U3 - Foreign Exchange and Balance of Payments

KRISTU JAYANTI COLLEGE (AUTONOMOUS) Unit 3: Foreign Exchange and Balance of Payments
FOREIGN EXCHANGE MARKET – OVERVIEW
As Kindle-Berger put, “the foreign exchange market is a place where foreign moneys are bought
and sold.” Foreign exchange market is an institutional arrangement for buying and selling of
foreign currencies. Exporters sell the foreign currencies. Importers buy them. The foreign
exchange market is merely a part of the money market in the financial centers. It is a place where
foreign moneys are bought and sold. The buyers and sellers of claim on foreign money and the
intermediaries together constitute a foreign exchange market. It is not restricted to any given
country or a geographical area. Thus, the foreign exchange market is the market for a national
currency (foreign money) anywhere in the world, as the financial centers of the world are united
in a single market. There is a wide variety of dealers in the foreign exchange market. The most
important among them are the banks. Banks dealing in foreign exchange have branches with
substantial balances in different countries. Through their branches and correspondents, the
services of such banks, usually called “Exchange Banks,” are available all over the world. These
banks discount and sell foreign bills of exchange, issue bank drafts, effect telegraphic transfers
and other credit instruments, and discount and collect amounts on the basis of such documents.
Other dealers in foreign exchange are bill brokers who help sellers and buyers in foreign bills to
come together. They are intermediaries and unlike banks are not direct dealers. Acceptance
houses are another class of dealers in foreign exchange. They help effect foreign remittances by
accepting bills on behalf of customers. The central bank and treasury of a country are also
dealers in foreign exchange. Both may intervene in the market occasionally. Today, however,
these authorities manage exchange rates and implement exchange controls in various ways. In
India, however, where there is a strict exchange control system, there is no foreign exchange
market as such.
FOREIGN EXCHANGE MARKET- DEFINITION
The foreign exchange market or the ‘forex market’, is a system which establishes an
international network allowing the buyers and sellers to carry out trade or exchange of currencies
of different countries. A forex market can be stated as one of the most liquid financial markets
which facilitate ‘over-the-counter’ exchange of currencies.
FEATURES / CHARACTERISTICS OF FOREX MARKET
BBAA04A61: INTERNATIONAL FINANCE Page 1

High Liquidity
The foreign exchange market is the most liquid financial market in the world. It involves the
trading of various currencies across the globe. All traders in this market are free to buy or sell
currencies anytime as per their choice. They are free to exchange currencies without prices of
currencies being traded getting affected. Currencies prices remain the same both at the time of
order placed and executed thereby enabling to earn the expected prices.
Market Transparency
Trader in the foreign exchange market has full access to all market data and information. They
can easily monitor different countries’ currencies price fluctuations through real-time portfolio
and account tracking without the need of a broker. All this information helps in making better
trading decisions and control over investments.
Dynamic Market
The foreign exchange market is a dynamic market. In these markets, currency values change
every second and hour. These values changes in accordance with changing forces of demand and
supply which also helps in determining the exchange rates. Due to its fast-changing character,
this market is termed as the perfect market to trade.
Operates 24 Hours
Foreign exchange markets function 24 hours a day. It provides a platform where currencies can
be traded anytime by traders. It provides a convenient time to all necessary adjustments when
and wherever needed.
Lower Trading Cost
The forex market has a very low trading cost. In these markets, there are no commissions like in
case of any other investments. Any difference between buying and selling prices of currencies is
the only cost of trading in the forex market. As there are low costs then the possibility of
incurring losses is also minimum thereby making it possible for small investors to make good
profit from trading.
Dollar Most Widely Traded

