Balance of Payment (BOP)

 The balance of payment of a

country may be viewed as a
summary record of all transactions
involving payments or receipts of
foreign exchange between the
country and the rest of the world.
 Balance of Payment (BOP)
 Balance of Trade is a part of BOP that
deals with merchandise or visible imports
and exports.
 Balance of payment has four parts—
 Current Account
 Capital Account
 Unilateral Transfers
 Official settlement account
 Current Account
 It is divided into two parts—
I. Visible: are those having transaction
receipts. It includes exports and imports
of mercantile.
II. Invisible: it includes—
 Export and Import of services
 Inflows and Outflows of investment
income
 Travel, transport, insurance etc.
 Capital Account
 It shows all flows that directly
affect the national balance
sheet.
 Capital Account in India is
classified into three sectors—
1. Private Capital
2. Banking Capital
3. Official Capital Transactions
Capital Account
 In short, it records long-term and
short-term capital flows.
 Unilateral Transfers
 It includes—
 Grants

 Remittances

 Aid

 Donations etc
Official Settlement
Account
 Settles the disequilibrium in BOP
 Relevance of BOP
 Following are the points showing
the relevance of the BOP:
1. It clearly indicated the economic
health and goodwill of a country
in the international market.
2. It severely indicated the level of
the country’s currency in the
international market.
 Relevance of BOP
3. BOP is also important to
determine the exchange rate of
a country with others.
 The BOP disequilibrium can be
corrected by two means:
1. Automatic correction
2. Deliberate measures
 Automatic Correction
 This was much prevalent under
the gold standard system.
 Under this provision the market

forces of demand and supply are

allowed to have a free play, which
automatically balances the
situation and brings it to
equilibrium.
 Deliberate Measures
 There are three measures—
A. Monetary Measures
B. Trade Measures
C. Miscellaneous Measures
 Monetary Measures
A. Monetary contractions or
expansions– the money supply is
regulated. This leads to reduction in
the purchasing power and therefore
the aggregate demand also reduces
and in this process the prices of
domestic market is also reduced.
Therefore, for others outside the
country the products become
cheaper and export increases.
 Monetary Measures
 Devaluation– a deliberate decrease in the
official value of a currency. India devalued its
currency in the year 1948, 1966 and 1991.
 Revaluation– an increase in the official foreign

exchange rate of a currency.

 Exchange control– relates to the value of
currency in the international market.
 Trade Measures
 Export Promotions—
i. Abolition or reduction of export duties.
ii. Export subsidies
iii. Export incentives
 Import controls—
i. Import duties
ii. Import quotas
iii. Import prohibition
 Miscellaneous Measures
i. Foreign loans
ii. Incentives for investment
iii. Tourism development
iv. Import substitution
v. Incentives for inward
remittances
 India’s BOP situation
 When India became
independent it had a sterling
balance of Rs. 1733 crores. But
all the balance was drained due
to three factors:
i. The effects of partition.
ii. Import of capital goods
iii. Greater reliance on imports.
 India’s BOP situation
 Current account 2001-02 have showed a
small surplus of $ 1.4 billion compared to
deficit of $ 2.6 billion in 2000-01. The reasons
are--
i. Invisibles have gone up especially in the case
of tourism, insurance, private transfer,
software exports and miscellaneous services
ii. The banking investment has increased it is
now $ 4.6 billion inflow.
iii. $ 587 million is registered under the heading
of Error and Emissions
 Depreciation
 A nation’s currency is said to
depreciate when it declines
relative to other currencies.
 Appreciation– the opposite of

