Balance Of Payments & Theories Of Exchagne Rate - Unit 3.docx

BALANCE OF PAYMENTS INTRODUCTION In the realm of international finance, one of the most heavily used data sources is an accounting statement known as the balance of payment, which records the economic transactions between residents and government of a particular country and the residents and government of the rest of the world during a given period of time, usually a year. For governments, the BOP provides valuable information for the conduct of economic and fiscal policy. For firms and individuals, it provides clues about expectations for such matters as volume of trade and capital flows, the movement of exchange rate and profitable course of economic policy. A country’s balance of payments affects the value of its currency, its ability to obtain currencies of other countries and its policy towards foreign investment. MEANING of BALANCE OF PAYMENTS The Balance of Payments (BOP) is an accounting system that records the economic transactions between residents and government of a particular country and the residents and government of the rest of the world during a given period of time, usually a year. ECONOMIC TRANSACTIONS include exports and imports of goods and services, lending and borrowing of funds (capital transfers), remittances (gifts), government aids, and military expenditures. RESIDENTS include individuals, business enterprises, including financial institutions that are permanently residing within a country’s borders, as well as all government agencies. BALANCE OF PAYMENTS ACCOUNTING The balance of payment statement is based on the principle of double entry bookkeeping, every credit in the account is balanced by matching debit and vice versa. A BOP statement is kept in the form of sources (credits) and uses (debits) of funds. This record enables us to know whether the country has/had a net surplus or deficit during the referred period. If a country receives more funds from abroad then it spends, it has a surplus of BOP. If expenditures abroad by residents exceed what the residents earn or receive from abroad, the country has a deficit of BOP.

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The major sources of funds for a country accrue from: 

Export of goods and services;



Sale of existing foreign financial assets;



Foreign loans/borrowings.

Likewise, the major uses are: 

Imports of goods and services;



Purchase of foreign financial assets;



Foreign lending.

Typical BOP Statement A. Current Account a. Goods Account Exports (+) Imports (-) Balance on goods account = A (1) b. Services Account Receipts as interest and dividends, tourism receipts for travel and financial charges (+) Payments as interest and dividends, tourism receipts for travel and financial charges (-) Balance on services account = A (2) c. Unilateral transfers Gifts, donations, subsidies received from foreigners (+) Gifts, donations, subsidies made to foreigners (-) Balance on unilateral transfers = A (3) Current Account Balance = A (1) +A (2) +A (3) = A B. Capital Account 2

a. Foreign Direct Investment Direct investments by foreigners (+) Direct Investment abroad (-) Balance on FDI = B (1) b. Portfolio Investment Foreigners investments in securities of the country (+) Investments in securities abroad (-) Balance on Portfolio Investment = B (2) c. Private Short term Capital Account Foreigners claim on the country (+) Short term claim on foreigners (-) Balance on short term capital a/c= B (3) Capital Account Balance = B (1) +B (2) +B (3) = B Overall Balance = A + B

THE BALANCE OF PAYMENT STATEMENTS A BOP statement is divided into several intermediate accounts. The three major segments are: (i) Current Account, (ii) Capital Account, and (iii) Official reserves Account. The data needed to prepare different accounts are collected from various sources. For instance, the data on imports and exports are gathered from customs authorities whereas the financing of these transactions appears largely among the data on changes in foreign assets and liabilities reported by financial institutions. 1. Current Account: It is a record of the trade in goods and services and unilateral transfers among countries. Entries in this account are ‘current’ in value as they do not give rise to future claims. a. The trade in goods is composed of exports (selling merchandize to foreigners) and imports (buying merchandize from abroad). Exports are a source of funds and result in a decrease in 3

