The document provides an in-depth analysis of the balance of payments (BoP), its components, and its significance in economic forecasting and foreign exchange management. It covers the current and capital accounts, their convertibility in India, and historical context surrounding India’s BoP challenges leading up to the 1990-91 crisis. Additionally, the document explores exchange rate systems, foreign exchange market dynamics, and key measures for correcting BoP imbalances.

1. BALANCE OF PAYMENT AND
EXCHANGE
Submitted To: Prof. Shrikant Iyenger
Submitted By:
Piyush Gaur
Krutarth Gandhi
Nishidh Shah
Pratyancha Suryavanshi
Sonal Nagpal

2. 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

3. 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.

4. FOREIGN EXCHANGE
TRANSACTIONS
Current Account Capital Account
FDI Portfolio Loan
Trade Invisibles
Tour (Govt/
Travel Pvt(ECB)
Remittance
Imports Gift Foreign Indian
Exports Profit/Div/int Source Source
Fcy A/C
(FII) (GDR/ADR) RI & NRI
4

5. Contents of BOP
Current account
Capital account
Financial account
Net errors and omissions account
Reserves and related items

6. 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

7. Current Account Deficit ( % of
GDP)

8. 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.

9. 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.

10. 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.

11. Capital Account Balance
(in US $ Bn)

12. Financial account
 Net foreign direct investment
 Net portfolio investment
 Other financial items

13. Net Foreign Investment in India
(in US $ Bn)

14. Net errors and omissions
account
 Missing data such as illegal
transfers

15. 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.

16. India’s Foreign Currency
Reserve (in $ Bn)

17. India’s Overall Balance Of Payment (April-Sept
2010 USD $ Million)
Item Credit Debit Net
A.CURRENT ACCOUNT
I. MERCHANDISE 110,518 177,457 -66,939
II.INVISIBLES 87,982 48,924 39,058
Total Current Account (I+II) 198,500 226,381 -27,881
B. CAPITAL ACCOUNT
1. Foreign Investment 120,179 91,042 29,137
2.Loans 50,110 34,394 15,716
3. Banking Capital 33,735 32,901 834
4. Rupee Debt Service - 17 -17
5. Other Capital 3,756 12,765 -9,009
Total Capital Account (1to5)
207,780 171,119 36,661
C. Errors & Omissions
- 1,750 -1,750
D. Overall Balance

18. 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.

19. 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.

20. 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.

21. Components of the trade
Imports
-bulk imports: petroleum, crude oil products, bulk
consumption goods, other bulk items.
-non bulk imports: capital goods, mainly export related
items
Exports
-agriculture and allied products, ores and minerals,
manufactured goods, mineral fuels.

22. 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.

23. India’s Foreign Trade
Major 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

24. India’s Foreign Trade
Major 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

25. Export, Import & Trade Deficit
(in $ Bn)

26. Invisibles Inflow & Outflow in
India

27. Invisibles (in $ Bn)

28. How to correct the Balance of
Payment ?
 Monetary Measures for Correcting the BoP
1. Deflation
2. Exchange Depreciation
3. Devaluation
4. Exchange Control
 Non-Monetary Measures for Correcting the BoP
1. Tariffs
2. Quotas
3. Export Promotion
4. Import Substitution

29. BOP & Macroeconomic
Variables
A 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

30. FOREIGN EXCHANGE
Method 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

31. Exchange Rates
The 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

32. Foreign Exchange Includes
A Currency Note Bills of Exchange
Bank balance in Foreign Currency Travellers Cheque

33. FOREIGN EXCHANGE
MARKETS
Peculiarities
Largest 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 pm
An 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.

34. Like any other commodity,
foreign exchange also has follow
market set up
WHOLESALE MARKET
OR
INTER BANK MARKET
RETAIL MARKET

35. 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)

36. Application of Foreign
Exchanges
 Import Payments
(Gold, Crude Oil, Electronic
Goods)
 Outward Remittances
(People send money Abroad)
 Loan Repayments

37. Players in Foreign Exchange
Market
Reserve Bank of Indi Exchange brokers
Authorized Money Changers
Authorized Dealers FEDAI

38. 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

39. 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)

40. Direct quotations
USD 1 = INR 45.58
GBP 1 = INR 73.70
- Foreign currency fixed
- Home currency variable
(Used in India from August 1993)

41. 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

42. 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

43. Fixed Exchange Rate
E E
Exchange rate
E
E
E2
E
E1
Quantity of dollars
43

44. 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

45. 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

46. Flexible Exchange Rate
Exchange rate
S
$2
E2
E1 $1 $”
E $’
$
D2
D1
D
Quantity of dollars
46

47. 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

48. Bretton Woods I
The 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

49. Role of IBRD & IMF
IBRD: 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

50. End of Bretton
Woods I
By 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

51. 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

52. Bretton Woods II
According 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

53. 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

54. US Trade with China

55. US-China Currency Issue
China 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.

56. US-China Currency Issue
China’s Currency is Undervalued by 40%.
Resulted in:
Chinese export to US Cheaper
& US export to China Expensive
Also rise in Trade Deficit from $ 30bn in 1994 to $
260bn in 2007.

57. 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.

58. China reformed its currency in July 2005 and
Treasury made following observation about
China:
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.

59. 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.

60. China Foreign Currency Reserve

61. Reasons China should let RMB appreciate,
in its own interest
1. Overheating of economy
2. 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

62. Policies to reduce the US CA deficit
Reduce 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

63. Problems with BW2: People’
Bank of China
U.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

64. Conclusions
In 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

65. 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

66. 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

67. References
RBI’s Master circular on risk management.
( www.rbi.org.in)
FEDAI Rules
www.tradingeconomics.com
www.chinability.com/Reserves.htm
International Economics - H G Mannur

68. Any Questions??????