FOREIGN EXCHANGE RATE & BALANCE OF PAYMENT
What is Foreign Exchange?
Foreign Exchange refers to all currencies other than the domestic currency of a given country.
For example, India’s domestic currency is Indian rupee and all other currencies like: US Dollar, Brit!, h Pound, Kuwaiti Dinar etc. are foreign exchange.
FOREIGN EXCHANGE RATE
Foreign exchange rate represents the price of one currency in terms of another currency in terms of another currency, Foreign Exchange Rate refers to the at which one currency is exchanged for the other
$ 1 = Rs. 40
Rs. 1 =1/40 Dollars = 0.025 Dollar 443
Exchange rate can be quoted in two ways i.e. one unit of foreign currency expressed in terms of So many units of domestic currency expressed in terms of so many units of foreign currency
Types of Foreign Exchange Rates
The three main types of exchange rate systems are:
1. Fixed exchange rate system (also known as pegged exchange rate system).
2. Flexible exchange rate system (also known as floating exchange rate system).
3. Managed floating rate system. (Also known as dirty floating exchange rate system)
1. Fixed exchange rate system:
The system in which the foreign exchange rate is officially fixed by the government/monetary authority and not determined by markets forces.
Under fixed exchange rate system: Each country keeps the value of its currency fixed in terms of some external standard.
This external standard can be gold, silver, other precious metal, another country’s currency, or even some internationally agreed unit of account.
In earlier times, exchange rates of all major countries were fixed according to the Gold Standard.
Merits:
(i) It ensures stability in exchange rate which encourages foreign trade.
(ii) It contributes to the coordination of macro policies of countries in an interdependent world economy.
(iii) Fixed exchange rates prevents capital outflow.
(iv) It prevents speculation in foreign exchange market.
(v) Fixed exchange rates are more conductive to expansion of world trade because it prevents risk and uncertainty in transactions.
Demerits:
(i) There is a fear of devaluation in situation of excess demand.
Central Bank uses its reserves to maintain fixed exchange rate.
But when reserves are exhausted and excess demand still persists, government is compelled to devalue domestic currency.
If speculators believe the exchange rate cannot be held for log, they buy foreign exchange in massive amount causing deficit in BOP. This may lead to larger devaluation.
This is the main flaw of fixed exchange rate system.
(ii) Benefits of free markets are deprived.
(iii) There is always possibility of undervaluation or overvaluation.
3. Flexible (fixating) Exchange Rate:
Flexible exchange rate is the rate which is determined by forces of supply and demand in the foreign exchange market.
There is no official (govt.) Intervention.
Here the value of a currency is left completely free to be determined by market forces of demand and supply of foreign exchange.
Merits:
(i) Deficit or surplus in BOP is automatically corrected.
(ii) There is no need for government to hold any foreign reserve.
(iii) It helps in optimum resource allocation.
(iv) It frees the government from problem of balance of payment.
(v) Flexible exchange rate increases the efficiency in the economy by achieving best allocation of resources.
Demerits:
(i) It encourages speculation leading to fluctuation in exchange rate.
(ii) Wide fluctuations in exchange rate can hamper foreign trade and capital movement between countries.
(iii) It generates inflationary pressure when prices of imports go up due to depreciation of the currency caused by deficit in BOP.
(iv) It discourages investment and international trade.
Managed floating rate system
Managed floating rate system refers to a system in which foreign exchange rate is determined by market force and central bank is a key participant to stabilize the currency in case of extreme, appreciation or depreciation.
Under Managed floating rate system, also called dirty floating, central banks to buy and sell foreign currencies in an attempt to moderate exchange rate movement whenever they feel that such actions are appropriate.
Determination of Exchange Rate (Flexible Exchange Rate System)
Rate of exchange is determined by the interaction of then force of demand and supply.
let us understand the various sources of demand and supply of foreign exchange.
Demand for Foreign Exchange Demand (outflow) for foreign exchange arises due to the following reasons
1. Import of Goods and Services: foreign exchange is demanded to make the payment for imports of goods and services.
2.Tourism: When Indian tourists go abroad, they need to have foreign currency with them to meet their expenditure abroad. So, foreign exchange is needed to undertake foreign tour.
3. Unilateral Transfers sent abroad: Foreign exchange is required for making unilateral transfers like sending gifts to other countries.
4. Purchase of Assets in Foreign Countries: Foreign exchange in needed to make payment for the purchase of assets (like land, building, share, bonds etc.) in foreign countries.
