INTRODUCTION

The foreign exchange market (forex, FX, or currency market) is a worldwide

decentralized over-the-counter financial market for the trading of currencies.
Financial centers around the world function as anchors of trading between a
wide range of different types of buyers and sellers around the clock, with the
exception of weekends. The foreign exchange market determines the relative
values of different currencies.

The primary purpose of the foreign exchange market is to assist international

trade and investment, by allowing businesses to convert one currency to
another currency. For example, it permits a US business to import British
goods and pay Pound Sterling, even though the business's income is in US
dollars. It also supports speculation, and facilitates the carry trade, in which
investors borrow low-yielding currencies and lend (invest in) high-yielding
currencies, and which (it has been claimed) may lead to loss of
competitiveness in some countries.

In a typical foreign exchange transaction a party purchases a quantity of one

currency by paying a quantity of another currency. The modern foreign
exchange market started forming during the 1970s when countries gradually
switched to floating exchange rates from the previous exchange rate regime,
which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of its

• huge trading volume, leading to high liquidity

• geographical dispersion
• continuous operation: 24 hours a day except weekends, i.e. trading from
20:15 GMT on Sunday until 22:00 GMT Friday
• the variety of factors that affect exchange rates
• the low margins of relative profit compared with other markets of fixed
income
• the use of leverage to enhance profit margins with respect to account
size

As such, it has been referred to as the market closest to the ideal of perfect
competition, notwithstanding market manipulation by central banks.

According to the Bank for International Settlements, average daily turnover

in global foreign exchange markets is estimated at $3.98 trillion, as of April
2010 a growth of approximately 20% over the $3.21 trillion daily volume as of
April 2007.

The $3.21 trillion break-down is as follows:

• $1.005 trillion in spot transactions

• $362 billion in outright forwards
• $1.714 trillion in foreign exchange swaps
• $129 billion estimated gaps in reporting
Determinants of FX rates

The following theories explain the fluctuations in FX rates in a floating

exchange rate regime (In a fixed exchange rate regime, FX rates are decided
by its government):

(a) International parity conditions: Relative Purchasing Power Parity,

interest rate parity, Domestic Fisher effect, International Fisher effect.
Though to some extent the above theories provide logical explanation
for the fluctuations in exchange rates, yet these theories falter as they
are based on challengeable assumptions [e.g., free flow of goods, services
and capital] which seldom hold true in the real world.

(b) Balance of payments model: This model, however, focuses largely on

tradable goods and services, ignoring the increasing role of global
capital flows. It failed to provide any explanation for continuous
appreciation of dollar during 1980s and most part of 1990s in face of
soaring US current account deficit.

(c) Asset market model: views currencies as an important asset class for
constructing investment portfolios. Assets prices are influenced mostly
by people’s willingness to hold the existing quantities of assets, which in
turn depends on their expectations on the future worth of these assets.
The asset market model of exchange rate determination states that “the
exchange rate between two currencies represents the price that just
balances the relative supplies of, and demand for, assets denominated in
those currencies.”
None of the models developed so far succeed to explain FX rates levels and
volatility in the longer time frames. For shorter time frames (less than a few
days) algorithm can be devised to predict prices. Large and small institutions
and professional individual traders have made consistent profits from it. It is
understood from above models that many macroeconomic factors affect the
exchange rates and in the end currency prices are a result of dual forces of
demand and supply. The world's currency markets can be viewed as a huge
melting pot: in a large and ever-changing mix of current events, supply and
demand factors are constantly shifting, and the price of one currency in
relation to another shifts accordingly. No other market encompasses (and
distills) as much of what is going on in the world at any given time as foreign
exchange.

Supply and demand for any given currency, and thus its value, are not
influenced by any single element, but rather by several. These elements
generally fall into three categories: economic factors, political conditions and
market psychology.

Economic factors

These include: (a)economic policy, disseminated by government agencies and

central banks,

(b)economic conditions, generally revealed through economic reports, and

other economic indicators.