depreciation. Which occurs

when the foreign exchange
rate of currency rises.
 Depreciation vs
Devaluation
 Devaluation is confined to situations in
which a country has officially pegged its
exchange rate to another country.
 Depreciation is when the a currency loses
its value against a currency. For example,
rupee against $ when this depreciation is
officially identified then value of currency is
fixed and this process is known as
devaluation.
 Appreciation Vs
Revaluation
 When a currency gains
value against a currency.
Process of fixing the value
of currency. Process of
fixing the value of the
currency is known as
Revaluation of currency.
 Devaluation
 In 1949 it was 30%
 In 1966 it was 36.5%-- it was due
to
i. Acute drought
ii. War with Pakistan
iii. Impact of China war
 Devaluation
 In 1991, it was 20% devaluation
was done due to—
i. A number of trading partners
devaluated their currencies
ii. U.S. – Iraq war (Gulf war)
 Benefits of Devaluation
(1991)
i. The import will become costlier and export
cheaper which will correct BOP
ii. Tourism would be boosted and ultimately the
current account will be positively boosted.
iii. FDI (Foreign direct Investment) and FIIs
(Foreign Institutional Investment) will increase
and this will steamline the foreign-exchange
reserve.
iv. Smuggling and other type of hoarding would
be discouraged.
 Limitations of Devaluation
1. Devaluation should not be
treated in isolation. A number of
measures related to other
spheres should also to be taken
simultaneously. The credit and
monetary policy must be
streamlined otherwise the
inflationary tendencies may
affect the internal market.
 Limitations of Devaluation
2. Devaluation is not likely to
produce favourable effects if
other countries retaliate by
devaluating their currency.
Thus, co-operation of other
countries is necessary to
make devaluation a success.
 Limitations of Devaluation
3. Devaluation will not
succeed in increasing
export and decreasing
import, if the domestic
prices rise by the rate
equal to or higher to the
rate of devaluation.
Limitations of Devaluation
4. According to Marshall-Lerner
condition of BOP devaluation
will improve the BOP only if
the sum of elasticities of
demand for the countries
exports increases.
 Limitations of Devaluation
 According to J curve:
devaluation will result in an
initial deterioration of the terms
of trade, because the import
will immediately be costlier and
export will take some time to
improve during this period.
 Convertibility
 Free convertibility of a currency means
that the currency can be exchange for
any other convertible currency without
any restriction, at the market
determined exchange rate.
Convertibility of rupee, thus means
that the rupee can be freely converted
into Dollar, Pound, Sterling, Yen, Euro
etc and vis-à-vis at the rate of
exchange, determined by the demand
and supply forces.
 Convertibility
 Exchange rate price is determined
by two ways—
 APM (Administered Price
Mechanism): demand and supply
regulated by the government.
 MDPM (Market Driven Price
Mechanism): no interference of
the government.
 Merits of Convertibility
1. It gives an indication of real value of Rupee.
2. It encourages export by increasing the profitability of
the exporters.
3. The high cost of Foreign Exchange encourages import
substitution in other areas also.
4. It provides incentives for remittances by NRIs
5. The convertibility and liberalization of gold imports
have been expected to make legal remittances and
gold smuggling less attractive.
 Problems of Convertibility
1. Convertibility could cause an
increase in prices because of the
increase in the import.
2. Under full convertibility, if the free
market exchange rate is very high,
the cost of essential imports will
correspondingly increase.
3. The government debt repayment
would become costlier.
 Convertibility
 In case of South-East Asia any micro level
destabilization or disequilibria can cause a
major crisis. Therefore, certain per-requisites
conditions are required for full convertibility.
Which are as following—
1. Maintainence of domestic stability.
2. Adequate foreign Exchange Reserves.
3. Restriction on non-essential goods.
 Convertibility
4. Much more incentives to
Export Oriented Units (EOUs)
5. An appropriate industrial
policy and a conducive
investment policy.
6. To control the expenses to
control the fiscal deficit.
 Foreign Exchange rate
 …refers to the price of one
money in terms of another.
 Equilibrium in the foreign
exchange market occurs at
the point where the foreign
exchange demand and supply
curves intersect.
 Foreign Exchange Market
Intervention
 …refers to buying and selling of
currencies by a central bank to
achieve a specified exchange rate.
 Free Market equilibrium exchange

rate refers to the equilibrium rates

that are established in the absence
of government foreign exchange
market intervention.
 Change in US demand for French Wine
Demand for Euro rises due
to the increase in demand
for Wine
SS
Exchange Rate ($ per euro)

E2
1.03
E1 Demand for Euro
1.00 falls due to the
E3 decrease in
0.97 demand for wine

D2
D1
D3
0 Q3 Q1 Q2 Quantity (Euro)
 Change in French Demand for US
Tractors Supply for Euro falls due to
the decrease in demand for
Tractors
S3
S1
Exchange Rate ($ per euro)

S2

E3
1.03
E1 Supply of Euro rises
1.00 E2 due to the inecrease in
0.97 demand for Tractors

DD

Q3 Q1 Q2 Quantity (Euro)
 Foreign Exchange Market Equilibrium
under Fixed and Flexible Exchange
Rates Increase in the demand for
Euro
S1
Exchange Rate ($ per euro)

S2

E2
1.03 Amount of Government
E1 E3 intervention required to
1.00
maintain the Fixed
Exchange Rate

D2

D1

Q1 Q2 Q3 Quantity (Euro)
 Monetary and Fiscal Policy
and the current account
 Any restrictive policy (monetary or
fiscal) reduces aggregate demand and
income will tend to move the current
account towards a surplus.
 Whenever there is an increase in
domestic income, a substantial
proportion of this increase goes into
additional purchases of imported goods
and services.
 Monetary and Fiscal Policy
and the current account

High Marginal Increase in Increase in

Propensity Aggregate Domestic
To Import Demand Income

People spend money

Restrictive Policy In purchasing
Will be implemented Imported goods
And services
 Monetary and Fiscal Policy
and the current account

When Restrictive Policy decrease in

implemented Aggregate
Demand

People spending decrease in

On Imported goods Domestic
And services decrease Income
 Monetary and Fiscal Policy
and the current account

When Restrictive Policy Reduces Inflation

implemented

Increases
exports Domestic goods become
Cheaper as compare
To imported goods
Current A/c Will move
To surplus
 Effects of Restrictive
Monetary Policy on the
BOP
Aggregate
When Restrictive Demand
Monetary Policy Investment Decreases
implemented Demand falls
Import Falls
Money Export Rise
Interest Rate
Supply
Rises
falls
Current A/c
Surplus BOP moves
Capital Inflows Towards
Capital A/c Surplus
Increases
Surplus
 Effects of Restrictive Fiscal
Policy on the BOP
When Restrictive Aggregate
Fiscal Policy Demand
implemented Decreases

Govt Import Falls

Budget Export Rise
Interest Rate
Deficit Rises
Reduces
Current A/c BOP moves
Reduces Surplus Towards
Govt Capital flows Surplus or
Capital A/c
Borrowing Out Deficit
Deficit
 Monetary Policy more effective
with floating exchange rate than
with fixed rates.
When Restrictive Aggregate
Monetary Policy Demand/Income
implemented
When Exchange Rate is
Pegged
RBI buys foreign Money Supply
Money Currency to Rises, Offsetting
Supply Stabilize Exchange Initial Restrictive
falls rates Policy

BOP moves Rupee will Export Decreases

Towards Appreciate Imports Increases
Surplus
When Exchange Rate is