Components of International Financial Environment

International financial environment is totally different from domestic financial environment. International financial management is subject to several external forces, like foreign exchange market, currency convertibility, international monitory system, balance of payments, and international financial markets.

1. Foreign Exchange Market

Foreign exchange market is the market in which money denominated in one currency is bought and sold with money denominated in another currency. It is an overthe counter market, because there is no single physical or electronic market place or an organized exchange with a central trade clearing mechanism where traders meet and exchange currencies. It spans the globe, with prices moving and currencies trading somewhere every hour of every business day. World’s major trading starts each morning in Sydney and Tokyo, and ends up in the San Francisco and Los-Angeles.

The foreign exchange market consists of two tiers: the inter bank market or wholesale market, and retail market or client market. The participants in the wholesale market are commercial banks, investment banks, corporations and central banks, and brokers who trade on their own account. On the other hand, the retail market comprises of travelers, and tourists who exchange one currency for another in the form of currency notes or traveler cheques.

The participants in the foreign exchange market comprise;

· Corporates

· Commercial banks

· Exchange brokers

· Central banks

Corporates: The business houses, international investors, and multinational corporations may operate in the market to meet their genuine trade or investment requirements. They may also buy or sell currencies with a view to speculate or trade in currencies to the extent permitted by the exchange control regulations. They operate by placing orders with the commercial banks. The deals between banks and their clients form the retail segment of foreign exchange market.

In India the Foreign Exchange Management (Possession and Retention of Foreign Currency) Regulations, 2000 permits retention, by resident, of foreign currency up to USD 2,000. Foreign Currency Management (Realisation, Repatriation and Surrender of Foreign Exchange) Regulations, 2000 requires a resident in India who receives foreign exchange to surrender it to an authorized dealer:

· Within seven days of receipt in case of receipt by way of remuneration, settlement of lawful obligations, income on assets held abroad, inheritance, settlement or gift: and

· Within ninety days in all other cases.

Any person who acquires foreign exchange but could not use it for the purpose or for any other permitted purpose is required to surrender the unutilized foreign exchange to authorized dealers within sixty days from the date of acquisition. In case the foreign exchange was acquired for travel abroad, the unspent foreign exchange should be surrendered within ninety days from the date of return to India when the foreign exchange is in the form of foreign currency notes and coins and within 180 days in case of travellers cheques. Similarly, if a resident required foreign exchange for an approved purpose, he should obtain from and authorized dealer.

Commercial Banks are the major players in the Forex market. They buy and sell currencies for their clients. They may also operate on their own. When a bank enters a market to correct excess or sale or purchase position in a foreign currency arising from its various deals with its customers, it is said to do a cover operation. Such transactions constitute hardly 5% of the total transactions done by a large bank. A major portion of the volume is accounted buy trading in currencies indulged by the bank to gain from exchange movements. For transactions involving large volumes, banks may deal directly among themselves. For smaller transactions, the intermediation of foreign exchange brokers may be sought.

Exchange brokers facilitate deal between banks. In the absence of exchange brokers, banks have to contact each other for quotes. If there are 150 banks at a centre, for obtaining the best quote for a single currency, a dealer may have to contact 149 banks. Exchange brokers ensure that the most favourable quotation is obtained and at low cost in terms of time and money. The bank may leave with the broker the limit up to which and the rate at which it wishes to buy or sell the foreign currency concerned. From the intends from other banks, the broker will be able to match the requirements of both. The names of the counter parties are revealed to the banks only when the deal is acceptable to them. Till then anonymity is maintained. Exchange brokers tend to specialize in certain exotic currencies, but they also handle all major currencies.

In India, banks may deal directly or through recognized exchange brokers. Accredited exchange brokers are permitted to contract exchange business on behalf of authorized dealers in foreign exchange only upon the understanding that they will conform to the rates, rules and conditions laid down by the FEDAI. All contracts must bear the clause “subject to the Rules and Regulations of the Foreign Exchanges Dealers ‘Association of India’.

Central Bank may intervene in the market to influence the exchange rate and change it from that would result only from private supplies and demands. The central bank may transact in the market on its own for the above purpose. Or, it may do so on behalf of the government when it buys or sell bonds and settles other transactions which may involve foreign exchange payments and receipts. In India, authorized dealers have recourse to Reserve Bank to sell/buy US dollars to the extent the latter is prepared to transact in the currency at the given point of time. Reserve Bank will not ordinarily buy/sell any other currency from/to authorized dealers. The contract can be entered into on any working day of the dealing room of Reserve Bank. No transaction is entered into on Saturdays. The value date for spot as well as forward delivery should be in conformity with the national and international practice in this regard. Reserve Bank of India does not enter into the market in the ordinary course, where the exchages rates are moving in a detrimental way due to speculative forces, the Reserve Bank may intervene in the market either directly or through the State Bank of India.

Some terms and concepts related to foreign exchange market

1 & 2. Exposure and Risk:

Exposure is a measure of the sensitivity of the value of a financial item (asset, liability or cash flow) to changes in the relevant risk factor while risk is a measure of variability of the value of the item attributable to the risk factor. Let us understand this distinction clearly. April 1993 to about July 1995 the exchange rate between rupee and US dollar was almost rock steady. Consider a firm whose business involved both exports to and imports from the US. During this period the firm would have readily agreed that its operating cash flows were very sensitive to the rupee-dollar exchange rate, i.e.; it had significant exposure to this exchange rate; at the same time it would have said that it didn’t perceive significant risk on this account because given the stability of the rupee-dollar fluctuations would have been perceived to be minimal. Thus, the magnitude of the risk is determined by the magnitude of the exposure and the degree of variability in the relevant risk factor.

3. Hedging:

Hedging means a transaction undertaken specifically to offset some exposure arising out of the firm’s usual operations. In other words, a transaction that reduces the price risk of an underlying security or commodity position by making the appropriate offsetting derivative transaction.

In hedging a firm tries to reduce the uncertainty of cash flows arising out of the exchange rate fluctuations. With the help of this a firm makes its cash flows certain by using the derivative markets.

4. Speculation:

Speculation means a deliberate creation of a position for the express purpose of generating a profit from fluctuation in that particular market, accepting the added risk. A decision not to hedge an exposure arising out of operations is also equivalent to speculation.

Opposite to hedging, in speculation a firm does not take two opposite positions in the any of the markets. They keep their positions open.

5. Call Option:

A call option gives the buyer the right, but not the obligation, to buy the underlying instrument. Selling a call means that you have sold the right, but not the obligation, to someone to buy something from you.

6. Put Option:

A put option gives the buyer the right, but not the obligation, to sell the underlying instrument. Selling a put means that you have sold the right, but not the obligation, to someone to sell something to you.

7. Strike Price:

The predetermined price upon which the buyer and the seller of an option have agreed is the strike price, also called the ‘exercise price’ or the striking price. Each option on an underlying instrument shall have multiple strike prices.

8. Currency Swaps:

In a currency swap, the two payment streams being exchanged are denominated in two different currencies. Usually, an exchange of principal amount at the beginning and a re-exchange at termination are also a feature of a currency swap.

A typical fixed-to-fixed currency swaps work as follows. One party raises a fixed rate liability in currency X say US dollars while the other raises fixed rate funding in currency Y say DEM. The principal amounts are equivalent at the current market rate of exchange. At the initiation of the swap contract, the principal amounts are exchanged with the first party getting DEM and the second party getting dollars. Subsequently, the first party makes periodic DEM payments to the second, computed as interest at a fixed rate on the DEM principal while it receives from the second party payment in dollars again computed as interest on the dollar principal. At maturity, the dollar and DEM principals are re-exchanged.

A floating-to-floating currency swap will have both payments at floating rate but in different currencies. Contracts without the exchange and re-exchange do exist. In most cases, an intermediary- a swap bank- structures the deal and routes the payments from one party to another.

A fixed-to-floating currency swap is a combination of a fixed-to-fixed currency swaps and a fixed-to-floating interest rate swap. Here, one payment stream is at a fixed rate in currency X while the other is at a floating rate in currency Y.

9. Futures

Futures are exchanged traded contracts to sell or buy financial instruments or physical commodities for future delivery at an agreed price. There is an agreement to buy or sell a specified quantity of financial instrument/commodity in a designated future month at a price agreed upon by the buyer and seller. The contracts have certain standardized specification.

10. Transaction Exposure

This is a measure of the sensitivity of the home currency value of the assets and liabilities, which are denominated, in the foreign currency, to unanticipated changes in the exchange rates, when the assets or liabilities are liquidated. The foreign currency values of these items are contractually fixed, i.e.; do not vary with exchange rate. It is also known as contractual exposure.

Some typical situations, which give rise to transactions exposure, are:

(a) A currency has to be converted in order to make or receive payment for goods and services;

(b) A currency has to be converted to repay a loan or make an interest payment; or

Note that in each case, the foreign value of the item is fixed; the uncertainty pertains to the home currency value. The important points to be noted are (1) transaction exposures usually have short time horizons and (2) operating cash flows are affected.

11. Translation Exposure

Also called Balance Sheet Exposure, it is the exposure on assets and liabilities appearing in the balance sheet but which is not going to be liquidated in the foreseeable future. Translation risk is the related measure of variability.

The key difference is the transaction and the translation exposure is that the former has impact on cash flows while the later has no direct effect on cash flows. (This is true only if there are no tax effects arising out of translation gains and losses.)

Translation exposure typically arises when a parent multinational company is required to consolidate a foreign subsidiary’s statements from its functional currency into the parent’s home currency. Thus suppose an Indian company has a UK subsidiary. At the beginning of the parent’s financial year the subsidiary has real estate, inventories and cash valued at, 1000000, 200000 and 150000 pound respectively. The spot rate is Rs. 52 per pound sterling by the close of the financial year these have changed to 950000 pounds, 205000 pounds and 160000 pounds respectively. However during the year there has been a drastic depreciation of pound to Rs. 47. If the parent is required to translate the subsidiary’s balance sheet from pound sterling to Rupees at the current exchange rate, it has suffered a translation loss. The translation value of its assets has declined from Rs. 70200000 to Rs. 61805000. Note that no cash movement is involved since the subsidiary is not to be liquidated. Also note that there must have been a translation gain on subsidiary’s liabilities, ex. Debt denominated pound sterling.