The dollar is the most dominant currency in the foreign exchange market. This currency is paired
with every country’s currency being traded in the forex market. In a major proportion of
transactions every day, the dollar is one of the two currencies being traded.
“Over-The-Counter” Market with an “Exchange-Traded” Segment:
Until the 1970s, all foreign exchange trading in the United States (and elsewhere) was handled
“over-the-counter,” (OTC) by banks in different locations making deals via telephone and telex.
In the United States, the OTC market was then, and is now, largely unregulated as a market.
Buying and selling foreign currencies is considered the exercise of an express banking power.
Thus, a commercial bank or Securities & brokerage firms in the United States do not need any
special authorization to trade or deal in foreign exchange.
International Network of Dealers:
The market is made up of an international network of dealers. The market consists of a limited
number of major dealer institutions that are particularly active in foreign exchange, trading with
customers and (more often) with each other. Most, but not all, are commercial banks and
investment banks. These dealer institutions are geographically dispersed, located in numerous
financial centers around the world. Wherever located, these institutions are linked to, and in
close communication with, each other through telephones, computers, and other electronic
means.
There are around 2,000 dealer institutions whose foreign exchange activities are covered by the
Bank for International Settlements’ central bank survey, and who, essentially, make up the global
foreign exchange market. A much smaller sub-set of those institutions accounts for the bulk of
trading and market-making activity. It is estimated that there are 100- 200 market-making banks
worldwide; major players are fewer than that.
At a time when there is much talk about an integrated world economy and “the global village,”
the foreign exchange market comes closest to functioning in a truly global fashion, linking the
various foreign exchange trading centers from around the world into a single, unified, cohesive,
worldwide market.

Foreign exchange trading takes place among dealers and other market professionals in a large
number of individual financial centers— New York, Chicago, Los Angeles, London, Tokyo,
Singapore, Frankfurt, Paris, Zurich, Milan, and many, many others. But no matter in which
financial center a trade occurs, the same currencies, or rather, bank deposits denominated in the
same currencies, are being bought and sold.
FUNCTIONS OF A FOREIGN EXCHANGE MARKET
1. To transfer finance, purchasing power from one nation to another. Such transfer is
affected through foreign bills or remittances made through telegraphic transfer. (Transfer
Function).
2. To provide credit for international trade. (Credit Function).
3. To make provision for hedging facilities, i.e., to facilitate buying and selling spot or
forward foreign exchange. (Hedging Function).
Transfer Function:
The basic function of the foreign exchange market is to facilitate the conversion of one currency
into another, i.e., to accomplish transfers of purchasing power between two countries. This
transfer of purchasing power is effected through a variety of credit instruments, such as
telegraphic transfers, bank draft and foreign bills. In performing the transfer function, the foreign

exchange market carries out payments internationally by clearing debts in both directions
simultaneously, analogous to domestic clearings.
Credit Function:
Another function of the foreign exchange market is to provide credit, both national and
international, to promote foreign trade. Obviously, when foreign bills of exchange are used in
international payments, a credit for about 3 months, till their maturity, is required.
Hedging Function:
A third function of the foreign exchange market is to hedge foreign exchange risks. Hedging
means the avoidance of a foreign exchange risk. In a free exchange market when exchange rate,
i. e., the price of one currency in terms of another currency, change, there may be a gain or loss
to the party concerned. Under this condition, a person or a firm undertakes a great exchange risk
if there are huge amounts of net claims or net liabilities which are to be met in foreign money.
Exchange risk as such should be avoided or reduced. For this the exchange market provides
facilities for hedging anticipated or actual claims or liabilities through forward contracts in
exchange. A forward contract which is normally for three months is a contract to buy or sell
foreign exchange against another currency at some fixed date in the future at a price agreed upon
now. No money passes at the time of the contract. But the contract makes it possible to ignore
any likely changes in exchange rate. The existence of a forward market thus makes it possible to
hedge an exchange position.

ADVANTAGES OF FOREIGN EXCHANGE MARKET
High Leverage: A forex investor can avail the facility of leverage or loan of up to 20 or 30
times of his/her capacity, for trading in the forex market.
International Trade: Every country has its currency and therefore, to facilitate trade activities
between two countries, the forex market is essential.
Trading Option: For the speculators or traders, foreign exchange market is just like other
financial markets where they can make money on short term fluctuations in the currencies.
Flexibility: We know that the forex market is a twenty-four-seven market, and there is no
minimum or maximum limit of the exchange amount. It provides the flexibility of investment or
exchange to the traders.
Hedging Risk: The forex market provides for hedging the risk of loss on currency fluctuations
while carrying global business operations and trading in foreign currency.
Low Transaction Costs: Since brokers are not very much entertained in the forex market, the
transaction cost (called as ‘spread’) charged by the dealers is reasonably low if compared to
other financial markets.
Inflation Control: To maintain the economic stability in the country and control situations like
inflation, the central bank maintains a forex reserve which consists of currencies of different

