Although there is no formal international clearinghouse through which sellers and buyers in foreign trade may settle their accounts, some sort of system or mechanism must exist if there is to be any important commerce between nations. It needs no elaborate proof, certainly, to demonstrate that if an American sells raw cotton to an English buyer, payment can be made only if the buyer has facilities for obtaining dollar exchange for remittance to the shipper or if the American shipper can obtain dollars for his sterling draft on the English buyer. To make this process possible merchants and bankers have developed a number of "instruments" or bills of exchange, and there exist at all times various sorts of markets--public or private, regulated or unregulated, legal or illegal--in which exchange may be bought and sold.
The Transfer Function
Theoretically, pairs of exporters and importers in each country could get together and arrange to circumvent the foreign exchange problem. This has actually been attempted in the barter schemes of Germany, Italy, and other countries. As a matter of practicability, however, even these modern private barter deals have required some sort of intermediary to bring the four parties into association. Under more normal circumstances the basis of a foreign exchange market is a group of professional intermediaries or middlemen who provide the dependable purchase and sale facilities essential to any continuous market.
What should be observed is that the two exporters are paid in their own currencies, the New Yorker in dollars and the Londoner in ster- ling, and that this result was possible because the two banks (here taken to be correspondents) stood ready to buy foreign exchange from the exporters.
There is a danger in drawing too many conclusions from a simple diagram, because in reality foreign exchange is not simple either in theory or in practice. It will, however, be useful to the reader later on if he will notice in this example that the two banks purchased foreign currency drafts from the exporters. They did so because they anticipated a demand for foreign exchange from importers and others who are in debt to foreigners. Or, following the diagram, if the money values are equal, the
London bank can swap its dollars for the New York bank's sterling. This illustrates in its most elementary form the financial link between the imports and the exports of a country, which is so seldom really understood. This link is the substance of the concept of reciprocity.
The principal function of foreign exchange, then, is to convert the money of one country into that of another--to enable exporters and other creditors to receive payment in their own currency. This we may call the transfer function of foreign exchange, as distinguished from its less important, but nonetheless useful, credit and hedging functions.
The Credit Function
Anyone at all familiar with the role of credit and credit instruments in domestic trade will perceive that similar facilities must be made available in foreign commerce and that there is nothing peculiar about the credit function of foreign exchange. If importers are unable to pay cash in advance or on delivery, there are several ways by which the burden of credit may be shifted to other shoulders.
In foreign trade, as in domestic, goods may be sold on open account. Under such terms--most attractive to the importer-the exporter "carries" his customer for a stated period, after which he receives a remittance, usually in his own currency. This latter will be the only instrument of exchange involved, since the exporter will not have drawn a draft. As we shall see later, a good deal of foreign trade, especially in manufactured goods, is carried on in this manner, particularly when conditions are favorable.
More usually the exporter will extend credit to the importer by drawing a time draft directly on the importer or the importer may arrange to open a letter of credit through his bank under which the exporter will draw drafts. This relieves the importer of the necessity of paying before the expiration of 30, 60, 90, or 120 days, as the case may be. If the draft has been drawn on a prime bank under a letter of credit, it provides the exporter with a prime credit instrument which he may easily discount at a favorable rate if he needs immediate cash. So through the use of time drafts the importer obtains credit and the exporter has the choice of holding the drafts till maturity or of discounting or otherwise borrowing against them. If he holds them, he is himself extending credit; if he discounts or borrows, he is transferring the credit burden to the general money market.
At all times there is in existence a vast number of bills of exchange which have arisen out of foreign trade. They reflect the short-term credit through which the trade is financed. Some of them will be sight or demand bills, payable on presentation to the drawee. In the case of these bills the credit or "time" element is limited to the collection time--for example, sight bills on London may be in collection up to 25 days. Generally sight drafts will have been drawn by exporters who need or wish to obtain prompt payment from the foreign buyer or payment before releasing the goods to him; or they will be drawn in foreign currencies by banks against their balances with foreign correspondents and sold to importers or other debtors who have to make payments in foreign currencies. In contrast are the bills of exchange drawn so as to be payable only after a specified number of days. These time bills are evidence that creditors in one country have agreed to extend "terms" or "credit" to debtors in another country.
The importance of the credit function of foreign exchange scarcely needs emphasis. Whenever an increase in the risk and uncertainty of international trade impels exporters to require cash in advance or on delivery of documents from their foreign customers, world commerce labors under a heavy handicap.
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