( Originally Published 1939 )
I DEBATED for some time whether or not to include a chapter on Foreign Exchange in a book of this character. However, considering the vital part which exports and imports play in our financial structure, and the manner in which remittances are trans-ported back and forth, whether it be the buying and selling of safety pins, munitions, or stocks and bonds, and the fact that the American-Foreign-Exchange department centers in the financial district of New York, I feel the investor will profit by grasping these fundamentals.
From an academic standpoint, Foreign Exchange, as its name implies, relates to the purchase and sale of foreign money. The subject includes the interpretation and significance of rates of ex-change, the operation of the foreign exchange market, and on the more theoretical side, the reasons why a particular currency is bought or sold, and all the factors accounting for its supply and demand.
A rate of exchange between England and America would be the price of one country's currency expressed in terms of the others. In New York all rates, except sterling, are quoted in cents per unit of foreign currency, and in London most rates are quoted in foreign currency per pound sterling.
If you pick up the paper and read where the pound sterling rate has moved from $4.86 to $4.90, it means that in London foreign currency has been cheapened, that it costs more to buy the pound, and the rate has moved against America. The opposite is true with the pound sterling sinking from $4.86 to $4.84. It means that it takes more sterling to buy dollars, and the rate has moved in favor of America.
Foreign Exchange is like any other commodity. A rise in the dollar rate in London, means that dollars have become cheaper and the pound dearer, for it takes more dollars to buy the pound. A fall in the rate means the exact opposite.
What is the cause of this fluctuation you ask? What causes the pound sterling to sell at one price one week and another the next? Again we find the answer in supply and demand. The people either want more sterling and less dollars, or they want more dollars and less sterling. Why do they want it?
We know that in England the pound sterling is legal tender and that in America the dollar is legal tender, hence to pay their debts one to the other, the English people require dollars, and the American people require pound sterling. In other words, every American manufacturer who wants to buy goods made in England, or wishes to pay his debts there, or to invest money there, needs to buy pound sterling to do it with. Likewise every one in England who buys American cotton, automobiles, American stocks and bonds, or hundreds of other items, must exchange pounds sterling into dollars to pay for it. When, as, and if, the British government pays its war debt to us, it must buy American dollars to pay it with. On the other hand, if we export cotton to Japan in British ships, calling at New Orleans or San Francisco, we must buy pound sterling to pay the freight.
In every walk of life all intercourse between the two nations must be settled in each other's currency. You must buy pound sterling to pay your insurance premiums to Lloyds of London, and if you collect on your policy, Lloyds must buy dollars to pay you. On and on the circle goes, from the American tourist buying sterling to pay his hotel bill, to the British investor buying dollars to purchase an American bond. The significance of the amounts needed can best be visualized in a table somewhat like the following:
STERLING IS NEEDED TO PAY FOR:
All goods shipped from Great Britain to the U. S. A. The American use of British ships, passengers, freight, etc. Commissions paid to British banks, merchants, etc. Insurance premiums to Lloyds and others. The purchase of stocks and bonds in England. American loans to Great Britain. English sales of American securities in the stock market, etc. Dividends and interest due British stockholders. Tourist expenditures.
DOLLARS ARE NEEDED TO PAY FOR:
All goods shipped from the U. S. A. to Great Britain. The British use of American ships. Claims of all Insurance Companies. All investments made in the stock market, etc. Repayment of loans made by America to Great Britain. Interest due on all loans. Dividends due to American holders of British stocks.
Many other items could be enumerated in the foregoing tables, but, for practical purposes, the above should suffice. We see the many and varied sources which require both sterling and dollars, hence we must inquire how these dollars and sterling are acquired.
If a textile manufacturer in Manchester buys ten thousand bales of American cotton, he pays for it with some form of bill of exchange. This bill might be drawn in sterling or it might be drawn in dollars. When accounts are extensive and trading between two firms are frequent, a credit might be opened for the American exporter of the cotton, and the exporter would then draw his bill on the bank. In other instances the buyer of the cotton would make payment by a check on his bank and send it direct to the American exporter. In many cases the man who owes the money will buy a draft, drawn on some American bank, from his own bank and send it direct to the exporter to pay for the cotton.
