Balance of payments 2

U N I T - VI B P ALANCE OF AYMENTS 9 C HAPTER (cid:1) (cid:8)(cid:4) (cid:8)(cid:3) (cid:14) (cid:2)(cid:3)(cid:4)(cid:5)(cid:6)(cid:7) (cid:9)(cid:10)(cid:11)(cid:12)(cid:7)(cid:6)(cid:4) (cid:12)(cid:13)(cid:4) (cid:15) (cid:8) (cid:8)(cid:16) (cid:4)(cid:12)(cid:7)(cid:5)(cid:7)(cid:6) (cid:12)(cid:7)(cid:16) (cid:4)(cid:13)(cid:4)(cid:3)(cid:15)(cid:5)(cid:7)(cid:12)(cid:13)(cid:5)(cid:2)(cid:7) A country’s economic stability is indicated, are traded for one another. Foreign among other things, by the stability in its exchange market performs, mainly, exchange rate. The strength of domestic three functions viz., to transfer the currency of a country is seen against that purchasing power between countries of currencies of other countries in the (transfer function), to provide credit world. Earnings from exports and channels for foreign trade (credit payments for imports would directly be function), and to protect against foreign affected by the exchange rate. Therefore, exchange risks (also known as hedging it is important to know the forces that function). operate upon the determination of foreign In view of the above three functions, exchange rate and the implications of demand for foreign exchange is the changes in it for the country concerned. demand for foreign currencies by the In this chapter we shall explain foreign residents of a country. When people exchange rate determination. wish to operate in the foreign exchange Meaning market they intend to buy or sell foreign exchange depending on their demand Foreign exchange rate is the price of one for and supply of foreign exchange. currency in terms of another. It is the Transactions in the foreign rate at which exports and imports of a exchange market are reflected in the nation are valued at a given point in balance of payments account. The time. The foreign exchange rates, by value of Indian residents’ expenditure linking the currencies of different abroad represents a supply of rupees countries, make the comparisons of to the foreign exchange market. This is international costs and prices. They also govern and are governed by the flow because if an Indian buys a Japanese and direction of foreign trade. radio from abroad, he will pay for it in rupees. Now this total expenditure also Foreign Exchange Market represents the demand for foreign The foreign exchange market is the exchange that is Japanese Yen, since market where the national currencies the Japanese dealer will expect 132 INTRODUCTORY MACROECONOMICS payment in Yen. So rupees have to be (c) foreign currencies flow into the exchanged for Yen in the foreign economy due to currency dealers exchange market. and speculators. Similarly, the foreign earnings of Hence the foreign exchange markets Indian residents reflect equal earnings are influenced by the above mentioned of foreign exchange. For example, underlying factors. The dominance of Indian exporters will expect to be paid demand or supply side is linked with in rupees. So in order to buy our goods, the nature of business fluctuations in foreigners have to sell their currency and a given time period. buy rupees in return. Hence, there is Equilibrium in the Foreign Exchange inflow of foreign exchange into India. Market Demand and Supply Side Foreign exchange market like any other We have already pointed out that market is characterised by a downward people’s intention to transact in the sloping demand curve and an upward foreign exchange market depends upon sloping supply curve. The price on the their demand and supply position with vertical axis is stated in terms of respect to foreign exchange. The causal domestic currency (that is, how many factors behind the demand and supply rupees for one US dollar, for instance). sides are mentioned below: The horizontal axis measures the quantity demanded or supplied. The Demand Side intersection of the supply and demand People desire to have or acquire foreign curves determines the equilibrium exchange for the following reasons: exchange rate (Req) and the equilibrium (a) to purchase goods and services quantity (Qeq) of foreign currency, that from other countries; US ($). This is shown in Figure 9.1. (b) to send a gift abroad; (c) to purchase financial assets in a Price particular country; and Rs/$ (d) to speculate on the value of foreign S$ currencies. R' S'$ Supply Side Req Foreign currencies, flow into the R" D'$ domestic economy due to the following: D$ (a) foreigners purchasing home country’s goods and services Qeq Q" Q' DemandandSupplyof through exports. US$ (b) foreign investment in home country through joint ventures or through Fig. 9.1 : Equilibrium in the Foreign financial market operations; and