countries around the world. It adopts other means too, like decreasing bank lending rates and
selling out domestic currency for foreign currency.
DISADVANTAGES OF FOREIGN EXCHANGE MARKET
Leverage Risks: Leverage refers to loan in other terms. Forex market initiates the leverage of up
to 20 to 30 times the investment capacity of the traders or speculators, which may even lead the
loss of the entire amount of the investor.
Counterparty Risks: The forex is highly unregulated with no central authority for currency
exchange or trading risk mitigation. Thus, it may encounter the risk of non-fulfilment of the
obligations by any of the parties involved in such a contract.
Operational Risks: Since forex is a twenty-four hours market, it is difficult to manage its
operations by humans. As a result, the traders and MNCs rely on the algorithms, and trading
desks spread, respectively, to safeguard their investment in their absence.

PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET
Central Bank: The central bank regulates the exchange rates of the currency of their respective
country to ensure fluctuations within the desired limit and keep control over the money supply in
the market.
Commercial Banks: The commercial banks are the medium of forex transactions, facilitating
international trade and exchange to its customers along with other forex functions like making
foreign investments.
Traditional Users: The traditional users involve foreign tourists, companies carrying out
business operations across the globe, patients taking treatment in other country’s hospitals and
students studying abroad.
Traders and Speculators: The traders and speculators are the opportunity seekers and look
forward to making a profit through trading on short-term market trends.
Brokers: They are considered to be financial experts who act as an intermediary between the
dealers and the investors by providing the best quotations.
Transactions in Foreign Exchange Market:

Spot Market Transactions
The forex transactions which are executed immediately, or usually within two days, is known as
the spot transaction. Such a forex market is termed as a spot market, and the rate of exchange is
called a spot rate.
Futures Market Transactions
The market in which the exchange of currencies involve a future delivery and payment and the
rate of exchange for the same is pre-determined is called a futures forex market. Such exchange
rate is known as a future rate. It protects the buyer from the risk of a rise in the value of the
currency.
Forward Market Transactions
A forward forex market is however very similar to the futures market, but here, the terms of the
contract are negotiable and can be amended by any of the parties involved.
 Options: In an options contract, the holder is not bound to but have the right to buy or
sell the specified asset quantity at the pre-determined price on the specific future.

 Futures: In a future contract, the quantity of an asset, date of execution and price of the
contract is fixed and standardized.
 Swap: Usually, commercial banks adopt swap contracts if they perform forward
exchange business operations. Here, they sell off a particular currency in the spot market
to buy that same currency in the forward market.
 Arbitrage: The rigorous buying and selling of different currencies in the forex market to
fetch gains out of such transactions are called arbitrage.
FOREIGN EXCHANGE RATE- MEANING
“Exchange rates are an amount of the domestic currency you will have to pay to obtain a unit of
a foreign currency.”
A foreign exchange rate is the price of the domestic currency stated in terms of another currency.
In other words, a foreign exchange rate compares one currency with another to show their
relative values.
Main Types of Foreign Exchange Rates
Some of the major types of foreign exchange rates are as follows:
 Fixed Exchange Rate System (or Pegged Exchange Rate System).

 Flexible Exchange Rate System (or Floating Exchange Rate System).
 Managed Floating Rate System.
1. Fixed Exchange Rate System:
Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed by
the government.
 The basic purpose of adopting this system is to ensure stability in foreign trade and
capital movements.
 To achieve stability, government undertakes to buy foreign currency when the exchange
rate becomes weaker and sell foreign currency when the rate of exchange gets stronger.
 For this, government has to maintain large reserves of foreign currencies to maintain the
exchange rate at the level fixed by it.

