FOREIGN EXCHANGES
In the course of this book reference has been made on several occasions
to the influence on the Money Market of the foreign exchanges. It
will be impossible in the course of a short treatise such as this to
enter fully into details and technicalities. Anyone wishing to obtain
a fuller explanation of the subject cannot do better than study Mr.
George Clare’s book entitled _The A B C of the Foreign Exchanges_.
Bills of exchange have been used in settling commercial transactions
since very early times. The Romans appear to have employed them to some
extent, but it is to the early Italian, and even more to the early
Jewish merchants, that we owe the development of the system. By the
fourteenth century the use of bills was firmly established, and their
form, and the laws and customs relating to them, were much the same as
at the present day.
Before inquiring into the effects which the foreign exchanges have on
our Money Market, we will state clearly what a foreign bill of exchange
really is. When a foreign bill is bought, what is it that is bought?
The transaction is simply this, that so much money is paid here for
the right to so much currency of a certain country to be delivered at
once, or at a given date, at a certain place, to the buyer of the bill
or to his nominee. The bill itself is merely an order to pay, and the
transaction resolves itself into bartering so much money of one country
for so much money of another country, to be delivered at a specified
place and time.
The value of the imports of the United Kingdom for 1901 was 522
millions of pounds, and of the exports 348 millions, together nearly
900 million pounds; and to understand how these huge transactions were
settled financially, it is necessary to have some knowledge of the
principles and customs of foreign exchanges. It is common knowledge
that we do not pay gold for our imports nor receive gold for our
exports. The imports are paid for mainly by the exports, the balance
being made up of sums due to us for interest on capital invested
abroad, for repayment of money invested abroad, and for freights,
etc. _Some_ gold, however, does enter into the settlement of these
transactions. This gold is sent from country to country, centre to
centre, and further on in this chapter we shall see the causes of these
movements and the effects arising from them.
There are certain technical terms used in connection with the foreign
exchanges which must be clearly understood before it is possible to
follow the various fluctuations in exchange rates, and the effect on
our monetary position which such fluctuations produce.
We will consider one or two transactions between London and Paris as
a practical illustration of these terms. Suppose a London merchant,
A, owes to a Paris merchant, B, 25,000 francs. How can he pay that
debt, and how much will it cost him to do so? He may either buy a
draft on Paris and remit it to B, or instruct B to draw on him, or he
may actually send gold. For the moment we will assume that he decides
to send gold. How many sovereigns will A have to send so that B may
receive the equivalent of the 25,000 francs due to him?
There are two ways of looking at a sovereign: one is that a sovereign
_is_ a sovereign, a coin of the realm, which everybody is pleased to
possess; the other is as a piece of the precious metal which, by our
English law, contains 7·988 grammes of standard gold—standard gold, by
our law, consisting of eleven parts pure gold and one part alloy. A
franc, or rather a twenty-franc piece, can be looked at in the same two
ways. According to French law, a kilo of gold, containing nine parts
pure gold and one part alloy, is coined into 155 twenty-franc pieces.
From these two sets of figures, by a simple calculation, we find that
the pure gold in one sovereign is equal to the pure gold contained in
25·2215 francs; that is, that as regards intrinsic worth, one sovereign
is equal to 25·2215 francs, and this exchange of 25·2215 (usually
regarded as 25·22) is what is known as the “Mint Par” between England
and France. A Mint Par represents the fixed intrinsic value of the
currency unit of one country, expressed in terms of another country,
which uses the same metal as a standard of value.
Thus when A sends gold to Paris to liquidate the debt, he must, on this
basis, send sovereigns containing in the aggregate just the quantity of
pure gold contained in 25,000 francs. This at the Mint Par of 25·22 is
about £991 5_s._ 6_d._ But A must also pay for carriage and insurance
of the parcel of coins, and these charges, we may assume, will amount
together to 10 centimes per £, which, on the remittance in question,
would amount to £3 18_s._ 7_d._ The total cost will therefore be £995
4_s._ 1_d._, which represents an exchange at the rate of about 25·12½.
Therefore if A liquidates his debt to B by sending gold, for each
sovereign expended he only obtains the right to 25·12½ francs in Paris.
This rate is called the “Export Specie Point,” or “Export Gold Point,”
between England and France, and when the Paris exchange falls to this
figure, we may expect gold to leave us for Paris, as gold is then as
cheap a mode of remittance as bills.
Let us now reverse the position and assume that B in Paris owes A in
London £1,000, and that he decides to send gold to pay his debt. What
rate of exchange will result from this transaction?