Exchange Market FOREIGN EXCHANGE RATE : MEANING AND DETERMINATION 133 Now, it is necessary to understand Similarly, an increase in the supply the slopes of demand and supply curves. of US dollars will cause the supply curve In this figure the demand curve (D$) is shift to S$ and exchange rate falls to downward sloping. This means that less R. In this case rupee cost of US dollar foreign exchange is demanded as the is decreasing and the Indian rupee is exchange rate increases. This is due to said to be appreciating. Currency the fact that the rise in the price of foreign appreciation takes place when there is exchange will increase the rupee cost of a decrease in the domestic currency foreign goods, which makes them more price of the foreign currency. In this case expensive. As a result, imports will domestic currency is more valuable. decline. Thus, the demand for foreign Types of Exchange Rate Regimes exchange will also decrease. The determination of foreign exchange The supply curve (S$) is upward depends on specific international sloping which means that supply of arrangement of procedure to determine foreign exchange increases as the the exchange rate of one country exchange rate increases. This makes vis-à-vis others. Exchange rate regimes home country’s goods become cheaper have evolved over time in response to to foreigner since the rupee is global economic events. We shall depreciating in value. The demand for present below major international our exports should therefore increase monetary systems that India has as the exchange rate increases. The implemented so far. increased demand for our exports will Fixed Exchange Rate Systems translate into greater supply of foreign exchange. Thus, the supply of foreign Under this system, exchange rate is exchange increases as the exchange rate officially declared and it is fixed. Only a increases. very small deviation from this fixed Having shown the equilibrium in value is possible. A typical fixed the foreign exchange market, let us now exchange rate system was associated analyse disequilibrium conditions. with the Gold Standard Systems of An increase in the demand for US 1880-1914. Under the Gold Standard dollars in India will cause the demand systems each currency value was curve to shift to D’$ and the exchange defined in terms of gold and hence, the raise rises. Note that the increase in the exchange rate was fixed according to exchange rate means that more rupees the gold value of currencies that have are required to buy one US dollar. When to be exchanged. This was referred to this occurs, Indian rupee is said to be as mint par value of exchange. For depreciating. Currency depreciation example, if one Indian Rupee is takes place when there is an increase exchangeable for 125 grams of fine gold in the domestic currency price of the and the US dollar ($) for 25 grams. Then foreign currency. The domestic one rupee is equal to 125/25 = 5 US currency is thus relatively less valuable. dollars. So, the price is fixed at Re.1=$5. 134 INTRODUCTORY MACROECONOMICS Adjustable Peg System of this system. Hence, they suggest a system of flexible exchange rates. The gold standard was abandoned in the 1920’s as it failed to automatically Flexible Exchange Rate System correct the disequilibrium in countries’ Flexible exchange rates point to an balance of payments. An alternate extreme situation where there is no system of fixed exchange rate called the intervention by Central Banks. The Bretton Woods system was established foreign exchange market is busy at all in 1944. Under this arrangement, the times with changes in the exchange rates. US dollar was made directly convertible Following are the advantages into gold at a fixed price. Member associated with flexible exchange rates. countries fixed their rates of exchange (a) Flexible exchange rates eliminate as against the US dollar. The Bretton the need for central banks to hold Woods system was an adjustable peg international reserves. system. The member countries were (b) Flexible exchange rates are helpful required to fix the parity of their to do away with barrier to trade and currencies with gold. A change in the capital movements. parity was possible only through a (c) Flexible exchange rate enhances the direction from the IMF. This system was efficiency in the economy by slightly modified from the fixed achieving optimum resources exchange rate system but the role of gold allocation. as ultimate unit of parity was pre- We have not provided a detailed eminent. critique of both fixed and flexible rate Fixed exchange rate system was of exchange as it is beyond the scope of supported due to its advantages as our study here. But it must be borne given