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Unit 5

Open-Economy Macroeconomics
Major components of balance of payments
Internal and external balance
Indias BOP
Foreign trade policy of India
Foreign exchange rate

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What is Balance of Payments


The balance of payments (BOP) of a country reveals the
final outcome of its economic transactions with the rest of
the world over a specific period of time.
Each country having regular economic transactions with
other countries prepares periodically the final accounts of
their foreign receipts and payments and of their financial
inflows and outflows arising out of its international
transactions.
In practice, BOP accounts are prepared on quarterly basis
also.

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Meaning of BOP
The balance of payments (BOP) is a summary statement of all
the economic transactions between the residents of once
country with the rest of the world during a particular period of
time, which is usually a year.
In BOP accounting, any transactions that involves a payment
by the residents of a country will be shown as a debit item while
any transaction that involves a receipt by the residents of a
country will be shown as a credit item.

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Three broad accounts


The transactions entering into the BOP can be grouped
under 3 broad accounts:
Current account
Capital account
Official international reserve account

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Terms used in BOP


Systematic accounting-

The system generally adopted is

double entry book-keeping system. In this accounting system,


both sides of a transaction debit and credit are recorded.
Economic transaction- include all the transactions that involve
the transfer of title or ownership of goods, services, money and
assets between the residents of a country and the rest of the
world. While some transactions involve physical transfer of
goods, money and assets along the transfer of the title, in some
transactions, physical transfer is not necessary

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Terms used in BOP contd

For ex., even if profits of a subsidiary of a foreign company is


not transferred abroad or reinvested within the country it is
located, it is deemed to be paid to the parent company abroad.
What is important is the transfer of the title, not the physical
transfer of what is transacted.

Residents- the nationals of the reporting country. Diplomatic


staff, foreign military personnel, tourists, migratory workers and
branches of the foreign companies are not treated as the
residents even though they work and operate in the reporting
country.
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Purpose of BOP
The purpose of BOP accounting is to take the stock of
countrys foreign receipts and payment obligations and of
assets and liabilities arising out of international economic
transactions with a view of taking stock of gains and
losses of foreign transactions and to correcting unhealthy
trends
It yields necessary information on the strength and
weakness of the country in international economic status.

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Purpose of BOP
By analyzing the BOP accounts of past years, one can
find the overall gains and losses from the international
economic transactions. It can be ascertained whether
composition and direction of international trade and
capital movements have improved or caused
deterioration in the economic condition of the country.
BOP statements give warning signals for future policy
formulation. For, even if the BOP position in recent past
has not been a matter of concern, there may be
unhealthy developments which might create problem in
future.
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BOP Accounts
For preparing BOP accounts, economic transactions between a
country and the rest of the world are grouped under three broad
categories, viz.
Current transactions/ account
Capital transactions/ account
Official international reserve account
Current transactions- Include export and import of goods and
services, that is visible and invisible trade, unrequited (nonrepayable) receipts and payments in the currents year. It
increase or decrease the current level of consumption of the
country or change the current level of its nominal income,
whereas capital transactions change the capital stock of the
country.

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Current account of BOP


The current account of the BOP includes the following
items:
1. Balance of trade
2. Balance of invisible trade
3. Unilateral transfers

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Balance of trade
This includes the export and import of goods and is also
called the balance of visible trade. The balance of trade is
the difference between exports and imports of goods.
While exports of goods are entered as a positive entry or
credit claims in the BOP, imports of goods are entered as a
negative entry or debits in the BOP
It is not necessary for the BOT to be always in balance
If exports > Imports- trade surplus or favorable BOT
If exports < Imports- trade deficit or unfavorable BOT

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Balance of invisible trade

Trade which includes the export and import of services. The


balance of invisible trade is the difference between the exports and
imports of services. The services include the following:
Travel, for example, expenditure by foreign tourists in India on
hotels will be a credit entry in Indias BOP
Insurance, banking, shipping and freight services, and others,
provided, for ex., by Indian firms to foreigners will again be a
credit entry in Indias BOP
Expenditure abroad by the govt. agencies (in India) will be
debit entry in India's BOP
Interest and dividend on foreign investment earned by
domestic entities will be a credit entry in Indias BOP
While the exports of services are entered as a positive entry or
credit claims in the BOP, imports of services are entered as a
negative entry or debits in the BOP.

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Unilateral transfers
These are also called unrequited transfers since they are
one way transactions as there is no claim involved as afar
as repayment is concerned, either at present or in the
future. Unilateral transfers include gifts, personal
remittances, indemnities (insurance) and others.
Credit side of the BOP include personal remittances of the
emigrants to relatives in the country and gifts and grants
which are received by the country from the individuals,
institutions and governments of the foreign countries.
Debit side of the BOP includes payments made by the
country to the other countries in the form of personal
remittances, gifts and grants.
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Current account of BOP

The current account item of international transactions are listed as


suggested by the IMF and currently followed in India
Transactions

Credit

Debit

Net Balance

Merchandise Trade

Exports

Imports

---

Foreign Travel

Earnings

Payments

----

Transportation

Earnings

Payments

---

Insurance Premium

Receipts

Payments

----

banking

Receipts

Payments

---

Investment Income

Receipts

Payments

----

Government Purchase & Receipts


sale of goods and service

Payments

---

Miscellaneous

Payments

----

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Receipts
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Current account of BOP


