Local Currency Settlement is an international payment process in which two parties involved in a transaction agree to make payments in their respective local currencies, without having to change currency into another currency. This means, in Local Currency Settlement, international transactions are carried out using the currencies of the country of origin and destination country.
This is important in international trade because Local Currency Settlement can reduce the risks associated with fluctuations in exchange rates and high transaction costs. By using local currency, parties involved in transactions can avoid unexpected exchange rate fluctuations, as well as the high transaction costs associated with currency conversion.
In addition, Local Currency Settlement can also increase trust between the two parties, because it can reduce credit risk and security risk associated with the use of foreign currency. Thus, Local Currency Settlement can increase the volume of international trade and speed up the trade process, which in turn can encourage economic growth and international development.
Local Currency Settlement Ways to Reduce the Risk of Exchange Rate Fluctuations and Transaction Fees
Local Currency Settlement can reduce the risks associated with fluctuations in exchange rates and transaction costs in international trade in the following ways:
1. Exchange rate fluctuations: In international transactions using foreign currencies, exchange rate fluctuations can affect the transaction value that must be paid or received by the parties involved. By using local currency, these parties can avoid unexpected exchange rate fluctuations and can estimate transaction costs with greater certainty.
2. Transaction fees: The use of foreign currency in international transactions often involves high transaction costs, such as currency conversion fees, cross-border transaction fees, and administration fees. In Local Currency Settlement, these costs can be avoided or reduced because no more currency conversion is required, and transaction costs are lower.
3. Credit risk: In transactions using foreign currencies, the parties involved often require guarantees or payment guarantees from other parties to avoid credit risk. In Local Currency Settlements, the parties involved can be more confident in making transactions because payments are made in local currency, so that credit risk can be reduced.
How the Local Currency Settlement System works
The Local Currency Settlement system works by allowing parties involved in international transactions to make payments in their respective local currencies, without having to change currency into another currency. Following are the steps involved in the Local Currency Settlement system:
a. Agreement between the two parties: The parties involved in an international transaction must first agree to make payments in their respective local currencies.
b. Currency exchange rate fixing: Once the agreement is made, the currency exchange rate must be fixed between the two parties to avoid any difference in the exchange rate between the respective local currencies.
c. Execution of transactions: Once the currency rate has been determined, transactions can be carried out with payments made by the buyer in his local currency, and received by the seller in his local currency as well.
d. Payment confirmation: After payment is received by the seller, payment confirmation must be given to the buyer.
Parties involved in Local Currency Settlement transactions include:
1. Buyer: Party that purchases goods or services in international transactions.
2. Seller: The party that sells goods or services in an international transaction.
3. Bank: The bank used by both parties to facilitate payment transactions in local currency.
4. Government: The government of the country of origin or destination of the transaction may also be involved in the regulation and supervision of Local Currency Settlement transactions.
In the Local Currency Settlement system, trust between the two parties is very important to ensure the success of the transaction. Therefore, good agreement and communication between them is the key to success in using this system.
Advantages and Disadvantages of Using Local Currency Settlement
There are several advantages and disadvantages in using Local Currency Settlement in international transactions, especially in terms of transaction costs and efficiency, as follows:
Advantages:
1. Avoid exchange rate fluctuations
In international transactions using foreign currencies, exchange rate fluctuations can affect the transaction value that must be paid or received by the parties involved. By using local currency, these parties can avoid unexpected exchange rate fluctuations and can estimate transaction costs with greater certainty.
2. Reducing transaction costs
The use of foreign currency in international transactions often involves high transaction costs, such as currency conversion fees, cross-border transaction fees, and administration fees. In Local Currency Settlement, these costs can be avoided or reduced because no more currency conversion is required, and transaction costs are lower.
3. Speed up the payment process
In international transactions using foreign currencies, the payment process can take a long time because it involves various parties, such as banks and international financial institutions. In Local Currency Settlement, the payment process can be accelerated because it does not involve complicated currency conversions.
Disadvantages:
a. Local exchange rate risk
Although the Local Currency Settlement can avoid fluctuations in foreign exchange rates, local exchange rate risks may arise which can affect the transaction value.
b. Difficulty finding a local bank
In some cases, it is difficult to find local banks willing to make transactions in certain local currencies, especially if those currencies are rarely used or not recognized internationally.
c. Difficulty in determining the exchange rate
Local currency rates are not always easy to determine as they depend on factors such as inflation and the stability of the country’s economy.
Impact of Using Local Currency Settlement
The use of Local Currency Settlements can have an impact on foreign exchange markets and global economic stability. Some of these impacts include:
– Reducing the volume of transactions in the foreign exchange market: The use of Local Currency Settlement can reduce the volume of transactions in the foreign exchange market because the use of local currency reduces the need for foreign currency conversions. This can affect the liquidity of the foreign exchange market and affect the level of price volatility.
– Reducing demand for foreign currency: In Local Currency Settlement, the demand for foreign currency may decrease because transactions can be made using local currency. This can affect the strength of foreign currency exchange rates against local and global currencies.
– Increase the stability of local currency: In Local Currency Settlement, the use of local currency in international transactions can increase the demand for that currency and can strengthen the exchange rate of the local currency. This can provide economic stability for countries that use local currencies in international transactions.
– Reducing risks in international transactions: The use of Local Currency Settlement can reduce the risks associated with fluctuations in foreign currency exchange rates, thereby minimizing the risks associated with international transactions and increasing the confidence of investors and business people.
However, the impact of the use of Local Currency Settlement on the foreign exchange market and global economic stability is still relatively small, because its use is still limited to international transactions between certain countries. Nonetheless, should their use become widespread, then their impact on foreign exchange markets and global economic stability will need to be monitored and evaluated carefully.
Challenges in Using Local Currency Settlement
Although Local Currency Settlement has significant benefits in international trade, there are still some challenges in its use, including:
1. Lack of infrastructure support: The use of Local Currency Settlement requires adequate infrastructure support, such as a payment system that can support transactions using local currency. This challenge can be overcome by increasing investment in payment infrastructure and developing technology to support transactions in local currencies.
2. Credit risk: Credit risk can be a problem in using Local Currency Settlement, especially in transactions with unknown parties or those with low credit ratings. This challenge can be overcome by carrying out a careful credit risk assessment before making a transaction and protecting yourself from the risk by taking out credit insurance.
3. Market confidence: The use of Local Currency Settlement is still relatively new and has not been fully adopted by the market, so it can affect the confidence of market players in the stability of international transactions. This challenge can be overcome by introducing education and promotion programs about the benefits of using Local Currency Settlement and building the trust of market players through transparent policies and practices.
4. Regulations and policies: Government regulations and policies may affect the use of Local Currency Settlement. This challenge can be overcome by promoting policies and regulations that support the use of local currencies in international trade.
To maximize the potential benefits of using Local Currency Settlement, collaboration between business people, government and financial institutions is needed to overcome the above challenges. In addition, it is also necessary to carry out continuous research and development to increase the efficiency and effectiveness of using Local Currency Settlements in international trade.
