International Trade and Finance

By Joseph Kolawole Okunato

This book is written for three purposes, 1) to ensure that candidates preparing for the examinations of The Chartered Institute of Bankers of Nigeria (CIBN) can safely cover most of the topics they are expected to cover and pass their examinations. 2) To serve as reference book for bankers, consultants, advisers and members of the academia, and 3), as a reference document to businessmen in areas of their foreign trade transactions.
The book is arranged into thirteen chapters. Starting with the theoretical basis upon which international trade and finance is based in chapter one.
Chapter two looks into the requirements for a contractual relationship for parties going into foreign trade contracts. It also focuses on the common platform of the international commercial terminologies, and concludes with the various documents required in international trade.
Chapter three is about the various methods of payment and settlement in international trade, including the new electronic method of payment, Bank Payment Obligations, BPO that came into force in 2013.
Chapter four deals with financing of international trade and all areas covering the various instruments, sources and the special instruments are covered.
Chapter five looks into the credit unions that support, finance, insure and guarantee credit facilities that are promoting international trade, while chapter six deals with International Collections and the rules of its application.
Chapters seven and eight are fully devoted to Documentary Credits. Chapter seven deals with the documentary credit processes. Chapter eight deals with the various ways of documentary credit settlement and its uses for financing international trade.
Chapters nine looks into the foreign exchange market, its historical development, factors and risks inherent therein and the roles of the monetary authorities. Chapter ten is devoted to the calculations which form the albatross area for students.
Chapter eleven is devoted solely to the rules, regulations, and laws of the 27 Exchange Control Memoranda governing foreign exchange transactions in Nigeria.
Chapter twelve is devoted to Exports from Nigeria and the various incentives for the exporter. The chapter is concluded with the guiding laws for exporters.
Chapter thirteen is devoted to the various international bodies that support international trade and their roles.
The book is written to make international trade and finance an interesting and enjoyable reading, in simple English for easy assimilation. It has provided the update no other literature on its coverage has in a single book in Nigeria.
Joseph Kolawole Okunato
2019

• Language: English
• Publisher: Balboa Press
• Release date: Oct 24, 2019
• ISBN: 9781982233846

Joseph Kolawole Okunato

OKUNATO, JOSEPH KOLAWOLE Skill Set/Expertise: Organizational Dynamics Position/Present Duty: Principal Partner, Kolawole Okunato and Company Qualifications: • Associate of the Chartered Institute of Bankers, (ACIB). London, 1981 • Associate of the Institute of Chartered Secretaries and Administrators, (ACIS). 1982; • Associate of the Institute of Chartered Accountants of Nigeria, (ACA). 1990; • Master of Science, (M.Sc.) Banking and Finance (University of Ibadan), 1989 with the following Prizes: o Best Student in Economic Theory and Policy, and o Best Class Student • Fellow of The Chartered Institute of Bankers of Nigeria, (FCIB). 2008; • Member Grade, The Chartered Institute of Arbitrators, (MCIArb) London UK. 2013 Experience: • Banking: I worked in all areas of Banking Business for a period spanning about 30 years, in Retail, Commercial, and Operations business units in Commercial and Merchant Banking. Some of the Strategic Departments I was Head include International Operations, Credit Compliance, Credit Appraisal, Commercial Treasury, Consumer Banking, Debt Recovery, Commercial & Retail Banking, Inspectorate as Chief Inspector, Regional Business Executive in charge of Federal Capital Territory and North Central, and Regional Director for Federal Capital Territory. I was the Group Head of Banking Operations overseeing E-Banking Operations, Branch Banking; Domestic and International Banking operations of Intercontinental Bank Plc. Other Banks I worked with were Union Bank of Nigeria Plc., Devcom Merchant Bank Ltd, Equitorial Trust Bank Ltd, and Gateway Bank Plc. • Media: I was the Pioneer Chief Finance Officer/Assistant General Manager of Daar Communications Plc., operators of Ray Power Radio and AIT. I had the privilege of setting up the Accounting System, Credit Control function; installed the Accounting Software (DacEasy), and managed the Loan Consortium Syndicate, among other Financial Functions, reporting to the Board of Directors • Capital Market Operations: I worked with Kinley Securities Limited (A Member of the Nigeria Stock Exchange) as the Head of the Corporate Finance Department. I had the privilege of setting up the Corporate Finance Department, developed the clientele base, and supervised the marketing and sales force of the company. • Publications: ‘The Market Structure of Merchant Banks in Nigeria’ The University Banker, 1990; Conquering Fear, 2000; ‘Term of Trade’ in International Banking’, Business Examinations Guide, 2002; Sin of Unbelief, 2014; and International Finance, The Chartered Institute of Bankers of Nigeria, 2015

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Copyright © 2019 Joseph Kolawole Okunato.

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ISBN: 978-1-9822-3382-2 (sc)

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Library of Congress Control Number: 2019912686

Balboa Press rev. date: 10/24/2019

CONTENTS

Dedication

Foreword

Acknowledgements

About The Author

Preface

1 International Trade andFinance: An Overview

Introductions to the Characteristics of Global Trade, The Basis and Theories of International Trade, Balance of Payments and Exchange Rate; The International Monetary System and Its Features; Challenges of International Trade; Risks Inherent in International Trade; The Importance of Foreign Exchange; What is Foreign Exchange; Approaches to Determining the Exchange Rate; Management of Foreign Exchange; Background to Exchange Control in Nigeria; Protection against Exchange Risk; Practice Questions

2 Contracting a Business Relationship in International Trade.

Contractual Relationship of Parties in International Trade; General Guidance for International Commercial Sale of Goods; Detailed Provision of Articles in the ‘Short’ Version of CISG 1980; Terms used in International Transactions; The Incoterm Rules; Terms for any Mode(s) of Transport; Terms for Sea and Inland Waterways Transport; Main changes in Incoterms 2010; Documents used in International Trade; Invoices; Insurance Documents; Documents of Movement; Financial Documents; Third-Party Documents. Practice Questions

3 Methods of Payment And Settlement

Methods of Payment: Payment in Advance; Open Account; Collections; Documentary Credit. Methods of Settlement: Cheques; Bank Draft; Mail Transfer; Telegraphic/Telex Transfer; SWIFT; Electronic Funds Transfer. Travel Facilities: Foreign Notes and Coins; Travellers’ Cheques; Credit Cards; Debit Cards; Open Credit Facility; Nostro and Vostro Accounts; Bank Payment Obligations; The Uniform Rules for Bank Payment Obligations; Practice Questions

4 Financing International Trade

Introduction; Sources of Finance; Financing Facilities; NEXIM; NERFUND; IFC; EIB; Financing Facilities; Acceptance Credit; Negotiation; Discounting; Specialised Financing Facilities: Factoring; Eurocurrency; Countertrade; Buy-Back Facility; Forfaiting; Eurobond/Foreign Bond. Contingent Facilities: International Guarantee/Bond; Surety; Guarantee; Bid/Tender Bond; Performance Bond; Advance Payment Bond; Warranty/Retention Monies Bond; Payment Guarantee; Appraisal of Facilities; Risk Evaluation Framework; Assessment of Country Risk. Practice Questions.

