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International Business

Prof. C.K.Sreedharan Unit No: 10

Purchasing Power Parity (PPP)


Different countries have different levels of economic development. One common measure of economic development of a country is Gross National Income (GNI) divided by per head of population- known as per capita income. GNI is regarded as a yardstick for the economic activity of a country.

Countries such as Sweden, Japan, Switzerland and USA are said to be among the richest countries. Japan for example had a GNI per capita of USD 36,000, where as China achieved USD 1100 and India achieved USD 550 in 2010. One of the worlds poorest countries, Mozambique had a GNI per capita of only USD 210 in 2010, while one of the Worlds richest, Switzerland had USD 40,000.

However, GNI per capita per person figures can be misleading because they do not consider differences in the cost of living. For example, although GNI per capita of Switzerland is USD 40,000, which exceeds the USA, which is at USD 37,000, the higher cost of living in Switzerland means that the USA citizens could actually afford more goods and services than Switzerland.

To account for differences in the cost of living among the countries, one can adjust GNI per capita by purchasing power referred as Purchasing Power Parity Adjustment. Purchasing Power Parity Adjustment allows a more direct comparison of living standards in different countries. The base for the adjustment is the cost of living in the USA.

PPP relationship with official exchange rates


The estimates of per capita income in various countries are not strictly comparable because they are based on the conversion of the per capita income of a country as measured in its local currency (Rupee in India) to a common currency( USD), the conversion being based on the official exchange rates.

The official exchange rates do not reflect the purchasing power of different countries in their respective countries. Thus, for example, if India has a lower per capita income say USD 420, but when converted into rupees, it may buy much more in India than what USD 420 can buy in the USA, due to relatively lower prices in India.

Hence comparison of national and per capita incomes do not reflect the true purchasing power in different countries. A change in exchange rate will also change the per capita income of a country as expressed in a foreign currency- which need not necessarily improve the purchasing power in a country.

An example is when India devalued its currency against the US dollar, even when there was no change in the economy.
In India, in 1990 - INR 21 = 1USD After devaluation, in Mar. 1992 - INR 29 = 1USD After 10 years, in 2007 - INR 46 = 1 USD After 5 years, in 2007 - INR 40 = 1 USD In Sep. 2011 - INR 49 = 1 USD ** The practice of devaluation and depreciation of local currency against the USD is a very common in developing and Least Developed Countries.

PPP Theory
The law of one price is the basis of this theory. As per this law- after making allowances for tariff and transport costs- the price of goods in one country should not significantly differ from that in another country.

Mathematically this can be expressed as: Price (Domestic) = e X P(Price of the same product in foreign mkt.)
where e is the official exchange rate between two countries.

Thus if an item costs USD 1 In the USA, exchange rate is Rs 45.5 = 1 USD, its price in India will be: Price in India = 45.5 X 1 = Rs. 45.5

The equation can be written as; e = P (Domestic) / P ( Foreign)


P(D) / P(F) is Inflation Ratio between two countries Exchange Rate = e = Ratio between inflation rates in two countries.
Real Exchange rate = Nominal exchange rate X Foreign price index

Domestic price index

Implications of PPP theory


1. Country must export to a country whose inflation rate is higher than the domestic rate. 2. In case of imports, the strategy is reverse. 3. It provides a tool for determining the real exchange rates.

Limitations
1. There are so many factors- interest rates, balance of payment position, intervention by Central Banks like RBI, in case of India are many factors which affect the exchange rate. Thus relative price level difference advocated by the theory alone can not determine the exchange rate between two countries.

2. The law of one price, has been challenged by Absolute Advantage Theory and Factor Endowment Theory. One price cant prevail in two countries, since the factor endowments conditions could be significantly different. 3. There is inconsistency in the basket of products considered for inflation calculations.

Offshore Banking
It is the provision of financial services by banks to non-residents. In its simplest form, this involves the borrowing of money from non-residents and lending to non-residents. An offshore bank is a bank located outside the country of resident of the depositor, typically in a low tax or tax haven country.

