CHAPTER VIII

THE FOREIGN EXCHANGES

In this chapter we are to consider the financial mechanism known as the foreign exchanges, by means of which the great majority of international trading and financial obligations are settled without requiring monetary payments. The "exchanges" have always been a sealed mystery to the rank and file of even well-informed people for the reason that an understanding of the mechanism involved requires a certain amount of simple technical information, which the "average citizen" is never willing to acquire. Of late, however, because of the great depreciation of foreign currencies that has resulted from the financial and trade exigencies of the Great War and the potential effects of this upon the American industrial situation, the subject has attracted unusual attention, and even the man in the street is now vaguely conscious that foreign exchange is, somehow or other, a subject of no little practical significance.

I. THE NATURE OF THE PROBLEM

Foreign exchange is concerned with the settlement of international financial obligations. Whenever an American travels in Europe he requires funds with which to meet the expenses incident to travel; whenever a merchant in the United States buys goods from Europe, he needs a means of paying his debt to the foreign seller; whenever a European wishes to buy American securities, some means of payment must be found; in a word, whenever any international transaction takes place, a settlement must be made. The nature of the problem may be most clearly revealed by a statement of the principal sources of international obligations that have normally existed between the United States and Great Britain.

a) Transactions tending to cause an outflow of funds from the United States:

1. American imports of British goods

2. American premiums on British insurance
3. Interest payments on British investments

4. American bank loans to British banks

5. American payments of freight bills to British ship owners 6. Expenditures of American tourists abroad

b) Transactions tending to cause an inflow of funds to the United States:

1. Exports of goods to Great Britain.

2. Payment of British insurance policies to Americans
3. British investments in American securities

4. British bank loans to American banks

Now it is obvious that if every individual transaction involving payments by Americans abroad were settled in actual money, and if every transaction involving payments by Great Britain to the United States were met by a shipment of specie,' a very considerable portion of our monetary resources would be constantly in transit between the two countries, for the volume of international settlements effected in the course of each year runs into hundreds of millions of dollars. Such shipments of actual money would obviously be subject to the risks of ocean transportation, and to substantial costs through loss of interest on the money while in transit and in connection with the packing and expressing of the currency. Clearly a mechanism that would make possible a reciprocal cancellation of the greater part of these obligations would be of very great economic advantage. In brief, it is the function of the foreign exchanges to cancel all except the net balance of indebtedness, that is, the difference between the total of transactions involving an outward flow, and the total of transactions involving an inward flow, of funds. This balance is met by currency ship

ments.

Specie, alone, is acceptable in international monetary settlements, and it is accepted by weight and fineness only.

II. THE EXCHANGE MECHANISM

The means by which international payments are effected largely without the shipment of specie is by sending bills of exchange abroad in lieu of actual cash. In order to make the process clear, it will be necessary to understand, first, precisely what is meant by the parity of exchange, "gold points," and bills of exchange.

Exchange between United States and England is said to be at par when a sterling bill is worth 4.866 in New York. What does par or parity of exchange mean, and how is this quotation, 4.866, derived? Parity of exchange is nothing but a simple statement of the relative value of American and British coins. The gold in the British monetary unit, the pound sterling, is worth 4.866 times as much as the gold in the American monetary unit, the dollar. The par exchange rate thus depends upon the varying gold content of the monetary units of the different countries.

The par of exchange between the United States and France is 5. 18, the American dollar being 5.18 times as valuable as the French unit, the franc. The franc is thus worth in terms of our money a little over 19 cents. France, Belgium, Italy, Switzerland, and Greece belong to the Latin Monetary Union, with monetary units of equal weight and fineness, though of different names; hence the par of exchange between the United States and all of these countries is 5.18. Parity of exchange with Germany is 23.8, the mark being worth 23.8 cents. It is of note that in quoting French exchange it is customary to state the number of francs in a dollar, while in comparing American and British coins we speak of the number of dollars that it takes to equal one pound sterling (4.866). The French quotations are thus stated inversely.

The money of each of the various countries has its particular parity as compared with United States coins, and in turn the pound sterling, franc, etc., each has its parity with the coins of all the other countries. It is unnecessary for our present purpose to enter into a detailed discussion of all these quotations, for they all involve a common principle.

The use of bills of exchange reduces currency shipments. The function of bills of exchange may best be revealed by the use of some concrete illustrations. Let us assume that Mr. A in New York has sold £1,000 worth of goods to Mr. X in London, and that at the same time Mr. B in New York has purchased £1,000 worth of goods from Mr. Y in London. It is apparent that if it could be arranged so that B could pay A and X could pay Y, it would be unnecessary to ship any currency in order to settle these obligations. If A were to draw an order (or bill of exchange) on X in London ordering X to pay Y £1,000 and then could sell the bill to B, he would receive his money from B; then if B sent this bill over to Y and Y presented it to X, who paid it, both obligations would have been settled without the use of any currency.

But in practice there are usually two difficulties which prevent this simple solution of the problem. In the first place, A is not usually acquainted with B, and X is not usually acquainted with Y. Secondly, the amounts involved in the two transactions are not usually identical. Accordingly, dealers in foreign exchange (banks and brokers) are required as financial intermediaries. When A draws his bill of exchange for £1,000 of exchange on the London buyer of his goods, he takes it to a foreign-exchange banker, who pays him, when exchange is at par, $4,866. The banker then sends the bill to a correspondent bank in London, which presents the bill to X for payment. The payment is next deposited with the London bank to the credit of the New York bank. Now when B wants to buy a bill of exchange he goes to the foreign exchange banker and the banker sells him a draft drawn against this London bank account-a draft for £1,000, or for whatever amount the buyer may desire. B then sends the draft to Y in London and Y presents it to the bank against which it is drawn and receives his payment. The New York banker thus acts as an intermediary between A and B, serving in effect to bring them together, and serving also to make "change," that is, to break up bills of exchange into whatever denominations are required.

I See p. 167 for a sample of one of these bills.

Sometimes these bills are drawn directly by the exporters against foreign banks with whom the foreign importer has made arrangements for the purpose. They are sometimes drawn payable at "sight," that is, when presented, and sometimes they run for thirty, sixty, or ninety days, etc. The drafts may have attached to them documents in the form of bills of lading and other shipping receipts, or they may be what are known as "clean bills," unaccompanied by any documentary evidence. There are many angles to the problem, giving rise to many different types of bills involving different methods of payment; but the foregoing simple illustration will suffice to reveal the essential principles in all cases.

It remains to be noted that bills of exchange are not always drawn by American banks or American exporters against foreign banks, and sold to American importers who have remittances to make. The process may be reversed-the method actually employed in any given case being a matter of agreement between the parties to the transaction.1

The price of exchange is determined by the demand and supply of bills. What now determines the price at which a bill of exchange can be bought or sold in the New York market? In the illustration above we assumed that exchange was at par. In fact, it is sometimes above and sometimes below par. The price of a bill of exchange is, like the price of wheat or any other commodity, a reflection of the relative demand for, and supply of, bills in the market at the moment. If at any given time £1,000,000 worth of sterling bills were offered for sale in New York and £1,000,000 worth were demanded, the price would be at par, that is, at 4.866. But if only £1,000,000 worth of bills were offered in the market for sale, and £1,200,000 worth were demanded, the price would be bid up above 4.866 by those who desired the bills as a means of meeting their obligations abroad. On the contrary, if only £800,000 were demanded, the sellers would have to make concessions in order to dispose of their bills.

I For a more detailed discussion see chap. xix.