17_BALANCE OF PAYMENT & FOREIGN EXCHANGE

 

 

 

 

 

ECONOMICS (CLASS-XII)

 

Chapter-17

BALANCE OF PAYMENT & FOREIGN EXCHANGE

 

Balance of Payment

Balance of payment: Balance of payment account is defined as a systematic record of a all the transaction that takes place between residents of a country and residents of other country over a given time period.

Transaction are either credited or debited. Transactions that bring foreign exchange are credited i.e. exports are credited in the balance of payment account. Transactions that cause an outflow of foreign exchange from the country are debited i.e. imports are always debited.

The balance of payment account will always balance.

STRUCTURE OFBALANCE OF  PAYMENT  ACCOUNT

(1)        Current account relates to all the activities that do not alter assets and liabilities of a country. It is the record of all the transactions for goods and services and unilateral transfers.

Following are the items of current account.

(a)        Balance of trade account or visible items : Balance of trade account reflects the export and import of goods such as paper, cloth, oranges, etc. It is also called balance of visible account as goods are visible and can be seen and touched. If exports are greater than imports, there will be surplus on the balance of trade account and if exports are less than imports, there will be deficit on the balance of payment account.

(b)        Balance of invisible accounts : Balance of invisible account records the transactions of exports and imports of services such as banking, insurance airlines, etc. It also records property and enterprenurenal income (Rent and Profit). If exports are greater than imports, there will be surplus on the balance of invisible account, if exports are less than imports, it will lead to deficit.

(c)        Unilateral transfer : Unilateral transfers are such payments and receipts for which there is no underlying goods and services that are provided. Such transfers can be either private or govt. e.g. gifts, scholarship, grants and aid.

(2)        Capital Account :It records the international transactions which affects the assets and liabilities of the domestic country with the rest of the world.

Following are the items :

(a)        Private transactions : These includes transactions that affects assets and liabilities of individual, business and non-profit organization e.g. sale and purchase of property, borrowing money from foreign lending agencies, repayment of foreign loans.

(b)        Official transactions: These includes the transactions undertaken by the govt, with the rest of the world, e.g. borrowing from foreign govt., world bank, foreign commercial bank.

(c)        Foreign direct investment : It includes investment made by multinational companies. These investment leads to ownership of domestic assets by MNC’s.

(d)        Portfolio investment:Portfolio investment refers to the acquisition of domestic assets by foreigners but without having control and influence over the management assets. It is short term in nature.

 

Current A/C	Capital A/C
It records economic transactions which records exchanges of goods and services. The transactions are of flow nature. These transactions brings changes in current level of country’s national income.	It records capital transactions. The transactions are of stocks nature. These transactions bring changes in assets and liabilities of a country.

 

DISEQUUBRIUM IN BALANCE OF PAYMENT

When the inflows are not equal to the outflows of foreign exchange in accountingentries of BOP account. It gives rise to the disequilibrium in the Bop account. This disequilibrium could be either deficit or surplus. Disequilibrium in the balance of payment of a country appear when autonomous receipts are not equal to autonomous payment. If receipt exceeds payment, there will be surplus otherwise deficit is unfavourable or adverse.

 

Following are the causes :

 

(A)       ECONOMIC FACTORS

1. Cyclic Fluctuations : Cyclic fluctuation in the business activity also lead to BOP disequilibrium . when there is a depression in a country, volume of both export and imports falls. But the fall in export may be greater than fall in import due to the decline in domestic production. Therefore there is adverse BOP situation.
2. Price Changes: If there is inflation in the country prices of the export increases. As a result, the export falls. At the same time, the demand for the imports increases. This result in adverse balance of payment.
3. Scope Of Economics Development : The country’s balance of payment also depends upon the stage of economic development. If a country is developing, it will have deficit in the balance of payment because it imports raw material, capital equipment, machinery and services associates with the development process and export primary products. The country has to pay more for the imports and receive less leading to disequilibrium.

