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FOREIGN EXCHANGEHEDGING TECHNIQUES

USED BY COMPANIES ANDGLOBAL FOREIGNEXCHANGE MARKET

FACULTY GUIDE :PROF. ARPITA AMARNANI MA’AM

SUBMITTED BY:

SLIMS Page 1

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PIYUSH GAURROLL NO: 35

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ACKNOWLEDGMENTS

At the outset, I would like to express my deepgratitude to Prof. Arpita Amarnani Ma’am for allowingme to work under his guidance, thereby, giving me anopportunity to gain tremendous knowledge and skills.I also thank her for the timely inputs and guiding theproject time to time.I also thank Mr. Asish Shah Sir for their timely inputs

which gave a proper shape and direction to theproject.I would also like to thanks all the Faculties (finance)for giving me an opportunity to interact with them andgiving me a firsthand exposure to the ForeignExchange Market.

Piyush Gaur

Roll No. 35

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 TABLE OF CONTENTS

Sr.No.

Particulars PageNo.

1 Executive Summary 42 Foreign Exchange Introduction 53 Global Foreign Exchange market 64 India’s Forex Market 85 Forex Market Participants 12

6 Foreign Currency Accounts 137 Foreign Exchange Derivatives 138 Hedging Introduction 179 Corporate Hedging In India 1810 Case of Ranbaxy Laboratories 1911 Case of Axis Bank 2012 Observations 2113 Forex Reserves and External Debt 22

14 Bretton Woods I 2315 Bretton Woods II 2416 USA – China Currency Issue 2517 USA Trade with China 2618 Ominibus Trade & Competitive Act 2719 China Forex Reserves 2820 Policies to Reduce USA Deficit 2821 Problem with China’s Bank 30

22 What USA & China Should do 3123 Euro Zone Crises 3524 Impact on Global Economy 3625 Impact on USA & China 37

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EXECUTIVE SUMMARY

 The gradual liberalization of Indian economy has

resulted in substantial inflow of foreign capital intoIndia. Simultaneously dismantling of trade barriers hasalso facilitated the integration of domestic economywith world economy. With the globalization of tradeand relatively free movement of financial assets, riskmanagement through derivatives products hasbecome a necessity in India also, like in otherdeveloped 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 toprovide them with a spectrum of hedging products foreffectively managing their foreign exchangeexposures.

 This research attempts to evaluate the various

alternatives available to the Indian corporates forhedging financial risks. By studying the use of hedginginstruments by major Indian firms from differentsectors, it concludes that forwards and options arepreferred as short term hedging instruments whileswaps are preferred as long term hedginginstruments. The high usage of forward contracts byIndian firms as compared to firms in other markets

underscores the need for rupee futures in India.

In addition, it also includes The Global ForeignExchange Market and Various issues going on inMarket such as USA – China Currency Issue and Euro

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

FOREIGN EXCHANGE

 The foreign exchange market is characterized byvolatility, which creates uncertainty in the market andmakes predictions regarding future exchange ratesdifficult, both in the short and long term. However, itis these constant fluctuations in the foreign exchange

market that make it possible for companies orindividuals to take advantage of the movements inexchange rates through speculative activities. Thesefluctuations also pose a threat for anyimporter/exporter trading in the global marketplace asinternational businesses are naturally exposed tocurrency risk. This necessitates the adoption of hedging strategies to mitigate risk. The volatility in

the foreign exchange market needs to be dealt with ina proper, prudent and timely manner. Otherwise,adverse currency fluctuations can inflict painfullessons on a company or individual.

Foreign exchange is an over-the-counter market where brokers/dealers negotiate directly withone another, so there is no central exchange or

clearing house. The biggest geographic trading centeris the United Kingdom, primarily London, whichaccording to The City UK estimates has increased itsshare of global turnover in traditional transactionsfrom 34.6% in April 2007 to 36.7% in April 2010. Dueto London's dominance in the market, a particular

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currency's quoted price is usually the London marketprice. 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, worldwide-decentralized financial market for trading currencies.Financial centers around the world function as anchorsof trading between a wide range of different types of buyers and sellers around the clock, with theexception of weekends. The foreign exchange marketdetermines the relative values of different currencies.