12. Contingent Exposure

The principle focus is on the items which will have the impact on the cash flows of the firm and whose values are not contractually fixed in foreign currency terms. Contingent exposure has a much shorter time horizon. Typical situation giving rises to such exposures are

1. An export and import deal is being negotiated and quantities and prices are yet not to be finalized. Fluctuations in the exchange rate will probably influence both and then it will be converted into transactions exposure.

2. The firm has submitted a tender bid on an equipment supply contract. If the contract is awarded, transactions exposure will arise.

3. A firm imports a product from abroad and sells it in the domestic market. Supplies from abroad are received continuously but for marketing reasons the firm publishes a home currency price list which holds good for six months while home currency revenues may be more or less certain, costs measured in home currency are exposed to currency fluctuations.

In all the cases currency movements will affect future cash flows.

13. Competitive exposure

Competitive exposure is the most crucial dimensions of the currency exposure. Its time horizon is longer than of transactional exposure – say around three years and the focus is on the future cash flows and hence on long run survival and value of the firm. Consider a firm, which is involved in producing goods for exports and /or imports substitutes. It may also import a part of its raw materials, components etc. a change in exchange rate gives rise to no. of concerns for such a firm, example,

1. What will be the effect on sales volumes if prices are maintained? If prices are changed? Should prices be changed? For instance a firm exporting to a foreign market might benefit from reducing its foreign currency priced to foreign customers. Following an appreciation of foreign currency, a firm, which produces import substitutes, may contemplate in its domestic currency price to its domestic customers without hurting its sales. A firm supplying inputs to its customers who in turn are exporters will find that the demand for its product is sensitive to exchange rates.

2. Since a part of inputs are imported material cost will increase following a depreciation of the home currency. Even if all inputs are locally purchased, if their production requires imported inputs the firms material cost will be affected following a change in exchange rate.

3. Labour cost may also increase if cost of living increases and the wages have to be raised.

4. Interest cost on working capital may rise if in response to depreciation the authorities resort to monetary tightening.

5. Exchange rate changes are usually accompanied by if not caused by difference in inflation across countries. Domestic inflation will increase the firm’s material and labour cost quite independently of exchange rate changes. This will affect its competitiveness in all the markets but particularly so in markets where it is competing with firms of other countries

6. Real exchange rate changes also alter income distribution across countries. The real appreciation of the US dollar vis-à-vis deutsche mark implies and increases in real incomes of US residents and a fall in real incomes of Germans. For an American firm, which sells both at home, exports to Germany, the net impact depends upon the relative income elasticities in addition to any effect to relative price changes.

Thus, the total impact of a real exchange rate change on a firm’s sales, costs and margins depends upon the response of consumers, suppliers, competitors and the government to this macroeconomic shock.

In general, an exchange rate change will affect both future revenues as well as operating costs and hence exchange rates changes, relative inflation rates at home and abroad, extent of competition in the product and input markets, currency composition of the firm’s costs as compared to its competitors’ costs, price elasticity of export and import, demand and supply and so forth.

A very brief account of certain important types of transactions conducted in the foreign exchange market is given below

Spot and Forward Exchanges

Spot Market:

The term spot exchange refers to the class of foreign exchange transaction which requires the immediate delivery or exchange of currencies on the spot. In practice the settlement takes place within two days in most markets. The rate of exchange effective for the spot transaction is known as the spot rate and the market for such transactions is known as the spot market.

Forward Market:

The forward transactions is an agreement between two parties, requiring the delivery at some specified future date of a specified amount of foreign currency by one of the parties, against payment in domestic currency be the other party, at the price agreed upon in the contract. The rate of exchange applicable to the forward contract is called the forward exchange rate and the market for forward transactions is known as the forward market. The foreign exchange regulations of various countries generally regulate the forward exchange transactions with a view to curbing speculation in the foreign exchanges market. In India, for example, commercial banks are permitted to offer forward cover only with respect to genuine export and import transactions. Forward exchange facilities, obviously, are of immense help to exporters and importers as they can cover the risks arising out of exchange rate fluctuations be entering into an appropriate forward exchange contract. With reference to its relationship with spot rate, the forward rate may be at par, discount or premium. If the forward exchange rate quoted is exact equivalent to the spot rate at the time of making the contract the forward exchange rate is said to be at par.

The forward rate for a currency, say the dollar, is said to be at premium with respect to the spot rate when one dollar buys more units of another currency, say rupee, in the forward than in the spot rate on a per annum basis.

The forward rate for a currency, say the dollar, is said to be at discount with respect to the spot rate when one dollar buys fewer rupees in the forward than in the spot market. The discount is also usually expressed as a percentage deviation from the spot rate on a per annum basis.

The forward exchange rate is determined mostly be the demand for and supply of forward exchange. Naturally when the demand for forward exchange exceeds its supply, the forward rate will be quoted at a premium and conversely, when the supply of forward exchange exceeds the demand for it, the rate will be quoted at discount. When the supply is equivalent to the demand for forward exchange, the forward rate will tend to be at par.

Futures

While a focus contract is similar to a forward contract, there are several differences between them. While a forward contract is tailor made for the client be his international bank, a future contract has standardized features the contract size and maturity dates are standardized. Futures cab traded only on an organized exchange and they are traded competitively. Margins are not required in respect of a forward contract but margins are required of all participants in the futures market an initial margin must be deposited into a collateral account to establish a futures position.

Options

While the forward or futures contract protects the purchaser of the contract fro m the adverse exchange rate movements, it eliminates the possibility of gaining a windfall profit from favorable exchange rate movement. An option is a contract or financial instrument that gives holder the right, but not the obligation, to sell or buy a given quantity of an asset as a specified price at a specified future date. An option to buy the underlying asset is known as a call option and an option to sell the underlying asset is known as a put option. Buying or selling the underlying asset via the option is known as exercising the option. The stated price paid (or received) is known as the exercise or striking price. The buyer of an option is known as the long and the seller of an option is known as the writer of the option, or the short. The price for the option is known as premium.

Types of options: With reference to their exercise characteristics, there are two types of options, American and European. A European option cab is exercised only at the maturity or expiration date of the contract, whereas an American option can be exercised at any time during the contract.

Swap operation

Commercial banks who conduct forward exchange business may resort to a swap operation to adjust their fund position. The term swap means simultaneous sale of spot currency for the forward purchase of the same currency or the purchase of spot for the forward sale of the same currency. The spot is swapped against forward. Operations consisting of a simultaneous sale or purchase of spot currency accompanies by a purchase or sale, respectively of the same currency for forward delivery are technically known as swaps or double deals as the spot currency is swapped against forward.

Arbitrage

Arbitrage is the simultaneous buying and selling of foreign currencies with intention of making profits from the difference between the exchange rate prevailing at the same time in different markets.

2. Currency Convertibility

Foreign exchange market assumes that currencies of various countries are freely convertible into other currencies. But this assumption is not true, because many countries restrict the residents and non-residents to convert the local currency into foreign currency, which makes international business more difficult. Many international business firms use “counter trade” practices to overcome the problem that arises due to currency convertibility restrictions.

Current account convertibility refers to freedom in respect of payments and transfers for current international transactions. In other words, if Indians are allowed to buy only foreign goods and services but restrictions remain on the purchase of assets abroad, it is only current account convertibility. As of now, convertibility of the rupee into foreign currencies is almost wholly free for current account i.e. in case of transactions such as trade, travel and tourism, education abroad etc.

The Government of India introduced a system of Partial Rupee Convertibility (PCR) (Current Account Convertibility) on February 29,1992 as part of the Fiscal Budget for 1992-93. PCR is designed to provide a powerful boost to export as well as to achieve as efficient import substitution. It is designed to reduce the scope for bureaucratic controls, which contribute to delays and inefficiency. Government liberalized the flow of foreign exchange to include items like amount of foreign currency that can be procured for purpose like travel abroad, studying abroad, engaging the service of foreign consultants etc. What it means that people are allowed to have access to foreign currency for buying a whole range of consumables products and services. These relaxations coincided with the liberalization on the industry and commerce front which is why we have Honda City cars, Mars chocolate and Bacardi in India.

Components of Current Account

Covered in the current account are all transactions (other than those in financial items) that involve economic values and occur between resident non-resident entities. Also covered are offsets to current economic values provided or acquired without a quid pro quo. Specifically, the major classifications are goods and services, income, and current transfers.

1. Goods and services

Goods

· General merchandise covers most movable goods that residents export to, or import from, non residents and that, with a few specified exceptions, undergo changes in ownership (actual or imputed).

· Goods for processing covers exports (or, in the compiling economy, imports) of goods crossing the frontier for processing abroad and subsequent re-import (or, in the compiling economy, export) of the goods, which are valued on a gross basis before and after processing. The treatment of this item in the goods account is an exception to the change of ownership principle.

· Repairs on goods covers repair activity on goods provided to or received from non residents on ships, aircraft, etc. repairs are valued at the prices (fees paid or received) of the repairs and not at the gross values of the goods before and after repairs are made.

· Goods procured in ports by carriers covers all goods (such as fuels, provisions, stores, and supplies) that resident/nonresident carriers (air, shipping, etc.) procure abroad or in the compiling economy. The classification does not cover auxiliary services (towing, maintenance, etc.), which are covered under transportation.

· Non-monetary gold covers exports and imports of all gold not held as reserve assets (monetary gold) by the authorities. Non-monetary gold is treated the same as any other commodity and, when feasible, is subdivided into gold held as a store of value and other (industrial) gold.

Services

· Transportation covers most of the services that are performed by residents for nonresidents (and vice versa) and that were included in shipment and other transportation in the fourth edition of the Manual. However, freight insurance is now included with insurance services rather than with transportation. Transportation includes freight and passenger transportation by all modes of transportation and other distributive and auxiliary services, including rentals of transportation equipment with crew.

· Travel covers goods and services—including those related to health and education—acquired from an economy by non resident travelers (including excursionists) for business and personal purposes during their visits (of less than one year) in that economy. Travel excludes international passenger services, which are included in transportation. Students and medical patients are treated as travelers, regardless of the length of stay. Certain others—military and embassy personnel and non resident workers—are not regarded as travelers. However, expenditures by non resident workers are included in travel, while those of military and embassy personnel are included in government services

· Communications services covers communications transactions between residents and nonresidents. Such services comprise postal, courier, and telecommunications services (transmission of sound, images, and other information by various modes and associated maintenance provided by/for residents for/by non residents).