 

4. Capital Movement: Borrowings and lending or movement of capital by countries also result in disequilibrium in BOP. A country which gives loans and grants in a large scale to other countries has deficit in BOP on the other hand developing countries borrowing large funds from other countries and international institution may have a favourable(surplus) BOP. Such borrowing helps on reducing BOP deficit.

 

(B) POLITICAL FACTORS :           

The political uncertainty and inflow of foreign exchange are inversely related to each other. The higher the level of uncertainty regarding economic policies, lower is the investor’s interest both in terms of foreign interest both in terms of foreign direct investment and portfolio investment. The level of BOP will be in deficit and vice versa.

(C) SOCIAL FACTORS :

Social factors include taste and preferences, fashion and trends. There social factors could also adversely affect the BOP situation in the domestic economy.

Balance of Trade	Balance of Payment
It records only the transactions relating to goods. It does not record transactions relating to capital nature. It is a part of current account of BOP. It may be favourable, unfavou­rable or in equilibrium.	It records the transactions relating to both goods and services. It records the transactions relating to capital. It includes both current and capital account. It always remains in balance in the sense that receipt side is always made to be equal to payment side.

 

MEASURES TO CORRECT DISEQUILIBRIUM IN BOP                        _

(1)        Export Promotion : Exports should be encouraged by granting various benefits to manufactures and exporters. At the sometime, imports should be discouraged by undertaking import such situations.

(2)        Reducing Inflation : Inflation discourages exports and encourages imports. Thereforegovt, should check inflation and lower the prices in the country.

(3)        Exchange Control :Govt, should control foreign exchange by ordering all the exporters to surrender the foreign exchange to the central bank.

(4)        Devaluation of Domestic Currency: It means fall in the external value of the domestic currency which makes the domestic goods cheaper for the foreigners. Devaluation is done by government order, when government has adopted fixed exchange rate system.  –

(5)        Depreciation : It also mean falls in the external value of domestic currency. It occurs in a free market system when demand for foreign exchange exceeds the supply in foreign exchange market.

AUTONOMOUS  ITEMS

Autonomous items refers to the international economic transaction that take place due to some economic motives as profit maximization.

These transactions are independent of the state of country’s balance of payment. These are called “above the line items of the country’s balance of payment”. An autonomous item (both current and capital account) gives rise to deficit or surplus in the balance of payment.

 

3          ACCOMODATING ITEMS

These are of the nature of official reserve transaction. These are earned out by the government or central bank in pursuit of some international economic policy objectives.

These are often called “below the line items in the balance of payment” like central bank may finance deficit by reducing

(1)        Reserves of foreign currencies.

(2)        By borrowing from IMF.

(3)        By borrowing from monetary authorities.

Central bank may use surplus to purchase:-

(1)        Foreign securities.

(2)        Foreign currencies

(3)        Gold

 

FOREIGN EXCHANGE RATE

 

Foreign Currency : Foreign currency is any currency other than the domestic currency of a country. It is like any commodity which is bought or sold in the market.

Foreign exchange market: Foreign exchange market is a place where buyers and sellers of foreign currency can interact with each other. It performs the following three functions:

(1)        It transfers the purchasing power between the countries, i.e. transfer function.

(2)        It provides credit channels for foreign trade, i.e. credit function.

(3)        It protects against foreign exchange risks.i.e. Hedging function.

 

FOREIGN EXCHANGE RATE

 

The rate at which one currency is exchange for another is called foreign exchange rate. It is the price of country’s currency in terms of another currency, eg =>1$ =>Rs 50.

Demand For Foreign Currency

The people who buy foreign currency constitutes the demand for foreign exchange. Payment in foreign exchange causes the demand for foreign exchange. The following are the sources of demand for foreign currency.

 

(1)        For making payments for the imports of goods and services i.e. imports.   E.g. purchase of plant      and machinery by domestic firms from United States.

(2)        For unilateral transfer such as sending gifts abroad.

(3)        For making investment and lending abroad by the domestic residents e.g. shares, debentures,            loans, etc.

(4)        To speculate on the value of foreign currencies i.e. buying and selling foreign currency with            intentions of making profits.

(5)        To make the payment of international trade.