 The foreign exchange market assists internationaltrade and investment, by enabling currencyconversion. For example, it permits a business inthe United States to import goods from the United Kingdom and pay pound sterling, even though itsincome is in United States dollars. It also supportsdirect speculation in the value of currencies, andthe carry trade, speculation on the change in interestrates in two currencies.[2]

In a typical foreign exchange transaction, a partypurchases a quantity of one currency by paying aquantity of another currency. The modern foreignexchange market began forming during the 1970safter three decades of government restrictions on

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foreign exchange transactions (the Bretton Woodssystem of monetary management established therules for commercial and financial relations among theworld'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 inearnest less than three decades ago when in 1978 thegovernment allowed banks to trade foreign exchange

with one another. Today over 70% of the trading inforeign exchange continues to take place in the inter-bank market. The market consists of over 90Authorized Dealers (mostly banks) who transactcurrency 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 regulatoryassociation of dealers. Since 2001, clearing andsettlement functions in the foreign exchange marketare 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 allowingboth banks and corporations greater flexibility inholding and trading foreign currencies. The SodhaniCommittee set up in 1994 recommended greaterfreedom to participating banks, allowing them to fixtheir own trading limits, interest rates on FCNRdeposits and the use of derivative products. Thegrowth of the foreign exchange market in the last few

years has been nothing less than momentous. In thelast 5 years, from 2000-01 to 2005-06, trading volumein the foreign exchange market (including swaps,forwards and forward cancellations) has more 3 thantripled, growing at a compounded annual rateexceeding 25%.In March 2006, about half (48%) of the transactionswere spot trades, while swap transactions (essentially

repurchase agreements with a one-way transaction –spot or forward – combined with a longer- horizonforward transaction in the reverse direction)accounted for 34% and forwards and forwardcancellations made up 11% and 7% respectively.

About two-thirds of all transactions had the rupee onone side. In 2004, according to the triennial central

bank survey of foreign exchange and derivativemarkets conducted by the Bank for InternationalSettlements (BIS (2005a)) the Indian Rupee featuredin the 20th position among all currencies in terms of being on one side of all foreign transactions aroundthe globe and its share had tripled since 1998. As a

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host of foreign exchange trading activity, India ranked23rd among all countries covered by the

BIS survey in 2004 accounting for 0.3% of the world

turnover. Trading is relatively moderatelyconcentrated in India with 11 banks accounting forover 75% of the trades covered by the BIS 2004survey.

FOREIGN EXCHANGE MARKET PARTICIPANTS

Unlike a stock market, the foreign exchange market isdivided into levels of access. At the top is the inter-bank market, which is made up of the largestcommercial banks and securities dealers. Within theinter-bank market, spreads, which are the difference

between the bids and ask prices, are razor sharp andusually unavailable, and not known to players outsidethe inner circle. The difference between the bid andask prices widens (from 0-1 pip to 1-2 pips for somecurrencies 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 smallerdifference between the bid and ask price, which isreferred to as a better spread. The levels of accessthat 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 inter-bank 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 tradebillions of dollars daily. Some of this trading isundertaken on behalf of customers, but much isconducted by proprietary desks, trading for the bank'sown account. Until recently, foreign exchange brokersdid large amounts of business, facilitating interbanktrading and matching anonymous counterparts forsmall fees. Today, however, much of this business has

moved on to more efficient electronic systems. Thebroker squawk box lets traders listen in on ongoinginterbank trading and is heard in most trading rooms,but turnover is noticeably smaller than just a fewyears ago.Commercial companies

An important part of this market comes from the

financial activities of companies seeking foreignexchange to pay for goods or services. Commercialcompanies often trade fairly small amounts comparedto those of banks or speculators, and their tradesoften have little short term impact on market rates.

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Nevertheless, trade flows are an important factor inthe long-term direction of a currency's exchange rate.Some multinational companies can have anunpredictable impact when very large positions are

covered due to exposures that are not widely knownby other market participants.

Central banks

National central banks play an important role in theforeign exchange markets.

 They try to control the money supply, inflation, and/or

interest rates and often have official or unofficialtarget rates for their currencies. They can use theiroften substantial foreign exchange reserves tostabilize the market. Milton Friedman argued that thebest stabilization strategy would be for central banksto buy when the exchange rate is too low, and to sellwhen the rate is too high—that is, to trade for a profitbased on their more precise information.