· Construction services covers construction and installation project work that is, on a temporary basis, performed abroad/in the compiling economy or in Extra territorial enclaves by resident/non resident enterprises and associated personnel. Such work does not include that undertaken by a foreign affiliate of a resident enterprise or by an unincorporated site office that, if it meets certain criteria, is equivalent to a foreign affiliate.

· Insurance services covers the provision of insurance to non residents by resident insurance enterprises and vice versa. This item comprises services provided for freight insurance (on goods exported and imported), services provided for other types of direct insurance (including life and non-life), and services provided for reinsurance.

· Financial services (other than those related to insurance enterprises and pension funds) covers financial intermediation services and auxiliary services conducted between residents and nonresidents. Included are commissions and fees for letters of credit, lines of credit, financial leasing services, foreign exchange transactions, consumer and business credit services, brokerage services, underwriting services, arrangements for various forms of hedging instruments, etc. Auxiliary services include financial market operational and regulatory services, security custody services, etc.

· Computer and information services covers resident/non resident transactions related to hardware consultancy, software implementation, information services (data processing, data base, news agency), and maintenance and repair of computers and related equipment.

· Royalties and license fees covers receipts (exports) and payments (imports) of residents and non-residents for (i) the authorized use of intangible non produced, nonfinancial assets and proprietary rights—such as trademarks, copyrights, patents, processes, techniques, designs, manufacturing rights, franchises, etc. and (ii) the use, through licensing agreements, of produced originals or prototypes—such as manuscripts, films, etc.

· Other business services provided by residents to nonresidents and vice versa covers merchanting and other trade-related services; operational leasing services; and miscellaneous business, professional, and technical services.

· Personal, cultural, and recreational services covers (i) audiovisual and related services and (ii) other cultural services provided by residents to non-residents and vice versa. Included under (i) are services associated with the production of motion pictures on films or video tape, radio and television programs, and musical recordings. (Examples of these services are rentals and fees received by actors, producers, etc. for productions and for distribution rights sold to the media.) Included under (ii) are other personal, cultural, and recreational services—such as those associated with libraries, museums—and other cultural and sporting activities.

· Government services i.e. covers all services (such as expenditures of embassies and consulates) associated with government sectors or international and regional organizations and not classified under other items.

2. Income

· Compensation of employees covers wages, salaries, and other benefits, in cash or in kind, and includes those of border, seasonal, and other non-resident workers (e.g., local staff of embassies).

· Investment income covers receipts and payments of income associated, respectively, with residents’ holdings of external financial assets and with residents’ liabilities to nonresidents. Investment income consists of direct investment income, portfolio investment income, and other investment income. The direct investment component is divided into income on equity (dividends, branch profits, and reinvested earnings) and income on debt (interest); portfolio investment income is divided into income on equity (dividends) and income on debt (interest); other investment income covers interest earned on other capital (loans, etc.) and, in principle, imputed income to households from net equity in life insurance reserves and in pension funds.

3. Current transfers

Current transfers are distinguished from capital transfers, which are included in the capital and financial account in concordance with the SNA treatment of transfers. Transfers are the offsets to changes, which take place between residents and nonresidents, in ownership of real resources or financial items and, whether the changes are voluntary or compulsory, do not involve a quid pro quo in economic value.

Current transfers consist of all transfers that do not involve (i) transfers of ownership of fixed assets; (ii) transfers of funds linked to, or conditional upon, acquisition or disposal of fixed assets; (iii) forgiveness, without any counterparts being received in return, of liabilities by creditors. All of these are capital transfers.

Current transfers include those of general government (e.g., current international cooperation between different governments, payments of current taxes on income and wealth, etc.), and other transfers (e.g., workers’ remittances, premiums—less service charges, and claims on non-life insurance).

Exchange Rate System in India

The rupee was historically linked i.e. pegged to the pound sterling. Earlier, during British regime and till late sixties, most of India’s trade transactions were dominated to pound sterling. Under Bretton Woods system, as a member of IMF Indian declared its par value of rupee in terms of gold. The corresponding rupee sterling rate was fixed 1 GBP = RS 18.

When Bretton Woods system bore down in August 1971, the rupee was de-linked from US $ and the exchange rate was fixed at 1 US $ = Rs 7.50. Reserve bank of India, however, remained pound sterling as the currency of intervention. The US $ and rupee pegging was used to arrive at rupee-sterling parity. After Smithsonian Agreement in December 1971, the rupee was de-linked from US $ and again linked to pound sterling. This parity was maintained with a band of 2.25%. Due to poor fundamental pound got depreciated by 20%, which cause rupee to depreciate.

To be not dependent on the single currency, pound sterling on September 25, 1975 rupee was de-linked from pound sterling and was linked to basket of currencies, the currencies includes as well as their relative weights were kept secret so that speculators don’t get a wind of the direction of the movement of exchange rate of rupee.

From January 1, 1984 the sterling rate schedule was abolished. The interest element, which was hitherto in built the exchange rate, was also de-linked. The interest was to be recovered from the customers separately. This not only allowed transparency in the exchange rate quotations but also was in tune with international practice in this regard. FEDAI issued guidelines for calculation of merchant rates.

The liquidity crunch in 1990 and 1991 on forex front only hastened the process. On March 1, 1992 Reserve Bank of India announced a new system of exchange rates known as Liberalized Exchange Rate Management System.

LERMS was to make balance of payment sustainable on ongoing basis allowing market force to play a greater role in determining exchange rate of rupee. Under LERMS, the rupee become convertible for all approved external transactions. The exporters of goods and services and those who received remittances from abroad were allowed to sell bulk of their forex receipts. Similarly, those who need foreign exchange to import and travel abroad were to buy foreign exchange from market-determined rate.

From March 1 1993 modified LERMS under which the all forex transactions, under current and capital account, are being put through by Authorized Dealers at market determined exchange rate.

3. International Monetary System

Any country needs to have its own monetary system and an authority to maintain order in the system, and facilitate trade and investment. India has its own monetary policy, and the Reserve Bank of India (RBI) administers it. The same is the case with world, its needs a monetary system to promote trade and investment across the countries. International monetary system exists since 1944. The International Monetary Fund (IMF) and the World Bank have been maintaining order in the international monetary system and general economic development respectively.

International Financial Institutions: International Monetary Fund (IMF)

Origin

The IMF also called the Fund is an International monetary institution/ supranational financial institution established by 45 nations under the Bretton Woods Agreement of 1944. Such an institution was necessary to avoid repetition of the disastrous economic policies that had contributed to Great depression of 1930’s. The principal aim was to avoid the economic mistakes of the 1920s and 1930s. It started functioning from March 1, 1947. In June, 1996, the Fund had 181 members. The IMF was established to promote economic and financial co-operation among its members in order to facilitate the expansion and balanced growth of world trade. It performs the activities like monitoring national, global and regional economic developments and advising member countries on their economic policies (surveillance); lending member hard currencies to support policy programmes designed to correct BOP problems; offering technical assistance in its areas of expertise as well as training for government and central bank officials.

Objectives

The fundamental purposes & objectives of the Fund had been laid down in Article 1 of the original Articles of Agreement and they have been upheld in the two amendments that were made in 1969 & 1978 to its basic charter. They are as under:

1. To promote international monetary co-operation through a permanent institution which provides the machinery for consumption & collaboration in international monetary problems.

2. To facilitate the expansion and balanced growth of international trade.

3. To promote exchange stability, to maintain orderly exchange arrangements among members, and to provide competitive exchange depreciation.

4. To assist in the establishment of a multilateral system of payments in respect of current transactions between member and in the elimination of foreign exchange restrictions which hamper the growth in the world trade.

5. To lend confidence to members by making the Fund’s resource available to them under adequate safeguards.

6. In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international balance of payments of members.

Functions

To fulfill the above objectives, The IMF performs the following functions:

1. The IMF operates in such a way as to fulfill its objectives as laid down in the Bretton Woods Articles of Agreements. It’s the Fund’s duty to see that these provisions are observed by member countries.

2. The Fund gives short term loans to its members so that they may correct their temporary balance of payments disequilibrium.

3. The Fund is regarded “as the guardian of good conduct” in the sphere of balance of payments. It aims at reducing tariffs and other trade restrictions by the member countries.

4. The Fund also renders technical advice to its members on monetary and fiscal policies.

5. It conducts research studies and publishes them in IMF staff papers, Finance and Development, etc.

6. It provides technical experts to member countries having BOP difficulties and other problems.

Organisation and Structure

The Second Amendment of the Articles of Agreement made important changes in the organization and structure of the Fund. As such, the structure of the fund consists of a Board of governors, an Executive Board, a Managing Director, a council and a staff with its headquarters in Washington, U.S.A. There are ad hoc and standing committees appointed by the Board of Governors and the Executive Board. There is also an Interim Committee appointed by the Board of Governors. The Board of Governors and the Executive Board are decision making organs of the Fund. The Board of Governors is at the top in the structure of the Fund. It is composed of one Governor and one alternate Governor appointed by each member. The alternate Governor can participate in the meeting of the Board but has the power to vote only in the absence of the Governor.

· The Board of Governor which has now 24 members meets annually in which details of the Fund activities for the previous year are presented. The annual meeting also takes few decisions with regards to the policies of Fund.

· The Executive Board has 21 members at present. Five Executive Directors are appointed by the five members (USA, UK, W. Germany, France and Japan) having the largest quotas)

· There is a Managing Director of the Fund who is elected by the Executive Directors.

· The Executive Board is the most powerful organ of the Fund and exercise vast powers conferred on it by the Articles of Agreement and delegated to by the Board of Governors. So its power relates to all Fund activities, including its regulatory, supervisory and financial activities.

· The Interim Committee (now IMFC) was established in October 1974 to advice the Board of Governors on supervising the management and adaptation of the international monetary in order to avoid disturbances that might threaten it. It currently has 22 members.

· The Development Committee was also established in October 1974 and consists of 22 members. It advices and reports to the Board of Governors on all aspects of the transfer of real resources to developing countries and makes suggestions for their implementation.

Working of International Monetary Fund (IMF)

Recommended Reading: International Monetary Fund (IMF)

1. Financial Resources:

IMF’s resources mainly come from two sources Quotas and Loans. The capital of the Fund includes quotas of member countries, amount received from the sale of gold, General Arrangements to Borrow (GAB), New Arrangements to Borrow (NAB) and loans from members nations.

