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Module I


Balance of Payments (BOP)

Balance of payments is an accounting record of all monetary

transactions of a country with rest of the world which includes
payments for exports and imports of goods, services, capital and
financial transfers for a specific period, usually a year, and is prepared
in a single currency, typically the domestic currency for the country

The balance of payments of a country is a systematic record of all

economic transactions between the residents of a country and the rest
of the world. It presents a classified record of all receipts on account of
goods exported, services rendered and capital received by residents
and payments made by them on account of goods imported and
services received and capital transferred to non-residents or foreigners

BOP - Deficits & Surplus

Exports and receipts of loans and investments are recorded as surplus items.

Imports or funds used to invest in foreign countries are recorded as deficit items.

A negative balance of payments means that more money is flowing out of the
country than coming in, and vice versa.

A BOP surplus means a nation has more funds coming in than it pays out to other
countries from trade and investments, which results in appreciation of its national
currency versus currencies of other nations.

A deficit in the balance of payments has the opposite effect: an excess of imports
over exports, a dependence on foreign investors, and an overvalued currency.
Countries experiencing a payments deficit must make up the difference by
exporting gold or Hard Currency reserves, such as the U.S. Dollar, that are accepted
currencies for settlement of international debts

BOP Types of Accounts

The Current Account: It reports the various trades in import and

export plus income derived from tourism, profits earned overseas and
payments of interest

The Capital Account: It reports sum of bank deposits, private

investments and debt securities sold by a central bank or official
government agencies.

The Official Reserve Account: It is a subdivision of the capital

account which contains foreign currency and securities held by the
government or the central bank, which is used to balance the payments
from year to year. It is known as the balancing item and can be
considered a "plug factor" for summing the balance of payments
accounts to zero

Overall Balance of Payments

Current Account Balance = Balance of Visible Trade(goods) + Balance

of Invisible Trade(services) + Balance of Unilateral transfers

Capital Account Balance = Inflow of foreign exchange outflow of

foreign exchange

Official Reserves: The holdings of foreign reserves and gold by official

institutions like the central bank

Overall Balance of Payment = Current Account Balance + Capital

account balance+ Official Reserve Account

Crisis of 1990-91

This crisis had its origin from the fiscal year 1979-80 onwards.

By the end of the 6th plan, Indias BoP deficit (Current account) rose to Rs.
11384 crore. It was the mid of 1980s when the BoP issue occupied the
centre position in Indias macroeconomic management policy.

The second Oil shock of 1979 was more severe and the value of the imports
of India became almost double between 1978-78 and 1981-82.

From 1980 to 1983, there was global recession and Indias exports suffered
during this time.

Apart from the external assistance, India had to meet its colossal deficit in
the current account through the withdrawal of SDR and borrowing from IMF
under the extended facility arrangement.

Crisis of 1990-91

A large part of the accumulated foreign exchange fund was used to offset
the BoP.

During the 7th plan, between 1985-86 and 1989-90, Indias trade deficit
amounted to Rs. 54, 204 Crore.

India was under a sever BoP crisis. In 1991, India found itself in her worst
payment crisis since 1947. The things became worse by the 1990-91 Gulf
war, which was accompanied by double digit inflation.

Indias credit rating got downgraded. The country was on the verge of
defaulting on its international commitments and was denied access to the
external commercial credit markets. In October 1990, a Net Outflow of NRI
deposits started and continued till 1991.

Crisis of 1990-91

Sharp rise in imports due to growth orientation

Capital inflows mainly consisted of aid flows, commercial deposits and

Non resident Indian deposits

FDI was heavily restricted and foreign portfolio investments generally

channelized to public sector issued bonds

Gradual loss of for-ex reserves and deterioration of trade balance due to

fixed nominal exchange rate which was declining over the 1980s

Earlier Fixed exchange rate was followed and constant devaluations by

the central bank to promote exports raised the amount of external debt.

Crisis of 1990-91

The only option left to fulfil its international commitments was to borrow against the
security of Indias Gold Reserves as collateral. The prime Minister of the countrys
caretaker government was Chandrashekhar and Finance Minister was Yashwant Sinha.
The immediate response of this Caretaker government was to secure an emergency
loan of $2.2 billion from the International Monetary Fund by pledging 67 tons of Indias
gold reserves as collateral.

