BALANCE OF PAYMENT AND EXCHANGESubmitted To: Prof. Shrikant Iyenger Submitted By: Piyush Gaur Krutarth Gandhi Nishidh Shah Pratyancha Suryavanshi Sonal Nagpal
Balance of Payments The BOP is a statistical record of the flow of all of the payments between the residents of a country and the rest of the world in a given year. Transactions are recorded on the basis of double entry bookkeeping – by definition it has to balance. - Every “source” must have a “use”. The two main components are: - Current Account - Capital/Financial Account
Importance of BOP The BOP is an important indicator of pressure on a country’s foreign exchange rate . The BOP helps to forecast a country’s market potential, especially in the short run. Changes in a country’s BOP may signal the imposition or removal of controls over payment of dividends and interest, license fees, royalty fees, or other cash disbursements to foreign firms or investors.
FOREIGN EXCHANGE TRANSACTIONS Current Account Capital Account FDI Portfolio Loan Trade Invisibles Tour (Govt/ Travel Pvt(ECB) Remittance Imports Gift Foreign IndianExports Profit/Div/int Source Source Fcy A/C (FII) (GDR/ADR) RI & NRI 4
Contents of BOPCurrent accountCapital accountFinancial accountNet errors and omissions accountReserves and related items
Current account (CA) This is record of a country’s trade in goods and services in the current period. CA = Exports (X) – Imports (M) It is divided into 4 sub-categories: Goods trade Services trade Income Current transfers The sum of the four sub-categories = CA balance
Current Account Convertibility In India, In Current Account can be converted into Foreign Currency (E.g. $) or Vice-versa. It is Freely permitted in India by Reserve Bank of India.
Capital account (KA) This includes all short- and long-term transactions pertaining to financial assets. KA = Capital Inflow (cr) – Capital outflow (dr) The two main components: Capital account. Financial account (direct, portfolio, other). KA balance = Sum of capital account and financial account.
Capital Account Convertibility In India, Partial Capital Account convertibility is there, i.e. up to $200,000 is allowed by Reserve bank of India. Up to $500 million the bank need not to take permission from RBI for Foreign Loan.
Net errors and omissionsaccount Missing data such as illegal transfers
Official Reserves Records the purchase or sale of official reserve assets by the central bank. These assets include Commercial paper, Treasury bills and bonds Foreign currency Money deposited with the IMF This account shows the change in foreign exchange reserves held by the central bank. Since the BOP must balance CA + KA + ∆RFX = 0 CA + KA = – ∆RFX For floating rate regime countries, such as the U.S., official reserves are relatively unimportant.
India’s Overall Balance Of Payment (April-Sept 2010 USD $ Million)Item Credit Debit NetA.CURRENT ACCOUNTI. MERCHANDISE 110,518 177,457 -66,939II.INVISIBLES 87,982 48,924 39,058Total Current Account (I+II) 198,500 226,381 -27,881B. CAPITAL ACCOUNT1. Foreign Investment 120,179 91,042 29,1372.Loans 50,110 34,394 15,7163. Banking Capital 33,735 32,901 8344. Rupee Debt Service - 17 -175. Other Capital 3,756 12,765 -9,009Total Capital Account (1to5) 207,780 171,119 36,661C. Errors & Omissions - 1,750 -1,750D. Overall Balance
BOP Trends and 1991 crisis Protectionist Policies The main objective of the Second Five Year Plan (1956-57 to 1960-61) was to attain self reliance through industrialization. Heavy capital goods were imported but other imports were severely restricted to shut off competition in order to promote domestic industries. The high degree of protection to Indian industries led to inefficiency and poor quality products due to lack of competition. The high cost of production further eroded our competitive strength. Rising petroleum products demand, the two oil shocks, harvest failure, all put severe strain on the economy. The BOP situation remained weak throughout the 1980s, till it reached the crisis situation in 1990-91.
External Debt India had to resort to large scale foreign borrowings for its developmental efforts in the field of basic social and industrial infrastructure. Government of India resorted to heavy foreign borrowings to correct the BOP situation in the short run out of panicky. By the Seventh Five Year Plan, the debt service obligations rose sharply because of harder average terms of external debt, involving commercial borrowing, repayments to the IMF and a fall in concessional aid flow.
