The rate of exchange, or the price of drafts on a given point, may, therefore, fluctuate between a premium equal to the cost of shipping cash to that point and a discount of the same amount. Beyond these extremes, these fluctuations cannot ordinarily go, because customers may demand cash of their banks in payment of checks against their own credit balances and ship it to their out-of-town creditors at their own expense, and would do so if the rates charged on drafts should make such procedure profitable. The actual rate of exchange will not ordinarily reach either of these extremes, on account of competition either between the banks which are desirous of selling drafts on their correspondents or between those which are forced to buy as an alternative to cash shipments. If the aggregate balances of the banks of a town with their out-of-town correspondents are large and increasing, the pressure to sell drafts will be greater than that to buy and the rate of exchange will go to a discount, the amount of which, however, will be fixed by competition between the selling banks. In the opposite case, the rate will go to a premium and be fixed by competition between the buying banks.
In most towns in the United States there is little or no competition between banks in the business of buying and selling drafts and consequently no open market for exchange and no quotations of exchange rates. In such cases each bank acts more or less independently; shipments of cash to or from correspondents are the ordinary means of regulating balances; and the cost of such shipments are charged to the general expense account of the bank and taken out of customers either by a fixed and more or less invariable charge on drafts sold, or in other ways.
Since the balances of the banks of a town with their out-of-town correspondents depend primarily upon the commercial and gift relations of their customers with the outside world, it is pertinent to inquire whether as a result of a long continued excess of purchases from outsiders over sales to them and of gifts to over gifts from them, the cash resources of a community might not be completely exhausted, and if not, how such an outcome is prevented.
Bankers have no direct control over the purchases and sales of their customers, but through the rate of interest they charge on loans and discounts and their ability absolutely to discontinue such accommodations they exert a very potent indirect influence. The rates of interest and discount charged are an important element in the cost of doing business and, if loaning and discounting is discontinued, sales of property to meet maturing obligations are forced, with the result of price readjustments between the town in question and the outside world which speedily change the relations between purchases and sales.
When the cash resources of the banks of a town approach the limit of safety and their balances with their correspondents fall to an ominously low point, the normal method of procedure is to raise the rates on loans and discounts, and if conditions grow worse, to raise them higher still and as a last resort to cease temporarily to make them at any price. By increasing the cost of doing business this rise in the rates will check purchases by diminishing or annihilating the profits resulting, and will stimulate sales by rendering it more profitable for some customers to secure funds by sales to outsiders at lower prices than were formerly asked rather than by borrowing from banks. Under ordinary circumstances this procedure will be sufficient to change an unfavorable into a favorable balance of indebtedness with the outside world, with the result that more checks on outside institutions will be deposited with the banks and a smaller amount of drafts purchased. Bankers' balances with their correspondents will, therefore, increase, and with them their ability to command cash in case of need. The demands made upon them for cash will also decrease, since the volume of loans and of business transacted will fall.
If the banks stop discounting, a more or less violent readjustment with the outside world results. Business men who have obligations to meet, and most of them will belong to this class, are obliged to sell their goods and property at whatever prices are necessary and to stop purchasing entirely. The outcome, so far as the banks are concerned, is as above indicated. If conditions are such that sales at any price cannot be forced, a crisis ensues; that is, business operations are temporarily suspended and transfers of property in settlement of obligations are made through bankruptcy and other court proceedings.
7. Foreign Exchange
The business relations between banks located in different countries do not differ in any essential respect from those between banks located in the same country. Interchange of checks, the conduct of checking accounts, shipments of cash, and borrowing and lending proceed in the same manner as between domestic institutions. The chief peculiarities of the foreign exchanges are due to the fact that different units of value and sometimes different standards must here be reckoned with, and that the precious metals, chiefly gold, are used in the settlement of balances. Drafts drawn in the United States on English points, for example, call for the payment of pounds sterling, those on French points for francs, and those on German points for marks, while all must be paid for in dollars.
The translation of the language of values of one country into that of others thus involved requires the calculation of a so-called par of exchange. By this is meant the relation between the weights of pure metal contained in their respective units of value, if the countries in question have the same standard, and the relation between the market values of the metallic content of their units, if their standards are different. Thus the par of exchange between this country and England is $4.8665, since our dollar contains 23.22 grains of pure gold and the English pound sterling 4.8665 times as many grains, or 113.0016. Our par of exchange with France is 19.294 cents, the quotient of 4.4802, the number of grains of pure gold in the French franc, divided by 23.22. Between China and the United States the par of exchange is the market value in our dollars of the amount of silver contained in the tael, the Chinese unit.
Another technical term employed in connection with the foreign exchanges is the gold points. These are the points above and below the par of exchange fixed by the addition in the one case, and the subtraction in the other, of the cost of shipping gold between the two places in question. They are the points between which the rates of exchange fluctuate, or the points at which, when the rate of exchange reaches them, gold moves between gold standard countries. Assuming for example, that the cost of shipping gold between New York and London is two cents per pound sterling, the gold points are 4.8865 and 4.8465, it being profitable to ship gold from New York to London when sterling exchange reaches the former figure and to import gold from London when it reaches the latter figure.