Balance of Trade: The net balance of the visible trade, that
is, the difference between exports (X) and imports (M) of
goods is called trade balance. If X > M, it shows trade
surplus, and if M>X, it means trade deficit. The sum of the
visible net and invisible net gives balance on the current
account. In general usage it is called current account
balance. If sum of the entries in the credit column is
greater than that of the debit column it shows a current
account surplus otherwise it shows a current account
deficit.
The current account balance is transferred to the capital
account.
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Capital account of BOP


The capital account of the BOP measures the outflow and
inflow of capital into the economy. The outflow of capital
occurs due to the purchase of foreign assets by the
households and firms in the domestic country. The inflow
of capital occurs due to the purchase of assets in the
domestic country by the households and firm of the foreign
countries.
Capital transactions include inflows and outflows of capital
including foreign investments, gold transfers, and foreign
exchange reserves.
Are mostly stock in nature.

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Capital account of BOP


The capital account of the BOP includes the following capital
transactions:
Long- term movements of capital: This includes:
Portfolio investment which refers to the purchase of long term
securities by foreigners from the residents of the domestic
country. The holding/ maturity period is normally greater than
a year. This involves the acquiring of an asset which does not
give any control to the investor, for example purchase of the
shares of a company in the country by a foreigner.
Direct investment which refers to the private direct foreign
investment in shares, bonds, plant and machinery in the
country. In direct investment, the investor has a controlling
power.

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Capital account of BOP


Short- term movements of capital: this includes
Purchase of the
short- term government and corporate
securities (with maturity
period of one year or less than one year);for example, commercial
bills and treasury bills.
Holdings of cash balances by foreigners due to, for ex., political
uncertainty
Purchase of foreign currency for speculation.
Loan repayments: this includes:
Loans by the international financial institutions to the government
of a country
Loans received by the government of the country from the
government of another country
Receipts of funds in the repayments of loans, for ex., to loans
extended to business firms and governments in the foreign
countries.
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The foreign exchange reserve


The foreign exchange reserves are maintained not only to
make payments in case of deficits in the BOP but also to
stabilize the foreign exchange rate.
The transactions in the international reserve account
determine the foreign exchange reserve which are
available for settling a deficit in the current or capital
account of the country.

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The official international reserve account


The official reserve of a country include:
Foreign currencies:
Most countries prefer to hold their foreign exchange resrves
in dollars which is the most widely accpeted and improtant
currency in the world today.
Gold:
as far as gold is concerned, it can be divided into two
categories:
Monetary gold, where the movements occur when gold is
used as a means of payment. Hence, all monetary gold
movements are included under the official reserves.
Non- monetary gold according to which gold is a
commodity. Hence, all exports and imports of gold are
treated like any other commodity in the BOP.
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The official international reserve account


Special depository receipts (SDRs):
When a country becomes a member of the IMF, it has to
deposit a subscription of which 25 percent is in the form
of gold or even SDRs while the rest is in the form of the
countrys own currency.
Depending on its subscription a country can draw other
convertible currencies from the IMF, and the this enters
as a positive entry or credit claims in the BOP credit
claims in the BOP

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Disequilibrium in the BOP


The balance of payments always balances itself as it is
prepared on the entry system of book-keeping. This leads
us to a very important issue of how a surplus or a deficit
occurs in the BOP.
For this purpose we consider :
Autonomous transactions
Accommodating transactions

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Autonomous Transactions
Autonomous transactions are those that take place
independently of other items in the BOP
They take place in both current and capital accounts
CURRENT ACCOUNT:
Here autonomous transactions include export and
import of goods and services. Unilateral transfers are
also included though they are not commercial
transactions.
CAPITAL ACCOUNT:
It includes long term movement of capital as they are
commercial transactions for the explicit purpose of
making profits
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Accommodating Transactions
Accommodating transactions are those that take place
for a specific purpose of equalizing the BOP from an
accountants point of view
They include short term movements of capital, monetary
gold movements and variations in the foreign exchange
reserves
They are not motivated by profit

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Kinds of disequilibria
Structural disequilibrium
Cyclical disequilibrium
Exchange Rate disequilibrium
Monetary disequilibrium

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Structural Disequilibrium
This occurs due to structural imbalances caused by the
international demand and/or by the supply of the factors of
production, goods or services. They persist for a long time
and are difficult to eliminate.
CAUSES:
Change in the production pattern
Loss of capital
Resource deficiencies
Change in the supply of long term flows of capital
Change in the demand pattern
Changes in the political, economic and social environment
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Cyclical Disequilibrium

Business cycles affect almost all the countries though to


different

degrees.

recession

and

inflation

are

accompanied by a trade surplus in some countries and a


deficit in the others depending on the nature of exports
and imports
Countries with a high marginal propensity to import
experience huge trade deficits during inflation and
smaller deficits during recession times

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Exchange Rate Disequilibrium


There occurs an overvaluation or undervaluation of a
currency on the foreign scenario
Overvaluation: When the official value of the currency is
fixed at a higher rate then what would have been
determined by the demand and supply. Its effects are
similar to that of inflation
Undervaluation: When the official value of the currency is
fixed at a lower rate than what would have been
determined by the demand and supply
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Monetary Disequilibrium
Inflation and deflation are the accompaniments of a
monetary disequilibrium. Inflation has a two fold effect on
trade
Inflation makes imports relatively cheaper leading to an
increase in the demand for imports
On the other hand, it makes exports costlier leading to a
decrease in the demand for exports
Inflation thus leads to a deficit in the BOP.