Quotas and Loans and their Fixation: The Fund has General Account based on quotas allocated to its members. When a country joins the Fund, it is assigned a Quota that governs the size of its subscription, its voting power, and its drawing rights. The country will be assigned with an initial quota in the same range as the quotas of existing members that are broadly comparable in the economic size and characteristics. At the time of the formation of the IMF, each member is required to pay its subscription in full or on joining the Fund – of which 25 percent of its quota in gold/SDR/widely accepted currencies such as USD/ Euro/Yen/UK Pound and the rest in their own currencies. In order to meet the financial requirements of the Fund, the quotas are reviewed every five years and are raised from time to time. Loans from members and non-members constitute another major source of funds for the IMF. Since 1980 IMF has been authorized to borrow from commercial capital markets too. Quotas are denominated in Special Drawings Right , which is the IMF’S Unit of account. IMF has a weighted voting system . the larger a country’s Quota in the IMF (determined broadly by its economic size) the more the vote the country has, in addition to its basic votes of which each member has an equal number.

2. Fund Borrowings:

Besides performing regulatory and consultative functions, the Fund is an important financial institution. The bulk of its financial resources come from quota subscriptions of member countries. Besides, it increases its funds by selling gold to members. While Quota subscriptions of member countries are its major source of financing, the IMF can activate supplementary borrowing arrangements if it believes that resources might fall short of the members’ needs. Through the General Arrangements to Borrow (GAB) and the New Arrangements to Borrow (NAB), a number of member countries and institutions express their readiness to lend additional funds to the IMF. GAB and NAB are credit arrangements between IMF and group of members and institutions to provide supplementary resources of up to US$54 billion to cope with the impairment of the international monetary system or deal with an exceptional situation that poses threat to the stability of the system. The GAB enables the IMF to borrow specified amount of currencies from 11 developed countries or their Central Banks under certain circumstances at market related interest rates. Whereas the NAB is a set of credit arrangement between the IMF and 26 Members and Institutions. The NAB is the first and principal resource in the event of a need to provide supplementary resources to the IMF.

Commitments from individual participants are based predominantly on relative economic strength as measured by the IMF Quotas. Like other financial institutions IMF also earns income from the interest charges and fees levied on its loans.

4. Fund Lending:

The Fund has a variety of facilities for lending its resources to its member countries. Lending by the Fund is linked to temporary assistance to members in financing disequilibrium in their balance of payments on current account. Reserve tranche and Credit tranche facilities are two basic facilities available for meeting BOP deficits.
Reserve tranche: Every member country is entitled to borrow without any conditions a part of its Quota (i.e., the subscription paid by the member country to the IMF). If a member has less currency with the Fund than its quotas, the difference is called Reserve tranche. It can draw up to 25 percent on its reserve tranche automatically upon representation of the Fund for its balance needs. It is not charged on any interest on such drawings, but is required to repay within a period of three to five years.

Credit Tranche: A member can draw further annually from balance quota in 4 installment up to 100% of its quota from credit tranche. Drawings from credit tranches are conditional because the members have to satisfy the Fund adopting a viable programme to ensure financial stability.

Other Credit Facilities:

· Buffer Stock Financing Facility (BSFF): It was created in 1969 for financing commodity buffer stock by member countries. The facility is equivalent to 30 percent of the borrowings member’s quota.

· Extended Fund Facility (EFF): It is another specialized facility which was created in 1974. Under EFF, the Fund provides credit to member countries to meet their balance of payments deficits for longer periods, and in amounts larger than their quotas under normal credit facilities.

· Supplementary Financing /Reserve Facility (SFF/SRF): It was established in 1977 to provide supplementary financing under extended or stand-by arrangements to member countries to meet serious balance of payments deficits that are large in relation to their economies and their quotas.

· Structural Adjustment Facility (SAF): The Fund setup SAF in March 1986 to provide concessional adjustment to the poorer developing countries.

· Enhanced Structural Adjustment Facility (ESAF): The EASF was created in December 1987 with SDR 6 billion of resources for the medium term financing needs for low income countries. The objectives, eligibility and basic programme features of this facility are similar to those of the SAF.

· Compensatory & Contingency Financing Facility (CCFF): The CCFF is created in August 1988 to provide timely compensation for temporary shortfalls or excesses in cereal import costs due to factors beyond the control of the member and contingency financing to help a member to maintain the momentum of Fund-supported adjustment programmes in the face of external shocks on account of factors beyond its control.

· Systematic Transformation Facility (STF): In April 1993, the IMF established STF with $6billion to help Russia and other Central Asian Republics to face balance of payments crisis.

· Emergency Structural Adjustment LOAN (ESAL): The Fund established ESAL facility in early 1999 to help the Asian and Latin American countries inflicted with the financial crisis.

· Contingency Credit Line (CCL): The CCL was created in 1999 to protect fundamentally sound countries from the contagion of financial crisis occurring in other countries, rather than from domestic policy weaknesses.

· Poverty Reduction and Growth Facility (PRGF) and Exogenous Shock Facility (ESF): These are concessional lending arrangements to low income countries and are unpinned by comprehensive country –owned strategies, delineated in their Poverty Reduction Strategy Papers (PRSP). In recent years PRGF has accounted for the largest number of IMF loans. The interest levied on these loans is 0.5% only and the repayment period is over 5-10 years.

· Stand- By Agreements (SBA): SBA is designed to help countries having deficit BOP with an extended repayment period of 2 to 4 years. Under Stand-By and Extended Arrangements a member can borrow up to 100% of its quota annually and 300% cumulatively.

5. Exchange Rate:

The original Fund Agreement provided that the par value of each member country was to be expressed in terms of gold of certain weight and fineness or US dollars. The underlining idea was to create a system of stable exchange rates with ordinary cross rates. But the Fund was obliged to agree to changes in exchange rates which did not exceed +/- 1 percent of the initial par value. A further change of +/- 1 percent required the permission of the Fund.

6. Other Facilities:
The IMF advices its member countries on various problems concerning their BOP and exchange rate problems and on monetary and fiscal issues. It sends specialists & experts to help solve BOP and exchange rate problems of member countries.

The Fund has setup three departments to solve banking and fiscal problem of member countries:

· There is the Central Banking Service Department which helps member countries with the services of its experts to run and manage their central banks and to formulate banking legislation.

· The Fiscal Affairs Department renders advice to member countries concerning their fiscal matters.

· The IMF institutes conducts short-term training courses for the officers of member countries relating to monetary, fiscal, banking and BOP policies.

The World Bank or The International Bank for Reconstruction and Development (IBRD)

The International Bank for Reconstruction and Development (IBRD) or the World Bank was established on December 27, 1945 following international ratification of the Bretton Woods Agreement of 1944 , which emerged from the United Nations Monetary and Financial Conference (July 1-22,1944).to assist in bringing about a smooth transition from a war time to peace time economy. It is the sister institution of IMF. Since its inception in 1944, the World Bank has expanded from a single institution to an associated group of coordinated development institutions. The Bank’s mission evolved from a facilitator of post-war reconstruction and development to its present day mandate of worldwide poverty alleviation, social sector funding and comprehensive development framework. The term ‘World Bank’ now refers to World Bank Group which includes

· International Bank for Reconstruction and Development (IBRD) established in 1945 for providing debt financing on the basis of sovereign guarantees.

· International Financial Corporation (IFC) established in 1956 for providing various forms of financing without sovereign guarantees primarily to the private sector.

· International Development Association (IDA) established in 1960 for providing concessional financing (interest free loans, grants etc.) usually with sovereign guarantees.

· International Centre for Settlement of Investment Disputes (ICSID) established in 1966 which works with various governments of various countries to reduce investment risks.

· Multilateral Investment Guarantee Agency (MIGA) established in 1988 for providing insurance against certain types of risks including political risks primarily to the private sector.

Functions

The IBRD also called the World Bank performs the following functions:

1. To assist in reconstruction and development of territories of its members by facilitating the investment of capital for productive purpose and to encourage the development of productive facilities and resources in less development countries.

2. To promote private foreign investment by means of guarantees on participation in loans and other investment made by private investors.

3. To promote the long range balanced growth of international trade and the maintenance of equilibrium in the balance of payments of member countries by encouraging international investments for the development of their productive resources.

4. To arrange the loans made or guaranteed by it in relation to international loans through other channels so that more useful and urgent small and large projects are dealt with first.

Membership

World Bank is like a cooperative where its 185 member countries are its shareholders. The shareholders are represented by a Board of Governors, which is the ultimate policy making body of the World Bank. Generally governors are member countries ministers of finance or ministers of development who will meet once in a year at the Annual Meeting of the Board of Governors of the World Bank Group and IMF

The members of International Monetary Fund are the members of the IBRD. If a country resigns its memberships, it is required to pay back all loans with interest on due dates. If the Bank incurs a financial loss in the years in which a member resigns, it is required to pay its share of the loss on demand.

Organisation

Like the IMF, the IBRD has a three-tier structure with a President, Executive Directors and Board of Governors. The President of the World Bank Group (IBRD, IDA and IFC) is elected by the Bank’s Executive Directors whose number is 21. Of these, 5 are appointed by the five largest shareholders of the World Bank. They are the US, UK, Germany, France and Japan. The remaining 16 are elected by the Board of Governors. There are also Alternate Directors. The first five belong to the same permanent member countries to which the Executive Directors belong. But the remaining Alternate Directors are elected from among the group of countries who cast their votes to choose the 16 Executive Directors belonging to their regions.

The President of the World Bank presides over the meetings of the Board of Executive Directors regularly once a mouth. The Executive Directors decide about policy within the framework of the Articles of Agreement. They consider and decide on the loan and credit proposal made by the President. They also present to the Broad of Governors at its annual meetings audited accounts, an administrative budget, and Annual Report on the operations and policies of the Bank. The President has a staff of more than 6000 persons who carry on the working of the World Bank. He is assisted by a number of Senior Vice-Presidents and Directors of the various departments and regions. The Board of Governors is the supreme body. Every member country appoints one Governor and an Alternate Governor for a period of five years. The voting power of each Governor is related to the financial contribution of its government.

Workings

The World Bank operates under the leadership and direction of the President, Vice Presidents and other senior management staffs who will look after the functions like Fund generation, Loans, Grants and other analytical and advisory services.

