other due to the presence of a financial system.
2. Links Savers and Investors: The financial system serves as a means of bridging the gap between savings and
investment. It acquires money from those with whom it is lying idle and transfers it to those who need it for
investing in productive ventures.
3. Minimizes Risk: It aims at reducing the risk by diversifying it among a large number of individuals. The financial
system distributes funds among a large number of peoples due to which risk is shared by many peoples.
4. Helps in Capital Formation: The financial system has an efficient role in capital formation of the country. It
enables big corporate and industries to acquire the required funds for performing or expanding their operations
thereby leading to capital formation in the nation.
5. Raises Standard of living: It raises the standard of living of peoples by promoting regional and rural
development of the country. The financial system promotes the development of weaker sections of society
through cooperative societies and rural development banks.
6. Enhance liquidity: Maintaining optimum liquidity in an economy is another important role played by the
financial system. It facilities free movement of funds from households (savers) to corporate (investors) which
ensures sufficient availability of funds in the economy.
7. Promotes Economic Development: The financial system influence the pace of economic growth or development
of an economy. It aims at optimum utilization of all financial resources by investing all idle lying resources into
useful means which leads to the creation of wealth.

Disadvantages of Financial system

1. Lack of Co-ordination among financial institutions: The financial system faces a
lack of coordination among various financial institutions. The presence of a large
number of financial institutions and government roles in controlling authorities of
these institutions leads to a lack of coordination.
2. Monopolistic Market Structure: Many institutions in the Indian financial system
occupy a monopolistic position in the market. LIC and UTI are two institutions that
have grabbed a large part of the life insurance business and the mutual fund
industry. These large structures could lead to mismanagement or inefficiency of
funds.
3. High Rate of Interest: There is a possibility of the high-interest rate charged by
several financial institutions in the financial system of our country. Various
institutions due to their monopolistic structure in the market may charge high or
unfair interest rates.  
4. Inactive Capital Market: Our country’s financial system faces the problem of the
inactive capital market. All corporate in India are mostly able to acquire funds
through development banks and do not need to go to the capital market.
5. Imprudent Financial Practice: The financial system of India has developed
imprudent financial practices due to the dominance of development banks.
Development banks provide funds to corporate in the form of term loans which
makes the capital structure of borrowed concerns uneven. These banks even permit
the use of unwarranted debts which is against the sound capital structure.
INTERNATIONAL MONETARY SYSTEM Vs. INTERNATIONAL FINANCIAL SYSTEM
Theories of International Trade
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