BBA607 - Role of International Financial Institutions

SET - I

Q1. What is Globalization? Explain its advantages and disadvantages.

a) Definition of Globalization.

b) Advantages & disadvantages

Answer:-

Globalization is defined as a concept which connects countries across the world through information, trade and
technology. In practical terms globalization means the integration of economies and societies through flow of
ideas, information, technologies, capital, finance, goods, services and people from one country to another. This is
also termed as ‘cross-border integration’ and has many dimensions such as social, political, cultural and of
course economic. Economic integration can happen through these channels:

• Movement of capital

• Flow of finance

• Trade in goods and services

• Through movement of human resource

For most of the economies of the world, globalization has led to a large number of beneficial effects. There is
also a section of people who believe that globalization has only benefited the developed economies whereas the
developing ones are still struggling with inequality and poverty. Thus, we see that globalization can have both
positive and negative impact on the economy of a nation, its people and the organizations within a specific
industry.

Some of the advantages of globalization are:

• Movement of capital: It has been seen that foreign capital flows in the form of Foreign Direct Investment (FDI)
and Foreign Institutional/Portfolio Investments (FIIs) play a very important role in the development of an
economy by enhancing the production base of a developing economy especially.

• Trade in goods and services: Globalization helps in the growth of emerging economies by facilitating
international trade in goods and services.

• Financial flows: The process of globalization leads to financial flows which further leads to the development of
the capital market.
Some of the disadvantages of globalization are:

• Although globalization was responsible for the development of many countries through increase in the
international trade, there were also certain disadvantages associated with it. Many studies released by UNDP
revealed that it has increased the disparities between the developed and developing countries, thus increasing the
gap between the rich and the poor.

• Unequal distribution of international trade gains is another disadvantage of globalization. Various studies
conducted in the past have proved that there is a cost to this globalization. Findings have proved that since
developing countries have underdeveloped capital markets and high risk premiums, they cannot fully participate
in this growth and increased investment brought about by globalization. As a result, these inadequacies tilt the
gains of globalization to developed and prospering nations.

• It has been found that developing nations have to face problems on international trade due to rising tariff and
trade barriers. Although commodities produced by developing countries may be given higher value and generate
greater profits due to international trade, yet this may lead to higher tariffs as well.

Q2. Elucidate the determinants of Exchange Rates.

Answer:-

Although in a free market the exchange rate should be determined by the demand and supply of currencies, there
are many other factors which influence the exchange rates, such as:

• Balance of Payment (BOP): The BOP position of a country is a clear indicator of the demand and supply of
foreign currency. If a country has a BOP surplus i.e. more supply of foreign currency, then foreign currency will
be cheaper than the domestic currency i.e. domestic currency will appreciate and vice versa.

• Strength of the economy: The demand and supply of foreign currency also depends on the relative strength of
the country. An economy with a faster growth rate as indicated by various parameters such as Gross Domestic
Product, and Gross National Product, drop in unemployment level, growth in industrial production and capacity
utilization, etc. may lead to a better performance on balance of trade. However, it is also possible that in the short
run, increasing economic activity may lead to higher imports as compared to exports.

• Interest rate differential: A higher rate of interest in a particular country may lead to a demand of the currency
of that country and greater supply of the foreign currency as speculative capital is attracted provided there are no
controls.
• Inflation rate differential: When two countries have different inflation rates, the currency of the country whose
inflation rate is higher will depreciate vis-à-vis the other country. This will lead to a change in exchange rate.

• Fiscal policy: If an expansionary policy is followed by the government by lowering the interest rates, which in
turn may fuel economic growth, it may lead to increase in exports. On the contrary, if the expansionary policy is
followed by resorting to higher budget deficit and monetizing this deficit, this may result in high inflation in the
economy and can be detrimental for the growth in export.

• Monetary policy: The monetary policy of any country is an important tool to control money supply in a
economy, keep a check on inflation, ensure price stability and growth of the economy. It also gives an indication
of the interest rates in the economy. Too much of money supply leads to inflation. In such as case, the central
bank raises the interest rates, sells government securities and may raise reserve requirements. It is, therefore,
clear that the monetary policy influences inflation, interest rates, employment etc. and thereby affects the
exchange rates.

• Speculation: Speculators influence exchange rates by buying and selling a particular currency in the
expectation of making profits and as a result may strengthen or weaken any currency in the short run. This is
known as the ‘bandwagon affect’.

• Government interventions: Sometimes the government of a country intervenes in the foreign exchange market
by imposing restrictions on currency movements, restrictions on currency dealings and by their monetary and
taxation policies. All this influences the exchange rate of the country.