5 The Credit and Monetary Unions

The Role of Credit in International Trade; Benefits and Problems of Granting Credits; Export Credit Guarantee Department (ECGD); The Nigerian Export Import Bank (NEXIM); International Credit Granting Organisations: Organisation for Economic Co-operation and Development (OECD); The Paris Club; The London Club; The Monetary Unions; The West African Clearing House (WACH); The European Currency Unit (ECU). Practice Questions.

6 International Collections

International Collections: Introduction; Uses of International Collections; Types of Collection: Clean Collection; Documentary Collection; Information Requirements by the Remitting Bank; Inward Documentary Collections; Responsibilities of the Collecting Bank; Benefits and Demerits of Collection. Practice Questions.

7 Documentary Credit - The Processes

Definition; What Documentary Credit means to both Exporter and Importers; Why Letter of Credit is required in a Sales Contract for Exports; Types of Documentary Credit; The Effects of Types of Credit; How Documentary Credit Works; The process of a documentary credit; Credit Application; Bank’s Consideration for Issuing Credit; Nominated Bank; Amendments to a Documentary Credit; Presentation; International Standard Banking Practice for the Examination of Documents under UCP 600; Discrepancies; Bill of Lading Indemnity. Practice Questions.

8 Documentary Credit II –

Its’ Uses for Financing

The various Methods of Settlement in Documentary Credit; Details of International Standard Banking Practice for the Examination of Documents under UCP 600 for Drafts (Bills of Exchange) and Calculation of Maturity Date; Special Credits: Revolving Credit; Red Clause Credit; Transferable Credit; Back-to-Back Credit; Counter-Credit; Standby Documentary Credit; Introduction to UCP 600; Overview of UCP 600 Articles; Practice Questions.

9 The Foreign Exchange Market

What is Foreign Exchange?; How Foreign Exchange Business Emerges; Banks and the Foreign Exchange Market; The Foreign Exchange Market - Historical Review; The Gold Standard (1880 - 1914); Exchange Rate Management between 1914 - 1944; The Gold Exchange Standard (1944 - 1970). The Nigerian Foreign Exchange Market: The Period prior to 1986; The Period since Introduction of Second-Tier Foreign Exchange Market (SFEM). Terms Used in Foreign Exchange Market; Factors Influencing Exchange Rates; Risks in Foreign Exchange and Capital Adequacy Requirements.

10 Basic Arithmetic of Exchange

Rate Quotation Systems: Volume/Currency or Indirect Rate System; Price or Direct Rate System; Spot Transactions; Forward Contracts; Determination of Premium or Discount; Fixed Forward Contract; Option Forward Contract; Close-Out of Forward Contracts; Extension of Forward Contracts; Other related Matters; Financial Forward Operations; Cost of Forward Cover; Swap Transactions; Foreign Exchange Options; Practice Questions

11 Exchange Control Regulations in Nigeria

Exchange Control Act, 1962; Detailed Exchange Control Memoranda regulating Foreign Exchange Transactions in Nigeria;; Documentation Requirements for Foreign Exchange Transactions; Exchange Control Abuses;

12 Exporting from Nigeria

and Export Incentives

The role of Nigeria Export Promotion Council, NEPC; Exchange Control Regulations and Guidelines for Exports; Export Incentives; Problems of the Export Sector and Impediments to Exporting; Basic guide to Exporting; Export (Incentives and Miscellaneous Provisions) Act, 2004; Practice Questions

13 International Organizations Supporting International Trade

International Chamber of Commerce (The World Business Organisation), ICC; The Berne Union (BU); International Finance Corporation (IFC); International Standard Organisation, (ISO); World Trade Organisation, (WTO); United Nations Conference on Trade and Development (UNCTAD); Bank for International Settlement, BIS; International Monetary Fund, IMF; African Development Bank, AfDB;

Glossary Of Technical Terms

Appendix A National Economic Reconstruction Fund Act

Appendix B Second-Tier Foreign Exchange Market Decree No. 23 of 1986

Appendix C © International Chamber of Commerce (ICC), Uniform Rules for Demand Guarantees (URDG 758, 2010 Revision)

Appendix D Uniform Rules for Forfaiting (URF 800) © International Chamber of Commerce (ICC),

Appendix E Import Guidelines, Procedures and Documentation Requirements in Nigeria

Appendix F Uniform Rules for Bank Payment Obligations, (URBPO 750) © 2013

Appendix G Central Bank Of Nigeria Non-Oil Export Stimulation Facility (NESF)

Appendix H Nigerian Investment Promotion Commission Act

List of Tables

DEDICATION

To my wife, Modupe, and our children, Tosin, Damilola, Mayowa and Nifemi

FOREWORD

I nternational finance is the branch of financial economics that is concerned with monetary and macroeconomic interrelations between two or more countries. It examines the dynamics of the global financial system, international monetary systems, balance of payments, exchange rates, foreign direct investment, and how they relate in the context of international t rade.

International finance is further concerned with matters of international financial management where investors and multinational corporations identify and manage international risks such as political risk and foreign exchange risk, including economic exposure, transaction exposure and translation exposure.

Full knowledge of international finance is required as a subject for candidates majoring in banking in institutions of higher learning as well as those sitting for professional examinations of the Chartered Institute of Bankers of Nigeria and other professional bodies. Putting all these requirements together is what Mr. Joseph Okunato has done creditably in this book titled International Finance.

The common slogan that the whole world has become a global village would have better meaning and applicability when citizens of one country can tap into the business opportunities in some other countries seamlessly. Such a feat can only be achieved by having a good knowledge of International Finance.

From its beginning, this book elaborately discusses the core economic issue of exchange rate determination between currencies and the interrelationship of the subject to the roles of the monetary systems. It goes further to educate readers on what individuals and corporate entities must do to cover risks that are inherent in foreign exchange transactions. It emphasizes its essence for practitioners and students, and the need for them to understand the intricacies and implications in the handling of international trade transactions. These issues were explicitly handled in the book.