• Economic policy comprises government fiscal policy (budget/spending

practices) and monetary policy (the means by which a government's
 central bank influences the supply and "cost" of money, which is
reflected by the level of interest rates).
• Government budget deficits or surpluses: The market usually reacts
negatively to widening government budget deficits, and positively to
narrowing budget deficits. The impact is reflected in the value of a
country's currency.
• Balance of trade levels and trends: The trade flow between countries
illustrates the demand for goods and services, which in turn indicates
demand for a country's currency to conduct trade. Surpluses and
deficits in trade of goods and services reflect the competitiveness of a
nation's economy. For example, trade deficits may have a negative
impact on a nation's currency.
• Inflation levels and trends: Typically a currency will lose value if there
is a high level of inflation in the country or if inflation levels are
perceived to be rising. This is because inflation erodes purchasing
power, thus demand, for that particular currency. However, a currency
may sometimes strengthen when inflation rises because of expectations
that the central bank will raise short-term interest rates to combat
rising inflation.
• Economic growth and health: Reports such as GDP, employment levels,
retail sales, capacity utilization and others, detail the levels of a
country's economic growth and health. Generally, the more healthy and
robust a country's economy, the better its currency will perform, and
the more demand for it there will be.
• Productivity of an economy: Increasing productivity in an economy
should positively influence the value of its currency. Its effects are more
prominent if the increase is in the traded sector.
Political conditions

Internal, regional, and international political conditions and events can have a
profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations

about the new ruling party. Political upheaval and instability can have a
negative impact on a nation's economy. For example, destabilization of
coalition governments in Pakistan and Thailand can negatively affect the
value of their currencies. Similarly, in a country experiencing financial
difficulties, the rise of a political faction that is perceived to be fiscally
responsible can have the opposite effect. Also, events in one country in a
region may spur positive/negative interest in a neighboring country and, in
the process, affect its currency.

Market psychology

Market psychology and trader perceptions influence the foreign exchange

market in a variety of ways:

• Flights to quality: Unsettling international events can lead to a "flight to

quality," with investors seeking a "safe haven." There will be a greater
demand, thus a higher price, for currencies perceived as stronger over
their relatively weaker counterparts. The U.S. dollar, Swiss franc and
gold have been traditional safe havens during times of political or
economic uncertainty.
• Long-term trends: Currency markets often move in visible long-term
trends. Although currencies do not have an annual growing season like
physical commodities, business cycles do make themselves felt. Cycle
 analysis looks at longer-term price trends that may rise from economic
or political trends.
• "Buy the rumor, sell the fact": This market truism can apply to many
currency situations. It is the tendency for the price of a currency to
reflect the impact of a particular action before it occurs and, when the
anticipated event comes to pass, react in exactly the opposite direction.
This may also be referred to as a market being "oversold" or
"overbought". To buy the rumor or sell the fact can also be an example
of the cognitive bias known as anchoring, when investors focus too
much on the relevance of outside events to currency prices.
• Economic numbers: While economic numbers can certainly reflect
economic policy, some reports and numbers take on a talisman-like
effect: the number itself becomes important to market psychology and
may have an immediate impact on short-term market moves. "What to
watch" can change over time. In recent years, for example, money
supply, employment, trade balance figures and inflation numbers have
all taken turns in the spotlight.
• Technical trading considerations: As in other markets, the accumulated
price movements in a currency pair such as EUR/USD can form
apparent patterns that traders may attempt to use. Many traders study
price charts in order to identify such patterns.[17]

Algorithmic trading in foreign exchange

Electronic trading is growing in the FX market, and algorithmic trading is

becoming much more common. According to financial consultancy Celent
estimates, by 2008 up to 25% of all trades by volume will be executed using
algorithm, up from about 18% in 2005.
Financial instruments

Spot

A spot transaction is a two-day delivery transaction (except in the case of

trades between the US Dollar, Canadian Dollar, Turkish Lira and Russian
Ruble, which settle the next business day), as opposed to the futures contracts,
which are usually three months. This trade represents a “direct exchange”
between two currencies, has the shortest time frame, involves cash rather than
a contract; and interest is not included in the agreed-upon transaction.

