FOREIGN EXCHANGE HEDGING TECHNIQUES USED BY COMPANIES AND GLOBAL FOREIGN EXCHANGE MARKET

FACULTY GUIDE : PROF. ARPITA AMARNANI MA’AM

SUBMITTED BY:
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PIYUSH GAUR ROLL NO: 35

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ACKNOWLEDGMENTS

At the outset, I would like to express my deep gratitude to Prof. Arpita Amarnani Ma’am for allowing me to work under his guidance, thereby, giving me an opportunity to gain tremendous knowledge and skills. I also thank her for the timely inputs and guiding the project time to time. I also thank Mr. Asish Shah Sir for their timely inputs which gave a proper shape and direction to the project. I would also like to thanks all the Faculties (finance) for giving me an opportunity to interact with them and giving me a firsthand exposure to the Foreign Exchange Market.

Piyush Gaur Roll No. 35

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TABLE OF CONTENTS Sr. No. 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Particulars Executive Summary Foreign Exchange Introduction Global Foreign Exchange market India’s Forex Market Forex Market Participants Foreign Currency Accounts Foreign Exchange Derivatives Hedging Introduction Corporate Hedging In India Case of Ranbaxy Laboratories Case of Axis Bank Observations Forex Reserves and External Debt Bretton Woods I Bretton Woods II USA – China Currency Issue USA Trade with China Ominibus Trade & Competitive Act China Forex Reserves Policies to Reduce USA Deficit Problem with China’s Bank What USA & China Should do Euro Zone Crises Impact on Global Economy Impact on USA & China Page No. 4 5 6 8 12 13 13 17 18 19 20 21 22 23 24 25 26 27 28 28 30 31 35 36 37

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EXECUTIVE SUMMARY The gradual liberalization of Indian economy has resulted in substantial inflow of foreign capital into India. Simultaneously dismantling of trade barriers has also facilitated the integration of domestic economy with world economy. With the globalization of trade and relatively free movement of financial assets, risk management through derivatives products has become a necessity in India also, like in other developed and developing countries. As Indian businesses become more global in their approach, evolution of a broad based, active and liquid Forex (Foreign Exchange) derivatives markets is required to provide them with a spectrum of hedging products for effectively managing their foreign exchange exposures. This research attempts to evaluate the various alternatives available to the Indian corporates for hedging financial risks. By studying the use of hedging instruments by major Indian firms from different sectors, it concludes that forwards and options are preferred as short term hedging instruments while swaps are preferred as long term hedging instruments. The high usage of forward contracts by Indian firms as compared to firms in other markets underscores the need for rupee futures in India. In addition, it also includes The Global Foreign Exchange Market and Various issues going on in Market such as USA – China Currency Issue and Euro

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Zone Crises, and its impact on Various Countries including India, USA, and China.

FOREIGN EXCHANGE The foreign exchange market is characterized by volatility, which creates uncertainty in the market and makes predictions regarding future exchange rates difficult, both in the short and long term. However, it is these constant fluctuations in the foreign exchange market that make it possible for companies or individuals to take advantage of the movements in exchange rates through speculative activities. These fluctuations also pose a threat for any importer/exporter trading in the global marketplace as international businesses are naturally exposed to currency risk. This necessitates the adoption of hedging strategies to mitigate risk. The volatility in the foreign exchange market needs to be dealt with in a proper, prudent and timely manner. Otherwise, adverse currency fluctuations can inflict painful lessons on a company or individual. Foreign exchange is an over-the-counter market where brokers/dealers negotiate directly with one another, so there is no central exchange or clearing house. The biggest geographic trading center is the United Kingdom, primarily London, which according to The City UK estimates has increased its share of global turnover in traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to London's dominance in the market, a particular
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currency's quoted price is usually the London market price. For instance, when the International Monetary Fund calculates the value of its Special Drawing Rights every day, they use the London market prices at noon that day.

GLOBAL FOREIGN EXCHANGE MARKET The foreign exchange market (forex, FX, or currency market) is a global, worldwidedecentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies. The foreign exchange market assists international trade and investment, by enabling currency conversion. For example, it permits a business in the United States to import goods from the United Kingdom and pay pound sterling, even though its income is in United States dollars. It also supports direct speculation in the value of currencies, and the carry trade, speculation on the change in interest rates in two currencies.[2] In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on
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foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.