To pay in gold he will have to send such a number of twenty-franc
pieces that the gold in them shall be equal to the gold in 1,000
sovereigns; that is, as we have seen, 25,220 francs. But B will have to
pay for carriage and insurance at, say, an average rate of 10 centimes
per £1—that is 100 francs—making a total cost of 25,320 francs. This
is an exchange of 25·32, and is called the “Import Specie Point” from
France to England. When the exchange reaches this figure, gold should
leave Paris for London. As a matter of fact, gold does not always
come to us when the exchange is at this figure, as the Bank of France
interposes difficulties in the way of the export of gold. This has the
effect of preventing gold coming in any large quantities unless the
exchange rises above the Import Specie Point of 25·32. So we see that
the Mint Par of London with Paris is 25·22 nominally—the Import Specie
Point (gold to us) about 25·32, and the Export Specie Point (gold from
us) about 25·12½.
In the same way the Mint Par and the gold points can be calculated with
any foreign centre which has gold as the basis of its currency. With
silver using countries these points cannot be fixed. Gold is with them
a commodity only, and its value is measured in silver prices. With
us and other gold using countries the reverse is the case as regards
silver. Hence with silver using countries no common measure exists for
determining the rates.
It is important for those concerned with this business to have firmly
fixed in mind the Mint Par and Gold Points of London with Paris,
Berlin, and New York; as of all exchanges these three are by far the
most important, and have the greatest effect on our Money Market.
The figures relating to Paris have already been given. Those of Berlin
are:—
Mint Par 20·43 (marks to a sovereign).
Import Gold Point about 20·52.
Export Gold Point about 20·33.
As with France, the export of gold from Germany is hindered by the
Reichsbank. That institution, on the other hand, places facilities at
the disposal of importers of the metal. For this reason gold does not
come to us readily when the exchange rises to the figure at which we
should otherwise expect it to come, and conversely, gold frequently
leaves us before the rate has fallen to the nominal figure at which we
expect it to go.
With New York the Mint Par is $4·866 to £1, or 49⁵/₁₆_d._ to $1;
the Import Gold Point is $4·89½ to £1, or 49_d._ = $1;
and the Export Gold Point is $4·83½ to £1, or 49⅝_d._ = $1.
When an exchange is between the Mint Par and the Import Gold Point,
it is said to be “for us,” or “favourable”; and when an exchange is
between the Mint Par and the Export Gold Point, it is said to be
“against us,” or “unfavourable.”
The reasons for these terms are apparent on giving the matter a little
consideration. If an exchange is tending to such a figure that gold
is likely to come to us, it is regarded as favourable, because if
gold does come, it strengthens the Reserve of the Bank of England;
and a strong Reserve means a low value for money here, which is
generally considered to be good for trade. The reverse applies to the
“unfavourable” exchange.
Having now arrived at an understanding of the terms Mint Par and Export
and Import Gold Points, we will consider how and why rates fluctuate
between these figures. As regards the merchants A in London and B in
Paris, we have so far assumed that they have settled their indebtedness
in gold. Such a mode of settling debts is unusual in international
transactions; the ordinary course for A to follow would be either to
buy a draft on Paris and remit it to B, or for B to draw a bill on A
and sell it.
If the aggregate of debts between England and France exactly balanced,
it can be assumed that in theory the exchange would stand at the Mint
Par, because the total amount of drafts for sale would exactly equal
the demand. But amid the multitudinous transactions of modern business
we never are in a position to know when the mutual transactions of
two countries balance, and the fluctuations in the rate of exchange
are primarily due to the relative degrees of urgency of buyers and
eagerness of sellers—to a question of supply and demand.
Let us suppose that as a result of the aggregate dealings between
France and England, France at one period owes us more than we
owe her. Now it will be apparent that in the settlement of the
transactions comprised in the aggregate, the merchants in France
will find a difficulty in procuring sufficient drafts to settle all
their indebtedness, and consequently there will be a likelihood of
some of the merchants there having to send gold and bear the cost of
remittance. Hence there will be competition among them to obtain what
bills are offering—demand will exceed supply—and rather than be forced
to send gold, buyers of drafts on London will be willing to pay more
for them than the face value represented; that is, they will be willing
to pay more than Mint Par.
For example, B in Paris owes A in London £1,000. He wishes to buy a
draft for that amount, and expects to pay only 25,220 francs for it.
He will find that there are many buyers who are competing for the
available drafts, and to secure a remittance he perhaps may offer
25,250 francs, that is, an exchange at the rate of 25·25. Possibly he
may obtain his draft at this price; but if buyers are urgent, sellers
will take advantage of the situation and raise their price still
further. If the demand continue, the price may be raised to such a
level that B will find that he can send gold without incurring extra
expense. When this level is reached, gold is likely to pass from Paris
to London.
