Topic 8

Balance of Payments and Foreign

Exchange rates

1
 Reference

Chapter 19 of Krugman-Wells
 Open Economy
Is one where buying and selling take place
between residents* of an economy and the
rest of the world of:
Goods and services (Current Account)
Capital assets (Capital or Financial Account)

(* Residents
individuals and enterprises:
Not based on nationality or legal criteria but on
Center of Interest in the economy)

3
 Balance of payments (BOP)
Record of transactions between residents and
the rest of the world during a specified period
usually a year.

4
Indias BOP Table Credit Debit Net
A) Current Account
A.1) Merchandise
A.2) Invisibles
B) Capital Account

B.1) Foreign Investment

B.2) Loans
B.3) Banking Capital

B.4) Rupee Debt Service

B.5) Other Capital

C) Errors and Omissions

D) Overall Balance

E) Monetary Movements
E.1) I.M.F

E.2) Foreign Exchange

Reserves change
5
 Current account
Merchandise - Goods
Invisibles
Services (Software, tourism, shipping, insurance etc)
Unilateral transfers (Grants, gifts, NRI remittances
etc)
Income (Interest, dividends, Compensation of
employees)

6
 Capital account
Foreign investment:
Foreign direct investment
Foreign portfolio investment (e.g., FIIs)
Loans:
External assistance
Commercial borrowings (MT & LT)
Short-term
Banking capital (NRI deposits etc)
Other capital (e.g., leads & lags in export receipts)
7
 Credit & Debit in BOP Table
Credit item:
Any transaction that brings in foreign exchange to
the country, for example exports, foreign
institutional investment in stock market
Debit item:
Any transaction that takes out foreign exchange
from the country, for example imports, external
assistance to another country.

8
 BOP Deficits
Trade deficit:
Excess of Imports of (merchandise) goods over
exports of goods
Current Account deficit (CAD):
Excess of Outflow of foreign exchange in both goods
and invisibles transactions over such Inflow
Overall balance:
Aggregate figures after adding up all the current and
capital accounts adjusting for errors & omissions

9
Indias BOP Table Credit Debit Net
A) Current Account
A.1) Merchandise
A.2) Invisibles
B) Capital Account

B.1) Foreign Investment

B.2) Loans
B.3) Banking Capital

B.4) Rupee Debt Service

B.5) Other Capital

C) Errors and Omissions

D) Overall Balance

E) Monetary Movements
E.1) I.M.F

E.2) Foreign Exchange

Reserves change
10
 Monetary movements
When overall balance is positive (as in 2013-14), i.e.,
total foreign exchange inflows > foreign exchange
outflows:
Forex reserves go up: debit entry in BOP table
When overall balance is negative (as in India in 2008-
09), deficit can be financed by:
Loan from IMF: credit entry under IMF in BOP table or
Using forex reserves: credit entry under forex reserves

11
Indias BOP Table, 2013-14,
US $ million Credit Debit Net
A) Current Account 551838 584235 -32397
A.1) Merchandise 318607 466216 -147609
A.2) Invisibles 233231 118019 115212
B) Capital Account 511823 463035 48787

B.1) Foreign Investment 246766 220380 26386

B.2) Loans 134836 127071 7765
B.3) Banking Capital 108049 82601 25448

B.4) Rupee Debt Service 0 52 -52

B.5) Other Capital 22171 32932 -10761

C) Errors and Omissions 887 1769 -882

D) Overall Balance 1064548 1049040 15508

E) Monetary Movements 0 15508 -15508

E.1) I.M.F 0 0 0

E.2) Foreign Exchange

Reserves (increase/decrease) 0 15508 -15508
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Indias BOP Table, 2008-9,
Rs crores Credit Debit Net
A) Current Account 1544992 1677263 -132271
A.1) Merchandise 798956 1341069 -542113
A.2) Invisibles 746036 336194 409842
B) Capital Account 1373684 1341303 32381

