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FOREIGN EXCHANGE

THE FINANCING MECHANISM
OF INTERNATIONAL COMMERCE



BY
EDGAR S. FURNISS, Ph.D.

PROFESSOR OF SOCIAL AND POLITICAL SCIENCE
IN YALE UNIVERSITY




HOUGHTON MIFFLIN COMPANY

BOSTON NEW YORK CHICAGO SAN FRANCISCO



i 8 1 (-5 5



COPYRIGHT, 1922

BY EDGAE S. FURNISS
ALL SIGHTS RESEKVED



CAMBRIDGE • MASSACHUSETTS
PRINTED IN THE U.S.A.



I PREFACE

practice of most writers on Foreign Exchange is to treat
^ .. subject as a phase of the banking problem, emphasizing

tii^ bankers' methods of handKng foreign bills of exchange,
and giving but minor stress to the relations of the business
man with the exchange markets. It is the opinion of the
present writer that the needs of the business world and of the
student are not adequately met by this common method of
presenting the subject. The rapid expansion of the foreign
"^ trade of the United States, coupled with the abnormal condi-
v>^ tion of the exchange markets of the world, has increased, on
'^ the one hand, the importance of foreign bills in the transac-
^V tions of our business men, and, on the other, the problems of
national welfare and national policy which are the especial
concern of the student. This volume is written with a view
toward bringing into greater prominence these somewhat neg-
^ lected aspects of the subject of Foreign Exchange. Without
"^ ' neglecting the banking mechanism through which the bills of
exchange pass, the attempt is made to bring the discussion to
bear upon the problems of the business man concerned with
foreign trade, as well as upon the broader questions of na-
tional policy.

In stating and developing the basic principles of the subject,
^ it has been necessary to assume a normal state of the exchange
i market, such as existed prior to the Great War. This method
X^ of treatment does not, however, place the book out of relation
to present-day problems of the exchange markets. Wlicrever
significant changes have taken place in the practice of the
markets, allusion is made to these changes at appropriate
points in the text as a means of emphasizing and qualifying
the normal practices. That there is need for a thorough un-
derstanding of the principles which normally govern is daily
disclosed by the devices which are put forward as remedies for
existing abnormalities, and the attempts which arc made to



iv PREFACE

explain the present situation by tlie logic of post hoc ergo
propter hoc. After nil, our present difficulties are produced by
the outworkini^ of the same forces which, in normal times,
govern the markets unnoticed. We cannot understand the
situation to-day, much less effect an intelligent correction of
it, witliout a thorough comprehension of normal principles.

No claim is made tliat this book contains an original con-
tribution to the subject; it attempts only to make our knowl-
edge of Foreign Exchange more accessible and intelligible to
the business man and the student. The writer has found it
impracticable to refer at each point to the published work of
others upon which he has drawn, for his indebtedness is
difficult to measure. Especial mention should be made of
Goschen's The Theory of the Foreign Exchanges, Spaulding's
Foreign Exchange and Foreign Bills, Whitaker's Foreign Ex-
change, and of the publications of the New York banks and
the Federal Reserve Board. To Mr. Karl Llewellyn, formerly
of the faculty of the Yale Law School and now of the legal
department of the National City Bank, I am particularly in-
debted for contributions to the legal phases of the subject
and for helpful criticism of a large part of the manuscript.

Edgab S. FusNisa
Yale Univehsitt
New Haven, Conn.



CONTENTS

Introduction. By Allyn A. Young . . . . . . ix

Chapter I. Nature and Use of Bills of Exchange . . 1

I. Introductory — 2. Definitions — 3. Commercial use of bills of
exchange — 4. Banking relations created by foreign bills of ex-
change — 5. Clearing the accounts of the bankers in foreign ex-
change.

Chapter II. Demand and Supply of Bills of Exchange . 21
6. Sources of demand and supply of bills of exchange — 7. Inter-
national purchase of services — 8. International trade in securities

— 9. International payments of interest and dividends — 10.
Travelers' expenditures, immigrants' remittances, and the like —

II. Short-term loans between financial centers — 12. Summary of
demand and supply factors of the exchange market — 13. Balanc-
ing international payments by means of bills of exchange.

Chapter III. Rates of Exchange 40

14. Determining factors of the rates of exchange — 15. Money
factors and the mint pars of exchange — 16. Market fluctuations
of the exchange rates — 17. The specie points — 18. Determina-
tion of the specie points — 19. The gold exchange standard — ■

20. Causes of abnormal fluctuations in the rates of exchange —

21. Relation of the exchange bankers to the rates of exchange.

Chapter IV. Interrelations of the Rates of Exchange . 83

22. The schedule of rates in the same market — 23. The cable rate

— 24. The rate for bankers' long bills — 25. Rate of exchange for
commercial bills — 26. Arbitrage — 27. Speculation.

Chapter V. The Rates of Exchange and the Currents op
Commerce 109

28. Fluctuations of the rates caused by the balance of payment —

29. Reaction of the rates of exchange upon the currents of trade —
80. Fluctuations of the rates caused by a depreciated currency —
31. The silver exchanges and their relation to international com-
merce — 32. National interest as affected by fluctuations of the
rates of exchange — 33. The embargo on gold — 34. Pegging the
rate of exchange.

Chapter VI. Bankers' Bills of Exchange .... 130
35. Bankers' demand drafts and cal)lcs — 36. Bankers' long bills

— .37. Finance bills — 38. The dollar loaD — 39. The sterling
loan.



vi CONTENTS

Chapter VII. Commercial Bills 159

40. Dofinition and classification — 41. Commercial long bills —
ii. Documentary commercial bills — 43. Documentary instruc-
tions 14. Documentary acceptance bills — 45. Documentary

payment bills — 4(>. Clean bills — 47. Commercial bills at sight
anil short sight — 48. Modification of the commercial bill.

Chapter VIII. Letters of Credit 205

49. Purpose and nature of letters of credit — 50. Commercial let-
ter of credit issued by a bank upon itself — 51. Letter of credit is-
sued upon a second bank — 5i. Banking relations involved in let-
ter of credit — 53. Superiorities of the commercial letter of credit

— 54. Travelers' letters of credit — 55. Travelers' checks.

Chapter IX. Other Forms of Bank Credit .... 240

86. Variations of the bank credit — 57. Acceptance credits estab-
lished by the exporter — 58. The authority to purchase — 59. Re-
lation of bank credits to the exchange market.

Chapter X. Services of Bills of Exchange in Foreign
Trade 259

60. Summary of the methods of making payment by means of bills
of exchange — 61. Distribution of risk by means of bill of exchange

— 62. The allocation of the transportation and financing costs —
63. How the risk of exchange is handled — 64. Economic func-
tions of commercial bills — 65. The collection function of bills of
exchange — 66. The financing function of bills of exchange.

Chapter XI. Foreign Investments and the Exchange
Market 295

67. Investments in long bills of exchange — 68. Foreign long-term
investments — 69. The effect of investments on international
commerce — 70. Investment trusts.

Chapter XII. The Exchange Market — London . . 313

71. Correspondent relations between London and foreign banks —

72. The foreign balance — 73. The acceptance account — 74.
Commission charges of London correspondent banks — 75. The
London discount market — 76. Relation of the London banks to
the discount market — 77. The bill brokers and discount houses —
78. The Bank of England — 79. The position of the Bank of Eng-
land Rate in the London market.

Chapter XIII. The London Market {continued) . . . 343

80. The Bank Rate and the flow of gold — 81. Other expedients
for controlling the movement of gold — 82. The bases of London's
supreniacy.



CONTENTS vii

Chapter XIV. The New York Market 366

83. Former position of the New York market — 84. The Federal
Reserve Act and its relation to the exchange market — 85. The
present mechanism of the open market in New York — 86. Pri-
mary investors in the open market of New York — 87. The New
York bill brokers — 88. The Federal Reserve Bank in relation to
the discount market — 89. Dollar exchange.

Index ' . . 405



FORMS AND SPECIMEN LETTERS

Page

Domestic Bill of Exchange 10

Foreign Bill of Exchange 13

Depreciation of Foreign Exchange compared with Depre-
ciation OF Foreign Currency 59

Typical Exchange Market Report 96

Order for Cable Transfer 134

Application for Foreign Exchange 135

Banker's Sterling Demand Draft 136

Banker's Sterling Long Bill 146

General Letter of Hypothecation .... 168, 169
Documentary Blank to accompany a Collection Bill of

Exchange 174

Trust Receipts 183, 184, 185

Application for Letter of Credit (Boston Bank) . . 207
Contract for the Purchase of Dollar Import Letter of

Credit 210

Import Letter of Credit (Dollars) 212

Sterling Import Letter of Credit Agreement . 218, 219
Import Letter of Credit (Pounds Sterling) .... 223

Letter of Confirmation 224

Traveler's Sterling Letter of Credit 235

Traveler's Check in Dollars 238

Letter Confirming an Irrevocable Credit . . ... 243

Acceptance Agreement 246, 247

Letter of Guarantee 249, 250

Authority to Draw . . • 253, 254



INTRODUCTION

There appears to be a fairly common impression that there is
something peculiarly mysterious or recondite about the sub-
ject of foreign exchange. Professor Furniss's lucid and well-
proportioned account should do much to correct that im-
pression. The truth is that the operation of the foreign ex-
changes is in many respects simpler and less obscure than that
of other parts of our monetary mechanism. That the subject
has this undeserved reputation for obscurity must be at-
tributed, I suppose, to the manner in which the books have
dealt with it.

Books on foreign exchange fall for the most part into two
classes. First, there are the books that are weighted down
with purely technical details respecting such matters as
monetary standards, commercial laws, stamp taxes, the arith-
metic of exchange rates, and the like — excellent desk books,
doubtless (if only they could be kept up to date) , for dealers
in exchange. Second, there are the more philosophical dis-
cussions, dealing with the general principles of foreign ex-
change. Too many of the books of this second type make the
subject unduly obscure by making it unduly abstract and
unreal or by entangling it with the intricate problems of the
general theory of international trade.

Professor Furniss has chosen a middle course. On the one
hand he is careful to avoid petty technical detail. On the
other hand he is equally careful to keep close to concrete
realities. For these reasons, I believe, his book will commend
itself to two different classes of students. Those who, in
schools of commerce or elsewhere, are preparing themselves
for business careers will find in it an orderly account of the
principal operations of the foreign exchange market. He
leaves to one side such minor matters of detail as can be more
profitably acquired through actual experience in the work of
the foreign exchange department of a bank. Those whose inter-



X INTRODUCTION

ests are in economic science rather than in affairs will find that
the best ap})roach to the study of foreign exchange — as to
the stud^v of other monetary problems — is through the anal-
ysis of the actual mechanism of the market. In these matters
Professor Furniss, wTiting with first-hand knowledge of his
subject, is a safe guide.

I suspect that the largest use of the book will be as a text in
colleges and schools of commerce. But other readers will be
attracted to it by the present importance of the subject with
which it deals. During the last few years disordered ex-
changes have stood in the way of the full restoration of that
international economic cooperation upon which, under mod-
ern conditions, the economic welfare of the world depends.
In foreign exchange, as elsewhere, our attention is rarely
drawn to certain of the most fundamental and elementary
features of our monetary mechanism until, for some reason,
that mechanism fails to operate smoothly. In this respect, of
course, the present volume has an advantage over such de-
scriptive accounts of the foreign exchange market as were
written before the war. While avoiding disproportionate
emphasis upon what we may hope is only a temporary phase,
it affords an excellent introduction to the study of the factors
which determine the price of exchange upon (or in) a coun-
try with an inconvertible paper currency. This feature,
quite apart from its other qualities, will commend it to many
readers. ~'~

At.t.yn a. Young



FOREIGN EXCHANGE



CHAPTER I

NATURE AND USE OF BILLS OF EXCHANGE

1. Introductory. When viewed as a whole, international
trade is barter; the people of one nation obtain a supply of
the goods and services of other peoples by offering in ex-
change the peculiar products of their own land and labor.
The ability of Americans to command for their own use a
share in the production of foreign peoples is conditioned upon
the desire of foreigners to obtain a portion of our national
product. In other words, our power to import is limited by
our ability to export. Conversely, when we consider all
nations outside our own boundaries as a unit, it is apparent
that the ability of foreign peoples to buy our goods is con-
ditioned upon our willingness to accept their goods in ex-
change, since they have no other means with which to make
payment. Hence, our power to export is limited by our
willingness to import. Nations, like individuals, may, it is
true, fall into debt to each other on account of business
transactions which remain uncompleted; but in the long run,
men, whether in groups or as individuals, will refuse to sur-
render their wealth to one another except in exchange for
other wealth.

If international trade were carried on by national groups
instead of by individual business men, the use of the exchange
market, and of the many different forms of credit instru-
ments with which our modern money economy complicates
the basic forces underlying the commerce of nations, would
to a great extent disappear; however, in spite of these
complexities, the principles of barter are still the governing



S FOREIGN EXCHANGE

principles of international trade. This fact must be firmly
grasped at the outset of any study of foreign exchange; for,
as we shall see in due course, it is the barter of goods for goods
in international trade which controls the operations of the
exchange markets of the world.

Since the world's trade is not carried on by national groups,
but by individual business men, each in pursuit of private
profit, the problem of effecting payment in international
commercial transactions is one of great importance. The
American manufacturer or merchant who has found a market
for his goods outside our boundaries cannot exploit this op-
portunity to his own advantage unless some agency is avail-
able through which he can obtain from his foreign customer
the amount due him. It is no aid to the conduct of his busi-
ness to be told that the nation of which he is a member must
in due course receive from foreign peoples payment in goods
for all commodities exported. The problem of the individual
trader is immediate and practical; he must receive in dollars
and cents, and without too great delay, the sale price of his
goods, otherwise he cannot meet the current expenses of his
business and must withdraw from foreign trade. At the
same time, the peculiar complexities of foreign trade deny
him recourse to many of the means by which he is accus-
tomed to make collection from debtors in the domestic
market. The distance which separates the two parties; the
difference in language, business customs and legal institu-
tions; the fact that the foreign buyer's money has no cur-
rency in the seller's market and that his checks and other
credit instruments will not be honored by the seller's banker,
increase the seller's reliance upon some agent capable of
bridging the distance between the two markets and resolving
the sum of money paid out by the foreign buyer in a distant
city and a foreign coinage into a sum available in the seller's
city and in the coinage of his nation.

This need of the exporter can be most simply met by the
offer of a third party to assume the exporter's right against his
foreign customer and to pay the exporter, either immediately
or at some definite future date, the sum of money owing him.



NATURE AND USE OF BILLS OF EXCHANGE 3

If this third party is a neighbor of the exporter operating
under the same laws and customs, the problem of financing
foreign sales loses much of its complexity. In actual prac-
tice, payment for the greater part of the world's international
trade is effected in precisely this manner: by a transference
to a third party of the seller's claim against the buyer in con-
sideration of a payment of money by the third party to the
seller. The third party in question is the foreign exchange
banker; the instrument which gives effect to the transfer of
rights is a bill of exchange.

2. Definitions. As defined by the Negotiable Instruments
Law a bill of exchange is ''an unconditional order in writing
addressed by one person to another, signed by the person giving it,
requiring the person to whom it is addressed to pay 07i demand
or at a fixed or determinable future time a sum certain in money
to order or to bearer." There are three parties to this transfer
of funds: A orders B in writing to pay a stated amount of
money to C (or his order) either on demand or at a definite
future time. These parties are given distinctive names: A,
who writes the order, is known as the drawer; B, to whom the
order is addressed, as the drawee; C, the recipient of the money
or beneficiary of the order, the payee. In the market, bills of
exchange are differentiated to a certain extent according to
the character of the drawers; thus the term, banker's bill, is
used to describe a bill of exchange whose drawer is a banker,
and the term, commercial bill, one whose drawer is a merchant
or business man. The practical effect of this classification
upon the treatment of the different bills of exchange by the
exchange market will presently appear.

Again, bills of exchange are classified according to the
method used for determining the date upon which payment
is due from the drawee. From the definition which has been
given, it will be seen that the date of payment may be cither
"on demand" or "at a fixed or determinable future date."
A bill of exchange payable on demand is called a demand or
sight bill, or, frequently, a check, for ui)on examination it will
appear that the credit instrument known as a check, so com-
monly used in domestic transactions, answers all the re-



4 FOREIGN EXCHANGE

qiiircmcnts of the definition for a demand bill of exchange.
All bills payable at a future date are grouped together as
time or lomj bills. But the time bill may be so worded as to
specify either of two different methods of determining the
future date upon which payment is due. If A's instructions
to B, borne by the face of the order, read, "Pay to the order
of C one hundred dollars thirty days after date," the order
becomes payable thirty days after writing regardless of any
loss of time involved in presenting it to B ; it may, therefore,
result in giving B less than thirty days in which to prepare for
payment after presentment. On the other hand, if A's in-
structions read, "Pay to the order of C one hundred dollars
thirty days after sight," the bill does not commence its life
until it has been presented to B, who is accordingly allowed
thirty days' time in which to prepare for payment. In for-
eign trade the majority of time bills of exchange are drawn
payable after sight, though the practice of making them
payable after date is not unknown and is growing in favor
for reasons which will be discussed.

In no case may a bill of exchange be drawn payable at a
date which depends upon the occurrence of some non-pre-
dictable future event, for such terms would violate the pre-
scription of the law that the date of payment must be either
fixed or determinable. It frequently happens that the basing
of the date of payment of a bill of exchange upon the arrival
of a ship or the delivery of a consignment of goods would be
a convenience to both buyer and seller; but these expedients
cannot be adopted, for the courts will hold that an order so
drawn is not a true bill of exchange and the bankers will
refuse to negotiate it because of this weakness. However, when
the convenience of permitting the drawee to calculate the
date of payment on the basis of such an event is especially
great, informal custom often sanctions a departure from the
strict terms of the order. Assuming, for example, that the
drawee is a South American importer of merchandise from
the United States, and the drawer, the exporter to whom is
due the sale price of the merchandise, the custom of the
drawee's market may permit him to postpone payment of a



NATURE AND USE OF BILLS OF EXCHANGE 5

sight draft or the calculation of the date of payment of a
time draft until the goods have arrived and have been ex-
amined. In fact, this custom is so firmly rooted in certain
South American countries that the refusal of the drawee to
pay a sight draft until after the arrival of the goods leaves
the drawer no recourse but to acquiesce, despite his apparent
legal right to enforce payment upon presentation. Similar
customs obtain in other countries, in Holland, for example,
where the payment of a sight draft is ordinarily postponed
until three days' notice has been given the drawee. Because
of such local customs, it is impossible to say that demand or
sight drafts are always paid on presentation. In the case of
time drafts, too, the date of actual payment is somewhat
aflFected by local laws regarding "days of grace" which ex-
tend the date of payment after maturity from one to ten days
according to the practices of the particular country or state
in which the drawee lives.

Since the bill of exchange is an order to the drawee to pay
out a sum of money, the drawing of the bill may be taken as
presumptive evidence that the drawer has a legal right to
demand this sum from the drawee. But it must not be as-
sumed that possession of the bill of exchange bestows upon
the payee a right of action against the drawee, even when the
drawer is a bona fide creditor and has acted well within his
powers in addressing the order to the drawee. The posses-
sion by C of A's order instructing B to pay a sum of money
gives C no power to enforce the order by legal action in case
B chooses to disregard the instructions. If B's refusal to
honor the bill is a violation of some agreement he has made
with the drawer, any action brought against him must be
brought by the drawer and must be based on his violation
of the contract in pursuance of which the bill was drawn.

To transfer this right of action against the drawee from
the drawer to the payee of the bill of exchange, the order
must be presented to the drawee and receive his acknowledg-
ment. If the bill is drawn payable upon demand, the
drawee's acknowledgment of the order will, of course, con-
sist simply of his payment of the amount of money stated on



6 FOREIGN EXCHANGE

its face. If it is a time draft, however, the acknowledgement
must be given in such form as to bestow upon the holder of
the bill a rii:;ht of action against the drawee in case payment
is refused at maturity, and this the drawee usually does by
writing the word "accepted," together with his signature and
the date, across the face of the order. After this act, whose
effect is to transmute the order into the drawee's promise to
pay at a definite future date, the bill of exchange will be
spoken of as an acceptance by the business world and may
change hands before maturity upon terms which reflect the
estimate placed by investors in the acceptor's willingness
and ability to discharge his debts; for now its lawful posses-



Online LibraryEdgar Stephenson FurnissForeign exchange, the financing mechanism of international commerce → online text (page 1 of 37)