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UNIT 1 International Financial Management

Components of BOP

Current account Capital account & Financial account Reserves and related items: official reserve account Net errors and omissions account

Current Account

Current account covers the transactions other than those in financial items that involveeconomic values and occur between resident and nonresident entities.

Net export/import of goods (trade balance) Net export/import of services Net income (investment income from direct and portfolio investment plus employee

compensation)

Net transfers (sums sent home by migrants and permanent workers aboard, gifts, grantsand pensions)

BOP on current account= (visible+invisible exports)-(visble+invisible imports)components of the current account: goods, services, income and current transfers .

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).

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).

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Income- Income is money going in (credit) or out (debit) of a country from salaries,

portfolio investments (in the form ofdividends,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.

Current Transfers- Current transfers are unilateral transfers with nothing received in

return. These include workers' remittances, donations, aids and grants, official assistance

and pensions. Due to their nature, current transfers are not considered real resources that

affect economic production.

The following variables go into the calculation of the current account balance (CAB):X = Exports of goods and services

M = Imports of goods and services

NY = Net income abroadNCT = Net current transfers

The formula is:

CAB = X - M + NY + NCT

The Capital and Financial Accounts

Along with transactions pertaining to non-financial and non-produced assets, the capitalaccount relates to dealings including debt forgiveness, the transfer of goods and financial

assets by migrants leaving or entering a country, the transfer of ownership onfixedassets,the transfer of funds received to the sale or acquisition of fixed assets, gift and

inheritance taxes, death levies, patents, copyrights, royalties and uninsured damage to

fixed assets.

Direct investment

Basic data are obtained from the exchange control records, but information on noncash

inflows and reinvested earnings is taken from the Survey of Foreign Liabilities and

Assets, supplemented by other information on direct investment flows. Up to 1999/2000,

direct investment in India and direct investment abroad comprised mainly equity flows.

From 2000/2001 onward, the coverage has been expanded to include, in addition to

equity, reinvested earnings, and debt transactions between related entities. The data on

equity capital include equity in both unincorporated business (mainly branches of foreign

banks in India and branches of Indian banks abroad) and incorporated entities. Because

there is a lag of one year for reinvested earnings, data for the most recent year

(2003/2004) are estimated as the average of the previous two years. However, as
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intercompany debt transactions were previously measured as part of other investment, the

change in methodology does not make any impact on India's net errors and omissions.

Portfolio investment

Basic data are obtained from the exchange control records. These are supplemented with

information from the Survey of Foreign Liabilities and Assets. In addition, the details of

the issue of global depository receipts and stock market operations by foreign

institutional investors are received from the Foreign Exchange Department, RBI.

Other investment

Most of the information on transactions in other investment assets and liabilities is

obtained from the exchange control records, supplemented by information received from

the departments of the RBI and various government agencies. Entries for transactions in

external assets and liabilities of commercial banks are obtained from their periodic

returns on foreign currency assets and rupee liabilities. Data on nonresident deposits with

resident banks are obtained from exchange control records, the survey of unclassified

receipts, and information submitted by the relevant banks to the RBI.

Reserve assets

Transactions under reserve assets are obtained from the records of the RBI. They

comprise changes in its foreign currency assets and gold, net of estimated valuation

changes arising from exchange rate movement and revaluations owing to changes in

international prices of bonds/securities/gold. They also comprise changes in SDR

balances held by the government and a reserve tranche position at the IMF, also net ofrevaluations owing to exchange rate movement.

Officials Reserve Account- The official reserve account records the change in stock of reserve

assets (also known as foreign exchange reserves) at the country's monetary authority .

Frequently, this is the responsibility of a government established central bank. Reserves include

official gold reserves, foreign exchange reserves, IMF Special Drawing Rights (SDRs), or nearly

any foreign property held by the monetary authority all denominated in domestic currency.

Changes in the official reserve account equal the differences between the capital account and

current account (and errors & omissions) by accounting identity and are mostly composed offoreign exchange interventions and deposits into international organizations such as the IMF; the

magnitude of these changes will depend upon monetary policy and government mandate.

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Net errors and omissions- This is the last component of the balance of payments and

principally exists to correct any possible errors made in accounting for the three other accounts.

These errors are common to occur due to the complexity of the calculations and difficulty in

obtaining measurements.

Omissions are rarely used usually by governments to conceal transactions. They are often

referred to as "balancing items".

Though the credit and debit are written balanced in the balance of payment account, itmay not remain balanced always. Very often, debit exceeds credit or the credit exceeds

debit causing an imbalance in the balance of payment account. Such an imbalance is

called the disequilibrium. Disequilibrium may take place either in the form of deficit or in

the form of surplus.

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Reasons for Adverse Balance of Payment

1. Population Growth

Most countries experience an increase in the population and in some likeIndia and China the population is

not only large but increases at a faster rate. To meet their needs, imports become essential and the

quantity of imports may increase as population increases.

2. Development ProgrammesDeveloping countries which have embarked upon planned development programmes require to

import capital goods, some raw materials which are not available at home and highly skilled andspecialized manpower. Since development is a continuous process, imports of these items continue for thelong time landing these countries in a balance of payment deficit.