On 21 May 1991, Rajiv Gandhi was assassinated in an election rally and this triggered
a nationwide sympathy wave securing victory of the Congress. The new Prime Minister
was P V Narsimha Rao. P V Narsimha Rao was Minister of Planning in the Rajiv Gandhi
Government and had been Deputy Chairman of the Planning Commission. He along
with Finance Minister Manmohan Singh started several reforms which are collectively
called Liberalization. This process brought the country back on the track and after
that Indias Foreign Currency reserves have never touched such a brutal low.

Crisis of 1990-91

In 1991, Rupee was once again devaluated.

Due to the currency devaluation the Indian Rupee fell from 17.50 per
dollar in 1991 to 45 per dollar in 1992. The Value of Rupee was
devaluated 23%.

Industries were Delicensed.

Import tariffs were lowered and import restrictions were dismantled.

Indian Economy was opened for foreign investments. Market

Determined exchange rate system was introduced. This was initiated
with LERMS

Liberalized Exchange Rate

Management System - LERMS

Earlier Fixed exchange rate was followed and constant devaluations by the central bank to
promote exports raised the amount of external debt.

In the Union Budget 1992-93, a new system named LERMS was started. The LERMS was
introduced from March 1, 1992 and under this, a system of double exchange rates was
adopted. Under LERMS, the exporters could sell 60% of their foreign exchange earning to
the authorized Foreign Exchange dealers in the open market at the open market exchange
rate while the remaining 40% was to be sold compulsorily to RBI at the exchange rates
decided by RBI.

Another important feature of LERMS was that the Government was providing the foreign
exchange only for most essential imports. For less important imports, the importers had to
arrange themselves from the open market. Thus, we see that LERMS was introduced with
twin objectives of building up the Foreign Exchange Reserves and discourage imports. At
that time, the government was successful in achieving both of these objectives.

The gold Standard (1876 1913)

A system of setting currency values whereby the participating countries

commit to fix the prices of their domestic currencies in terms of a
specified amount of gold. The gold standard as an international
monetary system gained acceptance in Western Europe in the 1870s.
The United States was something of a latecomer to the system, not
officially adopting the standard until 1879.

The rules of the game under the gold standard were clear and simple.
Each country set the rate at which its currency (paper or coin) could be
converted to a weight of gold. The United States, for example, declared
the dollar to be convertible to gold at a rate of $20.67/ ounce of gold (a
rate in effect until the beginning of World War 1).

The gold Standard (1876 1913)

The British pound was pegged at 4.2474/ounce of gold. As long as both

currencies were freely convertible into gold, the dollar/pound exchange
rate was:

The gold Standard (1876 1913)

Because the government of each country on the gold standard agreed to buy
or sell gold on demand to anyone at its own fixed parity rate, the value of
each individual currency in terms of gold, and therefore the fixed parities
between currencies, was set.

Under this system it was very important for a country to maintain adequate
reserves of gold to back its currencys value. The system also had the effect
of implicitly limiting the rate at which any individual country could expand its
money supply. The growth in money was limited to the rate at which
additional gold could be acquired by official authorities.

The gold standard worked adequately until the outbreak of World War 1
interrupted trade flows and the free movement of gold. This caused the main
trading nations to suspend the operation of the gold standard

Bretton Woods - Fixed Exchange

Rates (1945 - 1973)

In 1944, as World War II drew toward a close, the Allied Powers met at
Bretton Woods, New Hampshire, in order to create a new post-war
international monetary system.

The Bretton Woods Agreement, implemented in 1946, whereby each

member government pledged to maintain a fixed, or pegged, exchange
rate for its currency vis-vis the dollar or gold. These fixed exchange
rates were supposed to reduce the riskiness of international
transactions, thus promoting growth in world trade.

The Bretton Woods Agreement established a US dollar-based

international monetary system and provide for two new institutions, The
IMF and the World Bank.

Bretton Woods - Fixed Exchange

Rates (1945 - 1973)

Under the original provisions of the Bretton Woods Agreement, all

countries fixed the value of their currencies for gold. Only the dollar
remained convertible into gold (at $35 per ounce). Therefore, each country
decided what it wished its exchange rate to be vis-vis the dollar and then
calculated the gold per value of its currency to create the desired dollar
exchange rate.