Nevertheless, the effectiveness of central bank"stabilizing speculation" is doubtful because centralbanks do not go bankrupt if they make large losses,like other traders would, an there is no convincingevidence that they do make a profit trading.

Hedge funds as speculators

About 70% to 90% of the foreign exchangetransactions are speculative. In other words, theperson or institution that bought or sold the currencyhas no plan to actually take delivery of the currency inthe end; rather, they were solely speculating on the

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movement of that particular currency. Hedge fundshave gained a reputation for aggressive currencyspeculation since 1996. They control billions of dollarsof equity and may borrow billions more, and thus may

overwhelm intervention by central banks to supportalmost any currency, if the economic fundamentalsare in the hedge funds' favor.

Investment management firms

Investment management firms (who typically managelarge accounts on behalf of customers such as

pension funds and endowments) use the foreignexchange market to facilitate transactions in foreignsecurities. For example, an investment managerbearing an international equity portfolio needs topurchase and sell several pairs of foreign currenciesto pay for foreign securities purchases.

Retail foreign exchange brokers

Retail traders (individuals) constitute a growingsegment of this market, both in size and importance.Currently, they participate indirectly through brokersor banks. Retail brokers, while largely controlled andregulated in the USA by the CFTC and NFA have in thepast been subjected to periodic foreign exchangescams. To deal with the issue, the NFA and CFTC

began (as of 2009) imposing stricter requirements,particularly in relation to the amount of NetCapitalization required of its members. As a resultmany of the smaller, and perhaps questionablebrokers are now gone. They charge a commission or

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mark-up in addition to the price obtained in themarket.

Non-bank foreign exchange companies

Non-bank foreign exchange companies offer currencyexchange and international payments to privateindividuals and companies. These are also known asforeign exchange brokers but are distinct in that theydo not offer speculative trading but currencyexchange with payments. I.e., there is usually aphysical delivery of currency to a bank account. Send

Money Home offers an in-depth comparison into theservices offered by all the major non-bank foreignexchange companies.It is estimated that in the UK, 14% of currencytransfers/payments are made via Foreign ExchangeCompanies. These companies' selling point is usuallythat they will offer better exchange rates or cheaperpayments than the customer's bank.

Money transfer/remittance companies

Money transfer companies/remittance companiesperform high-volume low-value transfers generally byeconomic migrants back to their home country. In2007, the Aite Group estimated that there were $369billion of remittances (an increase of 8% on the

previous year). The four largest markets (India, China,Mexico and the Philippines) receive $95 billion. Thelargest and best known provider is Western Union with345,000 agents globally followed by UAE ExchangeFinancial Service Ltd.

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Foreign Currency Accounts:

Nostro and Vostro Account:

Nostro and vostro (Middle Italian, from Latin, nosterand voster; English, ours and yours) are accountingterms used to distinguish an account you hold foranother entity from an account another entity holdsfor you. The entities in question are almost always,but need not be, banks.

It helps to recall that the term account refers to arecord of transactions, whether current, past or future,and whether in money, or shares, or other countablecommodities. Originally a bank account just meant therecord kept by a banker of the money they wereholding on behalf of a customer, and how thatchanged as the customer made deposits andwithdrawals (the money itself probably being in the

form of species, such as gold and silver coin). The terms nostro and vostro remove the potentialambiguity when referring to these two separateaccounts 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 normallyunderstood, including personal or corporate loan, andsavings 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; althoughthere 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 bankon behalf of a third party; that is, my record of theiraccount with you. In practice this is rarely used, themain 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 derivativewhere the underlying is a particular currency and/or

its exchange rate. These instruments are used eitherfor currency speculation and arbitrage or for hedgingforeign exchange risk. For detail see:

· Foreign exchange option· Forex swap· Currency future· Forwards

Hedging Strategies/ Instruments

A derivative is a financial contract whose value isderived 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 theyreallocate risk among financial market participants,help to make financial markets more complete. This

section outlines the hedging strategies usingderivatives with foreign exchange being the only riskassumed.Forwards: A forward is a made-to-measureagreement between two parties to buy/sell a specifiedamount of a currency at a specified rate on aparticular date in the future. The depreciation of thereceivable currency is hedged against by selling a

currency forward. If the risk is that of a currencyappreciation (if the firm has to buy that currency infuture say for import), it can hedge by buying thecurrency forward. E.g if RIL wants to buy crude oil inUS dollars six months hence, it can enter into aforward contract to pay INR and buy USD and lock in afixed exchange rate for INR-USD to be paid after 6months regardless of the actual INR-Dollar rate at the

time. In this example the downside is an appreciationof Dollar which is protected by a fixed forwardcontract. The main advantage of a forward is that itcan be tailored to the specific needs of the firm andan exact hedge can be obtained. On the downside,these contracts are not marketable, they can’t be soldto another party when they are no longer required andare binding.

Futures: A futures contract is similar to the forwardcontract but is more liquid because it is traded in anorganized exchange i.e. the futures market.

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Depreciation of a currency can be hedged by sellingfutures and appreciation can be hedged by buyingfutures. Advantages of futures are that there is acentral market for futures which eliminates the

problem of double

• Forecasts

• Risk Estimation

• Benchmarking

• Hedging

• Stop Loss

Reporting and review Corporate Hedging for ForeignExchange Risk coincidence. Futures require a smallinitial outlay (a proportion of the value of the future)with which significant amounts of money can begained or lost with the actual forwards pricefluctuations. This provides a sort of leverage.

 The previous example for a forward contract for RILapplies here also just that RIL will have to go to a USD

futures exchange to purchase standardized dollarfutures equal to the amount to be hedged as the riskis that of appreciation of the dollar. As mentionedearlier, the tailor ability of the futures contract islimited i.e. only standard denominations of money canbe bought instead of the exact amounts that arebought in forward contracts.

Options: A currency Option is a contract giving theright, not the obligation, to buy or sell a specificquantity of one foreign currency in exchange foranother at a fixed price; called the Exercise Price orStrike Price. The fixed nature of the exercise pricereduces 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 forcontingent cash flows, as is the case in biddingprocesses. Call Options are used if the risk is an

upward trend in price (of the currency), while PutOptions are used if the risk is a downward trend.Again taking the example of RIL which needs topurchase crude oil in USD in 6 months, if RIL buys aCall option (as the risk is an upward trend in dollarrate), i.e. the right to buy a specified amount of dollars at a fixed rate on a specified date, there aretwo scenarios. If the exchange rate movement is

favorable i.e the dollar depreciates, then RIL can buythem at the spot rate as they have become cheaper.In the other case, if the dollar appreciates comparedto today’s spot rate, RIL can exercise the option topurchase it at the agreed strike price. In either caseRIL benefits by paying the lower price to purchase thedollar

Swaps: A swap is a foreign currency contractwhereby the buyer and seller exchange equal initialprincipal amounts of two different currencies at thespot rate. The buyer and seller exchange fixed orfloating rate interest payments in their respectiveswapped currencies over the term of the contract. Atmaturity, the principal amount is effectively re-swapped at a predetermined exchange rate so that

the parties end up with their original currencies. Theadvantages of swaps are that firms with limitedappetite for exchange rate risk may move to apartially or completely hedged position through themechanism of foreign currency swaps, while leavingthe underlying borrowing intact. Apart from covering

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the exchange rate risk, swaps also allow firms tohedge the floating interest rate risk. Consider anexport oriented company that has entered into a swapfor a notional principal of USD 1 mn at an exchange

rate of 42/dollar. The company pays US 6months LIBOR to the bank andreceives 11.00% p.a. every 6 months on 1st January &1st July, till 5 years. Such a company would haveearnings in Dollars and can use the same to payinterest for this kind of borrowing (in dollars ratherthan in Rupee) thus hedging its exposures.

Foreign Debt: Foreign debt can be used to hedgeforeign exchange exposure by taking advantage of the International Fischer Effect relationship. This isdemonstrated with the example of an exporter whohas to receive a fixed amount of dollars in a fewmonths from present. The exporter stands to lose if the domestic currency appreciates against thatcurrency in the meanwhile so, to hedge this, he could

take a loan in the foreign currency for the same timeperiod and convert the same into domestic currencyat 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 theliberalization of the economy since 1992. In thiscontext, the market for hedging instruments is still inits developing stages. In order to understand thealternative hedging strategies that Indian firms can

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adopt, it is important to understand the regulatoryframework for the use of derivatives here.