Now we will suppose the contrary of this supposition; that is, that
England owes more to France than France to England. Under these
conditions a debtor in London will find a difficulty in procuring a
draft on Paris. He may try to procure it at the rate of 25·22 francs,
but he will find others competing for the available drafts, and he will
be forced to buy at a lower rate of exchange, say 25·17. Competition
will result in further reductions, until a point is reached when it is
as cheap to send gold and pay the cost of transmission; that is, when
the rate falls to about 25·12½.
Thus though one sovereign is always equal to 25·22 francs, coin for
coin, yet the price of bills expressed in these coins will vary within
certain limits according to demand and supply.
The exchange in London on Paris, or any other centre, will always
tend to keep approximately level with the exchange at that centre on
London. As an illustration, let us take an extreme case. Suppose
we quoted Paris at 25·20 and Paris quoted us at 25·30. A foreign
banker in London, on seeing these quotations, would wire to his
Paris correspondent to draw on him for, let us say, £1,000 and sell
the draft, which would realise 25,300 francs. At the same time he
would draw on his Paris friend for 25,300 francs and sell the draft
in London, for which, at the rate of 25·20, he would receive £1,004
nearly. The Paris correspondent would be cleared, as he has drawn and
sold a draft for 25,300 francs, and he has paid a draft drawn on him
for the same amount; but the foreign banker in London has received
£1,004, and only has to provide £1,000 to meet the draft drawn on
him, leaving a profit of £4. He would not be the only one to perform
this little operation, however, and the combined action of all such
arbitrage dealers would promptly level quotations.
We will now turn our attention from theories to some actual facts,
and examine how the business in foreign bills is conducted in London.
The usual meaning of the term “Bourse” or “Exchange” is a place
where merchants assemble to transact their business. We have our own
famous Royal Exchange, although nowadays it is hardly famous for the
meetings of merchants. It is a building which has survived its original
purpose, but it is of interest as being an historic relic of the place
where the foundation of our great commercial supremacy was laid.
In the early part of the sixteenth century the London merchants met
at regular times at some rendezvous in Lombard Street to transact
their business. As their transactions and the number of the merchants
represented increased, inconvenience arose, and in 1564 Sir Thomas
Gresham offered to erect a suitable building for the merchants’ meeting
house if the City would provide the site. This offer was accepted,
and the land where the Royal Exchange stands was purchased by a
subscription of the citizens—a Mansion House fund. The edifice was
duly built, and opened for business in 1571 by Queen Elizabeth. It was
unfortunately destroyed by fire in 1666; rebuilt, and again destroyed
in 1838. The present building was then erected, dating 1844, and the
late Queen Victoria attended in state to open it, as is commemorated in
one of the pictures exhibited in the building. The opening of the first
building by Queen Elizabeth is the subject of another of these pictures.
The merchants in various trades used to assemble in groups, in corners
and round the various pillars of the building; but it very soon became
too small for this purpose, and as the various groups waxed bigger and
wealthier, they gradually deserted the building and erected exchanges
of their own, such as the Stock Exchange, Coal Exchange, Hop Exchange,
Metal, Wool, Corn, etc., exchanges. At the present day the Exchange is
used only by the money merchants and a few dealers in some of the less
important industries who occasionally meet there in the afternoon.
The money merchants hold their meetings in the Royal Exchange on
Tuesdays and Thursdays, which days are called “post days.” This term
is a survival of the times when the foreign mails were despatched only
twice a week.
The principals of the great foreign banking houses and a few brokers
are the only persons who attend “’Change.” As a result of the business
then effected and the negotiations entered into, certain rates of
exchange are arrived at as the ruling rates of the day. After the
meeting the brokers publish a list of these rates, which is called
the “Course of Exchange.” A specimen “Course of Exchange” is here
appended:—
LONDON COURSE OF EXCHANGE
TUESDAY, SEPTEMBER 8TH, 1903
---------------------------------+---------+---------------------
| | PRICES AS NEGOTIATED
| | THIS DAY.
