Money and Banking Services - Essay Example

? Money & Banking: Foreign Trade Introduction Money and banking services constitute some of the inevitable elements of the modern life. Unlike olden days where the scope of money was limited to buying goods/services and paying debtors, today money is deployed as a tradable commodity to make further profits. Similarly, modern people largely depend on banking services including but not limited to check settlement, money transfer, online purchases, and payment of bills and subscriptions. With the emergence of globalization, countries worldwide liberalized their cross border trade laws which in turn promoted the concept of foreign trade. Today, foreign trade accounts for a noticeable percent of GDP in all the countries except some poorly developed economies. Evidently, the highly developed banking network worldwide has notably contributed to the fast growth of international trade. The foreign trade sector relies on commercial banks for services like corporate finance, foreign branch banking, and trade finance. Although the global financial crisis 2008-09 severely affected the foreign trade sector, this sector can still grow further through strategic business alliances. Since the global economy has not yet recovered from the shock of the recent global recession, level of market uncertainty is high and this situation increases the possibility of foreign exchange rate fluctuations. Due to this financial market uncertainty, commercial banks are reluctant to finance foreign trade operations and investors hesitate to experiment their luck in an unpredictable global market environment. However there are some potential internal and external currency-hedging techniques to avoid foreign exchange rate risks to a great extent. This paper will discuss foreign trade with particular focus given to money and banking. History of Money and Banking The history of money can be dated back to nearly 2500 years. Coinage was first minted in seventh to sixth century BC. Historically, money was considered to be any identifiable object which had a particular value and was used for the payment for goods or services and for repayment of debts within a market environment. Historians suggest that since ancient times, people have exchanged items of value, such as livestock and cereal grain, in order to meet their needs for different goods and services. It is also identified that ancient people followed a commonly shared system of tokens with intent to make market transactions more convenient. The concept of commodity money was developed followed by barter system and gift economy. This concept assisted people overcome the limitation of bartering and to make commodities more liquid. The period between 700 and 500 BC witnessed the emergence of standardized coinage. Paper money was first introduced in China over the 11th century. The US dollar was developed only 200 years ago. Banking history started around 2000 BC in Babylonia and Assyria. The first prototype banks of merchants during the ancient period represent the starting point in the banking history. These banks had granted grain loans to traders and farmers who carried goods between townships (The lawyers & jurists). Later in ancient Greece, lenders developed two innovative practices including accepting deposits and changing money. Northern rich cities such as Florence, Venice, and Genoa had a great influence on shaping the word banking in the modern sense. Banking activities in Florence over the 14 century were dominated by Bardi and Peruzzi families, who established branches across many other parts of Europe. Banking operations notably developed in Amsterdam and London during 16th and 17th century respectively. On the strength of advancements in telecommunication and information technology over the 20th century, banking operations have undergone dramatic changes. Since this time, banks have been significantly increasing its size and geographic coverage. The global financial crisis 2008-09 led to a series of bank failures, which in turn sparked the debate on banking regulations. Money and Banking Transactions in the Modern Era In the modern era, the scope of money is not just limited to paying for goods and services and for repaying debts. Today money has become another commodity that people uses to trade and make profit. Nowadays even common people increasingly spend money to purchase company stock and thereby to trade them on the stock market. The urge for profit and excessive risk taking attitude persuade people to use money as a trading tool. Surprisingly, although money is the basic pillar for all trading transactions, today people do not need to actually keep currency with them to perform various monetary tasks. In the modern banking era, people and business entities make use of checks, promissory notes, debentures, and other negotiable instruments to carry out their daily activities. Today, every country has its own currency; but the lack of global currency creates many problems for international market players. In order to address this issue, US dollar has been set to be the standard currency and all other currencies globally are valued against it. Global market players need to convert money to the respective currency of the overseas market in which they operate. In addition to the primitive forms of money such as metallic money and paper, there is a new form of money in the modern economic environment called credit money. With the development of banking activities across the globe, policy makers believe that this form of convertible money can best serve the needs of parties involved. Banks demand deposits and issuance of checks are currently accepted as a mode of payment by the business world. It is to be noted that a check is just a credit instrument but the bank deposit behind that check makes it valuable and serves as money. In economically advanced countries like US and UK, bank money accounts for a significant part of money supply in the market. In America, bank