Development of Derivative Markets in India

 The economic liberalization of the early ninetiesfacilitated the introduction of derivatives based oninterest rates and foreign exchange. Exchange rateswere deregulated and market determined in 1993. By1994, the rupee was made fully convertible on currentaccount. The ban on futures trading of manycommodities was lifted starting in the early 2000s. As

of October 2007, even corporate have been allowed towrite options in the atmosphere of high volatility.

Institutional investors prefer to trade in the Over-The-Counter (OTC) markets to interest rate futures, whereinstruments such as interest rate swaps and forwardrate agreements are thriving. Foreign exchangederivatives are less active than interest rate

derivatives in India, even though they have beenaround for longer. OTC instruments in currencyforwards and swaps are the most popular. Importers,exporters and banks use the rupee forward market tohedge their foreign currency exposure. Turnover andliquidity in this market has been increasing, althoughtrading is mainly in shorter maturity contracts of oneyear or less.

CASE OF RANBAXY LABORATORIES:

∗ Ranbaxy Laboratories Limited is anIndian pharmaceutical company that wasincorporated in India in 1961.

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∗  The company went public in 1973 and Japanesepharmaceutical company Daiichi Sankyo gainedmajority control in 2008.

∗ Ranbaxy exports its products to 125 countrieswith ground operations in 46 and manufacturingfacilities in seven countries.

∗ In year 2008 Company entered into numerousForex 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 CALLOptions.

∗ Rs. 784 Crore Loss to Company.

∗ Ranbaxy Laboratories, India's largest drugmakerby sales, may be sitting on mark-to-market (MTM)losses of over Rs 2,500 crore on foreign currencyderivatives transactions entered into with various

banks, according to estimates by one of itslenders in February this year.

∗ With this lender alone, the company is running anMTM loss of Rs 600 crore on the derivativescontracts it had signed in April-May 2008

∗ Company opted for CALL & PUT option so riskshould 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 forwardexchange and derivative contracts:

Rs. In Crores

2010-11 2009-10

Forward Contracts 194,049 126,535

Interest Rate Swaps, CurrencySwaps, Forward RateAgreement &Interest Rate Futures

164,701 131,757

Foreign Currency Options 14,125 5,616

TOTAL 372,877 263,909

For Foreign Branches:

∗ Assets and liabilities (both monetary and non-monetary as well as contingent liabilities) aretranslated 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 areaccumulated in a separate ‘Foreign Currency

 Translation Reserve’ till the disposal of the netinvestments.

∗ Premium/discount on currency swaps isrecognized as interest income/expense and isamortized on a pro-rata basis over the underlyingswap period.

∗ Other obligations in foreign currencies aredisclosed 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 exchangerates. Firms need to look at instituting a sound riskmanagement system and also need to formulate theirhedging strategy that suits their specific firmcharacteristics and exposures. In India, regulation hasbeen steadily eased and turnover and liquidity in theforeign currency derivative markets has increased,although the use is mainly in shorter maturity

contracts of one year or less. Forward and optioncontracts are the more popular instruments.Regulators had initially only allowed certain banks todeal in this market however now corporate can alsowrite 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 causedhuge Loss to Indian Companies such as RenukaSugars, 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 acceleratedinflation, the United States was running not just abalance 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 billionfled the United States. In response, on August 15,1971, President Nixon unilaterally “closed the gold

window.”

“Bretton Woods II” is a term coined by threeDeutsche Bank economists — Michael Dooley, PeterGarber, and David Folkers-Landau — in a series of papers in 2003–2004 to describe the currentinternational monetary system:In this system, the United States and the Asian

economies have entered into an implicit contractwhere the U.S. runs current account deficits and theAsian countries keep their currencies fixed andundervalued 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 onpotentially explosive pressures rising large

pools of surplus labor.

US-China Currency Issue

China have trade surplus with USA & World.

