The Economics of Foreign Exchange: How Foreign Trade Is Carried Out

How Foreign Trade Is Carried Out Suppose an American grain dealer arranges to sell 10,000 bushels of grain to a French milling company. If the price of the grain is $4 per bushel, the total transaction involves $40,000. Naturally, the American grain dealer will want to be paid in dollars rather than francs, while the French miller will want to pay for the grain in francs. Suppose the exchange rate is 10 francs to the dollar. To finance the transaction, the French miller will write a check for 400,000 French francs, the equivalent of $40,000. The miller will then send the check directly to the U.S. grain dealer, who will present it to the bank for conversion to dollars. The miller can also purchase a bank draft (a check drawn on the bank) made out to the grain dealer in U.S. dollars, a more common option. The French miller will pay the bank a small fee for the draft. In effect the French bank, in assisting the miller in the international trade transaction, loses deposits of 400,000 francs. Where do these francs go? They go to a U.s. bank or other foreign exchange dealer who obtains the 400,000 francs in exchange for $40,000. Assume the francs are sold to a U.S. bank. This bank then holds the francs as a deposit in a French bank, called a correspondent bank, in which it has an account, or in its French branch (if it has one) for future use or sale. As long as the French francs are held in a French bank after the sale of the grain, there is no reduction in the French money stock. U.S. banks acquire deposits in a French bank that can be invested in French assets or used to buy French goods and services. The grain exporter in turn has its deposits increased by $40,000 at its bank when the exporter deposits the draft from the French bank. The $40,000 draft will be written against the French bank's account in a U.S. correspondent bank. As a result of the export transaction, U.S. banks obtain assets of 400,000 francs, which are held in foreign banks, and new liabilities of $40,000. The table in Box 1 summarizes the immediate financial implications of the grain export transaction. How Foreign Trade Is Carried Out: An Import Transaction Suppose a U.S. distributing company imports 20,000 videocassette recorders from a producer in Japan. The wholesale price of the VCRs is 12,500 Japanese yen per unit. If the exchange rate of the yen is $0.008 per yen, the dollar price of a VCR is Dollar price = (12,500 yen)($0.008 per yen) = $100 The total cost of the 20,000 VCRs in dollars is $2 million, equivalent to 250 million Japanese yen at the current exchange rate of $0.008 per yen. Note that at this exchange rate it will take 125 yen to purchase each dollar. The exchange rate of the dollar in this example is therefore 125 yen per dollar. The mechanics of the transaction are similar to those we discussed for the export of grain from the United States to France. However, in this case the U.S. distributor goes to the local bank to arrange the exchange of dollars into yen to pay for the purchase of imported goods. The distributor writes a check for $2 million (plus a small fee to the bank) in exchange for a bank draft made out to the Japanese exporter for 250 million yen. The U.S. importer's account is debited by $2 million as a result of the purchase. The $2 million ends up in the hands of a Japanese bank or other foreign exchange dealer who purchases the dollars in exchange for 250 million yen. For example, the yen could be supplied by any U.S. bank holding deposits denominated in yen at a Japanese bank. The Japanese exporter ends up with 250 million yen more in the exporter's account. As long as the Japanese bank or other dealer purchasing the dollars for yen keeps these dollars on deposit at an American correspondent bank, there is no reduction in the U.S. money stock. The dollars held in these accounts can be used to purchase U.S. financial assets, such as corporate bonds or government securities, or held to finance future import transactions in which dollars will be sold for foreign currency. The table in Box 2 summarizes the immediate impact of the import transaction on assets and liabilities in U.S. and Japanese banks.