Question Paper

International Finance and Trade – II (222) July 2005

Section D : Case Study (50 Marks)
This section consists of questions with serial number 1 - 5.
Answer all questions.
Marks are indicated against each question.
Do not spend more than 80 - 90 minutes on Section D.

Case Study
Read the case carefully and answer the following questions:
1. Compare the centralized cash management system with decentralized cash management system.
(8 marks) < Answer >
2. The following are the minimum cash balances required at three centers:
($’ 000)

Affiliate Singapore Hongkong London

Minimum balance 100 250 125
Based on the above, project the borrowing and investment plan of each subsidiary for next five months
under the current policy of the company.
(18 marks) < Answer >
3. Prepare a projected cash flow statement to evaluate the borrowing/ investment plan for the next five months
if the cash management is completely centralized. (Assume borrowing and investments will be done at the
beginning of each month)
(6 marks) < Answer >
4. Discuss in brief various instruments available to raise funds in international financial markets.
(10 marks) < Answer >
5. State how the Eurocurrency interest rates are determined?
(8 marks) < Answer >
Increasing globalization of a company’s activities has stimulated demand for more efficient, cost –
effective means of doing business across borders. The objective of cash management is to maximize the
return by proper allocation of short – term investments and to minimize the cost of borrowing by borrowing
in different money markets. To achieve this objective, there should be a good management information
system (MIS). Cash positions, expected receipts must be reported without fail and forecast of cash flows
should be developed in a comprehensive, accurate and timely manner. The treasury manager at the Head
Quarters must obtain the financial positions of affiliates. The next step is to forecast (i) the cash
requirements or surpluses, (ii) local and international money market conditions and (iii) likely movements
of exchange rates.
As a result of rapid and pronounced changes in the international monetary arena, the need for most frequent
reports has become acute. Companies that had been content with receiving information quarterly now felt
the need of getting them monthly, weekly and even on daily basis.
Midwest Trading Inc. is one such company based in Texas U.S. The company is involved in trading
activities mainly in North America, London and Southeast Asian Countries. It has three subsidiaries in
London, Singapore and Hongkong. The headquarters in Texas maintains a central cash pool in US for all
these subsidiaries. Each day, at the close of banking hours, every affiliate reports its current cash balances
in cleared funds to central cash pool that is, its cash positions net of all receipts and payments that have
cleared during the day. All balances are reported in a common currency, which is the US dollar, with local
currencies translated at the market rates. The following are the cash positions of three subsidiaries at the
end of June 2005.

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 Subsidiary Cash position ($ 000)
Singapore - 150
Hongkong + 350
London + 100
The following are the forecasts of local currency cash flows of the three subsidiaries for the next five
months converted into US$.
Singapore Subsidiary ($’ 000)

Month July August September October November

Receipts 400 125 300 275 250
Payments 200 225 700 275 100
Net * + 200 - 100 - 400 0 + 150

Hongkong Subsidiary ($’ 000)

Month July August September October November

Receipts 430 360 500 750 450
Payments 50 760 370 230 120
Net * + 380 - 400 + 130 + 520 + 330

London Subsidiary ($’ 000)

Month July August September October November
Receipts 100 260 150 300 200
Payments 50 110 350 50 300
Net * + 50 + 150 - 200 + 250 - 100

* All the above net positions are at the end of the month.
The company follows a laid down policy to manage its cash position in these subsidiaries. The policy
stipulates that:
(i) All the investments and borrowings requirement should be met at the local market to the extent
of current month’s inflows and outflows.
(ii) All excess amounts beyond the minimum balance to be maintained should be transferred to the
central pool.
(ii) The investments/borrowings with the central pool should be done at the Eurodollar interest rate.
Interest will be received/paid at the time of liquidation only. The applicable interest rate for
investments/borrowings will be the interest rate for the number of months, the fund remains
invested/borrowed.
The estimates given in the forecast are arrived at by converting local currency of the subsidiaries using
the following spot and forward rates.

Exchange rate Spot on Forward

June 30
July August September October November
S$ / $ 1.6665/67 8/6 15/13 24/22 30/28 35/33
HK$ / $ 7.8125/27 10/12 18/20 28/30 35/37 38/40
$/£ 1.8735/37 15/17 28/30 45/47 56/58 60/62
The interest rates prevailing now are given below. It is assumed that interest rates will remains unchanged
for the next five months.

