Professional Documents
Culture Documents
1. Meaning
The principal items on the Debit side (-) include imports of goods and services,
transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending to
foreign countries, investments by residents to foreign countries, and official purchase
of reserve assets or gold from foreign countries and international agencies.
These credit and debit items are shown vertically in the balance of payments account
of a country according to the principle of double-entry book-keeping.
Horizontally, they are divided into three categories:
The current account, the capital account, and the offcial settlements account or the
Official reserve assets account.
The balance of payments account of a country is constructed in Table 1.
1. Current Accounting:
The current account of a country consists of all transactions relating to trade in goods
and services and unilateral (or unrequited) transfers. Service transactions include
costs of travel and transportation, insurance, income and payments of foreign
investments, etc. Transfer payments relate to gifts, foreign aid, pensions, and private
investments. In other words, the capital account shows international flow of loans
and investments, and represents a change in the countrys foreign assets and
liabilities.
Long-term capital transactions relate to international capital movements with
maturity of one year or more and include direct investments like building of a foreign
plant, portfolio investment like the purchase of foreign bonds and stocks, and
international loans. On the other hand, short-term international capital transactions
are for a period ranging between three months and less than one year.
There are two types of transactions in the capital accountprivate and government.
Private transactions include all types of investment: direct, portfolio and short-term.
Government transactions consist of loans to and from foreign official agencies.
In the capital account, borrowings from foreign countries and direct investment by
foreign countries represent capital inflows. They are positive items or credits because
these are receipts from foreigners. On the other hand, lending to foreign countries
and direct investments in foreign countries represent capital outflows. They are
negative items or debits because they are payments to foreigners. The net value of the
balances of short-term and long-term direct and portfolio investments is the balance
on capital account.
Sodersten and Reed refer to the external wealth account of a country which shows
the stocks of foreign assets held by the country (positive item) and of domestic assets
held by foreign investors (liabilities or negative item). The net value of a countrys
assets and liabilities is its balance of indebtedness. If its assets are more than its
liabilities, then it is a net creditor. If its liabilities are more than its assets, then it is a
net debtor.
Basic Balance:
The sum of current account and capital account is known as the basic balance.
3. The Official Settlements Account:
The official settlements account or official reserve assets account is, in fact, a part of
the capital account. But the U.K. and U.S. balance of payments accounts show it as a
separate account. The official settlements account measures the change in nations
liquidity and non-liquid liabilities to foreign official holders and the change in a
nations official reserve assets during the year. The official reserve assets of a country
include its gold stock, holdings of its convertible foreign currencies and SDRs, and its
net position in the IMF. It shows transactions in a countrys net official reserve
assets.
Errors and Omissions:
Errors and omissions is a balancing item so that total credits and debits of the three
accounts must equal in accordance with the principles of double entry book-keeping
so that the balance of payments of a country always balances in the accounting sense.
3. Is Balance of Payments Always in Equilibrium?
Balance of payments always balances means that the algebraic sum of the net credit
and debit balances of current account, capital account and official settlements
account must equal zero. Balance of payments is written as.
B = Rf -Pf
B =where, represents balance of payments,
Rf receipts from foreigners,
Pf payments made to foreigners.
When = Rf-- Pf = 0, the balance of payments is in equilibrium.
When Rf Rf > 0, it implies receipts from foreigners exceed payments made to
foreigners and there is surplus in the balance of payments. On the other hand, when
Rf - Pf < 0 or Rf < Pf - there is deficit in the balance of payments as the payments made
to foreigners exceed receipts from foreigners.
If net foreign lending and investment abroad are taken, a flexible exchange rate
creates an excess of exports over imports. The domestic currency depreciates in
terms of other currencies.
The export becomes cheaper relatively to imports. It can be shown in
equation form:
X + = M + If
Where X represents exports, M imports, 1, foreign investment, foreign borrowing
or X-M= If -B
or (X-M)-(If -B) = 0
The equation shows the balance of payments in equilibrium. Any positive balance in
its current account is exactly offset by negative balance on its capital account and vice
versa. In the accounting sense, the balance of payments always balances. This can be
shown with the help of the following equation:
C + S + T= C + I + G + (X-M)
or Y=C + I + G + (X M) [. Y = + S + T]
where represents consumption expenditure, S domestic saving, T tax receipts, I
investment expenditures, G government expenditures, X exports of goods and
services, and M imports of goods and services.
In the above equation
+ S + T is GNI or national income (Y), and
+ I + G =A,
where A is called absorption.
In the accounting sense, total domestic expenditures ( + I + G) must equal current
income (C + S + T) that is A = Y. Moreover, domestic saving (Sd) must equal
If the balance of payments always balances, then why does a deficit or surplus arise
in the balance of payment of a country? It is only when all items in the balance of
payments are included that there is no possibility of a deficit or surplus. But if some
items are excluded from a countrys balance of payments and then a balance is
struck, it may show a deficit or surplus.