• Central bank interventions: The central bank of a country can influence the exchange rate of the country by
selling and buying foreign currency in the foreign exchange market. For example, RBI buys dollars whenever the
rupee starts appreciating beyond a particular level and sells dollars whenever the rupee starts depreciating
beyond a desired level. This is called ‘open market operations’ of the central bank. A highly appreciating rupee
is favorable to importers and unfavorable to exporters and vice versa. However, it is important to understand that
for these operations, the central bank of the country should have huge reserves of dollar.

• Market expectations: The demand and supply of foreign currency will also be affected by market expectations
like changes in policy with respect to foreign trade, taxation, changes in government, inflation, and trade and
industrial policies.

• Political factors: In case there is a likelihood that the government of a particular government may fall, it will
have an impact on the exchange rate. However, whether the currency of any country will weaken or strengthen,
will depend upon the policies implemented by the new government. At such times, it is tendency of the people to
move funds into ‘safe haven’ currencies like dollar and Swiss franc.
• Technical factors: These factors can impact the exchange rate in the short run. For example, if the central bank
makes it mandatory to limit the size of open position and if the banks have ‘huge short positions’, they may have
to buy foreign exchange in order to cover such positions. Similarly, if the central bank raises the reserve
requirement limits for deposit money banks, it will impact the exchange rate.

• Exchange controls: Exchange rate controls are imposed by countries to restrict free capital flows and thus
impact the exchange rates. By this mechanism, the countries are able to keep the price of their currency at an
artificial level.

• Overseas investment: If overseas investment from any country, let us say the US, increases in India, the supply
of dollars will increase leading to a downward pressure on the dollar and strengthen the rupee.

Q3. What is Letter of Credit? List and explain the different types of Letters of Credit.

a) Definition of Letter of Credit.

b) Explanation of the different types of Letters of Credit.

Answer:-

Letter of Credit (LC) is one of the methods of making trade payment while dealing with unknown exporters or
importers. LC is one of the most secured modes of payment for international traders, especially when the foreign
buyer’s reliable credit information is not there. The exporter has to be content with the creditworthiness of the
importer’s bank. Through this method, the specific performance of both the parties i.e. exporters and importers is
ensured. Also, the exporter is protected since payment is only made once the goods are delivered or shipped as
promised.

The main parties involved in a letter of credit transaction are the applicant, the beneficiary, the issuing bank, the
confirming bank, and the nominated bank. The importer sends an application to his bank i.e. the issuing bank to
open a letter of credit in favour of the beneficiary i.e. the exporter through another bank called the correspondent
bank. Therefore, a Letter of Credit is a commitment by a bank to honour the payment to the exporter on behalf of
the importer, subject to the fulfillment of the terms and conditions mentioned in the LC. For rendering this
service the bank is paid a fee by the buyer or importer.

The different types of Letter of Credit are:

(i) Commercial Letters of Credit: Commercial letters of credit are used as a primary payment tool in
international trade. Majority of commercial letters of credit are issued subject to the latest version of UCP
(Uniform Customs and Practice for Documentary Credits). The ICC publishes UCP, which are the set of rules
that governs the commercial letters of credit procedures.

(ii) Standby letters of Credit: Commercial letters of credit are a means of payment to be utilized when the
principal perform its duties. In standby letters of credit, a payment is made to the beneficiary when there is a
breach of the principal’s obligation. As an example, let us consider a construction company that has been
awarded with a tender. If this construction company cannot fulfill its obligations under the project contract
beneficiary of the standby letter of credit can apply to the nominated bank for the payment. However, the
nominated bank considers only the terms and the conditions of the standby letter of credit and the rules
governing the credit when deciding a complying presentation. Standby letters of credit have their own rules,
which are called the International Standby Practices 1998 (ISP98). They are also published by ICC. However, a
standby letter of credit can be issued subject to either the UCP or the ISP.

(iii) Back-to-back letter of credit: Back-to-back documentary credit is used in situations where a transferable
documentary credit cannot or is not allowed to be used for some reason. Upon the intermediary’s request the
bank issues a back-to-back documentary credit in favour of the supplier. The documentary credit, opened by
intermediary’s bank, is based on documentary credit (so-called initial documentary credit) previously opened in
favour of the intermediary. Legally, these are two independent documentary credits; therefore, contrary to the
transferable documentary credit, the bank may require the intermediary to provide additional security for the
issuing of a back to-back documentary credit (as the initial documentary credit is not a 100 per cent security for a
bank). At the same time the use of back to-back documentary credit allows the intermediary to avoid direct
contacts between the buyer and the seller.