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The process of adjustment in the BOP


Disequilibrium in the BOP is a cause for concern in any
economy. More so if it is in the form of deficit. They can
be grouped under two heads:
1. Expenditure reducing or expenditure changing policies
a.

Monetary policy

b.

Fiscal policy

2. Expenditure switching policies


a.

Devaluation: The elasticity approach

b.

Devaluation: The absorption approach

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Expenditure Switching Policies


They are aimed at bringing about a change in the
aggregate expenditure in the country. Thus the BOP can
be written as:
B= Y E
Where, B = BOP
Y = domestic output
E = domestic expenditure
- Y>E: Surplus in the BOP
- Y=E: Equilibrium in the BOP
- Y<E: Deficit in the BOP
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Monetary Policy
The monetary policy proved unsuccessful in bringing
about stabilization during the Great Depression. In the
1950s, their popularity was revived.
Tools:
i. Change in the interest rates
ii. Open market operations

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Fiscal Policy

Fiscal policy can also be used to reduce expenditure. They are


divided into two groups:

i. Those that work on the income side of the government budget


-

Increase in direct taxes

- Increase in indirect taxes

ii. Those that work on the expenditure side of the government budget
- Reduction in the transfer payments
- Decrease in the public consumption
- Decrease in the public investment expenditure

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Devaluation: The Elasticity Approach


The expenditure switching policies work mainly through
changing the relative price of exports and imports
Devaluation refers to the conscious action to lower the
value of a currency with respect to the price of gold
The Marshall Lerner condition:
B = Kx1(e 1m+e 2m - 1)
B = change in trade balance

k = devaluation in percentage terms


X1 = value of exports in terms of foreign currency
e1m = elasticity of demand for imports
e2m = elasticity of demand for exports
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Devaluation: The Elasticity Approach


A devaluation leads to a :
Increase in the price of imports
Decrease in the price of exports

Devaluation has some adverse effects on the economy. It


has an inflationary impact which is limited if devaluation is
pursued with a contractionary monetary and fiscal policy. It
is also felt that devaluation leads to a redistribution of
income from the labor class to others.

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Devaluation- The Absorption Approach

Sidney Alexander 1952


B = Y-A

Where B = balance of trade


Y = national income
A = total absorption or total demand
(A = C+I, since total demand includes consumption and investment)

Devaluation affects the balance of trade,


B = Y - A

Devaluation- The Absorption Approach Contd


The effect of devaluation of absorption can be in two parts:
i. Direct effect on absorption which depends mainly on the real income at
which the devaluation occurs
ii. Indirect effect on absorption which depends on the propensity to absorb, c
Y.
A = D + c y
Where A = change in absorption
D = direct effect on absorption
c Y = indirect effect on absorption

Foreign Trade Theory


The theory of absolute advantage: Adam smith

Man hours required to produce one unit of wheat and cloth


USA

India

Wheat

10

Cloth

Gain in output when labor resources are transferred


USA

India

World
output

Wheat

+2

-1

+1 Wheat

Cloth

-1

+2.5

+1.5 Cloth

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Foreign Trade Theory


Theory of comparative cost advantage ( David Ricardo) - A
country will tend to specialize in the production of those
goods for which it has got relative or comparative
advantage.
International trade is the difference in costs of production
arising out of specialization.
Man-hours required to produce one unit of wheat and cloth
Wheat

Cloth

Domestic exchange ratio


between wheat and cloth

USA

1 wheat = 0.5 cloth

India

12

1 wheat = 1.33 cloth

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Foreign Trade Theory


Gain in output when labor resources are transferred
USA

India

World
output

Wheat

+2

-1

+1 Wheat

Cloth

-1

+1.33

+1.5 Cloth

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The Foreign trade


The foreign trade policy is concerned with whether a
country should adopt the policy of free trade or of
protection. If the policy of protection of domestic industries
is adopted, the question which is faced whether protection
should be achieved through imposing tariffs on imports or
thru the fixation of quota or through licensing of imports.
Instruments for protection:
Tariffs and quotas
Both tariffs and quotas can be imposed both on
imports and exports but mostly imposed on imports.
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The Foreign trade


Tariffs - These are excise duties imposed on imported
goods. The objective of imposing tariffs may be either
raising revenue of the government or providing
protection to the domestic industries. Two types of tariffs
one is revenue tariffs and another protective tariffs.
Import quotas - it refers to the maximum quantities of
goods which may be permitted to be imported during any
period of time. They are also known as quantitative
restrictions on imports. Are more effective method of
reducing trade than tariffs.
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Case for free trade