There are three ways of measuring deficit or surplus in the balance of
payments:
First, there is the basic balance which includes the current account balance and the
long-term capital account balance.
Second, there is the net liquidity balance which includes the basic balance and the
short-term private non-liquid capital balance, allocation of SDRs, and errors and
omissions.
Third, there is the official settlements balance which includes the total net liquid
balance and short-term private liquid capital balance.
If the total debits are more than total credits in the current and capital accounts,
including errors and omissions, the net debit balance measures the deficit in the
balance of payments of a country. This deficit can be settled with an equal amount of
net credit balance in the official settlements account.
On the contrary, if total credits are more than total debits in the current and capital
accounts, including errors and omissions, the net debit balance measures the surplus
in the balance of payments of a country. This surplus can be settled with an equal
amount of net debit balance in the official settlements account.
The relationship between these balances is summarised in Table 2 below.
TABLE 2:
Trade balance.. a
Transfer payments balance b Autonomous
Current Account Balance (= a + b) Items
Long-term capital balance d
Basic Balance.. e (= + d)
Short-term private non-liquid capital
Balance.. f
Allocation of SDRs g Accommodating
Errors and omissions.. h Items
Net Liquidity Balance i (= e + f + g + h)
Short-term private liquid capital balance j
Official Settlements Balance.. k (= i + j)
accommodating items lies in the motives underlying a transaction, which are almost
impossible to determine.
Conclusion:
The above analysis is based on the assumption of fixed exchange rates. Thus a deficit
(or surplus in the balance of payments is possible under a system of fixed exchange
rates. But under freely floating exchange rates, there can in principle be no deficit (or
surplus) in the balance of payments.
The country can prevent a deficit or (surplus) by depreciating (or appreciating) its
currency. Further, balance of payments always balances in an ex-post accounting
sense, according to the basic principle of accounting. Lastly, such a balance of
payments can be in equilibrium only if there are no compensating transactions.
5. Balance of Trade and Balance of Payments
In equation form, the balance of payments of Y = C + I+G + (X-M) which includes all
transactions which give rise to or exhaust national income. In the equation, Prefers
to national income, C to consumption expenditure, I to investment expenditure, G to
government expenditure, X to exports of goods and services and M to imports of
goods and services. The expression (X M) denotes the balance of trade. If the
difference between X and M is zero, the balance of trade balances. If X is greater than
M, the balance of trade is favourable, or there is surplus balance of trade. On the
other hand, if X is less than M, the balance of trade is in deficit or is unfavourable.
6. Disequilibrium in Balance of Payments
It is caused by such dynamic factors as: (1) Changes in consumer tastes within
the country or abroad which reduce the countrys exports and increase its imports.
(2) Continuous fall in the countrys foreign exchange reserves due to supply
inelasticitys of exports and excessive demand for foreign goods and services. (3)
Excessive capital outflows due to massive imports of capital goods, raw materials,
essential consumer goods, technology and external indebtedness. (4) Low
competitive strength in world markets which adversely affects exports. (5)
Inflationary pressures within the economy which make exports dearer.
3. Structural Changes (or Disequilibrium):
Structural changes bring about disequilibrium in BOP over the long run.
They may result from the following factors:
(a) Technological changes in methods of production of products in domestic
industries or in the industries of other countries. They lead to changes in costs, prices
and quality of products.
(b) Import restrictions of all kinds bring about disequilibrium in BOP.
(c) Deficit in BOP also arises when a country suffers from deficiency of resources
which it is required to import from other countries.
(d) Disequilibrium in BOP may also be caused by changes in the supply or direction
of long-term capital flows. More and regular flow of long-term capital may lead to
BOP surplus, while an irregular and short supply of capital brings BOP deficit.
4. Changes in Exchange Rates:
Changes in foreign exchange rate in the form of overvaluation or undervaluation of
foreign currency lead to BOP disequilibrium. When the value of currency is higher in
relation to other currencies, it is said to be overvalued. Opposite is the case of an
undervalued currency. Overvaluation of the domestic currency makes foreign goods
cheaper and exports dearer in foreign countries. As a result, the country imports
more and exports less of goods. There is also outflow of capital. This leads to
imports raw materials, machinery, capital equipment, and services associated with
the development process and exports primary products. The country has to pay more
for costly imports and gets less for its cheap exports. This leads to disequilibrium in
its balance of payments.
9. Capital Movements:
Borrowings and lendings or movements of capital by countries also result in
disequilibrium in BOP. A country which gives loans and grants on a large scale to
other countries has a deficit in its BOP on capital account. If it is also importing
more, as is the case with the USA, it will have chronic deficit. On the other hand, a
developing country borrowing large funds from other countries and international
institutions may have a favourable BOP. But such a possibility is remote because
these countries usually import huge quantities of food, raw materials, capital goods,
etc. and export primary products. Such borrowings simply help in reducing BOP
deficit.