Forward

One way to deal with the foreign exchange risk is to engage in a forward
transaction. In this transaction, money does not actually change hands until
some agreed upon future date. A buyer and seller agree on an exchange rate
for any date in the future, and the transaction occurs on that date, regardless
of what the market rates are then. The duration of the trade can be one day, a
few days, months or years. Usually the date is decided by both parties. and
forward contract is a negotiated and agreement between two parties

Future

Foreign currency futures are exchange traded forward transactions with

standard contract sizes and maturity dates — for example, $1000 for next
November at an agreed rate. Futures are standardized and are usually traded
on an exchange created for this purpose. The average contract length is
roughly 3 months. Futures contracts are usually inclusive of any interest
amounts.
Swap

The most common type of forward transaction is the currency swap. In a

swap, two parties exchange currencies for a certain length of time and agree
to reverse the transaction at a later date. These are not standardized contracts
and are not traded through an exchange.

Option

A foreign exchange option (commonly shortened to just FX option) is a

derivative where the owner has the right but not the obligation to exchange
money denominated in one currency into another currency at a pre-agreed
exchange rate on a specified date. The FX options market is the deepest,
largest and most liquid market for options of any kind in the world..

Speculation

Controversy about currency speculators and their effect on currency

devaluations and national economies recurs regularly. Nevertheless,
economists including Milton Friedman have argued that speculators
ultimately are a stabilizing influence on the market and perform the
important function of providing a market for hedgers and transferring risk
from those people who don't wish to bear it, to those who do. Other
economists such as Joseph Stiglitz consider this argument to be based more on
politics and a free market philosophy than on economics.

Large hedge funds and other well capitalized "position traders" are the main
professional speculators. According to some economists, individual traders
could act as "noise traders" and have a more destabilizing role than larger
and better informed actors.

Currency speculation is considered a highly suspect activity in many

countries. While investment in traditional financial instruments like bonds or
stocks often is considered to contribute positively to economic growth by
providing capital, currency speculation does not; according to this view, it is
simply gambling that often interferes with economic policy. For example, in
1992, currency speculation forced the Central Bank of Sweden to raise
interest rates for a few days to 500% per annum, and later to devalue the
krona. Former Malaysian Prime Minister Mahathir Mohamad is one well
known proponent of this view. He blamed the devaluation of the Malaysian
ringgit in 1997 on George Soros and other speculators.

Gregory J. Millman reports on an opposing view, comparing speculators to

"vigilantes" who simply help "enforce" international agreements and
anticipate the effects of basic economic "laws" in order to profit.

In this view, countries may develop unsustainable financial bubbles or

otherwise mishandle their national economies, and foreign exchange
speculators made the inevitable collapse happen sooner. A relatively quick
collapse might even be preferable to continued economic mishandling,
followed by an eventual, larger, collapse. Mahathir Mohamad and other
critics of speculation are viewed as trying to deflect the blame from
themselves for having caused the unsustainable economic conditions.
FUNCTIONS OF FOREIGN EXCHANGE MARKET

A foreign exchange market is a place in which foreign

exchange transactions take place. In other words it is a
market where foreign money are bought and sold. It is a
part of money market in the financial center

The foreign exchange market serves two functions: converting currencies and
reducing risk.

There are four major reasons firms need to convert currencies.

1. First, the payments firms receive from exports, foreign investments, foreign
profits, or licensing agreements may all be in a foreign currency. In order to
use these funds in its home country, an international firm has to convert funds
from foreign to domestic currencies.

2. Second, a firm may purchase supplies from firms in foreign countries, and
pay these suppliers in their domestic currency.

3. Third, a firm may want to invest in a different country from that in which it
currently holds underused funds.

4. Fourth, a firm may want to speculate on exchange rate movements, and

earn profits on the changes it expects. If it expects a foreign currency to
appreciate relative to its domestic currency, it will convert its domestic funds
into the foreign currency. Alternately stated, it expects its domestic currency
to depreciate relative to the foreign currency. An example similar to the one in
the book can help illustrate how money can be made on exchange rate
speculation. The management focus on George Soros shows how one fund has
benefited from currency speculation.