Exchange rate The instability of the exchange value of the rupee was another problem. The constant devaluations (to promote exports) raised the amount of external debt India followed a strongly inward looking policy, laying stress on import substitution. Ideally, imports should be financed by export earnings. But because there was export pessimism, the deficit was financed either by the invisible earnings or by foreign aid or depletion of valuable foreign exchange reserve. Much import constraint to check trade deficit was also not possible because India’s imports were mainly ‘maintenance imports’. On one hand import reduction was not possible and on the other exports suffered due to the recession in the 1980s. india’s BOP was thus beset with several problems. The process of liberalization began from the mid 1980s. Restriction on certain imports were removed, particularly those which were used as inputs for export production. But by then the situation was already bad and all the mismanagement ultimately led to the 1990-91 BOP crisis.
Components of the tradeImports-bulk imports: petroleum, crude oil products, bulk consumption goods, other bulk items.-non bulk imports: capital goods, mainly export related itemsExports-agriculture and allied products, ores and minerals, manufactured goods, mineral fuels.
Specialization And Trade Absolute Advantage: Where one country can produce goods with fewer resources than others. Comparative Advantage: Where one country can produce the goods with low opportunity costs – It sacrifices its less resources in production.
India’s Foreign TradeMajor Export Destinations Country 2008-09 ($ bn) % share in Total 1 USA 19.7 12% 2 United Arab Emirates 17.8 11% 3 China 8.5 5% 4 Singapore 7.6 5% 5 Hong Kong 6.4 4% 6 United Kingdom 6.2 4% 7 Germany 5.9 4% 8 Netherlands 5.9 4% 9 Saudi Arabia 4.8 3% 10 Belgium 4.3 3% 23
India’s Foreign TradeMajor Import Commodities Commodity 2008-09 % share in Total ($ bn)1 Petroleum, Crude and products 93.1 32.36%2 Machinery, Electrical and non-electrical 24.3 8.44%3 Electronic goods 21.5 7.48%4 Gold and silver 19.5 6.76%5 Fertilizer, crude and manufactured 13.6 4.72%6 Pearls, precious and semi-precious 12.8 4.44%7 Organic and inorganic chemicals 12.8 4.43%8 Coal, coke and briquettes 10.5 3.64%9 Iron & Steel 9.5 3.30%10 Metaliferrous ores and metal scrap 8.3 2.89% 24
How to correct the Balance ofPayment ? Monetary Measures for Correcting the BoP1. Deflation2. Exchange Depreciation3. Devaluation4. Exchange Control Non-Monetary Measures for Correcting the BoP1. Tariffs2. Quotas3. Export Promotion4. Import Substitution
BOP & MacroeconomicVariablesA nation’s balance of payments interacts with nearly all of its key macroeconomic variables.Interacts means that the BOP affects and is affected by such key macroeconomic factors as: Gross Domestic Product (GDP) Exchange rate Interest rates Inflation rates
FOREIGN EXCHANGEMethod by which rights to wealth expressed in terms of currency of one country are converted into rights to wealth in terms of currency of another country are known as Foreign Exchange. Prices of foreign currencies expressed in terms of other currencies is called Foreign Exchange Rate. Determinants of Exchange Rates: Exchange rates are determined by the demand for and the supply of currencies on the foreign exchange market
Exchange RatesThe demand and supply of currencies is in turn determined by: Relative interest rates The demand for imports The demand for exports Investment opportunities Speculative sentiments Global trading patterns Changes in relative inflation rates
Foreign Exchange Includes A Currency Note Bills of ExchangeBank balance in Foreign Currency Travellers Cheque
FOREIGN EXCHANGEMARKETSPeculiaritiesLargest financial market in the world.No single location, No barriers.Open 24 hours a day.Indian market timings are 9.00 am to 5.00 pmAn over the counter market (OTC).Exchange rate fluctuate almost every 2/3 seconds.Controls/policies of respective countries.Effect of other markets-Money,capital,debt.