10. Political Conditions:
Political condition of a country is another cause of disequilibrium in BOP. Political
instability in a country creates uncertainty among foreign investors which leads to
the outflow of capital and retards its inflow. This causes disequilibrium in BOP of the
country. Disequilibrium in BOP also occurs in the event of war or fear of war with
some other country.
Implications of Disequilibrium:
A disequilibrium in the balance of payments whether a deficit or surplus has
important implications for a country. A deficit in the combined current and capital
accounts is regarded as undesirable for the country. This is because such a deficit has
to be covered by borrowing from abroad or attracting foreign exchange or capital
from abroad. This may require paying high interest rates.
There is also the danger of withdrawing money by foreigners, as happened in the
case of the Asian crisis in the late 1990s. An alternative may be to draw on the
reserves of the country which may also lead to a financial crisis. Moreover, the
reserves of a country being limited, they can be used to pay for BOP deficit upto a
limit.
But the above analysis of a combined current and capital account deficit is not
correct in practice. The reason being that a current account deficit is the same thing
as a capital account surplus. However, it is beneficial for a country to have a current
account deficit even if it equals capital account surplus in BOP.
In the short-run, the country may benefit from a higher level of consumption through
import of goods and consequently a higher standard of living. But the excess of
imports over exports may be financed by foreign investments in the country. These
may lead to increased production, employment and income in the country. In the
long-run, foreign investors may purchase large assets in the country and thus
adversely affect domestic industry as is the case with MNCs (multinational
corporations).
The current account deficit in BOP of a country may have either good or bad effects
depending on the nature of an economy.
Take a country where domestic industries are rapidly growing and it has current
account BOP deficit. These industries offer a high rate of return on their investment.
This would, in return, attract foreign investments. As a result, the country would
have a capital account surplus due to the inflow of capital and a current account
deficit.
This current account deficit is good for the economy. No doubt, the external debt of
the country increases, but this debt is being utilised to finance the rapid growth of
the economy. The real burden of this debt will be very low because it can be repaid
out of higher income in the future.
On the contrary, a country having an inefficient and unproductive domestic industry
will be adversely affected by its current account BOP deficit. The country borrows
from abroad to finance the excess of spending over consumption. To attract foreign
borrowings, the country will have to pay high interest rates.
These will increase the money burden of the debt. The real burden of the debt will
also increase because of the low productive capacity of domestic industries. If the
current consumption is being financed by foreign borrowings, the wealth of the
economy will decline. This, in turn, will lead to either a reduction in domestic
expenditure or a change in government policy so as to control the rising debt.
On the other hand, if foreign borrowings are being used to finance real investment,
the current account BOP deficit will be beneficial for the economy. A higher rate of
return on real investment than the interest on foreign borrowings would increase the
countrys wealth over time through rise in its national income. Thus a current
account BOP deficit is not always undesirable for a country.
7. Measures to Correct Deficit in Balance of Payments
Depreciation of a currency means that its relative value decreases. Depreciation has
the effect of encouraging exports and discouraging imports. When exchange
depreciation takes place, foreign prices are translated into domestic prices. Suppose
the dollar depreciates in relation to the pound. It means that the price of dollar falls
in relation to the pound in the foreign exchange market.
This leads to the lowering of the prices of U.S. exports in Britain and raising of the
prices of British imports in the U.S. When import prices are higher in the U.S., the
Americans will purchase less goods from the Britishers. On the other hand, lower
prices of U.S. exports will increase exports and diminish imports, thereby bringing
equilibrium in the balance of payments.
2. Devaluation or Expenditure-Switching Policy:
Devaluation raises the domestic price of imports and reduces the foreign price of
exports of a country devaluing its currency in relation to the currency of another
country. Devaluation is referred to as expenditure switching policy because it
switches expenditure from imported to domestic goods and services. When a country
devalues its currency, the price of foreign currency increases which makes imports
dearer and exports cheaper. This causes expenditures to be switched from foreign to
domestic goods as the countrys exports rise and the country produces more to meet
the domestic and foreign demand for goods with reduction in imports. Consequently,
the balance of payments deficit is eliminated.
3. Direct Controls:
To correct disequilibrium in the balance of payments, government also adopts direct
controls which aim at limiting the volume of imports. The government restricts the
import of undesirable or unimportant items by levying heavy import duties, fixation
of quotas, etc. At the same time, it may allow Imports essential goods duty free or
at lower import duties, or fix liberal import quotas for them.
For instance the government may allow free entry of capital goods, but impose heavy
import duties on luxuries. Import quotas are also fixed and the importers are
required to take licenses from the authorities in order to import certain essential
commodities in fixed quantities.
In these ways, imports are reduced in order to correct an adverse balance of
payments. The government also imposes exchange controls. Exchange controls have
a dual purpose. They restrict imports and also control and regulate the foreign
exchange. With reduction in imports and control of foreign exchange, visible and
invisible imports are reduced. Consequently, an adverse balance of payment is
corrected.
4. Adjustment through Capital Movements
A country can use capital imports to correct a deficit in its balance of payments. A
deficit can be financed by capital inflows. When capital is perfectly mobile within
countries, a small rise in the domestic rate of interest brings a large inflow of capital.