Exchange rates change on a daily basis. The price at any given time is called
the spot rate, and is the rate for currency exchanges at that particular time.
One can obtain the current exchange rates from a newspaper or online. The
fact that exchange rates can change on a daily basis depending upon the
relative supply and demand for different currencies increases the risks for
firms entering into contracts where they must be paid or pay in a foreign
currency at some time in the future.

Forward exchange rates allow a firm to lock in a future exchange rate for the
time when it needs to convert currencies. Forward exchange occurs when two
parties agree to exchange currency and execute a deal at some specific date in
the future. The book presents an example of a laptop computer purchase
where using the forward market helps assure the firm that will won't lose
money on what it feels is a good deal. It can be good to point out that from a
firm's perspective, while it can set prices and agree to pay certain costs, and
can reasonably plan to earn a profit; it has virtually no control over the
exchange rate. When spot exchange rate changes entirely wipe out the profits
on what appear to be profitable deals, the firm has no recourse.

When a currency is worth less with the forward rate than it is with the spot
rate, it is selling at forward discount. Likewise, when a currency is worth
more in the future than it is on the spot market, it is said to be selling at a
forward premium, and is hence expected to appreciate. These points can be
illustrated with several of the currencies. A currency swap is the simultaneous
purchase and sale of a given amount of currency at two different dates and
values.

EXCHANGE RATE DETERMINATION

The exchange rates (also known as the foreign-exchange

rate, forex rate or FX rate) between
two currencies specifies how much one currency is worth
in terms of the other. It is the value of a foreign nation’s
currency in terms of the home nation’s currency.[1] For
example an exchange rate of 91 Japanese yen(JPY, ¥) to
the United States dollar (USD, $) means that JPY 91 is
worth the same as USD 1. The foreign exchange market is
one of the largest markets in the world. By some
estimates, about 3.2 trillion USD worth of currency
changes hands every day.

The determination of exchange rate is one question that crops up in

everyone’s mind, whenever we read reports such as, Rs. appreciating, US
Dollar falling down, everywhere.
In a very simple language ,we can say that Demand and supply determines the
value of any currency against any other currency. Suppose the demand for
Rupee is higher owing to excess supply of dollar (i.e. more number of people
want to convert their dollar in to Rupee), value of dollar will naturally decline
against Rupee. This is the fundamental principle of Demand and Supply
driven Exchange rate.
Not every nation on the earth follows the system of Demand and supply for
determining the exchange rate. Some have pegged the value of their currency
against others (like china) and some follow the route of `Free float` and
intervention (by central bank) now and then whenever required (like India).
`Gold Standard`It was the earliest method used for determining the value of a
currency… Under the gold standard, currency issuers guarantee to redeem
notes, upon demand, in that amount of gold. Governments that employ such a
fixed unit of account, and which will redeem their notes to other governments
in gold, share a fixed-currency relationship.This system avoids frivolous
printing of currency and keeps the inflation under check. With expanding
trade beyond geographies and transactions taking place across nations, this
system of Gold standard was ill equipped to address the concerns and
complexities of the new changing and dynamic world order.
Bretton Woods SystemThis new order came in to exisistence in 1944.
Preparing to rebuild the international economic system as World War II was
still raging, 730 delegates from all 44 Allied nations gathered at the Mount
Washington Hotel in Bretton Woods,for the United Nations Monetary and
Financial Conference. The delegates deliberated upon and signed the Bretton
Woods Agreements during the first three weeks of July 1944.Here the
participating countries agreed to fix the value of their currencies with in the
fixed value (i.e. plus or minus some percentage in terms of gold) and it was
also agreed that IMF would help those nations in case of serious problems in
Balance of Payments.But this system also collapsed in 70s when US
unilaterally decided to move out of this system and refused to convert the
dollar into gold.
Demand and Supply This is the simple and most effective method to
determine the value of currency which is used almost everywhere worldwide.
(With some exceptions and modifications)This is also popularly called as free
float system, where the market forces are given a free hand to determine the
value of any currency based on Demand and supply for respective
currencies. Today in India we follow a middle path that is in-between free
hand to market forces and occasional intervention by central banker. Still we
have very long way to go so that our exchange rate is completely determined
by market forces. , For that various other regulatory issues including `Capital
account convertibility `have to be sorted out. Then what are the advantages or
disadvantages of opting for `no intervention policy by government` is another
topic for debate and we will discuss some time later…
Just to give you an example of how the Foreign exchange
rate can work and to help you better understands it we
can compare the United States dollar with the Japanese
yen. Let's say that on a certain day the US dollar is able to
buy one hundred and ten Japanese yens, this would
indicate that the exchange rate for that day is 1:110 or a
one to one hundred and ten ratio. This ratio in the
exchange rate is also known as pairing. When you take it
vice versa you can use it to indicate how many US dollars
a single unit of Japanese yen can buy. Another term that is
used in the Foreign exchange rate is 'cross rates'. This
term however is only used when it does not involve US
dollars; it is only used when relating two foreign
currencies.

