Chapter two

Balance of Payment and Its Relevance to Foreign

Exchange
Balance of payment meaning and definition
 Balance of payment: - is systemic records of all economic
transaction b/n the residents of the 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 capital transferred to non-residents or
foreigner.
 Nations continually carry out economic commercial and financial
transactions b/n residents of one nations and the rest of world in
the form of :-
Exchange of goods for service
Goods and services for money ………etc
 The systemic record of all economic transactions b/n residents
of a country and the rest of the world in given period is called
Balance of payments.
 Bop is a double entry system statement of the following:-
All receipts for good export
All services render
Capital received by residents of the nations &
A payment made by residents for goods imported and services
received in addition to capital transferred to non-residents and
foreigners.
 Residents means individuals, business and government agencies,
Military personnel, diplomat, tourists, and workers who emigrate
temporarily are considered residents of the country of their
citizen ship.
 Bop:- international business transactions occur in many d/t forms
over the course of the year.
 The measurements of all international economic transactions b/n
the residents of a country and foreign residents is called Balance
of payment.
 Bop: - record of all financial transactions made b/n consumers,
business and government in one country with other nations.
Inflows of foreign currency :- are accounted as positive entry
(e.g. export sold oversea)
Out flows foreign currency:- are accounted as negative entry(e.g.
imported goods and services
 BOP data is important for government policymakers and MNEs
as it is a gauge of a nation’s competitiveness or health (domestic
and/or foreign).
 For a MNE both home and host country BOP data is important
as: An indication of pressure on a country’s foreign exchange rate
 By recording all international transactions over a period of time
such as a year, it tracks the continuing flows of purchases and
 It does not add up the value of all assets and liabilities of a
country on a specific date (as an individual firm’s balance sheet
would do).
 A record of international transactions between residents of one
country and the rest of the world
 International transactions include exchanges of goods, services or
assets
 Generally, a system of accounts that measures transactions of
goods, services, income and financial assets between domestic
households, businesses, and governments and residents of the
rest of the world during a specific time period is balance of
payment.
The balance of payments accounts
 is a record of all international transactions that are
undertaken between residents of one country and residents
of other countries during some period of time.
 The accounts are divided into several sub-accounts, the most
important being the current account and the financial
account.
 The current account is often further subdivided into the
merchandise trade account and the service account.
Accounts of Balance of payment
 Accounts are divided into Current, financial, merchandize
and Service accounts.
 Current Account
 A record of all international transactions for goods and
services. The current account combines the transactions of the
trade account and the services account.
Merchandise Trade Account
 a record of all international transactions for goods only. Goods
include physical items like autos, steel, food, clothes, appliances,
furniture.
Services Account
 a record of all international transactions for services only.
Services include transportation, insurance, hotel, restaurant,
legal services, consulting
 Financial Account
 a record of all international transactions for assets. Assets
include bonds, treasury bills, bank deposits, stocks, currency,
 The balance on each of these accounts is found by taking
the difference between exports and imports.
 the current account balance is defined as
 CA = EXG&S - IMG&S where the G&S superscript is meant to
include exports and imports of both goods and services.
 If CA > 0, then exports of goods and services exceed
imports and the country has a current account surplus.
 If CA < 0, then imports exceed exports and the country has
a current account deficit.
 the trade balance (or goods balance) can be defined as, GB =
EXG - IMG , where we record only the export and imports of
merchandise goods.
 If GB > 0, the country would have a (merchandise) trade
surplus. If GB < 0, the country has a trade deficit.
The service balance can be defined as SB = EX S - IMS,
where we record only the export and import of services.
 If SB > 0, the country has a service surplus.
If SB < 0, the country has a service deficit.
the financial account balance can be defined as FA = EX A -
IMA
where EXA and IMA refer to the export and import of
assets, respectively.
 If FA > 0, then the country is exporting more assets than it
is importing and it has a financial account surplus.
 If FA < 0 then the country has a financial account deficit.
 Features of balance of payment
 It is a systematic records of all economic transactions b/n one country
and the rest
 It includes all transactions, visible as well as in visible.
 It relates to a period of time. Generally it is annual statement.
 It adopts double-entry bookkeeping system.
 (Bookkeeping) It has two sides. Credit side and debit side
 Receipts are recorded on the credit side and payment on the debit side
The importance of balance of payment
1. Bop records all the transactions that create demand for a supply of a
currency
2. Judges economic & financial status of a country in a short time
3. Bop may confirm trend in economies of international trade and
exchange rate of the currency. This may also indicate changes or
reserve in trends.
4. This may indicate policy shift of the monetary authority of the country
 Balance of trade
 The difference between a country’s imports and its exports.
Balance of trade is the largest component of country’s balance of
payment.