Any international business unit is always looking for funds for their operations. Sometimes the company cant take funds from their home country due to strict regulations, interest rates or taxes. An IB unit is in search of locations where their investments are safe, and from which the funds can be taken out without any restrictions and invested abroad for any ventures in any part of the world.

The bank does not deal in the currency of the country, where it is operating, so that it dealings do not affect the countrys economy where it is operating. Offshore banks provide an alternativeusually- cheaper source of funding for MNCs so they do not have to rely totally on their own national markets.

The term offshore originates from the fact that most of these banks operate in islands, however these banks also operate in landlocked nations such as Switzerland, Luxembourg and Andorra.

Offshore banks have the following features: - A very lenient, flexible with least regulations - Operates in a economically / politically stable countries. - Operates in a low taxation country- hence called as tax havens. - Maintains utmost secrecy about the account holders. - Operates in those tax haven countries where there is absence of exchange control.

Advantage to host country: The offshore banks can raise foreign currency loans for the host country at reasonable interest rates. Hence host country gains better access to international capital markets. Onshore banks are forced improve their services.

Advantages:
1. It provides a politically and economically stable place for those residents who are residing in countries which are politically unstable, possibility of confiscation and a persistent civil war . 2. These banks may provide a higher rate of interest than the home country banks since they operate with a low cost base. 3. Interest is paid by these banks without tax being deducted.

4. Offshore finance is one of the few industries, along with tourism, in which geographically remote island nations can competitively engage. It can help developing countries source investment and create growth in their economies, and can help redistribute world finance from the developed to the developing countries. 5. They provide anonymous bank accounts and complete secrecy regarding identify of the account holders.

Criticisms: 1. Offshore banks are are associated with tax evasion, money laundering and underworld crime. 2. They serve the interest of those in higher income. 3. They are less financially secure because of less transparency in their dealings and least regulatory control .

Offshore financial centers: (Few examples) 1. Singapore 2. Mauritius 3. Barbados 4. Bahrain 5. Switzerland 6. Luxembourg

Forex Dealing
Different countries have currencies. The currencies are neither equivalent in value nor stable. The foreign exchange market is a market where currencies are bought and sold. The exchange rate is the rate at which one currency is exchanged for another currency. US dollar is the currency through which most of the international transactions are carried out.

Forex dealings are carried out through banks or authorized dealers who are authorized to deal in foreign currency by RBI, in India.

Two way quotations: Typically, the quotation in the interbank market is a two way quotation. It means that the rate quoted by the bank will indicate two prices- one at which it is willing to buy the foreign currency, and the other at which it is willing to sell the foreign currency. For example, a Mumbai bank may quote its rate for US dollar as under: 1 USD = Rs. 48.1525 / 1650

If one dollar is bought and sold, the bank makes a gross profit of Rs. 0.0125. The difference between the rates is also known as the Spread. The buying rate is known as the bid rate and the selling rate is known as the offer rate.

Exchange quotations are given in two ways: 1. Direct quotation and 2. Indirect quotation

1. Direct quotation: The exchange quotation which gives the rate for the foreign currency in terms of the domestic currency is known as direct quotation. - Example: 1 USD = Rs. 48.1525 / 48.1650

Types of exchange rates: The transactions in a Forex market can take place under the following ways: 1. On the same day (Value today) 2. Two days later or (Spot) 3. Some days later (Forward)

1. On the same day (Value today) : - Where the agreement to buy and sell is agreed upon and executed on the same date, is known as cash or ready transaction. It is also known as value today.

2. Two days later or (Spot) - The transaction where the exchange of currencies takes place two days after the date of the contract is known as the spot transaction. - For instance, if the contract is made on Monday, the delivery should take place on Wednesday. - If Wednesday is a holiday, the delivery will take place on the next day, i.e., on Thurday.

3. Some days later (Forward) - The transaction in which the exchange of currencies takes place at a specified future date, subsequent to the spot date, is known as a forward transaction. - The forward transaction can be for delivery one month or two months or three months etc. - The forward contract for delivery one month means the exchange of currencies will take place after one month from the date of contract.