Fund Generation: IBRD lending to developing countries is primarily financed by selling AAA rated bonds in the world financial markets. It earns a small margin on this lending where major proportion of its income comes from lending of its own capital which consists of, reserves built over the years and money paid to the Bank from its 185 member countries. International Development Association (IDA) provides interest free loans and grant assistance to poorest countries which is replenished every three years by 40 donor countries. Additional funds are generated through repayments of loan principle on 35 to 40 years interest free loans which are then available for relending. IDA accounts for nearly 40% of total lending of the World Bank.

Loans: Through IBRD and IDA, the bank offers two basic types of loans and credits- Investment Loans and Development Policy Loans. Investment Loans are made to countries for goods, works and services in support of economic and social development projects in a broad range of economic and social sectors.
Development Policy Loans on the other hand provide quick disbursing financing to support countries policy and institutional reforms. IDA provides long term interest free credits at a small service charge of o.5 %to 0.75%.

Grants: Grants are designed to facilitate development projects by encouraging innovation and co- operation between organizations and local stakeholders participation in projects.; which are either funded directly or managed through partnerships used mainly to relieve debt burden of heavily indebted poor countries, improve sanitation and water supplies, support vaccination and immunization programs to reduce the occurrence of communicable diseases ,combat HIV/AIDS pandemic, support civil society organizations and create initiatives to cut the emission of green house gases.

Analytical and Advisory Services: Through economic research on board issues such as the environment, poverty ,infrastructure, trade, social safety, and globalization the Bank evaluates a country’s economic prospects and assists in the following activities:

· Public poverty assessments

· Public Expenditure reviews

· Country economic memoranda

· Social and structural reviews

· Sector reports

· Capital building

Recent Developments in International Financial Markets

Recent financial market developments have also blurred the distinction between different segments of the financial markets. Creditors and investors now compete with each other for good financial transactions. In addition, borrowers can now structure the best deals available in the entire market rather than focusing on specific market segments. By borrowing in the most accessible financial market segment and then swapping aspects of the debt to other markets, successful borrowers tailor the currency, cost, maturity, and form of their financial transactions to their financial needs.

These developments in international financial markets do entail some adverse consequences for developing country borrowers. Lenders and investors can be more selective in choosing their financial transactions, using swaps and other hedging techniques to pass on unacceptable risks. Given the present shortage of available financing, securitization provides flexibility and more accessible financing to creditworthy borrowers, limiting the options available to less creditworthy borrowers, such as developing countries. Borrowers can mitigate this impact by structuring financing proposals that address the risk concerns of specific groups of financial actors. It is easier for investors to assess specific project-related risks than the numerous categories of risk that can affect general purpose financing. Borrowers should also structure their funding proposals to link the timing, amount, and currency of their repayment obligations more directly to cash flow.

If developing countries are to gain access to international financing, they will need to ascertain how investors perceive the risks associated with their debt issue in relation to the risks associated with other debt issues. Investor perception can be influenced by commercial and political risk assessments of the borrower and the anticipated marketability of the debt instruments. All developing countries who borrow, regardless of their dealings with international financial markets, should make an effort to understand some of the new financing techniques. By doing so, borrowers with access to international financial markets can maximize the benefits they derive from funds raised in these markets, while borrowers with no present access to these markets can apply these techniques to renegotiate existing commercial bank debt. Debt managers and their lawyers who understand the new financing techniques may also be able to use this information in developing overall international borrowing strategies.

Balance of Payments

International trade and other international transactions result in a flow of funds between countries. All transactions relating to the flow of goods, services and funds across national boundaries are recorded in the balance of payments of the countries concerned.

Balance of payments (BoPs) is systematic statement that systematically summarizes, for a specified period of time, the monetary transactions of an economy with the rest of the world. Put in simple words, the balance of payments of a country is a systematic record of all transactions between the ‘residents’ of a country and the rest of the world. The balance of payments includes both visible and invisible transactions. It presents a classified record of:

1. All receipts on account of goods exported, services rendered and capital received by ‘residents’ and

2. Payments made by then on account of goods imported and services received from the capital transferred to ‘non-residents’ or ‘foreigners’.

Thus the transactions include the exports and imports (by individuals, firms and government agencies) of goods and services, income flows, capital flows and gifts and similar one-sided transfer of payments. A rule of thumb that aids in understanding the BOP is to “follow the cash flow”. Balance of payments for a country is the sum of the Current Account, the Capital Account, and the change in Official Reserves.

The Capital Account component in Balance of Payments (BoP)

Capital account records public and private investment, and lending activities. It is the net change in foreign ownership of domestic assets. If foreign ownership of domestic assets has increased more quickly than domestic ownership of foreign assets in a given year, then the domestic country has a capital account surplus. On the other hand, if domestic ownership of foreign assets has increased more quickly than foreign ownership of domestic assets in a given year, then the domestic country has a capital account deficit. It is known as “financial account”. IMF manual lists out a large number of items under the capital account. But India, and many other countries, has merged the accounting classification to fit into its own institutional structure and analytical needs. Until the end of the 1980s, key sectors listed out under the capital account were: (i) private capital, (ii) banking capital, and (iii) official capital.

Private capital was sub-divided into (i) long-term and (ii) short-term, with loans of original maturity of one year or less constituting the relevant dividing line. Long-term private capital, as published in the regular BOP data, covered foreign investments (both direct and portfolio), long-term loans, foreign currency deposits (FCNR and NRE) and an estimated portion of the unclassified receipts allocated to capital account. Banking capital essentially covered movements in the external financial assets and liabilities of commercial and cooperative banks authorized to deal in foreign exchange. Official capital transactions, other than those with the IMF and movements in RBI’s holdings of foreign currency assets and monetary gold (SDRs are held by the government), were classified into (i) loans, (ii) amortization, and (iii) miscellaneous receipts and payments.

Components of Capital Account: From 1990-91 onwards, the classification adopted is as follows:

1. Foreign Investment – Foreign investment is bifurcated into Foreign Direct Investment (FDI) and portfolio investment. Direct investment is the act of purchasing an asset and at the same time acquiring control on it. The FDI in India could be in the form of inflow of investment (credit) and outflow in the form of disinvestment’s (debit) or abroad in the reverse manner. Portfolio investment is the acquisition of an asset, without control over it. Portfolio investment comes in the form of Foreign Institutional Investors (FIIs), offshore funds and Global Depository Receipts (GDRs) and American Depository Receipts (ADRs). Acquisition of shares (acquisition of shares of Indian companies by nonresidents under section 5 of FEMA, 1999) has been included as part of foreign direct investment since January 1996.

2. Loans – Loans are further classified into external assistance, medium and long-term commercial borrowings and short-term borrowings, with loans of original maturity of one-year or less constituting the relevant dividing line. The principal repayment of the defense debt to the General Currency Area (GCA) is shown under the debit to loans (external commercial borrowing to India) for the general currency area since 1990-91.

3. Banking Capital – Banking capital comprises external assets and liabilities of commercial and government banks authorized to deal in foreign exchange, and movement in balance of foreign central banks and international institutions like, World Bank, IDA, ADB and IFC maintained with RBI. Non-resident (NRI) deposits are an important component of banking capital.

4. Rupee Debt Service – Rupee debt service contains interest payment on, and principal re-payment of debt for the erstwhile rupee payments area (RPA). This is done based on the recommendation of high-level committee on balance of payments.

5. Other Capital – Other capital is a residual item and broadly includes delayed exports receipts, funds raised and held abroad by Indian corporate, India’s subscriptions to international institutions and quota payments to IMF. Delayed export receipts essentially arises from the leads and lags between the physical shipment of goods recorded by the customs and receipt of funds through banking channel. It also includes rupee value of gold acquisition by the RBI (monetization of gold).

6. Movement in Reserves – Movement in reserves comprises changes in the foreign currency assets held by the RBI and SDR balances held by the government of India. These are recorded after excluding changes on account of valuation. Valuation changes arise because foreign currency assets are expressed in terms US dollar and they include the effect of appreciation/depreciation of non-US currencies (such as Euro, Sterling, Yen and others) held in reserves. Furthermore, this item does not include reserve position with IMF.

Structure of Capital Account in India’s BOP Statement

B. CAPITAL ACCOUNT

1. Foreign Investment (a + b)

a. In India
i. Direct
ii. Portfolio
b. Abroad

2. Loans (a + b + c)

a. External Assistance
i. By India
ii. To India
b. Commercial Borrowings
i. By India
ii. To India
c. Short-term
i. To India

3. Banking Capital (a + b)

a. Commercial Banks
i. Assets
ii. Liabilities
iii. Non-resident deposits
b. Others

4. Rupee Debt Service

5. Other Capital

Total Capital Account = 1 + 2 + 3 + 4 + 5

The above discussion details that capital account transactions of financial assets and liabilities between residents and nonresidents, and comprises the sub-components: direct investment, portfolio investment, financial derivatives, and other investment.

The Current Account Component in Balance of Payments (BoP)

The Current Account Component

The Current Account records a nation’s total exports of goods, services and transfers, and its total imports of them. The current account is subdivided into two components (1) balance of trade (BoT), and (2) balance of invisibles (BOIs).

Structure of Current Account in India’s BOP Statement

A. CURRENT ACCOUNT

I. Merchandise (BOT): Trade Balance (A-B)

A. Exports, f.o.b.
B. Imports, c.i.f.

II. Invisibles (BOI): (a + b + c)

a. Services

i. Travel
ii. Transportation
iii. Insurance
iv. Govt. not elsewhere classified
v. Miscellaneous

b. Transfers

i. Official
ii. Private

c. Income

i. Investment Income
ii. Compensation to employees

Total Current Account = I + II

1. Balance of Trade (BoT)

Balance of payments refers the difference between merchandise exports and merchandise imports of a country. BOT is also known as “general merchandise”, which covers transactions of movable goods with changes of ownership between residents and nonresidents. So, balance of trade deals with the export and import of merchandise, except ships, airline stores, and so on. Purchased by non-resident transport operators in the given country and similar goods purchased overseas by that country’s operators, purchases of foreign travelers, purchases by domestic missions. The data of exports and imports are obtained from trade statistics and reports on payments/receipts submitted by individuals and enterprises.

The valuation for exports should be in the form of f.o.b (free on board) basis and imports are valued on the basis of c.i.f (cost, insurance and fright). Exports, are credit entries. The data for these items are obtained from the various forms of exporters, which would be filled by exporter and submitted to designate authorities. While imports are debit entries. The excess of exports over imports denotes favorable (surplus) balance of trade, while the excess of imports over exports denotes adverse (deficit) balance of trade.