 

Supply of Foreign Exchange :

The person who sells foreign currency constitutes supply of foreign exchange :

(1)        The domestic exporters of goods and services are the suppliers of the foreign exchange.

(2)        The foreigners who invest and lend in the home country.

(3)        Loans and other borrowing undertaken by the govt, and private companies in foreign currencies.

(4)        To speculate on the value of foreign currencies i.e. buying and selling foreign currencies with the intention of making profits.

(5)        For unilateral receipts such as receiving gifts from abroad.

(6)        When foreign tourist come to India.

 

Determination of Foreign Exchange  Rate

The foreign exchange rate is determined by the market forces of DD and SS.

In the fig, the x-axis represents the quantity of foreign exchange demanded and supplied and y-axis represents price per unit of foreign currency.

Q1 Quantity of foreign currency	Quantity of foreign exchange

 

The price at which demand for foreign exchange equals the supply determines the equilibrium exchange rate i.e. point E. The equilibrium occurs at the rate at which the quantity demanded equals quantity supplied of a currency. In the diagram, OP, is the exchange rate and OQ1 is the foreign exchange demanded and supplied.

 

DOWNWARD SLOPING DD CURVE

 

Exchange rate measures the effective cost of goods & services available abroad.Higherthe exchange rate, lower the demand for imported commodities &hence the demand for foreign currency is lower. Similarly lower the exchange rate higher the demand for imported commodities and hence the demand for foreign currency is higher. Thus there is an inverse relationship between foreign exchange rate and foreign exchange & hence demand curve is downward sloping. There are two reasons of rise in demand when exchange rate falls(inverse relationship), (l)when price of foreign currency falls imports from that country become cheaper (2). It promote tourism to that country.

Suppose,the price of US dollar in India falls from Rs. 50 to Rs. 40. It means that Indian people have to sacrifiesRs. 50 to buy one dollar worth of goods from USA .Now, they have to sacrifiesRs 40 to buy one dollar worth of goods from USA. It implies that American goods have become cheaper for the Indian people. Thus India is ready to buy more goods from USA. This raises the demand for US dollar.(Inverse relationship).

 

SUPPLY CURVE UPWARD SLOPING

The major component of the supply of foreign currency is the exports of a country’s goods & service. Higher the exchange rate i.e. l$=Rs. 48 to 1$= Rs. 50, higher will be the export or supply of foreign exchange. Thus the supply curve of foreign currency is upward sloping.

 

Suppose, the price of US $ in India falls from Rs 50 to Rs 40. It means earlier USA could buy Rs 50 worth of goods from India by giving one US dollar. Now it can buy only Rs 40 worth of goods. Indian goods become costlier for USA. Thus USA buy less of Indian goods. This reduces the supply of foreign exchange to India(direct relationship)

 

Depreciation of Domestic Currency

An increase in the price of a foreign currency in terms of domestic currency means that the domestic currency has depreciated:

i.e. 1$ = Rs. 48 to 1$ = Rs. 50

As the demand for the foreign currency-increased, DD Curve shifts towards right which leads to rise in exchange rate. In the fig, the equilibrium exchange rate is OP1 where demand for dollar equals its supply. Suppose, the Indian imports increases leading to increase in the demand for dollar which will cause the demand curve to shift to DID 1. This will increase the price of dollar to OP2 which is known as depreciation of domestic currency.

 

 

APPRECIATION OF DOMESTICCURRENCY

A decrease in the price of foreign currency in terms of domestic currency implies that domestic currency has appreciated.

i.e.       1$ = Rs. 48

1$ = Rs. 46

In the Fig. D and S are the initial demand and supply curve of foreign exchange. The equilibrium exchange rate is OP_l. Suppose, the demand for Indian Export Increases. This would result in increases in the supply of foreign currency leading to rightwardshift of the SS curve to SIS 1. Now exchange rate moves to OR₂ which is known as appreciation of domestic currency.

FIXED EXCHANGE RATE

 

Under this system, the govt, or monetary authority determines or specifies the rate at which the domestic currency will be exchanged with foreign currency. No changes are allowed in the foreign rate by market.