real assets. On the other hand, imports are a use of funds and result in an acquisition of real assets. b. The trade in services (also called invisibles) includes interest, dividends, tourism/travel expenses and financial charges, etc., Interest and dividends measure the services that the country’s capital renders abroad. Payments coming from tourists measure the services that the country’s shops and hotels provide to foreigners who visit the country. Financial, insurance and shipping charges measure the services that the country’s financial and shipping sectors render to foreigners. Receipts obtained by servicing foreigners on these counts constitute source of funds. On the other hand, when the country’s residents receive the services from foreign owned assets, utilization of funds, takes place. c. Unilateral transfers consist of remittances by migrants to their friends and family, and gifts, donations and subsidies received from abroad. Remittances so received are obviously sources; remittances made in forms of gifts/donations, etc., by immigrants cause utilization of funds. 2. Capital Accounts: It is divided into foreign direct investment (FDI), portfolio investment and private short term capital flows. a. Direct Investment occurs when the investor acquires equity, acquisition of firms or establishment of new subsidiaries. Firms undertake FDI when expected returns from foreign investment exceed cost of capital. b. Portfolio investments represent sales and purchases of foreign financial assets such as stocks and bonds. A desire for higher expected returns is what makes them invest in other country markets. FDIs are for relatively longer period of time and portfolio investments have a maturity of more than one year when they are made. The short term capital flows mature in a period of less than one year. c. Short term capital flows represent claims with a maturity of less than one year. Such claims include bank deposits, short-term loans, securities, money market investments, etc. These 3. Official Reserves Account As regards to Official Reserves Account, the monetary authority of a country, using the central bank, owns international reserves. These reserves are composed of gold, convertible currencies like dollar, euro, yen, SDRs (Special Drawing rights), etc., since BOP is expressed in national currency; an increase in any of these assets means a use of funds while their decrease implies a source of funds.

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If overall balance (current plus capital) is in deficit, this implies either a reduction in reserves or an increase in foreign debt or reduction of credit. It is important to note that, by convention, a deficit is shown by a + sign. In other words, it appears on the sources side. As a result, sum of all sources and uses becomes equal. The reverse is true when overall balance (i.e. the sum of current and capital account) is in surplus.

Disequilibrium in Balance of Payment Though the credit and debit are written balanced in the balance of payment account, it may not remain balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an imbalance in the balance of payment account. Such an imbalance is called the disequilibrium. Disequilibrium may take place either in the form of deficit or in the form of surplus. 



Disequilibrium of Deficit arises when our receipts from the foreigners fall below our payment to foreigners. It arises when the effective demand for foreign exchange of the country exceeds its supply at a given rate of exchange. This is called an 'unfavourable balance'. Disequilibrium of Surplus arises when the receipts of the country exceed its payments. Such a situation arises when the effective demand for foreign exchange is less than its supply. Such a surplus disequilibrium is termed as 'favourable balance'.

Causes of Disequilibrium in Balance of Payment 1. Population Growth Most countries experience an increase in the population and in some like India and China the population is not only large but increases at a faster rate. To meet their needs, imports become essential and the quantity of imports may increase as population increases. 2. Development Programmes Developing countries which have embarked upon planned development programmes require to import capital goods, some raw materials which are not available at home and highly skilled and specialized manpower. Since development is a continuous process, imports of these items continue for the long time landing these countries in a balance of payment deficit. 3. Demonstration Effect When the people in the less developed countries imitate the consumption pattern of the people in the developed countries, their import will increase. Their export may remain constant or decline causing disequilibrium in the balance of payments. 4. Natural Factors

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Natural calamities such as the failure of rains or the coming floods may easily cause disequilibrium in the balance of payments by adversely affecting agriculture and industrial production in the country. The exports may decline while the imports may go up causing a discrepancy in the country's balance of payments. 5. Cyclical Fluctuations Business fluctuations introduced by the operations of the trade cycles may also cause disequilibrium in the country's balance of payments. For example, if there occurs a business recession in foreign countries, it may easily cause a fall in the exports and exchange earning of the country concerned, resulting in a disequilibrium in the balance of payments.

6. Inflation An increase in income and price level owing to rapid economic development in developing countries, will increase imports and reduce exports causing a deficit in balance of payments.

