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BOP AND FOREIGN EXCHANGE BALANCE OF PAYMENTS (BOP) : The balance of payment is a comprehensive and systematic records of all economic transaction between normal residents of a country and rest of the world during an accounting year. Accounts of Balance of Payments: 1. Current Accoun...

BOP AND FOREIGN EXCHANGE BALANCE OF PAYMENTS (BOP) : The balance of payment is a comprehensive and systematic records of all economic transaction between normal residents of a country and rest of the world during an accounting year. Accounts of Balance of Payments: 1. Current Account: The current account records export and import of goods and services and unilateral transfers. Components of Current Account: (i) Export and Import of Goods (Merchandise Transactions or Visible Trade): A major part of transactions in foreign trade is in the form of export and import of goods (visible items). Payment for import of goods is written on the negative side (debit items) and receipt from exports is shown on the positive side (credit items). Balance of these visible exports and imports is known as balance of trade (or trade balance). (ii) Export and Import of Services (Invisible Trade): It includes a large variety of non-factor services (known as invisible items) sold and purchased by the residents of a country, to and from the rest of the world. Payments are either received or made to the other countries for use of these services. Services are generally of three kinds: (a) Shipping, (b) Banking, and (c) Insurance. Payments for these services are recorded on the negative side and receipts on the positive side. (iii) Unilateral or Unrequisted Transfers to and from abroad (One sided Transactions): Unilateral transfers include gifts, donations, personal remittances and other ‘one-way’transactions. These refer to those receipts and payments, which take place without any service in return. Receipt of unilateral transfers from rest of the world is shown on the credit side and unilateral transfers to rest of the world on the debit side. (iv) Income receipts and payments to and from abroad: It includes investment income in the form of interest, rent and profits. 2. Capital Account: It records of all such transactions between normal residents of a country and rest of the world which relates to sale and purchase of foreign assets and liabilities during an accounting year. Components of Capital Account: (i) Loans: Borrowing and lending of funds are divided into two transactions: Private Transactions -> These are transactions that are affecting assets or liabilities by individuals, businesses, etc. and other non-government entities. The bulk of foreign investment is private. -> For example, all transactions relating to borrowings from abroad by private sector and similarly repayment of loans by foreigners are recorded on the positive (credit) side. -> All transactions of lending to abroad by private sector and similarly repayment of loans to abroad by private sector is recorded as negative or debit item. Official Transactions -> Transactions affecting assets and liabilities by the government and its agencies. -> For example, all transactions relating to borrowings from abroad by government sector and similarly repayment of loans by foreign government are recorded on the positive (credit) side. -> All transactions of lending to abroad by government sector and similarly repayment of loans to Prepared by: Vineet Singh MA in ECONOMICS  abroad by government sector is recorded as negative or debit item. Private and official transactions borrowing are of two components: (i) Commercial borrowings, referring to borrowing by a country (including government and private sector) from international money market. This involves market rate of interest without considerations of any concession, (ii) Borrowings as External Assistance, referring to borrowing by a country with considerations of assistance. It involves lower rate of interest compared to that prevailing in open market. (ii) Foreign Investment (Investments to and from abroad): It includes: Investments by rest of the world in shares of Indian companies, real estate in India, etc. Such investments from abroad are recorded on the positive (credit) side as they bring in foreign exchange. Investments by Indian residents in shares of foreign companies, real estate abroad, etc. Such investments to abroad are recorded on the negative (debit) side as they lead to outflow of foreign exchange. ‘Investments to and from abroad’ includes two types of investments: -> Foreign Direct Investment (FDI) It refers to purchase of an asset in rest of the world, such that it gives direct control to the purchaser over the asset. For example, (i) acquisition of a firm in the domestic country by a foreign country’s firm (ii) transfer of funds from the parent company abroad to the subsidiary company in the domestic