Gains in output and well being specialization
Gains from economies of scale
Long run dynamic gains
Promotes competition and prevents monopoly
Political gain from free trade

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Case for protection


Nationalism
Employment argument
Infant industry argument
Anti-dumping argument
Correcting balance of payment deficit
Redistribution of income
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Foreign Trade Policy

Foreign trade policy plays an important role in achieving the objectives


of rapid growth and self-reliance.
Prof. Haberler, International division of labour and international trade
which enable every country to specialize and to export those things
which it can produce in exchange for what others can provide at a
lower cost have been and still are one of the basic factors promoting
economic well-being and increasing national income of every
participating country.
He emphasizes on how trade promotes growth:
Developing countries can get material resources such as capital equipment,
machinery and raw materials which are so essential for industrial growth.
Developing countries through trade can import and use superior technology which
has been invented in advanced developed countries and is embodied in the
machines, capital equipment which they import.
Foreign trade enables the transmission of technical know how, skills, managerial
talents to the developing countries
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Indias Trade policy of Import Substitution


As we began our planning for development, the two
options were open to us with regard to our foreign trade
policy.
First to lay stress on export promotion in our strategy of
development for accelerating economic growth.
The second option was to adopt import-substitution as a major
element of our trade policy.
When exports could not be increased substantially, we could not
pay for imports on large scale. Therefore, India's strategy of
industrialization was based on substitution of imports rather than
export-oriented trade policy. Thus India adopted the policy of
import substitution/ export pessimism

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Export pessimism of 50s and 60s

Paul Prebisch postulated that the terms of trade of developing


countries have a tendency to deteriorate overtime regardless of the
policies of developing countries
Demand for primary products which under-developed countries were
exporting were income inelastic.
Technological progress that was taking place in developed countries
was of the nature that saved the use of raw materials which
underdeveloped countries were exporting.
Because of the prevailing monopolies in the manufacturing industries
of the developed countries, the prices of their manufactured products
was relatively higher than the prices of primary and agricultural
products whose production sale were being done under competitive
conditions.
Thus export expansion by developing countries were quite
unprofitable.
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Dr. Manmohan Singhs view

Dr. Singh was the first economist who challenged this export
pessimism of early development economists, especially in the context
of India.
Arguing the case for export-orientation of strategy of development he
says, whatever the development strategy the function of international
trade as a supplier of material means indispensable for development
is likely to retain its importance for most underdeveloped countries in
their quest for higher rates of economic growth. Imports, however,
have to be paid for either by current export earnings or by withdrawal
from reserves of foreign exchange or by a fresh capital inflows. The
withdrawal from reserves is not unlimited process,.. Capital inflows
ultimately lead to higher services charges and repayment obligations.
In the long run, therefore, the import capacity of an economy and its
ability to utilize the above mentioned benefits of international trade is
crucially dependent on its export capacity.
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Export promotion strategy-Global example

Japan used export promotion strategy in 1960s and achieved a fast


rate

of

economic

growth,

beginning

from

the

stare

of

underdevelopment. Japanese growth experience is called as


Japanese miracle.

The same success story was shared by South Korea, Taiwan, China,
Thailand, Singapore and Honkong through outward looking strategy.
Owing to their rapid growth they have been called as Asian Tigers.

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Import Substitution

Somehow up to 1980, India adopted inward-looking strategy.


Imports of several commodities were banned and quantitative
restrictions were imposed.
To give protection to the domestic industries, customs duties were
levied on a number of commodities to discourage their imports by
raising their prices. The customs duties levied in India on certain
commodities were as high as 200 or 150 percent which were one
often highest in the world.
The import licensing was used so as to regulate the quantities of
some essential goods and raw materials that could be imported and
accordingly licenses for import quotas were issued by the
Government.
Stringent foreign exchange regulations were introduced and foreign
exchanges was released to the holders of import licenses for
importing specific commodities.
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Results of Import substitution Policy


Import substitution contributed significantly to industrial growth
between 1956-66. But several weaknesses of became evident during
the course of time.
Growth of import substituting industries required large quantities of
imports of capital goods machines, raw materials. As a result, whereas
imports increased substantially there was no adequate growth in
exports resulting in BOP problems. In 1966 we had to devalue the
rupee to promote exports and discourage imports in order to solve
balance of payments problem. However, 1966 devaluating did not
succeed in improving the trade deficit.
In the 3rd (1961-66) and 4th plan (1969-74) including devaluation
several export promotion measure were taken.
Inefficiencies crept into the system resulting in the Indian economy
becoming high-cost economy. Despite various incentives and
concessions given by the Government for export promotion we were
not competitive due to high-cost and inefficiency
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Export-promotion Measures in the Eighties


Committee headed by P.L. Tandon made large recommendations for
export-promotion in Jan 1991.
Exim Scripts: Exim Scripts equivalent to the 30 percent value of the
exports were given to the exporters. These exim scripts could be even
sold in the market at premium. This entitled exporters to import a certain
amount of materials and machinery for expanding exports.
DDS- The important fiscal concession was the introduction of Duty
Drawback Scheme under which taxes paid on materials used in the
manufacture of goods for export were refunded. Besides a good
proportion of profits or income earned from exports was exempted from
income tax. Further 5 year tax holiday was provided to the units set up
in Special Exporting Zones (SEZ).
Liberal credit facilities at concessional rates of interest were given by
the commercial banks to the exporters.
Bilateral Trade Agreements with some countries were made to step up
exports.
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Export-promotion Measures in the Eighties