| TIME. |---------+-----------
| | FROM | TO
+---------+---------+-----------
Amsterdam, Rotterdam, etc. | Short | 12·06½ | 12·07¾
Ditto |3 Months | 12·3¾ | 12·4½
Antwerp, Brussels, etc. | ” | 25·37½ | 25·42½
Paris | Cheques | 25·17½ | 25·18½
Ditto |3 Months | 25·32½ | 25·37½
Marseilles, Lyons, etc. | ” | 25·32½ | 25·37½
Zurich, Basle, etc. | ” | 25·35 | 25·40
Hamburg, Berlin, and German Bank | | |
Places | ” | 20·58 | 20·62
St. Petersburg |3 Months | 24¹⁵/₁₆ | 25¹/₁₆
Moscow | ” | 24¹⁵/₁₆ | 25¹/₁₆
Vienna, etc. | ” | 24·17½ | 24·22½
Madrid | ” | 34¼ | 34½
Other Spanish Bank Places | ” | 34¼ | 34½
New York | Demand | 48·6½ | 48·7[4]
Ditto | 60 Days | 48¹¹/₁₆ | 48¹⁵/₁₆
Rome and Italian Bank Places |3 Months | 25·40 | 25·45
Lisbon and Oporto | ” | 42 | 42⅛
---------------------------------+---------+---------+-----------
[Footnote 4: This quotation is for £10, and is not now in use. The
present mode of quotation is for dollars to the £ only—as 4·87.]
The rates quoted in the table indicate the number of foreign coins
given for one sovereign, with the exception of those on Spain,
Portugal, Russia, and the United States. For Spain the quotation is the
number of pence given for the peso, for Portugal the number of pence
for a milreis, for Russia the number of pence for a rouble, and for
America the number of pence for a dollar.
In London all rates are quoted _as they are quoted at the foreign
centres on London_, with the exception only of Spain, where London
quotes so many pence to the peso, while Spain quotes piastres to the
£1; Russia, where we quote so many pence to the rouble, and Russia so
many roubles to £10; and New York, where we quote so many pence to
the $1, while New York quotes so many dollars to the £1. With regard
to the New York quotation, however, London now as frequently uses the
quotation of dollars to the £1 as pence to the dollar.
Except when otherwise stated, the rates quoted in the “Course” are for
bills having three months to run, or in technical language, they are
the rates for the “Long exchange.” Rates quoted as “cheque,” “sight,”
or “demand,” are known as the “Short exchange.”
The rates of the Long exchange are arrived at as follows: We will
suppose that a merchant in London has to pay a debt in Paris of 25,000
francs, and for simplicity we will assume that the sight rate on Paris
is 25. If the merchant buys a sight draft on Paris for 25,000 francs
and remits it to his creditor, it closes the transaction, and the
remittance has cost the merchant £1,000.
But if instead of buying a sight draft at this rate he bought a three
months draft, what would be the result? When he sent this draft to his
friends in Paris they could not credit him with it at once, and so
close the transaction, as they would then be out of their money for
three months. So the parties in Paris to whom the draft was remitted
would discount it with their banker, and credit the London merchant
with the _proceeds only_. He would also be charged for a bill stamp,
and in addition, he would be liable for any contingencies which might
arise, interfering with the due payment of the bill, until payment was
actually made. So instead of the London merchant being credited with
25,000 francs, he would only be credited with 25,000 francs _minus_
discount at the French market rate, say 4 per cent. for three months =
250 francs, and _minus_ the bill stamp = 12·5 francs, that is 24,737·5
francs. Moreover, he would be under liability on his endorsement of
the draft until its maturity, and for this he ought to receive some
consideration. Consequently when the London merchant buys his bill,
if a three months bill is offered him instead of a sight draft, he
demands an allowance in the rate sufficient to cover interest at the
foreign market rate, plus stamp, plus allowance for contingencies. And
the rate for such a transaction will be arrived at as follows: First,
as the presumed sight rate is 25, to this must be added three months’
interest at the foreign market rate (say at 4 per cent.) on 25, which
is ·25, bill stamp at ½ per mille must also be added, say ·01¼, and an
allowance for risk which we may take at ·00¾. Thus the rate for such a
three months draft would be 25 + ·25 + ·01¼ + ·00¾ = 25·27.
Now at this new rate, or “long rate” of 25·27, let us suppose our
merchant to buy and remit a draft of 25,270 francs for £1,000. His
friends in Paris will then credit him with the full amount of his debt,
and a little more, being the allowance for risk.
It must be distinctly borne in mind that adding interest, etc., to the
“sight” rate to obtain the “long” rate only holds good when we are
dealing with rates quoted in _foreign currency_, and that when we deal
with rates quoted in _sterling_ we must deduct these allowances from
the short rate instead of adding them.