INDIAN FOREIGN EXCHANGE MARKET The foreign exchange market in India started in earnest less than three decades ago when in 1978 the government allowed banks to trade foreign exchange with one another. Today over 70% of the trading in foreign exchange continues to take place in the interbank market. The market consists of over 90 Authorized Dealers (mostly banks) who transact currency among themselves and come out “square” or without exposure at the end of the trading day. Trading is regulated by the Foreign Exchange Dealers Association of India (FEDAI), a self regulatory association of dealers. Since 2001, clearing and settlement functions in the foreign exchange market are largely carried out by the Clearing Corporation of India Limited (CCIL) that handles transactions of
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approximately 3.5 billion US dollars a day, about 80% of the total transactions. The liberalization process has significantly boosted the foreign exchange market in the country by allowing both banks and corporations greater flexibility in holding and trading foreign currencies. The Sodhani Committee set up in 1994 recommended greater freedom to participating banks, allowing them to fix their own trading limits, interest rates on FCNR deposits and the use of derivative products. The growth of the foreign exchange market in the last few years has been nothing less than momentous. In the last 5 years, from 2000-01 to 2005-06, trading volume in the foreign exchange market (including swaps, forwards and forward cancellations) has more 3 than tripled, growing at a compounded annual rate exceeding 25%. In March 2006, about half (48%) of the transactions were spot trades, while swap transactions (essentially repurchase agreements with a one-way transaction – spot or forward – combined with a longer- horizon forward transaction in the reverse direction) accounted for 34% and forwards and forward cancellations made up 11% and 7% respectively. About two-thirds of all transactions had the rupee on one side. In 2004, according to the triennial central bank survey of foreign exchange and derivative markets conducted by the Bank for International Settlements (BIS (2005a)) the Indian Rupee featured in the 20th position among all currencies in terms of being on one side of all foreign transactions around the globe and its share had tripled since 1998. As a
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host of foreign exchange trading activity, India ranked 23rd among all countries covered by the BIS survey in 2004 accounting for 0.3% of the world turnover. Trading is relatively moderately concentrated in India with 11 banks accounting for over 75% of the trades covered by the BIS 2004 survey.

FOREIGN EXCHANGE MARKET PARTICIPANTS Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the interbank market, which is made up of the largest commercial banks and securities dealers. Within the inter-bank market, spreads, which are the difference between the bids and ask prices, are razor sharp and usually unavailable, and not known to players outside the inner circle. The difference between the bid and ask prices widens (from 0-1 pip to 1-2 pips for some currencies such as the EUR). This is due to volume. If a trader can guarantee large numbers of transactions
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for large amounts, they can demand a smaller difference between the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign exchange market are determined by the size of the "line" (the amount of money with which they are trading). The top-tier interbank market accounts for 53% of all transactions. Banks The interbank market caters for both the majority of commercial turnover and large amounts of speculative trading every day. A large bank may trade billions of dollars daily. Some of this trading is undertaken on behalf of customers, but much is conducted by proprietary desks, trading for the bank's own account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading and matching anonymous counterparts for small fees. Today, however, much of this business has moved on to more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago. Commercial companies An important part of this market comes from the financial activities of companies seeking foreign exchange to pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks or speculators, and their trades often have little short term impact on market rates.

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Nevertheless, trade flows are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies can have an unpredictable impact when very large positions are covered due to exposures that are not widely known by other market participants. Central banks National central banks play an important role in the foreign exchange markets. They try to control the money supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They can use their often substantial foreign exchange reserves to stabilize the market. Milton Friedman argued that the best stabilization strategy would be for central banks to buy when the exchange rate is too low, and to sell when the rate is too high—that is, to trade for a profit based on their more precise information. Nevertheless, the effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if they make large losses, like other traders would, an there is no convincing evidence that they do make a profit trading. Hedge funds as speculators About 70% to 90% of the foreign exchange transactions are speculative. In other words, the person or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end; rather, they were solely speculating on the
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movement of that particular currency. Hedge funds have gained a reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if the economic fundamentals are in the hedge funds' favor. Investment management firms Investment management firms (who typically manage large accounts on behalf of customers such as pension funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For example, an investment manager bearing an international equity portfolio needs to purchase and sell several pairs of foreign currencies to pay for foreign securities purchases. Retail foreign exchange brokers Retail traders (individuals) constitute a growing segment of this market, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail brokers, while largely controlled and regulated in the USA by the CFTC and NFA have in the past been subjected to periodic foreign exchange scams. To deal with the issue, the NFA and CFTC began (as of 2009) imposing stricter requirements, particularly in relation to the amount of Net Capitalization required of its members. As a result many of the smaller, and perhaps questionable brokers are now gone. They charge a commission or

