THE BHOPAL SCHOOL OF SOCIAL SCIENCES

Promoted by the Catholic Archdiocese of Bhopal

NAAC Re-accredited Autonomous College, affiliated to Barkatullah University, Bhopal

UNIT 3

INTERNATIONAL FINANCIAL ENVIRONMENT

Module 1
INTRODUCTION
International financial environment differs from domestic financial environment. There are
several factors and forces that influence international financial arrangement. Factors like
foreign exchange market, currency convertibility, international monitory system,
international financial markets etc influence international financial system and environment.
The era of liberalisation has brought about significant reforms in international financial
system. The phase of liberalisation and globalisation opened up economies thereby
integrating the financial markets. This integration rapidly enhanced capital mobilisation
activities across the globe and triggered business. The active players in international financial
system comprise of constituencies such as international banks, stock exchanges, international
financial institutions, international capital markets, Euro currency market etc. Today’s
financial environment is characterised with aggressive financial services, institutions,
resources increased uncertainties etc. The growing financial market has enabled mobilisation
of funds from the party of excess to the party which experience fund deficit in order to keep
the commercial activities ongoing.
Following factors have brought about profound effect on the international financial
environment:
1. The end of the Cold War
2. The emergence of growing markets among the developing countries of east Asia and
Latin America and
3. The increasing globalization of the international economy
4. Emergence of multinational companies
5. Communication and technological revolution
6. Entrance of financial players in the market

INTERNATIONAL FINANCIAL SYSTEM

Financial system facilitates mobilisation of funds from the saver (investor) to the borrower
(buyer). The international financial system is the framework within which countries borrow,
lend, buy, sell and make payments across national frontiers. It constitutes full range of
interest and return bearing assets, banks and non-banking financial institutions, financial

Subject : Economic History of India (1858-1947) 1

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 THE BHOPAL SCHOOL OF SOCIAL SCIENCES
Promoted by the Catholic Archdiocese of Bhopal
NAAC Re-accredited Autonomous College, affiliated to Barkatullah University, Bhopal

markets, financial instruments, financial regulators and so on. The increasing volatility in the
exchange rate gave opportunity for enhanced growth and development. Firms and investors
entered into the forex market in order to reap profit with a proper understanding of the
market. Although, the risk was high, this market introduced opportunity to grow along with
risk and profit.

Following are the components of financial system

Components of financial system

The International Financial System represents a worldwide framework of legal agreements
and institutions, including both formal and informal that facilitates international flow
of financial capital for the purpose of investment and trade financing. The international
monetary system is a structure within which foreign exchange rates are determined,
international trade and capital flows are accommodated, and balance-of-payments (BOP)
adjustments are made.
Globalization has made the world economies to witness an immense surge of financial flow
across nations. There are various institutions and regulators at international level who
regulate the entire global financial environment. The major players in this are International
Monetary Fund, Bank for international settlement, etc. They act as a watchdog of financial
risks and uncertainties. To improve the functioning of international financial system,
financial supervision and regulation is essential among the policy officials. The paralyses of
global economy after the World-War II, demanded a policy framework to restabilise our
global economy. World Bank and IMF thereafter were formed as a measure to revive the
devastated economies from the destruction caused due to the world war.
International financial system relates to the management of and trading in international
money and monetary assets. These monetary assets are claims on foreign currency, foreign

Subject : International Business 2

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 THE BHOPAL SCHOOL OF SOCIAL SCIENCES
Promoted by the Catholic Archdiocese of Bhopal
NAAC Re-accredited Autonomous College, affiliated to Barkatullah University, Bhopal

deposits and investments and/or foreign assets. These claims may be denominated in various
foreign currencies purchased and sold. Thus international financial system is an integration of
financial institutions that facilitates and regulates the flows of investment and capital funds
worldwide. National and international banking systems, the international bond market etc.
are the constituencies of International Financial System.
Structure of Financial System:
Financial structure comprises of various instruments, institutions, markets, services, etc. The
system plays a significant role in mobilising funds worldwide. Thus, these transactions give
rise to borrowing and lending operations in foreign currencies or trading in financial assets
denominated in foreign currencies that involve exchange of one currency for another. The
other components of the international financial system are international capital market and
bonds market.
Following are the constituents of International financial system:
 National banks and financial institutions which deal in foreign currencies

 International brokers

 Regional or multi-national banks and corporations dealing in international market’s

borrowing and lending
 Regional Finance and Development Corporations and banks such as the Asian
Development Bank, Banks for international settlement etc
 International financial organisations like International Monetary Fund (IMF),
International Bank for Reconstruction and Development (IBRD), International
Finance Corporation (IFC), and International Development Agency (IDA)

FOREIGN EXCHANGE MARKET AND RISK MANAGEMENT

International currency market or foreign exchange market is a market where internationally
accepted currencies are traded. This is a market where participants all around the world are
engaged in buying and selling of foreign currencies. These relate to the deposit of such
currencies with international banks at an agreed rate of interest. The currencies are in demand
for meeting the balance of payments deficits or for investment purposes.
Any currency other than the local currency which is used in settlement of international
transactions is called foreign currency. Foreign exchange is popularly called as forex and also
occasionally abbreviated as "FX”. Foreign exchange is the exchange of one currency for
another It indicates conversion of one currency into another currency.
An exchange rate is the value of one nation's currency versus the value of another nation’s
currency. It indicates conversion of one country’s currency into that of the other.. It is the