International trade has grown significantly in recent time and the trend is bound to continue as nations meet their internal deficit of goods and services by drawing from the corresponding surplus of other countries. Exchange of currencies and correct documents still remains the medium widely adopted internationally for passing goods and services from the exporter to the importer. Hence, the author was particularly meticulous as he devotes space in giving detailed description and thoroughly explains the delivery of documents required in contracts of sale and the terminologies that traders and businessmen should be accustomed to. The book also discusses the various methods through which the contracts are consummated, including the recently introduced Bank Payments Obligations, coming on the trail of the Supply Chain Financing. All these give the reader a good grasp of the subject. The structuring of the book to contain updated information to reflect current practices should be of great delight to the reader.

The chapter on financing international trade is a must read for bankers, students, consultants, businessmen and financial experts as they will find its content very useful in enhancement of knowledge and the discharge of their day to day operations. The author further deliberates on risks that are engendered in international trade and the ways of effectively mitigating them. Through clear understanding of these, investors, traders and financiers involved in international trade are expected to have insight into ways of ensuring adequate cover for the risks they take regularly in their international business transactions.

The writer further devotes many chapters to deal extensively with Collections and Documentary Credit. These chapters are must read for students of international trade for avoidance of landmines in international finance. Practitioners would find the chapters very instructive.

I feel greatly enthused by the way the author manifests deep research in his articulation of the historical development of the Foreign Exchange market, the structure of the market and the risks embedded in the market throughout the book. The basic elements of individual transactions, dealing with the basic arithmetic of exchange, book entries and how risks should be covered are thoroughly handled for easy assimilation by the reader. Following this is the role of the Central Bank of Nigeria and the various participants in the market, the regulatory framework, including documentation of transactions in foreign trade. The book also covers the various incentives that are in place for exporters in Nigeria, which those who are eligible should be encouraged to take advantage of. The book also delves on the roles of various international organisations in the development of international trade and how individuals and corporate entities should access them for various opportunities.

I have known Mr. Okunato for well over two decades. I believe that his vast exposure and experience garnered in the course of working in the Foreign Exchange Department of Union Bank of Nigeria Plc. at various supervisory levels have influenced substantially in writing this book. I had a closer relationship with the author when he worked with Devcom Merchant Bank where I was the pioneer Managing Director and the responsibilities of Mr. Okunato included the supervision of the functions of the International Trade Department. Mr. Okunato was widely known for thoroughness and deep knowledge of international trade.

I recall that Mr. Okunato was also a lecturer of International Trade with The Chartered Institute of Bankers Nigeria at some of the Institute’s training centres for preparation of banking students for the Institute’s professional examinations. He later served as an examiner of the subject with the Institute. He also lectured for Obafemi Awolowo University in their outreach station in Lagos between 1998 and 1999 in the same subject. I am therefore delighted that he eventually took the bold decision to share this vast knowledge and experience with a wider public.

The Nigerian economy still needs substantial capital inflow through import finance, equipment suppliers’ credit and direct foreign investment to booster local resources for international competitiveness. Alongside, Nigeria needs to stimulate exports of locally produced goods and services where the country has competitive advantage. In recent time, some corporate entities that sourced long-term foreign funds reportedly ran into repayment problem due to their poor knowledge of the interplay of interest rate risk with exchange rate risk. This book titled International Trade would serve to provide succor to present and prospective importers of capital, goods and service.

I therefore highly commend this book as a useful text for students of International Finance; as a reference book for consultants on international trade; for bankers as guide on foreign exchange transactions; for businessmen for guidance on international trade; and for financial experts for update of knowledge in the handling of international finance.

Femi Ekundayo

Past President, The Chartered Institute of Bankers of Nigeria

October 2014

ACKNOWLEDGEMENTS

I Am using this medium to express my gratitude to people whom I consulted at one time or another and had provided assistance, whose names are inadvertently omitted on this page in the course of preparation and development of this book.

First, my gratitude goes to the hundreds of International Finance students I have had the privilege to teach over many years. Their enthusiasm, comments and questions had challenged my thinking about many topics for review.

Secondly, I thank the following people for their comments and advice during the preparatory stage. Chief S Olufemi Dada (Former Registrar/Chief Executive of The Chartered Institute of Bankers of Nigeria), Mr. Femi Ekundayo, (Former Managing Director of Devcom Merchant Bank Limited and Past President of The Chartered Institute of Bankers of Nigeria) and Mr. R. O. Rapu, my former colleague and confidant in Devcom Merchant Bank.

It is not easy for me to forget my roots. I would like to place on record the training, inspiration and encouragement I received from Union Bank of Nigeria Plc. The conception and making of this book would not have been possible without all the necessary enabling tools in the various training opportunities and banking business exposures which I gathered at the Bank during my years of service with it. I am equally indebted to so many people within the organisation itself but only very few names such as J. O. O. Akinleye; T. O. I. Akinola; Bayo Ologunde; M. Olakunle Aluko; G. B. O. Ashiru; T. Oshopitan-Ayeni; Mrs. A. O. Osayimwen; Denis Ayerume; and my colleagues ‘Tony Olufidipe and Pastor Samuel Oladele Obasa (who read through the scripts), and special friends: Seye Awojobi and Hajia Rukayat Yusuf of the Chartered Institute of Bankers of Nigeria, CIBN. I thank you all for your contributions and encouragement.

Finally, I acknowledge the contributions from The Chartered Institute of Bankers of Nigeria, Lagos Branch and the Headquarters for giving me the opportunity of being of service to them at various levels and its permission to reproduce some past questions in the book. The International Chamber of Commerce, (ICC), Paris, France; the Swiss Bank Corporation, Zurich, Switzerland for their kind permissions for the use of excerpts from their many publications and materials in the making of the book. I am most grateful.

Joseph Kolawole Okunato

ABOUT THE AUTHOR

J oseph Kolawole Okunato, M.Sc.; FCIB; ACA; ACIS; MCIArb; MNIM, an Accountant, Banker, as well as a Financial, Management and Investment Consultant, worked in all areas of banking for about 30 years. These include Retail, Commercial and Merchant Banking, while he has headed such strategic departments like International Operations, Credit Compliance, Credit Appraisal, Commercial Treasury, Consumer Banking, Debt Recovery, Commercial and Retail Banking and as Chief Inspector. He later worked in the marketing section and became Regional Business Executive and Regional Director in charge of business develop ment.

He rose to the position of Group Head, Banking Operations of Intercontinental Bank Plc. overseeing the operations of E-Banking, Branch Operations, Head Office Operations, International Operations and Customers Services.