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mark-up in addition to the price obtained in the market. Non-bank foreign exchange companies Non-bank foreign exchange companies offer currency exchange and international payments to private individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer speculative trading but currency exchange with payments. I.e., there is usually a physical delivery of currency to a bank account. Send Money Home offers an in-depth comparison into the services offered by all the major non-bank foreign exchange companies. It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign Exchange Companies. These companies' selling point is usually that they will offer better exchange rates or cheaper payments than the customer's bank. Money transfer/remittance companies Money transfer companies/remittance companies perform high-volume low-value transfers generally by economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents globally followed by UAE Exchange Financial Service Ltd.

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Foreign Currency Accounts: Nostro and Vostro Account: Nostro and vostro (Middle Italian, from Latin, noster and voster; English, ours and yours) are accounting terms used to distinguish an account you hold for another entity from an account another entity holds for you. The entities in question are almost always, but need not be, banks. It helps to recall that the term account refers to a record of transactions, whether current, past or future, and whether in money, or shares, or other countable commodities. Originally a bank account just meant the record kept by a banker of the money they were holding on behalf of a customer, and how that changed as the customer made deposits and withdrawals (the money itself probably being in the form of species, such as gold and silver coin). The terms nostro and vostro remove the potential ambiguity when referring to these two separate accounts of the same balance and set of transactions. Speaking from the bank's point-of-view: • A nostro is our account of our money, held by you • A vostro is our account of your money, held by us Note that all "bank accounts" as the term is normally understood, including personal or corporate loan, and savings accounts, are treated as vostros by the bank. They also regard as vostro purely internal funds such
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as treasury, trading and suspense accounts; although there is no "you" in the sense of an external customer, the money is still "held by us". Loro Account: There is also the notion of a loro account ("theirs"), which is a record of an account held by a second bank on behalf of a third party; that is, my record of their account with you. In practice this is rarely used, the main exception being complex syndicated financing. In the same style as above: • A loro is our account of their money, held by you Foreign Exchange Derivative A Foreign exchange derivative is a financial derivative where the underlying is a particular currency and/or its exchange rate. These instruments are used either for currency speculation and arbitrage or for hedging foreign exchange risk. For detail see: · · · · Foreign exchange option Forex swap Currency future Forwards

Hedging Strategies/ Instruments A derivative is a financial contract whose value is derived from the value of some other financial asset, such as a stock price, a commodity price, an
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exchange rate, an interest rate, or even an index of prices. The main role of derivatives is that they reallocate risk among financial market participants, help to make financial markets more complete. This section outlines the hedging strategies using derivatives with foreign exchange being the only risk assumed. Forwards: A forward is a made-to-measure agreement between two parties to buy/sell a specified amount of a currency at a specified rate on a particular date in the future. The depreciation of the receivable currency is hedged against by selling a currency forward. If the risk is that of a currency appreciation (if the firm has to buy that currency in future say for import), it can hedge by buying the currency forward. E.g if RIL wants to buy crude oil in US dollars six months hence, it can enter into a forward contract to pay INR and buy USD and lock in a fixed exchange rate for INR-USD to be paid after 6 months regardless of the actual INR-Dollar rate at the time. In this example the downside is an appreciation of Dollar which is protected by a fixed forward contract. The main advantage of a forward is that it can be tailored to the specific needs of the firm and an exact hedge can be obtained. On the downside, these contracts are not marketable, they can’t be sold to another party when they are no longer required and are binding. Futures: A futures contract is similar to the forward contract but is more liquid because it is traded in an organized exchange i.e. the futures market.

