BALANCE OF PAYMENTS

Objectives

Explanation of the balance of payments.

Distinguish between the current account and capital account.

Causes and consequences of balance of payments disequilibrium.

Policy measures for correcting balance of payments disequilibrium.

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Defining Balance of Payments

The

balance of payments is a record of all economic transactions

conducted between a country and the rest of the world for a given
time period, usually one year.

An

economic transaction is an exchange of value. It involves a receipt

and a payment of money in exchange for economic goods and services.

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Accounting Treatment of Items

In standard accounting double entry book-keeping, each transaction will

result in a debit and a credit entry of equal size or amount.

Thus in that sense, a countrys balance of payments accounts for any given
year always balances.

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Accounting Treatment of Items

In terms of actual receipts and payments, a country may be faced in any

given year with one of two situations.
(a)

A surplus or favourable balance on the BOP accounts.

(b)

A deficit or unfavourable balance on the BOP accounts.

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Accounting Treatment of Items (Debit

and Credit Items)

Any item which gives rise to a sale of foreign exchange (an inflow) is
recorded as a credit item (+) in the accounts e.g. export of goods and
services

Any item which gives rise to the purchase of foreign exchange (an
outflow) is recorded as a debit item (-) in the accounts e.g imports of
goods and services.

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The Components of the BOP Account

The

Balance of Payments Account consists of two parts:

(i) A current account

(ii)

A capital (and financial) account

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The Components of the BOP Account

The

Current Account generally comprises two sections:

(a)

Visible balance (balance of visible trade): primarily

the
import and export of merchandise or goods)

(b)

Invisible balance (Balance of invisible trade): primarily

the import and export of services.

N.B. The sum of the two balances is referred to as the

balance on the current account.
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The Components of the BOP Account

The

Current Account generally comprises four main items:

(a)

Merchandise Trade Balance

(b)

Services Balance

(c)

Net Property Income Balance

(d)

Current Transfers Balance

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The Components of the BOP Account

The capital account records all movement of capital from both private
sources as well as official government sources between a country and the rest
of the world.

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10

The Components of the BOP Account

The Capital Account deals primarily with short term and long term
flows/movements of capital, that is, it is concerned with international loans
and investments.

It may consist of transfer of ownership of a fixed asset; direct investments,

portfolio investments, other investments and reserve assets.

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11

The Components of the BOP Account

It must be noted that when the balances of both

sections are added there can be a surplus or a
deficit.
The account must therefore show the treatments
of any of these two situations as well as the item
to balance off the account. This is strictly for
accounting purposes. All surplus or deficits must
be dealt with.
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Sample BOP Accounts

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Sample BOP Accounts

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14

Balance of
Payments Disequilibrium

A deficit or an unfavourable balance exists when the

value of autonomous debit items exceeds the value
of autonomous credit items.

A surplus or a favourable balance exists when the

value of autonomous credit items exceeds the value
of autonomous debit items.

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15

CAUSES OF DISEQUILIBRIUM IN THE BOP

Cyclical fluctuations

Short fall in the exports

Economic Development

Rapid increase in population

Structural Changes

Natural Calamites

International Capital Movements

How to correct the Balance of Payment?

Deflation

- Deflation means falling prices. Deflation has been

used as a measure to correct deficit disequilibrium. A country
faces deficit when its imports exceeds exports.

Deflation

is brought through monetary measures like bank rate

policy, open market operations, etc. or through fiscal measures
like higher taxation, reduction in public expenditure, etc.
Deflation would make our items cheaper in foreign market
resulting a rise in our exports. At the same time the demands for
imports fall due to higher taxation and reduced income.
This would build a favourable atmosphere in the balance of
payment position. However Deflation can be successful when the
exchange rate remains fixed.

Cont

Exchange Depreciation -

Suppose the rate of exchange between Indian rupee and US dollar is $1 = Rs. 40. If India
experiences an adverse balance of payments with regard to U.S.A, the Indian demand for US
dollar will rise.

The price of dollar in terms of rupee will rise. Hence, dollar will appreciate in external value
and rupee will depreciate in external value. The new rate of exchange may be say $1 = Rs.
50. This means 25% exchange depreciation of the Indian currency.

Exchange depreciation will stimulate exports and reduce imports because exports will
become cheaper and imports costlier. Hence, a favourable balance of payments would
emerge to pay off the deficit.