 The item which include imports, foreign aid, domestic spending
abroad and domestic investment abroad come under imports.
 The items which include exports, foreign spending in the
domestic economy and foreign investment in the domestic
economy comes under exports.
 When exports are greater than imports then the BOP is favorable
and if imports are greater than exports then it is unfavorable.
 Favorable balance of trade indicates the good economic
condition of the country.
Major element of balance of payment
1.Financial capital
 Financial assets can be classified in a number of different ways
including the length of the life of the asset (maturity) and the
nature of the ownership (public or private).
 The Financial Account, however, uses a third method. This
focuses on the degree of investor control over the assets or
operations.
 The Financial Account consists of three components;
 Direct Investment – in which the investor exerts some explicit
degree of control over the assets
 Portfolio Investment – in which the investor has no control over the
assets
 Other Investment – consists of various short-term and long-term
trade credits, cross-border loans, currency deposits, bank deposits
 Direct Investment
 This is the net balance of capital dispersed from and into the US
for the purpose of exerting control over assets.
 Foreign direct investment arises from 10% ownership of voting
shares in a domestic firm by foreign investors.
 The source of concern over foreign investment in any country
focuses on two topics: control and profit.
 Some countries possess restrictions on foreigners may own in
their country.
 The general rule or premise is that domestic land, assets and
industry should be owned by residents of the country.
 Concerns over profit stem from the same argument.
Portfolio Investment
 This is the net balance of capital that flows in and out of the US
but does not reach the 10% threshold of direct investment.
 The purchase of debit securities across borders is classified as
portfolio investment because debit securities by definition do not
provide the buyer with ownership or control.
 Portfolio investment is motivated by a search for returns rather
than to control or manage the investment.
2. Capital account
 The Capital Account of the balance of payments measures all
international economic transactions of financial assets.
 Capital account records all international transactions that involve
a resident of the country concerned changing either his assets or
his liabilities to residents of another country. Transaction in the
capital accounts reflects a change in a stock- either assets or
 It is difference b/n the receipts and payments on account of capital
account. It refers to all financial transactions.
 The capital account involves inflows and out flows in relating to
investments, short terms borrowing/ lending and medium terms to
long term borrowing /lending.
 There can be surplus or deficit in capital account.
 It includes:-privet foreign loan flows, movement in banking capital,
official capital transactions, reserve, gold movement …etc.
 It is a part of Bop statements showing flows of foreign loans/
investments and banking funds.
 Capital account transactions take place in the following ways
Capital account receipts
1. Long term in flow of funds
2. Short term in flows of funds
 Capital account payments
1. Long term out flows of funds
2. Short term out flows of funds.
3, the current Account: the current accounts comprise the balance of
trade in goods and services net investment income and net transfers.
If a country is running a current deficit, there is a net out flow of
demand and income from circular flows.
 The Current Account includes all international economic transactions
with income or payment flows occurring within one year, the current
period. It consists of the following four subcategories:
A. Goods trade and import of goods
B. Services trade
C. Income
D. Current transfers
 The Current Account is typically dominated by the first component
which is known as the Balance of Trade (BOT) even though it
excludes service trade.
 Balance of trade on the current account is a statements of actual
receipts and payments in short period.
 It includes the value of exports and imports of both visible and non-
visible goods. There can be either surplus or deficit in current
accounts.
 The current account include: - exports and imports of services,
interests, profits, dividends’ and unilateral receipts /payments/ to
abroad.
 Also balance of payment on current account includes: - values of
exports and imports of visible items and receipts and payments on
invisible i.e. services like banking, insurances travels, tourism,
transportations….etc.
 Balance of payment on current account is added to determine nations
(GDP).
 To summarize balance of payment means:-
1. Balance of trade =Export of goods-Imports of Goods
2. Balance of current account=balance of trade +Net earing on
invisibles
3. Balance of capital account=foreign exchange inflow- outflows
on account of foreign investment, foreign loans, banking
transactions and other capital flows
4. Overall balance of payment=balance of current account +balance
of capital account + statistical discrepancy (difference).
International Finance and Monetary Relations
History
 the first commodity exchange, the Bruges Bourse in 1309 in
Europe and the first financiers and banks in the 1400–1600s
in central and western Europe.
 The first global financiers the Fugger (1487) in Germany;
 the first stock company in England (Russia Company 1553);
 the first foreign exchange market (The Royal Exchange
1566, England);
 the first stock exchange (the Amsterdam Stock Exchange
1602).
 Milestones in the history of financial institutions are:-
 the Gold Standard (1871–1932),
 the founding of International Monetary Fund (IMF), World
Bank at Bretton Woods, and
 the abolishment of fixed exchange rates in 1973.