Like any other commodity,foreign exchange also has followmarket set up WHOLESALE MARKET OR INTER BANK MARKET RETAIL MARKET
Sources of Foreign Exchanges Export Receipts (Diamond, Pharmacy, Cotton, etc) Inward Remittances(Money sent by NRI through bank to India) Borrowings (Company borrow from Foreign banks)
Players in Foreign Exchange MarketReserve Bank of Indi Exchange brokers Authorized Money ChangersAuthorized Dealers FEDAI
Money Changers in India Restricted Money Changers Can only Buy Foreign Currency e.g. Hotels Full Fledged Money Changers Can buy & sell Foreign currency e.g. Thomas Cook
Indirect quotations INR 1 = USD 0.02225 INR 1 = GBP 0.01419- Home currency fixed. - Foreign currency variable .(Indirect quotations were being used in India till July 1993)
Direct quotations USD 1 = INR 45.58 GBP 1 = INR 73.70 - Foreign currency fixed - Home currency variable (Used in India from August 1993)
Inflation And Foreign Exchange High Inflation in India (5% Average Inflation in India, more than 8% now) Whereas In developed countries Inflation is below 1% Due to High Inflation Interest rate are higher in India Foreign Currency is Appreciating & Indian Currency is Depreciating
Fixed Exchange Rate In a fixed exchange rate system – foreign central banks buy and sell their currencies at a fixed price in terms of the domestic currency Prior to 1973, most countries had fixed exchange rates against each other However, if the country persistently runs deficits in the BOP, the central bank eventually runs out of foreign currencies, and will not be able to carry out the interventions In such a situation, the central bank will have to ultimately devalue its currency
Fixed Exchange Rate E EExchange rate E E E2 E E1 Quantity of dollars 43
Pros and Cons of Fixed Exchange Rate Argument in favor of fixed exchange rate Certainty Less inflationary Promotes money and capital markets Helps in the smooth working of the international monetary system Prevents monetary shocks Argument against fixed exchange rate Heavy burden on exchange reserve Country must have sufficient reserve Fails to solve the balance of payment disequilibrium Does not prevent real shock It is not a long term solution if the underlying economy is weak
Flexible Exchange Rate In a flexible exchange rate system, the central bank allows the exchange rate to adjust to equate the supply and demand for foreign currency. In effect since 1973 Clean floating – the central bank stands aside completely and allows the exchange rate to be freely determined in the forex market – official reserve transactions are zero Managed float - the central bank intervenes to buy or sell foreign currencies periodically in an attempt to influence the exchange rates
Flexible Exchange RateExchange rate S $2 E2 E1 $1 $” E $’ $ D2 D1 D Quantity of dollars 46
Pros and Cons of Flexible Exchange Rate Argument in favor of flexible exchange rate Simple operation, smoother, more fluid adjustment Brings realism in forex transactions Disequilibrium in balance of payment autostabilized No need for forex reserve to manage exchange rate Prevents real shocks Reinforces the effectiveness of monetary policy expansionary contractionary Argument against flexible exchange rate Exchange rate risk –futures market Adverse effect of speculation Encourages inflation Far from perfect system, but no better system exists
Bretton Woods IThe original Bretton Woods system was the system of fixed exchange rates that existed from the end of World War II (1946), until its collapse in 1971. John Maynard Keynes was a principle architect of the Bretton Woods System. Global financial system would have fixed exchange rates in order to prevent the beggar-thy-neighbor policies of currency devaluations that characterized the 1930’s. The dollar could be converted to any other major 48
Role of IBRD & IMFIBRD: International Bank For Reconstruction And Development Give loans to countries for reconstruction of Infrastructure.IMF: International Monetary Fund To monitor Exchange rate stability Advice country to follow Fixed exchange rate system Give loans to countries to overcome BOP problems
End of BrettonWoods IBy the early 1970s, as the Vietnam War accelerated inflation, the United States was running not just a balance of payments deficit but also a trade deficit. The crucial turning point was 1970, which saw U.S. gold coverage deteriorate from 55% to 22%.In the first six months of 1971, assets for $22 billion fled the United States. In response, on August 15, 1971, President Nixon unilaterally “closed the gold window.” 50
Bretton Woods II“Bretton Woods II” is a term coined by three Deutsche Bank economists — Michael Dooley, Peter Garber, and David Folkers-Landau — in a series of papers in 2003–2004 to describe the current international monetary system:In this system, the United States and the Asian economies have entered into an implicit contract where the U.S. runs current account deficits and the Asian countries keep their currencies fixed and undervalued by buying U.S. government debt. 51
Bretton Woods IIAccording to Dooley, Folkert-Landau, and Garber (DFG), this system has benefits to both parties: The U.S. obtains a stable and low-cost source of funding for its current account and budget deficits, and can easily reduce taxes, and increase government spending at the same time. For the Asian countries, the undervalued currency creates export-led development strategy that produces economic and employment growth to keep the lid on potentially explosive pressures rising large pools of surplus labor. 52
US-China Currency Issue China have trade surplus with USA & World. Chinese central bank maintained currency exchange fixed ($ = 8.28 Yuan) YEAR China Forex China Trade Reserve (in $) Surplus (in $) 2006 1.06 Trillion 178 Billion 2007 1.5 Trillion 268 Billion 2008 1.9 Trillion 297 Billion 2009 2.39 Trillion 198 Billion 2010 2.64 Trillion 184.7 Billion
US-China Currency IssueChina Modified its Currency Policy on July 21, 2005.Yuan’s Exchange rate become adjustable with respect to Market Demand & Supply of currency in Basket.Basket includes Dollar, Euro, & Yen etc.So $ = 8.11 Yuan (2.1% appreciation)Also Yuan can fluctuate by 0.3% on daily basis against basket.
