Chapter Two

International Financial 2
Management

Chapter Objectives:

•Understanding BALANCE OF PAYMENT

1
Principles Of Balance Of Payments
•BOP is a systematic record of all economic transaction
between the residents of a given country and the residents of
other countries.

•BOP account is based on the standard double entry system

of bookkeeping.

•Any transaction which is source of foreign currency is a

credit entry. They are recorded with plus sign.

•Any transaction which is a use. Example – imports,

Borrowing money etc is a debit entry. They are recorded
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with minus sign. Slide 1
Sources of foreign exchange – Credit Entry

•Export of goods.

•Export of services like travel, insurance etc.

•Capital inflow into the country – Borrowings.

Transactions reducing the external purchasing

power of the country is recorded as – Debit Entry
•Imports of goods

•Capital outflow - Lending

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Slide 2
Components of BOP

BOP statement is divided into three major groups of

accounts

•CURRENT ACCOUNT

•CAPITAL ACCOUNT

•ERRORS AND OMISSIONS

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Slide 3
CURRENT ACCOUNT
1. MERCHANDISE DR CR
a. Exports (on free On Board)
b. Imports (Cost, Insurance Freight

2. INVISIBLES
• Services
i. Travel
ii. Transportation
iii. Insurance
iv. G.n.i.e
v. Miscellaneous

b. Transfers
vi. Official
vii. Private

c.Investment Income
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Slide 4
CAPITAL ACCOUNT
DR CR
1.Foreign Investment

2.Loans

3.Banking Capital

4.Rupee Debt Service

5.Other Capital

ERRORS AND OMISSIONS

It indicates the value of discrepancies. A negative value indicates that receipts
are overstated or payments are understated. Persistently large errors with the
same sign indicate serious weaknesses in the recording of transactions. 6
Slide 5
CURRENT ACCOUNT
•Current account records trade transaction and invisibles.

• Exports on f.o.b (free on trade) basis are shown as credit.

• Imports valued on c.i.f (Cost Insurance Freight) basis are shown as debit.

• Invisibles comprises the value of services rendered by resident to non-resident.

• G.n.i.e implies govt not included elsewhere. Funds received from foreign govt for the

maintenance of their embassy, consulates etc in India are shown as – Credit Entry.
Payment made to foreign consultant for professional services rendered by him will
appear as debit item.

• Transfers are of two types – Official & Private.

Official – Contribution by govt of India to International Institution – Dr
Private – Cash remittances by non-resident Indians for their family maintenance in
India. 7
Slide 6
CAPITAL ACCOUNT
• All financial transactions are recorded in capital account –

• Foreign Investment – Investment made by foreign residents in the

acquisition of physical assets in India is a Foreign Direct Invt. – Cr Entry.

• When a Foreign country portfolio investor directly purchases financial assets

in the Indian securities market it is termed as Foreign Portfolio Invt.– Dr

Entry

• Loans – Disbursements received by Indian resident entities are – Cr Entry.

While repayment of loan is recorded as – Dr Entry.

• Rupee Debt Service – Is defined as the cost of meeting interest payments and

regular contractual repayments of principal of a loan with any administrative

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charges in rupees by India. Slide 7
 EXCHANGE RATE MECHANISM

Exchange rate is formally defined as the value of one currency in

terms of another country.

Types of Exchange Rate Mechanism are –

•Fixed Exchange Rate System

•Floating Exchange Rate System

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Slide 8
 EXCHANGE RATE MECHANISM

Types of Fixed Rate System are –

• Currency Board System

• Target zone arrangement

• Monetary Union

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Slide 9
 EXCHANGE RATE MECHANISM

Types of Fixed Rate System are –

• Currency Board System – Under currency board system, a

country fixes the rate of its domestic currency in terms of a
foreign currency and its exchange rate in terms of other currencies
depends on the exchange rates between the other currencies.

Target Zone arrangement – A group of countries sometimes get

together and agree to maintain the exchange rates between their
currencies within a certain band around fixed central exchange
rates.

Monetary Union – Under this system a group of countries agree to

use a common currency instead of their individual currencies. 11
 EXCHANGE RATE MECHANISM

Types of Floating Exchange Rate System

Free Float –

Under this system the exchange rates between currencies are

variable. These rates are determined by the demand and supply for
the currencies.

Managed Float –

Uncertainties increase the risk associated with International trade

and thus reduce overall efficiency of the world economic system.
In order to reduce these inefficiencies central bank generally
intervene in the currency markets to smoothen the fluctuations. 12
 FACTORS AFFECTING THE COMPONENTS OF BOP
ACCOUNT

Exports of goods & services –

1. Prevailing Exchange rate of the domestic currency – Lower

value – lower international price – increase demand for exports
– hence high demand for the domestic currency.

2. Inflation rate

3. World price of commodity

4. Income of foreigners

5. Trade barriers
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 FACTORS AFFECTING THE COMPONENTS OF BOP
ACCOUNT

Imports of goods & services –

1. Value of domestic currency.

2. Level of domestic income.

3. International Prices

4. Inflation Rate

5. Trade barriers

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 HISTORY OF MONETARY SYSTEM

Following are the Monetary System –

• The Gold Standard

• Bretton Woods System

• Post Bretton Woods System

• The European Monetary System

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 HISTORY OF MONETARY SYSTEM

The Gold Standard

a) Gold standard was followed from 1870 – 1914.

a) Due to first world war in 1914 it was discontinue.

a) The exchange rate between two currencies was determined on

the basis of the rates at which the respective currencies could be
converted into gold.

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 HISTORY OF MONETARY SYSTEM

Bretton Woods System

a) In 1944 representatives of 44 countries met in Bretton Woods

(USA) and a agreement to establish a new monetary system
known as Bretton Woods System.

b) Two new institutions were to be established namely the IMF &

World Bank.

c) Terms of agreement were all member countries were required

to subscribe to IMF capital. The subscription was to be in the
form of gold (1/4) and balance in its own currency.

d) Each countries quota was decided by IMF as per the position in

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 HISTORY OF MONETARY SYSTEM

POST BRETTON WOODS SYSTEM

Principles of exchange rate management was adopted –

a) A member country neither should manipulate exchange rate to

prevent correction in BOP nor it should use it to gain
competitive advantage in International market.

b) A member country should prevent short term movements in the

exchange rates which could hamper international transactions.

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 HISTORY OF MONETARY SYSTEM

THE EUROPEAN MONETARY UNION

a) The treaty of Rome was signed by Belgium, France, German,

Italy, Netherlands etc to form European Economic Community.

b) In the same year it adopted wa Common Agriculture Policy

(CAP) under which uniform prices were set for farm products.

c) Structure of EEC.

d) EMS was quite similar to the Bretton Woods System with the
exception that instead of the currencies being pegged to the
currency of one of the participating nations, a new currency
was created for the purpose. 19