 Under this system, each country keeps 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.
 When value of domestic currency is tied to the value of another currency, it is known as
‘Pegging’.
 When value of a currency is fixed in terms of some other currency or in terms of gold, it
is known as ‘Parity value’ of currency.
Basis Devaluation Depreciation
Meaning: Devaluation refers to reduction in Depreciation refers to fall in market
price of domestic currency in terms of price of domestic currency in terms of
all foreign currencies under fixed a foreign currency under flexible
exchange rate regime. exchange rate regime.
Occurrence: It takes place due to Government. It takes place due to market forces of
demand and supply.
Exchange It takes place under fixed exchange It takes place under flexible exchange
Rate System: rate system. rate system.
2. Flexible Exchange Rate System:
Flexible exchange rate system refers to a system in which exchange rate is determined by forces
of demand and supply of different currencies in the foreign exchange market.
 The value of currency is allowed to fluctuate freely according to changes in demand and
supply of foreign exchange.
 There is no official (Government) intervention in the foreign exchange market.
 Flexible exchange rate is also known as ‘Floating Exchange Rate’.
 The exchange rate is determined by the market, i.e. through interactions of thousands of
banks, firms and other institutions seeking to buy and sell currency for purposes of
making transactions in foreign exchange.

Fixed Exchange Rate System vs Flexible Exchange Rate System:
Basis Fixed Exchange Rate Flexible Exchange Rate
It is officially fixed in terms of

Determination of It is determined by forces of demand
gold or any other currency by
Exchange Rate: and supply of foreign exchange.
government.
There is complete government There is no government intervention

Government
control as only government has the and it fluctuates freely according to
Control:
power to change it. market conditions.
The exchange rate generally

Stability in The exchange rate keeps on
remains stable and only a small
Exchange Rate: changing.
variation is possible.
3. Managed Floating Rate System:
Traditionally, International monetary economists focused their attention on the framework of

either Fixed or a Flexible exchange rate system. With the end of Bretton Woods’s system, many
countries have adopted the method of Managed Floating Exchange Rates.
 It refers to a system in which foreign exchange rate is determined by market forces and
central bank influences the exchange rate through intervention in the foreign exchange
market.
 It is a hybrid of a fixed exchange rate and a flexible exchange rate system.
 In this system, central bank intervenes in the foreign exchange market to restrict the
fluctuations in the exchange rate within certain limits. The aim is to keep exchange rate
close to desired target values.
 For this, central bank maintains reserves of foreign exchange to ensure that the exchange
rate stays within the targeted value.
 It is also known as ‘Dirty Floating’.

Factors affecting the Foreign Exchange Rates
1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower
inflation rate than another will see an appreciation in the value of its currency. The prices of
goods and services increase at a slower rate where the inflation is low. A country with a
consistently lower inflation rate exhibits a rising currency value while a country with higher
inflation typically sees depreciation in its currency and is usually accompanied by higher interest
rates
2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates,
and inflation are all correlated. Increases in interest rates cause a country's currency to appreciate
because higher interest rates provide higher rates to lenders, thereby attracting more foreign
capital, which causes a rise in exchange rates
3. Country’s Current Account / Balance of Payments
A country’s current account reflects balance of trade and earnings on foreign investment. It
consists of total number of transactions including its exports, imports, debt, etc. A deficit in
current account due to spending more of its currency on importing products than it is earning
through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its
domestic currency.
4. Government Debt
Government debt is public debt or national debt owned by the central government. A country
with government debt is less likely to acquire foreign capital, leading to inflation. Foreign
investors will sell their bonds in the open market if the market predicts government debt within a
certain country. As a result, a decrease in the value of its exchange rate will follow.
5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export
prices to import prices. A country's terms of trade improves if its exports prices rise at a greater

rate than its imports prices. This results in higher revenue, which causes a higher demand for the
country's currency and an increase in its currency's value. This results in an appreciation of
exchange rate.
6. Political Stability & Performance
A country's political state and economic performance can affect its currency strength. A country
with less risk for political turmoil is more attractive to foreign investors, as a result, drawing
investment away from other countries with more political and economic stability. Increase in
foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country
with sound financial and trade policy does not give any room for uncertainty in value of its
currency. But, a country prone to political confusions may see a depreciation in exchange rates.
7. Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances
to acquire foreign capital. As a result, its currency weakens in comparison to that of other
countries, therefore lowering the exchange rate.
8. Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in
order to make a profit in the near future. As a result, the value of the currency will rise due to the
increase in demand. With this increase in currency value comes a rise in the exchange rate as
well.