The balance of payments is said to be in equilibrium when the domestic interest rate
equals the world rate. If the domestic interest rate is higher than the world rate, there
will be capital inflows and the balance of payments deficit is corrected.
5. Adjustment through Income Changes:
Given the foreign exchange rate and prices in a country, an increase in the value of
exports, causes an increase in the incomes of all persons associated with the export
industries. These, in turn create demand for other goods and services within the
country. This will raise the incomes of persons engaged in the latter industries and
services. This process will continue and the national income increases by the value of
the multiplier.
6. Stimulation of Exports and Import Substitutes:
A deficit in the balance of payments can also be corrected by encouraging exports.
Exports can e encouraged by producing quality products, by reducing exports
through increased production and productivity, and by better marketing. They can
also be increased by a policy of import substitution it means that the country
produces those goods which it imports.
In the beginning, imports are reduced u in the long run exports of such goods start.
An increase in exports causes the national income to rise by many times through the
operation of the foreign trade multiplier. The foreign trade multiplier expresses the
change in income caused by a change in exports. Ultimately, the deficit in the balance
of payments is removed when exports rise faster than imports.
7. Expenditure-Reducing policies:
A deficit in the balance of payments implies an excess of expenditure over income. To
correct it expenditure and income should be brought into equality. For this
expenditure reducing monetary and fiscal policies are used. A contractionary or tight
monetary policy relates to cut in interest rates to reduce money supply and a
contractionary fiscal policy relates to reduction in government expenditure and or
increase in taxes.
Thus expenditure reducing policies reduce aggregate demand through higher taxes
and interest rates, thereby reducing expenditure and output. The reduction in
expenditure and output, in turn, reduces the domestic price level. This gives rise to
switching of expenditure from foreign to domestic goods. Consequently, the
countrys imports are reduced and the balance of payments deficit is corrected
(7) Countries which rely a lot on foreign remittances may fall into a BoP crisis if these
remittances drop significantly. Pakistans economy is open to such a shock, because
remittances form an important component of the current account balance.
(8) Finally, unpaid import bills or loans by foreigners may also cause a BoP crisis. This
form of BoP crisis is the counterpart of a domestic financial crisis caused by bad debt.
Having outlined the main external factors responsible for BoP crises, lets look at the
internal causes of such crises.
(a) Arguably, the most fundamental internal cause of a BoP crisis is expansionary
policies. Expansionary fiscal or monetary policies adopted to stimulate the economy may
cause aggregate demand to grow at a pace higher than domestic supply. The gap
between aggregate demand and domestic supply is filled by imports. The result is that
imports grow more quickly than exports. Current account deficit goes up, which has to
be financed through either falling foreign exchange reserves or capital inflows. Capital
inflows, however, may not be forthcoming owing to lack of trust in the countrys financial
situation.
When faced with such a situation, an easy option for the government or the central bank
is to de-value the currency to push up exports and reduce imports. Devaluation may or
may not lead to a significant expansion in exports. But, devaluation enhances the real
value of foreign debt. If devaluation leads to a significant increase in exports, it may
offset the rise in the value of foreign debt. On the other hand, if exports do not go up
significantly, the country may face foreign exchange problems. Great care therefore,
needs to be taken while pursuing expansionary policies. Stimulation of the aggregate
demand must match domestic supply capacity.
(b) Fiscal deficit may also underlie a BoP crisis. To finance its fiscal deficit, the
government resorts to borrowing either from the central bank or from foreigners.
Borrowing from the central bank causes inflation. Inflation is bad for trade, because it
distorts prices. In particular, inflation heightens the input cost of exportable goods and
makes them less price competitive. Again, this is happening in case of Pakistan as the
fiscal deficit is largely being financed by printing money.
(c) The next factor is capital flight. A real or perceived financial crisis may induce foreign
and domestic investors to take their money out of the country, as happened to many
East Asian economies in late 1990s. This may give rise to a BoP crisis if the country does
not have enough foreign reserves to cover these outflows and has other obligations like
debt-servicing.
(d) In case the exchange rate is fixed to a relatively stable currency and expansionary
monetary policies start causing inflation, exchange rate appreciates in real terms. The
result is that exports become expensive and thus less competitive, while imports become
cheaper. Balance of trade deteriorates and a BoP crisis may ensue.
(e) If a country follows protectionist policies, such as higher tariffs or quantitative
restrictions, the final prices of imports in the domestic market shoot up. If these imports
are used in final exportable goods, exports become less competitive. The result may be a
drastic fall in foreign exchange earnings, hence deteriorating the balance of trade. Such
problems are more likely to be faced by developing countries than by developed
countries. This is for two reasons: one, in case of developing countries, there exists on
aggregate a big gap between applied and bound tariffs so applied tariffs are likely to
fluctuate. Two, as opposed to developed countries, in case of developing countries,
customs duties or tariffs are a principal source of revenue. Therefore, tariffs are enlarged
to generate more revenue.