Chinese central bank maintained currency

exchange fixed ($ = 8.28 Yuan)

 YEAR China Foreign CurrencyReserve (in $)

China Trade Surplus$)

2006 1.06 Trillion 178 Billion

2007 1.5 Trillion 268 Billion

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2008 1.9 Trillion 297 Billion

2009 2.39 Trillion 198 Billion

2010 2.64 Trillion 184.7 Billion

US Trade with China

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Steps Taken by China to avoid Manipulationin 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 Deficitfrom $ 30bn in 1994 to $ 260bn in 2007.

1988 Omnibus Trade & Competitiveness Act.

Act requires the Treasury Department to report onexchange rate policies of Countries which have large

Global Current Account Surplus & Trade Surplus withUS. The aim was to find out, if they manipulate theircurrencies against dollar.

And if manipulation found than Treasury is required tonegotiate & end such practices.

China reformed its currency in July 2005 andTreasury made following observation aboutChina:

• Current Account Surplus has reduced by Chinese

Government.

• 2006 – China made progress to make currency

more flexible.

• 2007 – Under US law China has no currency

manipulation.

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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 becauseof:High amount of Export

And Hot money arrival i.e. foreign funds bought intothe 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 itsown 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 notinvested 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 topurchase assets, mostly U.S. Treasuries.

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Much of the $400 billion fiscal deficit is financed byChina.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 doneanything.

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 smallappreciations 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 Chinesemonetary policy.

What the U.S. Should Do?

Since these are temporary tax cuts and the likelihoodthey will be made permanent is low, basic economictheory tells us that their positive incentive effects aresmall.

Since the President and the Congress are unable tocontrol spending, the simplest way for the U.S. to

reduce its fiscal deficit (and, indirectly, currentaccount deficit) would be to repeal the 2001–2003 taxcuts.

EURO ZONE CRISES

 The European sovereign debt crisis is anongoing financial crisis that has made it difficult orimpossible for some countries in the euro area to re-finance their government debt without the assistanceof third parties.

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From late 2009, fears of a sovereign debt crisis developed among investors as a result of therising government debt levels around the world together with a wave of downgrading of 

government debt in some European states. Concernsintensified in early 2010 and thereafter, leadingEurope's finance ministers on 9 May 2010 to approvea rescue package worth €750 billion aimed atensuring financial stability across Europe by creatingthe European Financial Stability Facility(EFSF). InOctober 2011 and February 2012, the euro zone leaders agreed on more measures designed to

prevent the collapse of member economies. Thisincluded an agreement whereby banks would accept a53.5% write-off of  Greek debt owed toprivate creditors, increasing the EFSF to about €1trillion, and requiring European banks to achieve9% capitalisation. To restore confidence in Europe, EUleaders 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 afew eurozone countries, it has become a perceivedproblem for the area as a whole. Nevertheless, theEuropean currency has remained stable. As of mid-November 2011, the euro was even trading slightlyhigher against the bloc's major trading partners thanat the beginning of the crisis. The three countries

most affected, Greece, Ireland and Portugal,collectively account for six percent of theeurozone's gross domestic product (GDP).

On 23 April 2010, the Greek government requested aninitial 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 toBB+ or " junk" status amid fears of default, in whichcase investors were liable to lose 30–50% of their

money. Stock markets worldwide and the Eurocurrency declined in response to this announcement.

On 1 May 2010, the Greek government announced aseries of austerity measures to secure a threeyear €110 billion loan. This was met with great angerby the Greek public, leading to massive protests, riots

and social unrest throughout Greece. The Troika (EU,ECB and IMF), offered Greece a second bailout loanworth €130 billion in October 2011, but with theactivation being conditional on implementation of further austerity measures and a debt restructureagreement. A bit surprisingly, the Greek primeminister George Papandreou first answered that call,by announcing a December 2011 referendum on thenew bailout plan, but had to back down amidst strongpressure from EU partners, who threatened towithhold an overdue €6 billion loan payment thatGreece needed by mid-December. On 10 November2011 Papandreou instead opted to resign, following anagreement with the New Democracy party andthe Popular Orthodox Rally, to appoint non-MPtechnocrat Lucas Papademos as new prime minister of an interim national union government, with

responsibility for implementing the needed austeritymeasures to pave the way for the second bailout loan.