(iv) Revolving letter of credit: A revolving documentary credit is suitable for making payments for regular
deliveries made over a longer period of time. The buyer asks his bank to issue a letter of credit with a socalled
‘revolving clause’ that allows the seller to present documents to the bank after a certain period of time defined in
the documentary credit, submitting then under the same documentary credit without the buyer having to make
any amendments.

(v) Revocable Letters of Credit: Revocable letters of credit give issuer the amendment or cancellation right of
the credit any time without prior notice to the beneficiary. Since revocable letters of credit do not provide any
protection to the beneficiary, they are not used frequently. In addition, UCP 600 has no reference to revocable
letters of credit. All credits issued subject to UCP 600 are irrevocable unless otherwise agreed between the
parties.

(vi) Irrevocable Letters of Credit: Irrevocable Letters of Credit cannot be amended or cancelled without the
agreement of the credit parties. Unconfirmed irrevocable letters of credit cannot be modified without the written
consent of both the issuing bank and the beneficiary. Confirmed irrevocable letters of credit need also
confirming bank’s written consent in order any modification or cancellation to be effective.

SET - II

Q1. Explain the main functions, lending activities and lending policies of World Bank.

a) Explanation of main function

b) Explanation of lending activities

c) Explanation of lending policies

Answer:-

a) Explanation of main function

(i) To aid in the reconstruction and the developing of territories of its member governments by facilitating
investment of capital for productive purposes.

(ii) To advertize private foreign investment by guaranteeing or by participating in loans and other investments of
capital for productive purposes.

(iii) Where private capital is not available on fair terms, to make loans for productive purposes out of its own
resources or out of the funds borrowed by it.

(iv) To promote the long-range growth of international trade and uphold equilibrium in the balance of payments
of the members. International investment should be promoted for the growth of the productive resources of
members.

(v) The bank has adopted, as a principal object, a policy of lending for productive projects which will lead to
economic growth in its less developed member countries.

b) Explanation of lending activities

• By way of participation in direct loans out of its own funds.

• By participating in direct loans out of funds raised in the market of a member, or otherwise borrowed by the
bank.

• By guaranteeing in whole or part, loans made by private investors through the usual investment channel.

The Bank may give loans directly to member countries or it may guarantee loans granted to member countries. It
normally makes loans for productive purposes like agriculture and surplus. The total amount of loans granted by
the Bank should not exceed 100 per cent of its total subscribed capital and surplus. After calculation of the
interest, an additional commission of 1 per cent for creating a special reserve against loss and 0.5 per cent for
administrative expenses are charged.

c) Explanation of lending policies

(i) All loans are for the governments or they must be guaranteed by the governments

(ii) Repayment period is within a period of ten to thirty-five years

(iii) Loans are only made in circumstances in which other sources are not readily available

(iv) Investigations are made regarding the probability of repayment, considering both the soundness of the
project and the financial responsibility of the government

(v) Sufficient surveillance is maintained by the Bank over the carrying out of the project to assure that it is
relatively well executed and managed

(vi) Loans are sanctioned on economic and not on political considerations

(vii) The loan is meant to finance the foreign exchange requirements of specific projects; normally the borrowing
country should mobilize its domestic resources.

Q2 Explain Basel III, list its key features and its impact on Indian Banking System.

a) Explanation of Basel III

b) Key features of Base III

c) Impact of Basel III on Indian Banking system

Answer:-

a) Explanation of Basel III

Basel III is a global regulatory standard on capital adequacy of the banks, their market liquidity risks and stress
testing, as agreed upon by members of Basel Committee on Banking Supervision overseen by the Bank for
International Settlement (BIS). Basel III, which was released in December 2010, is the third in the series of Basel
Accords which deal with the risk management aspects of the banking sector. Base I and Basel II, which were the
earlier versions of Basel III, were less stringent as compared to Basel III. As mentioned earlier the basic aim of
Basel III Accord is to improve the banking sector’s ability to deal with economic and financial stress to be able
to absorb shocks, their risk management abilities and governance and bring transparency in their operations and
disclosures.
b) Key features of Base III

• Better capital quality: This implies that banks will be stronger and will have higher loss absorbing capacity.

• Capital conservation buffer: This means that banks maintain an extra cushion of capital that can absorb losses
in times of financial and economic stress.

• Countercyclical buffer: This innovative buffer has been introduced to increase capital requirements in good
times and decrease it in tough times.

• Leverage ratio: Taking a lesson from the financial crisis of 2008, this is a safety net which has been
introduced in Basel III to cap the increase of leverage in the banking sector at the global level.

• Liquidity ratios: A framework of liquidity risk management will be created under Basel III.