The balance of the current account tells us if a country has a deficit or a surplus. If there is a deficit, does that mean the economy is weak? Does a surplus automatically mean that the economy is strong? Not necessarily. But to understand the significance of this part of the BOP, we should start by looking at the components of the current account: goods, services, income and current transfers.

1. Goods – These are movable and physical in nature, and in order for a transaction to be recorded under “goods”, a change of ownership from/to a resident (of the local country) to/from a non-resident (in a foreign country) has to take place. Movable goods include general merchandise, goods used for processing other goods, and non-monetary gold. An export is marked as a credit (money coming in) and an import is noted as a debit (money going out).

2. Services – Service trade is export / import of services; common services are financial services provided by banks to foreign investors, construction services and tourism services. These transactions result from an intangible action such as transportation, business services, tourism, royalties or licensing. If money is being paid for a service it is
recorded like an import (a debit), and if money is received it is recorded like an export (credit).

3. Current Transfers – Financial settlements associated with change in ownership of real resources or financial items. Any transfer between countries, which is one-way, workers’ remittances, donations, a gift or a grant, official assistance and pensions are termed a current transfer. Current transfers are unilateral transfers with nothing received in return. Due to their nature, current transfers are not considered real resources that affect economic production.

4. Income – Predominately current income associated with investments, which were made in previous periods. Additionally the wages & salaries paid to non-resident workers. In other words, income is money going in (credit) or out (debit) of a country from salaries, portfolio investments (in the form of dividends, for example), direct investments or any other type of investment. Together, goods, services and income provide an economy with fuel to function. This means that items under these categories are actual resources that are transferred to and from a country for economic production.

2. Balance of Invisibles (BoI)

These transactions result from an intangible action such as transportation, business services, tourism, royalties on patents or trade marks held abroad, insurance, banking, and unilateral services. All the cash receipts received by the resident from non-resident are credited under invisibles. The receipts include income received for the services provided by residents to non-residents, income (interest, dividend) earned by residents on their foreign financial investments, income earned by the residents by way of giving permission to use patents, and copyrights that are owned by them and offset entries to the cash and gifts received in-kind by residents from non-residents. On the other hand debits of invisible items consists of same items when the resident pays to the non-resident. Put in simple debit items consists of the same with the roles of residents and nonresidents reversed.

The sum of the net balance between the credit and debit entries under the both heads Merchandise, and invisibles is Current Account Balance (CAB). Symbolically: CAB = BOT +BOI It is surplus when the credits are higher than the debits, and it is deficit when the credits are less than debits.

Use of Current Account

Theoretically, the balance should be zero, but in the real world this is improbable. The current account may have a deficit or a surplus balance, that indicates about the state of the economy, both on its own and in comparison to other world markets.

A country’s current accounts credit balance (surplus) indicates that the country (economy) is a net creditor to the rest of the countries with which it has dealt. It also shows that how much a country is saving as opposed to investing. It indicates that the country is providing an abundance of resources to other economies, and is owed money in return. By providing these resources abroad, a country with a current account balance surplus gives receiving economies the chance to increase their productivity while running a deficit. This is referred to as financing a deficit.

On the other hand a country’s current account debit (deficit) balance reflects an economy that is a net debtor to the rest of the world. It is investing more than it is saving and is using resources from other economies to meet its domestic consumption and investment requirements. For example, let us say an economy decides that it needs to invest for the future (to receive investment income in the long run), so instead of saving, it sends the money abroad into an investment project. This would be marked as a debit in the financial account of the balance of payments at that period of time, but when future returns are made, they would be entered as investment income (a credit) in the current account under the income section.

A current account deficit is usually accompanied by depletion in foreign exchange assets because those reserves would be used for investment abroad. The deficit could also signify increased foreign investment in the local market, in which case the local economy is liable to pay the foreign economy investment income in the future. It is important to understand from where a deficit or a surplus is stemming because sometimes looking at the current account, as a whole could be misleading.

Balance of Payments (BOP) and Exchange Rates

The International Monetary Fund (IMF) defines the BOP as a statistical statement that systematically summarizes, for a specific time period, the economic transactions of an economy with the rest of the world. BOP data measures economic transactions include exports and imports of goods and services, income flows, capital flows, and gifts and similar ―one-sided transfer payments. The net of all these transactions is matched by a change in the country‘s international monetary reserves.

The significance of a deficit or surplus in the BOP has changed since the advent of floating exchange rates. Traditionally, BOP measures were used as evidence of pressure on a country‘s foreign exchange rate. This pressure led to governmental transactions that were compensatory in nature, forced on the government by its need to settle the deficit or face a devaluation.

Exchange Rate Impacts:

The relationship between the BOP and exchange rates can be illustrated by use of a simplified equation that summarizes BOP data:

BOP = (X-M) + (CI-CO) + (FI-FO) +FXB

· Where: X is exports of goods and services,

· M is imports of goods and services,

· (X-M) is known as Current Account Balance

· CI is capital outflows,

· CO is capital outflows,

· (CI-CO) is known as Capital Account Balance

· FI is financial inflows,

· FO is financial outflows,

· (FI-FO) is known as Financial Account Balance

· FXB is official monetary reserves such as foreign exchange and gold

The effect of an imbalance in the BOP of a country works somewhat differently depending on whether that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system.

a) Fixed Exchange Rate Countries. Under a fixed exchange rate system, the government bears the responsibility to ensure a BOP near zero. If the sum of the current and capital accounts does not approximate zero, the government is expected to intervence in the foreign exchange market by buying or selling official foreign exchange reserves. If the sum of the first two accounts is greater than zero, a surplus demand for the domestic currency exists in the world. To preserve the fixed exchange rate, the government must then intervence in the foreign exchange market and sell domestic currency for foreign currencies or gold so as to bring the BOP back near zero. It the sum of the current and capital accounts is negative, an exchange supply of the domestic currency exists in world markets. Then the government must intervene by buying the domestic currency with its reserves of foreign currencies and gold. It is obviously important for a government to maintain significant foreign exchange reserve balances to allow it to intervene effectively. If the country runs out of foreign exchange reserves, it will be unable to buy back its domestic currency and will be forced to devalue. For fixed exchange rate countries, then, business managers use balance-of-payments statistics to help forecast devaluation or revaluation of the official exchange rate. Normally a change in fixed exchange rates is technically called ―devaluation‖ or ―revaluation, while a change in floating exchange rates is called either ―depreciation or ―appreciation.

b) Floating Exchange Rate Countries. Under a floating exchange rate system, the government of a county has no responsibility to peg the foreign exchange rate. The fact that the current and capital account balances do not sum to zero will automatically (in theory) alter the exchange rate in the direction necessary to obtain a BOP near zero. For example, a country running a sizable current account deficit with the capital and financial accounts balance of zero will have a net BOP deficit. An excess supply of the domestic currency will appear on world markets. As is the case with all goods in excess supply, the market will rid itself of the imbalance by lowering the price. Thus, the domestic currency will fall in value, and the BOP will move back toward zero. Exchange rate markets do not always follow this theory, particularly in the short-to-intermediate term.

c) Managed Floats. Although still relying on market conditions for day-to-day exchange rate determination, countries operating with managed floats often find it necessary to take actions to maintain their desired exchange rate values. They therefore seek to alter the market‘s valuation of a specific exchange rate by influencing the motivations of market activity, rather than through direct intervention in the foreign exchange markets. The primary action taken by such governments is to change relative interest rates, thus influencing the economic fundamentals of exchange rate determination. A change in domestic interest rates is an attempt to alter capital account balance, especially the short-term portfolio component of these capital flows, in order to restore an imbalance caused by the deficit in current account. The power of interest rate changes on international capital and exchange rate movements can be substantial. A country with a managed float that wishes to defend its currency may choose to raise domestic interest rates to attract additional capital from abroad. This will alter market forces and create additional market demand for domestic currency. In this process, the government signals exchange market participants that it intends to take measures to preserve the currency‘s value within certain ranges. The process also raises the cost of local borrowing for businesses, however, and so the policy is seldom without domestic critics. For managed-float countries, business managers use BOP trends to help forecast changes in the government policies on domestic interest rates.

Floating or Flexible Exchange Rate System

A floating or flexible exchange rate system is one in which the exchange rate between currencies is determined purely by supply and demand of the currencies without any government intervention. The rates depend on the flow of money between the countries, which may either result due to international trade in goods or services, or due to purely financial flows. Hence in case of a deficit or surplus in the balance of payments, the exchange rates get automatically adjusted and this leads to a correction of the imbalance.

In a floating exchange rate system, economic parameters like price level changes, interest differentials, economic growth and government policies have an impact on the exchange rate as these factors influence the supply and demand of currencies.

A purely floating exchange rate system is more of a theoretical benchmark rather than reality in practice. Most economies fall in between the two extremes – a rigidly fixed system and a purely floating system. The United States, the EU, and Japan are close to the flexible exchange rate system, although central banks of these countries intervene in the foreign exchange market from time to time.

Key features of a floating exchange rate system are:

· No government intervention required.

· Exchange rate determined by market forces.

· Frequent fluctuations.

· Balance of payments adjusts simultaneously with the exchange rate.

Floating exchange rates can be of two types:

1. Free float: Under the free float, market exchange rates are determined by the interaction of currencies supply and demand. The supply and demand schedules, in turn, are influenced by price level changes, interest differentials and economic growth. As these economic parameters change, market participants will adjust their current and expected future currency needs. There is no intervention either by the government or by the central bank.

2. Managed float: In the free float, there is always an uncertainty in exchange rate movements that reduce economic efficiency by acting as a tax on trade and foreign investments. In order to reduce the volatility associated with the free float, the central bank generally intervenes in the currency markets to smoothen the fluctuations. Such a system of managed exchange rates is referred to as a managed float or a dirty float.

There are three approaches to manage the float:

1. Smoothing out daily fluctuations: The central bank may occasionally enter the market on the buy or sell side to ease the transition from one rate to another, rather than resist fundamental market forces, tending to bring about long-term currency appreciation or depreciation.

2. “Leaning against wind”: This approach is an intermediate policy designed to moderate an abrupt short and medium-term fluctuations brought about by random events whose effects are expected to be only temporary. Intervention may take place to prevent these short and medium-term effects, while letting the markets find their own equilibrium rates in the long-term, in accordance with the fundamentals.