money constitutes nearly 90 percent of the total money supply. In contrast, the volume of currency money noticeably exceeds the volume of bank money in poor countries. However, in the modern economic environment, currency money and bank money combinedly represent the total money supply. The major difference between currency money and bank money is that the former has general acceptability whereas the latter lacks general acceptability. It is surprising to note that some tribal communities are still unfamiliar to the use of money and they follow the traditional barter system. In the modern business transactions, ownership of money is electronically transferred to the party concerned. Similarly, modern banking operations have been connected worldwide through computer networks. As a result, today’s banking customers can easily and conveniently perform and satisfy their needs through facilities like online banking and mobile banking. Today, banks pay electricity bills, telephone charges, and other subscription on behalf of their customers. As a result, customers can save their time and money to a great extent. Fund transfer is another service provided by modern banking institutions. This facility benefits customers to transfer funds from one part of the globe to another part instantly. In addition, today banks provide a variety of loans including commercial loans, properly loans, and educational loans to finance different needs of people. Modern bankers provide their reputed customers with bank overdraft facility, which is a banking service by which the client can withdraw up to a fixed amount of money even if there is insufficient balance to process the operation. It is identified that modern business organizations increasingly depend on banks to convert negotiable instruments like checks, drafts, and bill of exchange into money. Undoubtedly, ATM service is a terrific innovation in the modern banking system. Today, people can withdraw money from any part of the world using the ATM facility. This service assists people to get rid of the risks of keeping huge amounts of money in hand while they are on move. Most of the leading banks offer direct online credit/debit payment facilities to their clients. Hence, people can purchase any good or service as and when required in spite of geographical barriers. In short, modern banking system allows people to perform their daily tasks and to operate trade transactions from home easily and conveniently. Banks play a more important role in the context of international business. This will be discussed in the following sections. Foreign Trade Foreign trade or international trade can be simply referred to cross border exchange of capital, goods, and services. Henius defines foreign trade as “the designation used for importing and exporting transactions and everything connected with their execution, including financing and shipping” (as qtd in Kemp 23). In developed and developing countries, foreign trade accounts for a significant percent of the GDP. Although such trade has been present throughout the history, its political, economic, and social importance was clearly documented in recent centuries. Evidently, globalization is the major driving force behind foreign trade because this process eliminated cross border trade barriers and enhanced the inter-border movement of capital, labor, goods/services, ideas, and cultures. In addition, industrialization, advancements in transportation, emergence of multinational corporations, and growing prevalence of outsourcing can have also a notable impact on the foreign trade system. It is clear that absence of foreign trade would compel nations to limit their consumption to domestically produced goods and services. Since the basic motivation and behavior of parties/entities involved in the trade do not change with regard to geographical location differences, foreign trade is not so different from domestic trade. The major point of difference is that the foreign trade is generally more expensive than domestic trade. It happens because cross border trade involves additional costs such as export tariffs, time costs, and other legal costs. In foreign trade, gathering factors of production such as capital and labor is more difficult as these factors are relatively less mobile across borders than within a country. There are several models of international trade including Adam Smith’s model, Ricardian model, Heckscher-Ohlin model, new trade theory, Gravity model, and modern Ricardian theory of international trade. According to Adam Smith’s model, foreign trade is particularly based on costs advantages provided by countries over others. Similarly, the Ricardian model specifically emphasizes on comparative advantages that are resulted from the differences in natural resources or technology. Heckscher-Ohlin model suggests that the patter of foreign trade is influenced by differences in factor endowments. While it comes to foreign trade, finance has an important role to play. For instance a multinational corporation has to operate in a numbers of overseas markets which have separate and unique governmental regulations. To illustrate, some countries adopt a friendly approach to exporting and hence charge low export duties whereas some others impose high export duties to support domestic trade. In order to deal with such issues, there is a separate branch of economics named international finance. This financial economics sector particularly focuses on the monetary and macroeconomic relations between countries. According to Gandolfo, international finance evaluates areas such as global financial system, exchange rates, international monetary systems, foreign direct investment, bills of payments and how these areas are linked to foreign trade (1-2). Since foreign trade is connected to a range of monetary transactions, it is never possible for exporters/importers to keep adequate currency money always. Therefore, international players inevitably need to rely on electronic money