All the implemented austerity measures, have so farhelped Greece bring down its primary deficit before

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interest payments, from €24.7bn (10.6% of GDP) in2009 to just €5.2bn (2.4% of GDP) in 2011, but as aside-effect they also contributed to a worsening of theGreek recession, which began in October 2008 and

only became worse in 2010 and 2011. Overall theGreek GDP had its worst decline in 2011 with -6.9%, ayear where the seasonal adjusted industrial outputended 28.4% lower than in 2005, and with 111,000Greek companies going bankrupt (27% higher than in2010).

As a result, the seasonal adjusted unemployment ratealso grew from 7.5% in September 2008 to a recordhigh of 19.9% in November 2011, while the Youthunemployment rate during the same time rose from22.0% to as high as 48.1%. Overall the share of thepopulation living at "risk of poverty or socialexclusion" did not increase noteworthy during the first2 year of the crisis. The figure was measured to 27.6%in 2009 and 27.7% in 2010 (only being slightly worsethan the EU27-average at 23.4%), but for 2011 thefigure was now estimated to have risen sharply above33%. In February 2012, an IMF official negotiatingGreek austerity measures admitted that excessivespending cuts were harming Greece.

Some economic experts argue that the best option for

Greece and the rest of the EU, would be to engineeran “orderly default”, allowing Athens to withdrawsimultaneously from the eurozone and reintroduce itsnational currency the drachma at a debasedrate. However, if Greece were to leave the euro, theeconomic and political impact would be devastating.

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According to Japanese financial company Nomura anexit would lead to a 60 percent devaluation of the newdrachma. UBS warned of "hyperinflation, military coups and possible civil war that could afflict a

departing country".

 To prevent this from happening, the troika (EU, IMFand ECB) eventually agreed in February 2012 toprovide a second bailout package worth €130billion, conditional on the implementation of anotherharsh austerity package (reducing the Greekspendings with €3.3bn in 2012 and another €10bn in2013 and 2014). For the first time, the bailout deal

also included a debt restructure agreement with theprivate holders of Greek government bonds (banks,insurers and investment funds), to "voluntarily" accepta bond swap with a 53.5% nominal write-off alongwith lower interest rates and the maturity prolongedto 11-30 years (depending on the previous maturity).

It is the world's biggest debt restructuring deal everdone, affecting some €206 billion of Greekgovernment bonds. The debt write-off had a seizeof €107 billion, and caused the Greek debt level to fallfrom roughly €350bn to €240bn in March 2012, withthe predicted debt burden now showing a moresustainable size equal to 117% of GDP, somewhatlower than the originally expected 120.5%.

On 9 March 2012 the International Swaps and Derivatives Association (ISDA) issued a communiquecalling the PSI/debt restructuring deal a "RestructuringCredit Event" which will cause credit default swaps.

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According to Forbes magazine Greece’s restructuringrepresents a default.

IMPACT ON GLOBAL ECONOMY

∗ Portugal, Ireland, Italy, Greece and Spain havehuge debt-GDP ratios and unsustainably hugefiscal deficits.

∗ Rating agency Standard & Poor's cut thesovereign credit ratings of nine Euro zonecountries.

∗ 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 therupee value.

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∗ IT exporters earn 20-30% from the Europeanmarket.

∗ Now only US remains the major market forcompanies.

∗ Impact of sluggish growth in the Europeaneconomies could be limited.

∗  Tata Steel earns almost 60% of its revenues fromoperations in Europe.

∗ Costs for raw materials such as iron ore andcoking coal have risen sharply.

IMPACT ON USA

∗ US exports to Europe are such a small part of theeconomy.

∗ If any bank in core Europe Fails, The Bank will beNationalized by US Government.

∗ Financial Market, Real Estate Market will beaffected.

∗ Debt markets have been negatively affected bythe euro-crisis.

∗ Since Oct 2011, commercial mortgage-backedsecurities issuance has posted only $1 billion permonth versus $5 billion in 2011.

IMPACT ON CHINA

∗ Chinese Export reduced by 17.1% in December2011.

∗ Imports increased but it will get affected byChinese Monetary Policy.

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∗ Decline in the amount of foreign capital flowinginto China.

∗ China’s foreign exchange reserves lost$87.9 billion in value.

∗ China growth reduced to 8.4% from 9.1%.