MODULE-5

Balance of payments and

its impact on exchange rate
Balance Of Payment : Definition

The balance of payments of a country is a systematic record of all economic

transactions between the residents of a country and the rest of the world. It

presents a classified record of all receipts on account of goods exported, services

rendered and capital received by residents and payments made by them on account

of goods imported and services received from the capital transferred to non-

residents or foreigners. - Reserve Bank of India

Features
➢ It is a systematic record of all economic transactions between one

country and the rest of the world.

➢ It includes all transactions, visible as well as invisible.

➢ It relates to a period of time. Generally, it is an annual statement.

➢ It adopts a double-entry book-keeping system. It has two sides: credit side

and debit side. Receipts are recorded on the credit side and payments on the

debit side.
Balance of Trade (BOT)
The balance of trade (BOT), also known as the trade balance, refers to the difference between

the monetary value of a country’s imports and exports over a given time period. A positive

trade balance indicates a trade surplus while a negative trade balance indicates a trade deficit.

The BOT is an important component in determining a country’s current account.

Balance of Trade (BOT)=Value of Exports -Value of Imports

•Value of Exports is the value of goods that are sold to buyers in other countries.

•Value of Imports is the value of goods that are bought from sellers in other countries.
Importance of Balance of Payments
1. The BOP of a country reveals its financial and economic status.
2. A BOP statement can be used to determine whether the country’s currency value is
appreciating or depreciating.
3. The BOP statement helps the government to decide on fiscal and trade policies.
4. It provides important information to analyze and understand the economic dealings
with other countries.
5. BOP records all the transactions that create demand for and supply of a currency.
6. BOP may confirm trend in economy’s international trade and exchange rate of the
currency. This may also indicate change or reversal in the trend.
7. This may indicate policy shift of the monetary authority (RBI) of the country.
The General Rule in BOP Accounting

a. If a transaction earns foreign currency for the nation, it is a credit entry and is

recorded as a plus item.

b. If a transaction involves spending of foreign currency it is a debit entry and is

recorded as a negative item.

The various components of a BOP statement

1. Current Account

2. Capital and Financial Account

3. Reserve Account

4. Errors & Omissions

1. Current Account Balance
The current account is a major component of a country's balance of
payments (BoP), which is a systematic record of its economic transactions
with the rest of the world over a specific period. The current account reflects
the flow of goods, services, income, and unilateral transfers between a
country and the rest of the world.
The current account is composed of four main categories:

1.Visible Trade Balance (Trade in Goods): This includes the value of visible exports
(goods that leave the country, such as manufactured goods, raw materials, and
agricultural products) minus the value of visible imports (goods that enter the country).

Visible Balance=Visible Exports−Visible Imports

2. Invisible Trade Balance (Trade in Services): This accounts for the value of invisible
exports (services provided by the country to other nations, such as tourism, financial
services, and consulting) minus the value of invisible imports (services purchased
from other nations).

Invisible Balance=Invisible Exports−Invisible Imports

3. Income Balance: This reflects the earnings from investments abroad (such
as dividends and interest received by residents on foreign investments) minus
the payments made to foreign investors (dividends and interest on domestic
investments owned by non-residents).
Income Balance=Income Receipts−Income Payments

4. Unilateral Transfers: This category includes one-way transfers of assets

between countries without receiving anything in return, such as foreign aid,
gifts, and remittances.

The overall current account balance is the sum of these four components:

Current Account=Visible Balance + Invisible Balance + Income Balance + Unilateral Transfers

