Foreign And Domestic Exchange
( Originally Published 1918 )
Foreign exchange is commonly thought to be complicated because some of the principles involved are not familiar. But they are the same as those of domestic exchange, except that in foreign exchange coinage bases have to be equalized. Domestic exchange is free from this necessity. That is all the difference.
Transactions of importance cannot be settled in currency, even though the currency be in large denominations and the transaction is local. Bank checks obviate the necessity of using currency. In most circumstances a creditor is just as willing to receive the right to demand, money as he is to receive the money itself.
Bank Credits.—A bank is an institution which permits persons to create credits either by the deposit of cash or by borrowing at the market rate of interest. It permits these creditors to draw orders upon it for any amount up to the limit of their credit. These orders or checks give the holder the right to demand the cash or to create credit for himself by a deposit of the checks. These credits on the books of the banks in favor of their patrons furnish a means of pay-ment which has largely superseded the use of cash in. If there were only one bank in a town all the checks drawn against it would be returned to it, either for payment or deposit. Where there are several banks, a system is required for settling the debt and credit balances between them.
Payments between different cities increases the complexity of making settlements, but the principles remain the same. If a man in Chicago wants to pay a bill in Cincinnati he will probably draw a check on his Chicago bank exactly as though the other man also did business in Chicago. The Cincinnati man will deposit the check in his home bank and put the burden of collection on that bank. The charge for making collections in such cases used to be so heavy that the creditors frequently refused to take the checks. When that happened the debtor was obliged to buy from his bank a draft payable in the city where the debt was due.
New York being the commercial and financial center of the United States, business men in every city and town are likely to have financial relations with that city, either as purchasing goods or selling goods. This has made it advisable for banks throughout the country to maintain deposits in New York banks. There are always payments to be made to New York buyers and payments to be made from New York to sellers.
Without the use of exchange it would be necessary to pay for every shipment of goods by 'forwarding cash and to receive payment for every consignment by transporting cash in the opposite direction. With the use of credit the ship-per in the inland town receives payment for his consignment by drawing a draft upon the consignee, or by awaiting receipt of a draft upon a New York bank. Either of these instruments he deposits in his local bank, which forwards it to New York and receives a credit there upon the books of the New York bank. The local bank has then the right to receive a certain sum of money in New York, and can realize this right either by requesting the shipment of cash or by drawing a draft against it.
Merchants who have made purchases from New York must provide a means of payment in New York when the bills are due. The local banks, having deposits in New York, are quite willing to sell orders upon the New York bank. Thus by means of buying and selling the right to sums of money in New York the payments which are necessitated by the movement of goods in and out are made.
New York exchange, being orders upon de-posits in New York banks, are acceptable every-where, because there are so many persons wishing to make payments in that city, and because every banking institution in the country deals either directly or indirectly with some New York bank.
Settlement Between Banks.—While in the long run the movement of goods from New York and to New York must practically balance, yet it would be a rare coincidence if the commodities sent from any given locality to New York exactly balanced the goods received from to New York. Any bank, therefore, has occasion to purchase more New York exchange than it needs to sell, or it has a demand for more than it needs to buy or receive on deposit from its customers. Unless the country bank wishes to shift its deposit account from a New York bank to some other bank it must make a shipment of currency if it wishes to reduce its deposit.
If a country bank has a large enough de-posit with its New York correspondent, it will accept deposits of checks on New York only with the intention of making shipments of cash to reimburse itself for the sums paid out. The shipment of currency involves expense and it is quite likely that it will not accept superfluous New York exchange unless it receives a fee which will cover the cost of collecting the same in cash. This cost depends upon three items; first the express charge, second insurance and third the loss of interest. The charge for transportation is usually combined with the charge for insurance by the express company. The moment the New York bank delivers the cash to the express company for shipment to the country bank upon its order it ceases to pay interest upon that sum. The country bank therefore loses the interest upon the same until it receives it and uses it as a basis for interest paying loans.
Currency shipments between New York and Chicago cost in the neighborhood of 50 cents per thousand dollars ; between St. Louis and New York it is 60 cents; between New Orleans and New York it is 75 cents, and between San Francisco and New York it is $1.50.
