Foreign Exchange, currency and money claims, such as bank balances and bank drafts, expressed in the equivalent value in foreign money. Thus, a pound sterling note is money in Great Britain but is a foreign exchange in the United States. A deposit of US$1,000 in an American bank to the account of a French company constitutes that amount of foreign exchange in France. The term foreign exchange is also used to refer to transactions involving the conversion of money of one country into that of another or to the international transfer of money and credit instruments.
The use of foreign exchange arises because different nations have different monetary units, and the currency of one country cannot be used for making payments in another country. Because of trade, travel, and other transactions between individuals and business enterprises of different countries, it becomes necessary to convert money into the currency of other countries in order to pay for goods or services in those countries. The transfer of money values from one country to another and the determination of the price at which the currency of one country will be surrendered for that of another constitute the main problems of foreign exchange.
The introduction of a single European currency, the Euro, in 12 European Union (EU) countries on January 1, 2002, means that no foreign exchange transactions are required for intra-EU trade in those states. This reduction in transaction costs should further encourage trade between EU members. See also Economic and the Monetary Union.
II PRICE FLUCTUATION
Foreign exchange is a commodity, and its price fluctuates in accordance with supply and demand; exchange rates are published daily in the principal newspapers of the world. By international agreement fixed exchange rates with a narrow margin of fluctuation existed following the Bretton Woods Conference until 1973, when floating rates were adopted that fluctuate as supply and demand dictate.
When the exchange rate is floating, free of government intervention, the rate of exchange, or the price of the currency of one country in terms of that of another, will depend on overall supply and demand and on the relative purchasing power of the two currencies, that is, on the competitive position of the two countries in world markets. Gold and wealth tend to flow from countries that buy more than they sell abroad. At times, speculation in foreign exchange by dealers, brokers, or others becomes a major influence on exchange rates. However, governments are often not prepared to allow their currencies to float freely. A leading example of an alternative to floating was the European Exchange Rate Mechanism that existed until the 1990s. Under this system, individual governments pledged to keep their currencies within a specified “band” around a central parity. Up to 1992, the system appeared to be working well with most currencies fluctuating within relatively tight bands of ±2.25 percent. However, the concerted speculative attacks of currency speculators (such as George Soros) resulted in some countries leaving the ERM (such as Great Britain and Italy) and others loosening their bands to ±15 percent. These events raised doubts as to the ability of ERM members to keep their currencies in line, although ultimately they did nothing to delay the introduction of the single European currency (the Euro) in January 2002. Countries now realize that defending a currency against speculative attack—in terms of lost foreign currency reserves—especially in liberalized international financial markets can be very expensive.
III GOVERNMENT CONTROL
When the foreign exchange needs of a country exceed total receipts from abroad, and it has little gold and is unable to receive foreign credits, the exchange value of the currency of the country tends to decline. Under these conditions, the government has the alternative of allowing freedom of transactions in foreign exchange and permitting its currency to depreciate, or of abandoning free transfer of currency by the establishment of exchange control. The aim of such control is to limit the demand for and to increase the supply of foreign exchange in order to maintain a stable exchange rate. Control usually provides for allocating foreign exchange only for approved imports and requires that all or part of the foreign exchange derived from exports or other sources be given to the central bank in exchange for local currency. Since the worldwide Great Depression of the early 1930s, many countries, particularly the developing ones with limited exchange reserves, have periodically instituted foreign exchange controls. To help resolve the unbalanced international payments situation after World War II, the United Nations established in 1946 the International Monetary Fund and the International Bank for Reconstruction and Development. The fund promotes currency stability and removal of foreign exchange restrictions by granting member nations foreign exchange loans to cover temporary deficits in their international accounts. The bank grants long-term foreign currency loans to member countries for specific projects.
The changes that took place in the world market in the 1970s, such as the tremendous rise in the price of oil, altered the roles that major currencies played as foreign exchange reserve units for most trading countries. The US dollar, in particular, underwent wide swings in value. In the 1970s it was considered a weakened currency in international markets, but by the early 1980s, the value of the dollar had risen to a new high against all major foreign currencies. In 1985 the United States and its main trading partners began taking steps to better align their currencies, and by 1987 the dollar had weakened considerably. In the 1990s economic growth greatly strengthened the dollar, although recession and the economic effects of the terrorist attacks of September 11, 2001, had a weakening effect.