payments and other banking services. In addition, banking services are also vital for these multinational market players to depend upon banking sector to exchange money between their different overseas markets. Territorial specialization is one of the major characteristics of foreign trade. It means that every country pays particular attention to the production of goods and services in which it has competitive advantages. In foreign trade, sellers are really separated from buyers because these groups belong to different countries. Hence, they need to depend on intermediaries to perform business transactions. Since currencies of importers and exporters are generally different, they often use mutually acceptable currencies like dollar or pound sterling to do business. Finally, while engaging in foreign trade, companies need to adhere to the rules and regulation of countries in which they operate. Opportunities and Threats of Foreign Trade Evidently, international trade has a range of potential opportunities as compared to domestic trade. While operating in a global context, firms can easily transplant their manufacturing plants and other production facilities to other overseas countries where labor and raw materials are available at cheaper costs. This situation is greatly beneficial for global marketers to reduce operating costs and to improve profitability. In the current business environment, employers struggle to recruit and retain skilled workers because of many reasons. Hence, foreign trade provides companies with the opportunity to recruit potentially skilled workers from different parts of the globe. Foreign trade is a potential way for individuals/companies to obtain better access to highly advanced technologies, goods, and services. In addition, foreign trade is a greater strategy to spread risks so that losses incurred in a foreign market can be counterbalanced by additional profits achieved in another overseas market. Technological developments, particularly in the banking sector, greatly contribute to the growth of foreign trade. A strong worldwide banking network aids foreign traders to easily deal with cross border financial activities such as receipt payments and fund transfer easily and securely. Mergers and acquisitions give a set of potential opportunities to multinational companies, especially in the post-crisis market environment. Such strategic business alliances are helpful for foreign traders to take advantages of synergies and to successfully confront with domestic marketers. At the same time, international trade faces a set of potential challenges too. From a global perspective, a country cannot reap the benefits of foreign trade unless it has adequate industrial set up and social infrastructure that would meet global standards (Economy watch). For instance, a multinational company would be reluctant to operate in an overseas market where market environment is poor and issues like corruption are on the rise. In addition, a chaotic legal spectrum can also be a barrier to international trade. Therefore, it is clear that Third World countries do not have adequate features to support foreign trader in their territory. Market uncertainty is another major potential challenge to foreign trade. With the occurrence of global financial crisis 2008-09, the global business environment has become more uncertain and therefore international traders are reluctant to make huge investments. To worsen this issue, investors worldwide are also not interested to risk their money by purchasing the stocks of companies in this current uncertain global business context. In addition, growing government interventions also reduce the scope of foreign trade. Although these post-crisis regulations aim to strengthen an underperforming economy, many of such regulations actually become a barrier to foreign trade and hence impede economic growth (United Nations). As economists point out, foreign exchange at the same time can be both an opportunity and threat for international trade. Foreign exchange, usually abbreviated as ‘forex’ of ‘FX’, can be simply referred to the conversion of one currency into another. Foreign exchange is an inevitable component in the international trade because currency conversion is essential in overseas money transactions. The process of foreign exchange is based on currency exchange rate. Currency exchange rate is the “amount of one currency it takes to buy one unit of another currency” (Randel CXV). Since the recent global recession, financial markets are extremely vulnerable to exchange rate fluctuations. From the perspective of a foreign trader, favorable exchange rate fluctuations are beneficial to make additional profits. In contrast, the trader would suffer huge currency losses if exchange rate variations are adverse. Decline in bank lending, which is direct impact of global financial crisis, is another threat for foreign trade. A series of bank failures, including the collapse of some of the world’s largest banks, occurred during the global financial crisis could be ascribed to thoughtless and risky lending. Hence, today banks worldwide extremely hesitate to grant loans. To illustrate, in 2011, UK’s four leading banks – Royal Bank of Scotland, Lloyds Banking Group, HSBC, and Barclays – cut down their commercial real estate property lending by a combined total of ?17.2 billion (Trotman). Although a flagship plan designed by the Bank of England and the finance ministry to improve bank lending in UK, it could not address anxieties of bankers. This issue is creating many challenges for international trade in United States too. As a result of restricted bank lending, foreign traders do not have enough funds to invest in expansion activities. Finally, growing environmental concerns also raise some level of challenges to foreign trade because many international companies have little funds to contribute to environmental sustainability after their liabilities are paid off. Role of Banks in Foreign Trade Banks play an