In the period of his services in the various banks he worked with, he had a privileged opportunity of working in the foreign exchange departments at both the branch levels in Sapele, Ibadan and Lagos branches of Union bank of Nigeria Plc; Gatewaybank Plc and Intercontinental Bank Plc; handling the transactions of reputable customers and at the International Department of the Head Offices of these banks at various levels up to the Dealing room of the bank and as Open Position Accountant.

The author was also the pioneer Chief Finance Officer (CFO) of Daar Communications Plc., operators of African Independent Television and Ray Power Radio Station. In this capacity, he set up the Accounting System, including the installation of its accounting software, managed the Credit Syndication for the firm’s business development, and set up the Credit Control system of the firm.

He was also involved in the capital market operations having worked with Kinley Securities Limited (A Member of the Nigerian Stock Exchange) as Head of Corporate Finance Department, which he set up and also developed the clientele base while supervising the marketing function of the firm.

He has been a lecturer of International Finance with the Chartered Institute of Bankers since 1987. He was an Examiner, Assistant Chief Examiner and Acting Chief Examiner for the subject from 1987 to 1998.

He is a member of the Arbitration and ADR and Banking Commissions of the International Chamber of Commerce, Nigeria.

He has also published other books that are currently in the market, namely, Sin of Unbelief, 2014 and Conquering Fear, 2000, and some others that are yet to be published.

Mr. Okunato is presently the Principal Partner of Kolawole Okunato and Company, a Financial, Management and Investment Consulting firm, and a Business Development Services Provider.

PREFACE

M Y interest in international trade finance was kindled in the late 1970s by Mrs. E O Osayimwen and later Mr. Wayas Otorokpo and Mrs. F. A Itobore in Union Bank of Nigeria Plc. Sapele. These senior officers of the bank taught me how to handle some foreign exchange transactions. I must confess that I was really enjoying the new knowledge being impacted in me, though, to them, I was helping in clearing the backlog of transactions on their desks. This opportunity continued when I moved over to the Ibadan branch of the bank in 1979 to 1981 and subsequently at the then Nigerian Foreign Exchange Centre, NIFEX, Lagos between 1982 and 1988.

In 1987, the then Chairman of the Lagos Branch of the Chartered Institute of Bankers of Nigeria, (CIBN), and later the President of the Institute, Mr. J Olufemi Ekundayo and the Director of Studies, later Registrar/CEO, The Chartered Institute of Bankers of Nigeria, Chief S Femi Dada encouraged me to lecture the subject at the Lagos Branch Centre. No sooner I got involved that I saw the challenge which brought about the writing of this book. First, where do I get a book that would cover not less than 80% of the syllabus? At this point, I was wondering what the students and candidates were going through. Then I promised to write a book that would resemble what I expected.

The topics covered by this book are to serve three purposes. First, to ensure that candidates preparing for the examinations of The Chartered Institute of Bankers of Nigeria (CIBN) can safely hold the book and cover most of the topics they are expected to cover and pass their examinations. Secondly, as bankers, consultants, advisers and members of the academia, we need a reference book from which we can continue to enhance our daily jobs and callings. For these reasons, the book has been fashioned in a way to satisfy these two groups of people primarily. Thirdly, the book will serve as reference document to businessmen and women in areas of their import and export transactions and foreign exchange dealing generally.

The book is arranged into thirteen chapters. Starting with the theoretical basis upon which international trade finance is based in chapter one. The chapter also looks into what global trade is all about and reviews the basis and theories of international trade and international monetary economics; the relationship between Balance of Payment and Exchange Rate, the International Monetary systems and its features. It looks into the basis for determining exchange rates, the management of foreign exchange and the challenges that international traders face, as well as the various ways of mitigating those challenges.

Chapter two started with the requirements for a contractual relationship for parties going into import/export contract and what each party should do when entering into foreign trade contracts. It also focuses on the common platform of the international commercial terminologies, the rules of its usage and the guidance provided by the International Chamber of Commerce (ICC), and concludes with the various documents that are used in international trade. This becomes very important in view of the recent guidelines issued by the ICC on the examinations of these documents under documentary credit.

Chapter three is about the various methods of payment and settlement, which are used in international trade. The new electronic method of payment, Bank Payment Obligations, BPO, coming into force in 2013, are dealt with in details, including the new rules guiding the operations of the system, in this chapter for the students and practitioners alike.

Chapter four deals with the financing of international trade and all areas covering the various instruments, sources and the very uncommon but relevant and equally available financial sources and instruments are covered. The chapter goes further to deal with details of the various contingent and trade facilities available in financing international trade and how bankers appraise the various facility requests for the guidance of businesses, students and practitioners’ alike.

Chapter five looks into the credit unions that support finance insure and guarantee credit facilities that are promoting international trade. The various ways in which these are done are discussed in details using the Exports Credit Guarantee Department (ECGD) of UK and Nigerian Export-Import Bank (NEXIM) as the nexus for this discussion.

Chapter six dealt with International Collections. Full details of the of international collections as a method of payment for international trade, including the International Chamber of Commerce Rules governing collections, are thoroughly examined and treated.

Chapters seven and eight are fully devoted to Documentary Credits. Chapter seven is devoted to the documentary credit processes, involving the application and examination of the request as a credit facility; examination of the letter of credit vis-à-vis the contract of trade entered into by the parties and compliance therewith; treatment of amendments and the responsibilities of the parties thereto; the presentation of the documents and the examinations in line with the International Standard for Banking Practices for the examinational of documents. The literature on documentary credit is enhanced by the recently released International Standard for Banking Practice, coming on the heels of the 2010 Revision of the Uniform Customs and Practice, (UCP 600), for the examination of documents. All these are thoroughly treated. Chapter eight dealt exhaustively with the various ways of settling the payments in documentary credit and the various types of documentary credit and their uses for financing international trade.

Chapters nine looks into the foreign exchange market, its historical development, factors and risks inherent therein and the roles of the monetary authorities.

Chapter ten is devoted to the calculations which form the albatross area for students. The chapter is able to illustrate in pieces all areas which students may find difficult.

Chapter eleven is devoted solely to the rules, regulations, laws and documents required for foreign exchange transactions in Nigeria. The details of the 27 Exchange Control Memoranda governing all exchange control rules and regulations in Nigeria are full fully covered for students, the banking practitioners and any business entity having an export, import, investment dealings with or in Nigeria. This chapter is particularly important for every one whether as an importer, exporter, banking practitioner, trader, advisor, consultant or an investor. It is a must read for everybody.’