Cash Compensatory Scheme- Cash assistance was given
to the exporter to compensate them for the taxes paid by
them on the imported inputs used by them for the
production of exported goods.
In the later half of eighties quota system was replaced by
tariffs.
IMF also advised India to use export promotion and not
restrictions as the strategy for reducing deficit in BOP.
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Highlights- Foreign Trade Policy, 2009-14

Annual export growth of 15 % with an annual export target of $200


billion by March 2011
2011-14 annual export growth of 215 % per annum. Double Indias
export of goods and services by 2014
Double Indias share in global trade by 2020
26 new markets added under Focus Market scheme, incentives hiked
from 2.5 to 3 %
EPCG (Export promotion capital goods) scheme at 0 duty introduced
Duty Entitlement Passbook Scheme-Exporter obtain a refund on a
proportion of indirect taxes paid by them. Since this is not WTO
complaint alternative scheme is being worked out.
Duty drawback on Jeweler exports allowed exported oriented Units
allowed to sell products in domestic tariff area to an extent of 90%

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Highlights- Foreign Trade Policy, 2009-14


Reference for latest FTP:
Ministry of Commerce and Industry, Directorate General of Foreign
Trade-http://dgftcom.nic.in/exim/2000/policy/ftp-plcontent-0910.htm
Government of India, Ministry of Commerce and Industry,
Department of Commerce- http://commerce.nic.in/
Foreign Trade Procedurehttp://dgftcom.nic.in/exim/2000/procedures/ftp-hbcontents-011.htm

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Foreign Exchange- Introduction

Today, all economies are open and dealing in transactions with the
rest of the world.
They all are involved in the export and import of goods and services.
They are engaged in borrowing and lending in the financial markets of
the different countries.
All these countries/economies have their own currencies, which are
generally (barring Euro) legal tender only within the periphery of the
country.
Thus, rupee is acceptable within India where as the dollar is
acceptable within the US economy.
The problem occurs when one country trades with another.
This problem can be solved by fixing the rate of exchange between
the different currencies.

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Foreign Exchange- Introduction


Interaction with other economies of the world widens
choice in three broad ways:
Consumers and firms have the opportunity to choose between
domestic and foreign goods. This is the product market linkage
which occurs through international trade.
Investors have the opportunity to choose between domestic and
foreign assets. This constitutes the financial market linkage.
Firms can choose where to locate production and workers to
choose where to work. This is the factor market linkage. Labor
market linkages have been relatively less due to various
restrictions on the movement of people through immigration laws.
Movement of goods has traditionally been seen as a substitute for
the movement of labor.

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Foreign Exchange- Market

The foreign exchange market is a market where foreign currencies (or


foreign exchange) are purchased and sold by individuals, firms,
commercial banks and the central banks of the different countries.
When goods move across national borders, money must move in the
opposite direction. At the international level, there is no single
currency that is issued by a central authority.
Foreign economic agents will accept a national currency only if they
are convinced that the currency will maintain a stable purchasing
power. Without this confidence, a currency will not be used as an
international medium of exchange and unit of account since there is
no international authority with the power to force the use of a
particular currency in international transactions.

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Foreign Exchange- Market


Governments have tried to gain confidence of potential
users by announcing that the national currency will be
freely convertible at a fixed price into another asset, over
whose value the issuing authority has no control. This
other asset most often has been gold, or other national
currencies.
There are two aspects of this commitment that has
affected its credibility:
The ability to convert freely in unlimited amounts and the price at
which conversion takes place. The international monetary system
has been set up to handle these issues and ensure stability in
international transactions. A nations commitment regarding the
above two issues will affect its trade and financial interactions with
the rest of the world.
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Foreign Exchange- Market


Your

currency

exchange

for

in
the

dollar?
Should
rates

exchange
between

currencies

two

continue

like this?

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Foreign Exchange- Market

Let us assume that an Indian resident wants to visit London on a


vacation (an import of tourist services). She will have to pay in pounds
for her stay there. She will need to know where to obtain the pounds
and at what price. Her demand for pounds would constitute a demand
for foreign exchange which would be supplied in the foreign exchange
market the market in which national currencies are traded for one
another.

The major participants in this market are commercial banks, foreign


exchange brokers and other authorized dealers and the monetary
authorities. It is important to note that, although the participants
themselves may have their own trading centre's, the market itself is
world-wide. There is close and continuous contact between the
trading centre's and the participants deal in more than one market.

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Foreign Exchange- Market

The price of one currency in terms of the other is known as the exchange rate.
Since there is a symmetry between the two currencies, the exchange rate
may be defined in one of the two ways. First, as the amount of domestic
currency required to buy one unit of foreign currency, i.e. a rupee-dollar
exchange rate of Rs 50 means that it costs Rs 50 to buy one dollar, and
second, as the cost in foreign currency of purchasing one unit of domestic
currency. In the above case, we would say that it costs 2 cents to buy a rupee.

