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International Finance – I March 27, 2010

Posted by Chetan Chitre in International Business Management, International Finance.
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Exchange Rates and BoP

In order to arrive at a fair exchange rate between two currencies, it was earlier thought that it is essential to know the intrinsic value of each of the currencies. However, fixing intrinsic value of currency is a complicated issue.

Gold Standard –

For a long time policy makers all over the world developed a practice of benchmarking the value of their currency against a certain quantity of gold. Every currency note or coin issued could be exchanged for gold from the monetary authority. Currency notes or coins could not be printed unless there is appropriate amount of gold back-up in the government treasury. This put a severe limitation of exercise of monetary policy.

Most countries in the world were on some form of Gold standard between the period 1500 to 1930. In the later part of this period increasingly countries found it difficult to adhere to a fixed gold exchange commitment. Devaluations were more frequently done and were looked upon as a sign of weakness. However, countries strived to adhere to the gold standard to whatever extent they could.

The great depression however, sounded a death knell on the gold standard. During times of depression most countries were looking for additional monetary resources to boost economic activity and generate employment. However, commitment to gold standard meant that governments could not freely create additional money supply, unless they acquired additional gold.

From international exchange rate regime perspective, however, this was a simple an easy mechanism as gold was internationally accepted metal. As all currency had their gold values openly stated, it was easy to convert one currency in another based on the common factor i.e. gold value.

Bretton Woods System –

At the Bretton Woods Conference (1944) countries finally decided to do away with the gold standard. During this period the European currencies were gradually losing their economic dominance and the USD was taking their place as the dominant currency.

Destruction on account of the WW-II was also severe in Europe and post war reconstruction meant need for additional monetary resources.

It was therefore decided that the USD would peg its value to gold and all other currencies of the world would fix their values in terms of the USD. The world thus moved to a dollar defined Fixed Exchange Rate Regime. The value of USD was in 1944 fixed at 1 USD = 0.81 gms. (35 USD = 1 oz.) of gold.

Even in this system, countries often found it difficult to constantly maintain a fixed value of their currency in terms of USD and had to constantly resort to devaluation. USD itself was devalued a few times when its value in terms of gold was reduced.

Finally in late 1960s the US government faced with increasing expenditures on account of the Vietnam War, rising oil prices, etc. decided to give-up the currency’s peg to gold.

Floating Exchange Rate System –

Finally in 1973, countries once again decided to revise the system of international exchange rates. The USD’s peg to gold was removed and the USD was declared floating. The we now have a system where –

# The value of a country’s currency is completely delinked from the amount of gold reserves with a country.

# All major currencies of the world are now declared as floating – which means that their value against other currencies is decided on the basis of demand and supply for the respective currencies at the given point of time.

# Quite often what is seen in the real world is not a free float but a ‘managed float’ where the central banks allows to fluctuate a currency between a wide band. However, in case the central bank feels that the currency markets are getting volatile beyond a certain limit, it may choose to step in and defend a particular value of a currency.

Fixed or Pegged Exchange Rate –

Some currencies however continue to fix their value against the dollar or some other major currency or group of currency – as was done in India until 1991. This is called a Fixed Exchange Rate System and in some ways is a continuation of the pre-1973 mechanism. For example – The RBI (prior to 1991) declared a fixed Rupee – USD exchange rate. The rate remained constant for a long period regardless of shifting economic fundamentals. The exchange rate is often allowed to move between a narrow pre-defined band (say + or – 1%)

Dollarization –

Some countries have a very small domestic economy. Further because of their geographical proximity to the US, the economy is largely dependent on the US. Such countries do not bother to print their own currencies and accept the USD as a domestic currency. Or the USD is accepted parallel to or instead of domestic currency. This system is known as Dollarization. The system not only refers to USD but to any other foreign currency accepted as domestic currency.

Balance of Payment –

A Balance of Payment statement is a record of a country’s transaction with other countries of the world. A typical Balance of Payment statement has the following entries –

A Current Account Inflow Outflow Net
I Merchandise (goods) Exports (X) Imports (M) (X-M)*
*(X-M) is referred to as Balance of Trade
II Invisibles
(i) Services
(1)    Travel
(2)    Transportation
(3)    Insurance
(4)    Miscellaneous
(ii) Transfers
(1)    Official
(2)    Private
(iii) Income
(1)    Investment Income
(2)    Compensation to Employees
Total Current Account Balance (I + II)
B Capital Account Inflow Outflow Net
I Foreign Investment
(i) Direct
(ii) Portfolio
II Loans
(i) External Assistance (govt. sector)
(ii) Commercial Borrowings (only Medium and Long Term)
III Banking Capital
(i) Assets
(ii) Liabilities
(iii) Non- resident Deposits
IV Rupee Debt Service
V Miscellaneous
Capital Account Balance (I + II + III + IV + V)
C Balance of Payments (A + B)
Official Reserve Transactions (Compensatory Official Financing) Below the line balancing entries

BoP Surplus / Deficit – Strictly speaking as the BoP is arrived at using a double entry system, there should not the account should invariably balance i.e. there should be no surplus or deficit.

However, a distinction is made on the basis of requirement of policy intervention. All transactions above row ‘C’ in the above table are referred to as autonomous transactions i.e. transactions which occur for their own sake and are independent of other events in the BoP table. The Balance of such autonomous transactions (A + B) is normally referred to as a BoP surplus or Deficit.

All transactions below row ‘C’ are referred to as compensatory or balancing transactions i.e they are undertaken deliberately by governments with a view to balance the BoP account.

Thus if the BoP at row C shows a deficit, the government may finance the same by way of a drawing down from the Official Foreign Exchange Reserve and equal amount to balance the BoP. These are also normally referred to as ‘below the line’ entries.

BoP in Fixed and Floating Exchange Rate Systems –

In a Fixed exchange rate system the Government is committed to maintain a fixed exchange rate. In case of a BoP deficit, the demand for foreign currency is more than its supply. This may result in an upward pressure on the price of foreign currency thereby causing a change in the Exchange Rate. At such times the Government would resort to Official Reserve Transactions where it will draw down the Official Reserve account to fill in the gap in demand and supply of the foreign currency thereby ‘defending’ the exchange rate. This may also happen in case of a managed float.

However, in case of a freely floating currency mechanism, the government allows the price of the currency to fluctuate freely as per the demand and supply conditions (i.e. BoP Deficit or Surplus)

Mundell – Flemming Model –

The Mundell – Flemming (MF) model brings out the effect of exchange rates on domestic monetary policy. In simple words the MF model can be stated as follows –

“In a fixed exchange rate regime, the country cannot conduct an independent monetary policy.”

This can be explained as follows –

If the Central Bank is committed to a fixed exchange rate -> A BoP Surplus would mean large inflow of foreign currency -> This would result in over-supply of foreign currency and thereby change the exchange rates -> The Central Bank therefore has to purchase the excess foreign currency in order to keep the exchange rate constant -> This leads to increase in money supply

The Central Bank thus loses its freedom to decide the level of Money Supply as it would now depend on the BoP Deficit or Surplus.

Corrective Mechanism –

The BoP is said to be in disequilibrium if it either has a sustained deficit or surplus. This calls for corrective measures. Corrective measures can be classified as –

(i) Automatic Adjustment Mechanisms and

(ii) Deliberate Adjustment Mechanisms

(i) Automatic Mechanisms – Here certain variables automatically adjust their values as a result of free market forces, thereby bringing about equilibrium in the BoP. These variables are –

(a) Exchange Rate – A BoP Deficit means demand for forex is greater than supply. This will result in an increase in price of foreign currency. If foreign currency becomes expensive, imports will become costlier thereby reducing the BoP Deficit

(b) Inflation – A BoP surplus would mean an excess inflow of foreign currency. This would result in an increase in domestic money supply as explained in the MF model. Increase in domestic money supply would lead to inflation making exports non-competitive. Thus as exports reduce the BoP surplus will get corrected.

(c) Rate of Interest – A BoP Surplus would mean and increase in Money Supply. This would result in a fall in the rate of interest. A fall in interest rates makes the country unattractive as an investment destination to foreign capital. This would result in large capital outflows, thus reversing the BoP Surplus.

(d) Rise in Incomes – A BoP Surplus results in extra money coming in the economy. This leads to a rise in incomes. Rise in incomes leads to a rise in propensity to import. This increases the imports and corrects the BoP Surplus.

(ii) Deliberate Mechanisms – Where market forces fail or are not allowed to operate in adjustment of variables such as prices, exchange rates, interest rates, etc., the adjustment has to be done by way of conscious policy action on the part of the government.

Examples of such policy interventions include –

(a) Monetary policy – An expansionary in situations of low capital inflows or contractionary monetary policy in situations of excess inflows

(b) Exchange Controls – Restrictions on inflow and outflow of forex, foreign currency loans, etc.

(c) Devaluation – Change in currency values by official order so as to bring it in line with equilibrium level values

(d) Export Promotion measures to correct BoT deficits

(e) Use of Tariff and non-tariff barriers



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