UNIT 2

FOREIGN EXCHANGE AND BALANCE OF PAYMENTS

Foreign Exchange Market
Meaning & Definition of Foreign exchange

Foreign exchange is the exchange of one currency for another or the conversion of one currency
into another currency. It is a process of settling accounts or debts between persons residing in
different countries. Foreign currency or current short-term credit instruments payable in such
currency.

Importance of foreign exchange

(i) Foreign exchange situation of a country indicates the strength of the economy. If it possesses
large reserves of foreign exchange, it is an indication of developed economy whereas tight
foreign exchange position indicates an underdeveloped economy. Thus, foreign exchange
position is indicative of the stage of development.

(ii) Shortage of foreign exchange refers to the position of adverse balance of payments and Its
surplus a position of favorable balance of payments. In case of adverse balance of payments
situation, the central bank or the government must try to balance the situation by increasing its
exports and restricting the outflow of foreign currency.

(iii) Foreign exchange simplifies the complexities arising out of the vast participation of nations
in the international trade. Payments are easily made on the mutually accepted and predetermined
rates. Thus, it makes the international trade easy.

(iv) The foreign exchange ‘ratio shows a direct relationship between the prices of the
commodities in the national and international markets.

 (v) Foreign exchange position shows a comparative soundness of two nations. A hard-currency
nation is certainly a sound nation for the other country for which the currency of that nation is
not easily available. For example, for India, American Dollar and British Pound-sterling are hard
currencies. It means, the economies of America and Britain are certainly richer.

 (vi) The stability in exchange rates, is of high importance without which various other problems
may crop up. Instability in exchange rate may lead a country to devaluation or revaluation.
Meaning of foreign exchange market
Foreign exchange market is the market where the currency of one country is exchanged for the
currency of another country. In other words it is a market where currencies are bought and sold
just like equity shares are bought and sold in equity markets.

Characteristics of foreign exchange market

Given below are some of the main features of foreign exchange market –

1. Foreign exchange market is the only market which is open 24 hours a day, except for
weekends unlike equity or commodities market which are open only for few hours.

2. Volume of transactions which are executed in foreign exchange market is extremely huge
because of many big players in foreign exchange market. Foreign exchange markets are more
liquid than any other market because of this reason.

3. Foreign Exchange Market are present in every country and therefore geographically they are
located everywhere in the world, which makes them quite unique.

4. Foreign exchange markets are the most difficult market to trade in as the exchange rates of
countries are affected by so many factors like interest rates, liquidity, geo political factor and so
on.

5. Foreign exchange market is a big player market, because mostly it is the big banks and
government who are the players in foreign exchange market.

Functions of foreign exchange market

Foreign exchange market performs the following three functions:

1. Transfer Function:

It transfers purchasing power between the countries involved in the transaction. This function is
performed through credit instruments like bills of foreign exchange, bank drafts and telephonic
transfers.
2. Credit Function:

It provides credit for foreign trade. Bills of exchange, with maturity period of three months, are
generally used for international payments. Credit is required for this period in order to enable the
importer to take possession of goods, sell them and obtain money to pay off the bill.

3. Hedging Function:

When exporters and importers enter into an agreement to sell and buy goods on some future date
at the current prices and exchange rate, it is called hedging. The purpose of hedging is to avoid
losses that might be caused due to exchange rate variations in the future.
Kinds of Foreign Exchange Markets:

Foreign exchange markets are classified on the basis of whether the foreign exchange
transactions are spot or forward accordingly, there are two kinds of foreign exchange markets:

(i) Spot Market,

(ii) Forward Market.

(i) Spot Market:

Spot market refers to the market in which the receipts and payments are made immediately.
Generally, a time of two business days is permitted to settle the transaction. Spot market is of
daily nature and deals only in spot transactions of foreign exchange (not in future transactions).
The rate of exchange, which prevails in the spot market, is termed as spot exchange rate or
current rate of exchange.

The term ‘spot transaction’ is a bit misleading. In fact, spot transaction should mean a
transaction, which is carried out ‘on the spot’ (i.e., immediately). However, a two day margin is
allowed as it takes two days for payments made through cheques to be cleared.