integral role in the foreign trade. It can be claimed that international trade would not have been developed as it looks today if it had not been backed up by a strong banking network worldwide. While operating in the international context, it is necessary for individuals/businesses to conduct financial transaction between their different overseas markets. Evidently, they cannot take much time to transfer money from one country to another because such a situation would adversely affect the operational efficiency and competitiveness of the business. Today, the banking industry maintains a strong global network which assists foreign traders to transact money instantly and securely. In addition, commercial banks fund the daily needs of international trade if they are convinced that the borrower is financially sound enough to repay the loan. Therefore, it can be argued that banks act as intermediaries that move money from capital markets to businesses including foreign trade. Banks greatly benefit the international trade sector to distribute valuable economic and business information to clients worldwide. Many economists indicate that commercial banking sector can be considered as a global indicator of economic health and market trends. Foreign branch banking is of considerable importance in the foreign trade sector. As Duff describes, under foreign branch banking, banks offer full commercial banking services in the home country and maintain branches in many other countries. Sometimes this type of banks may act as affiliates of small-sized banks that do not have a presence in overseas countries. Therefore, foreign branch banking is extremely helpful for international trade because it would aid multinational companies to consolidate their financial transactions at one bank that manages their trade finance, project loans, currency transactions, pay roll, investments, deposit accounts, and other cash management activities throughout the world (Duff). Trade finance is another service offered by commercial banks in foreign trade. More precisely, commercial banks finance trade between firms and their customers located across the globe. In order to deal with this business practice, banks issue LOCs which indicate that the client has deposited the full amount due on a particular order placed with a company located in another part of the globe. Therefore, the seller can obtain payment guarantee on the order and hence he can risklessly ship the goods to the offshore customer. The LOC is also beneficial for firms to guarantee manufacturer’s loan, which is meant to finance the production of goods to be delivered. In the absence of LOCs, it would be a difficult and costly task for companies to investigate the legitimacy and creditworthiness of their foreign customers and to comply with laws and regulations of different overseas markets in which they operate. In addition, banks assist international traders to convert foreign currencies. Some other services offered by commercial banks to the foreign trade sector include corporate finance, currency specific credit cards, corporate checking accounts, and lock boxes. Exchange Rate Risks in International Trade Unfavorable global market fluctuations may negatively affect foreign exchange rates and this issue often causes either of the parties involved to suffer huge currency loss. To illustrate, assume that an American manufacturing company has signed a business contract with its German partner at $1 million. At the time of the contract 1 Dollar equaled 1 Euro and the contract amount was expressed in Euros. Over the next two years, the value of Euro increased against Dollar and reached status 1 Euro equals 2 Dollars. This market fluctuation will cause the American manufacturer to incur a foreign currency loss worth $500,000. As Collier et al point out, foreign exchange exposures can be categorized into three including transaction exposure, economic exposure, and translation exposure (473). As Dayananda et al argue, global investors and multinational companies are extremely troubled with exchange rate risk and this situation can have dreadful consequences on international business. The authors add that foreign exchange risk is one of the several concerns to be addressed while operating in an international context (303). With the emergence of the recent global financial crisis, many MNCs and investors suffered huge currency losses and this situation contributed to the end of many organizations. It is observed that weaker currencies like Mexican Peso are prone to exchange rate fluctuations and therefore foreign companies hesitate to make business deal with Mexican firms. In sum, exchange rate fluctuations significantly affect the flow of foreign trade and impede the growth of countries with weaker currencies. How to Address Exchange Rate Risks Currency hedging is an effective tool to address exchange rate risks while dealing with foreign currency transactions. According to one definition, “hedging means securing oneself against loss from various risks that arises in international financial markets” (Machiraju 94). Since currency hedging techniques are helpful to get rid of the risks associated with unforeseen shifts in the global financial market, they assure beneficiaries a reasonable or fixed amount of return even if there is a huge drop in the value of the specified currency over the period of the business contract. An idea related to currency hedging is that exchange currency while exchange rates are favorable and then invest the amount in the home currency of the respective country where the person/company has business interests. There is a number of currency hedging techniques to eliminate the risk of currency loss in foreign trade. Before choosing a hedging technique, a firm must consider several factors such as firm’s hedging needs, current market environment, and the possibility of future financial market fluctuations. According to Agyei-ampomah and Collier, currency hedging techniques can be divided into