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 Interest rate 1 month 2 month 3 month 4 month 5 month
LIBOR
$ 2.75 – 3.25% 2.80 – 3.30% 2.90 – 3.35% 3.00 – 3.50% 3.05 – 3.55%
S$ 2.50 – 3.00% 2.60 – 3.10% 2.75 – 3.25% 2.85 – 3.35% 3.00 – 3.50%
HK$ 2.10 – 2.50% 2.15 – 2.55% 2.20 – 2.60% 2.25 – 2.65% 2.30 – 2.70%
£ 4.60 – 5.10% 4.70 – 5.20% 4.80 – 5.30% 4.90 – 5.40% 5.00 – 5.50%
END OF SECTION D

Section E : Caselets (50 Marks)

This section consists of questions with serial number 6 - 12.
Answer all questions.
Marks are indicated against each question.
Do not spend more than 80 - 90 minutes on Section E.

Caselet 1
Read the caselet carefully and answer the following questions:
6. What is meant by a nation’s balance of payments? How can a deficit or surplus in the balance of payments
be measured?
(7 marks) < Answer >
7. Discuss the factors that affect a country’s exports of goods and services.
(7 marks) < Answer >
8. What can be the impact of a balance of payments crisis on the economy?
(6 marks) < Answer >
India's foreign exchange reserves zoomed by over $12 billion in five weeks ending March 19, 2005.
According to banking sources familiar with Reserve Bank of India data, the major accretion has been on
account of invisibles and external commercial borrowings (ECBs). In invisibles, the areas that have
contributed the most are private transfers, software and export-related services. In ECBs, the number of
borrowers have gone up although funds raised are not very high. The balance of payment data, yet to be
released by the RBI for the fourth quarter of financial year ended March 2005, are likely to show a current
account surplus as against deficits in last two quarters, said sources. Non resident Indian (NRI) deposits’
kitty, which has been drying down with net outflows, has started improving after the government decided
to continue with the tax exemption in the last Union budget. Under capital flows, portfolio investments
stood at over $ 2 billion. While there has been positive accretion in the foreign direct investment,
investment of around $900 million by Holcim was the largest FDI for the quarter, said sources. For the
week ended March 25, the foreign exchange reserves stood at around $141 billion. The comforting factor in
the data is the fact that the foreign exchange inflows are no longer dependent on the interest rate sensitive
flows like portfolio investments.
Although there has not been much growth in foreign institutional investor inflows, overall growth in the
forex reserves has been phenomenal. In the third quarter, the current account deficit continued further
inflated by clocking $5.4 billion as against $4 billion in the second quarter 2004-05, according to the
balance of payment data released by the Reserve Bank of India. This has been due to steady expansion in
trade deficit taking it to historic highs of $11.8 billion as against $9.8 billion in the second quarter.
The last BoP data showed that the capital account remains in surplus at $ 12 billion as against $ 4.6 billion ,
primarily due to surge in FII inflows, sharp rise in external commerial borrowings, short-term credits and
overseas borrowings by banks. While foreign investment has gone down to $7.3 billion as against $10.1
billion the same quarter last year, ECBs grew to $ 4.1 billion as against a negative accretion of $3.4 billion.
Short-term credit was at $ 2.7 billion. Non-resident Indian deposits, on the other hand, fell by $1.3 billion
as against a growth of $3.7 billion. The components boosting foreign exchange reserves during the third
quarter were a 40 per cent growthh in foreign investment, 22.5 per cent growth in ECBs, 3.8 per cent
growth in external assistance, 14.8 per cent growth in short credit. Net invisibles were marginally down to
$6.3 billion as against $7.2 billion in the corresponding quarter last year.
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 Caselet 2
Read the caselet carefully and answer the following questions:
9. What makes Asia feasible for common currency criteria? Discuss.
(7 marks) < Answer >