(f) Weaknesses of domestic financial systems also contribute to the eruption of a BoP
crisis. Foreign capital plays a major role in economic development. Nonetheless, in many
cases capital inflows have been volatile. Extensive capital flows have been followed
abruptly by equally massive capital outflows. Countries with weak and in transparent
financial system are particularly vulnerable to this problem, as happened in case of the
East Asian crisis. This brings home the need for a strong financial system to cope with
volatile capital flows. It may be mentioned that though Article 8 of the IMF prevents
members from putting restrictions on current account, restrictions may be placed on
capital account. A related factor is liberalisation of the financial sector. Liberalisation of
the financial sector may be necessary to attract foreign investment. However, there is
the need for sequencing the liberalisation of financial markets.
Letter of credit
A letter of credit - sometime known as 'documentary credit' - is basically a guarantee
from a bank that a particular seller will receive a payment due from a particular
buyer. The bank guarantees that the seller will receive a specified amount of money
within a specified time. In return for guaranteeing the payment, the bank will require
that strict terms are met. It will want to receive certain documents - for example
shipping confirmation - as proof.
A letter of credit is an obligation of the bank that opens the letter of credit (the issuing
bank) to pay the agreed amount to the seller on behalf of the buyer, upon receipt of
the documents specified in the letter of credit.
Why use a letter of credit?
Letters of credit are most commonly used when a buyer in one country
purchases goods from a seller in another country. The seller may ask the
buyer to provide a letter of credit to guarantee payment for the goods.
The main advantage of using a letter of credit is that it can give security
to both the seller and the buyer.
Advantages for sellers
By asking for an appropriate letter of credit a seller is reassured that they
will receive their money in full and on time. A letter of credit is one of the
most secure methods of payment for exporters as long as they meet all
the terms and conditions. The risk of non-payment is transferred from the
seller to the bank (or banks).
Advantages for buyers
When a buyer uses a letter of credit they get a guarantee that the seller
will honour their side of the deal and provide documentary proof of this.
Other things to consider
It's important to be aware of the additional costs involved in using a letter
of credit. Banks make charges for providing them, so it's sensible to
weigh up the costs against the security benefits.
If you're an exporter you should be aware that you'll only receive
payment if you keep to the strict terms of the letter of credit. You'll need
to give documentary proof that you have supplied exactly what you
contracted to supply. Using a letter of credit can sometimes cause delays
and other administrative problems.
If you do decide that a letter of credit is the best option you'll need to consider which type of
letter to use. A 'confirmed and irrevocable' letter of credit is the most secure type.
It's wise to have a clear policy in your business about when to consider using a letter of
credit. Reviewing your policy on a regular basis will help you avoid using them unnecessarily
and possibly putting off would-be customers.
irrevocable
revocable
unconfirmed
confirmed
transferable
Other types include:
standby
revolving
back-to-back
Sometimes a letter of credit may combine two types, such as 'confirmed' and 'irrevocable'.
issues a counterfeit letter of credit. In this case, the beneficiary never receives its payment
for the goods it has shipped.
Risks to the Applicant:
In a letter of credit transaction, main risk factors for the applicants are non-delivery, goods
received with inferior quality, exchange rate risk and the issuing bank's bankruptcy risk.
Risks to the Beneficiary:
In a letter of credit transaction, main risk factors for the beneficiaries are unable to comply
with letter of credit conditions, counterfeit L/C, issuing bank's failure risk and issuing bank's
country risk.
Risks to the Banks:
Every bank in a L/C transaction bears risks more or less. The risk amount increases as
responsibility of the bank increases.
Definition
Foreign direct investment (FDI) is an investment in a business by an investor from another
country for which the foreign investor has control over the company purchased.
The Organization of Economic Cooperation and Development (OECD) defines control as
owning 10% or more of the business. Businesses that make foreign direct investments are often
called multinational corporations (MNCs) or multinational enterprises (MNEs). A MNE may
make a direct investment by creating a new foreign enterprise, which is called a greenfield
investment, or by the acquisition of a foreign firm, either called an acquisition or brownfield
investment.
Access to markets. FDI can be an effective way for you to enter into a foreign market.
Some countries may extremely limit foreign company access to their domestic markets.
Acquiring or starting a business in the market is a means for you to gain access.
Access to resources. FDI is also an effective way for you to acquire important natural
resources, such as precious metals and fossil fuels. Oil companies, for example, often
make tremendous FDIs to develop oil fields.
Reduces cost of production. FDI is a means for you to reduce your cost of production if
the labor market is cheaper and the regulations are less restrictive in the target foreign
market. For example, it's a well-known fact that the shoe and clothing industries have
been able to drastically reduce their costs of production by moving operations to
developing countries.
Source of external capital and increased revenue. FDI can be a tremendous source of
external capital for a developing country, which can lead to economic development.