Exchange depreciation means decline in the rate of

exchange of domestic currency in terms of foreign currency. This device implies that a
country has adopted a flexible exchange rate policy.

Cont

Devaluation - Devaluation refers to deliberate attempt made by monetary authorities

to bring down the value of home currency against foreign currency.

When devaluation is effected, the value of home currency goes down against foreign
currency, Let us suppose the exchange rate remains $1 = Rs. 10 before devaluation.
Let us suppose, devaluation takes place which reduces the value of home currency
and now the exchange rate becomes $1 = Rs. 20.

After such a change our goods becomes cheap in foreign market. This is because, after
devaluation, dollar is exchanged for more Indian currencies which push up the demand
for exports. At the same time, imports become costlier as Indians have to pay more
currencies to obtain one dollar. Thus demand for imports is reduced.

Generally devaluation is resorted to where there is serious adverse balance of

payment problem.

Cont
2.

Non-Monetary Measures

Export

Promotion

The

government can adopt export promotion measures to correct

disequilibrium in the balance of payments. This includes substitutes,
tax concessions to exporters, marketing facilities, credit and
incentives to exporters, etc.

The

government may also help to promote export through

exhibition, trade fairs; conducting marketing research & by providing
the required administrative and diplomatic help to tap the potential
markets

Cont

Quotas

Under the quota system, the government may fix and permit the maximum
quantity or value of a commodity to be imported during a given period. By
restricting imports through the quota system, the deficit is reduced and the
balance of payments position is improved.

Tariffs

Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices
of imports would increase to the extent of tariff. The increased prices will reduced
the demand for imported goods and at the same time induce domestic producers to
produce more of import substitutes. Non-essential imports can be drastically
reduced by imposing a very high rate of tariff.

HEDHING AND SPECULATION

IN FORWARD MARKET

Hedging

The forward market can be used to protect international trades and investors from
the risks involved in fluctuations of the spot rate.

The process of avoiding or covering a foreign exchange risk is known as hedging.

People who expect to make or receive payments in a foreign currency at a future

date are concerned that if the spot rate changes ,

they will have to make a grater payment or

they will receive less in terms of the domestic currency than expected .

This could wipe out anticipated profit levels.

How can firms and investors insulate themselves from volatile currency values?

They can deal in the forward market as shown in the following example.

Example 1: US importer hedges against a

dollar depreciation.

Assume A import 1 million francs swizz watch in three months time. During this period
, A is in an exposed uncovered position . He bears the risk that dollar price of the franc
might rise in three months ( the dollar might depreciate against the franc), say from $
0.60 to $ 0.70 per franc. If so , purchasing 1 million francs would require an extra
$100,000.

To cover itself against this risk,

He could immediately buy 1 million francs in the spot market , but this would
immobilize its funds for three months.
Alternatively ,he could contract to purchase 1 million franc in the forward
market , at todays forward rate for delivery in three months. In three months , he would
purchase francs with dollars at the contract price and use the francs to pay the Swiss
exporter .
Hedging in the forward market does not require to tie up its own funds when its purchases
from forward market.

Example 2: US exporter hedges against a

dollar appreciation.

Assume that Microsoft Corporation anticipates receiving 1 million francs in three

months from its exports of computer software to a Swiss retailer. During this
period , Microsoft is in an uncovered position .If the dollar price of franc falls (the
dollar appreciates against the franc ) say from $0.50 to $ 0.40 per franc ,
Microsoft s receipts will be worth $ 100,000 less when the 1 million francs are
converted in to dollars.

To avoid this foreign exchange risk, Microsoft can contract to sell its expected
franc receipts in the forward market at todays forward rate.

Microsoft is guaranteed that value of its franc receipts will be maintained in

terms of the dollar , even if the value of the franc should happen to fall.

Conclusion

The forward market thus eliminates the uncertainty of fluctuating spot rates from
international transactions.

Exporters can hedge against the possibility that the domestic currency will appreciate
against the foreign currency and importers can hedge against the possibility that the
domestic currency will depreciate against the foreign currency .

Hedging is not limited to exporters and importers . It applies to any one who is
obligated to make a foreign currency receipts at a future time.
Ex: International investors.

Speculation

Speculation is the attempt to profit by trading on expectations about prices

in the future.