Chapter twelve is devoted to Exports from Nigeria and the various incentives for the exporter. It examines 1) the role of the Nigerian Export Promotion Council in the context of export development in Nigeria. 2) It also looks at the Central Bank’s Exchange Control Memorandum as it affects exporting from Nigeria. 3) The chapter reviews the various incentives available to exporters and how these can be tapped by exporters. 4) The chapter examines the problems facing exports in Nigeria and the various impediments to exporting. 5) We would also find a literature for a basic guide to exporting; and 6) How to develop and create an export plan for a business wishing to go into the international market. The chapter is concluded with the guiding laws for exporters.

Chapter thirteen is devoted to the various international bodies that support international trade and their roles.

The book is written to make international trade finance an interesting and enjoyable reading, in simple English for easy assimilation.

The book title is a dynamic one that requires constant update of knowledge. This book has provided that update that no other literature on its coverage can boast of in a single book in Nigeria.

Joseph Kolawole Okunato

2018

CHAPTER ONE

INTERNATIONAL TRADE AND

FINANCE: AN OVERVIEW

After completing this chapter, you should be able to:

1. Acquaint yourself with the seven fundamental processes through which international finance operations are based;

2. Familiarise yourself with the four risks that are inherently faced by all parties in international trade and the mitigants for such risks;

3. Understand exchange risk as a key component of the risks and the various ways with which exchange risk can be mitigated;

4. Have a better knowledge on the importance of foreign exchange to a country; and

5. Have a good grasp of the background to exchange control regulations in Nigeria.

Introduction

International Trade can be defined as ‘the exchange of capital, goods, and services across international borders or territories. It is the exchange of goods and services among nations of the world’.

In most countries of the world, international trade represents a significant share of their gross domestic product (GDP) and this explains while international trade has taken so much importance in the annals of trade policies of nations. While international trade has existed throughout history (for example Uttarapatha, Silk Road, Amber Road, Scramble for Africa, Atlantic Slave Trade, salt roads), its economic, social, and political importance has continued to be on the rise in for centuries.

Characteristics of Global Trade

Trading globally gives consumers and countries the opportunity to be exposed to new markets and products.

Almost every kind of product can be found on the international market from food, clothes, spare parts, oil, jewellery, wine, stocks, and currencies and to water. Services are also traded: tourism, banking, consulting and transportation. A product that is sold to the global market is an export, and a product that is bought from the global market is an import.

Imports and exports are accounted for in a country’s current account in the balance of payments.

Industrialization, advanced technology, including transportation, globalization, multinational corporations, and outsourcing are all having major impacts on the international trade system. Increasing international trade is crucial to the continuance of globalization. Without international trade, nations would be limited to the goods and services produced within their own borders.

International trade is, in principle, not different from domestic trade as the motivation and the behavior of parties involved in a trade do not change fundamentally regardless of whether trade is across a border or not.

1. The main difference is that international trade is typically more costly than domestic trade. The reason is that a border typically imposes additional costs such as

• Tariffs,

• Time costs due to border delays and

• Costs associated with country differences such as

ο Language,

ο The Legal System and/or

ο Culture.

2. Another difference between domestic and international trade is that factors of production such as capital and labour are typically more mobile within a country than across countries.

Thus international trade is mostly restricted to trade in goods and services, and only to a lesser extent to trade in capital, labor or other factors of production. Trade in goods and services can serve as a substitute for trade in factors of production. Instead of importing a factor of production, a country can import goods that make intensive use of that factor of production and thus embody it. An example is the import of labour-intensive goods by the United States from China. Instead of importing Chinese labour, the United States imports goods that are produced with Chinese labour.

The Basis and Theories of International Trade

International Trade and the basis of its growth over the centuries developed on the basis and theories of economic scholars starting from Adam Smith in his book, The Wealth of Nations.

A brief review of the various theories and the basis upon which governments all over the world promulgate policies and regulations, and direct their economic actions and inactions over the centuries are listed hereunder.

1. Absolute Advantage

In economics, the principle of absolute advantage refers to the ability of a party (an individual, or firm, or country) to produce a greater quantity of a good, product, or service than competitors, using the same amount of resources.

Adam Smith first described the principle of absolute advantage in the context of international trade, using labour as the only input.

Since absolute advantage is determined by a simple comparison of labour productiveness, it is possible for a country to have NO absolute advantage in anything; and in that case, according to the theory of absolute advantage, NO trade will occur with any other country.

2. Theory of Comparative Advantage

The theory of comparative advantage is an economic theory about the work gains from trade for individuals, firms, or nations that arise from differences in their factor endowments or technological progress.

In this economic model, countries would have comparative advantage over others in producing a particular good if they can produce that good at a lower relative opportunity cost or autarky price, i.e. at a lower relative marginal cost prior to trade.

One does not compare the monetary costs of production or even the resource costs (labour needed per unit of output) of production. Instead, one must compare the opportunity costs of producing goods across countries.

The closely related law or principle of comparative advantage holds that under free trade, an agent will produce more of and consume less of a good for which they have a comparative advantage.

David Ricardo developed the classical theory of comparative advantage in 1817 to explain why countries engage in international trade even when one country’s workers are more efficient at producing every single good than workers in other countries. He demonstrated that if two countries capable of producing two commodities engage in a free market trade, then each country will increase its overall consumption by exporting the good for which it has a comparative advantage while importing the other good, provided that there exist differences in labour productivity between both countries.

Widely regarded as one of the most powerful yet counter-intuitive insights in economics, Ricardo’s theory implies that comparative advantage rather than absolute advantage is responsible for much of international trade.

Comparative advantage is a theory about the benefits that specialization and trade would bring, rather than a strict prediction about actual behaviour.

3. The Theory of Mercantilism

Mercantilism was a type of national economic policy designed to maximize the trade of a nation and especially to maximize the accumulation of gold and silver.

It was dominant in modernized parts of Europe from the 16th to the 18th centuries and promoted governmental regulations of a nation’s economy for the purpose of augmenting state power at the expense of rival national powers. With the establishment of overseas colonies by northern European powers early in the 17th century, mercantile theory gained a new and wider significance, in which its aim and ideal became both national and imperialistic.

Mercantilism functioned as the economic counterpart of the older version of political power – ‘the divine right of kings and absolute monarchy’. Mercantilism includes a national economic policy aimed at accumulating monetary reserves through a positive balance-of-trade, especially of finished goods.

