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 deposits and investments and/or foreign assets. The claims may be denominated in various foreign currencies purchased and sold and involve exchange as between various currencies. Thus, these transactions give rise to (i) Borrowing and lending operations in foreign currencies or trading in financial assets denominated in foreign currencies and (ii) A foreign exchange transaction involving an exchange of one currency for another. The first is called the foreign currency market and the second is the foreign exchange market.
Foreign Exchange Market:
International economic and commercial relations between countries involve exchange of goods and services and payments for these exchanges. The payments lead to conversion of one currency into another. Each country has its own financial system and its own currency and financial assets. Exchanges between the money and financial assets of one country for money or financial assets of another country constitutes international financial transactions. These transactions are put through the foreign exchange market. The demand for any currency as against its supply in such markets determines the exchange rate. These financial assets could be money or near-money assets, cheques, drafts, mail transfers and other negotiable instruments.
The difference between the domestic financial system and international financial system lies in the introduction of exchange of one currency for another or exchange of one instrument in one currency for another denominated in a different currency. In the process of such exchange, the transfer problem arises in the international markets which relates to the problem of finding the proper source of supply to suit the demand for any foreign currency. This leads to an adjustment process in the balance of payments of the various countries which in turn depends upon the type of international monetary system in vogue. These will be dealt with in another chapter.
The basic principle involved is that economic and commercial transactions between one country and another are adjusted by the corresponding purchase and sale of financial assets, including money and near-money by one country for that of another country. The prices of goods and services of one country vis-a-vis the prices of the corresponding goods and services of another country will determine the purchasing power of each currency. Exchange rate is primarily a reflection of the purchasing power of the currency domestically. Exchange rate fluctuations on a day-to-day basis will depend, however, upon the competitive forces of demand for and supply of any currency in these markets. In the short run and long run, exchange rates would depend upon the relative degrees of inflation in the domestic economies and changes in the purchasing power of currencies. Exchanges standard and the international monetary system would facilitate such adjustment of exchange rates to changes in supply and demand and to changes in purchasing power parities. Speculative purchases and sales of currencies and hedge trading in these currencies would also take place daily and would depend upon their relative strengths in international markets, market confidence in those currencies and intrinsic strength of the domestic economies.
The International Monetary Fund was established to facilitate transactions as between the member-countries and impart an element of stability in the international monetary scene. Each country can purchase and sell its currency from the International Monetary Fund for another currency of the member country to meet its requirements of international payments for goods and services.
International Currency Markets:
As an adjunct to the exchange markets, there are international currency markets where internationally accepted currencies, namely, the so-called reserve currencies, are traded. These relate to the deposits of such currencies with international banks at an agreed rate of interest. The excess funds in these reserve currencies owned by countries, institutions and governments having surplus receipts over payments would be lent out to banks and other financial institutions for various durations at a rate of interest. The currencies are in demand for meeting the balance of payments deficits or for investment in fixed capital or for working capital purposes.
The other components of the international financial system are international capital markets and bonds markets. The international capital markets such as London, New York, Zurich etc. have lost much of their popularity due to national restrictions and scarcity of funds in those centres. Bond markets in these centres are still operating and international banks are arranging these issues on a selective basis. Now, Euro¬currency and Euro-bond markets are the most popular international means of medium and long-term financing.
The relations between the foreign exchange market and international currency markets are not difficult to comprehend. The trade and other economic and commercial transactions involve receipts and payments as between countries. These will lead to exchange of one currency for others. The demand for and supply of each of the currencies against an alternative currency determines the rate at which two currencies are exchanged. This is called the exchange rate and the market is the foreign exchange market. In the process of such economic and commercial transactions, a country can be a net creditor or a debtor. If a country is a net creditor or has a positive trade surplus or receives more than it pays out, it has net foreign claims on others. Such claims are held in the form of deposits, balances, etc., abroad or investments in Treasury Bills, Government and Private securities etc. Such claims would lead to international currency holdings which are generally held in convertible currencies by the creditor countries for reasons of facilitating subsequent use and conversion for international payments. Any market representing the demand for and supply of such currencies is called the international currency market. While thus the foreign currency market refers to trading in external dollars or other currencies held abroad, foreign exchange market refers to the conversion of such dollars into other currencies. The obvious inter-relations between these two segments in the international financial system need no elaboration.
Institutions in International Financial System:
There are a number of institutions who are part of the international financial system. These institutions can be classified into the following categories:
• >National banks and domestic financial institutions which deal in foreign currencies and foreign credits.
• International brokers of repute.
• Regional or multi-national banks or corporations dealing in international markets and borrowing/ lending in these markets.
• Regional Finance and Development Corporations and banks such as the Asian Development Bank, Commonwealth Finance Corporation, Latin American Development Bank, Bank for International Settlements, 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).