7. Poor Marketing Strategies The superior marketing of the developed countries have increased their surplus. The poor marketing facilities of the developing countries have pushed them into huge deficits.

8. Globalisation Due to globalisation there has been more liberal and open atmosphere for international movement of goods, services and capital. Competition has been increased due to the globalisation of international economic relations. The emerging new global economic order has brought in certain problems for some countries which have resulted in the balance of payments disequilibrium.

Measures of Correcting Disequilibrium (i) Export promotion: Exports should be encouraged by granting various bounties to manufacturers and exporters. At the same time, imports should be discouraged by undertaking import substitution and imposing reasonable tariffs. (ii) Import: Restrictions and Import Substitution are other measures of correcting disequilibrium. 6

(iii) Reducing inflation: Inflation (continuous rise in prices) discourages exports and encourages imports. Therefore, government should check inflation and lower the prices in the country. (v) Devaluation of domestic currency: It means fall in the external (exchange) value of domestic currency in terms of a unit of foreign exchange which makes domestic goods cheaper for the foreigners. Devaluation is done by a government order when a country has adopted a fixed exchange rate system. Care should be taken that devaluation should not cause rise in internal price level. (vi) Depreciation: Like devaluation, depreciation leads to fall in external purchasing power of home currency. Depreciation occurs in a free market system wherein demand for foreign exchange far exceeds the supply of foreign exchange in foreign exchange market of a country (Mind, devaluation is done in fixed exchange rate system.)

Solved Exercises

A.

Current Account

Goods Account (A1) Export of souvenirs Sale of part of the production in Asian countries Import of Machinery b. Services Account (A2) Hotel and Travel bills (export of services) Dividends paid

a.

c.

Unilateral transfers (A3)

B.

Capital Account

3,000 (+) 1,00,000 (+) 1,00,000 (-) 5,000 (+) 5,000(-)

Nil

Current Account Balance = A(1) +A(2) +A(3) = 3,000 (+)

Foreign Direct Investment (B1) Modernization of Indian Subsidiary b. Portfolio Investment (B2) Increase in claim on India c. Private Short term Capital Account (B3) Borrowings from German Money Market

a.

3,00,000(+) 40,000(+) 2,00,000(+)

Capital Account Balance = B(1) +B(2) +B(3) = 5,40,000 (+) Overall Balance = Capital A/C + Current A/C = 5,43,000 (+)

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INTERNATIONAL EXCHANGE RATE THEORIES Exchange Rate is the number of units of a given currency that can be purchased for one unit of another currency. E.g. $1 = €4 read as 4 units of Euros can be purchased for 1 unit of Dollar. Exchange rates are influenced by supply and demand of one currency for another. It is the reflection / mirror of the economic well being of a country. NRI investments and business depends on it. When exchange rates move in wrong direction, profitable transactions can turn unprofitable for the business and economy. It is therefore important to predict the future exchange rate to protect from potential unfavorable future developments. The subject of exchange rate movement is an important issue in global finance and managers of MNCs, international investors, importers, exporters and government officials attach much importance to it. Still, the determination of exchange rates remains something of a mystery. Forecasters with the most impressive records often go wrong in their calculations by substantial margins.  Are changes in exchange rates predictable?  How does interest rate related to exchange rate?  What is the proper exchange rate in theory? To answer fundamental questions like these, it is essential to understand the different theories of exchange rate determination. The two theories of exchange rate determination are: 1. Purchasing Power Parity (PPP) Theory 2. Interest Rate Parity (IRP) Theory Purchasing Power Parity Theory A Swedish economist, Gustav Cassel, stated in 1938 that purchasing power of a currency is determined by the amount of goods and services that can be purchased with one unit of that currency. If there are two currencies, it would be 8