Historically, such policies frequently led to war and also motivated colonial expansion, and with the establishment of overseas colonies by northern European powers early in the 17th century, mercantile theory gained a new and wider significance, in which its aim and ideal became both national and imperialistic

The Policies and features of Mercantilism included among others:

• Forbidding colonies to trade with other nations

• Monopolizing markets with staple ports

• Banning the export of gold and silver, even for payments

• Forbidding trade to be carried in foreign ships, as per, for example, the Navigation Acts

• Subsidies on exports

• Promoting manufacturing and industry through research or direct subsidies

• Limiting wages

• Maximizing the use of domestic resources

• Restricting domestic consumption through non-tariff barriers to trade

4. Heckscher-Ohlin’s Theory of International Trade

The new theory propounded by Heckscher and Ohlin went deeper into the underlying forces which cause differences in comparative costs.

They explained that it is differences in factor endowments of different countries and different factor-proportions needed for producing different commodities that account for difference in comparative costs. This new theory is therefore-called Heckscher-Ohlin theory of international trade.

It is worthwhile to note that, contrary to the viewpoint of classical economists, Ohlin asserts that there does not exist any basic difference between the domestic (inter-regional) trade and international trade. Indeed, according to him, international trade is only a special case of inter-regional trade.

Thus, Ohlin asserts that it is not the cost of transport which distinguishes international trade from domestic trade, for transport cost is present in the domestic inter-regional trade. International trade is different because currencies of different countries are related to each other through foreign exchange rates which determine the value or purchasing power of different currencies.

Ohlin, therefore, regards different nations as mere regions separated from each other by national frontiers, different languages and customs, etc. But these differences are not such that prevent the occurrence of trade between nations. He, therefore, asserts that general theory of value which can be applied to explain inter-regional trade can also be applied equally well to explain international trade.

According to general equilibrium theory of value, relative prices of commodities are determined by demand for and supply of them. In the long-run equilibrium under conditions of perfect competition, relative prices of commodities, as determined by demand and supply, are equal to average cost of production.

The cost of production of a commodity, as is well-known, depends upon the prices paid for the factors of production employed in the production of that commodity. Factor prices in turn determine the incomes of the factor owners and hence the demand for goods.

Thus, trade is mutual inter-dependence between prices of commodities and prices of factors, and the exchange of goods and factors between demand for commodities and demand for factors. This is how general equilibrium theory of value explains prices of commodities and factors between different individuals in a region or a country.

5. The New Trade Theory

New trade theory (NTT) is a collection of economic models in international trade which focuses on the role of increasing returns to scale and network effects, which were developed in the late 1970s and early 1980s.

New trade theorists relaxed the assumption of constant returns to scale, and some argued that using protectionist measures to build up a huge industrial base in certain industries will then allow those sectors to dominate the world market.

The models developed predicted the national specialization-by-industry observed in the industrial world (movies in Hollywood, watches in Switzerland, etc.). The model also showed how path-dependent industrial concentrations can sometimes lead to monopolistic competition or even situations of oligopoly.

6. Raymond Vernon’s Product Life-cycle Theory

The product life-cycle theory is an economic theory that was developed by Raymond Vernon in response to the failure of the Heckscher-Ohlin model to explain the observed pattern of international trade.

The theory suggests that early in a product’s life-cycle all the parts and labour associated with that product come from the area where it was invented. After the product becomes adopted and used in the world markets, production gradually moves away from the point of origin. In some situations, the product becomes an item that is imported by its original country of invention. A commonly used example of this is the invention, growth and production of the personal computer with respect to the United States.

The model applies to labour-saving and capital-using products that (at least at first) cater for the high-income groups.

• In the new product stage, the product is produced and consumed in the US; no export trade occurs.

• In the maturing product stage, mass-production techniques are developed and foreign demand (in developed countries) expands; the US now exports the product to other developed countries.

• In the standardized product stage, production moves to developing countries, which then export the product to developed countries.

The model demonstrates dynamic comparative advantage. The country that has the comparative advantage in the production of the product changes from the innovating (developed) country to the developing countries.

There are four stages in a product’s life cycle in respect to the Product Life Cycle Theory:

• Introduction

• Growth

• Maturity

• Decline

The location of production depends on the stage of the cycle.

On costs and revenues: Low production costs and a high demand ensure a longer product life. When production costs are high and demand is low, it is not offered on the market for a long time and, eventually, is withdrawn from the market in the ‘‘decline’’ stage. Note that a particular firm or industry (in a country) stays in a market by adapting what they make and sell, i.e., by riding the waves.

What is Trade Finance?

Trade finance is the process of financing of international trade flows. It exists to mitigate, or reduce, the risks involved in international trade transactions.

There are two players in a trade transaction: (1) the exporters, who require payment for their goods or services, and (2) the importers who want to make sure they are paying for the correct quality and quantity of goods. Other players in trade transactions are:

a. The Banking System that handle the financial instruments;

b. The Transportation System that handles the movement of the goods;

c. The Insurance System that handles the Risk mitigation; and

d. Other Services Providers.

The study of International Finance (also known as International Monetary Economics) was first introduced into the banking syllabus as a subject, (then known as Finance of International Trade), by the Chartered Institute of Bankers, London in the ‘50s. It’s aim was to highlight the importance of international trade as a realisation of the nature of the international monetary system and how it’s measurement has a great deal to do with international prosperity.

In the words of Andrew Crocket, International monetary economics (International Finance) is the study of the network of institutions, rules and conventions which govern the conditions under which currencies are exchanged and international payments disequilibria are eliminated. (International Money - Issues and Analysis, 1977). If we take this definition as the basis on which this book is written, it means that in the course of the book, we shall focus our attention on:

• The Network of individual institutions that are involved in international financial systems;

• The Rules and Regulations of the network of the various institutions that govern interactions as well as how they affect international transactions relating to individuals, corporate entities and the country; and

• The Conventions that govern the conditions under which currencies are exchanged and international payments disequilibria are eliminated.

Balance of Payments and Exchange Rate

The exchange of goods across national frontiers poses different challenges in their nature and character from those caused by exchanges taking place within the domestic economy. While, in either case, a payment has to be made because a buyer has purchased goods or services from a seller or because a lender has lent money to a borrower, and, in each case, a purchasing power has been transferred from the purchaser or lender to the seller or borrower, a different problem is created because of a sale of goods or services between, say, Nigeria and Germany.

International transactions affect the balance of payments. This calls for the need to finance the deficits or surpluses which may occur, and take action to eliminate that imbalance.

Balance of payments is a concept which is applied to transactions between countries and sometimes problems of financing and adjustments do arise between regions and individual units. When the spending of an individual or country exceeds income, that deficit must be financed and ultimately, the deficit is closed either by increasing incomes or reducing spending.

The monetary authority does not usually, as a matter of policy, intervene with the balance of payments disequilibrium of units or individuals in the domestic economy. When the spending of an individual economic unit exceeds his/her income, in the normal course of events, automatic adjustment incentives come to play. An individual cannot spend in excess of his/her income unless there is an acceptable financial asset or credit which could be transferred in exchange. By the time the stock of his/her financial assets or creditworthiness declines, he/she will become unable or unwilling to continue the deficit. This will force him/her to tailor his/her consumptions to the level of his/her income.

For the states/regions, say within Nigeria, the mechanism of financing and adjustment is similar to that of the economic units. A deficit will result in the transfer of financial claims to residents in other parts of the country. As long as the rest of the country is prepared to accommodate claims on the deficit state/region, the deficit may continue to the point where each economic unit within the state/region is forced by the decline in its net worth to leave for other states/regions in order to better their lot. Regional balance of payments adjustments can cause economic and social unrests, which would require governmental policies towards alleviating the hardships involved. This also does not call for a monetary adjustment because the state/region uses the same currency as other states/regions in the country.

In the case of international transactions for countries in different currency areas or zone, the difference lies in the fact that different currencies are involved. When a Nigerian sells palm oil to a German, he will expect to be paid in Naira while the German buyer is expected to pay in Euro. Evidently, an additional transaction will be needed to complete the sale. There must be a market where the German can sell his Euro for the purchase of the Naira needed to pay the Nigerian seller.

Since the supply of Naira is determined by the policies of the Central Bank of Nigeria and the supply of Euro by the policies of the European Central Bank in Brussels, governments inevitably influence developments in the foreign exchange market, either deliberately or as a by-product of their actions.

In view of the fact that the mobility of labour is very limited across frontiers, securing regional adjustments to disequilibrium is borne by changes in relative prices, that is, in the real purchasing power of one currency in terms of the other.

These make international payments different from domestic payments and explain the concern of policymakers with international monetary questions. The balance of payments questions are described in terms of the reserve assets as its base.

The International Monetary System and Its Features

International monetary systems are sets of internationally agreed rules, conventions and supporting institutions that facilitate international trade, cross-border investment and generally the reallocation of capital between nation states. They provide a means of payment acceptable between buyers and sellers of different nationalities, including deferred payments.

To operate successfully, they need to inspire confidence, provide sufficient liquidity for fluctuating levels of trade and provide means by which global imbalances can be corrected.

The systems can grow organically as the collective result of numerous individual agreements between international economic factors spread over several decades. Alternatively, they can arise from a single architectural vision as happened at Bretton Woods in 1944.

The major features of international monetary arrangements which the Bretton Woods system hoisted on the world economy are:

1. The Adjustment Mechanism

The most important aspect of the international monetary system is the mechanism which is employed to adjust payment deficits and surpluses.

The law of economics which states that ‘the nominal value of output in an economy will tend to adjust to the volume of monetary assets available for the finance of trade’ holds sway. During the gold era, gold would be shipped out to pay for deficits and the resulting shortage of gold in the deficit country would lead to a contraction of internationally traded goods, then a downward pressure on prices and, ultimately, an improvement in the balance of payments.

Free floating exchange rate, on the other hand, is a situation whereby the monetary authority does not intervene in the market for the support of its currency against others nor is it influenced in its economic policies by considerations relating to exchange value of its currency. For this country, a weak balance of payments would lower its exchange rate and discourage imports and other payments abroad because foreign purchases become more expensive in terms of the domestic currency. Conversely, it would encourage exports and inward investments by making its domestic currency cheaper for foreigners to acquire.

The two extremes are hardly tenable and countries tend to prescribe a set of broad guidelines for the management of their external reserves, policies that would be designed to permit a measure of choice in the selection of her adjustment policies and, at the same time, providing safeguards against actions that would be contrary to the general interest of the people. This is the essence of the ‘Managed Floating’ system.

2. The Nature of the Assets in Terms of which the Currency is expressed - The International Reserves

This is the second major feature of the international monetary system. The natures of the assets to be used for settling payments imbalances, and as the unit of account, among others are.

• Gold

Gold acquired its importance as an international medium of exchange as a result of its role as a domestic monetary asset in the developed economies, and had continued to retain this role in the international monetary system.

One should note, however, that the use of a commodity as money imposes resource costs in the production of the commodity. Secondly, it renders the stock of money subject to the various factors of production. These disadvantages led to the growth of financial intermediation which economized the use of the physical gold.

• Clearing and Credit Arrangements

Due to the collapse of the gold standard in the 1930s, there grew bilateral clearing arrangements prescribing that currency earned by exporters of country A in country B can be used only to purchase goods in B for export to country A. This scheme, which later brought into it many countries, was multilateralised and a central clearing house, where adjustments were made by way of debits and credits, became effective.

The scheme in which payment imbalances are settled by adjusting national credit balances has the advantage of making the volume of international liquidity subject to control. Secondly, such liquidity would not be dependent on commodity money like gold.

The role of credit operations was limited to lending by the International Monetary Fund, (IMF), to finance payment deficits of countries.

• Foreign Exchange Holdings

The use of foreign exchange in reserve was necessitated by the inadequacy of gold supplies. Secondly, the rapid expansion of trade and the rising level of prices prompted the other means for holding reserves. The need to supplement gold as a means of international reserve to meet balance of payment requirements thus prompted the introduction of the following:

a. The United States Dollars, which was adopted as a convertible currency and used as a reserve currency. However, its convertibility created its own difficulties. In 1971, the convertibility of the US Dollar was removed but it still remains the major reserve holding than gold;

b. Special Drawing Rights (SDR). With the rising difficulties in the convertibility of the US Dollar into gold, the articles of the International Monetary Fund, (IMF) were amended in 1969, thereby creating an ‘International Fiduciary Asset’ (Special Drawing Rights, SDR), to supplement gold in reserves.

3. The Integration of the Monetary System

Another important feature of the monetary arrangements is the extent to which the national monetary policy furthers the multilateral financial and trading relationships.

Free market economy postulates that the allocation of resources and its uses be left to individual entities without state interference. The individual transactions are usually governed by private considerations of cost and price by the traders and investors involved, but these may not always correspond with government perception of the broader national interest.

The Bretton Woods system was intent on an integrated monetary system for member countries, requiring that national monetary institutions have a broad liberal framework in the mutual interest of all nations. It is, however, recognised that to permit any and all international transactions to take place might impose intolerable strains on the system. This is recognised by the Articles of Agreement of the International Monetary Fund, which place greater emphasis on freedom from restrictions for payments for goods and services on current account than for capital transfers. It is clear that the free movement of capital could contribute to an optimum allocation of resources and economic development in the least developed countries.

4. The Management of Balance of Payment System

This refers to the terms of the degree of discretionary management which the system requires.

The achievement of an agreement between sovereign countries is not an easy one, particularly when national interests differ and the numbers of parties to the agreement are many.

There is a considerable advantage when a system that provides for an automatic harmonisation of policy decisions made by national monetary authorities is in place. In a free floating exchange rate system, it allows market forces to achieve the necessary harmonisation of policies. If countries eschew any specific balance of payments or exchange rate targets, there would be no need for mechanisms to ensure that national policies are in harmony.

Free floating rates have proved to be an unattainable objective since countries may always perceive a national advantage in intervening to influence their exchange rate. The extent of this intervention can have the result of failing to harmonise economic policies and provoking international reprisal.

In the absence of a system that provides for an automatic harmonisation of economic policies, there is a need for an internationalisation of decision-making. Relative currency values should not be the result of uncoordinated national actions. Decisions on exchange rates should be acknowledged to have international importance and a forum for the arbitration of conflicting views should be in place. This principle was reaffirmed in the amended provisions of the IMF Charter on exchange rates in 1976.

The objectives of internationalisation of decision making are widely accepted and this provides a sound basis for international economic co-operation. They require a willingness on the part of individual countries to give up a certain amount of freedom over their own policies in order to obtain a measure of influence over the policies of others.

The Importance of Foreign Exchange

What is Foreign Exchange?

Foreign exchange is a monetary authorities claim on foreigners in the form of bank deposits, treasury bills, short-term and long-term government securities and other claims usable in the event of a balance of payments deficit, including non-marketable claims arising from inter-central bank and inter-governmental arrangements, without regard to whether the claim is denominated in the currency of the debtor or the creditor. –

International Monetary Fund, 1985.

The Nigerian Exchange Control Manual defines foreign exchange as:

Any currency, other than the Nigerian currency, and includes any notes or coins which are, or have, at any time been legal tender in any territory outside Nigeria; postal orders, money order, bills of exchange, promissory notes, drafts, letters of credit and travellers’ cheques payable or expressed otherwise than in Nigerian currency. -

Central Bank of Nigeria,

1982.

The above definitions imply that foreign exchange includes all claims to foreign currency payable abroad by both individuals and corporate entities as well as the government..

The importance of foreign exchange is determined by the need for imports, in which case it is a derived demand. This need depends on the following factors:

a. Possession of natural endowments for production, that is, raw materials for industrial uses.

This requires the exploitation of the various raw materials available and or their processing for export to the user countries to earn foreign exchange.

Availability on its own without exploitation will not make their possession of any importance, therefore, making them available to the international market at competitive prices is very important.

On the other hand, in an industrial economy, if the raw materials needed to feed the various industries are not available in the country, they must be imported. Sourcing for them requires using the scarce foreign exchange for payment and this has direct effect on the country’s economy.

The importance now is reined on the premises of the percentage contribution of the natural endowment to the foreign exchange earnings or savings made by their availability in the country. A classic example of this is the availability of petroleum in Nigeria which had over the years been exploited and contributing up to 90% to the foreign exchange earnings for the country.

b. A Country’s Population Density and Ability to feed herself.

A large population is good for market. However, if the populace cannot feed herself, they have to import food from other countries for consumption.

The implication for this is the drawdown on the scarce foreign exchange of the country. The large population (market) becomes a disadvantage to her but an advantage to food producing trading partners.

The importance lies in the fact that if the large population has no means of feeding herself, it has to import food and this calls for the need to pay using the scarce foreign exchange and depleting same which could have been used for other developmental purposes.

c. The Level of Industrialisation.

Industrialisation means the process by which traditionally non-industrial sectors (such as agriculture, education, health) of an economy become increasingly similar to the manufacturing sector of the economy.

The various established factories with their required raw materials for the production of goods for uses will compete and over time, comes a sustained economic development based on factory production, division of labor, concentration of industries and population in certain geographical areas, and urbanization.

The sustenance of this level of development requires constant provision of goods and services which the economy can no longer provide in full. Therefore, the need for imports to supplement the available resources locally generated becomes inevitable.

In this level of development, the importance of foreign exchange is key to the sustenance of development already attained and the need to keep the economy cruising at that level; and

d. The Standard of Living of the Citizenry.

Standard of living refers to the level of wealth, comfort, material goods and necessities available to a certain socio-economic class in a certain geographical area.

The standard of living includes factors such as income, quality and availability of employment, class disparity, poverty rate, quality and affordability of housing, hours of work required to purchase necessities, gross domestic product, inflation rate, amount of leisure time every year, affordable (or free) access to quality healthcare, quality and availability of education, life expectancy, incidence of disease, cost of goods and services, infrastructure, national economic growth, economic and political stability, political and religious freedom, environmental quality, climate and safety.

For a country to attain the standard of living parameters listed above would ultimately require a level of production surpassing just the industrialisation level. In this wise, export and import of goods and services will be paramount in the economy. In this regard, the importance of foreign exchange to sustain that standard of living will be key to the economic managers.

The monetary authorities may decide whether to operate an open economic regime in which there will be minimal controls in the operations of the foreign exchange market or a regimented system with controls in place.

In operating an open system, the rate of exchange for the local currency will be subject to market forces of demand and supply, while the central bank will only use the various instruments of rate adjustment policies to guide the economy to its desired target.

Approaches to Determining the Exchange Rate

The foreign exchange rate calculates the amount of a particular currency that must be traded for one unit of a competing currency. The question therefore is, how do we determine the rate at which, say the Naira, must be traded with the United States Dollar or any other currency?

There are basically three approaches through which the exchange rate between two trading currencies can be determined, namely:

a. The Purchasing Power Parity (PPP) approach;

b. The Balance of Payments approach; and

c. The Monetary and Portfolio approach.

a. The Purchasing Power Parity Approach

This approach is based on the ‘Law of One Price’. This is an economic rule which states that in an efficient market, a security must have a single price, no matter how that security is created. This means that there must be only one price for a commodity or service regardless of location. If the price is cheaper in another location, then self-interested businessmen would take the opportunity to make profit by shipping to the more expensive location (an arbitrage opportunity)

This law is based on the assumption that identical goods are sold at equal prices. The law provides that an exchange rate of currencies has to compensate for the differences in prices of goods. It is also hinged on the fact that the exchange rate has to compensate for the difference in inflation rate.

The ‘Law