country. -> Portfolio Investment Portfolio Investment refers to the purchase of financial asset by the foreigners that does not give the purchaser control over the asset. A foreign Institutional Investment (FII) is also a part of portfolio investment. For instance, purchase of shares of a foreign company, purchase of foreign government’s bonds, etc. are treated as portfolio investments. (iii) Change in Foreign Exchange Reserves The foreign exchange reserves are the financial assets of the government held in central bank. A change in reserves serves as the financing item in India’s BOP. So, any withdrawal from the reserves is recorded on the positive (credit) side and any addition to these reserves is recorded on the negative (debit) side. It must be noted that ‘change in reserves’ is recorded in the BOP account and not ‘reserves’. Components of Current Account Components of Capital Account 1. Visible items (import and export of goods). 1. Foreign Direct investment. 2. Invisible items (import and export of services). 2. Loans. 3. Unilateral transfers. 3. Portfolio investment. 4.Income receipts and payments from and to abroad. 4. Banking capital transactions. 5. These are the transactions which do not affect the 5. These are the transactions which affect assets or assets or liabilities position of the country. liabilities position of the country. 6. It is a flow concept. 6.It is a stock concept. Prepared by: Vineet Singh MA in ECONOMICS Balance of trade It is the net difference of Import and export of all visible items between the normal residents of a country and rest of the world. Basis Balance of Trade (BOT) Balance of Payments (BOP) Meaning Balance of Trade refers to It is an accounting statement that difference between amounts of provides a systematic record of all exports and imports of visible economic transactions, between items. residents of a country and rest of the world in a given period of time. Components BOT includes only visible items BOP includes visible items, invisible items, unilateral transfers and capital transfers Capital It does not record any transaction It records all transactions of capital transactions of capital nature nature Scope It is a narrower concept as it is only It is a wider concept and it includes a part of BOP account BOT Settlement Unfavourable BOT can be met out Unfavourable BOP cannot be met out of favorable Bop of favorable BOT Debit items include imports, foreign aid, domestic spending abroad and domestic investments abroad. Credit items include exports, foreign spending in the domestic economy and foreign investments in the domestic economy. When exports are greater than imports than the BOT is favourable and if imports are greater than exports then it is unfavourable Prepared by: Vineet Singh MA in ECONOMICS AUTONOMOUS ITEMS V/S ACCOMMODATING ITEMS: Basis Autonomous Items Accommodating Items Meaning Autonomous items refer to those Accommodating items refer international economic to the transactions that are transactions, which take place due undertaken to to some economic motive cover deficit or surplus in such as profit maximization. autonomous transactions. Effect on BOP account Autonomous Accommodating transactions transactions are independent of the are undertaken to maintain state of BOP account the balance in BOP account Current/Capital Account Autonomous Accommodating transactions transactions take place on both take place only on capital current and capital accounts account Alternate Name These items are also known as These items are also known as ‘above the line items’ ‘below the line items’ Deficit in BOP (a) The balance of payments of a country is a systematic record of all economic transactions between the residents of foreign countries during a given period of time. (b) The transaction in the balance of payment account can be categorized as autonomous transactions and accommodating transactions. (c) Autonomous transactions are transactions done for some economic consideration such as profit. (d) When the total inflows on account of autonomous transactions are less than total outflows on account of such transactions, there is a deficit in the balance of payments account. (e) Suppose, the autonomous inflow of foreign exchange during the year is $500, while the total outflow is $600. It means that there is a deficit of $100. Disequilibrium in Balance of Payments: There are a number of factors that cause disequilibrium in the balance of payments showing either a surplus or deficit. These causes are: (a) Economic Factors (i) Large scale development expenditure that may cause large imports. (ii) Cyclical fluctuations in general business activity such as recession or depression. (iii) High domestic prices may result in imports. (b) Political Factors: Political factors instability may cause large capital outflows and hamper the inflows of foreign capital. (c) Social Factors: Changes in tastes, preference