FIXED EXCHANGE RATE

A fixed exchange rate, sometimes called a pegged exchange rate, is 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.

A fixed exchange rate is usually used to stabilize the value of a currency

against the currency it is pegged to. This makes trade and investments
between the two countries easier and more predictable, and is especially
useful for small economies where external trade forms a large part of their
GDP.

It can also be used as a means to control inflation. However, as the reference

value rises and falls, so does the currency pegged to it. There are no major
economic players that use a fixed exchange rate (except the countries using
the Euro). The currencies of the countries that now use the euro are still
existing (e.g. for old bonds). The rates of these currencies are fixed with
respect to the euro and to each other. The most recent such country to
discontinue their fixed exchange rate was the People's Republic of China,
which did so in July 2005

Typically, a government wanting to maintain a fixed exchange rate does so by

either buying or selling its own currency on the open market. This is one
reason governments maintain reserves of foreign currencies. If the exchange
rate drifts too far below the desired rate, the government buys its own
currency in the market using its reserves. This places greater demand on the
market and pushes up the price of the currency. If the exchange rate drifts too
far above the desired rate, the government sells its own currency, thus
increasing its foreign reserves.
Another, less used means of maintaining a fixed exchange rate is by simply
making it illegal to trade currency at any other rate. This is difficult to enforce
and often leads to a black market in foreign currency. Nonetheless, some
countries are highly successful at using this method due to government
monopolies over all money conversion. This was the method employed by the
Chinese government to maintain a currency peg or tightly banded float
against the US dollar. Throughout the 1990s, China was highly successful at
maintaining a currency peg using a government monopoly over all currency
conversion between the yuan and other currencies

The main criticism of a fixed exchange rate is that flexible exchange rates
serve to automatically adjust the balance of trade. When a trade deficit
occurs, there will be increased demand for the foreign (rather than domestic)
currency which will push up the price of the foreign currency in terms of the
domestic currency. That in turn makes the price of foreign goods less
attractive to the domestic market and thus pushes down the trade deficit.
Under fixed exchange rates, this automatic rebalancing does not occur.

Government also has to invest many resources in getting the foreign reserves
to pile up in order to defend the pegged exchange rate. Moreover a
government, when having a fixed rather than dynamic exchange rate, cannot
use monetary or fiscal policies with a free hand. For instance, by using
reflationary tools to set the economy rolling (by decreasing taxes and injecting
more money in the market), the government risks running into a trade deficit.
This might occur as the purchasing power of a common household increases
along with inflation, thus making imports relatively cheaper.

Additionally, the stubbornness of a government in defending a fixed exchange

rate when in a trade deficit will force it to use deflationary measures
(increased taxation and reduced availability of money) which can lead to
unemployment. Finally, other countries with a fixed exchange rate can also
retaliate in response to a certain country using the currency of theirs in
defending their exchange rate.