Whether it is dividends, interest coupons, drafts, checks, or what not, for our purposes they can be regarded as bills of ex-change. This constant and large circulating mass of paper, drawn in every conceivable currency upon various individuals, banks and nations, requires some special facility to handle it. It is thus the function of the Foreign Exchange market to handle this mass of paper. How is this done?
The cotton exporter in New Orleans, who sold his cotton to the manufacturer in Manchester, might draw on the manufacturer in sterling at sight, and then hand the bills and document to his bank, which in turn sends it on to its New York correspondent for collection. The New York Bank has a foreign exchange department, and they in turn send it on to their London correspondent, who acts as its agent. The London agent then presents the draft to the English buyer, who pays it.
The cash, which the English buyer pays, is credited to the New York Bank's account which in turn notifies the New Orleans Bank, and the latter bank credits the exporter's account with the dollar equivalent of sterling. There is nothing complicated about the transaction, but there is one important thing in it to remember. The New York Bank has had its sterling account increased in London and its dollar account decreased in America. This is because the cotton exporter in New Orleans had his sight sterling bill paid to him in dollars.
Let's take an opposite example. A Wall Street brokerage house sells some stocks belonging to a London client. He sends his check, drawn on a New York bank, in payment. When the client receives this check, he can do one of two things. He can give it to his bank for collection; or he can sell it to his bank outright. Irrespective of which course he pursues, the London bank sends it on to its New York correspondent, who in turn collects it, and then credits the London bank's account with dollars.
It is quite obvious that if the London client sold the check, he would receive its equivalent in sterling then and there. However, if he gave it to his bank for collection, which in turn would send it to New York for collection, the client would not be paid until after the check was collected. In any case, however, the London bank's account in New York has been increased in dollars.
Thus you have, in the foregoing examples, the New York bank's sterling balance increased in London, and the London bank's dollar balance increased in New York. The examples illustrate how a great deal of foreign commerce is handled. There are other methods, however, which can best be illustrated by the following:
A Frenchman living in New York wants to send his wife, who resides in Paris, ten thousand francs. He goes to a New York bank which has a Paris correspondent and buys a draft for ten thousand francs, and mails it to his wife. She in turn cashes the draft in Paris, and the Paris bank debits the New York bank's franc ac-count. In this instance he surrendered dollars in New York, and, in return, received a draft payable in francs.
The three examples set forth the foundation of all modern foreign-exchange dealings. It consists principally of the balance held by the banks of one country, with the banks which act as their agents in foreign countries. Whether it be England, France, or Germany, the modus operandi is the same. For example purposes, we will continue to confine our illustrations to the sterling balances of London and the dollar balances of New York.
It is obvious, in the examples given, that each transaction ends in an increase, or decrease, in the balance held by one bank in one country, with its agent in another. Now, if there was a complete equilibrium every day, it is obvious that they would cancel each other out, but, in examining the table heretofore suggested, you will see that such an equilibrium is impossible. This being so, some banks are always finding that their foreign balances are growing too large, while others find their balances being depleted. It is this state of affairs which necessitates the buying and selling of foreign currencies in an effort to effect equilibrium; and this buying and selling of foreign currencies is what is known as the foreign-exchange market.
This foreign exchange market is a highly specialized business. In London, for instance, every bank which deals in foreign exchange has a dealer whose job it is to watch the size of its foreign balances, and to buy and sell foreign currencies or exchange accordingly. Now, circulating among the dealers are brokers. One set may specialize in francs, another in dollars, another in Italy's lira, Turkey's piasters, or Russia's chervonetz. So the dealer who works for the bank knows just which broker to approach. These brokers stay in constant touch with the dealers throughout the day, quoting them rates. One dealer may want to replenish his bank's franc account, while another wishes to sell its Turkish piasters, while still another wants to buy American dollars. The dealer who needs dollars to replenish his banks account, naturally wants them as cheap as he can get them, and, on the other hand, the dealer who has them to sell wants all he can get.
The broker steps in here as an intermediary between the dealers. Between the price bid, and the price offered, the broker tries to get what is known as a "fit" price, and, in the middle of it, other buyers and sellers may come in at varying rates.