5. Speculation: Demand for foreign exchange arises when people want to make gains from appreciation of the currency.
Demand curve of Foreign Exchange
1. Demand for foreign exchange rises with all in the exchange rate and falls with rise in exchange rate.
2. Suppose the price of US dollar falls from $ 1 = Rs 47 to $ 1 = Rs 40.
This makes American goods cheaper for Indians as Rs 40 (and not Rs. 47) is needed to purchase American goods $ 1.
This will induce Indian individuals and firms to import more from the USA, resulting in an increase in ithe quantity of dollars demanded by Indians.
3. A rise in the Price of US dollar from relative expensive than before $ 1 = Rs 45 to $ 1 = Rs 50 will make the American goods and it will decrease the demand for dollars by Indians
. 4. Thus, there exists an inverse relationshi foreign exchange.
This makes p between foreign exchange rate and the demand in th m andfoer the demand curve of foreign exchange downward sloping, diagram.
The demand for foreign exchange say, US dollars and the rate of foreign exchange are shown on X-axis and Y-axis respectively. The negatively sloped demand curve (DD) shows that more foreign exchange (0Q1) is demanded at a low rate of exchange (002) whereas, demand for US dollars falls to OQi when the exchange rate rises to OR1.
Supply of Foreign Exchange
Supply (inflow) of foreign exchange comes from the following sources.
1. Exports of Goods and Services: Supply of foreign exchange comes through exports of goods and services.
2. Foreign Investment: The amount, which foreigners invest in the home country, increases the supply of foreign exchange.
3. Remittance (Unilateral transfers) from abroad: Supply of foreign exchange increase in the form of gifts and other
remittances from abroad.
4. Speculation: Supply of foreign exchange comes from those who want to speculate on the value of foreign exchange.
5. Foreign tourism in our country.
Supply Curve of Foreign Exchange
1. Supply of foreign exchange rises with increase in the exchange rate and falls with decrease in the rate of exchange.
2. Suppose the price of US dollar rises from $ 1 = Rs 40 to $ 1 = Rs 45.
This make Indian goods cheaper for Americans as $ 1 can now be used to purchase Indian imports from India. As a result supply off foreign exchange will rise.
3. On the other hand, a fall in the price of US dollar from $ 1 = Rs 40 to $ 1 = Rs 47 will make Indian goods relatively expensive than before and it will decrease the supply of dollars.
4. Thus, there exist a direct relationship between foreign exchange rate and the supply of foreign exchange. This makes the supply curve of foreign exchange upwards sloping.
The supply curve of foreign exchange is shown in the diagram, where supply of foreign exchange (say, US dollar) and the rate of foreign exchange have been shown on X-axis and Y-axis respectively. The positively sloped supply curve (SS) shown that supply of foreign exchange rises from 0Q, to 002 when the exchange rate rises from 0E1 to 0E2.
Equilibrium Rate of Exchange
The equilibrium exchange rate is determined at a level where demand for foreign exchange is equal to the supply of foreign exchange.
In the diagram, demand and supply of foreign exchange are measured on the X-axis, and the rate of foreign exchange is measured on the Y-axis.
DD is the downward sloping demand curve of foreign exchange and SS is the upward sloping supply curve of foreign exchange.
Foreign Exchange Market
Foreign exchange market is the market in which foreign currencies are bought and sold.
Functions of Foreign Exchange Market
Foreign exchange market performs the following three functions.
1. Transfer Function: Foreign exchange market transfers purchasing power between the countries involved in the transaction.
This function is performed through credit instruments like bills of foreign exchange, bank drafts and telephonic transfers.
2. Credit Function: Foreign exchange market provides credit for foreign trade.
Bills of exchange, with maturity period of three months, are generally used for international payments.
Thus, credit is required for this period to enable the importer to take possession of goods, sell them and obtain money to pay off the bill.
3. Hedging Functions:Hedging in an important function of foreign exchange market.
When exporter and importers enter into an agreement to sell and buy gods on some future date at the current prices and exchange rate, it is called hedging.
The purpose of hedging is to avoid losses that might be caused due to exchange rate variations in the future.
Spot Market
Spot market refers to the market in which the receipts and payments are made immediately (generally, a time of two business days is permitted to settle the transaction).
Spot market is of daily nature and deals only in spot transaction.
Forward Market
Forward market refers to the market in which sale and purchase of foreign currency is settled on a specified future date at a rate agreed upon today.
When buyers and sellers enter into an agreement to buy and sell foreign currency on some future date, it is called forward transaction.