FLEXIBLE EXCHANGE RATE

Unlike the fixed rate, a floating exchange rate is

determined by the private market through supply and
demand. A floating rate is often termed "self-correcting",
as any differences in supply and demand will
automatically be corrected in the market. Take a look at
this simplified model: if demand for a currency is low, its
value will decrease, thus making imported goods more
expensive and stimulating demand for local goods and
services. This in turn will generate more jobs, causing an
auto-correction in the market. A floating exchange rate is
constantly changing.
In reality, no currency is wholly fixed or floating. In a fixed
regime, market pressures can also influence changes in
the exchange rate. Sometimes, when a local currency does
reflect its true value against its pegged currency, a "black
market", which is more reflective of actual supply and
demand, may develop. A central bank will often then be
forced to revalue or devalue the official rate so that the
rate is in line with the unofficial one, thereby halting the
activity of the black market.

In a floating regime, the central bank may also intervene

when it is necessary to ensure stability and to avoid
inflation; however, it is less often that the central bank of
a floating regime will interfere. The floating exchange rate
is a market-driven price for currency, whereby the
exchange rate is determined entirely by the free market
forces of demand and supply of currencies with no
government intervention whatsoever.

Broadly, the floating exchange rate regime consists of the

independent floating system and the managed floating
system. The former is where exchange rate is strictly
determined by the free movement of demand and supply.
For managed floating system, exchange rate is also
determined by free movement of demand and supply but
the monetary authorities intervene at certain times to
"manage" the exchange rate to prevent high volatilities.
The floating exchange rate boasts various merits. Firstly,
there is automatic correction in the floating exchange rate
as the country simply lets it move freely to the equilibrium
of demand and supply. Secondly, there is insulation from
external economic events as the country's currency is not
tied to a possibly high world inflation rate as is under a
fixed exchange rate. The free movement of demand and
supply helps to insulate the domestic economy from world
economic fluctuations. Thirdly, governments are free to
choose their domestic policy as a floating exchange rate
would allow for automatic correction of any balance
of payment disequilibrium that might arise from the
implementation of domestic policy.

Nonetheless, there are also specific concerns about the

exchange rate being unstable and uncertain under the
floating exchange rate regime. Also, speculation tends to
be higher in the floating exchange rate regime, hence
leading to more uncertainty especially
for traders and investors.

FIXED OR FLEXIBLE
No one system has operated flawlessly in all circumstances. Hence, the best we
can do is the highlight the pros and cons of each system and recommend that
countries adopt that system that best suits its circumstances.
Probably the best reason to adopt a fixed exchange rate system is to commit to
a loss in monetary autonomy. This is necessary whenever a central bank has
been independently unable to maintain prudent monetary policy leading to a
reasonably low inflation rate. In other words, when inflation cannot be
controlled, adopting a fixed exchange rate system will tie the hands of the
central bank and help force a reduction in inflation. Of course, in order for
this to work, the country must credibly commit to that fixed rate and avoid
pressures that lead to devaluations. Several methods to increase the credibility
include the use of currency boards and complete adoption of the other
country's currency (i.e., dollarization or euroization). For many countries, for
at least a period of time, fixed exchange rates have helped enormously to
reduce inflationary pressures.
Nonetheless, even when countries commit with credible systems in place,
pressures on the system sometimes can lead to collapse. Argentina, for
example, dismantled its currency board after 10 years of operation and
reverted to floating rates. In Europe, economic pressures recently have
resulted in "talk" about giving up the Euro and returning to national
currencies. The Bretton-Woods system lasted for almost 30 years, but
eventually collapsed. Thus, it has been difficult to maintain a credible fixed
exchange rate system for a long period of time.
Floating exchange rate systems have had a similar colored past. Usually,
floating rates are adopted when a fixed system collapse. At the time of a
collapse, no one really knows what the market equilibrium exchange rate
should be and it makes some sense to let market forces (i.e., supply and
demand) determine the equilibrium rate. One of the key advantages of
floating rates is the autonomy over monetary policy that it affords a country's
central bank. When used wisely, monetary policy discretion can provide a
useful mechanism for guiding a national economy. A central bank can inject
money into the system when the economic growth slows or falls, or it can
reduce money when excessively rapid growth leads to inflationary tendencies.
Since monetary policy acts much more rapidly than fiscal policy, it is a much
quicker policy lever to use to help control the economy.