Forward Margin / Swap points


Forward rate may be the same as the spot rate for the currency. Then it is said to at par with the spot rate. But this rarely happens. More often the forward rate for a currency may be costlier or cheaper than its spot rate. The difference between the forward rate and the spot rate is known as the forward margin or swap points.

The forward margin may be either at premium or at discount. If the forward margin is at premium, the foreign exchange contract will be costlier under forward rate than under the spot rate. If the forward margin is at a discount, the foreign currency will be cheaper for forward delivery than for spot delivery. Under direct quotation, premium is added to spot rate to arrive at the forward rate. Discount is deducted from the spot rate to arrive at the forward rate.

Interpretation of interbank quotation: The market rte for a currency consists of the spot rate and the forward margin. For example, US dollar is quoted as under in the interbank market on 25 January, as under: Spot USD 1 = Rs. 48.4000 / 4200 Spot / February 2000 / 2100 Spot / March 3500 / 3600

The forward rates for dollar can be derived from the above quotation as below: Buying rate Selling rate Feb Mar. Feb Mar.
Spot rate 48.4000 48.4000 48.4200 48.4200 Add; premium 0.2000 0.3500 0.2100 0.3600 Forward rate 48.6000 48.7500 48.6300 48.7800
Note: Where the forward margin for a month is given in an ascending order as in the example, it indicates that the forward currency is at premium.

If the forward currency is at discount, it would be indicated by quoting the forward margin in the descending order. Suppose that on 20 April, the quotation for pound sterling in the interbank market is as follows: Spot GBR 1 = Rs. 73.4000 /4300 Spot / May 3800 / 3600 Spot / June 5700 /5400

Since the forward margin is in descending order (3800/3600) forward sterling is at discount: Buying rate Selling rate May Jun May Jun
Spot rate 73.4000 73.4000 73.4300 73.4300 less; discount 0.3800 0.5700 0.3600 0.5400 Forward rate 73.0200 72.8300 73.0700 72.8900

Cross rate: If the quotation for a particular currency is not available, this can be arrived through other rates. Example:
If dollar to Indian rupee is - $ 1 = Rs. 34.2400/ 34.2600 If dollar to French franc is - $ 1 =fr. 4.9660 / 4.9710 Rupee to French franc is = Fr. 1 = 34.2600 / 4.9660 = 6.8989

Factors determining spot exchange rates


1. 2. 3. 4. 5. Balance of payments Rate of inflation Interest rate National income Political factors

Types of merchant rates


Principle types of merchant buying rates: There are two types of buying rates: 1. TT buying rates ( TT stands for telegraphic transfer): - This is rate applied when transaction does not involve any delay in realization of the foreign exchange by the bank. - In this case the nostro account of the bank would already have been credited.

Nostro account: A foreign currency account maintained by a bank in India with a bank abroad. Example: State Bank of India, Mumbai maintaining an account with Citibank. Examples of TT rate: Payment of demand drafts, mail transfers etc.
Note: Though the name implies telegraphic transfer, it is not necessary that the proceeds of the transaction are received by telegram. Any transaction where no delay is involved will be done at TT rate.

2. Bill buying rate: - This is the rate which is applied when a foreign bill is purchased. - When a bill is purchased, the rupee equivalent of the bill is paid to the exporter immediately.

Principle types of selling rates: Depending on whether the sale involves handling of documents by the bank or not two types of selling rates are quoted in India: 1. TT selling rate and 2. Bills selling rate.

1. TT selling rate: - This is the rate which is applied for all transactions that do not involve handling of documents by the bank. - Example: Issue of demand drafts .

2. Bills selling rate: - This rate is applied when the bank needs to handle documents. - Example: Payment against import bills.

Type of exchange rates: A country can have any one type of the following two currency regimes: 1. Fixed exchange rate and 2. Floating exchange rate.

Fixed exchange rate regime: The rate of the domestic currency with respect to a foreign currency is fixed by the central bank. Fixed rate provide stability in international prices for the conduct of trade. Central bank (RBI in case of India), has to maintain large international currency to maintain fixed rate.

Floating exchange rate: The rate of domestic currency against a foreign currency depends on the market forces- supply and demand. Most major currencies are floating when compared to the US dollar, British pound, Euro and Japanese Yen.