For example, if a large factory is constructed in a small developing country, the country will
typically have to utilize at least some local labor, equipment and materials to construct it. This will
result in new jobs and foreign money being pumped into the economy. Once the factory is
constructed, the factory will have to hire local employees and will probably utilize a least some
local materials and services. This will create further jobs and maybe even some new businesses.
These new jobs mean that locals have more money to spend, thereby creating even more jobs.
Additionally, tax revenue is generated from the products and activities of the factory, taxes
imposed on factory employee income and purchases, and taxes on the income and purchases
now possible because of the added economic activity created by the factory. Developing
governments can use this capital infusion and revenue from economic growth to create and
improve its physical and economic infrastructure such as building roads, communication
systems, educational institutions and subsidizing the creation of new domestic industries.
Development of new industries. Remember that a MNE doesn't necessary own all of
the foreign entity. Sometimes a local firm can develop a strategic alliance with a foreign
investor to help develop a new industry in the developing country. The developing
country gets to establish a new industry and market, and the MNE gets access to a new
market through its partnership with the local firm.
Learning. This is more of an indirect advantage. FDI exposes national and local
governments, local businesses and citizens to new business practices, management
techniques, economic concepts, and technology that will help them develop local
businesses and industries.
In recent years, FDI has been used more as a market entry strategy for investors, rather
than an investment strategy. Despite the decline in trade barriers, FDI growth has increased at
a higher rate than the level of world trade as businesses attempt to circumvent protectionist
measures through direct investments. With globalization, the horizons and limits have been
extended and companies now see the world economy as their market.
Additionally for investors, FDI provides the benefits of reduced cost through the realization of scale
economies, and coordination advantages, especially for integrated supply chains. The preference
for a direct investment approach rather than licensing and franchising can also been viewed in
terms of strategic control, where management rights allows for technological know-how and
intellectual property to be kept in-house.
In recent years, FDI has been used more as a market entry strategy for investors, rather
than an investment strategy. Despite the decline in trade barriers, FDI growth has increased at
a higher rate than the level of world trade as businesses attempt to circumvent protectionist
measures through direct investments. With globalization, the horizons and limits have been
extended and companies now see the world economy as their market.
Additionally for investors, FDI provides the benefits of reduced cost through the realization of scale
economies, and coordination advantages, especially for integrated supply chains. The preference
for a direct investment approach rather than licensing and franchising can also been viewed in
terms of strategic control, where management rights allows for technological know-how and
intellectual property to be kept in-house.
Summary
1. FDI is an investment that a parent company makes in a foreign
country. On the contrary, FII is an investment made by an investor
in the markets of a foreign nation.
2. FII can enter the stock market easily and also withdraw from it
easily. But FDI cannot enter and exit that easily.
3. Foreign Direct Investment targets a specific enterprise. The FII
increasing capital availability in general.
4. The Foreign Direct Investment is considered to be more stable
than Foreign Institutional Investor
5) While the FDI flows into the primary market, the FII flows into
secondary market. While FIIs are short-term investments, the FDIs
are long term.
The Foreign Direct Investment is considered to be more stable than
Foreign Institutional Investor. FDI not only brings in capital but
also helps in good governance practises and better management
skills and even technology transfer. Though the Foreign
Institutional Investor helps in promoting good governance and
improving accounting, it does not come out with any other benefits
of the FDI.
FDI (Foreign Direct Investment) is when a foreign company invests in India directly by setting up
a wholly owned subsidiary or getting into a joint venture, and conducting their business in India.
IBM India is a wholly owned subsidiary of IBM, and is a good example of FDI where a foreign
company has set up a subsidiary in India and is conducting its business through that company.
Whats amazing about IBM is that, it is now the largest Indian IT company in India. It is serving
Indian customers, and a large domestic market that was not tapped by the Indian players
themselves.
Foreign companies partnering with Indian companies to set up joint ventures is more typical
andStarbucks partnering with Tata Global Beverages Limited is a recent example of FDI
through joint venture, but there are several others in the insurance, telecom, food industry etc.
FII is when foreign investors invest in the shares of a company that is listed in India, or in bonds
offered by an Indian company. So, if a foreign investor buys shares in Infosys then that qualifies
as FII Investment.
It is easy to see why you would prefer FDI to FII investments. FDI investments are more stable
because companies like IBM set up offices, hire employees, and have a long term plan for the
country. IBM cant just pull out a few million dollars from India overnight, which is what FII
investors do from time to time and that leads to market crashes.
In India, attracting FII has been easier than FDI because of the policy uncertainty and procedural
delays. An RBI study has the following par
Transaction exposure This arises from the effect that exchange rate
fluctuations have on a companys obligations to make or receive
payments denominated in foreign currency in future. This type of
exposure is short-term to medium-term in nature.
This is the risk of an exchange rate changing between the transaction date
and the subsequent settlement date, i.e. it is the gain or loss arising on
conversion.
This type of risk is primarily associated with imports and exports. If a company
exports goods on credit then it has a figure for debtors in its accounts. The
amount it will finally receive depends on the foreign exchange movement from
the transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of a company,
most companies choose to hedge against such exposure. Measuring and
monitoring transaction risk is normally an important component oftreasury risk
management.