EXCHANGE RATE REGIME IN INDIA
Before 1991, Indian rupee had followed the initial devaluation with Sterling pound in 1949 and
was maintained at the same per value for the next 16 years. In 1966, the rupee was devaluated by
57.5% to Rs.7.50 per US dollar again. In 1975, India delinked from sterling and pegged with in
2.25 % until January 1980. The process of steady depreciation of rupee began in1980s from 7.96
to 18.07. IMFs assistance of 5million SDR during Indira Gandhi’s regime.
Before LPG, exchange rate was highly over-valued. Strict exchange controls applied to not just
capital account but also current account transactions. Foreign investment was subject to stringent
restrictions and foreign investment amounted to a paltry $100-200 million annually. Indian
economy underwent a severe balance-of-payments crisis. By the summer of 1991, India's foreign
exchange reserves covered less than two weeks of imports resulted to high rate of inflation and
fleeing non-resident deposits. Declining production and a serious likelihood of an unprecedented
external payments default by India.
The 1991 Balance of Payments crisis forced India to procure a $1.8 billion IMF loan. The
economic reforms were thus introduced because of the IMF conditionality's and not because of
any sudden change of economic philosophy by the Government. The fiscal tightening and
devaluation of the rupee by nearly 25% adequately reduced the current account deficit.
After LPG, RBI announced depreciation of the rupee, in two installments on July 1 and 3, 1991.
The value of the rupee declined by 18-19 % against major currencies to improve the
competitiveness of Indian exports in March 1992 the LERMS (Liberalized Exchange Rate
Management System) involving dual exchange rate was introduced.
All foreign exchange receipts on current account transactions (exports, remittances, etc.) were
required to be surrendered to the Authorized Dealers (ADs) in full. The rate of exchange for
conversion of 60per cent of the proceeds of these transactions was the market rate quoted by the
Ads. Remaining 40per cent of the proceeds were converted at the Reserve Banks official rate.
The ADs, in turn, were required to surrender these 40 per cent of their purchase of
foreign currencies to the Reserve Bank.

The dual exchange rate system was replaced by a unified exchange rate system in March
1993, whereby all foreign exchange receipts could be converted at market determined exchange
rates. With the rupee becoming fully convertible on all current account transactions, the risk-
bearing capacity of banks increased and foreign exchange trading volumes started rising.
Fixed and flexible exchange rates:
Fixed Exchange Rates:
 The fixed exchange rate is officially fixed by the government or a competent authority,
not by the market forces.
 In fixed exchange rate wherein the government and central bank attempts to keep the
value of the currency is fixed against the value of other currencies.
 The value of each currency was set in terms of gold and exchange rate was fixed
according to the gold value of currencies that have to be exchanged.
 For example in India, a currency price is fixed an official price of its currency in reserve
is issued by the central bank.
 Once the rate determined, the central bank undertakes to buy and sell foreign exchange
and the private purchase and sales are postponed.
 An apex bank changes the exchange rate if needed.
 It is also known as pegged exchange rate or par value.
Flexible exchange rates:
 A flexible exchange rate is also known as a floating exchange rate.

 In a flexible exchange rate, a rate is set according to the demand and supply of market
forces.
 A country's economic situation will determine the market demand and supply of its
currency.
 It is particularly determined concerning other currency it means higher the demand of
particular currency, the higher its exchange rate.
 If an economy is strong the flexible exchange rate is higher and vice a versa. So the
government has no control over the flexible exchange rate.