2. Capital and Financial Account
▪ The capital account records all international transactions that involve a resident of
the country concerned changing either his assets with or his liabilities to a resident
of another country. Transactions in the capital account reflect a change in a stock –
either assets or liabilities.
It is difference between the receipts and payments on account of capital account. It
refers to all financial transactions.
The capital account involves inflows and outflows relating to investments, short
term borrowings/lending, and medium term to long term borrowing/lending.
Capital and Finance Account
▪Capital Account:
•The capital account in the balance of payments records transactions
related to non-financial assets. These transactions involve the buying and
selling of non-financial assets, such as real estate, patents, trademarks,
and other intangible assets.
•It also includes capital transfers, which involve the transfer of ownership
of a fixed asset or the forgiveness of a liability. For example, if a country
receives a grant for the construction of a public infrastructure project, it
would be recorded in the capital account.
•The capital account is often less liquid and more long-term in nature
compared to the financial account.
Capital and Finance Account
▪Financial Account:
•The financial account in the balance of payments captures transactions involving
financial assets and liabilities. These transactions include the purchase and sale of
stocks, bonds, foreign exchange, and other financial instruments.
•It is divided into direct investment, portfolio investment, and other investment
categories:
• Direct Investment: Involves the acquisition of a significant ownership stake
(usually 10% or more) in a foreign enterprise. It includes investments in foreign
subsidiaries and branches.
• Portfolio Investment: Encompasses transactions in equity securities (stocks) and
debt securities (bonds) across borders. These investments do not entail a
significant degree of control.
• Other Investment: Involves short-term and long-term transactions in financial
assets and liabilities that do not fall into the direct or portfolio investment
categories. This can include items like loans and currency deposits.
3. The Reserve Account

The Official Reserve Account reflects changes in a country's official reserves, which primarily

consist of foreign exchange reserves held by the central bank.

Official reserve assets are financial assets held by the central bank or monetary authorities

of a country to support the stability and confidence in the national currency and to facilitate

international transactions.

The most common type of official reserve asset is foreign exchange, which includes

currencies of other countries, gold, special drawing rights (SDRs) created by the International

Monetary Fund (IMF), and reserve positions in the IMF.

4. Errors & Omissions
➢ The entries under this head relate mainly to leads and lags in reporting of transactions

➢ It is of a balancing entry and is needed to offset the overstated or understated

components.
Disequilibrium in Balance of Payment

Though the credit and debit are written balanced in the balance of payment account, it may 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.
Causes of Disequilibrium in Balance of Payment
1. Population Growth

Most countries experience an increase in the population and in some like India 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 Programs

Developing 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 and specialized
manpower. Since development is a continuous process, imports of these items continue for the long
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 development in developing countries,
will increase 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.

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. Globalization

Due to globalization there has been more liberal and open atmosphere for international movement of
goods, services and capital. Competition has beer increased due to the globalization 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.
Exchange Rate

In finance, an exchange rate is the rate at which one currency will be exchanged

for another currency. Currencies are most commonly national currencies.