Economic exposure[edit]
A firm has economic exposure (also known as forecast risk) to the degree that its market value is
influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely
affect the firm's market share position with regards to its competitors, the firm's future cash flows, and
ultimately the firm's value. Economic exposure can affect the present value of future cash flows. Any
transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but
economic exposure can be caused by other business activities and investments which may not be
mere international transactions, such as future cash flows from fixed assets. A shift in exchange rates
that influences the demand for a good in some country would also be an economic exposure for a firm
that sells that good.
Transaction exposure focuses on relatively short-term cash flows effects; economic exposure encompasses
these plus the longer-term affects of changes in exchange rates on the market value of a company. Basically this
means a change in the present value of the future after tax cash flows due to changes in exchange rates.
There are two ways in which a company is exposed to economic risk.
Directly: If your firm's home currency strengthens then foreign competitors are able to gain sales at your
expense because your products have become more expensive (or you have reduced your margins) in the eyes of
customers both abroad and at home.
Indirectly: Even if your home currency does not move vis-a -vis your customer's currency you may lose
competitive position. For example suppose a South African firm is selling into Hong Kong and its main competitor
is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong dollar the South African firm
has lost some competitive position.
Economic risk is difficult to quantify but a favoured strategy to manage it is to diversify internationally, in terms of
sales, location of production facilities, raw materials and financing. Such diversification is likely to significantly
reduce the impact of economic exposure relative to a purely domestic company, and provide much greater
flexibility to react to real exchange rate changes.
If an importer (payment) expects that the currency it is due to pay will depreciate, it may attempt to delay
payment. This may be achieved by agreement or by exceeding credit terms.
If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next three months it
may try to obtain payment immediately. This may be achieved by offering a discount for immediate payment.
The problem lies in guessing which way the exchange rate will move.
Matching
When a company has receipts and payments in the same foreign currency due at the same time, it can simply
match them against each other.
It is then only necessary to deal on the forex markets for the unmatched portion of the total transactions.
An extension of the matching idea is setting up a foreign currency bank account.
Bilateral and multilateral netting and matching tools are discussed in more detail here.
Decide to do nothing?
The company would "win some, lose some".
Theory suggests that, in the long run, gains and losses net off to leave a similar result to that if hedged.
In the short run, however, losses may be significant.
One additional advantage of this policy is the savings in transaction costs.
Forward Contracts
A forward contract is an agreement between two parties a buyer and a seller to
purchase or sell something at a later date at a price agreed upon today. Forward
contracts, sometimes called forward commitments , are very common in everyone
life. Any type of contractual agreement that calls for the future purchase of a good
or service at a price agreed upon today and without the right of cancellation is a
forward contract.
Future Contracts
A futures contract is an agreement between two parties a buyer and a seller to
buy or sell something at a future date. The contact trades on a futures exchange
and is subject to a daily settlement procedure. Future contracts evolved out of
forward contracts and possess many of the same characteristics. Unlike forward
contracts, futures contracts trade on organized exchanges, called future markets.
Future contacts also differ from forward contacts in that they are subject to a daily
settlement procedure. In the daily settlement, investors who incur losses pay them
every day to investors who make profits.
Options Contracts
Options are of two types calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or
before a given future date. Puts give the buyer the right, but not the obligation to
sell a given quantity of the underlying asset at a given price on or before a given
date.
Swaps
Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are interest rate swaps and
currency swaps.
1. Interest rate swaps: These involve swapping only the interest related cash flows
between the parties in the same currency.
2. Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those
in the opposite direction.
SEBI Guidelines:
SEBI has laid the eligibility conditions for Derivative Exchange/Segment and its
Clearing Corporation/House to ensure that Derivative Exchange/Segment and
Clearing Corporation/House provide a transparent trading environment, safety and
integrity and provide facilities for redressal of investor grievances. Some of the
important eligibility conditions are :
1. Derivative trading to take place through an on-line screen based Trading System.
2. The Derivatives Exchange/Segment shall have on-line surveillance capability to
monitor positions, prices, and volumes on a real time basis so as to deter market
manipulation.
3. The Derivatives Exchange/ Segment should have arrangements for dissemination of
information about trades, quantities and quotes on a real time basis through at least
two information vending networks, which are easily accessible to investors across
the country.
4. The Derivatives Exchange/Segment should have arbitration and investor grievances
redressal mechanism operative from all the four areas/regions of the country.
5. The Derivatives Exchange/Segment should have satisfactory system of monitoring
investor complaints and preventing irregularities in trading.
6. The Derivative Segment of the Exchange would have a separate Investor Protection
Fund.
7. The Clearing Corporation/House shall perform full novation, i.e., the Clearing
Corporation/House shall interpose itself between both legs of every trade, becoming
the legal counterparty to both or alternatively should provide an unconditional
guarantee for settlement of all trades.