DISEQUILIBRIUM

Types and causes of disequilibrium in the balance of payments

In general terms, a deficit in the balance of payments is called
disequilibrium. Such a deficit may be at the capital account, current account ;
occasional, chronic ; cyclical, enlarging deficits. Each type is caused by
different set of factors. But in general, disequilibrium is an unfavourable
position in BoP caused by continuous deficits which are large.

Types of disequilibrium in BoP :

Following are the different types of disequilibrium in BoP :

1. Cyclical disequilibrium : This is caused by the trade cycles. The

economic activity changes in cyclical fashion with boom depression. In
each state, the disequilibrium is caused depending on the spurt of incomes,
intensity of demand for imports, domestic prices and nature of exports and
imports.
The impact of cyclical disequilibrium is found in developed economies
as compared with less developed economies.

2. Secular equilibrium : Secular disequilibrium depends on the level of

growth in an economy.An economy can be a primitive economy, or an
economy under preparatory stage for development or an economy in the
take-off stage or an economy with high mass consumption. Secular
disequilibriumis characterised by the level of population, capital
accumulation, technology and resources.

3. Structural disequilibrium : This is caused mainly due to the nature and

composition of exports and imports. The elasticities of exports and imports
determine the efficiency of any methods of correcting the trade. For
example , stagnant exports and elastic imports cause BoP problems.
Correction of such disequilibrium will need structural changes in the
composition of trade and foreign exchange position.

Causes of disequilibrium in developing countries :

BoP disequilibrium is common with most developing economies. Study of the
factors and nature of disequilibrium will help in correction and design of
methods of protection.
Following are the important causes of disequilibrium :
• Large population, increasing growth rates of population.
• Stagnant exports due to out dated products
• Increasing demand for imports.
• Low productivity and poor growth rates.
• Lack of bargaining power.
• Large external debt due to which the burden of debt servicing increases.
• Adverse terms of trade.
• Cyclical fluctuations in economic activity.
• Problems of international liquidity.
• Absence of ant trading association or regional block
• Weak currency
• Absence of trade ties with developed economies.

In addition all the problems of under development contribute to

disequilibrium in BoP. Since there is no effective mechanism to correct, the
disequilibrium becomes chronic.

Methods of correcting balance of payments disequilibrium

There are several methods to correct balance of payment disequilibrium. The
methods depend on the nature and causes of disequilibrium.
The methods can be classified into two groups : viz. monetary and non
monetary methods.
I) Monetary methods :
Monetary methods of correction affect the balance payments by changing the
value or flow of currencies ; both domestic and foreign. Indirectly, it affects
the volume and value of exports and imports.
With flexible exchange rate it is possible to affect the value and volume of
exports and imports.
Following are the various monetary methods of BoP correction :

1. Devaluation : Devaluation means decreasing the value of domestic

currency with respect to a foreign exchange. Devaluation is done by the
Government of the country of origin. Devaluation id done deliberately to
get its advantages.

Export prices Volume of exports

Value of money BoP improve

Import prices Volume of imports

 The Government officially declare the devaluation, indicating the extent
of decrease in the value of its currency. The Government can decide the time
and the amount of decrease.
Devaluation can determine a specific currency with which it is
devalued. In such case the trade with the target country improves. The
devaluation is irreversible. The country can not change the value of currency
frequently. With a decrease in the value of its currency, the country has to pay
more in exchange to a foreign currency In case of exports the price show a
decline to the extent of decrease. The exports become cheaper.
At the same time the imports become expensive because more domestic
currency is payable. With this the exports increase and the imports decrease.
This way the balance of payments position improves. The country gets better
terms of trade.
Devaluation is opted during such times when:
a. The imports are increasing rapidly,
b. The exports are stagnant,
c. The domestic currency has low demand
d. The foreign currency is in high demand
The efficiency of devaluation , however depends on

MARSHALL-LERNER CONDITION.