3. Unofficial pegging: In the third variation, though officially the exchange rate may be floating, in reality the central bank may intervene regularly in the currency market, thus unofficially keeping it fixed.

Advantages of Floating Exchange Rate System

· Since the country is not required to defend the exchange rate at a certain level, the government and central bank are free to choose independent domestic macroeconomic policies to deal with domestic issues such as inflation or unemployment.

· Under floating exchange rate regime, market intervention by the central bank is not required to defend the exchange rate.

· Since there is no need for market intervention, there is only very low requirement for international reserves.

· For countries that lack monetary and fiscal disciplines, a floating exchange rate sets no pressure for a country to observe these disciplines.

Disadvantages of Floating Exchange Rate System

· Floating exchange rate system is susceptible to large swings in the exchange rate causing substantial swings in the real economy, especially in the case of small emerging market economies where exports, imports, and international capital flows make up a relatively large share of the economy.

· Floating exchange rate system provides uncertainty and exchange rate risk in international trade and investment. Although exchange rate risk could be hedged under a floating exchange rate regime, such hedges could be expensive.

· Since the volatility in exchange rate is higher under floating exchange rate system, any depreciation of the domestic currency may disrupt the financial system, especially in the case of a country where banks make significant loans in foreign currency.

Disequilibrium in Balance of Payments

We have noted above that the balance of payments is always in balances from accounting point of view. Besides, in the accounting procedure, a deficit in the current account is offset by a surplus in capital account resulting from either borrowing from abroad or running down the gold and foreign exchange reserves. Similarly, a surplus in the current account is offset by a corresponding deficit in capital account resulting from loans and bills to debtor country or by decline of its gold and foreign exchange reserves. However, disequilibrium in the balance of payments does arise because total receipts during the reference period need not be necessarily equal to the total payments. When total receipts do not match with total payment of the accounting period, this is a position of disequilibrium in the balance of payments. The final balance of payments position is obtained in the manner described below.

For assessing the over-all balance of payments position, the total receipt and total payments arising out of transfer of goods and services and long-run capital movements are taken into account. All the transactions are regrouped into autonomous and induced transactions. Autonomous transactions take place on their own all account of peoples desire to consume more or to make a larger profit. For example, export and imports of items in current account are undertaken with a view to, make profit or consume more goods. Another autonomous item in the current account is gift or donations. They are voluntary and deliberate. In the capital account, export and import of long-term capital are autonomous transactions. In addition, the short-term capital movements motivated by the desire to invest abroad for higher return fall in the category of autonomous transactions. Thus all exports and imports of goods and services, long-term and short-term capital movements motivated by the desire to earn higher returns abroad or to give gifts and donation are the autonomous transactions. Exports and imports take place irrespective of other transactions included in the balance of payments accounts. Hence, these are autonomous transactions. If exports (Xg) equal imports (Mg) in value, there will be no other transaction. However, if Xg is less than Mg, it leads to short-run capital movements, e.g., international borrowing or lending. Such international borrowings or lending are not undertaken for their own sake, but for making payment for the deficit in the balance of trade. Hence, these are called induced transactions. They involve accommodating capital flows. On the other hand, the short-term capital movement’s viz., gold movements it and accommodating capital movements on accounts of the autonomous transactions are induced transactions. These transactions lead to reduction in the gold and foreign exchange reserves of the country.

In the assessment of balance of payments position only autonomous transactions are taken into account. The total receipt and payments resulting from the autonomous transaction determine the deficit or surplus in the balance of payments. If total receipts and payments are unequal, the balance of payments is in disequilibrium. If the total payments exceed the total receipts, the balance or payment shows deficit. On the contrary, if receipts from autonomous transactions exceed the payments for autonomous transactions, the balance of payments is in surplus. Naturally, if both are equal, there is neither deficit nor surplus, and the balance of payments is in equilibrium. From the policy point of view, the depletion in the gold and foreign exchange reserves is generally taken as an indicator of balance of payments running into deficit, which is a matter of concern for the government. However, if reserves are plentiful and the government has adopted a deliberate policy to run it down, then the deficit in the balance of payments is not a healthy sign for the economy. Besides, the disequilibrium of surplus nature except the one that might cause inflation is not a serious matter as the disequilibrium of deficit nature. We will be therefore, concerned here mainly with the deficit kind of disequilibrium in the balance of payments.

Causes of BoP Disequilibrium

The deficit kind of disequilibrium in the balance of payments arises when a country’s autonomous payments exceed its autonomous receipts. The autonomous payments arise out of imports of goods and services and export of capital. Similarly, autonomous receipts result from the merchandise exports and import of capital. It may therefore be said that disequilibrium of deficit nature arises when total imports exceed total exports. However, imports and exports do not determine themselves. The volume and value of imports and exports are determined by a host of other factors. As regards the determinants of imports, the total import of country depends upon three factors: (i) internal demand for foreign goods, which largely depends on the total purchasing power of the residents of the importing country, (ii) the prices of imports and their domestic substitutes, and (iii) people’s preference for foreign goods. Similarly, the total export of a country depends on (i) foreign demand for its goods and services, (ii) competitiveness of its price and quality, and (iii) exportable surplus.

Under static conditions, these factors remain constant. Therefore, equilibrium in the balance of payments, once achieved, remains stable. However, under dynamic conditions, factors that determine imports and exports keep changing, sometimes gradually but often violently and unexpectedly. The changes differ in their duration and intensity from country to country and from time to time. The changes, which occur as a result of disturbances ,in the domestic economy and abroad, create conditions for dis-equilibrium in the balance of payment.

1. Price Changes and Disequilibrium

The first and the major cause of disequilibrium in the balance of payment is the change in the price level. Price changes may be inflationary or deflationary. Deflation normally causes surplus in the balance of payment. The balance of payments surplus does not cause a serious concern from the country’s point of view. It may, however lead to wasteful expenditure and mal-allocation of resources. On he other hand, inflationary changes in prices causes deficits in the balance of payments. The balance of payments deficit result in increased indebtedness, depletion of gold reserves. loss of employment and distortions in the domestic economy and causes other economic problems in the deficit countries. Therefore, we will discuss only the impact of inflationary price changes on the balance of payments position.

Inflation causes a change in the relative prices of imports and exports. While exchange rate remains same, inflation causes increase in imports because domestic prices become relatively higher than the import prices. On the other hand, inflation leads to decrease in exports because of decrease in foreign demand due to increase in domestic prices. The increase in imports depends also on price-elasticity of demand for imports in the home market and decrease in the exports depends on the price-elasticity of foreign demand for home-products. In case price-elasticity of imports and exports is not equal to zero, imports are bound to exceed the exports. As a result, there will be a deficit in the balance of payments. If inflationary conditions perpetuate, it will produce long-run disequilibrium. If the size of deficit is large and disequilibrium is inflexible, it is termed as a fundamental disequilibrium. The price changes or fluctuations may be local, confined to one or few countries or it may be global as it happened in the world economy in 1930s. If price fluctuations take the form of business cycle, most countries face depression and inflation almost simultaneously. Since economic size of the nations differs, their imports are affected in varying degrees. Deficits and surpluses in the balance of payment vary from moderate to large. The countries with higher marginal propensity to import accumulate larger deficits during inflationary phase of trade cycle and a moderate deficit or even surplus, during depression. Such disequilibrium is known as cyclical disequilibrium. This is however only a theoretical possibility. Since little is known about the marginal propensities to import, any generalization would be unwise.

3. Structural Changes and Disequilibrium

Structural changes, in an economy are caused by factors, such as, (i) depletion of the cheap natural resources (ii) change in technology with which a country is not in a position to keep pace, i.e., technology lag and, (iii) change in consumers taste and preference. Such changes incapacitate exporting countries and they find it difficult to face competition in the international market, due to either high cost of production or lack of foreign demand.

All such changes bring change in demand and supply conditions. If size of foreign trade is fairly large, then the balance of payments is adversely affected. The ultimate result is disequilibrium in the balance of payments. It is called structural disequilibrium. The structural disequilibrium may also originate from the discovery of new resources, which may invite foreign capital in a large measure. The large-scale capital inflow may turn the balance of payments deficit into a surplus.

3. Other Factors

In addition to the fundamental factors responsible for disequilibrium in the balance of payments, there are certain other factors, which may cause temporal disequilibrium, Some of them are as follows:

· Disturbances or crop failure particularly in the countries, producing primary goods.

· Rapid growth in population leading to large-scale imports of food materials.

· Ambitious development projects requiring heavy imports of technology, equipments,machinery and technical know-how.

· Demonstration-effect of advanced countries on the consumption pattern of less developed countries.

Correction of Balance of Payments (BoP) Deficit

Balance of Payments Adjustments

The short-term and small deficits in balance of payments are quite likely to emerge in wide range of international transactions. These deficits do not call for immediate corrective actions. More importantly, irregular short-term changes in the domestic economic policies with a view to remove the short-term deficits in balance of payments may do more harms than good to the economy. Since these changes cause dislocations in the process of reallocation of resources and short-term fluctuations in the economy. Therefore, short-term deficits of smaller magnitude are not a serious concern to the policy makers. A constant deficit indicates that the country’s imports dominates exports or depreciation of its foreign exchange and gold reserves. These countries lose their international liquidity and credibility. This situation often leads to compromise with economic and political independence of these countries.

India faced a similar situation in July 1990. Therefore, a country facing constant large deficits in balance of payments is forced to adopt corrective measures, such as changes in its internal economic policies for wiping out the deficits, or at least to bring it in a manageable size. It is a widely accepted view that the conditions for an automatic corrective mechanism visualized under gold standard, based on international price mechanism do not exist. Therefore, the government has no option but to intervene with the market conditions of demand and supply with the policy measures available to them. It should be borne in mind that policy-mix in this regard may vary from country to country and from time to time depending on the prevailing economic conditions.

Measures used to Correct Deficits in Balance of Payments

The various measures used to correct deficits in balance of payments are as follows:

· Indirect measures to correct adverse BoP: Under free trade system, the deficits in balance of payments arise either due to greater aggregate domestic demand for goods and services than the total domestic supply of goods and services or domestic prices are significantly higher than the foreign prices. Thus, the deficit may be removed either by increasing domestic production at an internationally comparable cost of production or by reducing excess demand or by using the two methods simultaneously. It may be very difficult to increase the output in the short-run, specially when a country is close to full-employment or when there are other limiting factors to its industrial growth. Therefore the only way to reduce deficit is to reduce the demand for foreign goods.