It will be noticed that two prices are quoted opposite each centre in
the “Course of Exchange.” These prices do not represent the figure at
which bills can be bought and sold, like Stock Exchange quotations. As
regards the “long” rates, the two prices indicate the price ruling for
different classes of paper, _bank_ paper and _trade_ paper. Bank bills
will discount abroad at a lower rate than commercial bills, as with us;
and therefore in calculating the long exchange on bank bills a smaller
amount has to be allowed for interest than with commercial bills.
Hence, of these two quotations the lower rate is for bank paper, and
the higher rate for trade paper.
As regards the two rates for short quotations, the explanation is that
“demand” bills are understood to mean any draft having up to ten days
to run. A bill which is not due for ten days is, of course, not worth
as much as a draft due at once. The standing of the parties to the
draft also affects the quotation to some extent.
There is still to be considered the important question of how the
Foreign Exchanges are connected with our Money Market, and how they
influence and are influenced by the Bank Rate and the value of money in
England.
It is evident that if the market rate of discount for first-class
paper is higher in London than in Paris, a French banker will earn
more interest on his money if he buys London bills than if he buys
Paris bills. But when dealing with foreign bills, “exchange” comes into
the question as well as interest. This further factor introduces an
element of speculation which is not present with the home article.
Suppose, for example, the Paris market rate to be 3 per cent. and the
London rate 4 per cent.—the cheque exchange standing at 25·22 and the
long rate in Paris of bills on London consequently at about 24·97. A
banker in Paris buys a three months bill _on_ London for £100, paying
for it 2,497 francs. When the bill falls due it can be sold as a
sight draft. If the _short_ exchange remains at 25·22 it will realise
2,522 francs, showing 25 francs as the interest for three months on
the amount invested, that is at the rate of 4 per cent. per annum, as
against 3 per cent. per annum, which is the rate which would have been
earned in France for these three months. If when the bill matures the
short exchange is, say, 25·12, for the £100 draft the interest will be
15 francs only, or at the rate of 2½ per cent. per annum. On the other
hand, if the short rate is 25·32 when the draft matures, the interest
will be 35 francs, or about 5½ per cent. per annum.
Thus there is a wide fluctuation in the interest that may be earned
on a foreign bill. When the French exchange is low, and the rate of
interest ruling in London is above that ruling in Paris, there is
consequently an incentive for a French banker to invest in English
bills; for not only is the rate of interest greater than would be
obtained in Paris, but the chances are in favour of a rise taking place
in the rate of exchange, which will, of course, be to his advantage.
From this it follows that when our _interest_ is _above_ that ruling at
foreign centres, and the exchanges on us are _low_, a heavy investment
demand from continental bankers sets in, in order to take advantage,
not only of the higher interest obtainable in London, but also of the
possible profit on the exchange. This demand will not only have the
effect of stopping a further fall in exchange rates, but will often
send them in the opposite direction. If, from some cause or other, the
rate remains low, the continental holders of our bills will keep them
until they become due and so earn the higher interest. If the rate
rises to any extent, certain holders will at once begin to sell, as
they will have earned their interest for the time they have held the
bills, and seeing their way to secure a certain profit on the exchange,
they think it well to take this, and employ their money in some other
centre which promises more profit.
We can now appreciate the value and importance of this investment
business. When our interest is high and exchanges low, it indicates
that we are having more or less of a money squeeze at home, and the low
exchanges threaten an export of gold, which would make matters worse.
The continental banker then steps in for his own profit, and benefits
us at the same time, as, by his action, he tends to support or raise
the exchange, and thus to stop the outflow of gold. He also places some
of his capital at our disposal, as continental bankers, when investing
in foreign paper, usually only buy first-class bills. There is only
a limited amount of these bills for sale on the Continent, and so
the continental bankers adopt the course of instructing their London
representatives to buy what they require, and remit funds to cover the
purchase.
When exchange rates rise and point to a possible inflow of gold to
London, continental bankers cease their investments and realise their
holdings, thus stopping the rise of rates and, for the time at any
rate, the possible inflow of gold.
Thus the investment business in foreign bills acts really as a pendulum
to the exchanges, steadying the fluctuations and having a most
important influence on the export and import of gold.
We are now in a position to understand how it is that a change in our
Bank Rate is so clearly allied with the question of foreign exchange.
If we find that exports of gold threaten us, which may reduce our
“Reserve” below the figure at which it is desired to maintain it, the
Bank of England will increase its official rate. If this increase in
rate is then followed by the Market, or, if the Market lags behind,
steps be taken to compel it to follow suit, we hold out the advantage
to the continental bankers of an increased interest over what they
can earn at home, and a prospective profit through a possible rise in
exchange. Then, in all probability, their purchases of London bills
will gradually have the effect of raising the rate and stopping the
outflow of gold.