Some speculators are traders acting for financial institutions or firms; others
are individuals.

In either case , speculators buy currencies that they expect to go up in value

and sell currencies that they expect to go down in value.

Speculating in the spot market

Imagine that you are a currency speculator in New York, willing to risk money on your
opinion about future prices of a foreign currency say, the Swiss franc . Consider the
following scenarios .

Case 1: Speculating on a Swiss franc appreciation.

Given: Todays spot rate is $0.40 per franc.
Assumption : In 3 months , the spot rate of the franc will rise to $ 0.50.
Procedure

1. Purchase Franc at todays spot price of $0.40 and deposit them in a bank to earn
interest .
2. In 3 months, sell the francs at the prevailing spot price of $0.50 per franc.
Out come
If the assumption is right , profit=$0.10 per franc. If assumption is wrong and the spot
price of the franc falls instead , you incur a loss, reselling francs a t a price lower than
the purchase price.

Cont

Case 2: Speculating on a Swiss franc depreciation.

Given: Today's spot price is $ 0.40 per franc.

Assumption: In 3 months, the spot price of the franc will fall to $0.25.
Procedure
1. Borrow francs today, exchange them for dollars at the prevailing spot price of
$0.40 per franc and deposit the dollars in a bank to earn interest.
2. In 3 months, buy francs at the prevailing spot price of $0.25 per franc and use
them to pay back the loan.
Outcome:
If assumption is right , profit =$0.15 per franc.

Speculating in the Forward market

Although speculation on the spot market can lead to profit, it has a serious
drawback: The speculator must have a large amount of idle cash or browning
privileges, which require interest payment.

Speculation in the forward market , however does not require cash or credit
facilities .

All the speculators need to do is sign a forward contract with bank to either
purchase or sell a specific amount of foreign currency at a specific date.

The bank may impose a margin requirement , requiring the speculator to put up
percentage value of the foreign contact as security.

Forward market speculation occurs when a speculator believes that a currencys

spot rate at some future date will differ from todays forward rate that same
date.

Cont

Case 1 :Speculating that the spot rate of the Swiss franc in 3 months will be
higher than its current 3 months forward rate .

Given: The current rate of the 3 month forward franc is $0.40.

Assumption: In 3 months , the prevailing spot price of the franc will be

$0.50.

Procedure

1.Contact to purchase a specified amount of francs in the forward market, at

$ 0.40 per franc for 3 month delivery.

2.After receiving delivery of the francs in 3 months, resell them in the spot
market at prevailing price of $0.50 per franc.

Outcome: If the assumption is right, profit= $0.10per franc. If assumption is

wrong and the prevailing spot price in 3 months is lower than $0.40 per franc,
you occur a loss.

Cont

Case 2 : Speculating that the spot rate of the Swiss franc in 3 months will be
lower than its current 3 months forward rate .

Given: The current rate of the 3 month forward franc is $0.40.

Assumption: In 3 months , the prevailing spot price of the franc will be

$0.30.

Procedure

1.Contract to sell a specified amount of franc for delivery in 3 months , at

the forward price of $0.40 per franc.

2.In 3 months , purchase an identical amount of francs in the spot market at

$0.30 and delivery them to fulfill the forward contract .

Outcome :If the assumption is right, profit= $0.10per franc. If assumption is

wrong and the prevailing spot price in 3 months is higher than $0.40 per
franc, you occur a loss.

INTERNATIONAL ORGANIZATION IN TRADE

AND FINANCE

IMF
The international Monetary Fund was created in 1944, with a goal to stabilize
exchange rates and supervise the reconstruction of the worlds internationl
payment system.
IMF is an organization of 185 countries.

Purpose of IMF
The purposes of the International Monetary Fund are as follows:
1. To promote international monetary cooperation through a permanent
institution which provides the machinery for consultation and collaboration
on international monetary problems.
2. To facilitate the expansion and balanced growth of international trade, and to
contribute thereby to the promotion and maintenance of high levels of
employment and real income and to the development of the productive
resources of all members as primary objectives of economic policy.
3. To promote exchange stability, to maintain orderly exchange arrangements
among members, and to avoid competitive exchange depreciation.

Criticisms
1.