8. The Clearing Corporation/House shall have the capacity to monitor the overall
position of Members across both derivatives market and the underlying securities
market for those Members who are participating in both.
9. The level of initial margin on Index Futures Contracts shall be related to the risk of
loss on the position. The concept of value-at-risk shall be used in calculating
required level of initial margins. The initial margins should be large enough to cover
the one-day loss that can be encountered on the position on 99 per cent of the days.
10. The Clearing Corporation/House shall establish facilities for electronic funds transfer
(EFT) for swift movement of margin payments.
11. In the event of a Member defaulting in meeting its liabilities, the Clearing
Corporation/House shall transfer client positions and assets to another solvent
Member or close-out all open positions.
12. The Clearing Corporation/House should have capabilities to segregate initial margins
deposited by Clearing Members for trades on their own account and on account of
his client. The Clearing Corporation/House shall hold the clients margin money in
trust for the client purposes only and should not allow its diversion for any other
purpose.
13. The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the
trades executed on Derivative Exchange/Segment.
SEBI has specified measures to enhance protection of the rights of
investors in the Derivative Market. These measures are as follows:
1. Investors money has to be kept separate at all levels and is permitted to be used
only against the liability of the Investor and is not available to the trading member
or clearing member or even any other investor.
2. The Trading Member is required to provide every investor with a risk disclosure
document which will disclose the risks associated with the derivatives trading so that
investors can take a conscious decision to trade in derivatives.
3. Investor would get the contract note duly time stamped for receipt of the order and
execution of the order. The order will be executed with the identity of the client and
without client ID order will not be accepted by the system. The investor could also
demand the trade confirmation slip with his ID in support of the contract note. This
will protect him from the risk of price favour, if any, extended by the Member.
4. In the derivative markets all money paid by the Investor towards margins on all
open positions is kept in trust with the Clearing House /Clearing Corporation and in
the event of default of the Trading or Clearing Member the amounts paid by the
client towards margins are segregated and not utilised towards the default of the
member. However, in the event of a default of a member, losses suffered by the
Investor, if any, on settled/closed out position are compensated from the Investor
Protection Fund, as per the
The SEBI, that is, the Securities and the Exchange Board of India, is the national regulatory body
for the securities market, set up under the securities and Exchange Board of India Act, 1992, to
protect the interest of investors in securities and to promote the development of, and to regulate
the securities market and for matters connected therewith and incidental too.
SEBI as the watchdog of the industry has an important and crucial role in the market in ensuring
that the market participants perform their duties in accordance with the regulatory norms. The
Stock Exchange as a responsible Self Regulatory Organization (SRO) functions to regulate the
market and its prices as per the prevalent regulations. SEBI play complimentary roles to enhance
the investor protection and the overall quality of the market.
MISSION OF SEBI
Securities & Exchange Board of India (SEBI) formed under the SEBI Act, 1992 with the prime
objective of :
Regulating, the securities market and for matters connected therewith or incidental thereto.
Focus being the greater investor protection, SEBI has become a vigilant watchdog
PREAMBLE
The Preamble of the Securities and Exchange Board of India describes the basic functions of the
Securities and Exchange Board of India as to protect the interests of investors in securities and
to promote the development of, and to regulate the securities market and for matters connected
therewith or incidental thereto.[1]
SEBI is regulator to control Indian capital market. Since its establishment in 1992, it is
doing hard work for protecting the interests of Indianinvestors. SEBI gets education from
past cheating with naive investors of India. Now, SEBI is more strict with those who
commit frauds in capital market.
The role of security exchange board of India (SEBI) in regulating Indian capital market is
very important because government of India can only open or take decision to open
new stock exchange in India after getting advice from SEBI.
If SEBI thinks that it will be against its rules and regulations, SEBI can ban on any stock
exchange to trade in shares and stocks.
Now, we explain role of SEBI in regulating Indian Capital Market more deeply with
following points:
1. Power to make rules for controlling stock exchange :
SEBI has power to make new rules for controlling stock exchange in India. For example,
SEBI fixed the time of trading 9 AM and 5 PM in stock market.
2. To provide license to dealers and brokers :
SEBI has power to provide license to dealers and brokers of capital market. If SEBI sees
that any financial product is of capital nature, then SEBI can also control to that product
and its dealers. One of main example is ULIPs case. SEBI said, " It is just like mutual
funds and all banks and financial and insurance companies who want to issue it, must
take permission from SEBI."
3. To Stop fraud in Capital Market :
SEBI has many powers for stopping fraud in capital market.
It can ban on the trading of those brokers who are involved in fraudulent and unfair
trade practices relating to stock market.
It can impose the penalties on capital market intermediaries if they involve in insider
trading.
4. To Control the Merge, Acquisition and Takeover the companies :
Many big companies in India want to create monopoly in capital market. So, these
companies buy all other companies or deal of merging. SEBI sees whether this merge or
acquisition is for development of business or to harm capital market.
Share trading transactions carry forward can not exceed 25% of broker's total
transactions.