UNIT X
BALANCE OF PAYMENTS & FOREIGN EXCHANGE RATE
FOREIGN EXCHANGE RATE
1. Meaning of the term Foreign Exchange Rate:
It refers to the rate at which one unit of currency of a country is exchanged for
the currency of other country. In other words, it is the price of one currency in
terms of another currency.
Types of Exchange rates :
TYPES OF EXCHANGE RATE SYSTEM
FIXED ECHANGE RATE FLEXIBLE MANAGED FLOATING
EXCHANGE RATE
2. Fixed Exchange Rate System
Fixed Exchange rate refers to the system in which the rate of exchange is
determined by govt. or monetary authorities. It can be classified into Gold
Standard System or Mint Parity of Exchange & Adjustable Peg System.
Merits of fixed Exchange Rate Demerits of Fixed Exchange rate
system system
1. It ensures stability and fluctuations has 1. Countries needs huge international reserve
been avoided hence encourage foreign trade. of gold which results in inflation and
devaluation of currency.
2. Prevents capital outflow and speculations 2.Restrictions in movement of capital due to
in foreign exchange market the need of huge reserves of gold
3. It Promotes capital movement 3.Discouraged venture capital and rigid in
resource allocation
4.It forces the government to keep inflation 4.Leads to undervaluation and overvaluation
under check of currency.
3. Flexible Exchange Rate System: -
Flexible Exchange Rate System refers to such a rate of exchange which is
determined by the demand for & supply of the foreign exchange in the foreign
exchange market. Under this system, the govt. or central bank does not intervene
in the determination of exchange rates.
The exchange rate is determined by the free play of two forces viz. demand &
supply of concerned foreign currencies. The rate of exchange is determined when
both demand & supply of foreign exchange are equal to each other.
Merits of fixed Exchange Rate Demerits of Fixed Exchange rate
system system
1. It eliminates the problem of over and 1It creates situations of instability and
under evaluation of currency and thus helps fluctuations
to correct BOP imbalances automatically.
2. There is no need for the government to 2.It encourages speculations and crates
hold any reserves instability in the market.
3.It enhances the efficiency of the economy 3. The uncertainty in currency value
by achieving optimum resource allocation discourage foreign trade.
4. Sources of demand for foreign exchange:
Import of goods & services
Investment in other countries
Payment of gifts & grants to abroad
Direct purchase made in abroad
Repayment of loans and other payments involved in international
transactions.
The demand for foreign exchange and exchange rate is inversely related to the
exchange rate.
5. Sources of Supply of foreign exchange:
Export of goods & services
Investments by ROW in the resident country
Receiving gifts, donations & grants from the ROW
Remittances by the non-residents from the ROW
Direct purchase made by the non-residents in the domestic country &
other receipts involved in international transactions etc.
The supply of foreign exchange is directly related to the exchange rate.
6. Managed float system :
It is a Mixture of flexible exchange rate (the float part ) and the fixed exchange
rate (the managed part) system , also called dirty floating. Central Bank intervenes
to buy and sell foreign currencies to moderate exchange rate movements whenever
they feel such intervention is appropriate.
7.Appreciation and Depreciation of Currency ;
Appreciation and depreciation of a currency takes place due to changes in demand
for and supply of foreign exchange .
Depreciation: - Depreciation means decline in external value of a domestic
currency in relation to a foreign currency. The Value of foreign currency
appreciate when domestic currency depreciate.
Appreciation : -Appreciation means rise in external value of a domestic currency
in relation to a foreign currency .The value of foreign currency depreciate when
domestic currency appreciate .
8. Revaluation and devaluation of currency
Currency value is revaluated and devaluated by the monetary authority/Central
bank .
Revaluation means increase in the external value of a country’s currency as a
measure to protect the domestic currency by central bank .
Devaluation means reduction in the external value of a country’s currency as a
conscious policy measure adopted by the Government.
BALANCE OF PAYMENT
1.Meaning of Balance of Payments(BOP):
It is a systematic record of all economic transactions between the residents of a
country & rest of the world during a financial year. In other words, it is a summary
record of all international economic transactions of a resident country with the rest
of the world during a given period of time.
2.Meaning of Balance of Trade(BOT):
It refers to the systematic record of visible items in a financial year. In other
words, it is the difference between value of imports and exports of commodities
i.e. merchandise. Exports and imports of goods are called transactions of visible
items. Therefore balance of trade is also called Balance on visible.
If the exports exceed imports, the BOT is said to be favourable, and unfavourable
in case of vice versa. Thus,
Favourable BOT = Exports receipts > Import payments.
3. Difference between BOP and BOT:
The term 'Balance of Payments' refers to the account of both visible items &
invisible items while 'Balance of Trade' refers to the record of visible items only.
BOT is only one of the components of BOP while the BOP is a wider concept &
therefore offers a more comprehensive picture of economic transactions of a
country with the rest of the world.
Moreover, the BOT may be balanced, deficit or surplus, while BOP as a whole
always remain balanced. BOT is a simple statements related to the foreign trade of
the country while BOP presents a classified record of all receipts on account of
goods exported, services rendered and capital received, and payments made on
account of goods imported, services rendered from, and capital transferred to
abroad.
4. The Items included in BOP account.
Ans : 1. Visible Items include all merchandise imports and exports i.e. the items
which are recorded at the port & made of some material.