10. Explain the various benefits a common currency can offer to Asia.
(7 marks) < Answer >
The introduction of euro in 1999 has resulted in the currency system slowly shifting towards common
currency regime. The universal dominating currencies like dollar, yen and now euro have given the
concerned countries competitive advantage over the Asian countries. As a result, Asian economies are now
debating over the feasibility of introducing common currency for their region.
The idea for an Asia common currency was first proposed by the Philippines and Hong Kong. The
suggestion was for the creation of an Asian Currency Unit (ACU), analogous to the European the Currency
Unit (ECU), which was the precursor of the euro. Creating a synthetic currency like the ACU may be a
viable route to monetary union in Asia in light of the absence of a single dominant currency or country.
Steps have already been initiated in this regard as China and the 10 member association of South East
Asian Nation (ASEAN)-Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, the Philippines,
Singapore, Thailand, and Vietnam-has already announced that they would create the world’s largest free
trade area: The ASEAN-China Free Trade Area (AFTA). Therefore, it has led to the debate on the
establishment of the Asian common market on the basis of European style.
The creation of AFTA would significantly change the economic scenario in this region. It will be first East
Asian economic group to operate without US as a member. A combined ASEAN-China market would be a
formidable market player, with 1.7 billion consurners, a combined GDP of approximately US$2tn, and total
international trade of about US$1.2 tn. However, it has been planned that the two neighboring countries,
Japan and South Korea will make this new organization the world’s second largest trading bloc after
European Union with a combined GDP of approximately US$6tn.
Earlier, Asian countries had not considered any economic integration, unlike their European counterparts.
But economic developments after East Asian crisis of 1997-1998 have changed the attitude of these
countries significantly, and as a result, it led to the emergence of a new regional group.
Thus, the idea of AFTA led many Asian leaders to consider the creation of a common East Asian currency
with the ultimate objective of the regional integration of Asia. This idea got impetus from the East Asian
crisis of 1997-1998 and more recently, due to the launch of euro, the common currency of Europe.
Caselet 3
Read the caselet carefully and answer the following questions:
11. How the oil price rise affects the currency of a country? Explain.
(8 marks) < Answer >
12. Discuss the impact of oil price rise on the Indian economy.
(8 marks) < Answer >
Oil prices in the international markets have of late been rising relentlessly sending shock waves across the
world. The prices of Brent and WTI-the leading benchmark types of physical crude oil crossed the $30 per
barrel mark in the early 2004. From then oil prices increased continuously and almost reached $50 per
barrel, settling at slightly lower levels during the third week of August 2004. The world economy is heated
up over this issue and analysts predict that there is very little scope for oil prices to reverse their direction
immediately.
Analysts across the world opine that the increase in oil prices is caused by a number of factors. Mounting
fear of uncertain future supplies of oil from Iraq owing to the destruction of the Iraqi oil facilities and
pipelines by the American military forces has created a major impact on the world oil prices. Increasing
terrorist attacks in Saudi Arabia has also created nervousness regarding the supplies from that country.
Surprisingly, in the existing scenario, OPEC’s failure to take necessary action to increase oil production
has triggered oil prices. The vows of the giant Russian oil company Yukos also supplemented to the rise in
prices. Apart from these, minor disturbances in any one of the oil producing countries like the ones in
Venezuela or Norway is also a trigger to the price hike.