 A value of the currency is fluctuated or shift freely according to the demand and supply
of international exchange.
Differences between fixed and flexible exchange rates:
Basis Fixed exchange rate Flexible exchange rate

A fixed exchange rate is a rate which is A Flexible exchange rate is a rate
Meaning maintained and controlled by the central which is determined by the market
government. force.
A fixed exchange rate is controlled by an A flexible exchange rate is controlled
Controlled by
apex bank or a monetary authority. by the demand and supply forces.
A flexible exchange rate can
How it affects A fixed exchange rate has a devaluation and
depreciate and appreciate the value
currency revaluation in a currency.
of a currency.
Hedging is used to reduce the
There is no hedging risk if the country is
Hedging currency risks in the flexible
using fixed exchange rate.
exchange rate.
Definition of devaluation and depreciation
Devaluation:
A devaluation occurs when a country makes a conscious decision to lower its exchange rate in a
fixed or semi-fixed exchange rate.
Depreciation
When there is a fall in the value of a currency in a floating exchange rate. This is not due to a
government’s decision, but due to supply and demand-side factors. (Although if the government
sold a lot of their currency they could help cause a depreciation.
Base Devaluation of currency Depreciation of currency

Meaning Devaluation means to lower the The meaning of depreciation of the
value of country's currency as currency is the same as the meaning
compared to the another country’s of devaluation of the currency.
value
circumstances It is done by government authority. It is done by the force of demand
and supply in the international
market.

Rate It is done by using fixed exchange It is done by using floating

rate. exchange rate
Effect on economy It just for short term. It affects the economy for a longer
term
Changes There is no fixed time for it but it It occurs on a daily basis.
doesn’t occur in regularly.
Definition of Current Account
The Balance of Payment is a set of accounts which comprises of two major accounts, one of
which is the Current Account. Current Account is the record of the inflow and outflow of money
to and from the country during a year, due to the trading of commodity, service, and income. The
account is an indicator of the status of the economy. The major components of a current account
are:
The Balance of Trade (only visible items i.e. goods): Goods imported and exported to and from
the country.
Trading of Services: Services received from other countries and rendered to other nations.
Net investment income: Income from foreign investment less payments on foreign investments.
Net cash transfers: Current transfers in the form of donations, gifts, aids, etc. form part of net
cash transfer.
Current Account is the record of the exchange of commodities and services for the recent period.
It shows the flow of foreign trade. In India, reporting of the account is done by the Central Bank.
If the account shows a negative balance, then it means that the imports are greater than exports or
consumption exceeds savings. Similarly, if there is a positive balance, then it is a symbol of
exports over imports.
Definition of Capital Account
The remaining half of the Balance of Payment is Capital Account, which records the movement
of capital in the economy due to capital receipts and expenditure. It recognises foreign
investment in domestic assets and domestic investment in foreign assets. The details can be

recorded by analyzing the inflow and outflow of funds from the nation’s economy. The funds
can be in the form of loans or investments.
Under Capital Account, investments made by both public and private sectors are taken together.
The capital flow may either be debt creating or non-debt creating. The following are the
components of Capital Account:
Foreign Direct Investment: Investment and control in a company based in a country by a

foreign company.
Portfolio Investment: Investment in stocks, bonds, debts and other financial assets.
Government loans to the Government of other countries of the world.
BASIS FOR CURRENT ACCOUNT CAPITAL ACCOUNT

COMPARISON
Meaning An account which records the export An account which records the
and import of merchandise and trading of foreign assets and
unilateral transfers done during the liabilities during the year by a
year by a nation are known as Current country is known as Capital
Account. Account.
Reflects Net Income of the country. Net change in ownership in

national assets.
Deals with Receipt and disbursements of cash and Sources and application of
non-capital items. capital.
Components Trade in goods and services, Foreign Direct Investment,

investment income, unrequited Portfolio Investment,
transfers. Government loans etc.
Currency convertibility means the freedom to convert domestic currency (rupee) into other
international currencies (like Dollars etc.)
Before we discuss it further, read- What is current account and capital account?