When the govt, reduces the exchange rate or increases the value of domestic currency, | it is called evaluation.

When the govt, increases, the exchange rate or reduces the value of domestic currency I it is called devaluation.

Merits

(1)        Promotes international trade : Fixed exchange rate removes the uncertainty of exchange rate movement in the future. People undertake international trade and investment with surety and certainty. The importers are certain about the j price, they have to pay. Similarly investor are certain about the rate of conversion I of domestic currency. This encourage foreign trade and investment.

(2)        No speculation : Since exchange rate do not fluctuate, people do not invest in the foreign exchange market to make gain from movements in exchange rate. Speculative activities are controlled and prevented by monetary authorities.

(3)        Economic stabilization : It ensures economic stabilization. Businessman would like to exploit windfall gain from the fluctuating exchange rate which leads to hoarding activities. It ensures that major economic disturbances do not occur among the member countries.

(4)        Less inflation : In this system, there is no scope for the imported goods becoming costlier or account of the rising exchange rate.

 

Demerits

1. Large Foreign Exchange Reserve : Government maintain the stock of gold, foreign currency which is called foreign exchange reserves . If there is too much of the shortage or excess of foreign currency, it may be difficult to maintain fixed exchange rate. In the times of shortage, government starts selling the foreign currency out of its reserves. In times of surplus, it starts buying which is an unnecessary burden on government.
2. Dependence On External Sources: This system., may lead to borrowing, ftom foreign government or financial institutions, which reduces the freedom of goal in policy making Lenders put the conditions which may not be in the interest of the economy.
3. No Automatic Adjustment Of BOP : Balance of payment is in an adverse situation when country is facing the problem in the payment of foreign exchange. This problem can automatically be solved in flexible exchange rate but not in this system. Government has to take borrowing from the foreign government or financial institution or withdraw from its reserves.

 

FLEXIBLE EXCHANGE RATE

 

Flexible exchange rate is a system where the value of one currency in terms of another is free to fluctuate and establish the equilibrium level through the forces of demand and supply. These are also known as “floating exchange rate”.

Merits

1. No Need To Maintain Reserves: There is automatic adjustment in the balance of payment under this system, so there is no need to maintain the reserve. If there is any shortage of foreign currency , it is maintained through the force of demand and supply. Thus , it reduce the responsibility of government.
2. Automatic Adjustment In BOP: When a country is not able to make the foreign payment this raises the demand for foreign currencies which in turn leads to arise in foreign exchange rate. This makes export cheaper and imports dearer. As a result inflow of foreign exchange rises and outflow falls and BOP problem is solved .
3. NO Dependence On External Source: Since, BOP problem of foreign payment can be solved through the automatic adjustment in flexible exchange rate, thus, it reduces, the dependence of government on external sources.

Demerits

1. Unstable Conditions : This system leads to unstable conditions among the businessman and investor. There is a time gap between taking a business decisions and executing it. During this gap, the foreign exchange rate, may fall and upset the profit calculation of exporters. This affects foreign trade and investment.
2. Increases Speculation: Speculation means buying and selling, the foreign exchange with the motive of making profits. This destabalises the foreign exchange market.
3. Inflation :When the exchange rate rises very fast the demand for imports falls as it becomes costly. This also leads to rise in the prices of domestically produced goods this leads to inflation.

 

	Fixed	Flexible
(1)   (2)     (3)	It is officially determined by the govt. and remains fixed In this system, central banks is ready to purchases and sale their currencies at fixed price A very small variation from the fixed value is possible	It is determined by the forces of demand and supply In this system, central bank does not interfere with the foreign exchange rate.   There are changes in the exchanges rate all the time

 

Managed Floating Exchange Rate

It is a system, in which foreign exchange rate is determined by market forces and central bank influence the exchange rate through intervention in the foreign exchange market.

Central bank interferes to restrict the fluctuations in the exchange rate within limits.

For this central bank maintains the reserve of foreign exchange to ensure that the exchange rate stays within the targeted value. It is also known as “Dirty floating”.