3 – Money doesn’t MOVE! (Cont’)

Photo by Cory Woodward on Unsplash

Now we have seen how money “moves” between banks within a country, now let’s see how money moves “between” countries for example when a Malaysian firm, Proton Inc. wanted to buy high-tech production machines from a US manufacturer, Tera Inc. 

The total amount to pay is USD 25,000. 

Let’s say Proton Inc. has a bank account at Maybank (operating in Malaysia) and Tera Inc. has a bank account at Washington Bank (operating in the US). 

To make the payment to the US manufacturer, this means the money have to somehow “moves” from the bank account of Proton Inc. at Maybank in Malaysia to bank account of Tera Inc. at Washington Bank in the US.

To make things simpler, let’s assume that Maybank held central bank reserves account at both the Central Bank of Malaysia (CBOM) and Federal Reserves (also known as the Fed – the Central bank of the US). Same goes to Washington Bank. It held central bank reserves account at CBOM and the Fed.

There’re many ways payment can be completed, but let’s look at only 2 ways for the payment to be completed:

Option 1: In this case, Washington bank wanted to hold Malaysian Ringgit as FOREX assets.

  1. After Proton Inc. confirms on the transfer of USD 25,000 to bank account of Tera Inc. at Washington bank, an instruction is sent to Maybank to order Maybank to send USD 25,000 to Washington Bank.
  2. Following exchange rates of 1 USD = RM 4.00, Maybank sends an instruction to the computer system at CBOM to order CBOM to reduce its central bank reserves balance by RM 100,000 and increase the central bank reserves balance of Washington Bank at CBOM by RM 100,000.
  3. After the central bank reserves balance of Maybank is reduced and central bank reserves balance of Washington bank at CBOM is increased, computer system of Washington bank at the US is notified about the increase in the balance and subsequently increase the bank account balance of Tera Inc at Washington bank by USD 25,000.
  4. At the same time, the computer system of Maybank is notified to reduce the bank account balance of Proton Inc. at Maybank by RM 100,000.

Balance sheet changes after Step 4:

Diagram

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Figure 1: Balance sheet changes after the transaction completed via CBOM.

Option 2: In this case, Washington bank doesn’t want to hold Malaysian Ringgit as FOREX assets

  1. After Proton Inc. confirms on the transfer of USD 25,000 to bank account of Tera Inc. at Washington bank, an instruction is sent to Maybank to order Maybank to send USD 25,000 to Washington Bank.
  2. Since Washington bank doesn’t want to hold Malaysian Ringgit as FOREX assets, Maybank has to pay USD 25,000 using US dollar instead of Malaysian Ringgit. (i.e pay using its central bank reserves balance at the Fed)
  3. So, Maybank sends an instruction to the computer system of the Fed and order the Fed to reduce its central bank account balance at the Fed by USD 25,000 and increase the central bank account balance of Washington bank at the Fed by USD 25,000. 
  4. After the central bank reserves balance of Maybank is reduced and central bank reserves balance of Washington bank at the Fed is increased, computer system of Washington bank at the US is notified about the increase in the balance and subsequently increase the bank account balance of Tera Inc at Washington bank by USD 25,000.
  5. At the same time, the computer system of Maybank is notified to reduce the bank account balance of Proton Inc. at Maybank by RM 100,000 using exchange rate of 1 USD = RM 4.00.

Balance sheet changes after Step 6:

Diagram

Description automatically generated
Figure 2: Balance sheet changes after the transaction completed via the Fed.

Conclusion:

  1. When we say a bank have FOREX assets (for example USD100,000), it doesn’t mean that they store USD 100,000 in paper dollar in their bank vault. It means that it has USD 100,000 central banks reserves account balance at the Federal Reserve (i.e central bank of the US).
    1. Similarly, If a bank said that it has 100,000 pound of FOREX reserves (assets), this means that it holds a central bank reserves account at the Bank of England and it has 100,000 pound balance in that reserve account. 
  2. Again, Money doesn’t “move”! It’s the computer system increasing and decreasing account balance that trick us to believe that money “moves” from one bank account to another.

Reference:

*This is written based on my understanding of banking across border. If there’s any suggestion, pls put your thoughts at the comment section below.

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