B.1) Foreign Investment 743485 731725 11760

B.2) Loans 276833 257549 19284
B.3) Banking Capital 294488 314356 -19868

B.4) Rupee Debt Service 0 476 -476

B.5) Other Capital 58878 37197 21681

C) Errors and Omissions 2775 0 2775

D) Overall Balance 2921451 3018566 -97115

E) Monetary Movements 97115 0 97115

E.1) I.M.F 0 0 0

E.2) Foreign Exchange

Reserves (decrease) 97115 0 97115
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 BOP
Current account convertibility
When there are no restrictions on inflows and
outflows in current account
Capital account convertibility
When there are no restrictions on inflows and
outflows in capital account
 Before reforms
Current Account:
Extensive controls
Import licensing
Foreign exchange licensing
Capital account:
Volatile inflows such as foreign portfolio investment,
short term credit etc not permitted
Some restrictions on FDI
Till 1980s, capital flows overwhelmingly external
assistance
In 1980s, External commercial borrowings including
short term loans and NRI deposits
15
 After reforms
Current Account:
Almost fully convertible: practically no restrictions
on exports and imports of goods and services
Capital Account:
Not yet fully convertible
But substantial liberalization

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Capital mobility and interest rates
 BOP Deficits
Trade deficit:
Excess of Imports of (merchandise) goods over
exports of goods
Current Account deficit (CAD):
Excess of Outflow of foreign exchange in both goods
and invisibles transactions over such Inflow
Overall balance:
Aggregate figures after adding up all the current and
capital accounts adjusting for errors & omissions

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 Managing BOP
Managing Current Account
Exports
Imports
Managing Capital Account
Foreign investment
Foreign direct
Foreign portfolio
Foreign institutional

Loans
External commercial borrowing
Short term
Long term
External assistance:
Bilateral
Multilateral (IMF, World Bank etc)
NRI deposits

22
 Capital flows
In excess of CAD: is it necessarily good?
Issues:
Impact on forex rate
Capital flight
Volatility of capital inflows/outflows : capital flight leads to
severe crisis
Long term loans?
Foreign Direct Investment?

23
 Exchange Rate Regimes
Fixed exchange rate:
Hard pegs (e.g., currency board arrangements)
Soft pegs (crawling pegs, pegs within bands etc)
Flexible Regimes:
Independently floating
Managed floating:
Market determined with official intervention to
influence the rate
Currency pegged to a major currency or a basket
of currencies
 Exchange rate
Rs/$ (Rs 65 per dollar)
More common
$/Rs (USD 0.0154 per rupee)
 Exchange rate changes
Depreciation/devaluation of a currency
(RUPEE):
Reduction in the value of the currency e.g., $/Rs
, i.e.,
Rs/$
Appreciation/revaluation:
Increase in the value of the currency, e.g., $/Rs ,
i.e.,
Rs/$
 India: Managed Float since Dec 1993

Rupee devalued in 6 June, 1966: Forex rate changed from Rs 4.76 to Rs 7.5
Market determined from December 1993
 Rupees per USD

0
10
20
30
40
50
60
70

1950-51
1953-54
1956-57
1959-60
1962-63
1965-66
1968-69
1971-72
1974-75
1977-78
1980-81
1983-84
Forex Rate

1986-87
1989-90
1992-93
1995-96
1998-99
2001-02
2004-05
2007-08
2010-11
2013-14
28
 Earlier: Administered rate
(Below market clearing)

Rs/$ S
D

Shortage
Rs 20 But Logic ?
Rs 15
S
D
Excess demand

$
Market clearing exchange rate is Rs 20 per $ 29
 Now: Market determined Exchange rate

Rs/$ S
D

Rs 65

S
D

$
30
 Foreign Exchange Rate
Depends on:
Demand for foreign exchange (debit items in BOP)
and
Supply of foreign exchange (credit items in BOP)
If D > S, forex rate (Rs/$)
If S > D, forex rate
 Exchange rate movements
(Some examples, ceteris paribus)
US recession:
Exports from India : S$ , (Rs/$)
Foreign Institutional investment
S$ , Rs/$
Capital flight:
Non-residents pull out assets from India: D$ , (Rs/$)
Inflation:
Rising prices in country X makes imports from country Y more
attractive: D$ , (Rs/$)
Interest rate:
If rising interest rate in country X leads to more lending to the country:
S$ , Rs/$
 Demand and Supply curves in
Foreign exchange market
Demand Curve
Response of imports of goods and services to
changes in forex rate, ceteris paribus
Supply curve
Response of exports of goods and services to
changes in forex rate, ceteris paribus
 Demand Curve

As Rs/$ , rupee cost of imported goods

and hence DD
Rs/$
D
Crucial assumption:
Imports sensitive to forex rate.
Rs 70 Is it always true?
Rs 65

$
Supply curve
As Rs/$ , $/Rs , i.e., dollar price of
goods exported and hence SS

Rs/$ S

Rs 70

Rs 65
Crucial assumption:
Exports sensitive to forex rate.
S Is it always true?