This is the bilateral nominal exchange rate bilateral in the sense that they
are exchange rates for one currency against another and they are nominal
because they quote the exchange rate in money terms, i.e. so many rupees
per dollar or per pound.

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Foreign Exchange- Market

If one wants to plan a trip to London, she needs to know how expensive
British goods are relative to goods at home. The measure that captures
this is the real exchange rate the ratio of foreign to domestic prices,
measured in the same currency. It is defined as

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Foreign Exchange- Market

Where P and Pf are the price levels here and abroad, respectively, and
e is the rupee price of foreign exchange (the nominal exchange rate).
The numerator expresses prices abroad measured in rupees, the
denominator gives the domestic price level measured in rupees, so the
real exchange rate measures prices abroad relative to those at home.
If the real exchange rate is equal to one, currencies are at purchasing
power parity. This means that goods cost the same in two countries
when measured in the same currency. For instance, if a pen costs $4
in the US and the nominal exchange rate is Rs 50 per US dollar, then
with a real exchange rate of 1, it should cost Rs 200 (ePf = 50 4) in
India. If the real exchange rises above one, this means that goods
abroad have become more expensive than goods at home.
The real exchange rate is often taken as a measure of a countrys
international competitiveness.
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Foreign Exchange- Rate Changes


Foreign exchange markets have a special vocabulary. By definition, a
fall in the price of one currency in terms of one or all others is called a
depreciation.
A rise in the price of currency in terms of another currency is called an
appreciation.
When the price of dollar rose from Rs.45/1 $ to Rs. 54/1 $, the dollar
appreciated . The Rupee depreciated.
When a country has a fixed exchange rate system and it lowers the
official price of its currency in the market, this is called a devaluation.
The revaluation occurs when the official foreign exchange rate is raised.

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Foreign Exchange- Market

Nominal Effective Exchange Rate (NEER): Since a country interacts


with many countries, we may want to see the movement of the domestic
currency relative to all other currencies in a single number rather than by
looking at bilateral rates. That is, we would want an index for the
exchange rate against other currencies, just as we use a price index to
show how the prices of goods in general have changed. This is
calculated as the Nominal Effective Exchange Rate (NEER) which is
a multilateral rate representing the price of a representative basket of
foreign currencies, each weighted by its importance to the domestic
country in international trade (the average of export and import shares is
taken as an indicator of this).
Real Effective Exchange Rate (REER): This is calculated as the
weighted average of the real exchange rates of all its trade partners, the
weights being the shares of the respective countries in its foreign trade.
It is interpreted as the quantity of domestic goods required to purchase
one unit of a given basket of foreign goods.
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Foreign Exchange Transactions- Types

Spot Transactions- A spot transactions is one where the seller of the foreign
exchange has to deliver the exchange to the buyer on the spot, that is, within two
days of the deal.

Forward Transactions- It involves an agreement between the buyer and the seller
to purchase or sell a fixed amount of currency for a predetermined rate at a
specified date in the future. Usually, a forward contract is for a period of 3 months.

The spot market is one where there are spot sales and purchase of the foreign exchange
The spot exchange rate is the rate at which the foreign exchange is bought and sold in the spot
market.

Forward exchange market is one where there is a forward sale and purchase of foreign exchange
Forward exchange rate is the rate at which foreign exchange is bought and sold in the forward
exchange market.

.
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Foreign Exchange Market- Functions

International transfer of purchasing power between the different


countries: In foreign trade, there are tow types of transfers of
purchasing power, which are as follows:
From one country to another country
From one currency to another currency
These transfers take place through a clearing mechanism. When a firm in country
exports some goods to a firm in another country, the exporting firm acquires a claim
on the foreign firm where the foreign firm is under a debt obligation to the exporting
firm. Hence, there arise counter claims which are settled in the foreign exchange
market through bills of exchange.

Provision of credit for foreign trade: Similar to the domestic trade,


credit is essential for the smooth functioning of the foreign trade. There
is a considerable time gap involved in the movement of the goods
between the exporter and the importer. Hence, there is need for some
form of institutional credit to finance the transactions of the goods
between the time periods.
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Foreign Exchange Market- Functions


Hedging risks of foreign exchange: In a situation when the
exchange rate fluctuates freely, any forward foreign
exchange transactions will be subject to great risks. To
avoid such risks, the buyers and sellers of foreign
exchange resort to hedging facilities.
Hedging is an attempt at covering the risk involved in a foreign
exchange transaction through a forward transaction. The exporters
and importers are subject to risks relating to the exchange rate in
conducting their business
This risk can be avoided through a forward transaction where they
can enter into an agreement regarding the buying and selling of
goods at future date at a contracted rate of exchange. However,
where the rates of exchange are stable over long periods of time,
hedging is not required.
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Determination of the Exchange Rate

Two nominal exchange rate system are:


Flexible or floating exchange rate
Fixed exchange rate

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Determination of the Exchange Rate