and fashions of the people bring disequilibrium Prepared by: Vineet Singh MA in ECONOMICS in BOP by inflowing imports and exports. FOREIGN EXCHANGE RATE : Foreign exchange refers to all the currencies of the rest of the world other than the domestic currency of the country. For example, in India, US dollar is the foreign exchange. Foreign exchange rate refers to the rate at which one unit of currency of a country can be exchanged for the number of units of currency of another country. In simple words, we can say that the price of one currency in terms of other currency is known as foreign exchange rate or exchange rate. Foreign exchange market is the market where the national currencies are converted, exchanged or traded for one another. Functions of a foreign exchange market (a) Transfer Function: Transfer function refers to transferring of purchasing power among countries. (b) Credit Function: It implies provision of credit in terms of foreign exchange for the export and import of goods and services across different countries of the world. (c) Hedging Function: Hedging function pertains to protecting against foreign exchange risks. Where Hedging is an activity which is designed to minimize the risk of loss. SYSTEM OF EXCHANGE RATE: 1. Fixed exchange rate 2. Flexible exchange rate. In fixed exchange rate system, the rate of exchange is officially fixed or determined by Government or Monetary Authority of the country. Merits of Fixed Exchange Rate (i) Stability in exchange rate (ii) Promotes capital movement and international trade. (iii) No scope for speculation (iv) It forces the govt. to keep inflation in check. (v) Attracts foreign capital. Demerits of Fixed Exchange Rate (i) Need to hold foreign exchange reserves. (ii) No automatic adjustment in the ‘Balance of payments.’ (iii) It may result in undervaluation or overvaluation of currency. (iv) It discourages the objective of having free markets. In a system of flexible exchange rate (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply of foreign exchange. Merits of Flexible Exchange Rate (i) No need to hold foreign exchange reserves (ii) Leads to automatic adjustment in the ‘balance of payments’. (iii) To enhances efficiency in resources allocation. (iv) To remove obstacles in the transfer of capital and trade. (v) It eliminates the problem of undervaluation or overvaluation of currency. (vi) It promotes venture capital in the form of foreign exchange. Prepared by: Vineet Singh MA in ECONOMICS  Demerits of Flexible Exchange Rate (i) Fluctuations in future exchange rate. (ii) Encourages speculation. (iii) Discourages international trade and investment. (iv) It creates a situation of market instability. The demand of foreign exchange have the inverse relation with flexible exchange rate. If flexible exchange rate rise the demand of foreign exchange falls. Vice versa. Sources of Demand for Foreign Exchange (a) To purchase goods and services from the rest of world. (b) To purchase financial assets (i.e..,to invest in bonds and equity shares) in a foreign country. (c) To invest directly in shops, factories, buildings in foreign countries. (d) To send gifts and grants to abroad. (e) To speculate on the value of foreign currency. (f) To undertake foreign tours. The supply of foreign exchange have the positive relation with foreign exchange rate. If foreign exchange rate rises the supply of foreign exchange also rises and vice versa. Sources of Supply of Foreign Exchange (i) Direct purchase by foreigners in domestic market. (ii) Direct investment by foreigners in domestic market. (iii) Remittances by non-residents living abroad. (iv) Flow of foreign exchange due to speculative purchases by N.R.I. (v) Exports of goods and services. (vi) Foreign direct investment as well as portfolio investment from rest of the world. Determination of Equilibrium Foreign Exchange Rate: Equilibrium FER is the rate at which demand for and supply of foreign exchange is equal. Under free market situation, it is determined by market forces i.e., demand for and supply of foreign exchange. There is inverse relation between demand for foreign exchange and exchange rate. There is direct relationship b/w supply of foreign exchange and exchange rate. Due to above reasons demand curve downward sloping and supply curve is upward sloping curve Graphically intersection of demand Curve and supply curve determines the equilibrium foreign exchange rate. Prepared by: Vineet Singh MA in ECONOMICS  Currency depreciation : (i) Currency depreciation refers to decrease in the value of domestic currency in terms of foreign currency. It makes the domestic currency less valuable and more of it is required to buy a foreign currency. It is a part of flexible exchange rate. (ii) For example, rupee is said to be depreciating if price of $1 rises from 60 to Rs. 65. (iii) Effect of depreciation of domestic currency on exports: Depreciation of