2. Invisible Items include receipts & payments for the services viz. shipping,
banking, insurance, travel etc.; receipts and payments of income on foreign
investments; interest on foreign loans & remittances of NRI's etc; govt's current
expenditure in abroad viz. expenditure on embassies etc.; transfer payments &
receipts.
3. Capital transfers include the capital receipts & capital expenditure of a resident
country.
5. The structure /componenets of BOP account :
BOP account is categorized into Current Account & Capital Account.
BOP on Current Account refers to transactions related to goods, services, income
on investments & unilateral transfers. BOP on current account reveals the net
income of the country generated in abroad. Both visible & invisible items include
constitute the current account of BOP. It need not always be in balance. It may
show a surplus or deficit. It represents the difference between payments & receipts
of currently produced & consumed goods & services. A deficit in current account
indicates lowering down the level of
income, creating problem of the payments to the foreigners & have adverse impact
on country's exchange reserves, & may increase external borrowings.
The components of BOP on current account are:
1) Visible trade includes the export and import of the physical goods
2) Invisible items include cost of non-factor services; investment income, &
unilateral transfers.
(i) The non-factor services include transportation, finance, tour & travel etc. The
services rendered by the resident country to the ROW are recorded on the credit
side, while the services rendered by the foreigners for the resident country are
recorded on the debit side.
(ii) Income on investment includes interest payments on foreign loans & credits,
transfer of profits & miscellaneous for patents, royalties etc. The interest &
dividend payments made by the foreigners are recorded on the credit side, and vice
versa.
(iii) Unilateral Payments includes foreign gifts & grants, donations, military aid,
technical assistance etc. These are also referred to as unrequired transfers. These
refer to those receipts or payments which take place without getting anything in
return.
These transfers are further classified into Official & Private transfer payments.
Official unilateral transfers are the foreign donations & aids, while Private
transfers refer to the gifts & donations from foreign residents to the domestic
residents & vice versa. Payments of these transfers are recorded as debit & receipts
are recorded as credit.
Thus, the balance of visible trade, invisible trade & unilateral transfers is recorded
as BOP on current account.
BOP on Capital Account: It refers to the international transactions in financial
assets viz. bonds, equities, loans, bank account etc.; fixed plants &equipments, and
direct investments. It is a record of those transactions which leads to change in
assets or liability of the resident country. In other words, it is record of capital
transactions i.e. the private & the official capital transfers as well as the banking
capital flows. BOP on capital account deals with payments of debts and claims.
The components of BOP on capital account are:
Private Capital Transactions which refer to those transactions which affect
assets or liabilities of the resident country.
Official Capital Transactions refer to the transactions which affect assets &
liabilities of the govt. It includes loans, repurchase & resale of securities sold to
foreign residents, debt service, gold & foreign exchange reserves, & miscellaneous
receipts & payments.
Banking Capital Transactions includes movement in the external financial
assets and liabilities of those banks which are authorized to deal in the foreign
exchange.
6.The other items in the BOP account :
There are certain items which do not form the part of current & capital account.
These items are kept for balancing the BOP. These items are as follows:
I. Errors & Omissions are the balancing items in the BOP accounts which are
used for correcting the BOP as it is difficult to keep an accurate record of all the
transactions which may be due to sample of transactions, dishonesty of traders,
smuggling etc.
II. Official Reserve Transactions refer to those transactions which are carried out
by the govt. and the Central bank on behalf of govt. with regard to certain
economic policy & their effect on BOP, & the exchange rates. It includes the
Country's Official Reserve Assets & Foreign official Assets in the country.
The Official Reserves are held in the form of foreign currency or foreign
securities, gold & Special Drawing Rights (SDR) with the IMF. Reduction in these
reserves implies purchase of foreign exchange which is taken as credit items in the
BOP since it causes inflow of foreign exchange. On the contrary, an increase in
these reserve assets is taken as a debit in the BOP as it causes outflow of foreign
exchange.
The Foreign Official assets in the country are in the form of rupee reserves of
foreign central banks. Increase in these rupee reserves of foreign banks is taken as
a credit item as it causes inflow of foreign exchange in the resident country (India),
while decrease in these reserves is taken as debit as it causes outflow of foreign
exchange.
7. Differentiate between Autonomous &Accommodating Items.
Items in the BOP account can be also classified into two categories viz.
Autonomous or above the line items and Accommodating or below the line items.
Autonomous items refer to those items which are taken with the motive of profit
maximization. These transactions are not related to the country's BOP position. It
is, therefore, these items are called as autonomous items. These items are taken as
first items before calculating deficit or surplus in BOP account, therefore these
items are called as above the line items. If the receipts from autonomous items
exceed the payments for autonomous items; the BOP is called to be as surplus,
and vice versa. It implies that the resident country has net claims against the ROW.
On the other hand, if the payments for these items exceed the receipts from these
items, it implies that the ROW has some net
claims against the resident country.
Accommodating items refer to those items which are undertaken by the govt. to
keep the BOP balanced. These items are transacted when a country faces
disequilibrium in the BOP. Through these transactions, the govt. or monetary
authorities settle the deficit or surplus in the BOP.
8.Disequilibrium in the BOP
Ans: It refers to such a situation when the BOP of the country is deficit or surplus.
In other words, it is a situation when the net balance of all receipts & payments is
not zero. If the net balance is in (+), it is surplus; while the negative (-) balance is
deficit. In both of the situation, the BOP is in disequilibrium.
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