fair to say that the exchange rate between these two currencies would be such that it reflects their respective purchasing power. This principle is referred to as Purchasing Power Parity (PPP). If the current exchange rate is such that it does not reflect purchasing power parity, it is a situation of disequilibrium. It is expected that, eventually, the exchange rate between the two currencies will move in such a manner as to reflect purchasing power parity. Let us consider an example. Suppose at the period zero a basket of goods and services is costing £100 in the UK and $ 180 in US. There is no restriction of buying this basket of goods and services either from the UK or from the US. Then, it would be correct to conclude that the two amounts paid in respective currencies are equivalent. In other words, £100 = $180

or

£1 = $1.80

or, we can simply say that the exchange rate at the time zero is $1.80/£. If we use the symbol S0 to designate this exchange rate, then we write: S0 = $1.80/£ Calculation of Prices It should be noted that, often, inflation rates are calculated by using price indices rather than taking prices of individual goods and services. Generally, all countries have developed some price index series which are readily available from economic databases and can be used to calculate inflation rates. Deviations from Purchasing Power Parity Though this relationship has a sound theoretical base, in practice, it does not always give satisfactory results. In other words, there are differences between the rate predicted by the PPP and the actual future rate obtained in the market. Several factors could be responsible for the deviation 1. Different Basket Used for Calculating Inflation Rates: One factor could be inflation rates themselves that are used for calculating future exchange rates. Each country has its own standard basket with certain weights of goods and 9

services to make its price index. These standard baskets are not identical across countries and are not constituted by the items actually traded across borders. So if the price indices included only the items traded between countries, the exchange rate predictions might improve. 2. Capital Account Ignored: Another reason for deviation is that the PPP takes into account only movement of goods and services. It does not factor in the capital flows. In other words, it is concerned with only the current account part of the BOP, leaving out the capital account part totally. 3. Government Intervention: Still, another reason causing deviation may have to do with the government intervention in the exchange market directly or through trade restrictions, etc., The latter is becoming less and less significant in view of the constant endeavor through the bodies like WTO to liberalize the movement of goods and services across borders. 4. Speculative Activity: Speculative activity in the exchange market also affects the exchange rates since buying/selling of currencies has no underlying commercial transaction in the real economy. It has been seen that, despite its limitations the PPP has good predictive power over relatively longer periods and in conditions of higher inflation rates. Interest Rate Parity Theory It was made popular in 1920s by economists such as John M. Keynes. The theory underlying this relationship says that premium or discount of one currency against another should reflect interest rate differential between the two countries. In perfect market conditions, where there are no restrictions on the flow of money and there are no transaction costs, it should be possible to gain the same real value of one’s monetary assets irrespective of the country (or currency) in which they are invested.

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For example, an investor has one unit of pound sterling. He can invest it in the UK money market and earn an interest of i£ on it. The resulting value after one year will be: £1(1 + i£) The equilibrium condition demands that these two sums be equal. If the two sums were not equal, then the investor would invest in that currency where the end value of their monetary assets is going to be more. But once this action is generalized by the similar expectations of all investors, equilibrium is going to be established. Two major reasons why IRP does not hold fully in practice are: (i) Capital controls and, (ii) Transaction costs The governments the world over impose capital controls in varying degrees. To bring certain desired outcomes at macroeconomic level, governments restrict capital flows. At times, these transactions are only for outbound flows but they can be for both inbound as well as outbound flows. These restrictions on capital flows do not permit the arbitrage activity and thereby prevent equilibrium from being established. The other important reason for deviations from IRP is the existence of transaction costs. The interest rate at which an arbitrageur borrows is generally higher than the rate at which he can lend his money. Similarly, there is a spread in the exchange rates, meaning thereby, that there exists a difference between bid and ask rate. The arbitrageur buys foreign exchange at the higher rate and sells it at the lower rate. Besides the above two reasons, deviations from IRP can be also due to market structure and ease/difficulty of placement in a particular market. Speculation is an equally important factor. This becomes very significant during the crisis of confidence in the future of a currency. In such a situation, premium or discount on a currency becomes much larger than what the IRP can explain.

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