two broader groups – internal and external hedging techniques. They are discussed below. A. Internal hedging techniques Under this method, the marketer makes use of techniques available within the organization so as to eliminate exchange rate risks. Internal hedging techniques are not operated through foreign exchange markets and therefore associated costs can be eliminated. Some of those techniques are given below 1. Invoicing the home currency Under this technique, the company invoices customers in their home currency and thus passes exchange rate risks to them. 2. Bilateral and multilateral netting In bilateral netting, “pairs of companies in the same group net off their own positions regarding payables and receivables”, sometimes even without the involvement of the central treasury department (Agyei-ampomah and Collier). In contrast, participation of central treasury department is inevitable in multilateral netting which characterized with interaction of several subsidiaries with head office. 3. Restructuring Restructuring is a simple internal hedging technique to manage foreign exchange rate fluctuations and thereby avoid the resulting currency loss. Here, the organization simply restructures its business strategies like volume of sales in foreign markets, involvement of foreign suppliers, and the debt level denominated in foreign currencies. B. External hedging techniques Under this method, fluctuations in the value of foreign currency are hedged with the help of financial market policies. External hedging methods depend on financial markets and hence it is not possible to avoid direct costs. Some of the major external hedging techniques are described below. 1. Forward markets The forward markets technique would better serve the interests of the firm if it has entered into a forward exchange contract, in which the firm agrees to pay a fixed amount of a specified currency to another party at a fixed exchange rate on a predetermined future date. 2. Futures Financial futures represent contracts to purchase or sell a fixed amount of foreign currency on a particular future date. 3. Options Under this technique, the client is provided with the “right – but not obligation – to buy (call) or sell (put) a specific amount of currency at a specific price on a specific date” (Agyei-ampomah and Collier). 4. Swaps It simply refers to the regular exchange or cash flows in one currency against another currency. While hedging techniques like forward markets, futures, and options are used to eliminate exchange rate risks up to one year, currency swaps are helpful for hedging in the medium term and long term. However, these hedging techniques cannot be 100% effective always due to market strategy changes and amendments in financial market policies (364-379). Conclusion From the above discussion, it is clear that money and banking have a long dated history. Before the introduction of coinage and paper currency, people practiced the barter system to meet their daily needs. Today, the scope of money is not just limited to buying goods/services and paying debts. Currently, money is considered as another tradable commodity to make profit. Therefore, nowadays people use money to purchase company stocks and to invest in other productive ventures. Similarly, the scope of banking has also significantly increased. On the strength of advancements in information technology and internet facilities, today banks provide clients with technologically improved services including instant fund transfer, online payments, and foreign exchange. The elimination of cross border trade barriers enhanced foreign trade. Currently, foreign trade constitutes a significant percent of GDP in developing and developed economies. Evidently, finance and banking have a great role to play in international trade. Corporate finance, trade finance, and foreign exchange are some major services offered by banks to the foreign trade sector. Furthermore, the banking industry has a strongly global network, which assists foreign traders to monitor and connect their finance transactions all across the overseas markets. There are many opportunities and threats for foreign trade. Huge size of the market and a fast developing technological landscape offer a range of opportunities to foreign trade. At the same time, implications of the recent global recession including high level market uncertainty and fluctuating currency rates challenge the growth of the foreign trade sector. As a result of foreign exchange rate fluctuations, international traders often suffer huge currency losses. Currency hedging is a potential strategy to address financial risks associated with exchange rate fluctuations. Works Cited Collier, Paul and Agyei-ampomah, Samuel. Management Accounting: Risk and Control Strategy : Strategic Level. Elsevier, 2006. Print. Dayananda, Don et al. Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge University Press, 2002. Print. Duff, Victoria. “Role of Commercial Banks in International Business”. Chron, web 15 April 2013 Economy Watch. “”Challenges before International Trade - Challenges for International Trade, Trade Barriers”. 30 June 2010. Web 15 April 2013 Gandolfo, Giancarlo. International finance and open-economy macroeconomics. Springer, 2002. Print. Kemp, Robert L. Foreign Policy: 53rd Annual NUEA Discussion and Debate Source Book : Committee on Discussion and Debate. National University Extension Association, 1979. Print. The Lawyers & the Jurists. “The banking concepts in the world and its background-explain and illustrate in the basis of worldwide aspects” 7 Oct 2012. Web 15 April 2013 Machiraju, H. R. International Financial Markets And India. New Age International, 2007. Print. Randel, Jim. Street Smarts: Beyond the Diploma. RAND Media Co, 2011. Print. Trotman, Andrew. “UK banks reduce property lending by ?17.2bn”. The Telegraph, 28 Feb 2011. United Nations.  “”International Trade After the Economic Crisis: Challenges and New Opportunities””, 2010. Web 15 April 2013 Read More