domestic currency means a fall in the price of domestic currency (say, rupee) in terms of a foreign currency (say, $). It means, with the same amount of dollars, more goods can be purchased from India, i.e., exports to USA will increase as they will become relatively cheaper. Currency appreciation (i) Currency appreciation refers to increase in the value of domestic currency in terms of foreign currency. The domestic currency becomes more valuable and less of it is required to buy a-foreign currency. It is a part of flexible exchange rate. (ii) For example, Indian rupee appreciates when price of $1 falls from Rs. 60 to Rs. 55. (iii) Effect of appreciation of domestic currency on imports: Appreciation of domestic currency means a rise in the price of domestic currency (say, rupee) in terms of a foreign currency (say, $). Now, one rupee can be exchanged for more $, i.e., with the same amount of money, more goods can be purchased from the USA. It leads to increase in imports from the USA as American goods will become relatively cheaper. Managed floating system : 1) Under a managed float, market forces determine exchange rates until they move too far in one direction or another. The government then intervenes to maintain the currency within the broad range considered appropriate. The advantage of managed float is that it has the market-response nature of a freely floating system while allowing for government intervention when necessary. 2) The dominant exchange rate system in use among the world’s largest economies is the managed float system. Exchange Rates and Purchasing Power a. The graph below depicts the relationship between the supply of, and demand for, a foreign currency by consumers and investors who use a given domestic currency. Prepared by: Vineet Singh MA in ECONOMICS  1) The demand curve for the foreign currency is downward sloping. When that currency becomes cheaper, goods and services denominated in that currency are more affordable and domestic consumers need more of it. 2) The supply curve for the foreign currency is upward sloping. When that currency becomes more expensive, goods and services denominated in the domestic currency become more affordable to users of the foreign currency. Thus, they inject more of their currency into the domestic market. b. When one currency can be exchanged for more units of another currency, the first currency appreciates in relation to the second currency. The second currency depreciates in relation to the first. 1) This phenomenon has definite implications for international trade. The currency that appreciates has greater purchasing power. Any financial instrument denominated in that currency is more valuable (expensive). 2) The appreciation or depreciation affects the business strategies of firms. When a firm’s domestic currency depreciates, the demand for their product increases, so the firm is likely to expand operations. The opposite can also be true. 3) Other factors being constant, as the domestic currency depreciates, export prices decrease and import prices increase. Domestic goods become cheaper than foreign goods. Thus, export quantities increase and import quantities decrease. The opposite effects occur when the domestic currency appreciates. c. The five factors that affect currency exchange rates can be classified as three trade-related factors and two financial factors. 1) Trade-related factors a) Relative inflation rates b) Relative income levels c) Government intervention 2) Financial factors a) Relative interest rates b) Ease of capital flow Trade-Related Factors that Affect Exchange Rates a. Relative Inflation Rates 1) Recall from Study Unit 5 that the nominal interest rate consists of the real interest rate plus the expected inflation rate. 2) When the rate of inflation in a foreign country rises relative to the rate of inflation in a domestic country, the products of that foreign country become relatively expensive and the demand for that country’s currency falls. a) This leftward shift of the demand curve results from the reduced purchasing power of that currency. 3) As investors sell this currency, more of it is available, which is reflected in a rightward shift of the supply curve. 