Currency Depreciation v/s Currency Appreciation
urrency Depreciation refers to decrease in value of domestic currency in terms of foreign currency.
The domestic currency becomes less valuable and more of it is required to buy the foreign currency.
For example (i) Indian Rs.
Is said to be depreciating if the price of US $ 1 rises from Rs. 45 to Rs. 50 (ii) A change from $ 3 = £ 1 to $ 2 = £ 1 represents the UK pound is depreciation.
An increase in the price of a foreign currency in terms of the domestic currency means that the domestic currency has depreciated.
Currency Appreciation refers to increase in value of domestic currency in terms of foreign currency.
The domestic currency becomes more valuable and less of it is required to but the foreign currency. For example (i) Indian Rs appreciated when price of US $ 1 falls from Rs 45 to Rs 40 9 (ii) A change from $ 3 = £ 1 to $ 5 = £ 1 represents the UK pound is appreciating.
Meaning of Balance of Payments
Balance of Payments is accounting statement that provides a systematic record of all the economic transaction, between the residents of a country and the rest of the world, in a given period of time.
Economics Transaction
1. Visible Items: These include all types of physical goods are exported and imported. These are called visible items as they are made up of some matter or material and can be seen touched and measured. The movement of such items is open and can be verified by the customs officials.
2. Invisible Items: An invisible item of trade refers to all types of services like shipping, banking, insurance etc, which are given and receive. These are called invisible items as they cannot be seen felt touched or measured.
3. Unilateral Transfers: Unilaterally transfers include gifts, personal remittances and otherone way transactions. Since these transactions do not involve any claim for repayment, they are also known as unrequited transfers.
4. Capital Transfers: Capital transfers relate to capital receipts (through borrowings or sale of assets) and capital payments (through capital repayments or purchase of assets).
Meaning of Balance of Trade
‘Balance of trade’ (BOT) refers to the difference between the amount of exports and imports of visible items (goods) only.
Balance of Trade = Exports of goods — Imports of goods
Exports are entered as credit (positive) items in the balance of payments account, while import! are entered as debit (negative) items. Balance of trade is just a part of the BOP account and plays a crucial role in deciding the overall situation of the balance of payments of a country. Balance of trade is also known as ‘balance of visible trade’ or ‘trade balance’.
Difference between Balance of Trade and Balance of Payments
| Balance of Trade (BOT) | Balance of Payments (BOP) |
| Balance of trade includes only visible items. | Balance of Payments includes both visible and invisible items |
| BOT does not record any transactions of capital nature. | BOP records all the transactions of capital nature. |
| Balance of trade is a narrower concept and it is only a part of the balance of payments account. | Balance of payments is a wider concept and it in includes balance of trade. |
| BOT can be at surplus deficit or even at equilibrium. | BOP is always at equilibrium |
Current Account
Current account refers to an account which records all the transaction relating to export and import of goods and services and unilateral transfers during a given period of time.
Components of Current Account
The main components of Current Account are:
1. Export and Import of Goods (Merchandise Transaction or Visible Trade)
A country has to make payments for all the imports of goods and, therefore, the value of imports is written on the negative side (debit items).
Similarly, receipts from exports are shown on the positive side (credit items).
Balance of these visible exports and imports is known as the balance of trade (or trade balance).
2. Export and Import of Services(Invisible Trade)
It includes a large variety of non-factor services (known as invisible items) sold and purchased by the residents of a country, to and from the rest of the world.
So, payments are either received or made to the other countries for the use of these services. Services are, generally of three kinds:
(a) Shipping
(b) Banking
(c) Insurance.
Payments made for these services, are recorded on the positive side (credit items).
3. Unilateral or Unrequited Transfers(One sided Trade)
Unilateral transfers include gifts, donation, personal remittance and other ‘one-way’ transactions.
These refer to those receipt and payments which take place without any services in return in the current period.
Receipt of unilateral transfers from the rest of the world is shown on the positive (credit) side.
Similarly, for a country making such a payments, it is an outflow of foreign currency and is shown on the negative (debit) side.
4. Incomes
Incomes are classified into investment income and compensation of employees.
Investment income credits cover earnings received by residents from the ownership of foreign financial assets, like profit remitted by branches of Indians companies functioning abroad, interest received, dividends received, etc.
Compensation of employee include as credits if indian is working abroad.
Or debits that is a foreigner working in our country.
Balance on Current Account
1.Balance on current account is the difference between receipts and payments of foreign exchange on account of goods, services and unilateral transfer.