United States Sub-treasuries.—The cost of shipping currency from one city to the other is frequently saved to the banks by the treasury department of the government. For a good many years payments to be made between the treasury at Washington and the sub-treasuries in the various large cities were all conducted by cash shipments. It happened very frequently that while the treasury was forwarding considerable sums of cash between two cities, the banks would be shipping currency in the opposite direction. A cashier in New Orleans early in the seventies suggested to the Secretary of the Treasury that a saving both to the government and the banks might be effected if the banks when they wished to transmit money to a city in which a sub-treasury was located would ascertain whether the government at the same time did not wish to send money in the opposite direction. If this proved to be the case, it would be profitable to the banks and to the government to allow the banks to deposit the money in the treasury and receive an order upon the treasury in the other city. The treasury office in the first city would receive the currency it required from the depositing bank, and the bank in the other city would receive the currency from the treasury instead of from its correspondent; and all cost of transporting the money would be eliminated.
Exchange Rates.—Suppose there was a great demand for New York exchange in any city on account of the heavy bills falling due at some particular season of the year. The banks will discover that the demand for New York exchange far exceeds the supply of checks and drafts deposited by customers. Their deposits with their New York correspondents are reduced, and in order to continue selling New York exchange they must ship currency to that city. In that case they will be justified in charging at least 50 cents premium for every $1,000 of New York exchange sold, in order to reimburse themselves for the actual cost. Competition between the local banks will not become keen enough to bring about a much higher charge than this.
But if the receipts of New York exchange exceed the demand on account of heavy shipments of grain or produce to New York, the banks will find their deposits in New York larger than they care to maintain. They will be forced to order shipments of currency to them. To reimburse themselves for the expense they will subtract from the face value of the exchange bought or received on deposits the cost of doing the business. Thus it is possible for exchange on New York in San Francisco to be sold at a premium of $1.50 or to be offered at a discount of the same amount.
Why does it not happen that in certain circumstances a community may buy more goods than it sells during any particular period, and thus be forced to part with all its currency in settling the balance ? Since each trader is simply looking out for his own private profit and does not concern himself with the question of the amount of currency, there seems to be no reason why a community might not be drained of its currency. This brings up the question of the balance of trade, the principles of which are the same whether the exchange of goods is between two separate nations or between two localities within the same nation.
Suppose for any reason that there should be an unusually heavy purchase of goods by the members of a western state in any particular year. The merchants would buy New York exchange with which to pay their bills. The banks, after having exhausted their credits in New York, would be obliged to ship currency in order to cover the drafts on New York sold to the merchants.
The Clearing House Principle. -Domestic ex-change as we have seen, is simply a banking device to avoid the unnecessary shipment of money by settling balances only. The principle is exactly the same as that on which clearing houses are based. The banks in any one city find at the end of the day that they have received from their depositors a great number of checks drawn on neighboring banks: Before the days of the clearing house each bank sent a messenger to all the others with the items against them and received the cash in payment. At the same time each of the banks were sending out messengers to make collections they were paying cash over the counter to the messengers of other banks in settlement of the checks against them. By having common places of meeting the messengers could deliver the items to the debtor banks and could receive the checks representing the credits due them all at one time and could easily figure up the difference between the debts and the credits. Settlement could then be made by payments representing the differences which were likely to be less than 10 per cent of the total transaction, thus saving the handling of 90 per cent of the cash represented by the checks handled.
Balances Settled by Credits.—Methods have been found for eliminating the shipment of currency, even in order to pay balances. Banks which become debtors to others through the settlement of accounts may borrow the balance due from the creditor bank and pay interest thereon. This of course is not a final settlement of the balance, but simply postpones the settlement, yet if in the near future the balance happens to run in the opposite direction the loan may liquidate itself by a credit balance in lieu of cash.
Gold in Foreign Exchange.—In domestic ex-change, ultimate payments may be made in any form of currency but in settling balances between nations gold is used. Gold is the ultimate basis of credit in all civilized countries, and since a volume of currency very many times its amount is erected upon it, the movements of gold from one place to another are of more importance than movements of any other form of cash.
International Bankers.—The service to the business community of the banker who deals in foreign exchange is not only that he does away with over 90 per cent of the shipments of gold which would otherwise be necessary, and thus causes a great saving of expense and risk in settling commercial transactions, but of far greater importance is the service that he renders in steadying the credit conditions the world over. His function is more than to eliminate the shipments of money back and forth to make payments—he further decreases such shipments by borrowing and lending in foreign markets, so that the final and absolutely necessary shipments of gold are reduced to a low minimum as compared to the total amount of business trans-acted.