Exchange rates can be either

•Fixed exchange rate

•Flexible exchange rate

•Pegged exchange rate

•Managed float exchange rate

 Fixed exchange rate
A fixed exchange rate is a type of exchange rate system where the value of a country's currency is set, or "fixed," in relation
to the value of another currency or a basket of currencies. The decision to fix the exchange rate is typically made by the
government or the country's central bank. The fixed exchange rate is maintained by active government or central bank
intervention in the foreign exchange market.
Key features of a fixed exchange rate system include:
1.Official Rate:
There is an officially declared exchange rate at which the country's currency can be exchanged for another currency or
a basket of currencies. This rate is often set and maintained by the central bank.
2.Intervention:
To keep the exchange rate fixed, the central bank regularly intervenes in the foreign exchange market. It buys or sells
its own currency to maintain the predetermined rate.
3.Reserves:
Maintaining a fixed exchange rate often requires holding significant foreign exchange reserves. These reserves are
used to intervene in the market and stabilize the currency's value.
4.Adjustment:
In a fixed exchange rate system, the exchange rate does not fluctuate freely based on market forces such as supply
and demand. Instead, the authorities make adjustments as needed to keep the rate in line with the predetermined
level.
5. Trade Balance:
A fixed exchange rate can influence a country's trade balance. If the fixed rate is set at a level that makes the
country's exports more expensive and imports cheaper, it can lead to trade imbalances.
6. Stability:
One of the goals of a fixed exchange rate system is to provide stability and predictability in international trade
and finance. Businesses and investors can plan with greater certainty when they know the exchange rate will
remain relatively constant.
7. Discipline:
A fixed exchange rate system can impose discipline on a country's economic policies. To maintain the fixed rate,
the country must adopt policies that support the stability of its currency, such as controlling inflation and
maintaining fiscal discipline.
8. Risk:
While fixed exchange rates provide stability, they can also pose risks. If the fixed rate is misaligned with economic
fundamentals, it may lead to imbalances, and the authorities might need to make significant adjustments, which
can be challenging.
flexible exchange rate system
A flexible exchange rate system, also known as a floating exchange rate system, is a type of exchange rate
regime in which the value of a country's currency is determined by market forces, primarily the supply and
demand in the foreign exchange market. Under this system, the exchange rate is not fixed or pegged to the
value of another currency, and it is allowed to fluctuate freely based on economic conditions.
1.Market Determination:
1. The exchange rate is determined by the forces of supply and demand in the foreign exchange market. If
demand for a currency increases relative to its supply, its value appreciates. Conversely, if demand
decreases, its value depreciates.
2.No Fixed Parity:
1. Unlike in fixed exchange rate systems, there is no officially declared or fixed exchange rate. The
currency's value is allowed to fluctuate in response to changing economic conditions.
3.Absence of Official Intervention:
1. In a pure flexible exchange rate system, the central bank or government typically does not intervene
actively to influence the exchange rate. The rate is determined by market participants.
4.Automatic Adjustment:
1. Changes in the exchange rate serve as automatic adjustments to external economic shocks. If a country
experiences a trade deficit, for example, its currency may depreciate, making its exports more
competitive and helping to correct the imbalance.
flexible exchange rate system
1.Independence of Monetary Policy:
1. Countries with flexible exchange rates have more autonomy in conducting their monetary
policies. They can use interest rates and other monetary tools to address domestic
economic conditions without being constrained by the need to maintain a fixed exchange
rate.
2.Market Expectations:
1. Exchange rates in a flexible system are influenced by market expectations, economic data,
geopolitical events, and other factors that impact investor sentiment and confidence.
3.Volatility:
1. Flexible exchange rates can be more volatile than fixed rates, as they are subject to
constant market fluctuations. This volatility can be both an advantage and a challenge for
businesses and investors.
4.Reduced Need for Foreign Exchange Reserves:
1. Countries with flexible exchange rates typically do not need to hold large foreign
exchange reserves to defend a specific exchange rate. This can free up resources for other
uses.
pegged exchange rate
A pegged exchange rate system is a type of exchange rate regime in which the value of a country's currency is
fixed, or "pegged," to the value of another major currency, a basket of currencies, or some other measure of
value like gold. The purpose of a pegged exchange rate is to provide stability and predictability in international
trade and finance.
Key features of a pegged exchange rate system include:
1.Fixed Parity:
1. In a pegged exchange rate system, there is an officially declared and fixed exchange rate between the
domestic currency and the chosen anchor currency or basket of currencies. This rate is typically set
and maintained by the country's central bank or monetary authority.
2.Central Bank Intervention:
1. To maintain the pegged exchange rate, the country's central bank regularly intervenes in the foreign
exchange market. It buys or sells its own currency to ensure that the exchange rate remains consistent
with the established peg.
3.Stability and Predictability:
1. The primary goal of a pegged exchange rate system is to provide stability and predictability for
businesses, investors, and trading partners. This stability is intended to facilitate international trade
and investment.
pegged exchange rate
1.Discipline in Economic Policies:
1. Maintaining a pegged exchange rate often requires a country to adopt policies that support the stability of its
currency. This can include controlling inflation, managing fiscal policy responsibly, and implementing