(ii) Forward Market:

Forward market refers to the market in which sale and purchase of foreign currency is settled on
a specified future date at a rate agreed upon today. The exchange rate quoted in forward
transactions is known as the forward exchange rate. Generally, most of the international
transactions are signed on one date and completed on a later date. Forward exchange rate
becomes useful for both the parties involved in the transaction.
Factors affecting foreign exchange market

Like most commodities, demand and supply forces in the market influence currency prices.
These forces, in turn, are influenced by many factors which increase demand at times and supply
at others, causing the currency values to fluctuate.

There are several factors which influence forex prices in this way. Anything that affects the flow
of money in a country or between countries may impact currency values. Here are some of the
key factors that affect the value of a currency:

Economy

The state of a country’s economy determines its currency value. A growing economy is generally
the foundation for a stable currency that is valued highly in comparison with others. Any factors
which impact the growth of the economy, either positively or negatively also affect currency
prices. For example, during inflation, currency values typically fall. Inflation reduces the
purchasing power of money so that less can be bought for each unit of money.

There are many economic indicators that need to be considered before making a forex trade
decision. These indictors represent various aspects of the economy. As the general economic
condition influences the currency value, these indicators are very useful in determining how the
currency prices will fare given the current economic conditions.

 GDP – The Gross Domestic product of a country measures the industrial growth and
production. This figure is a good indicator of how active the economy is. A steady GDP
is the indication of a healthy, growing economy. Currency values are likely to rise when
such circumstances prevail.
 Purchasing Power Parity – PPP measures the comparative power of a currency to
purchase goods and services in a country. Consider two countries, A and B. 100 units of
currency of A are equal to 1 unit of currency of B as per prevailing exchange rates in the
market. PPP aims to measure the purchasing power of A’s currency with respect to B’s
currency.

What can be bought for 100 units of local currency in country A should be available for 1
unit of local currency in country B. Then the countries are at par as far as purchasing
power is concerned. If the countries are not evenly matched with respect to PPP and one
currency has greater purchasing power than the other then it has a higher value in the
forex market.

 Interest Rate Parity – The interest rates prevalent in both countries must also be
comparable so that investments yield similar returns. The ability of a country’s currency
to multiply in this way ultimately determines its own value. This is why interest rate
parity is also an important factor in determining currency prices.
 Employment Levels – Employment levels determine the productivity of a nation. This is
an indicator of future growth in the economy. A high level of employment means that
most of the country’s population is engaged in contributing to economic growth. A good
 employment rate is a sign of a healthy economy and forms the basis for more
investments.

This, in turn, increases the currency value. A low employment rate shows that fewer
people are contributing to the economy. Production of goods and services is being carried
out by a smaller proportion of the population, although consumption is at the same level.
Currency value will be subdued when employment levels are low.

 Consumer Spending – The amount of money which the people of a country are
spending gives an idea of what they think about the economy. If spending is low and
saving is high, then it shows that people fear an economic downturn. This indicates that
the currency value may fall in future.

Increased consumer spending shows that people are confident of their future earnings and
investment yields. Consumer spending is also an indicator of the purchasing power of the
average citizen and the standard of living. A prosperous economy is one where consumer
spending is at a sustainable level. Such an economy is likely to have a stable currency
with a high value.

Government Policies

The government constantly assesses the economy and takes actions. Government policies are
created and implemented to encourage prevailing economic conditions during a positive trend
and to correct the imbalance if the economy is not doing well.

Most economic policies fall under two categories – fiscal policies and monetary policies. Fiscal
policies are those which outline the spending of the government. The annual budget is a part of
the fiscal policy. It determines the areas where the government will be spending money.
Government spending boosts the prospects of industries and segments of the economy.

Monetary policies are those which influence the various components of the country’s financial
fabric to improve or sustain the economy. The central bank of a country implements the
government’s policies by using various investment strategies in the markets.

Given the huge amount of funds the central bank can control, any action by the bank has a huge
impact on the market. An inflationary trend can be curbed, falling prices can be shored and many
other economic imbalances can be set right by central banks though their market activities.

Both monetary and fiscal policies affect currency prices, though the impact of monetary policies
is almost immediate.