Foreign Exchange Quotations.—Quotations for sterling exchange are the prices at which the right to receive certain sums in England is bought and sold in New York and varies like everything else according to demand and supply.
The monetary unit of England is the pound sterling, which contains 113 grains of pure gold. Since our monetary unit is the dollar, composed of 23.22 grains of gold, it is easy to calculate that the English sovereign (the name of the coin containing a pound sterling) is exactly equivalent to $4.8665. In other words an English gold sovereign can be taken to a United States mint and recoined into 4.8665 American gold dollars.
The lowest equivalent of the English sovereign was that of March, 1917, being $4.7570. It rose to about normal after America declared war.
But there is a difference between the right to receive gold sovereigns in England and the use of gold sovereigns in the United States. A gold sovereign in England will not pay a debt in America unless it is first imported into its country and coined over. Therefore it is worth to its American owner $4.8665, less the cost of bringing it to this country, unless he can realize upon it by selling the right to receive it in England to someone who wishes to use it there.
The Minimum Sterling Exchange.—Calculating the total cost of shipping gold between America and Europe at the lowest figure of two cents per pound sterling, it is easy to understand why $4.8465 is called the minimum gold point for foreign exchange. If there should be an extra-ordinary supply of foreign bills for sale their price under normal conditions could never go far below this figure because there would always be some international banker who would be willing to pay for them the moment there was any profit in buying them, for the purpose of exporting gold, after they had been cashed in England. This minimum price does not mean that the value of foreign bills is an exception to the law of supply and demand, but that when the price falls below a certain minimum there arises automatically an unlimited demand.
Maximum Sterling Exchange..—On the other hand the price of sterling bills may not rise above $4.8865 under normal conditions because at that figure there is always an unlimited supply, so that no one who wishes to buy need pay more. The reason for this unlimited supply is this: The international bankers, seeing a chance for profit, will sell foreign exchange above the maximum gold point whether or not they have a credit balance abroad. Lacking such a balance, they buy gold with the proceeds of the bills. As soon as they have been issued they export gold to Europe so that it will arrive at the same time the bills are presented for payment, thus closing the transaction as far as the issuer of the bills is concerned.
Theoretically, the price of demand sterling cannot fall much below $4.8465 because of the great demand on bankers when it tends to fall below. But there are other conditions under which it may go considerably lower.
In March, 1907, the price fell to $4.83 for a time, and in the autumn it fell still lower. There were several reasons for this:
The rate for call loans in New York was very high and bankers who would otherwise have purchased the exchange did not do so because it was more profitable to loan the money than to invest it in exchange, which would have tied it up for at least two weeks, the time required to send the bills to London, exchange them for gold, and ship the gold to this country.
The reluctance of American bankers to with-draw gold from England at a time when it was needed there and when there was danger of a rise in the discount rate if the reserve in the Bank of England were endangered.
The difficulty in getting gold for export. The bills could be paid in notes, and although the Bank of England must redeem all notes when asked to do so, it has the right to pay out coins of less than full weight and make a difference of a cent profit in the pound.
The high price of gold bullion in London. To avoid the loss incidental to shipping coins, the abrasion and the light weight, bars of gold must be purchased in the market. Gold bullion is marketed in London as a commodity, but with fixed limits to fluctuation of price.
The premium on currency in New York in November, 1907, due to the suspension of cash payments by the banks.
The bulk of the gold produced in the world comes from South Africa direct to London to the amount of about $2,500,000 per week. The bullion brokers meet on Mondays to trade. Some of them have certain amounts of bullion to dispose of; others have buying orders. They begin by comparing notes and quite a variety of interesting situations may be disclosed. There may be a big amount to offer and a few small buyers, or vice versa.
The Bank of England is required to pay out notes for gold at the rate of 77s 9d per ounce and this fixes the minimum price. On the other hand. the bank is under legal obligation to redeem its notes for gold at the rate of 77s 10% d per ounce. This appears at first sight to limit the selling price, but on account of the right of the bank to pay out light weight coins for the notes the maximum is raised to practically 78s per ounce. There is a tacit understanding that the bank is to have preference when it is willing to pay the best price offered by any other bidder.