Participating countries agreed to try to maintain the value of their

currencies within 1% (later expanded to 2 %) of par by buying or selling
foreign exchange or gold as needed. Devaluation was not to be used as a
competitive trade policy, but if a currency became too weak to defend, a
devaluation of up to 10% was allowed without formal approval by the IMF.
Larger devaluations required IMF approval.

Bretton Woods - Fixed Exchange

Rates (1945 - 1973)

Widely diverging national monetary and fiscal policies, differential rates

of inflation, and various unexpected external shocks eventually resulted
in the systems demise.

The U.S. dollar was the main reserve currency held by central banks and
was the key to the web of exchange rate values. Unfortunately, the
United States ran persistent and growing deficits on its balance of
payments. A heavy capital outflow of dollars was required to finance
these deficits and to meet the growing demand for dollars from
investors and businesses.

Eventually, the heavy overhang of dollars held abroad resulted in a lack

of confidence in the ability of the United States to meet its commitment
to convert dollars to gold.

Floating Rate System

In a floating-rate system, it is the market forces that determine the exchange

rate between two currencies.

The advocates of the floating rate system put forth two major arguments. One
is that the exchange rate varies automatically according to the changes in the
macroeconomic variables. As a result, there is no gap between the real
exchange rate and the nominal exchange rate.

The country does not need any adjustment, which is often required in a fixed
rate regime and so it does not have to bear the cost of adjustment. The other
argument is that this system possesses insulation properties, meaning that
the currency remains isolated from the shocks emanating from other counties.
It also means that the government can adopt an independent economic policy
without impinging upon the external sector performance.

Floating Rate System

In case of Managed Floating with no preannounced path for the

exchange rate, the monetary authority influences the movements of the
exchange rate through active intervention in the foreign exchange
market without specifying, or pre-commiting to, a pre-announced path
for the exchange rate.

In case of Independent Floating, the exchange rate is marketdetermined, with any foreign exchange intervention aimed at
moderating the rate of change and preventing undue fluctuations in the
exchange rate, rather than at establishing a level for it.

Pegging of Currency

Normally, a developing country pegs its currency to a strong currency or

to a currency with which it conducts a very large part of its trade.

Pegging involves fixed exchange rate with the result that trade payments
are stable.

But in case of trading with other countries, stability cannot be guaranteed.

This is why pegging to a single currency is not advised if the countrys
trade is diversified.

In such cases, pegging to a basket of currencies is advised. But if the

basket is very large, multi-currency intervention may prove costly. Pegging
to SDR is not different insofar as the value of the SDR itself is pegged to a
basket of five currencies

Crawling Peg

Under this system, they allow the peg to change gradually over time to
catch up with changes in the market-determined rates.

It is a hybrid of fixed-rate and flexible rate systems. So this system

avoids too much of instability and too much of rigidity. In some of the
countries opting for the crawling peg, crawling bands are maintained
within which the value of currency is maintained.

The currency is adjusted periodically in small amounts at a fixed,

preannounced rate or in response to changes in selective quantitative

Euro Market

On January 1, 1999, 11 member states of the EU initiated the European Monetary


They established a single currency, the Euro, which replaced the individual
currencies of the participating member states.

On December 31, 1998, the final fixed rates between the 11 participating
currencies and the Euro were put into place. On January 4, 1999, the Euro was
officially traded.

The 15 members of the European Union are also members of the European
Monetary System.

According to the EU, EMU is a single currency area, now known informally as the
Euro Zone, within the EU single market in which people, goods, services and
capital move without restrictions.

Euro Market

The growth of global markets and the increasing competitiveness of the

Americas and Asia drove the members of the EU in the 1980s and
1990s to take actions that would allow their residents and their firms to
compete globally.

The reduction of barriers across all members countries to allow

economies of scale (size and cost per unit) and scope (horizontal and
vertical integration) was thought to be Europes only hope of not being
left behind in the new millennium.

The successful implementation of a single, strong, and dependable

currency for the conduct of life could well alter the traditional
dominance of the U.S. dollar as the worlds currency