Conditions for loans. The IMF makes the loan given to countries conditional on the
implementation of certain economic policies, which typically include the following:

Reducing government borrowing (higher taxes and lower spending)

Higher interest rates to stabilize the currency

Allowing failing firms to go bankrupt

Structural adjustment (privatization, deregulation, reducing corruption and bureaucracy)

2. Exchange rate reforms. When the IMF intervened in Kenya in the 1990s, they made
the Central bank remove controls over flows of capital. The consensus was that this decision
made it easier for corrupt politicians to transfer money out of the economy (known as the
Goldman scandal).
3. Devaluations. In the initial stages, the IMF has been criticized for allowing inflationary
devaluations.

Cont...

4.Free-market criticisms of the IMF. Believers in free markets argue that it is

better to let capital markets operate without attempts at intervention. They
argue attempts to influence exchange rates only make things worseit is better to
allow currencies to reach their market level

5.Lack of transparency and involvement. The IMF has been criticized for
imposing policy with little or no consultation with affected countries.

6.Supporting military dictatorships. The IMF has been criticized over the decades
for supporting military dictatorships.

Challenges

IMF, the funds strengths and opportunities include the following:

1. Flexibility and speed. In March 2009, the IMF created the Flexible Credit Line
(FCL), which is a fast-disbursing loan facility with low conditionality aimed at
reassuring investors by injecting liquidity

2.Cheerleading. The Fund is positioning itself to be less of an adversary and more

of a cheerleader to member countries. For some countries that need loans more for
reassurance than reform, these changes to the Fund toolkit are welcome
3.Adaptability. Instead of providing the same medicine to all countries regardless
of their particular problems, the new loan facilities are intended to aid reform-minded
governments by providing short-term resources to reassure investors. In this manner,
they help politicians in developing countries manage the downside costs of
integration.
4. Transparency. The IMF has made efforts to improve its own transparency and
continues to encourage its member countries to do so.

WORLD BANK
The world bank group was established in 1944 to rebuild post world war II Europe under
the International Bank for Reconstruction and Development.
Membership

184countries are shareholders in the IBRD.

To become a membership : a country must first join the International

monetary Fund.

Aims
Fights poverty by offering developmental assistance to middle income and low
income countries.
Give loans and offers advice and training in both the private and public sectors.

Eliminate poverty by helping people

Cont...

The World Bank Group includes the following interrelated institutions:

IBRD, which makes loans to countries with the purpose of building economies and
reducing poverty

IDA, which typically provides interest-free loans to countries with sovereign

guarantees

International Finance Corporation (IFC), which provides loans, equity, riskmanagement tools, and structured finance with the goal of facilitating
sustainable development by improving investments in the private sector

Multilateral Investment Guarantee Agency (MIGA), which focuses on improving the

foreign direct investment of the developing countries

International Centre for Settlement of Investment Disputes (ICSID), which

provides a means for dispute resolution between governments and private
investors, with the end goal of enhancing the flow of capital

Cont...

The current primary focus of the World Bank centers on six strategic themes:

1.The poorest countries. Poverty reduction and sustainable growth in the poorest
countries, especially in Africa.

2. Post conflict and fragile states. Solutions to the special challenges of post
conflict countries and fragile states.

3. Middle-income countries. Development solutions with customized services as

well as financing for middle-income countries.

Global public goods. Addressing regional and global issues that cross national
borders, such as climate change, infectious diseases, and trade.

5. The Arab world. Greater development and opportunity in the Arab world.

6. Knowledge and learning. Leveraging the best global knowledge to support

development.

Criticisms

Focusing on large projects rather than local initiatives. Some critics claim that
World Bank loans give preference to large infrastructure projects like building
dams and electric plants over projects that would benefit the poor, such as
education and basic health care.

Negative influence on theory and practice. As one of the two Bretton Woods
Institutions, the World Bank plays a large role in research, training, and policy
formulation. Critics worry that because the World Bank and the IMF are regarded
as experts in the field of financial regulation and economic development, their
views and prescriptions may undermine or eliminate alternative perspectives on
development.

Dominance of G7 countries. The industrialized countries dominate the World Bank

(and IMF) governance structures. Decisions are typically made and policies
implemented by these leading countriesthe G7because they are the largest
donors, some suggest without sufficient consultation with poor and developing
countries.

Challenges

The World Bank is focused on the following four key issues:

1. Increased transparency. In response to the criticisms over the decades, the World
Bank has made progress. More of the World Banks decision making and country
assessments are available publicly. The World Bank has continued to work with
countries to combat corruption both at the country and bank levels.