Current account convertibility means freedom to convert rupee into dollars etc and vice versa for
export and import of goods and services. It also includes freedom to convert currencies to make/
receive unilateral transfers like gifts, donations, etc and to pay/ receive interest, dividend, etc.
In India, there is full current account convertibility since August 20, 1993.
India had moved towards a market-determined exchange rate since March 1993. Then the RBI
announced in August 1993 that, effective from August 20, India has become fully convertible on
the current account. This was after India accepted the status and obligations of Article VIII with
the IMF. It was a mere formality as India had already come very close to Current Account
Convertibility.
Capital account convertibility is the freedom of foreign investors to purchase Indian financial
assets (shares, bonds, etc.) and that of the Indian investors to purchase foreign financial assets. It
involves the freedom to invest in financial assets.
There is partial capital account convertibility in India. It means there are certain restrictions on
the movement of capital. Though India has been liberalizing its capital accounts since the
launch of economic reforms in 1991, it has adopted a cautious approach towards full
convertibility, especially after the 1997 Asian financial crisis (which was exacerbated because
the countries affected had full capital account convertibility) and the financial crisis of 2008
(which led to huge foreign capital outflows from emerging countries)
Capital account convertibility
It means the freedom to convert local financial assets into foreign financial assets and vice versa
at market determined rates of exchange. It refers to the removal of restraints on international
flows on a country’s capital account, enabling full currency convertibility and the opening of the
financial system. Capital account convertibility is considered to be one of the major features of a
developed economy. It helps attract foreign investment. At the same time, capital account
convertibility makes it easier for domestic companies to tap foreign markets. It is sometimes
referred to as Capital Asset Liberation.

Current account convertibility
Current account convertibility allows free inflows and outflows for all purposes other than for
capital purposes such as investments and loans. In other words, it allows residents to make and
receive trade-related payments — receive dollars (or any other foreign currency) for export of
goods and services and pay dollars for import of goods and services, make sundry remittances,
access foreign currency for travel, studies abroad, medical treatment and gifts, etc.
Implications of Convertibility
Restrictions on convertibility was imposed

 To avoid sudden erosion of the foreign currency reserves (capital flight) and removed
restrictions slowly when the India’s reserves posted more than 200 billion dollars.
 To hold the value of home currency against other currencies when the country’s economy
prospects get disturbs, but it is believed now that the currencies will hold value when it is
converted into a foreign currencies and invested abroad.
 The restriction cannot be continued for long as the economy is highly integrated, India
cannot hold on to non-convertibility in its capital account.
 The non-convertibility will restrict the free flow of FDI and FIIs and economic growth as
well.
 The Tarapore committee favors full convertibility of rupee and the authorized dealers are
now empowered to release exchange which eased the exporters to transact businesses and
also simplified the importers job.
Limits to Partial CAC

 Private visit and Business travel
 Gift or donation
 Employment /For studies abroad
 Investment : Foreign stock markets
 Borrowings
Reasons Favoring Financial Openness & CAC
 Diversification and NRI Remittances
 Catalyst for financial market, institutional development, competition, new technologies &
discipline macroeconomic policies.
 Reduction in the size of Black money.

 Induces competition against Indian finance.

 Misallocation of Capital inflows.
 Export of domestic Savings.
 Entry of Foreign banks can create Unequal playing field.
 Highly volatile international finance (hot money) - Higher speculation.
BALANCE OF PAYMENTS
The balance of payments is the record of all international financial transactions made by a
country's residents. A country's balance of payments tells you whether it saves enough to pay for
its imports. It also reveals whether the country produces enough economic output to pay for its
growth. The BOP is reported for a quarter or a year.
 A balance of payments deficit means the country imports more goods, services and
capital than it exports.
 A balance of payments surplus means the country exports more than it imports. Its
government and residents are savers.
It includes all receipts on account of goods exported, services rendered, capital received by
residents, payments of residents, capital transferred to foreign investments.
COMPONENTS OF BALANCE OF PAYMENTS
Current Account - measures a country's trade balance plus the effects of net income and direct
payments. When the activities of a country's people provide enough income and savings to fund
all their purchases, business activity and government infrastructure spending, then the current
account is in balance.
Capital Account - measures financial transactions that don't affect a country's income,
production or savings. For example, it records international transfers of drilling rights,
trademarks and copyrights. Many capital account transactions happen infrequently, such as
cross-border insurance payments.
Financial Account - measures 1) changes in domestic ownership of foreign assets and 2) foreign
ownership of domestic assets. If foreign ownership increases more than domestic ownership
does, it creates a deficit in the financial account. This means the country is selling off its assets,
like gold, commodities and corporate stocks, faster than it is acquiring foreign assets.