In a system of flexible exchange rates (also known as floating
exchange rates), the exchange rate is determined by the forces of
market demand and supply. In a completely flexible system, the central
banks follow a simple set of rules they do nothing to directly affect the
level of the exchange rate, in other words they do not intervene in the
foreign exchange market (and therefore, there are no official reserve
transactions).
The link between the balance of payments accounts and the transactions
in the foreign exchange market is evident when we recognize that all
expenditures by domestic residents on foreign goods, services and
assets and all foreign transfer payments (debits in the BOP accounts)
also represent demand for foreign exchange. The Indian resident buying
a Japanese car pays for it in rupees but the Japanese exporter will
expect to be paid in yen. So rupees must be exchanged for yen in the
foreign exchange market.
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Determination of the Exchange Rate


Conversely, all exports by domestic residents reflect equal earnings of
foreign exchange. For instance, Indian exporters will expect to be paid
in rupees and, to buy our goods, foreigners must sell their currency and
buy rupees. Total credits in the BOP accounts are then equal to the
supply of foreign exchange. Another reason for the demand for foreign
exchange is for speculative purposes.
Let us assume, for simplicity, that India and the US are the only
countries in the world, so that there is only one exchange rate to be
determined. The demand curve (DD) is downward sloping because a
rise in the price of foreign exchange will increase the cost in terms of
rupees of purchasing foreign goods.
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Determination of the Exchange Rate

Imports will therefore decline and less foreign exchange will be demanded. For
the supply of foreign exchange to increase as the exchange rate rises, the
foreign demand for our exports must be more than unit elastic, meaning simply
that a one per cent increase in the exchange rate (which results in a one per
cent decline in the price of the export good to the foreign country buying our
good) must result in an increase in demand of more than one per cent. If this
condition is met, the rupee volume of our exports will rise more than
proportionately to the rise in the exchange rate, and earnings in dollars (the
supply of foreign exchange) will increase as the exchange rate rises.

However, a vertical supply curve (with a unit elastic foreign demand for Indian
exports) would not change the analysis. We note that here we are holding all
prices other than the exchange rate constant.
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Determination of the Exchange Rate

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Determination of the Exchange Rate


In this case of flexible exchange rates without central bank intervention, the
exchange rate moves to clear the market, to equate the demand for and
supply of foreign exchange. In Fig.6.1, the equilibrium exchange rate is e*.
If the demand for foreign exchange goes up due to Indians travelling abroad
more often, or increasingly showing a preference for imported goods, the
DD curve will shift upward and rightward.
The resulting intersection would be at a higher exchange rate.
Changes in the price of foreign exchange under flexible exchange rates are
referred to as currency depreciation or appreciation. In the above case, the
domestic currency (rupee) has depreciated since it has become less
expensive in terms of foreign currency.
For instance, if the equilibrium rupee dollar exchange rate was Rs 45 and
now it has become Rs 50 per dollar, the rupee has depreciated against the
dollar. By contrast, the currency appreciates when it becomes more
expensive in terms of foreign currency.
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Determination of the Exchange Rate

At the initial equilibrium exchange rate e*, there is now an excess


demand for foreign exchange. To clear the market, the exchange rate
must rise to the equilibrium value e1 as shown in Fig. 6.2. The rise in
exchange rate (depreciation) will cause the quantity of import demand to
fall since the rupee price of imported goods rises with the exchange
rate. Also, the quantity of exports demanded will increase since the rise
in the exchange rate makes exports less expensive to foreigners.

At the new equilibrium with e1, the supply and demand for foreign
exchange is again equal.

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Determination of the Exchange Rate

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Determination of the Exchange Rate


Speculation: Exchange rates in the market depend not only on the
demand and supply of exports and imports, and investment in assets,
but also on foreign exchange speculation where foreign exchange is
demanded for the possible gains from appreciation of the currency.
Money in any country is an asset. If Indians believe that the British pound
is going to increase in value relative to the rupee, they will want to hold
pounds.
For instance, if the current exchange rate is Rs 80 to a pound and
investors believe that the pound is going to appreciate by the end of the
month and will be worth Rs 85, investors think if they took Rs 80,000 and
bought 1,000 pounds, at the end of the month, they would be able to
exchange the pounds for Rs 85,000, thus making a profit of Rs 5,000.
This expectation would increase the demand for pounds and cause the
rupee-pound exchange rate to increase in the present, making the
beliefs self-fulfilling. The above analysis assumes that interest rates,
incomes and prices remain constant. However, these may change and
that will shift the demand and supply curves for foreign exchange.
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Determination of the Exchange Rate

Interest Rates and the Exchange Rate: In the short run, another factor that
is important in determining exchange rate movements is the interest rate
differential i.e. the difference between interest rates between countries.
There are huge funds owned by banks, multinational corporations and wealthy
individuals which move around the world in search of the highest interest rates.

If we assume that government bonds in country A pay 8 per cent rate of interest
whereas equally safe bonds in country B yield 10 per cent, the interest rate
differential is 2 per cent. Investors from country A will be attracted by the high
interest rates in country B and will buy the currency of country B selling their own
currency. At the same time investors in country B will also find investing in their
own country more attractive and will therefore demand less of country As
currency.
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Determination of the Exchange Rate

This means that the demand curve for country As currency will shift to
the left and the supply curve will shift to the right causing a depreciation
of country As currency and an appreciation of country Bs currency.