Expanding social issues in the fight on poverty. In 2001, the World Bank began to
incorporate gender issues into its policy.

Improvements in countries competitiveness and increasing exports. The World

Banks policies and its role as a donor have helped improve the ability of some
countries to secure more of the global revenues for basic commodities. In Rwanda,
for example, reforms transformed the countrys coffee industry and increased
exports. Kenya has expanded its exports of cut flowers, and Uganda has improved its
fish-processing industry. World Bank efforts have also helped African financial
companies develop.

Improving efficiencies in diverse industries and leveraging the private sector. The
World Bank has worked closely with businesses in the private sector to develop local
infrastructure, including power, transportation, telecommunications, health care,
and education.

WTO: The Beginnings/ History

The World Trade Organization (WTO) came into being

on January 1st 1995. It was the outcome of the lengthy
(1986-1994) Uruguay round of GATT negotiations. The
WTO was essentially an extension of GATT.

It extended GATT in two major ways. First GATT

became only one of the three major trade agreements that
went into the WTO (the other two being the General
Agreement on Trade in Services (GATS) and the
agreements on Trade Related Aspects of Intellectual
Property Rights (TRIPS)).

CONTI...

Second the WTO was put on a much sounder institutional

footing than GATT. With GATT the support services that
helped maintain the agreement had come into being in an
ad hoc manner as the need arose. The WTO by contrast is a
fully fledged institution (GATT also was, at least formally,
only an agreement between contracting parties and had no
independent existence of its own while the WTO is a
corporate body recognized under international law).

Current WTO members

153 members

Observers(31)

Why WTO?

To arrange the implementation, administration and

operations of multilateral (involving three or more
participants) and Plurilateral trade agreements (power
which shared between different countries)
To arrange the forum for deliberations for the member
nations in regard to their multilateral trade relations in
issues deal with under the agreements

CONTI...

To provide a framework for implementing of

the results arising out of the deliberations
(long and care full agreements/consideration)
which taken place at ministerial conference
level

To manage the created understanding on

rules and procedure governing the settlement
of disputes

CONTI...
To

manage effectively and efficiency the trade policy

review mechanism (TRIM)

To

create more together relationship with all nations in

respect of global economic policy-making, it would
cooperate with the IMF and the world bank & its
affiliated Organisations.

FUNCTIONS OF WTO
Administering WTO trade agreements

Forum for trade negotiations

Handling trade disputes

Monitoring national trade policies

Technical assistance and training for developing countries

Cooperation with other international organizations

PRINCIPLES OF WTO
The basic principles of the WTO (according to the WTO):

Trade Without Discrimination

1. Most-favoured-nation (MFN): treating other people equally
Under the WTO
agreements, countries cannot normally discriminate between their trading partners.
Grant someone a special favour (such as a lower customs duty rate for one of their
products) and you have to do the same for all other WTO members.
2. National treatment: Treating foreigners and locals equally
Imported and
locally-produced goods should be treated equally at least after the foreign goods
have entered the market. The same should apply to foreign and domestic services, and
to foreign and local trademarks, copyrights and patents.

CONTI...

Freer trade: gradually, through negotiation

Lowering trade barriers is one of the most obvious means of encouraging trade. The
barriers concerned include customs duties (or tariffs) and measures such as import
bans or quotas that restrict quantities selectively

Predictability: through binding and transparency

Sometimes, promising not to raise a trade barrier can be as important as lowering
one, because the promise gives businesses a clearer view of their future
opportunities. With stability and predictability, investment is encouraged, jobs are
created and consumers can fully enjoy the benefits of competition choice and
lower prices. The multilateral trading system is an attempt by governments to make
the business environment stable and predictable.

CONTI...

Promoting fair competition

The WTO is sometimes described as a free trade institution, but that is not entirely
accurate. The system does allow tariffs and, in limited circumstances, other forms of
protection. More accurately, it is a system of rules dedicated to open, fair and
undistorted competition.

Encouraging development and economic reform.

The WTO system contributes to development. On the other hand, developing

countries need flexibility in the time they take to implement the systems agreements.
And the agreements themselves inherit the earlier provisions of GATT that allow for
special assistance and trade concessions for developing countries.