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These issues have gained prominence in the recent past because of unmatched demand for and supply of
oil. Lately, there has been a spurt in demand for crude oil from US as well as other countries. Asian
demand for oil has grown by nearly 600,000 barrels per day in the first half of this year. The unexpectedly
high demand for crude oil from China has induced special interest among the analysts across the world.
China’s oil imports have increased by more than 40% since the beginning of the year. It is surprising to
know that China is hardly utilizing the imported oil for its consumption. It is recently unveiled that China is
in the process of building up its oil reserves so that it could in course of time replace its dollar reserves with
the oil reserves. On the same line even US is accumulating its Strategic Petroleum Reserves and is reluctant
to release these stocks to increase the supply. According to the newspaper reports. US is waiting for the
prices to rule between $55-60 per barrel before releasing those stocks. The US Department of Energy
predicts the global oil demand would cross 2 million barrels per day in the coming two years. Analysts
claim that the present oil price hike is lower in real terms when compared to the past price hikes.
OPEC has lately reacted to the situation and taken up the task of increasing oil production in the coming
months. But economists predict that this may not improve the situation as nothing much can be gained from
the two major oil producers. Iran and Venezuela, as Iran is producing to its maximum capacity and
Venezuela is opposed to further increase its production. Moreover, even if OPEC undertakes to increase the
production by one million barrels per day, it won’t reach the market until November of this year by which
time the demand would have risen again.
Generally, an oil price increase leads to a shift of income from oil importing countries to oil exporting
countries. Effect of an increase in oil prices especially for net oil importing countries depends upon the
percentage of the cost of oil in their national income, the extent to which the country depends upon
imported oil, and the readiness of the consumers to lessen their oil consumption and use alternative sources
of energy. An increase in oil prices leads to inflation, increased input costs, and lower investment in net oil
importing countries. Tax revenues fall and budget deficit increases due to rigidities in government revenues
and expenditure. For instance, the Indian government cut customs duties and excise duties on petrol, diesel,
kerosene and LPG, and ensured that consumers would not have to bear the burden of rising oil prices. This
may in course of time force the government to raise the interest rates if the same situation prevails.
Governments in many countries have also already started working in this direction.
Rising oil prices also affect the balance of trade between countries. Owing to imports becoming costlier,
net oil importing countries experience a worsening of their balance of payments. As a result, they
experience a drop in their real national income. On the other hand increased demand for dollars by the net
oil importing countries would lead to rise in the dollar value, putting pressure on other currencies. Higher
oil prices also put pressure on wage levels in the developing and underdeveloped countries and
consequently lead to unemployment in those countries.
A combination of higher inflation, higher unemployment, lower exchange rates and lower real income has
an impact on the overall impact on the economy over the longer term. Government polices may not
eliminate these adverse impacts but they can minimize them. Many governments are resorting to overly
contractionary or expansionary monetary and fiscal policies to contain inflationary pressures. But these
may worsen the impact of higher prices in the long run. The adverse economic impact of higher oil prices
on oil importing Asian and Sub-Saharan developing countries is generally more pronounced. On the basis
of a research conducted by IMF, a sustained $10 price rise in oil would cause changes in the inflation, real
GDP and Trade Balance of certain Asian and Sub-Saharan oil importing developing countries.
END OF SECTION E

