Economy of

Pakistan
Week 14
The Balance of Payments Problem and Its
Solution; The Exchange Rate Management Issue
and Its Impact on Trade
A. The Balance of Payments Problem and Its Solution

a. Introduction

A country has to deal with other countries in respect of the

following

Visible items which include all types of physical goods exported

and imported.

Invisible items which include all those services whose export and
import are not visible. e.g. transport services, medical services etc.

Capital transfers which are concerned with capital receipts and

capital payment.
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According to Kindle Berger, "The balance of payments of a
country is a systematic record of all economic transactions
between the residents of the reporting country and residents of
foreign countries during a given period of time".

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.

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Balance of Payments Vs Balance of Trade

Balance of Trade
The difference between a country's imports and its exports.
Balance of trade is the largest component of a country's balance of
payments. When exports are greater than imports than the BoT is
favorable and if imports are greater than exports then it is
unfavorable.

The Balance of Payment takes into account all the transaction

with the rest of the world.

The Balance of Trade takes into account all the trade transaction
with the rest of the world.

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b. Various Components of Balance of Payments

(i) Current Account Balance

BOP on current account is a statement of actual receipts and

payments in short period. It includes the value of exports and
imports of both visible and invisible goods. There can be either
surplus or deficit in current account.
The current account includes:- export & import of services,
interests, profits, dividends and unilateral receipts/payments
from/to abroad.

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Types of Balances

Trade Balance

Merchandise: exports - imports of goods

Services: exports – imports of services

Income Balance

Net investment income: net income receipts from assets

Net international compensation to employees: net compensation of
Employees

Net Unilateral Transfers

Gifts from foreign countries minus gifts to foreign countries

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(ii) Capital Account Balance

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.

(iii) The Reserve Account

Three accounts: IMF, SDR, & Reserve and Monetary Gold are collectively
called as The Reserve Account. The IMF account contains credits and debits
+from International Monetary Fund.

Special drawing rights (SDR) are supplementary foreign exchange reserve

assets defined and maintained by the International Monetary Fund. SDRs are
units of account for the IMF, and not a currency per se. They represent a claim
to currency held by IMF member countries for which they may be exchanged.
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(iv) Errors and 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.

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The Components of BoP

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Summary Balance of Trade of Pakistan (July-April 2018-19)

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c. Disequilibrium In The Balance Of Payments

A disequilibrium in the balance of payment means its condition of

Surplus or deficit.

A Surplus in the BOP occurs when Total Receipts exceeds Total

Payments.

Thus, Surplus BOP= CREDIT>DEBIT

A Deficit in the BOP occurs when Total Payments exceeds Total

Receipts.

Thus, Deficit BOP= CREDIT<DEBIT

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Causes of Disequilibrium In The Bop

 Cyclical fluctuations

 Short fall in the exports

 Economic Development

 Rapid increase in population

 Structural Changes

 Natural Calamites

 International Capital Movements

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d. Measures To Correct Disequilibrium in the BOP

(i) Monetary Measures

 Monetary Policy

The monetary policy is concerned with money supply and credit in the
economy. The Central Bank may expand or contract the money supply
in the economy through appropriate measures which will affect the
prices.

 Fiscal Policy

Fiscal policy is government's policy on income and expenditure.

Government incurs development and non - development expenditure. It
gets income through taxation and non - tax sources. Depending upon the
situation governments expenditure may be increased or decreased.
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 Exchange Rate Depreciation

By reducing the value of the domestic currency, government can

correct the disequilibrium in the BoP in the economy. Exchange
rate depreciation reduces the value of home currency in relation to
foreign currency. As a result, import becomes costlier and export
become cheaper. It also leads to inflationary trends in the country.

 Deflation

Deflation is the reduction in the quantity of money to reduce

prices and incomes. In the domestic market, when the currency is
deflated, there is a decrease in the income of the people. This puts
curb on consumption and government can increase exports and
earn more foreign exchange.
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 Exchange Control

All exporters are directed by the monetary authority to surrender their

foreign exchange earnings, and the total available foreign exchange is
rationed among the licensed importers. The license-holder can import
any good but amount is fixed by monetary authority.