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Depreciation of a currency can be hedged by selling futures and appreciation can be hedged by buying futures. Advantages of futures are that there is a central market for futures which eliminates the problem of double • • • • • Forecasts Risk Estimation Benchmarking Hedging Stop Loss

Reporting and review Corporate Hedging for Foreign Exchange Risk coincidence. Futures require a small initial outlay (a proportion of the value of the future) with which significant amounts of money can be gained or lost with the actual forwards price fluctuations. This provides a sort of leverage. The previous example for a forward contract for RIL applies here also just that RIL will have to go to a USD futures exchange to purchase standardized dollar futures equal to the amount to be hedged as the risk is that of appreciation of the dollar. As mentioned earlier, the tailor ability of the futures contract is limited i.e. only standard denominations of money can be bought instead of the exact amounts that are bought in forward contracts. Options: A currency Option is a contract giving the right, not the obligation, to buy or sell a specific quantity of one foreign currency in exchange for another at a fixed price; called the Exercise Price or Strike Price. The fixed nature of the exercise price reduces the uncertainty of exchange rate changes
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and limits the losses of open currency positions. Options are particularly suited as a hedging tool for contingent cash flows, as is the case in bidding processes. Call Options are used if the risk is an upward trend in price (of the currency), while Put Options are used if the risk is a downward trend. Again taking the example of RIL which needs to purchase crude oil in USD in 6 months, if RIL buys a Call option (as the risk is an upward trend in dollar rate), i.e. the right to buy a specified amount of dollars at a fixed rate on a specified date, there are two scenarios. If the exchange rate movement is favorable i.e the dollar depreciates, then RIL can buy them at the spot rate as they have become cheaper. In the other case, if the dollar appreciates compared to today’s spot rate, RIL can exercise the option to purchase it at the agreed strike price. In either case RIL benefits by paying the lower price to purchase the dollar Swaps: A swap is a foreign currency contract whereby the buyer and seller exchange equal initial principal amounts of two different currencies at the spot rate. The buyer and seller exchange fixed or floating rate interest payments in their respective swapped currencies over the term of the contract. At maturity, the principal amount is effectively reswapped at a predetermined exchange rate so that the parties end up with their original currencies. The advantages of swaps are that firms with limited appetite for exchange rate risk may move to a partially or completely hedged position through the mechanism of foreign currency swaps, while leaving the underlying borrowing intact. Apart from covering
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the exchange rate risk, swaps also allow firms to hedge the floating interest rate risk. Consider an export oriented company that has entered into a swap for a notional principal of USD 1 mn at an exchange rate of 42/dollar. The company pays US 6months LIBOR to the bank and receives 11.00% p.a. every 6 months on 1st January & 1st July, till 5 years. Such a company would have earnings in Dollars and can use the same to pay interest for this kind of borrowing (in dollars rather than in Rupee) thus hedging its exposures. Foreign Debt: Foreign debt can be used to hedge foreign exchange exposure by taking advantage of the International Fischer Effect relationship. This is demonstrated with the example of an exporter who has to receive a fixed amount of dollars in a few months from present. The exporter stands to lose if the domestic currency appreciates against that currency in the meanwhile so, to hedge this, he could take a loan in the foreign currency for the same time period and convert the same into domestic currency at the current exchange rate. CORPORATE HEDGING IN INDIA The move from a fixed exchange rate system to a market determined one as well as the development of derivatives markets in India have followed with the liberalization of the economy since 1992. In this context, the market for hedging instruments is still in its developing stages. In order to understand the alternative hedging strategies that Indian firms can
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adopt, it is important to understand the regulatory framework for the use of derivatives here. Development of Derivative Markets in India The economic liberalization of the early nineties facilitated the introduction of derivatives based on interest rates and foreign exchange. Exchange rates were deregulated and market determined in 1993. By 1994, the rupee was made fully convertible on current account. The ban on futures trading of many commodities was lifted starting in the early 2000s. As of October 2007, even corporate have been allowed to write options in the atmosphere of high volatility. Institutional investors prefer to trade in the Over-TheCounter (OTC) markets to interest rate futures, where instruments such as interest rate swaps and forward rate agreements are thriving. Foreign exchange derivatives are less active than interest rate derivatives in India, even though they have been around for longer. OTC instruments in currency forwards and swaps are the most popular. Importers, exporters and banks use the rupee forward market to hedge their foreign currency exposure. Turnover and liquidity in this market has been increasing, although trading is mainly in shorter maturity contracts of one year or less. CASE OF RANBAXY LABORATORIES:

Ranbaxy Laboratories Limited is an Indian pharmaceutical company that was incorporated in India in 1961.
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∗ The company went public in 1973 and Japanese pharmaceutical company Daiichi Sankyo gained majority control in 2008. ∗ Ranbaxy exports its products to 125 countries with ground operations in 46 and manufacturing facilities in seven countries. ∗ In year 2008 Company entered into numerous Forex Strip Options. ∗ At that time USD-INR was Rs. 39.90. ∗ Bought PUT Option from Bank. ∗ Sold CALL Option to Banks. ∗ Dollar Appreciated and Bank Exercised CALL Options. ∗ Rs. 784 Crore Loss to Company. ∗ Ranbaxy Laboratories, India's largest drugmaker by sales, may be sitting on mark-to-market (MTM) losses of over Rs 2,500 crore on foreign currency derivatives transactions entered into with various banks, according to estimates by one of its lenders in February this year. ∗ With this lender alone, the company is running an MTM loss of Rs 600 crore on the derivatives contracts it had signed in April-May 2008 ∗ Company opted for CALL & PUT option so risk should have been hedged. ∗ But the Ratio was 1:2.5CALLS. ∗ Loss due to writing off call option & Loss of premium paid. CASE OF AXIS BANK

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Liability on account of outstanding exchange and derivative contracts: Rs. In Crores 2010-11 Forward Contracts 194,049 Interest Rate Swaps, Currency 164,701 Swaps, Forward Rate Agreement & Interest Rate Futures Foreign Currency Options TOTAL 14,125 372,877

forward

2009-10 126,535 131,757

5,616 263,909

For Foreign Branches: ∗ Assets and liabilities (both monetary and nonmonetary as well as contingent liabilities) are translated at closing rates notified by FEDAI at the year end. ∗ Income and expenses are translated at the rates prevailing on the date of the transactions. ∗ All resulting exchange differences are accumulated in a separate ‘Foreign Currency Translation Reserve’ till the disposal of the net investments. ∗ Premium/discount on currency swaps is recognized as interest income/expense and is amortized on a pro-rata basis over the underlying swap period. ∗ Other obligations in foreign currencies are disclosed at closing rates of exchange.
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OBSERVATIONS Derivative use for hedging is only to increase due to the increased global linkages and volatile exchange rates. Firms need to look at instituting a sound risk management system and also need to formulate their hedging strategy that suits their specific firm characteristics and exposures. In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets has increased, although the use is mainly in shorter maturity contracts of one year or less. Forward and option contracts are the more popular instruments. Regulators had initially only allowed certain banks to deal in this market however now corporate can also write option contracts. ∗ Hedging through Options rather than futures. ∗ Currency swaps are more cost-effective for hedging foreign debt risk. ∗ Forward contracts are more cost-effective for hedging foreign operations risk. ∗ High Fluctuations in Indian Rupee has caused huge Loss to Indian Companies such as Renuka Sugars, Hindalco. Etc.

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FOREIGN EXCHANGE RESERVES

EXTERNAL DEBT

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USA – CHINA CURRENCY ISSUES Bretton Woods I The original Bretton Woods system was the system of fixed exchange rates that existed from the end of World War II (1946), until its collapse in 1971. – John Maynard Keynes was a principle architect of the Bretton Woods System. – Global financial system would have fixed exchange rates in order to prevent the beggar-thy-neighbor policies of currency devaluations that characterized the 1930’s. – The dollar could be converted to any other major currency or gold at a fixed exchange rate.