END OF QUESTION PAPER

5
 Suggested Answers
International Finance and Trade – II (222) July 2005
Section D : Case Study
1. A major task of international cash management is to determine the levels of currency denominations of a
multinational group’s investment in cash balances and money market instruments. A multinational
corporation with subsidiaries in different parts of the world has cash flows in a variety of currencies and
countries. It can leave cash management to individual subsidiaries or have a centralised cash management
system. If the subsidiaries manage the cash independently then it has to manage his investment and
borrowing requirement and also have to manage their currency exposures, independently. If the subsidiary
is considering whether it should invest or borrow in domestic or foreign currency, the independently
handling of such activities will only increase the transaction costs through different routes. Centralised cash
management, in such a case will be extremely useful in reducing the transaction costs.
In a multinational corporations there are large number of transactions occurs regularly between subsidiaries
and between subsidiaries and parent. If all the resulting cash-flows are matched on pairwise basis, a huge
savings can be done through few numbers of currency conversions. This system of cash management is
known as netting. With a centralised system, netting is possible whereby the centralised cash management
centre nets out receivables against payables and only the net cash flows are settled among different units of
the corporate family.
Centralised cash management centre can also act as the repository of all surplus funds. Under this system,
all units are asked to transfer their surplus cash to the CMC which transfers them among the units as
needed and undertakes investment of surplus funds and short term borrowing on behalf of the entire
corporate family.
If individual subsidiaries are left to manage their currency exposures, each will have to access the forward
market and thus increasing the transactions costs. The cash management centre can look at the overall
currency composition of receivables and payables and take the borrowing and investment decisions in
different markets. As the overall portfolio will be fairly diversified, currency risk should be considerably
reduced.
Despite the above advantages of centralised cash management centre, some funds have to be held locally in
each subsidiary to meet unforeseen payments. Also there may be some situations which have to settled on
spot for which purposes local banks have to be used. So, each corporations must evolve its own optimal
degree of centralisation depending upon its nature of global operations, location of subsidiaries etc.
< TOP >
2.
Subsidiary Singapore Hongkong London Central cash pool
Cash position - 150 + 350 + 100 300
Minimum balance to 100 250 125 475
be maintained
Surplus/(Deficit) (250) 100 (25) (175)`
Singapore
This subsidiary has a negative cash balance of $ 150 000 to begin with. As per the policy of the company
the unit can borrow locally at the beginning of the month to the extent of surplus that is projected for the
month. In July, Singapore subsidiary is likely to have surplus of $ 200,000. So the unit can borrow an
amount equivalent o $ 200,000 which will be repaid after one month. But still it will be short of $ 50,000
which it will borrow from central pool. At the end of July, from the surplus available, it can repay
$200,000 with interest. This borrowing will be done in the local market and in local currency i.e. in S $.
Amount to be borrowed = 200 000  1.6665 = S $ 333300
0.03
Interest for one month = 333300  12 = S $ 833.25
Amount repayable = S $ 334133.25
1
Interest paid in dollars = 833.25  1.6661 = $ 500.12
At the end of July there will be no surplus or deficit, but it has to carry the loan taken from central pool. In
6
August, the unit faces a deficit of $ 100 000. But as there is no net inflow, it cannot borrow from local
market. It therefore borrows from central pool. Similarly for September it will borrow from Central pool.
The net positive cash flow at the end of November will be used to repay the borrowing from central pool.
Central Pool
Month (Borrow)/ Repay Duration Interest
1 $ (50000) 4 months 3.5%
2 (100 000) 3 months 3.35%
3 (400 000) 2 months 3.30%
4 - - -
5 150 000 - -
Hongkong
This subsidiary has a surplus of $ 100 000 to begin with followed by a surplus at the end of July. At
beginning of July it transferred $ 100 000 to central pool. In July through it has surplus, it is followed by a
deficit of $ 400 000 in next month. Therefore, surplus of July should be invested for one month in local
market and $ 20,000 should be withdrawn from central pool to meet the short fall.
Amount invested = $ 380 000
= 380 000  7.8135
= HK $ 2969130
0.021
Interest earned = 2969130  12 = HK $ 5195.98
5195.98
= 7.8147
= $ 664.90
For next three months subsidiary should transfer funds in the Central Pool.
Central Pool
Month Invest Withdrawn Duration Interest
1 100 000 -- 4 months 80000 at 3%
2 -- 20 000 -- 20 000 at 2.75%
3 130 000 -- 2 months 2.80%
4 520 000 -- 1 month 2.75%
5 330 000 -- -- --
London
Though the opening cash position is a surplus, but it is less than the minimum cash balance required.
Therefore, the subsidiary will have to borrow from the local market to the extent of $ 25000
Amount to be borrowed = $ 25000
1
= 25000  1.8735
= £ 13344
0.051
Interest for one month = 13344  12
= £ 56.71
Amount repayable = £ 13400.71
Amount repayable in $ = 13400.71  1.8754
= $ 25131.69
Interest paid in $ = 56.71  1.8754
= $ 106.35
Amount to be transferred in central pool at the end of July (50000 – 25131.69) = $24868.31
Amount to be invested in the local market in August for one month = $150000
150000 
Χ 1 +
0.046 