DISEQUILIBRIUM IN BOP
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.
Deficit: Our Receipts from foreigners fall below our payment to foreigners. (Unfavorable)
Surplus: Receipts exceeds its Payment (Favorable)
BOP is a double entry accounting record, then apart from errors and omissions, it must always
balance. The BOP deficit or surplus indicate imbalance in the BOP. This imbalance is interpreted
as BOP Disequilibrium. A country’s balance of payments is said to be in disequilibrium when its
autonomous receipts (credits) are not equal to its autonomous payments (debits).
CAUSES OF DISEQUILIBRIUM
Social factors – The social factors may include changes in tastes & preferences due to
demonstration affect, population growth rate, rate of urbanization, change in fashion etc.
Political factors – The political factors may include – political stability / instability in a country,
war, change in diplomatic policy, Disturbance cause large capital outflow etc.
Economic Factors – The economic factors include Imbalance between export & Import, New
Source of supply & new substitutes, High Domestic Price, Structural changes, Changes in
exchange and interest rates, cyclical fluctuations, inflation/deflation, changes in the levels of
foreign currency reserves, etc.
MEASURES TO CORRECT DISEQUILIBRIUM IN BOP
Export Promotion: Export should be encouraged by granting various bounties to manufacturers

and exporters. At the same time, imports should be discouraged by undertaking import
substitution and imposing reasonable tariffs.
Import: Restrictions and Import Substitution are other measures of correcting disequilibrium.

Reducing Inflation: Inflation (continuous rise in prices) discourages exports and encourages
imports. Therefore, government should check inflation and lower the prices in the country.
Exchange Control: Government should control foreign exchange by ordering all exporters to
surrender their foreign exchange to the central bank and then ration out among licensed
importers.
Devaluation of Domestic Currency: It means fall in the external (exchange) value of domestic
currency in terms of a unit of foreign exchange which makes domestic goods cheaper for the
foreigners. Devaluation is done by a government order when a country has adopted a fixed
exchange rate system. Care should be taken that devaluation should not cause rise in internal
price level.
Depreciation: Like devaluation, depreciation leads to fall in external purchasing power of home
currency. Depreciation occurs in a free market system wherein demand for foreign exchange far
exceeds the supply of foreign exchange market of a country (Mind, Devaluation is done in fixed
exchange rate system).

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KRISTU JAYANTI COLLEGE (AUTONOMOUS) Unit 3: Foreign Exchange and Balance of Payments

FOREIGN EXCHANGE MARKET – OVERVIEW

FOREIGN EXCHANGE MARKET- DEFINITION

FEATURES / CHARACTERISTICS OF FOREX MARKET

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Lower Trading Cost

Dollar Most Widely Traded

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“Over-The-Counter” Market with an “Exchange-Traded” Segment:

International Network of Dealers:

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FUNCTIONS OF A FOREIGN EXCHANGE MARKET

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ADVANTAGES OF FOREIGN EXCHANGE MARKET

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DISADVANTAGES OF FOREIGN EXCHANGE MARKET

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PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET

Transactions in Foreign Exchange Market:

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Spot Market Transactions

Futures Market Transactions

Forward Market Transactions

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FOREIGN EXCHANGE RATE- MEANING

Main Types of Foreign Exchange Rates

Some of the major types of foreign exchange rates are as follows:

 Fixed Exchange Rate System (or Pegged Exchange Rate System).

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Basis Devaluation Depreciation

Meaning: Devaluation refers to reduction in Depreciation refers to fall in market

price of domestic currency in terms of price of domestic currency in terms of

all foreign currencies under fixed a foreign currency under flexible

exchange rate regime. exchange rate regime.

demand and supply.

Rate System: rate system. rate system.

2. Flexible Exchange Rate System:

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Fixed Exchange Rate System vs Flexible Exchange Rate System:

Basis Fixed Exchange Rate Flexible Exchange Rate

It is officially fixed in terms of

There is complete government There is no government intervention

The exchange rate generally

3. Managed Floating Rate System:

Traditionally, International monetary economists focused their attention on the framework of

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Factors affecting the Foreign Exchange Rates

3. Country’s Current Account / Balance of Payments

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6. Political Stability & Performance

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EXCHANGE RATE REGIME IN INDIA

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Fixed and flexible exchange rates:

Fixed Exchange Rates:

Flexible exchange rates: