Foreign Exchange Rate and Balance of Payments

Introduction
Foreign currency is any currency other than the domestic currency For India all currencies other than Indian Rupee (INR) are foreign currencies Exchange rate is the price of one currency in terms of another
US $ 1 = Rs 45 1 = Rs 105 1 = Rs 85

Foreign Exchange Market

Equivalent to any other commodity market Determinants of Exchange Rates
demand for currencies supply of currencies on the foreign exchange market

Demand for Foreign Currency

Importers Purchase of financial securities Sending remittances abroad Speculation
US $ flow out of India Oil Oil purchased from Dubai INDIA Purchase of financial assets abroad

Sending money to Sri Lanka

Supply for Foreign Currency

Exporters Foreign Investment Loans from abroad Speculation
Tea sold to Dubai hotel
$$

Foreign investment

US $ flow into India

INDIA Loans from foreign entities

Determination of Foreign Exchange Rate

Rs per $

S$

R1

D$ O Q1
Quantity of foreign currency (USD)

Shape of the Curves

Demand Curve
downward sloping inverse relationship between demand for foreign currency and exchange rate reflects the effective cost of goods and services available abroad upward sloping direct relationship between the supply for foreign currency and exchange rate reflects the effective cost of domestic exports in the overseas market

Supply Curve

Terminology used in Exchange Rate Movements

Rs per $

Depreciation of Rs E

S$

R1

The rise in demand creates a shortage in the $ market. Demand is greater than supply of $ the price (exchange rate) would rise

D Shortage
D$ O Q1 Q3 Q2
Quantity of foreign currency (USD)

Exchange Rates
Depreciation of the exchange rate: A fall in the value of Rs in relation to other currencies
each Rs buys less of the other currency e.g. $ 1 = Rs 45 $ 1 = Rs 50

Indian exports become relatively cheaper ( X) Imports to India become relatively more expensive ( M)

Terminology used in Exchange Rate Movements

Rs per $

Appreciation of Rs

S$ S

R1
R

E E

The rise in supply creates a surplus in the $ market. Demand is less than supply of $ the price (exchange rate) would fall

Surplus
D$ O Q1 Q3 Q2
Quantity of foreign currency (USD)

Exchange Rates
Appreciation of the exchange rate: A rise in the value of Rs in relation to other currencies
each Rs buys more of the other currency e.g. $ 1 = Rs 45 $ 1 = Rs 40

Indian exports become relatively more expensive ( X) Imports to India become relatively cheaper ( M)

Exchange Rates Regimes

Fixed Exchange Rate System
exchange rate determined by government no deviation from official rate permitted central bank plays a significant role in maintaining official rate Government could
revalue currency devalue currency

Advantages of fixed rate system:

certainty no speculation coordination of macroeconomic policies

Exchange Rate Mechanisms

Flexible Exchange Rate System
exchange rate determined by the market changes based on economic environment no role of central bank to maintain exchange rate market forces ensure
currency depreciation currency appreciation

Advantages of a flexible system:

no holding of foreign exchange reserves automatic correction of disequilibria in the balance of payments scenario resources are optimally utilised reduce barriers to trade and capital movement

Functions of Foreign Exchange Market

Transfer Function
Facilitates exchange of goods and services amongst nations Promotes international trade Facilitates domestic companies to borrow money in the international markets to import raw materials and machinery Allows discounting of international bills of exchange Provides instruments to avoid uncertainties in the foreign exchange market Forward market

Credit Function

Hedging Function

The Balance of Payments

A systematic record of all transactions between a country and the rest of the world Inflow of currency is shown as a credit Outflow of currency is shown as a debit

Structure of BOP Account

Balance of Payments Account

Current trade invisible unilateral transfers

Capital private official foreign investment

Other Items official reserves errors + omissions

Autonomous Entries

Accommodating Entries

Structure of BOP Account

Current Account
Balance of trade account
import and export of goods M > X = Surplus on trade account M < X = Deficit on trade account

Balance of invisible account

import and export of services M > X = Surplus on invisible account M < X = Deficit on invisible account

Unilateral Transfers
Payments made without any quid pro quo Private transfers scholarships Government transfers aid and grants

Structure of BOP Account

Capital Account
Private transactions
impact the assets and liabilities of individuals, business organisations e.g. sale and purchase of property

Official transactions
impact the assets and liabilities of government e.g. repayment of foreign loans by government

Foreign investment foreign direct investment

typically long term view of an economy exercise significant control in the management of investment termed as Strategic Investment typically short term view of an economy does not exercise significant control in the management of investment termed as Financial Investment

portfolio investment

Structure of BOP Account

Other items
Official reserve account
records the central banks transactions affecting BOP undertaken to balance the BOP account accommodating entry if BOP is in surplus, purchase of foreign assets shown as a negative entry in BOP account outflow of foreign currency from BOP account if BOP is in deficit, sale of foreign assets shown as a positive entry in BOP account inflow of foreign currency to BOP account

Errors and Omissions

arise due to statistical data collection under reporting for tax purpose

Disequilibria in BOP
Economic Factors
inflation developmental activities cyclical fluctuations access to new technology and new suppliers movements in oil prices

Political Factors
consistency in policies over time investor-friendly policies

Social Factors
tastes and preferences world-wide fashions