It is plain speculating in exchange—there is no getting away from it, and yet this practice of selling finance-bills gives such an opportunity to the exchange manager shrewd enough to read the situation aright to make money, that many of the big houses go in for it to a large extent. During the summer, for instance, if the outlook is for big crops, the situation is apt to commend itself to this kind of operation. Money in the summer months is apt to be low and exchange high, affording a good basis on which to sell exchange. Then, if the expected crops materialize, large amounts of exchange drawn against exports will come into the market, forcing down rates and giving the operator who has previously sold his long bills an excellent chance to cover them profitably as they come due.

VI. ARBITRAGING IN EXCHANGE.

Arbitraging in exchange—the buying by a New York banker, for instance, through the medium of the London market, of exchange drawn on Paris—is another broad and profitable field for the operations of the expert foreign exchange manager. Take, for example, a time when exchange on Paris is more plentiful in London than in New York—a shrewd New York exchange manager needing a draft on Paris might well secure it in London rather than in his home city.

Between such cities rates are not apt to be wide enough apart to afford a wide margin of profit, but the chance for arbitraging does exist and is being continuously taken advantage of. So keenly, indeed, are the various rates in their possible relation to one another watched by the exchange men that it is next to impossible for them to "open up" to any appreciable extent. The chance to make even a slight profit by shifting balances is so quickly availed of that in the constant demand for exchange wherever any relative weakness is shown, there exists a force which keeps the whole structure at parity. The ability to buy drafts on Paris relatively much cheaper at London than at New York, for instance, would be so quickly taken advantage of by half a dozen watchful exchange men that the London rate on Paris would quickly enough be driven up to its right relative position. If a chance exists to sell a draft on London and then to put the requisite balance there through an arbitration involving Paris, Brussels, and Amsterdam, the chances are that there will be some shrewd manager who will find it out and put through the transaction. Some of the larger banking houses employ men who do little but look for just such opportunities.

The foregoing are the main forms of activity of the average foreign department, though there are, of course, many other ways of making money out of foreign exchange.

Gold Movements

[117]When there is a heavy demand for exchange and little supply, the price of exchange gradually advances. The banker, called on by his customers to draw exchange for them, finding few bills in the market that he can remit to cover his drafts, sends gold and directs its equivalent in foreign coin to be placed to his credit, and against this credit he draws. There may be no market abroad for our crops or manufactures; but gold need not be sold in order to produce money; it need only be coined. As this process can be carried on indefinitely, the cost of sending gold is obviously the limit beyond which the price of demand bills cannot advance. Let us follow this transaction in detail. The pure gold contained in one English sovereign is exactly equal to the pure gold contained in $4.8665 of our gold coins; so that, apart from charges and expenses, $4.8665 of our gold will, when sent abroad, produce a credit of £1; to this cost must be added freight, insurance, and other expenses, amounting to about one-fourth of 1 per cent. This brings the cost of £1 through shipment of gold to about $4.88, which is, roughly, the gold export point for full weight coin. The exporting banker obtains his gold either by drawing gold coin from his bank or else by drawing suitable currency from his bank, and obtaining gold coin for it at the subtreasury. In either case, he obtains coin that has suffered more or less abrasion by handling, and this loss of weight by abrasion, amounting to perhaps one-tenth of 1 per cent., increases the cost of his remittance. Generally, however, the banker can obtain gold bars from the United States Assay Office at the nominal charge of one twenty-fifth of 1 per cent., although at times a larger charge is made. The banker prefers bars, because on these there is no loss by abrasion; the Government can afford to give bars, because their export prevents the export of coin, and so saves the cost of coining new money to replace that shipped.