· Income and Expenditure Policies: Here we discuss how reduction in income can lead to reduction in demand and how it helps reducing the deficit in the balance of payments. The two policy tools to change disposable income are monetary and fiscal policies. Monetary policy operates on the demand for and supply of money while fiscal policy operates on the disposable income of the people. The working and efficacy on these policies as instruments of solving balance of payment problem is described below.

1. Monetary Policy

The instruments of monetary policy include discount and bank rate policy, open market operations, statutory reserve ratios and selective credit controls. Of these, first two instruments are adopted in the context of balance of payment policy. This however should not mean that other instruments are not relevant. The government is free to choose any or all of these instruments and adopt them simultaneously.

To solve the problem of deficit in the balance of payments, a ‘tight money policy’ or ‘dear money policy’ is adopted. Under ‘dear money’ policy, central bank raise the bank rates and discount rates. Consequently, under normal conditions, the demand for institutional funds for investment decreases. With the fall in investment and through its multiplier effect, income of the people decreases. If marginal propensity to consume is greater than zero, demand for goods and services decreases. The decrease in demand also implies a simultaneous decrease in imports while other things remain same. This is how ‘a tight money policy’ corrects deficit in balance of payments.

The efficiency of ‘tight money policy’ is however doubtful under following conditions: (i) when rates of returns are much higher than the increased bank rate due to inflationary conditions, (ii) when investors have already affected their investment in anticipation of increase in the rate of interest. The tight money policy is then combined with open market operation, i.e., sale of government bonds and securities. These two instruments together help to reduce demand for capital and other goods. Therefore, if all goes well then the deficit in the balance of payments is bound to decrease.

2. Fiscal Policy

Fiscal policy as a tool of income regulation includes intervention in taxation and public expenditure. Taxation reduces household disposable income. Direct taxes directly transfer the household income to the public reserves while indirect taxes serve the same purpose through increased prices of the taxed commodities. Direct taxes reduce personal savings directly in a greater amount while indirect taxes do it in a relatively smaller amount. Taxation reduces the disposable income of the household and thereby the aggregate demand including the demand for imports. Taxation also helps to curtail investment by taxing capital at progressive rates.

The government can reduce income and demand also by adopting the policy of surplus budgeting in which the government keeps its expenditure less than its revenue. Taxation reduces disposable income of household and public expenditure increases household’s income and their purchasing power. However, multiplier effect of public expenditure is greater by one than the multiplier effect of taxation. Therefore, while adopting surplus-budget policy due consideration should be given to this fact. To account for this fact, it is necessary that surplus is so large that the total cumulative effect of taxation on disposable income exceeds the effect of public expenditure. The reduction in income that will be necessary to achieve a certain given target of reducing balance of payments deficit depends on the rate foreign trade multiplier.

Exchange Depreciation and Devaluation

Reducing excess demand through price measures involves changing relative prices of imports and exports. Relative prices of imports and exports can be changed through exchange depreciation and devaluation. Exchange depreciation refers to fall in the value of home currency in terms of foreign currency and devaluation refers to fall in the value of home currency in terms of gold. However, ill terms of purchasing power, parity between devaluation and depreciation turns out to be the same and its impact on foreign demand is also the same. Therefore, we shall consider them as one in their role of correcting adverse balance of payments.

Devaluation and exchange depreciation change the relative prices of imports and exports, i.e., import prices increase and export prices decrease, though not necessarily in the proportion of devaluation. As a result of change in relative prices of exports and imports, the demand for imports decreases in the country, which devalues its currency and foreign demand for its goods increases provided foreign demand for imports is price elastic. Thus, if devaluation or exchange depreciation is effective, imports will decrease and exports will increase. Country’s payments for imports would decrease and export earnings would increase. This ultimately decreases the deficits in the balance of payments in due course of time. However, whether expected results of devaluation or exchange depreciation are achieved or not depends on the following conditions.

· The most important condition in this regard is the Marshall-Lerner condition. The Marshall-Lerner condition states that devaluation will improve the balance of payments only if the sum of elasticities of home demand for imports and foreign demand for exports is greater than unity. If the sum of elasticities is less than unity, the balance of payments can be improved through revaluation instead of devaluation.

· Devaluation can be successful only if the affectcd countries do not devalue their currency in retaliation.

· Devaluation must not change the cost-price structure in favor of imports.

· Finally, the government ensures that inflation, which may be the result of devaluation, is kept under control, so that the effect of devaluation is not counter-balanced by the effect of inflation.

Use of Exchange Controls to Eliminate a Nation’s Balance of Payments (BoP) Deficit

The exchange control refers to a set of restrictions imposed on the international transactions and payments, by the government or the exchange control authority. Exchange control may be partial, confined to only few kinds of transactions or payments, or total covering all kinds of international transactions depending on the requirement of the country.

The main features of a full-fledged exchange control system are as follows:

· The government acquires, through the legislative measures, a complete domination over the foreign exchange transactions.

· The government monopolizes the purchase and sale of foreign exchange.

· Law eliminates the sale and purchase of foreign exchange by the resident individuals. Even holding foreign exchange without informing the exchange control authority’s declared illegal.

· All payments to the foreigners and receipts from them are routed through the exchange control authority or the authorized agents.

· Foreign exchange payments arc restricted, generally, to the import of essential goods and service such as food items, raw materials and some other essential industrial inputs like petroleum products.

· A system of rationing is adopted in the foreign exchange allocation for essential imports.

· To ensure the effectiveness of the exchange control system and to prevent the possible evasion, strict, stringent laws arc enacted.

· The circuitous legal procedure of acquiring import and export licences is brought in force. In the process, the convertibility of the home currency is sacrificed.

Why Exchange Control?

The exchange control system as a measure of adjusting adverse balance of payments. In contrast to the self-sustained and automatic functioning of the market system, the exchange control requires a cumbersome bureaucratic system of checks and controls. Yet, many countries facing balance of payment deficits opt for exchange control for lack of options. In fact, automatic adjustment in the balance of payments requires the existence of’ the following conditions.

· International competitive strength of the deficit countries.

· A fairly high elasticity of demand for imports.

· Perfectly competitive international market mechanism.

· Absence of government intervention with the demand and supply conditions.

The existence of these conditions has always been doubted. Owing to differences in resource endowments technology, and the level of industrial growth, countries differ in their economic strength and their industries lack the competitiveness. The protectionist policies adopted by various countries intervene with international market mechanism. Besides, automatic method of balance of payments adjustment requires a strict discipline, economic strength and political will to bear the destabilizing shocks which the automatic method is expected to bring to a country in the process of adjustment. Since these conditions rarely exist, the efficacy of international market mechanism to bring automatic balance of payments adjustment is often doubted.

For these reasons, exchange control remains the last resort for the countries under severe strain of balance or payments deficits. The exchange controls aid to possess a superior effectiveness in providing solutions to the deficit problem. Besides, it insulates an economy against the impact of economic distresses from foreign countries. Another positive advantage or exchange control lies in its effectiveness in dealing with the problem or capital movements. The governments monopoly over the foreign exchange can effectively stop or reduce the capital movements by simply refusing to release foreign exchange for capital transfer. Many countries adopted exchange control during 1930s great depression because of this advantage. Although the exchange control is positively a superior method of dealing with disequilibrium in the balance of payments, it docs not provide a permanent solution to the basic causes of deficit problem.

Issues with Exchange Control

Exchange control may no doubt provide solution to balance of payment deficits, but it also creates following problems:

· When restrictions on exchange control becomes wide spread then large number of currencies are rendered nonconvertible. This restricts foreign trade and the gains from foreign trade are either lost or reduced to a minimum.

· Even after the interest of an economy is secured, i.e., external deficit is recovered and insulation of economy against external influence is complete; the exchange-control countries instead of giving up exchange control, feel it to gear their internal polices, monetary and fiscal, towards the promotion of economic growth, achieving full employment and its maintenance. In doing so, they adopt easy monetary and promotional fiscal policies. Consequently, income and prices tend to rise, and inflationary trend is set in the economy.

· Price also tends to rise, since in an insulted economy, import-competing industries are not under compulsion to check cost increases and to improve efficiency. As a result, exports become relatively costlier and imports relatively cheaper and hence, exports tend to shrink and imports tend to expand. These are the first outcome of overvaluation of home-currency. The balance of payments is no doubt maintained in equilibrium, but the initial advantage gradually disappears.

The countries confronted with the problems arising out of exchange control are forced to find new outlets for their exports and new sources of imports. The efforts in this direction give rise to bilateral trade agreements between the countries having common interest. The basic feature of the bilateral trade agreements is to accept each other’s nonconvertible currency for exports and use the same for imports. Under the trade agreements, the commodities and their quantities or values should also be specified. Another outcome of exchange control leading to bilateral trade agreement is the emergence of disorderly cross exchange rates, i.e., the multiplicity of inconsistent exchange rates. In other words, the currencies have different exchange rates between them.

Nonconvertible currency has different exchange relation with the countries . The bilateral trade agreement therefore, exchange rates are not consistent with each other. The multiplicity of inconsistent exchange rates came inevitable when countries having trade surplus and deficits fix up official rates from time to time depending upon their requirements, maintain it through arbitrary rules. Exchange rates become multiple also because ‘exchange arbitrage‘, i.e., the simultaneous purchase and sale of exchange in different markets, becomes impossible.

Under the multiple exchange rate system, there may be a dual exchange rate policy. In dual exchange rate policy, there is an official rate for permissible private transactions and official transactions and a market rate for all other kinds of transactions. However, the multiple exchange rate system has its own shortcomings . The system adds complexity and uncertainty to international transactions. Besides, it requires efficient and honest administrative machinery in the absence of which it often leads to inefficient use of resources. It is, therefore, desirable for the deficit countries to first evaluate the consequences efficiently and practicability of exchange control and then decide on the course of action. It has been suggested that exchange control, if adopted, should be moderate and as temporary measure until the basic solution to the problems of balance of payments deficit is obtained The exchange control problem does not provide permanent solution to the balance of payments deficit and therefore, it should be adopted only with proper understanding.

International Financial Environment - Composite notes for BCom Program and B Com Hons III year

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