structural reforms.
2.Reduced Exchange Rate Risk:
1. A pegged exchange rate system can reduce exchange rate risk for businesses engaged in international trade.
They can plan and budget with greater certainty, knowing that the exchange rate will remain relatively
constant.
3.Anchor Currency or Commodity:
1. The pegged exchange rate is often tied to a major international currency, such as the U.S. dollar or the euro,
or to a commodity like gold. The choice of the anchor is crucial to the stability of the system.
4.Trade Imbalances:
1. While a pegged exchange rate system provides stability, it may not automatically correct trade imbalances. If
the fixed rate is misaligned with economic fundamentals, imbalances can persist, and adjustments may be
needed.
Managed float exchange rate
•A managed floating exchange rate (also known as dirty float’) is an exchange rate
regime in which the exchange rate is neither entirely free (or floating) nor fixed.
•Rather, the value of the currency is kept in a range against another currency (or
against a basket of currencies) by central bank intervention.
•It resembles the freely floating exchange rate in the sense that exchange rates can
fluctuate on a daily basis and official boundaries do not exist.
•The difference is that the government can intervene in order to prevent the currency
rate from fluctuating much in a certain direction.
•Under a managed float, the goal is to prevent sharp fluctuations in the short run, but
intervention does not target any particular rate over the long run.
•A managed floating exchange rate gives the central bank the power to set a corridor
for the exchange rate, in order to avoid situations of currency over- or under-valuation.
 Factors That Influence Currency Exchange Rates
1. Inflation
Inflation is the relative purchasing power of a currency compared to other currencies. For example, it
might cost one unit of currency to buy an apple in one country but cost a thousand units of a different
currency to buy the same apple in a country with higher inflation. Such differentials in inflation are the
foundation of why different currencies have different purchasing powers and hence different currency
rates. As such, countries with low inflation typically have stronger currencies compared to those with
higher inflation rates.
2. Interest Rates
Interest rates are tightly tied to inflation and exchange rates. Different country’s central banks use
interest rates to modulate inflation within the country. For example, establishing higher interest rates
attracts foreign capital, which bolsters the local currency rates. However, if these rates remain too high
for too long, inflation can start to creep up, resulting in a devalued currency. As such, central bankers
must consistently adjust interest rates to balance benefits and drawbacks.
3. Public Debt
Most countries finance their budgets using large-scale deficit financing. In other words, they borrow to
finance economic growth. If this government debt outpaces economic growth, it can drive up inflation
by deterring foreign investment from entering the country, two factors that can devalue a currency. In
some cases, a government might print money to finance debt, which can also drive up inflation.
4. Political Stability
A politically stable country attracts more foreign investment, which helps prop up the currency rate. The
opposite is also true – poor political stability devalues a country’s currency exchange rate. Political stability
also affects local economic drivers and financial policies, two things that can have long term effects on a
currency’s exchange rate. Invariably, countries with more robust political stability like Switzerland have
stronger and higher valued currencies.
5. Economic Health
Economic health or performance is another way exchange rates are determined. For example, a country
with low unemployment rates means its citizens have more money to spend, which helps establish a more
robust economy. With a stronger economy, the country attracts more foreign investment, which in turn
helps lower inflation and drive up the country’s currency exchange rate. It is worth noting here that
economic health is more of a catch-all term that encompasses multiple other drivers like interest rates,
inflation, and balance of trade.
6. Balance of Trade
Balance of trade, or terms of trade, is the relative difference between a country’s imports and exports. For
example, if a country has a positive balance of trade, it means that its exports exceed its imports. In such a
case, the inflow of foreign currency is higher than the outflow. When this happens, a country’s foreign
exchange reserves grow, helping it lower interest rates, which stimulates economic growth and bolsters
the local currency exchange rate.
7. Current Account Deficit
The current account deficit is closely related to the balance of trade. In this scenario, a country’s balance of
trade is compared to those of its trading partners. If a country’s current account deficit is higher than that of
a trading partner, this can weaken its currency relative to that country’s currency. As such, countries that
have positive or low current account deficits tend to have stronger currencies than those with high deficits.
8. Confidence/ Speculation
Sometimes, currencies are affected by the confidence (or lack thereof) traders have in a currency. Currency
changes from speculation tend to be irrational, abrupt, and short-lived. For example, traders may devalue a
currency based on an election outcome, especially if the result is perceived as unfavorable for trade or
economic growth. In other cases, traders may be bullish on a currency because of economic news, which
may buoy the currency, even if the economic news itself did not affect the currency fundamentals.
9. Government Intervention
Governments have a collection of tools at their disposal through which they can manipulate their local
exchange rate. Primarily, central banks are known to adjust interest rates, buy foreign currency,
influence local lending rates, print money, and use other tools to modulate currency exchange rates. The
primary objective of manipulating these factors is to ensure favorable conditions for a stable currency
exchange rate, cheaper credit, more jobs, and high economic growth.