US-China Currency IssueChina’s Currency is Undervalued by 40%.Resulted in: Chinese export to US Cheaper & US export to China ExpensiveAlso rise in Trade Deficit from $ 30bn in 1994 to $ 260bn in 2007.
1988 Omnibus Trade &Competitiveness Act.Act requires the Treasury Department to report on exchange rate policies of Countries which have large Global Current Account Surplus & Trade Surplus with US.The aim was to find out, if they manipulate their currencies against dollar.And if manipulation found than Treasury is required to negotiate & end such practices.
China reformed its currency in July 2005 andTreasury made following observation aboutChina:Current Account Surplus has reduced by Chinese Government.2006 – China made progress to make currency more flexible.2007 – Under US law China has no currency manipulation.2007 – China should accelerate the appreciation of RMB’s effective exchange rate in order to minimize risk.
China Foreign Currency reserve China has highest foreign currency reserve because of: High amount of Export & Hot money arrival i.e. foreign funds bought into the country. To tackle this the value of RMB should increase. In 2008 Foreign Exchange Regulations approach RMB exchange rate against other fully convertible currencies using floating system, based on Demand & Supply of Foreign Currency.
Reasons China should let RMB appreciate, in its own interest1. Overheating of economy2. Reserves are excessive. It gets harder to sterilize the inflow over time.1. Attaining internal and external balance. In a large country like China, expenditure-switching policy should be the exchange rate.1. Avoiding future crashes. 61
Policies to reduce the US CA deficitReduce the US budget deficit over time, thus raising national saving. After all, this is where the deficits originated.Depreciate the $ more. Better to do it in a controlled way than in a sudden free-fall. The $ already depreciated a lot against the € & other currencies from 2002 to 2007. Who is left? The RMB is conspicuous as the one major currency 62
Problems with BW2: People’Bank of ChinaU.S. absorbs 80 percent of world’s savings not invested at their home country.The large CAD sends billions of dollars abroad, particularly to China.People’s Bank of China uses the inflow of dollars to purchase assets, mostly U.S. Treasuries.Much of the $400 billion fiscal deficit is financed by China.If China stops purchasing U.S. assets and switches to Japan, Europe, or other markets, it will cause a fall in the dollar and long-term interest rates will increase. 63
ConclusionsIn any case, the new Chinese Exchange Rate Mechanism is a step to the right direction.The United States, in contrast, has not done anything.President Bush has not vetoed a single spending bill. The government spending has increased faster than at any time since the 1960’s (“the Great Society” welfare programs and Vietnam War).The massive tax cuts passed in 2001–2003 are set to expire in 2008–2010. 64
What the China should do?If China intends to allow a series of small appreciations in the renminbi then it either has to 1. Keep its interest rates below U.S. rates, so that low interest rates offset the expected return from renminbi appreciation over time (currently bank deposit rates in China are capped at 2.5%, below the 3.5% federal funds rate). 2. Intervene a lot. 3. Or do both.Either way, this policy prevents independent Chinese monetary policy. 65
What the U.S. Should Do?Since these are temporary tax cuts and the likelihood they waill be made permanent is low, basic economic theory tells us that their positive incentive effects are small.Since the President and the Congress are unable to control spending, the simplest way for the U.S. to reduce its fiscal deficit (and, indirectly, current account deficit) would be to repeal the 2001–2003 tax cuts. 66
ReferencesRBI’s Master circular on risk management. ( www.rbi.org.in)FEDAI Ruleswww.tradingeconomics.comwww.chinability.com/Reserves.htmInternational Economics - H G Mannur