3. Demonstration Effect

When the people in the less developed countries imitate the consumption pattern of the people in the

developed countries, their import will increase. Their export may remain constant or decline causing

disequilibrium in the balance of payments.

4. Natural Factors

Natural calamities such as the failure of rains or the coming floods may easily cause disequilibrium in the

balance of payments by adversely affecting agriculture and industrial production in the country. The

exports may decline while the imports may go up causing a discrepancy in the country's balance of

payments.

5. Cyclical Fluctuations

Business fluctuations introduced by the operations of the trade cycles may also cause disequilibrium in

the country's balance of payments. For example, if there occurs a business recession in foreign countries,

it may easily cause a fall in the exports and exchange earning of the country concerned, resulting in a

disequilibrium in the balance of payments.

6. Inflation

An increase in income and price level owing to rapid economic developmentin developing countries, willincrease imports and reduce exports causing a deficit in balance of payments.

7. Poor Marketing Strategies

The superior marketing of the developed countries have increased their surplus. The poor marketing

facilities of the developing countries have pushed them into huge deficits.

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8. Flight Of Capital

Due to speculative reasons, countries may lose foreign exchange or gold stocks People in developing

countries may also shift their capital to developed countries to safeguard against political uncertainties.

These capital movements adversely affect the balance of payments position.

9. Globalisation

Due to globalisation there has been more liberal and open atmosphere for international movement of

goods, services and capital. Competition has beer increased due to the globalisation of international

economic relations. The emerging new global economic order has brought in certain problems for some

countries which have resulted in the balance of payments disequilibrium.

A number of factors may cause disequilibrium in the balance of payments. These causes

may be broadly categorised into

1Economic factors

i. Development Disequilibrium

Large scale development expenditures usually increase the purchasing power, aggregate demand and

prices, resulting in substantially large imports. The development disequilibrium is common in developing

countries, because the above factores, and large scale capital goods imports needed for carrying out the

various development programmes, give rise to a deficit in the balance of payments.

ii. Capital DisequilibriumCyclical fluctuations in general business activity are one of the prominent reasons for the balance of

payments disequilibrium. As Lawrance W. Towle points out, depression always brings about a drastic

shrinkage in world trade, while prosperity stimulates it. A country enjoying a boom all by itself ordinarily

experiences more rapid growth in its imports than its exports, while the opposite is true of other countries.

But production in the other countries will be activated as a result of the increase exports to the boom

country.

iii. Secular disequilibrium

Sometimes, the balance of payments disequilibrium persists for a long time because of certain secular

trends in the economy. For instance in a developed country, the disposal income is generally very highand, therefore, the aggregate demand, too, is very high. At the same time, production costs are very high

because of the higher wages. This naturally results in higher prices. These two factors-high domestic

prices may result in the imports being much higher than the exports. This could be one of the reasons for

the persistent balance of payments deficits of the USA.

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iv. Structural disequilibrium

Structural changes in the economy may also cause balance of payments disequilibrium. Such structural

changes include the development of alternative sources of supply, the development of better substitutes,

the exhaustion of productive resources, the changes in transport routes and costs, etc.

2. Political Factors

Certain political factors may also produce a balance of payment disequilibrium. For, instance a country

plagued with political instability may experience large capital outflows, inadequacy of domestic

investment and production, etc. These factors may sometimes, cause disequilibrium in the balance of

payments. Further factors like wars, changes in world trade routes, etc. may also produce balance of

payments difficulties.

3. Social Factors

Certain social factors may also produce a balance of payments. For instance, changes in tastes,

preferences, fashion, etc. may affect imports and exports and thereby affect the balance of payments

Remedies for Adverse Balance of Payment

Solution to correct balance of paymentdisequilibriumlies in earning more foreign exchangethrough additional exports or reducing imports. Quantitative changes in exports and imports

require policy changes. Such policy measures are in the form of monetary, fiscal and non-

monetary measures.

Monetary Measures for Correcting the BoP

The monetary methods for correcting disequilibrium in the balance of payment are as follows :-

1. 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 forimports fall due to higher taxation and reduced income. This would built a favourable atmosphere in the

balance of payment position. However Deflation can be successful when the exchange rate remains fixed.
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2. Exchange Depreciation

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.

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.

Limitations of Exchange Depreciation:-

Exchange depreciation will be successful only if there is no retaliatory exchange depreciation byother countries.

It is not suitable to a country desiring a fixed exchange rate system. Exchange depreciation raises the prices of imports and reduces the prices of exports. So the terms

of trade will become unfavourable for the country adopting it.

It increases uncertainty & risks involved in foreign trade. It may result in hyper-inflation causing further deficit in balance of payments.