The fact that the Bank of England must buy and sell all the gold offered at the prices fixed by law, makes it very difficult for England to hold her supply of gold when other nations are bidding high for it by maintaining high interest rates. England for this reason is called a "free" gold market. The Bank of England exercises control over the gold supply by manipulating the rate of discount. A rise in the rate discourages both foreign and domestic borrowing, not only at the bank, but from all other banks that are forced to follow the bank rate. This means of control is effective, but it is expensive to the business interests of the country, to whom the difference of 1 per cent in interest payments means a great deal.
The system of France seems to have been superior in 1907, for while there were stringencies in all other markets, and the rate of the Bank of England was held for a long time at 6 per cent, customers of the Bank of France could always get funds at 3 per cent. The Bank of France has a monopoly of note issue, but is not compelled to redeem its notes in gold. When it desires to protect its gold reserve, the Bank of France refuses to pay out gold in quantities for export except at a premium. This premium is never so high that exporters are induced to gather up outside gold at greater expense, but it is high enough to discourage lending in foreign markets by French capitalists without interfering with foreign trade.
Proximity of the quotations for demand sterling to the minimum or maximum gold points indicates an approaching export or import of gold.
High quotations indicate exports, while low quotations indicate imports.
Shipments of gold interfere with the basis of credit and are therefore carefully watched by everybody whose interest can be effected by changed conditions in the credit market. The rate of interest and especially the rate of call loans is sometimes changed quite suddenly on this account. A sudden weakening of the call loan rates is very likely to lead to a calling of loans based on securities as collateral, with the result that stocks are likely to be thrown on the market for sale, thus depressing prices. This explains ,.he close relation between the foreign exchange market and the stock exchange.
Before the war, for some 'years, the thrift of the French people induced our financiers to make unusual efforts to establish a market for certain American securities in Paris. The Pennsylvania Railroad Company sold a very large issue of bonds in that country and at the present writing Morgan and Company are eagerly seeking the privilege of listing the securities of the United States Steel Corporation on the Paris Bourse.
The United States is now becoming a good market for many foreign securities. In fact nearly all foreign securities are at present quoted on our exchange. Portions of bond issues of South American states, such as Peru, Chile, Brazil, etc., are allotted to American bankers to be disposed of in this country, where they find a favorable market.
The movement of these securities to and fro is the most potent cause of fluctuation in the foreign exchange market. Stocks are probably the first thing in the country to feel the effect of the tendency to higher prices, caused by an in-creased amount of money or credit. A very small rise in the quotations of securities is sufficient to cause considerable selling of them in this market, which has a tendency to create a demand for foreign exchange to pay for them, hence a rise in the price of exchange until ex-ports of gold are induced.
London Time-Drafts.—Dealers who have sold time-drafts on London without having deposited credits there sometimes postpone the forwarding of funds until the drafts have reached maturity. They do this hoping perhaps the market may de-cline before the maturity date, and thus enable them to purchase exchange at a greater profit. Having waited so long without purchasing demand sterling, they are obliged to go into the market for cables at the last moment. The price of cables runs about twenty points above the price of demand sterling. This difference represents the price of cable messages and the interest for six or seven days. The dealer who sells a demand draft knows that the funds cannot be called for in London until the draft has reached that city by mail, which at the very best must require at least six days. In the meantime his London account is drawing interest.
Demand Sterling represents a draft which is payable on presentations and demand. There is a difference of five points between the quotations at opening and closing. This difference is ac-counted for by the difference in quality of the drafts in the matter of security. Drafts drawn by the best known and most reliable institutions command a slightly higher price than those is-sued by weaker firms. The price of ninety-day drafts is nearly 2 cents per pound sterling less than for demand drafts. This is because the purchaser of the draft must wait ninety days be-fore he can demand payment. The 2 cents represents the interest for ninety days.
The rate of interest which is to be substracted from the quotation for demand sterling in order to get the equivalent for ninety days drafts is reckoned at the English current rate of interest. The reason for this is that the purchasers of the bills may send them at once to London and rediscount them there at current rates of interest, and if they choose to realize on the funds may sell demand sterling at the market price, even before they forward the ninety-day bills.
Bill-Brokers.—England has a class of bankers called bill brokers, whose function is to discount time drafts for persons who desire to realize funds immediately and who are willing to pay a consideration to avoid waiting until the maturity of drafts. So universal is the custom in England of drawing drafts for accounts payable that the rate of discount is more important than the rate of loaning funds. Many English business men have no direct relations with banks, but deal with these bill brokers in much the same way that in legal matters English people deal directly with a solicitor who represents a barrister, who is the one who appears in court and actually handles the case. The rate at which the long bills can be discounted in London depends upon the official rate at the Bank of England.