Role of IBRD & IMF  IBRD: International Bank For Reconstruction And Development
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 Give loans to countries for reconstruction of Infrastructure.  IMF: International Monetary Fund  To monitor Exchange rate stability  Advice country to follow Fixed exchange rate system  Give loans to countries to overcome BOP problems By the early 1970s, as the Vietnam War accelerated inflation, the United States was running not just a balance of payments deficit but also a trade deficit. The crucial turning point was 1970, which saw U.S. gold coverage deteriorate from 55% to 22%. In the first six months of 1971, assets for $22 billion fled the United States. In response, on August 15, 1971, President Nixon unilaterally “closed the gold window.” “Bretton Woods II” is a term coined by three Deutsche Bank economists — Michael Dooley, Peter Garber, and David Folkers-Landau — in a series of papers in 2003–2004 to describe the current international monetary system: In this system, the United States and the Asian economies have entered into an implicit contract where the U.S. runs current account deficits and the Asian countries keep their currencies fixed and undervalued by buying U.S. government debt.

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According to Dooley, Folkert-Landau, and Garber (DFG), this system has benefits to both parties: – The U.S. obtains a stable and low-cost source of funding for its current account and budget deficits, and can easily reduce taxes, and increase government spending at the same time. – For the Asian countries, the undervalued currency creates export-led development strategy that produces economic and employment growth to keep the lid on potentially explosive pressures rising large pools of surplus labor.

US-China Currency Issue  China have trade surplus with USA & World.  Chinese central bank maintained exchange fixed ($ = 8.28 Yuan) YEAR 2006 2007 currency

China Foreign CurrencyChina Trade Surplus (in Reserve (in $) $) 1.06 Trillion 1.5 Trillion 178 Billion 268 Billion
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2008 2009 2010

1.9 Trillion 2.39 Trillion 2.64 Trillion

297 Billion 198 Billion 184.7 Billion

US Trade with China

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Steps Taken by China to avoid Manipulation in its Currency • China Modified its Currency Policy on July 21, 2005. • Yuan’s Exchange rate become adjustable with respect to Market Demand & Supply of currency in Basket. • Basket includes Dollar, Euro & Yen etc. So $ = 8.11 Yuan (2.1% appreciation) • Also Yuan can fluctuate by 0.3% on daily basis against basket.

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As per some Economist it was argued that: • China’s Currency is Undervalued by 40%. Which Resulted in: Chinese export to US Cheaper & US export to China Expensive Also rise in Trade Deficit from $ 30bn in 1994 to $ 260bn in 2007. 1988 Omnibus Trade & Competitiveness Act. Act requires the Treasury Department to report on exchange rate policies of Countries which have large Global Current Account Surplus & Trade Surplus with US. The aim was to find out, if they manipulate their currencies against dollar. And if manipulation found than Treasury is required to negotiate & end such practices. China reformed its currency in July 2005 and Treasury made following observation about China: • Current Account Surplus has reduced by Chinese Government. • 2006 – China made progress to make currency more flexible. • 2007 – Under manipulation. US law China has no currency

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• 2007 – China should accelerate the appreciation of RMB’s effective exchange rate in order to minimize risk.

China Foreign Currency reserve China has highest foreign currency reserve because of: High amount of Export And Hot money arrival i.e. foreign funds bought into the country. To tackle this the value of RMB should increase. In 2008 Foreign Exchange Regulations approach RMB exchange rate against other fully convertible currencies using floating system, based on Demand & Supply of Foreign Currency.

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Reasons China should let RMB appreciate, in its own interest 1. Overheating of economy 2. Reserves are excessive. – It gets harder to sterilize the inflow over time. 3. Attaining internal and external balance. – In a large country like China, expenditure-switching policy should be the exchange rate. 4. Avoiding future crashes.