Thus, a rise in the interest rates at home often leads to an appreciation


of the domestic currency. Here, the implicit assumption is that no
restrictions exist in buying bonds issued by foreign governments.

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Determination of the Exchange Rate

Income and the Exchange Rate: When income increases,


consumer spending increases. Spending on imported goods is also
likely to increase. When imports increase, the demand curve for foreign
exchange shifts to the right. There is a depreciation of the domestic
currency.
If there is an increase in income abroad as well, domestic exports will
rise and the supply curve of foreign exchange shifts outward. On
balance, the domestic currency may or may not depreciate.
What happens will depend on whether exports are growing faster than
imports. In general, other things remaining equal, a country whose
aggregate demand grows faster than the rest of the worlds normally
finds its currency depreciating because its imports grow faster than its
exports. Its demand curve for foreign currency shifts faster than its
supply curve.

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Determination of the Exchange Rate

If a shirt costs $8 in the US and Rs 400 in India, the rupee-dollar


exchange rate should be Rs 50. To see why, at any rate higher than Rs
50, say Rs 60, it costs Rs 480 per shirt in the US but only Rs 400 in
India. In that case, all foreign customers would buy shirts from India.
Similarly, any exchange rate below Rs 50 per dollar will send all the shirt
business to the US.

Next, we suppose that prices in India rise by 20 per cent while prices in
the US rise by 50 per cent. Indian shirts would now cost Rs 480 per shirt
while American shirts cost $12 per shirt. For these two prices to be
equivalent, $12 must be worth Rs 480, or one dollar must be worth Rs
40. The dollar, therefore, has depreciated.
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Determination of the Exchange Rate- Fixed


Exchange Rates

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Determination of the Exchange Rate

Countries have had flexible exchange rate system ever since the
breakdown of the Bretton Woods system in the early 1970s. Prior to
that, most countries had fixed or what is called pegged exchange
rate system, in which the exchange rate is pegged at a particular
level.
Sometimes, a distinction is made between the fixed and pegged
exchange rates. It is argued that while the former is fixed, the latter is
maintained by the monetary authorities, in that the value at which the
exchange rate is pegged (the par value) is a policy variable it may
be changed.
A devaluation is said to occur when the exchange rate is increased
by social action under a pegged exchange rate system. The opposite
of devaluation is a revaluation. Or, the government may choose to
leave the exchange rate unchanged and deal with the BOP problem
by the use of monetary and fiscal policy.
Most governments change the exchange rate very infrequently.

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Determination of the Exchange Rate

We examine the way in which a country can peg or fix the level of its exchange
rate. We assume that Reserve bank of India (RBI) wishes to fix an exact par
value for the rupee at Rs 45 per dollar (e1 in Fig. 6.3).

Assuming that this official exchange rate is below the equilibrium exchange rate
(here e* = Rs 50) of the flexible exchange rate system, the rupee will be
overvalued and the dollar undervalued. This means that if the exchange rate
were market determined, the price of dollars in terms of rupees would have to
rise to clear the market.

At Rs 45 to a dollar, the rupee is more expensive than it would be at Rs 50 to a


dollar (thinking of the rate in dollar-rupee terms, now each rupee costs 2.22
cents instead of 2 cents). At this rate, the demand for dollars is higher than the
supply of dollars
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Determination of the Exchange Rate

Since the demand and supply schedules were constructed from the BoP
accounts (measuring only autonomous transactions), this excess
demand implies a deficit in the BOP.
The deficit is bridged by central bank intervention. In this case, the RBI
would sell dollars for rupees in the foreign exchange market to meet this
excess demand AB, thus neutralizing the upward pressure on the
exchange rate.
Managed Floating- Without any formal international agreement, the
world has moved on to what can be best described as a managed
floating exchange rate system. It is a mixture of a flexible exchange
rate system (the float part) and a fixed rate system (the managed part).
Under this system, also called dirty floating, central banks intervene
to buy and sell foreign currencies in an attempt to moderate exchange
rate movements whenever they feel that such actions are appropriate.
Official reserve transactions are, therefore, not equal to zero.
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History of Exchange Rate system


At this stage, a brief history of the exchange rate systems
adopted by different countries is required. When the second
World War ended, there was a need for a new international
monetary and exchange rate system which would promote
growth of world trade.
Thus, Bretton Woods New Hampshire, in the year 1944,
delegates from 44 nations converged. They adopted fixed
rate exchange system in which each country pegged its
currency to the dollar and as all countries were pegged to
the dollar, they were pegged to each other also. The
International Monetary Fund (IMF) and the World Bank were
two new organizations, which emerged from Bretton Woods
conference.
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History of Exchange Rate system


There occurred in succession many crises in the exchange
rate. At a meeting held in 1971 at the Smithsonian Institute
in Washington, D.C between the finance ministers of the
leading countries of the world, the Bretton Woods system
was officially dissolved.
The dollar was devalued.
The major industrial countries of the world adopted flexible
rate of exchange in 1973. Thus as of today there are many
exchange rate arrangements; while some countries operate
under the flexible exchange rates, others operate under the
floating exchange rates and there are some for whom the
exchange rate system lie somewhere in between.
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