Few of the bill brokers expect to hold the bills until maturity, but they expect to rediscount them at one of the large banks; their profit lies in the difference between the discount which they get from the customer and that they have to pay the bank. The large stock banks of London are under normal circumstances willing to discount bills at about Y2 per cent less than the Bank of England. Therefore the official bank rate is nearly always higher than the actual rate.
Interest rates in the two countries are equalized by means of finance bills. A finance bill is a draft drawn by a banker in this country upon a foreign bank for the purpose of realizing funds here for the time being and with the intention of meeting the draft at maturity by the purchase of demand sterling or cables. It is ;simply a method by which a banker borrows money in a cheap market and loans it in a dear one. For example :
Suppose the actual rate of discount in London is 5 per cent and that the rate in this country is 6 per cent. If a banker is able to borrow funds in England and reloan them in this country he will be able to make a profit of 1 per cent per annum, less the expense of doing business. A banker desiring to engage in this transaction is not obliged to actually borrow the funds in England and ship the gold to this country. He can accomplish the same purpose with less expense and loss of time by drawing a ninety-day draft against a London bank and selling it in the foreign exchange market and loaning the proceeds at the prevailing rate. The price he will realize for the ninety-day draft will be the price of demand drafts less a discount equivalent to the London rate.
It is not necessary that the banker have a deposit credit abroad. Under the conditions mentioned it would be unprofitable to have a deposit there when he might loan funds to such better advantage here. Lack of deposit credit does not deter him from drawing drafts upon the London bank if he can make arrangements with the bank for accepting the draft so presented in order to give it negotiability with the bill brokers. At the expiration of ninety days, however, he is obliged to have the funds in the London bank to meet the draft. These funds he provides by purchasing demand sterling a week or so before maturity in order to give plenty of time to reach England before the draft is presented. If he waits too long he must buy a cable.
The amount of his profit depends entirely upon the difference between the proceeds realized from the sale of the ninety-day draft (which are near the face of the draft, as the discount rate in England is low), plus the interest he has gained by loaning the proceeds, and the price which he must pay for the means of covering the draft at maturity, plus the commission for acceptance payable to the English bank, and the British Government tax on bills.
The banker who issues finance bills is forced to become a speculator in sterling exchange because his profit depends upon the price at which he can buy demand sterling or cables eighty to ninety days after the date of issue of the finance bills. If he wishes to make sure of a profit and shift the risk to others, he may make a contract at the time of issuing the finance bills for demand sterling eighty days after at a certain fixed price.
The issuing of finance bills has the same effect upon the market value of foreign exchange as bills rising out of commercial transactions. If they are issued in large amounts at any one time they depress the market, but when the time of maturity of these bills approaches, the purchases of demand sterling to cover stimulate the market artificially.
Arbitrage consists in buying or selling exchange on a certain center indirectly through a third city. For example, a banker wishing to increase his London balance would buy Paris exchange and instruct his Paris correspondent to use the proceeds of the bill in purchasing sterling in Paris, thus increasing his London balance by the triangular operation.
Suppose a banker had an opportunity to sell a draft on Paris but had no funds there. It would be very easy for him to sell the draft, purchase with the proceeds sterling exchange, remit it to London with instructions to purchase Paris exchange in London with the proceeds, and forward for credit to the Paris correspondent to cover the draft sold at first.
If he sold a draft for 25,250 francs, he would receive therefrom $4,879.23 (25,250 divided by 5.175). To cover this draft in Paris by French exchange purchased in London, it would be necessary for him to buy sterling exchange at $4.84. If 25.25 francs in London sold for £, he would be required to buy £ 1,000 in order to get 25,250 francs. This would cost him in New York at $4.84, $4,840. His profit would be: $39.23.
His London banker would probably charge him 1-40 per cent for doing the business, which would cut down his profit by $1.21, leaving it net at about $38.00.
The quotations in New York for continental exchange are influenced largely by the price of sterling exchange, both in New York and in Faris. If from any cause the price of continental exchange in New York should tend to fall to a point where there would be a profit in the arbitrage transaction, the demand for it on the part of the bankers who wish to make a profit from arbitraging would immediately force up the price again. Therefore, there is a certain relation existing between all the quotations of foreign exchange. When there is neither profit nor loss from arbitraging, they are said to be at par.