below: in mind that these are two extreme (a) Fixed exchange rates ensure that positions and hence the debate on their major economic disturbances desirability is a continuing one. which will weaken the economic Therefore, there have been numbers policies of member countries, do not of alternative systems suggested as occur. ‘hybrid’ systems combining advantages (b) Fixed exchange rates contribute to of fixed and flexible exchange rates. We the coordination of macro policies shall briefly describe their salient of countries in an interdependent features. world economy. Wider Bands (c) Fixed exchange rates are more conducive to expansion of world This proposal considers the point that trade as they prevent risk and Bretton Woods system allowed only 1 uncertainty in transactions. per cent variation on either side of the But the critics of fixed exchange parity values. The proposal for wider rates have identified several drawbacks bands states that the permissible FOREIGN EXCHANGE RATE : MEANING AND DETERMINATION 135 variations around parity should be set exchange rate around the parity. In the at 10 per cent, for all member - crawling peg concept there is ceiling countries to carry on balance of and floor limits so that it can provide payment adjustment easily. For for some discipline on the part of example, if a country has a balance of monetary authorities. Figure 9.2 shows payments deficit, the currency could be the working of crawling peg. depreciated up to 10 per cent from its In this crawling peg example, the parity value to correct the exchange rate fluctuates within its nar- disequilibrium in the balance of row band until point A is reached. The payments. loss of reserves from A to B and any other indicators of currency weakness Crawling Peg trigger a small devaluation in the par- This is also a compromise between fixed ity value. When difficulties again occur and flexible rates. According to crawling from point C to point D, another small peg scheme, a country specifies a parity official devaluation takes place. This value for its currency and permits a new parity value continues until a re- small variation around that parity serve buildup occurs from point F to (such as ±1 per cent from parity). point G, whereupon the parity value of However, the parity rate is adjusted the home currency is raised. regularly by small amounts as Managed Floating warranted by the position of international reserves held by a The final hybrid in management of country, changes in money supply or exchange rates is the managed floating. prices, or recent variations in the This is characterised by some e (Units of home currency per unit of foreign currency) C D A B F G Time Fig. 9.2 : A Crawling Peg 136 INTRODUCTORY MACROECONOMICS hindrances with exchange rate the spot market. On the other hand movements but the intervention is market for foreign exchange for future discretionary on the part of monetary delivery is known as the forward authorities. market. In other words, there is official Spot Market for Foreign Exchange declaration of rules or guidelines for intervention, no prefixed parity values, Spot rate of foreign exchange is and no announced times for variations. certainly useful for current Authority take a decision to intervene transactions. But we should find what if a particular situation in their the spot rate is. Besides, it is also judgement requires it. Sometimes, this important to find the strength of the intervention may be coordinated with domestic currency with respect to that other countries as well. of the home country’s trading partners. Managed floating, in the absence of The measure of average relative rules and guidelines, could be strength of a given currency is called vulnerable to abuse of intervention. A the Effective Exchange Rate (EER). As particular country could manipulate its we do not eliminate the effect of price managed float to the detriment of other changes, this may also be called as countries. This behaviour is called dirty Nominal Effective Exchange Rate floating. (NEER). This section has so far If the domestic country (India) has summarized the two major systems ‘n’ trading partners then of exchange rates, namely, fixed and ∑n flexible rates of exchange. Since the NEER = (Ri )(W) index i arguments in favour of and against i=1 Where, for the ith trading partner these two systems are inconclusive, (say the USA) attempts have been made to devise hybrid systems such as wider bands, Ri = exchange rate in Rupees/$ crawling peg and managed floating. R i = exchange rate in year ‘a’ The main object in providing these a details is to highlight the point that i R = exchange rate in base year ‘b’ determination of exchange rate