• Minimum common equity and Tier I capital requirement: The minimum common equity capital
requirement has been increased from 2 per cent to 4.5 per cent and the minimum Tier I capital requirement has
increased from 4 per cent to 6 per cent under Basel III. Although the minimum total capital requirements remains
at 8 per cent but combined with capital conservation buffer, it has become 10.5 per cent.
• Systematically important financial institutions: It will be required to maintain capital beyond the Basel III
requirement as part of the macro prudential framework.

c) Impact of Basel III on Indian Banking system

Implementation of Basel III by Indian Banks will not only be a challenging task for the banks but also for the
Government of India as `6,00,000 crore will have to be raised by Indian banks by 2020. This may reduce their
margins.
Comparisons of capital requirements under Basel I and Basel II

Capital Requirements Basel II Basel III

Leverage ratio None 3.00%
Minimum Ratio of Total Capital to 8% 10.5%
Risk
Weighted Assets ( RWAs)
Tier I capital to RWAs 4% 6%
Core Tier I capital to RWAs 2% 5%
Minimum Ratio of Common Equity 2% 4.50% to 7.00%
to
RWAs
Capital Conservation Buffers to None 2.50%
RWAs
Countercyclical Buffer None 0% to 2.50%
Minimum Liquidity Coverage Ratio None To be decided by
2015
Systemically Important Financial Nil As of RBI’s June 2013
Institutions Charge notice, India does not
have any Globally
Systemically Important
Banks (G-SIBs)
figuring in the list of 28
G-SIBs.
Minimum Net Stable Funding Ratio None To be decided by
2018

Q3 Explain the Euro Zone Debt Crisis and China’s Yuan Revolution.
a) Explanation of The Euro Zone Debt Crisis.

b) Explanation of China’s Yuan Revolution.

Answer:-

a) Explanation of the Euro Zone Debt Crisis

The major causes of the European debt crisis are over-borrowed debts in the public and private sector, and
system failures and government failure. Looking at the impact of the crisis on the US, the UK and China, it is
believed that China would be more impacted than the US. The real economy of both the UK and the US are less
influenced by trade. This is because, even though Japan is the second-largest export market for the US after
China, the actual export is only 7 per cent of the total output which is only 1 per cent of the US GDP. On the
contrary, the recession in Europe leading to a lesser demand of exports will greatly impact both Japan and China.
Chinese growth is largely reliant on export as the European Union is the biggest importer of Chinese goods.

Experts believe the best way out of the crisis should be a collective action within the European Union. The future
of Euro as a common currency of the European Union is at a stake unless some quick and drastic measures are
taken by the stronger economies of the European Union to bail out the weaker economies ailing from the huge
fiscal deficit and sovereign debt burden like Spain and Greece.

b) Explanation of China’s Yuan Revolution

Time and again, remarks and statements from top officials of Central Bank of China have indicated that the
Yuan or Renminbi, the official currency of China, has started to show its potential and would soon be included in
the reserve currencies across different countries such as Europe, North America and the Middle East. Great
efforts are being made by Chinese officials to have yuan play a greater role in the international trade and
investment. A global yuan competing with dollar can be beneficial in bringing down the foreign exchange costs
for the Chinese companies and at the same time upgrading China’s status in the international monetary system.
The growth of yuan has been exponential in cross-border trade settlements with around 10 per cent of China’s
total trade being made up of yuan-denominated trade transactions. Investors, including the foreign exchange
central banks, are concerned about the long-term strength of the dollar and weakening euro and are, therefore,
trying to take corrective actions by thinking of diversifying their currency reserves to include the Yuan. Some of
them have entered into currency swap agreements with the People’s Bank of China, while others are thinking of
buying Yuan-denominated assets sold in Hong Kong. Despite these promising indicators, Yuan has still to go a
long way before it can become the reserve currency. Besides, the international use of yuan requires China’s
financial sector to be revamped through steps such as liberalizing the interest rates and exchange rates and also
remove restrictions on the capital flows. Global investors would only invest in yuan when they are free to buy
and sell yuan-denominated assets. However, some analysts are of the view that yuan’s internationalization can
lead to the financial sector reforms in China, whereas others feel both the financial sector reforms and
internationalization of yuan can go together. Still, there are others who feel that reforms should precede the
internationalization. Chinese financial economy has to do away with distortions like addressing the artificially
maintained low interest rates, which is favorable to the banks and the local governments, while hurting the
savers, before going for full capital account convertibility so that there is no risk of destabilization of capital
flows. Besides, this, over reliance on bank lending should be reduced and stocks and bonds should emerge as
funding options like in countries such as the UK and the US.