Amount received in September = 1.8767  12 
7
 = £80233.92
= 80233.92  1.8780
= $ 150679.30
Interest received in $ = $ 679.30
Amount borrowed from central pool in September
= 200 000 – 150679.30 – 24868.31
= 200 000 – 150679.30 – 24984.36
= $ 24336.34
Amount repayable to central pool after 1 month
= 24336.34
= $ 24402.25
Amount to be invested in local market = $ 100 000
Net transfer to central pool = $ 125597.75
Central Pool
Month (Borrow)/Invest Duration Rate
July 24868.31 2 months 2.80%
September (24336.34) 1 month 3.25%
October 125597.75 1 month 2.75%
< TOP >
3. If the cash management is fully centralized, then all the investment/borrowing activities will be done by the
central cash management center.
($’ 000)
Month Singapore Hongkong London Net flow
July 200 380 50 630
August (100) (400) 150 (350)
September (400) 130 (200) (470)
October 0 520 250 770
November 150 330 (100) 380
So central pool will invest $ 350 000 in July for 1 month so that the short fall in August can be met. It
invests $ 280 000 in July for 2 months to meet the shortfall in September. On September 01,05 it will
borrow $190000 to meet the gap/shortfall (470000 – 280000) for one month. $ 770000 can be invested for
one month at the end of October.
< TOP >
4. The various instruments used to raise funds in international financial markets include: equity, straight debt
or hybrid instruments.
Debt Instruments
The issue of bonds to finance cross-border capital flows has a history of more than 150 years. In the 19th
century, foreign issuers of bonds, mainly governments and railway companies, used the London market to
raise funds.
International bonds are classified broadly under two categories:
Foreign Bonds: These are the bonds floated in the domestic market denominated in domestic currency by
non-resident entities. Dollar denominated bonds issued in the US domestic markets by non-US companies
are known as Yankee Bonds, Yen denominated bonds issued in Japanese domestic market by non-Japanese
companies are known as Samurai Bonds and Pound denominated bonds issued in the UK by non-UK
companies are known as Bulldog Bonds. Similarly, currency sectors of other foreign bond markets have
special names like Rambrandt Dutch Guilder, and Matador Spanish Peseta etc.
Eurobonds: The term `Euro' originated in the fifties when the USA under the Marshall Plan was assisting
the European nations in the rebuilding process after the devastation caused by the second world war. The
dollars that were in use outside the US came to be called as "Eurodollars". In this context the term `Euro'
signifies a currency outside its home country. The term ‘Eurobonds’ thus refers to bonds issued and sold
outside the home country of the currency. For example, a dollar denominated bond issued in the UK is a
Euro (dollar) bond, similarly a Yen denominated bond issued in the US is a Euro (Yen) bond.
The companies wishing to come out with shorter maturities have an option to issue Euronotes in the
European Markets. The important ones being Commercial Paper (CP), Note Issuance Facilities (NIF) and
8
 Medium-Term Notes (MTNs).
Euro-Commercial Paper issued with maturity of up to one year, are not underwritten and are unsecured.
Equity Instruments
Issuers from developing countries, where issue of dollar/foreign currency denominated equity shares are
not permitted, are now able to access international equity markets through the issue of an intermediate
instrument called `Depository Receipt'.
A Depository Receipt (DR) is a negotiable certificate issued by a depository bank which represents the
beneficial interest in shares issued by a company. These shares are deposited with a local `custodian'
appointed by the depository, which issues receipts against the deposit of shares.
According to the placements planned, DRs are referred to as (i) Global Depository Receipts (GDRs) (ii)
American Depository Receipts (ADRs) and (iii) International Depository Receipts (IDRs). Each of the
Depository Receipt represents a specified number of shares in the domestic markets. Usually, in countries
with capital account convertibility, the GDRs and domestic shares are convertible (may be redeemed)
mutually. This implies that, an equity shareholder may deposit the specified number of shares and obtain
the GDR and vice versa.
Quasi-instruments
These instruments are considered as debt instruments for a time-frame and are converted into equity at the
option of the investor (or at company's option) after the expiry of that particular time-frame. The examples
of these are Warrants, Foreign Currency Convertible Bonds (FCCBs), etc. Warrants are normally issued
along with other debt instruments so as to act as a `sweetener'.
FCCBs have a fixed coupon rate with a legal payment obligation. It has greater flexibility with the
conversion option – at the choice of the investor – to equity. The price of the conversion of FCCB closely
resembles the trading price of the shares at the stock exchange.
A Euro Convertible Bond is issued for investment in Europe. It is a quasi equity issue made outside the
domestic market and provides the holder with an option to convert the instrument from debt to equity.
< TOP >
5. Eurocurrency interest rates cannot differ much from rates offered on similar deposits in the currency’s
home country. As we know, the rate offered to eurodollar depositors is slightly higher than in the United
States, and the rate charged to borrowers is slightly lower. Each country’s market interest rates influence
the euro currency interest rates, and vice versa, as they are all part of the global money market. The total
supply of each currency in this global market, together with the total demand, determines the rate of
interest.
The interest rate charged to borrowers of euro currencies are based on London Interbank Offer Rates
(LIBOR) in the particular currencies. LIBOR rates are those charged in interbank transactions and are base
rates for non-bank customers. LIBOR rates are calculated as the averages of the lending rates in the
respective currencies of six leading London banks. Borrowers are charged on a ‘LIBOR-plus’ basis, with
the premium based on the credit worthiness of the borrower. With borrowing maturities of over 6 months, a
floating interest rate is charged.
Every 6 months, the loan is rolled over, and the interest rate is reset based on the current LIBOR rate. This
reduces risk to both the borrowers and the lender, as neither will be left with a long-term contract that does
not reflect the current interest costs. For example, if interest rates rise after the credit is extended, the lender
will lose the opportunity to earn more interest rate for maximum 6 months. If interest rates fall after a loan
is arranged, the borrower will lose the opportunity to borrow more cheaply for only 6 months. With the
lower interest-rate risk, credit terms frequently reach 10 years.
< TOP >
Section E: Caselets
Caselet 1
6. A nation’s balance of international payments is a summary statement of all the economic transactions
between the residents of the nation and the residents of other nations during a specified period of time,
usually a calendar year. The U.S. and some other nations also keep such records on a quarterly basis. The
main purpose of the balance of payments is to inform government authorities of the nation’s international
position and to help them formulate monetary, fiscal and commercial policies.
If total debits exceed total credits in the current and capital accounts (including the statistical discrepancy),
the net debit balance measures the deficit in the nation’s balance of payments. This deficit must be settled