3. Devaluation

Devaluation refers to deliberate attempt made by monetary authorities to bring down the value of home

currency against foreign currency. While depreciation is a spontaneous fall due to interactions of market

forces, devaluation is official act enforced by the monetary authority. Generally the international

monetary fund advocates the policy of devaluation as a corrective measure of disequilibrium for the

countries facing adverse balance of payment position. When India's balance of payment worsened in

1991, IMF suggested devaluation. Accordingly, the value of Indian currency has been reduced by 18 to

20% in terms of various currencies. The 1991 devaluation brought the desired effect. The very next year

the import declined while exports picked up.

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

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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.

Limitations of Devaluation:-

Devaluation is successful only when other country does not retaliate the same. Ifboth the countries go for the same, the effect is nil.

Devaluation is successful only when the demand for exports and imports is elastic.In case it is inelastic, it may turn the situation worse.

Devaluation, though helps correcting disequilibrium, is considered to be a weakness for thecountry.

Devaluation may bring inflation in the following conditions :- Devaluation brings the imports down, When imports are reduced, the domestic supply of

such goods must be increased to the same extent. If not, scarcity of such goods unleash

inflationary trends.

A growing country like India is capital thirsty. Due to non availability of capital goods inIndia, we have no option but to continue imports at higher costs. This will force the

industries depending upon capital goods to push up their prices.

When demand for our export rises, more and more goods produced in a country would gofor exports and thus creating shortage of such goods at the domestic level. This results inrising prices and inflation.

Devaluation may not be effective if the deficit arises due to cyclical or structural changes.

4. Exchange Control

It is an extreme step taken by the monetary authority to enjoy complete control over the exchange

dealings. Under such a measure, the central bank directs all exporters to surrender their foreign exchange

to the central authority. Thus it leads to concentration of exchange reserves in the hands of central

authority. At the same time, the supply of foreign exchange is restricted only for essential goods. It can

only help controlling situation from turning worse. In short it is only a temporary measure and not

permanent remedy

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Non-Monetary Measures for Correcting the BoP

A deficit country along with Monetary measures may adopt the following non-monetarymeasures too which will either restrict imports or promote exports.

1. 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.

Drawbacks of Tariffs:-

Tariffs bring equilibrium by reducing the volume of trade. Tariffs obstruct the expansion of world trade and prosperity. Tariffs need not necessarily reduce imports. Hence the effects of tariff on the balance of

payment position are uncertain.

Tariffs seek to establish equilibrium without removing the root causes of disequilibrium. A new or a higher tariff may aggravate the disequilibrium in the balance of payments of a

country already having a surplus.

Tariffs to be successful require an efficient & honest administration which unfortunatelyis difficult to have in most of the countries. Corruption among the administrative staff

will render tariffs ineffective.

2.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.

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Types of Quotas :-

the tariff or custom quota, the unilateral quota, the bilateral quota, the mixing quota, and import licensing.

Merits of Quotas:-

Quotas are more effective than tariffs as they are certain. They are easy to implement. They are more effective even when demand is inelastic, as no imports are possible above

the quotas.

More flexible than tariffs as they are subject to administrative decision. Tariffs on theother hand are subject to legislative sanction.

Demerits of Quotas:-

They are not long-run solution as they do not tackle the real cause for disequilibrium. Under theWTOquotas are discouraged. Implements of quotas is open invitation to corruption.

3.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.

4. Import Substitution
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A country may resort to import substitution to reduce the volume of imports and make it self-

reliant. Fiscal and monetary measures may be adopted to encourage industries producing

import substitutes. Industries which produce import substitutes require special attention in the

form of various concessions, which include tax concession, technical assistance, subsidies,

providing scarce inputs, etc.

Non-monetary methods are more effective than monetary methods and are normally

applicable in correcting an adverse balance of payments.

Drawbacks of Import Substitution:-

Such industries may lose the spirit of competitiveness. Domestic industries enjoying various incentives will develop vested interests and ask for

such concessions all the time.

Deliberate promotion of import substitute industries go against the principle ofcomparative advantage.

Capital account convertibility

Capital Account Convertibility refers to the freedom to convert local financial assets intoforeign financial assets and vice versa at market determined rates of exchange. It is

associated with changes of ownership in foreign/domestic financial assets and liabilities

and embodies the creation and liquidation of claims on, or by, the rest of the world.

Convertibility is an IMF clause that all the member countries must adhere to in order towork towards the common goals of the organization. However CONVERTIBILITY perse can be looked into from various perspectives and incorporated accordingly by the

member nations. An economy can choose to be (a) partially convertible on CURRENT

ACCOUNT (b) partially convertible on CAPITAL ACCOUNT (c) fully convertible on

current account and (d) fully convertible on capital account.

It is important to state here that The IMFs mandate is conspicuous on current accountconvertibility as current account liberalization is among the IMFs official purposes

outlined in its Articles of Agreement, but it has no explicit mandate to promote capital

account liberalization. Indeed, the Articles give the IMF only limited jurisdiction over the

capital account however the IMF has given greater attention to capital account issues inrecent decades, given the increasing importance of international capital flows for

macroeconomic stability and exchange rate management in many countries. Thus there is

no official binding over any member state to opt for FULL CAPITAL ACCOUNT

CONVERTIBILTY but it has been a constant component of the IMFs advisory reports

on member countries.

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