(ii) Non- Monetary Measures

 Export Promotion

The country may adopt measures to stimulate exports like:

 export duties may be reduced to boost exports
 cash assistance, subsidies can be given to exporters to increase
exports
 goods meant for exports can be exempted from all types of taxes.
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 Import Substitutes

Steps may be taken to encourage the production of import substitutes. This will save
foreign exchange in the short-run by replacing the use of imports by these import
substitutes.

 Import Control

Import may be kept in check through the adoption of a wide variety of measures like
quotas and tariffs.

Under the quota system, the government fixes the maximum quantity of goods and
services that can be imported during a particular time period. By restricting imports
through the quota system, the deficit is reduced and the balance of payments position
is improved.

Tariffs are duties (taxes) imposed on imports. When tariffs are imposed, the prices of
imports would increase to the extent of tariff. The increased prices will reduced the
demand for imported goods and at the same time induce domestic producers to
produce more of import substitutes.
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B. The Exchange Rate Management Issue and Its Impact on
Trade

a. Introduction

An exchange rate is the rate at which one currency will be

exchanged for another.

The value of one country’s currency in terms of another currency.

b. Types of Exchange Rate

Some of the major types of foreign exchange rates are as follows:

1. Fixed Exchange Rate System 2. Flexible Exchange Rate
System 3. Managed Floating Rate System.
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(i) Fixed Exchange Rate System (or Pegged Exchange Rate System)

Fixed exchange rate system refers to a system in which exchange rate for a currency is fixed
by the government.

 The basic purpose of adopting this system is to ensure stability in foreign trade and capital
movements.

 To achieve stability, government undertakes to buy foreign currency when the exchange rate
becomes weaker and sell foreign currency when the rate of exchange gets stronger.

 For this, government has to maintain large reserves of foreign currencies to maintain the
exchange rate at the level fixed by it.

 Under this system, each country keeps value of its currency fixed in terms of some
‘External Standard’.

 This external standard can be gold, silver, other precious metal, another country’s currency
or even some internationally agreed unit of account.

 When value of domestic currency is tied to the value of another currency, it is known as
‘Pegging’.
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(ii) Flexible Exchange Rate System (or Floating Exchange Rate System)

Flexible exchange rate system refers to a system in which exchange rate

is determined by forces of demand and supply of different currencies in
the foreign exchange market.

 The value of currency is allowed to fluctuate freely according to

changes in demand and supply of foreign exchange.

 There is no official (Government) intervention in the foreign exchange

market.

 Flexible exchange rate is also known as ‘Floating Exchange Rate’.

 The exchange rates determined by the market, i.e. through intersection

of thousand of banks, firms and other institutions seeking to buy and
sell currency for purposes of making transactions in foreign exchange.
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(iii) Managed Floating Rate System

It refers to a system in which foreign exchange rate is determined by

market forces and central bank influences the exchange rate through
intervention in the foreign exchange market.

 It is a hybrid of a fixed exchange rate and a flexible exchange rate

system.

 In this system, central bank intervenes in the foreign exchange market

to restrict the fluctuations in the exchange rate within certain limits.
The aim is to keep exchange rate close to desired target values.

 For this, central bank maintains reserves of foreign exchange to ensure

that the exchange rate stays within the targeted value.

 It is also known as ‘Dirty Floating’.

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c. Ways Exchange Rates Affect Imports and Exports

A strengthening rupee (high exchange rate) can spell trouble for Pakistani
companies that export goods to other countries. With strengthening of rupee the
exports become more expensive for the foreign consumers.

But the rupee favorable exchange rate can also hurt Pakistani firms at home. That’s
because when the rupee is strong, Pakistani consumers are able to buy imported
goods at a lesser cost, making Pakistan-made products more costly in comparison.

While this makes it appear that Pakistani businesses benefit when the rupee
weakens, reality is not so simple. When the rupee falls (low exchange rate) in value
compared to other currencies, the price of imported raw materials like steel and oil
go up in price.
 
Conversely, if the rupee rises and the cost of imported materials drops, Pakistani
manufacturers that hold their prices steady will see their margins increase.
Alternatively, they have the option of dropping their prices to grab a bigger chunk
of the market, without surrendering any of their profits. Moves like this can
compensate for the loss of price competitiveness due to a stronger rupee.
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