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Policies to reduce the US CA deficit: • Reduce the US budget deficit over time, – thus raising national saving. – After all, this is where the deficits originated. • Depreciate the $ more. – Better to do it in a controlled way • than in a sudden free-fall. – The $ already depreciated a lot against the € • & other currencies • from 2002 to 2007. – Who is left? – The RMB is conspicuous as the one major currency that is still undervalued against the dollar. Problems with BW2: People’ Bank of China U.S. absorbs 80 percent of world’s savings not invested at their home country. The large CAD sends billions of dollars abroad, particularly to China. People’s Bank of China uses the inflow of dollars to purchase assets, mostly U.S. Treasuries.
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Much of the $400 billion fiscal deficit is financed by China. If China stops purchasing U.S. assets and switches to Japan, Europe, or other markets, it will cause a fall in the dollar and long-term interest rates will increase. Conclusions  In any case, the new Chinese Exchange Rate Mechanism is a step to the right direction.  The United States, in contrast, has not done anything.  President Bush has not vetoed a single spending bill. The government spending has increased faster than at any time since the 1960’s (“the Great Society” welfare programs and Vietnam War).  The massive tax cuts passed in 2001–2003 are set to expire in 2008–2010. What the China should do? If China intends to allow a series of small appreciations in the renminbi then it either has to 1. Keep its interest rates below U.S. rates, so that low interest rates offset the expected return from renminbi appreciation over time (currently bank deposit rates in China are
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capped at 2.5%, below the 3.5% federal funds rate). 2. Intervene a lot. 3. Or do both. Either way, this policy prevents independent Chinese monetary policy.

What the U.S. Should Do? Since these are temporary tax cuts and the likelihood they will be made permanent is low, basic economic theory tells us that their positive incentive effects are small. Since the President and the Congress are unable to control spending, the simplest way for the U.S. to reduce its fiscal deficit (and, indirectly, current account deficit) would be to repeal the 2001–2003 tax cuts.

EURO ZONE CRISES The European sovereign debt crisis is an ongoing financial crisis that has made it difficult or impossible for some countries in the euro area to refinance their government debt without the assistance of third parties.
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From late 2009, fears of a sovereign debt crisis developed among investors as a result of the rising government debt levels around the world together with a wave of downgrading of government debt in some European states. Concerns intensified in early 2010 and thereafter, leading Europe's finance ministers on 9 May 2010 to approve a rescue package worth €750 billion aimed at ensuring financial stability across Europe by creating the European Financial Stability Facility(EFSF). In October 2011 and February 2012, the euro zone leaders agreed on more measures designed to prevent the collapse of member economies. This included an agreement whereby banks would accept a 53.5% write-off of Greek debt owed to private creditors, increasing the EFSF to about €1 trillion, and requiring European banks to achieve 9% capitalisation. To restore confidence in Europe, EU leaders also agreed to create a common fiscal union including the commitment of each participating country to introduce a balanced budget amendment. While sovereign debt has risen substantially in only a few eurozone countries, it has become a perceived problem for the area as a whole. Nevertheless, the European currency has remained stable. As of midNovember 2011, the euro was even trading slightly higher against the bloc's major trading partners than at the beginning of the crisis. The three countries most affected, Greece, Ireland and Portugal, collectively account for six percent of the eurozone's gross domestic product (GDP). On 23 April 2010, the Greek government requested an initial loan of €45 billion from the EU and International Monetary Fund (IMF), to cover its financial needs for
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the remaining part of 2010. A few days later Standard & Poor's slashed Greece's sovereign debt rating to BB+ or "junk" status amid fears of default, in which case investors were liable to lose 30–50% of their money. Stock markets worldwide and the Euro currency declined in response to this announcement. On 1 May 2010, the Greek government announced a series of austerity measures to secure a three year €110 billion loan. This was met with great anger by the Greek public, leading to massive protests, riots and social unrest throughout Greece. The Troika (EU, ECB and IMF), offered Greece a second bailout loan worth €130 billion in October 2011, but with the activation being conditional on implementation of further austerity measures and a debt restructure agreement. A bit surprisingly, the Greek prime minister George Papandreou first answered that call, by announcing a December 2011 referendum on the new bailout plan, but had to back down amidst strong pressure from EU partners, who threatened to withhold an overdue €6 billion loan payment that Greece needed by mid-December. On 10 November 2011 Papandreou instead opted to resign, following an agreement with the New Democracy party and the Popular Orthodox Rally, to appoint non-MP technocrat Lucas Papademos as new prime minister of an interim national union government, with responsibility for implementing the needed austerity measures to pave the way for the second bailout loan. All the implemented austerity measures, have so far helped Greece bring down its primary deficit before
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interest payments, from €24.7bn (10.6% of GDP) in 2009 to just €5.2bn (2.4% of GDP) in 2011, but as a side-effect they also contributed to a worsening of the Greek recession, which began in October 2008 and only became worse in 2010 and 2011. Overall the Greek GDP had its worst decline in 2011 with -6.9%, a year where the seasonal adjusted industrial output ended 28.4% lower than in 2005, and with 111,000 Greek companies going bankrupt (27% higher than in 2010). As a result, the seasonal adjusted unemployment rate also grew from 7.5% in September 2008 to a record high of 19.9% in November 2011, while the Youth unemployment rate during the same time rose from 22.0% to as high as 48.1%. Overall the share of the population living at "risk of poverty or social exclusion" did not increase noteworthy during the first 2 year of the crisis. The figure was measured to 27.6% in 2009 and 27.7% in 2010 (only being slightly worse than the EU27-average at 23.4%), but for 2011 the figure was now estimated to have risen sharply above 33%. In February 2012, an IMF official negotiating Greek austerity measures admitted that excessive spending cuts were harming Greece. Some economic experts argue that the best option for Greece and the rest of the EU, would be to engineer an “orderly default”, allowing Athens to withdraw simultaneously from the eurozone and reintroduce its national currency the drachma at a debased rate. However, if Greece were to leave the euro, the economic and political impact would be devastating.
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According to Japanese financial company Nomura an exit would lead to a 60 percent devaluation of the new drachma. UBS warned of "hyperinflation, military coups and possible civil war that could afflict a departing country". To prevent this from happening, the troika (EU, IMF and ECB) eventually agreed in February 2012 to provide a second bailout package worth €130 billion, conditional on the implementation of another harsh austerity package (reducing the Greek spendings with €3.3bn in 2012 and another €10bn in 2013 and 2014). For the first time, the bailout deal also included a debt restructure agreement with the private holders of Greek government bonds (banks, insurers and investment funds), to "voluntarily" accept a bond swap with a 53.5% nominal write-off along with lower interest rates and the maturity prolonged to 11-30 years (depending on the previous maturity). It is the world's biggest debt restructuring deal ever done, affecting some €206 billion of Greek government bonds. The debt write-off had a seize of €107 billion, and caused the Greek debt level to fall from roughly €350bn to €240bn in March 2012, with the predicted debt burden now showing a more sustainable size equal to 117% of GDP, somewhat lower than the originally expected 120.5%. On 9 March 2012 the International Swaps and Derivatives Association (ISDA) issued a communique calling the PSI/debt restructuring deal a "Restructuring Credit Event" which will cause credit default swaps.
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According to Forbes magazine Greece’s restructuring represents a default.