According to the Marshall-Lerner condition. Devaluation helps only incase

the elasticities of demand of exports and imports is equal to 1
ex + em =1
It is advisable to devalue currency only when the sum of the elasticities of exports
and imports in equal to one.
Incase the exports and imports are inelastic, the devaluation will help the
country. Generally, the developing countries have inelastic exports and
imports. Devaluation in such countries is not always useful.

In case of inelastic exports , the decrease in price can not get proportionate
increase in the volume. So, there is a decrease in the revenue due to
devaluation When the exports are elastic. The increase in the volume of
exports will be greater than the decrease in the price. The revenue from trade
will increase after devaluation.
Similar case can be proved with imports where, outgoing are larger with
inelastic imports.
The Marshall-Lerner condition stipulates the limitations of applicability of
devaluation. Further, devaluation can also bring in large scale retaliation
from other countries. Which again affect the BoP position the devaluating
country.
There are some other methods which are similar to devaluation but the
nature is different.

2. Depreciation : Depreciation is similar to devaluation but it is done by the

exchange market. The exchange market is made up of demand and supply of
currency. Depending on the demand and supply, the value of currency can be
appreciated or depreciated, Depreciation is similar to devaluation. It involves
a decrease in value.
Depreciation is done by the market, the Government has no control over the
value. Further, the value changes are small and reversible depending on the
demand and supply conditions.

3. Pegging operations: Pegging down the value of currency is done by the

Government. The Central bank depending on the need may artificially,
increase or decrease the value of currency, temporarily.
Pegging operations can be done any number of times. Since it is done by the
Government, it may be beneficial. It is reversible, it offers the Government the
flexibility to manage the value of the currency for its advantage.

4. Deflation: With flexible exchange rate mechanism, the domestic value of

currency affects the international value of currency. The domestic value of
currency can be improves by any of the anti-inflationary methods. By
reducing the domestic money stock, the value of money can be improved. It
improves the foreign exchange rate aswell.

5. Exchange controls : Deliberate management of exchange markets, value,

and volumes of currencies form the exchange controls. There are several
methods of exchange controls which can affect the value and flows of
currencies for improving the BoP position.
Exchange controls include methods like, pegging operations, multiple
exchange rates, mutual clearing agreements etc.
It can be seen that, monetary methods of correcting BoP disequilibrium aim
at solving the crisis on capital account and directly managing flow of foreign
exchange. Indirectly, the value of currency can bring equilibrium on current
account as well by changing volume of exports and imports.

II) Non-monetary methods :

Non-monetary methods deal with real sector for correcting BoP
disequilibrium. All the non-monetary methods directly affect exports and
imports. Following are the important non-monetary methods :

1. Export Promotion : The country with deficits can take up export

promotion measures like providing fiscal incentives, financial aid,
Infrastructural facilities, marketing support and support of imported
inputs. The Government offers a package of tax incentives which will
reduce the costs and make exports competitive in the world market.

2. Import Substitution : The economy can progressively develop technology

of import substitution. A country produces those goods which were earlier
imported. It may require import of capital goods, technology or
collaborations.
3. Import Licensing : The Government can have stringent controls over the
usage of imports. This can be done by licensing the users based on
centralised imports.
4. Quota : Import quotas are important non-tariff barriers. They are
positive restrictions on incoming goods.
5. Tariffs : Tariff is a tax duty levied on imports. The objective is to make
imports expensive, which will in turn produce domestic demand and make
home industry competitive.

Every country has to use a combination of monetary and non-monetary

methods to effectively correct balance of payment disequilibrium and also
prevent retaliation from any developed country.
INTERNATIONAL
BUSINESS
ASSIGNMENT
SUBMITTED BY:-

ABHISHEK KHETAN
08D160
3
V BBA B
RESEARCH
ARTICLE