$
 Foreign Exchange Market

Rs/$ S
D

Rs 65

S
D

$
Market clearing exchange rate is Rs 65 per $
 Shift of Forex Demand Curve
Given forex rate, when other things change, e.g.,
more capital flows out, more imports due to output expansion etc

Rs/$

D S

S D

$
 Shift of Forex Supply Curve
Given forex rate, when other things change, e.g.,
more capital flows in, more exports due to world boom etc

Rs/$

D S

S D

$
 Exchange Rates
Nominal exchange rate
Price of one currency in terms of another currency
Real exchange rate
Purchasing power of a currency
Price of currency adjusted for cross-country differences
in prices of goods and service
Example:
Real exchange rate = Mexican pesos per $ x
(Pusa/Pmexico)
 Real Exchange Rate
Mexican goods and services one can buy with
dollar depends on:
Pesos/$
Prices in Mexico
USA imports vegetables from Mexico
Forex rate
10 pesos per $ to 15 pesos per $
Price of vegetables per kg
10 pesos to 15 pesos
Vegetables quantity per $ remains the same
 Effective Exchange Rates
Effective exchange rate
Average exchange rate over several other
currencies
Trade weighted
When averaging, using amount of trade to weight the
currency
 Exchange market intervention
Government (central bank) can maintain the
exchange rate at a target level below or above
the market clearing level by:
Buying /selling foreign exchange in the market
Foreign exchange controls
Economic policies to influence demand/supply of
foreign exchange
 Suppose India wants to keep Rupee overvalued
(i.e., $ undervalued)
Rs/$ S
D

Rs 65
Target, Rs 60

S
D

$
Market clearing exchange rate is Rs 65 per $
 Then, RBI can sell $ in the market

Rs/$ S
D

Rs 65
Target, Rs 60

S
Shortage D

$
 Or enforce Foreign exchange controls to limit demand

Rs/$ S
D

Rs 65
Target, Rs 60

S
Shortage D

$
 If India like China wants to maintain an undervalued
currency, i.e., overvalued $

Rs/$ S
D

Target, Rs 70

Rs 65

S
D

$
 Then RBI can buy $ from the market

Rs/$ S
D
Surplus
Target, Rs 70

Rs 65

S
D

$
 Fixed exchange rate system
Advantages:
Uncertainty is less
Induces the country to commit to anti-inflationary
measures: if not, with inflation exports suffer in fixed
exchange rate system (in a flexible system, with inflation as
exports suffer, Rs/$ rises to neutralize impact of inflation)
Disadvantages:
Effective when the country has large and stable forex
reserves
Independent Monetary Policy becomes difficult if capital
account is convertible
 Impossible Trinity
(Trilemma)
Convertible Capital account: no restrictions on capital inflows
(and outflows)
Depending on the domestic rate of interest, external loans may
become attractive leading to capital inflows and causing the forex rate
to move downwards
Pegged currency: target a fixed foreign exchange rate
Depending on the target foreign exchange rate, the Central Bank of a
country may want to intervene by demanding foreign exchange
leading to more liquidity in the economy and making the inflation
situation worse
Independent monetary policy: when controlling
inflation/recession is the more important objective
Depending on the inflation/recessionary conditions in the country, the
Central Bank may want to pursue a tight/easy monetary policy leading
to higher/lower interest rates
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 Impossible Trinity
Inflows of capital: Ceteris paribus, S$ > D$, Rs/$ (i.e., $/Rs
) export competitiveness
To keep forex rate fixed, if RBI buys $, liquidity in the economy

To pursue independent Monetary Policy, say to control the
inflationary consequences, if RBI resorts to sterilization,
Interest rate tends to rise:
May negatively influence investment expenditure
If capital account is convertible, ECBs, e.g., became more
attractive leading to more capital inflows and hence a
repetition of the cycle
This prompted RBI to allow the forex rate to float with Rs/$
determined at a lower level
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 Rupees per USD

0
10
20
30
40
50
60
70

1950-51
1953-54
1956-57
1959-60
1962-63
1965-66
1968-69
1971-72
1974-75
1977-78
1980-81
1983-84
Forex Rate

1986-87
1989-90
1992-93
1995-96
1998-99
2001-02
2004-05
2007-08
2010-11
2013-14
51