Now for gold import. When there is a large volume of bills offered to bankers, perhaps by grain and cotton exporters, and but little demand from buyers of exchange, the market gradually declines in price, while New York bankers, sending abroad the bills they buy, with little occasion to draw against them, accumulate large sums to their credit in London, with no way of getting the money back to New York through operations in the exchange market. They are not, however, helpless; they can order gold sovereigns sent here, and, once here, can have them melted down at the United States Assay Office and coined into eagles and double eagles, which they can deposit with their banks. Obviously, the amount received in dollars for each melted sovereign will mark the price the banker can afford to pay for sterling bills, and competition among bankers will prevent the rate of exchange from declining below this point by more than a fair margin of profit. The British sovereign, if full weight, will, when sent here and melted down, yield gold for which the United States Assay Office will pay $4.8665; the expense of sending the sovereign, freight, insurance, cartage, and kegs, will amount to about one quarter of 1 per cent., so that the net yield of the full weight sovereign in dollars will be $4.85-3/8. But between the day on which the banker buys the bill of exchange in New York and the day on which he receives in New York the gold which the bill entitled him to collect in London, there must elapse the time needed to send the bill to London, plus the time needed to send the gold back (roughly fifteen days), during which period the banker loses the use of the money. This loss of interest must be deducted from the net yield of the imported sovereign, and thus, if money is worth 6 per cent. per annum, the net yield of full weight sovereigns is brought down to about $4.84-1/4, which is the gold import point for demand exchange, when money is worth 6 per cent. per annum. Losses by abrasion will bring down this point by perhaps one-tenth of 1 per cent., to about $4.83-3/4. When money is higher, the import point will be lower, and vice versa. There is therefore a margin of profit in buying demand bills and importing gold sovereigns against the purchase, whenever the rate for demand bills falls below the gold import point. Active exchange bankers take advantage of this profit whenever exchange prices decline to the proper point, and their competition in buying bills to cover their gold importations stops further decline in exchange rates. It is interesting to note that during the recent crisis, when gold and currency were at a premium, bankers could sell the imported gold at a premium, and this constituted an additional and very large profit; gold importers could therefore pay higher prices than ordinarily for exchange bought to cover the importations, and the stress of competition so drove up the rate of exchange that gold was being imported at a profit, though exchange rates stood at what, under ordinary circumstances, would have been the gold export point.

Gold is, however, not always imported from England in the form of sovereigns. The Bank of England has in its vaults large quantities of American eagles and double eagles exported to England in the past and held without melting. The bank also holds foreign coin and bar gold. Any holder of Bank of England notes can get sovereigns on demand—other gold he can get only as the result of a special bargain. When gold is wanted for export, the bank is often glad to sell bar gold or double eagles at rates somewhat more advantageous to the exporter than would be the export of sovereigns; this the bank can afford to do, for the expense of coining sovereigns to replace those exported is thus saved, while the exporter, if he can get bar gold on the same basis as sovereigns, avoids the losses of abrasion. Eagles are even more advantageous to the exporter, for they are bought in England by weight and used in America by count; the banker therefore gets an advantage if they are light, so long as that lightness is not so great as to make them uncurrent—practically he buys them as light and uses them as full weight....

The mechanism of gold import to, and export from, Germany is practically the same as with England, the Reichsbank being required to give gold coin in exchange for its circulating notes. At times, however, German exchange has fallen below the theoretical gold import point, owing, not to the refusal of the Reichsbank to give gold, but to the practical obstacles that at times are somehow placed in the way of free export of gold. The Reichsbank does not refuse gold for its bank-notes, but German bankers say to their correspondents: "Don't ask us to get gold for you, or we shall lose caste," and on such occasions German exchange rates drop to a point that is theoretically impossible. I do not mean to criticise them: German banks, when they refuse to demand gold of the Reichsbank, do no more than our own banks and bankers did recently, when asked by foreign correspondents to collect in gold the maturing obligations of railroads and other corporations. As will be remembered, clearing-house funds rather than cash were at that time current here, and New York banks and bankers sent to their foreign correspondents the same answer as the Germans have at times sent us. I cite the German instance in partial mitigation of censure of our own course rather than as a reproach to them.