4) A new equilibrium point is at a lower price in terms of investors’ domestic Prepared by: Vineet Singh MA in ECONOMICS currencies. a) As a result of the higher inflation in a foreign country, the domestic currency has appreciated in relation to that foreign currency. b) The difference between the countries’ inflation rates approximately equals the change in the currency exchange rate between the two countries. i) For example, X has a 3% nominal inflation rate and Y has a 7% nominal rate. Because of the difference in nominal inflation rates, X’s currency appreciates against Y’s currency by approximately 4% (7% – 3%). This example assumes the real interest rate is constant between nations. b. Relative Income Levels 1) Persons with higher incomes look for new consumption opportunities in other countries, increasing the demand for those currencies and shifting the demand curve to the right. a) As domestic incomes rise, the prices of foreign currencies also rise and the local currency depreciates. Prepared by: Vineet Singh MA in ECONOMICS c. Government Intervention 1) Actions by national governments, such as trade barriers and currency restrictions, complicate the process of exchange rate determination. a) Trade barriers decrease imports of foreign goods and increase demand for domestic goods. Thus, the domestic currency appreciates without hurting domestic producers. i) However, trade barriers hurt consumers because consumers pay more for goods and ultimately have access to less diverse goods. b) Currency controls limit exchange rate volatility by restricting the use of foreign currency or using a fixed exchange rate. As more people purchase the domestic currency, it appreciates against the foreign currency. c) When the effects are not fully anticipated, an expansionary monetary policy (increase in money supply) reduces the exchange rate. A restrictive monetary policy (decrease in money supply) increases the exchange rate. d) When the effects are not fully anticipated, fiscal policy tends to have conflicting effects on the exchange rate. However, an expansionary fiscal policy generally is more likely to lead to currency appreciation, but a restrictive fiscal policy generally is more likely to lead to currency depreciation. Prepared by: Vineet Singh MA in ECONOMICS Financial Factors that Affect Exchange Rates a. Relative Interest Rates 1) When the interest rates in a foreign country rise relative to those of a domestic country, more investors are willing to buy the foreign country’s currency to make investments and the demand for the foreign currency rises. a) This rightward shift of the demand curve results because holders of other currencies seek the higher returns available in the foreign country. 2) As more investors buy the high-interest country’s currency to make investments, less of it is available, which is reflected in a leftward shift of the supply curve. 3) A new equilibrium point is at a higher price in terms of investors’ domestic currencies. a) An investor’s domestic currency has depreciated against the currency of a foreign country with higher interest rates. b. Ease of Capital Flow 1) If a country with high real interest rates removes restrictions on the cross border movement of capital, the demand for the currency and the currency’s value rises as Investors seek higher returns. 2) This factor has become by far the most important of those listed. a) The speed with which capital can be moved electronically and the huge amounts involved in the global economy are more significant than the effects of the trade-related factors. Prepared by: Vineet Singh MA in ECONOMICS Graphical Depiction: Exchange Rates a. The spot rate is the number of units of a foreign currency that can be received today (“on the spot”) in exchange for a single unit of the domestic currency. EXAMPLE A currency trader is willing to give 1.6 Swiss francs today in exchange for one British pound. Today’s spot rate for the pound is therefore 1.6 Swiss francs, and today’s spot rate for the franc is £0.625 (1 ÷ ₣1.6). b. The forward rate is the number of units of a foreign currency that can be received in exchange for a single unit of the domestic currency at some definite date in the future. EXAMPLE The currency trader contracts to provide 1.8 Swiss francs in exchange for one British pound 30 days from now. Today’s 30-day forward rate for the pound is therefore 1.8 Swiss francs, and the 30-day forward rate for the franc is £0.555 (1 ÷ ₣1.8). c. If the exchange rate for the domestic currency is higher in relation to a foreign currency in the forward market than in the spot market, the domestic currency is Prepared by: Vineet Singh MA in ECONOMICS trading at a forward premium in relation to the foreign currency. EXAMPLE The pound is currently trading at a forward premium in relation to the Swiss franc (₣1.8 > ₣1.6). The market believes that the pound is going to appreciate in relation to the Swiss franc. d. If the exchange rate for the domestic currency is lower in relation to a foreign currency in the forward market than in the spot market, the domestic currency is trading at a forward discount in relation to the foreign currency. EXAMPLE The Swiss franc is currently trading at a forward discount in relation to the pound (£0.555 < £0.625). The market believes that the Swiss franc is going to depreciate in relation to the pound. e. The implications of these relationships can be generalized as follows: If the domestic currency Then it is is trading at a forward expected to Premium Gain purchasing power Discount Lose purchasing power Prepared by: Vineet Singh MA in ECONOMICS