Subject : International Business 3

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 THE BHOPAL SCHOOL OF SOCIAL SCIENCES
Promoted by the Catholic Archdiocese of Bhopal
NAAC Re-accredited Autonomous College, affiliated to Barkatullah University, Bhopal

minimum number of units of one country’s currency required to purchase one unit of another
country’s currency. For example: number of dollar required to buy one euro. This is because
different countries have different currencies with different values.
 Indian - Rupee,
 American - Dollar
 China - Yuan,
 Japan - Yen etc.
 Brazil – Real
 Russia – Rouble

Countries require different currencies to make payments for international trade. The market
where exchange of currency takes place is called foreign exchange market. This market has
no geographical boundaries. This is the market in which international currency trade takes
place i.e. foreign currencies are bought and sold simultaneously. This market is called
Foreign Exchange (Forex) Market. It is an organisational framework within which banks,
merchants, firms, investors, individuals and government exchange foreign currencies. Forex
market has no geographical per say physical location. It is electronically linked network and
operates 24 hours a day. Foreign Exchange Market in India is regulated by Foreign Exchange
Management Act, 2000.
Basically there are three types of exchange rate:
 Fixed
 Floating
 managed

Fixed Exchange Rate

A fixed exchange rate, also referred to as pegged exchange rate indicates that a country tie
the value of its currency to some other widely-used commodity or currency. Today, most
currencies are pegged to the U.S. dollar. Countries peg their currencies to that of their most
frequent trading partners. In the past, currencies were fixed to an ounce of gold. It was the
year 1944, the Bretton Woods Agreement, where majority of the countries pegged their
currencies to U.S. dollar. The United States agreed to redeem all dollars for gold. In
1971, President Nixon took the dollar off of the gold standard to end the recession.

Advantages of fixed exchange rate:

Subject : International Business 4

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 THE BHOPAL SCHOOL OF SOCIAL SCIENCES
Promoted by the Catholic Archdiocese of Bhopal
NAAC Re-accredited Autonomous College, affiliated to Barkatullah University, Bhopal

 A fixed exchange rate provides currency stability: It brings stabilization to the real
economic activity as it reduces volatility and fluctuations in relative prices. Thereby it
eliminates Uncertainty and Risk.
 It makes the country's businesses attractive to foreign direct investors : Exchange
rate stability may encourage foreigners to park their investible funds in a country. If
the exchange rate changes rather frequently, it will discourage them to invest in a
country.
 Speculation Deterred
As exchange rate remains unchanged for a fairly long period of time, people expect
that such rate would not change in the immediate future. This then eliminates
speculation in the foreign exchange market.

 Prevention of Depreciation of Currency

Under the circumstances, any frequent changes in exchange rate will tend to
aggravate the BOP crisis. Such unstable exchange rates result in depreciation of
currencies. This can be prevented by the stable exchange rate.

 Anti Inflationary - Fixed exchange rate system is anti-inflationary in character.

Fluctuating exchange rates brings vulnerable situations. If exchange rate declines the
demand for imported goods increases. High cost of import goods then fuels inflation.
Such a situation can be prevented with fixed exchange rate.
 Promotes International Trade- Fixed or stable exchange rates ensure certainty about
the foreign payments and instill confidence among the importers and exporters. This
helps in promoting international trade.

Disadvantages:
 Speculators encouraged - A fixed exchange rate can make a country's currency
a target for speculators. Speculative activities tend to get a boost even under the fixed
exchange rate system. The Bretton Woods System of the IMF collapsed in 1971
because of such speculation made with the US dollars.
 Difficult to adjust BOT: The disadvantage is the impossibility of adjusting
the balance of trade and the need for governments to have a foreign asset reserve in
order to defend the fixed exchange rate.
 Internal Objectives of Growth and Full Employment Sacrificed – with fixed
exchange rate countries devalue their currencies and this can be the best measure to
reduce trade deficit and rectify BOP disequilibrium. But at the same this harsh
internal measure can contract the economies having fixed exchange rate.

Subject : International Business 5

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 THE BHOPAL SCHOOL OF SOCIAL SCIENCES
Promoted by the Catholic Archdiocese of Bhopal
NAAC Re-accredited Autonomous College, affiliated to Barkatullah University, Bhopal

Flexible Exchange Rate

When the exchange rate is determined by the market forces of supply and demand is called as
flexible exchange rate. Flexible exchange rate is also called as floating exchange rate .
A free-floating exchange rate rise and fall due to changes in the foreign exchange market.
There are two types of flexible exchange rates: pure floating regime and managed floating
regime. Pure floating regimes exist when there are absolutely no official purchases or sales of
currency. On the other hand, managed floating regime, are those flexible exchange rate
regime where at least some official intervention of monetary authority takes place.

Advantages of flexible exchange rate:

 Automatic stabilisers: Flexible exchange rate act as an automatic stabilizers

 Monetary policy autonomy: Under the flexible exchange rate regime,
countries can implement autonomous monetary policies to address problems
with inflation and output.
 It Frees the Government from Balance of Payments Problem: Since floating
exchange rates works automatically to restore balance of payment equilibrium,
the Government need not pay any attention to the balance of payment issue
other than extreme cases.

Disadvantages of flexible exchange rate

 Flexible Exchange Rates Create a Situation of Instability and Uncertainty:

Flexible exchange rate creates a condition of instability and uncertainty which in turn
in situations may reduce the volume of international trade and foreign investments.
Long-term foreign investments can be greatly reduced because of higher risks
involved due to high fluctuations in exchange rates.

 Dampening Effect on Foreign Trade:

Under the flexible exchange rate system, the price of foreign exchange or
international currency value can become quite uncertain. As a result of this there can
be unfavourable situation for taking decision on imports and exports.
 Exchange rate risk:
The main disadvantage of flexible exchange rate is the high volatility associated.

Subject : International Business 6

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