The global financial system (GFS) is the financial system
consisting of institutions and regulators that act on the
international level, as opposed to those that act on a
national or regional level.
The main players are the global institutions, such as
International Monetary Fund and Bank for International
Settlements, national agencies and government
departments.
 Foreign Exchange Rate
 The foreign exchange market (forex, FX, or currency market) :-a
worldwide decentralized over-the-counter financial market
for the trading of currencies.
 Foreign Exchange Rate:- Is the rate at which one nation’s
currency is exchanged for another country’s currency.
 It is the price of one unit of a particular currency in terms of
the other currency.
 The need for the foreign exchange rate arises because money
is the medium for settlement of most business transaction
today.
 Fixed and Flexible Exchange System
 The fixed exchange rate system represents an arrangement
where the exchange ratio between the specified currencies
remain constant.
 a type of exchange rate regime wherein a currency's value is
matched to the value of another single currency or to a
basket of other currencies, or to another measure of value,
such as gold
 Gold standard, adopted in 1821. the currency is backed by a
fixed quantity of gold that had to be officially declared by
the government
 The IMF system, the gold exchange standard or the Bretton
woods system.
 Until 1971 the US committed to the responsibility of
 Flexible Exchange rate
Free floating and managed flexibility of exchange rate.
a type of exchange rate regime wherein a currency's
value is allowed to fluctuate according to the foreign
exchange market.
Foreign Exchange rate in freely floating exchange rate
system is determined by the forces of demand and supply
without intervention from the government to influence the
rate.
Managed flexibility: flexibility by the influence of the
government.
 Devaluation
 Devaluation is an official reduction in the exchange value of a
currency by a lowering of its gold equivalency or its value
relative to another currency.
 Devaluation is a deliberate downward adjustment to the value of
a country's currency relative to another currency, group of
currencies or standard.
 Devaluation is a monetary policy tool used by countries that have
a fixed exchange rate or semi-fixed exchange rate.
 It is often confused with depreciation, and is when there is a fall
in the value of a currency in a floating exchange rate. This is not
due to a government’s decision, but due to supply and demand
side factors.
 Today, in many countries, especially the developing ones, the
weakening of their currency i.e. the decrease or depreciation of their
own currency in terms of foreign currencies has become a central
growth issue.
 Many development organizations like International Monetary Fund
(IMF) support the idea of devaluation of currency as one means of
economic growth besides the financial aid and loans to their member
countries for the development of domestic firms.
 It will increase competitiveness of firms and increase the production of
domestic products and output.
 One reason a country may devaluate its currency is to combat trade
imbalances.
 Devaluation causes a country's exports to become less expensive,
making them more competitive in the global market.
 This, in turn, means that imports are more expensive, making
domestic consumers less likely to purchase them, further
strengthening domestic businesses.
 While devaluating a currency can seem like an attractive option,
it can have negative consequences.
 By making imports more expensive, for example, it protects
domestic industries who may then become less efficient without
the pressure of competition.
 Higher exports relative to imports can also increase
aggregate demand, which can lead to inflation.
 Determinants of Foreign exchange
 Economic factors
Economic policy comprises government fiscal and monetary
policies
Government budget deficits or surpluses
Balance of trade levels and trends
Inflation levels and trends
Economic growth and macroeconomic stablity
Productivity of an economy
 Political Factors
Instability, international political conditions, security issues…
 Exchange Control
Refers to all those interventionist activities of government
intending to influence the rate of exchange or the business
connected with foreign exchange. includes:
Imposition of control on exchange rate
Capital investment
Management of Exchange Equalization accounts.
 conclusion of trade and payment agreements with
other countries.
Objectives of Exchange control
Overvaluation of home currency
Undervaluation of home currency
Stability in exchange rate
Check capital flight
Control imbalance in foreign trade
Protection to domestic industry
Import of essential goods
Prohibit/ban imports
Conserve foreign exchange reserve
Earn profit in exchange transaction
Trade discrimination
Methods of Exchange control
 Bank rate regulation
Foreign trade regulation
Foreign exchange rationing
Exchange pegging: the gov’t fixes the rate above or
blow
Exchange Equalization fund
Block account
Bilateral methods through
o Payment agreement: paying import by export
o Clearing agreements: paying in domestic currency
o Transfer moratorium: taking some time to repay
o Standstill agreements: movement of capital b/n 2 countries.
o Counter trade: barter system, balanced import-export..
 Pros and cons of Exchange control
Pros
Prevents exchange control fall
Prevent capital outflow
Helps during wartime
Helps development plans
Overcome short-term imbalances
Helps planned economy
 Cons
Contracts trade
Sacrifice comparative advantage
Expensive system
Source of corruption
Continuation of temporary measures
Capital flows slowdown