is a b complex process in the international i i R monetary system. R index= a for the year ‘b’ i R b Operation of Foreign Exchange W = ratio of trade volume with ith Market i partner to total trade volume of Foreign exchange markets could be domestic country studied in terms of period of transaction X +M carried out. If the operation is of daily = i i X +M nature, it is called current market or total total FOREIGN EXCHANGE RATE : MEANING AND DETERMINATION 137 Where, X = Exports to ith partner The absolute purchasing power parity i argument holds that commodities tend M = Imports from ith partner i to have the same price world wide when X = Total experts of domestic total measured in the same currency. There country is no empirical support to this line of M = Total imports of domestic total argument. The relative purchasing country power parity argument relates the Secondly, we must have a measure change in the exchange rate to the rates that could eliminate the effect of price of inflation in the two countries. changes that is, an exchange rate that would be based upon constant prices. Forward Market for Foreign For this purpose we find out Real Exchange Exchange Rate (RER). Unlike the spot market, the forward In the year ‘a’ for the partner ‘i’ market for foreign exchange covers  Priceindexincountry'i'in  transactions which occur at a future   year'a'withbaseyearas'b' date. It is common to see that most of RER i i ndex =R a i  PriceindexinIndiain year  the international transactions do not   occur on the same day. Usually they 'a'withbaseyearas'b'  materialise much later; that is beyond Thirdly, the Real Effective Exchange the value date when the transaction is Rates (REER) calculates an effective signed. Since transactions contracted exchange rate based on real exchange at one point of time are completed only rates instead of nominal rates. at a later date, we should pay attention For ‘n’ trading partners, to the forward exchange rate. It helps ∑n both the parties involved to hedge REER = (RERi (W) against risk in exchange rate at a future index i i = 1 date. Findings about exchange rate The forward market consists of appreciation or depreciation should be parties that demand or supply a given made with reference to REER and not currency at some future point in time. solely upon NEER. A forward contract is entered into for Fourth measure of the spot rate is two reasons: one is to minimize risk of related to the equilibrium rate that loss due to adverse change in exchange would make the current account being rate or to make a profit. First is called in balance. This is based on the hedging and the second is called argument that it is the relative prices of speculation. goods and services between countries We have thus far explained the that drive the exchange rates. This meaning and determination of foreign argument is also referred to as exchange rates. For an economy, the Purchasing Power Parity (PPP) exchange rate stability is an important argument. There are two versions of it. objective of its macroeconomic policies. 138 INTRODUCTORY MACROECONOMICS Today, we find that any problem with crisis mainly triggered by fluctuation the exchange rate could create and instability of the currencies in East enormous difficulties not only for the Asia. Those interested could study country concerned but to others as similar disturbances that have well. Recently, in the mid-1990’s we occurred in other parts of the world witnessed the East Asian currency as well. SUMMARY (cid:1) Foreign exchange rate has become an important variable that engages the attention of all those who are concerned with foreign trade. (cid:1) Foreign exchange market plays many roles to transfer purchasing power, to provide credit and help in hedging operations. (cid:1) Equilibrium in the freely fluctuating foreign exchange market is brought about by the intersection demand for and supply of foreign exchange. (cid:1) Apart from two extremes of fixed exchange and flexible exchange rates, some hybrid systems such as wider bands, crawling peg and managed floating are also followed by some countries. (cid:1) Distinction between spot and forward markets help understand the complex operation in the foreign exchange market. (cid:1) Instability in the exchange rate could give rise to currency crises. EXERCISES 1. What is a foreign exchange rate? 2. Define foreign exchange market. 3. Describe the equilibrium in the foreign exchange market. 4. What are: (a) spot, and (b) forward markets in foreign exchange? 5. Define: (a) NEER (b) REER and (c) RER. 6. Differentiate between fixed and flexible exchange rates. 7. What is a parity value? 8. Explain the meaning of crawling peg and managed float.