2. In the current account, receipts from export of goods and services and unilateral receipt are entered as credit (positive) items as they represent inflow of foreign exchange.
On the other hands, payments for import of goods and services and unilateral payments are entered as debit (negative) items as they represent outflow of foreign exchange.
3. Balance on Current Account.
It is defined as equal to the difference between the sum of credits and the sum of debits on current account.
Balance on current account = Sum of credits on current account — Sum of debits on current account.
It can be negative and positive both.
When the sum of credits is greater than the sum of debits, it is positive.
When the sum of credit is less than the sum of debits, it is negative.
4. Surplus On current account (when credit items are more than debit items) implies net inflow., of foreign exchange whereas, deficit on current account (when debit items are more than credit items) implies net outflow of foreign exchange.
Capital Account
Capital account of BOP records all those transactions, between the residents of a country and the rest of the world, which cause a change in the assets or liabilities of the country or its government.
Components of Capital Account
The main components of capital account are
1 Investments
“Credits” comprise investments from abroad in shares of Indian companies, in Indian branches of foreign Companies, in real estate, etc. It also includes repatriation of Indian investment abroad, etc. These bring in foreign exchange.
“Debits” comprise investments by Indians residents in shares of the companies registered outside India, in foreign branches of Indian companies, in real estate, etc., foreign and repatriations of foreign investment in India, etc. This takes away forex.
(a) Foreign Direct Investment: It refers to purchase of an asset in the rest of the world such that, it gives direct control to the purchaser over the asset.
For example, acquisition of a foreign firm by an Indian firm.
(b) Portfolio Investment: It refers to purchase of an assets of an asset in the rest of the world such that, it does not give the purchaser any direct control over the asset.
For example, purchase of shares of a foreign firm by an Indian firm. Foreign Institutional Investment (FII) is also a part of portfolio investment.
2. Borrowing and Lending:
“Credit” comprise all borrowings from abroad by private individuals, institutions, government, etc., and loan repayments by foreigners.
These bring in foreign exchange.
“Debits”comprise lending to abroad by private individuals and institutions, governments, etc., and repayments of foreign loans.
3. Changes in foreign exchange reserves:
The foreign exchange reserves are the financial assets of the government held in the central bank.
A withdrawal from this reserve leads to decrease in foreign financial assets, and is recorded on the credit side.
Any addition to these reserves is increase in foreign financial assets and is recorded on the debit side.
Difference between Current Account and Capital Account
| Current Account | Capital Account |
| Current account transactions bring a change in the current level of a country’s income | Capital transactions bring about a change in the capital stock of a country |
| It includes all items of flow nature and so, it in is a flow concept. | It includes all items expressing change stock and, hence, it is a stock concept. |
| Current Account = Visible Trade + Invisible Trade + Unilateral transfers + Incomes. | Capital account = Investments + Borrowings + Reserves |
Difference between Autonomous and Accommodating Items
| Autonomous | Non-Autonomous/Accommodating items |
| Autonomous items refer to those international economic transactions which take place due to some economic motive (such as profit maximization).
Such transactions are independent of the state of BOP account.
For example, if an MNC is making investment in India with aim of earning profit, then such a transaction is independent of the country ‘S BOP situation. |
Accommodating items refer to the transactions that are undertaken in order to maintain the balance in the BOP account.
These are compensating capital transactions which are meant to correct the disequilibrium in autonomous items of balance of payments.
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| These items are also known as ‘above the line items’
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These items are also known as ‘below the line items For example,-if there is a current account deficit in the BOP, then this deficit is settled by capital inflow from abroad.
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| Autonomous transaction take place on both, current and capital, accounts on the current account merchandise export and imports of goods are autonomous transactions on the capital account, receipts and repayments of long-term loans by private individuals are autonomous transaction.
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Generally, the sources used to meet a deficit in the BOP are accommodating items (i) foreign exchange reserves;(ii) Borrowings from IMF or foreign monetary authorities & if there is surplus Gov. act as ultimate recipient and if there is deficit govt act as a ultimate financier.
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Meaning Of Balance of Payment Deficit
A deficit in the with BOP occurs when during the year the autonomous inflow of foreign exchange falls short of autonomous outflow.
i.e. Autonomous payments > Autonomous receipts
If autonomous inflow of foreign exchange exceeds autonomous outflow, the difference is called surplus.
Suppose the autonomous inflow of foreign exchange during the year is $1000, while the total outflow is $1100. It means that there is a deficit of $100.