9
 (under a fixed exchange rate system) with an equal net credit balance in the official reserve account. On the
other hand, if total credits exceed total debits in the current and capital accounts (and the statistical
discrepancy), the net credit balance measures the surplus in the nation’s balance of payments. This surplus
must be settled (under a fixed exchange rate system) with an equal net debit balance in the official reserve
account. All transactions in the current and capital accounts are called autonomous items because they take
place for business or profit motives (except for unilateral transfers) and are independent of balance of
payments considerations. On the other hand, the items in the official reserve account are called
accommodating items because they result from or are needed to balance international transactions. Thus, a
deficit in a nation’s balance of payments is given either by the net debit balance in the nation’s autonomous
items or by the equal net credit balance in the nation’s accommodating items. The opposite is true for a
surplus.
< TOP >
7. Exports of gods and services are affected by the following factors :
• The prevailing exchange rate of the domestic currency : A lower value of the domestic currency
results in the domestic price getting translated into a lower international price. This increases the
demand for domestic goods and services and hence their export. This is likely to result in a higher
demand for the domestic currency. A higher exchange rate would have an exactly opposite effect.
• Inflation rate : The inflation rate in an economy vis-à-vis other economies affects the international
competitiveness of the domestic goods and hence their demand. Higher the inflation, lower the
competitiveness and lower the demand for domestic goods. Yet, a lower the demand for domestic
goods and services need not necessarily mean a lower demand for the domestic currency. If the
demand for domestic goods is relatively inelastic, then the fall in demand may not offset the rise in
price completely, resulting in an increase in the value of exports. This would end up increasing the
demand for the local currency. For example, suppose India exports 100 quintals of wheat to the US at a
price of Rs. 500 per quintal. Further, assume that due to domestic inflation, the price increases to Rs.
530 per quintal and there is a resultant fall in the quantity demanded to 96 quintals. The exports would
increase from Rs. 50,000 to Rs. 52,800 instead of falling.
• World prices of a commodity : If the price of a commodity increases in the world market, the value of
exports for that particular product shows a corresponding increase. This would result in an increase in
the demand for the domestic currency. A fall in the demand for domestic currency would be
experienced in case of a reduction in the international price of a commodity. This impact is different
from the previous one. The previous example considered an increase in the domestic prices of all
goods produced in an economy simultaneously, while this one considers a change in the international
price of a single commodity due to some exogenous reasons.
• Incomes of foreigners : There is a positive correlation between the incomes of the residents of an
economy to which the domestic goods are exported, and exports. Hence, other things remaining the
same, an increase in the standard of living (and hence, an increase in the incomes of the residents) of
such an economy will result in an increase in the exports of the domestic economy. Once again, this
would increase the demand for the local currency.
• Trade barriers : Higher the trade barriers erected by other economies against the exports from a
country, lower will be the demand for its exports and hence, for its currency.
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8. The impact of balance of payments crisis on the economy:
In the short run BoP crisis may have an immediate impact on the exchange rate. If the exchange rate is
market-determined., the BoP crisis will immediately depreciate the value of a currency. If the exchange rate
is controlled by the government, then in the long run the monetary authority have to devalue the currency
to keep its exports competitive.
As a result of BoP crisis the price level will rise, as the monetary authority will print money to cover its
deficits.
Negative BoP means that investment requirement of an economy is exceeding the savings generated by the
economy. So due to insufficient capital the economy will not be able to produce required amount of goods
and services to keep itself in a growing track. As a result the country may resort to external borrowings,
thus increasing the probability of falling into a debt-trap.
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 Caselet 2
9. Various factors that make Asia to have a common currency are discussed below. First, intra-regional trade,
led by foreign direct investment has developed rapidly in recent decades. Large companies and
transnational corporations have established horizontal and vertical production linkages among the
neighboring Asian countries in order to exploit large-scale economies and to enhance their value chain.
This in turn has created an enhanced production network across the region and increasingly close economic
ties, providing a strong impetus for Asian governments to seek closer economic collaboration. The
economic success of other regional trading blocs such as the EU and NAFTA has convinced the Asian
governments that they could achieve similar results by emulating such organizations.
Second, Asian countries were greatly dismayed by the solutions prescribed by the international monetary
fund and western governments for tackling the Asian crisis of 1997-98. To a certain extent, some are still
suffering from the side effects. Unable to change the existing international frameworks, many Asian
countries realized that in order to avoid future economic crisis and reduce their reliance on external
support, they should cooperate more closely.
Third, new WTO negotiations – albeit unsuccessful so far – have added a new sense of urgency to the calls
for greater regional collaboration. Some developing Asian countries are also increasingly concerned that
labor and environmental proposals made by some rich members will undermine their competitiveness. The
growing demand for East Asian countries to speak in one voice has added impetus with the specter of a
more unified EU and a strong NAFTA together deciding the future agenda for international trade.
Fourth, China’s WTO accession has added further impetus to regional cooperation. In addition to
increasing access to each other’s markets and encouraging mutual investment, many Asian governments
also believe that closer economic ties will help them reap the benefits of China’s membership, thereby
reducing their dependence on US markets.
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10. The benefits of common currency are numerous, consisting primarily of the following:
Reducing transaction costs across the frontiers. Conversion of one currency to another involves cost
that increases production and distribution costs.
Facilitating the movement of scientific and technical manpower among member nations, as