IMPACT ON GLOBAL ECONOMY ∗ Portugal, Ireland, Italy, Greece and Spain have huge debt-GDP ratios and unsustainably huge fiscal deficits. ∗ Rating agency Standard & Poor's cut the sovereign credit ratings of nine Euro zone countries. ∗ Impact on Oil Demand. ∗ Long-term interest rate doubled reaching 18% in Greece and 12% in Ireland and Portugal. IMPACT ON INDIAN ECONOMY ∗ Capital outflows and sharp depreciation in the rupee value.
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∗ IT exporters earn 20-30% from the European market. ∗ Now only US remains the major market for companies. ∗ Impact of sluggish growth in the European economies could be limited. ∗ Tata Steel earns almost 60% of its revenues from operations in Europe. ∗ Costs for raw materials such as iron ore and coking coal have risen sharply. IMPACT ON USA ∗ US exports to Europe are such a small part of the economy. ∗ If any bank in core Europe Fails, The Bank will be Nationalized by US Government. ∗ Financial Market, Real Estate Market will be affected. ∗ Debt markets have been negatively affected by the euro-crisis. ∗ Since Oct 2011, commercial mortgage-backed securities issuance has posted only $1 billion per month versus $5 billion in 2011. IMPACT ON CHINA ∗ Chinese Export reduced by 17.1% in December 2011. ∗ Imports increased but it will get affected by Chinese Monetary Policy.
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∗ Decline in the amount of foreign capital flowing into China. ∗ China’s foreign exchange reserves lost $87.9 billion in value. ∗ China growth reduced to 8.4% from 9.1%.

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