Thus the huge machine grinds on with the broker dropping out every time he can get a buyer and seller to agree, and he leaves them to effect the actual transfer of the dollars between them. This is done by cable, from the buying and selling banks in Lon-don, to their agents in New York. Two days after the deal is concluded, one London bank pays another in sterling for what it sold, and the bank who sold the dollars has its dollar account in New York debited. Naturally the London bank which paid out the sterling has as its New York account credited with dollars.
The orders of the various foreign agents for execution are dispatched by cable, hence the rates at which these deals go through are known as cable rates. Such ,rates are published in the daily newspapers and form the basic rates for all exchange transactions and remittances made by banks for their customers.
While, as I said before, cable rates are the basic rates, they have four principal sub-divisions, known as the check rate, the sight rate, the long rate, and the forward rate. A check rate is known as the rate at which a bank will buy foreign currency checks from its customers, and credit their account then and there for the equivalent. In buying these checks, the banks insist on buying them a little under the cable rate. For instance, if the cable rate is $4.86, the check rate would be a little higher, say $4.86. Bear in mind that the cable rates were established by the dealers for the banks which wanted to sell or buy dollars, and that all rates are based on these cables.
The banks demand a little higher rate on the check for several reasons. They have to take the risk that the checks may not be paid. Also, the bank must pay out its money immediately, and the bank's account is not credited until the check reaches New York. If the holder of the check does not sell it, he must wait for his money until his bank collects the check, and then he gets paid at the cable rate on the day the check is paid, and not the rate prevailing when he handed the check in for collection. He must also pay the bank for collecting the check.
When you see what is known as a sight draft quoted, it means the rate at which a bank will buy foreign currency bills, payable at sight, or in other words, when presented. The same consideration which governs a check, govern sight documents.
Another type of rate is known as the long rate. The long rate means the rate at which a bank will buy foreign bills or documents payable at some definite period of time after sight. In other words, the bank may buy a document payable thirty days later, and, in doing this, they immediately advance the money at the prevailing cable rate of the day, plus a little higher charge, and then wait until the documents mature for their money.
The final sub-division of the rates established by the cable; that is, check, sight and long, is the rate known as the forward rate. This rate, more than any other, tends to keep the foreign exchange market somewhat evenly balanced. It was promoted especially for this purpose. During the post-war period, and, in fact, up until 1926, there were wild fluctuations in the foreign exchange market, and both the buyer and seller of commodities found themselves at a disadvantage. For instance, the Manchester textile manufacturer purchased ten thousand bales of cotton for future delivery at a specific price in dollars. When the cotton arrived, currencies may have so moved against him, that the rate of converting sterling into dollars may have proven prohibitive. This is overcome by the forward rate, just as one buys and sells futures. Once he has bought forward dollars, say so many to the pound, he need not worry about what he must pay for his cotton, irrespective of which way the rate of exchange goes. The enaction of the forward rate, or in other words futures, has proven a blessing to manufacturers and merchants alike, inasmuch as it predetermines what they must pay for what they buy, or what they will get for what they sell.
Notwithstanding that even in the normal function of business, consisting of billions of dollars each year in exports and imports, all of which must be conducted through foreign exchange, there is another large item, or in fact several of them, which contributes to this great machine of foreign exchange. Investors, whether they are in England, France or America,- always turn to the market where they can get the highest and safest return on their money. This also applies to financiers and banks. They want to deposit and do deposit their funds in whatever centre provides them with the highest rate of interest, granting that they get adequate safety.
In 1924 many American bankers knew that England was going back to the gold standard. So they bought the depreciated pound. When their hopes were realized in April, 1925, the prevailing rates of interest were so high in London that they left their funds there. They could earn more there than they could in New York. However, during the fall, when rates were lowered in London, and they found they could earn more in New York, back came their money, and London lost millions of dollars in gold to New York.
We can accept as a rule, that favourable exchange conditions to us would be England's low internal commodity and stock prices, and high internal interest rates. With such a condition, the American banker could profitably employ his funds in England. The opposite conditions would quite naturally be adverse to such employment.
The foreign exchange market is an academic study in itself, but, throughout, it is operated along the lines and basic fundamentals described.