conversion losses will be neutralized.
As conversion costs are eliminated, a common currency could play a major role in formal trade. If
free trade is permitted in the region, much of the informal trade may be translated into formal trade,
which in turn, would earn valuable revenue for the governments.
Preempting a South Asian Central Bank, which will facilitate further economic intergration.
A common currency for any region needs to have strong fundamentals. Prolonged periods of economic
cooperation in matters relating to trade, investments and flow of people are some of the necessary trends
that normally precede the creation of a common currency. Other issues that need to be addressed include
lowering tariffs-or better still, tariff-free imports between concerned countries and freer investment norms
and visa regimes. A common currency for 1.3 billion people will make South Asia an even bigger market
for foreigners to invest in. Companies will be able to raise funds from different markets. It will also help
tourists as they travel across the region by eliminating the hassle of having to change currency. Having a
common currency across Asian countries will encourage tourism and combination packages can be offered
to several South Asian nations.
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Caselet 3
11. It may seem weird to bring in an analogy between the oil prices and currency rates. But there certainly
exists a relationship between these two issues. A particular country’s dependency on oil plays a major role
in determining how much its currency is affected by a change in oil prices. Currencies of countries with net
oil imports would be negatively impacted owing to an increase in oil prices. Countries which have access to
alternative sources of energy or fuel can switch from oil to those sources, reducing their dependency on oil.
Such countries have a chance to minimize the exposure of their currencies. A particular currency’s
exposure to changes in oil prices also depends on that country’s reaction to rising inflation and its monetary
policy. There are no strict evidences that rising oil prices cause a rise in inflation. However, as rising oil
prices tend to affect the prices of all raw materials and other commodities in various oil dependent
countries, which in turn impacts the wholesale price index or consumer price index, it would lead to
consequent rise in inflation. Inflation and interest rates are the key drivers of currency rate movements. A
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 rising inflation in a particular country generally causes the currency of that country to depreciate against the
currencies of its trading partners because it affects the purchasing power of the concerned country. Thus the
rising oil prices cause inflation to rise, which in turn tends to have an impact on the currency rates. As oil
prices are external to any economy, the Central Banks of respective countries take measures to curb
inflation so that it may not cause internal shocks to their economies. They normally adjust their monetary
policies accordingly. For instance, recently the Reserve Bank of India had proposed to increase the CRR
from 4.5% to 5% as a measure to curtail inflation. Similarly, the Bank of England raised its benchmark
interest rate by a quarter point. As a measure to curtail inflation, the central banks generally tend to increase
interest rates in the economy. As interest rates and currency are highly correlated, increased interest rates
do affect the exchange rates. Higher interest rates facilitate flow of foreign capital into the country and
gradually lead to the appreciation of their currencies, thus reversing the effects of inflation.
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12. Previously in 1991, when oil prices shot up due to the Gulf war, India was not exposed to the external
shock as its dependence on imported oil was very limited. India then imported less than one-third of its oil
requirement. Oil produced domestically just served to meet the demand. But now the situation has reversed
and India imports nearly three fourth of its crude oil requirement since the crude oil produced domestically
is insufficient to meet the demand. Therefore, the rise in crude oil prices is making the economy more
vulnerable to economic shocks.
The Reserve Bank of India has estimated that for every one dollar rise in the price per barrel of crude oil,
the Indian import bill increases by around $600 mn (approximately Rs. 28 bn). Apart from a rise in the
import bill, there are more adverse impacts from the rise in oil prices. On the day when oil prices reached
their highest level in August 2004, the Indian inflation also peaked to touch almost 8%, the highest in
three-and a-half years. The rising inflation is bound to increase domestic consumption and diminish
savings and investments.
Locally, Indian oil refining and marketing companies in the country had increased the prices of petroleum
products since June 2004. The new government was forced to raise the petrol prices by Rs. 2 per litre,
diesel prices by Re. 1 per litre, and cooking gas by Rs. 20 per cylinder in June 2004. With a relentless rise
in oil prices, again in July 2004, the government hiked the petrol prices by an average of Rs. 1.10 per litre
and diesel prices by Rs.1.42 per litre.
As an immediate consequence, the cost of many manufactured and primary goods and services have
increased tremendously. The prices of essential industrial inputs like steel, aluminium, copper and cotton
have also increased. Rise in prices of petrol and diesel led to a hike in transportation charges. This in turn
has increased the prices of wages and mass consumption goods to levels not known to Indian consumers
earlier.
Thus, the Indian consumer was heavily burdened. The effect of oil price hike can be even looked at from
another angle. As crude oil accounts for a significant proportion of India’s import bill, the rise in crude oil
prices would definitely impact the demand for and supply of dollars. If the dollar value of oil goes up,
Indian importers would have to spend more rupees to buy the same quantity of oil. This leads to an
increase in demand for dollars in India, implying more outflow of dollars from India. Increased outflow of
dollars tends to deplete the foreign exchange reserves, reducing the supply of dollars in the market. What
does an increasing demand for and a decreasing supply of dollar mean to the Rs./$ exchange rate? Pure
economics says that when the supply of a commodity is lower than the demand, the price of that
commodity goes up. The same logic applies to currencies also. As the demand for dollars is increasing,
their price in terms of rupees also increases. That means one has to spend more number of rupees to get a
dollar. This automatically leads to an appreciation of the dollar and a depreciation of the rupee. Though
the effects of increasing oil prices seem to be very pronounced on the Indian economy, analysts predict
that India with its improved macroeconomic fundamentals and forex reserves can absorb the global oil
price hike in the long run.
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