Natural Factors

A natural disaster like floods, famine or drought in a country will have a negative impact on its
currency value. The flow of money within the county’s boundaries is restricted severely under
adverse circumstances like these.
The general public is more cautious in spending and there is likely to be a dramatic reduction in
the overall amount of funds which are being used for investments. High risk investments like
forex do not find many takers during these times. Government spending is also reduced because
of huge expenditure in relief measures. Any excess funds are diverted toward rehabilitation
programs because the government’s focus is on getting the country back on its feet.

International Trade

Countries trade with each other to buy and sell products and services. As with any transaction,
this too requires an exchange of money. In fact, the level of international trade is a good
indicator of demand for a country’s currency. When countries with different currencies trade, the
deal influences the value of currencies for both of them.

Such international trade is a permanent feature of any economy with goods and services being
bought and sold from many different countries at any given point in time. When imports are
higher than exports, the economy is said to have a trade deficit and when exports are higher than
imports, there is a trade surplus. Governments publish the balance of trade figures showing this
status every month.

A government has to pay for its purchases or imports and it receives money for its exports. In a
trade deficit situation, it will be spending more of the domestic currency to buy foreign currency
to fund the purchases. In this case, the domestic currency will fall in value in comparison with
the foreign one. When exports exceed imports, there is a trade surplus which also translates into
a higher domestic currency value. The status of this equation is given by the capital flow of a
country.

Both capital flow and balance of trade are combined into the balance of payments statistics,
which are released by the government. Three components make up the balance of payments of a
country:

 Current account – Measures the goods bought and sold in international trade.
 Capital account – Measures the acquisition of disposal of assets that are non-financial in
nature.
 Financial account – Measures the cross-border flow of money.

The balance of payments statistics play an important role in determining currency value of any
country. This is one of the most important factors that a forex trader must consider when he
makes investment decisions, especially long term ones.

Market Sentiment

Market sentiments play an important role in determining currency values. These directly
influence demand and supply within the market. During times of global economic unrest, values
will increase for stronger currencies which are linked to countries viewed as stable.
A country whose inflation levels are high will be viewed as a poor prospect for forex trading
because future economic growth is likely to be hampered by high prices. Investors’ perception of
an economy and interpretation of various economic indicators determine the overall market
sentiment for a currency.

Political Factors

Politics often determines the direction which an economy will take. Political unrest brings a lot
of uncertainty about the future and subdues both economic growth and currency value. An
upcoming election or war may give rise to a cautious investment approach, reducing the capital
flow into a country.

A change in leadership also often subdues the price movement of a currency in the forex market.
Until the new leadership’s political views, monetary and fiscal policies and views on
international trade become clear, the markets do not show a clear trend in the currency’s value.

A country that is considered politically unstable will not be a favored trading partner. This will
affect its forex trade and the value of its currency in this market. On the other hand, a progressive
political leader and a stable leadership pave the way for increased investments as investor
confidence becomes strong.

Forex market and its intermediaries

There are many players in the forex market with different goals and needs. The high liquidity,
flexibility and versatile nature of the market makes this an ideal playing ground for many kinds
of investors. Let’s have a brief look at the participants in this market:

Businesses

Business are regular players in the forex market. This market makes it easy for them to buy and
sell from counterparts in other countries. Any buy or sell transaction involves exchange of
money for some products and when the two parties come from different countries, the difference
in currencies can create a huge obstacle to trade.

By letting businesses convert their currency into that of the selling firm’s country, the forex
market facilitates trade. The liquid nature of the market and the huge volume ensures that no
matter how much currency is required, it can be accessed from the forex market.

As businesses increasingly expand operations into locations across the world, a new need has
emerged. Employees in different countries have to be paid in foreign currency. Many multi
nationals opt for forex trading to meet their foreign currency requirements to fulfill this need.
Banks

Banks serve as distribution houses for forex currency to individuals. A bank customer who needs
to travel abroad may convert domestic currency to foreign currency to meet his expenses during
travel. Small investors may also use banks as dealers to conduct forex trade. As the volume of
his trade is likely to be just a fraction of what the bank actually trades in, his deals are enabled
from the bank’s reserves directly.

The bank’s own reserves of currencies are managed with the help of interbank transactions.
These transactions involve trading currencies with other banks and financial institutions. Small
investor trades and customer-bank trades form a very small proportion of the forex market when
compared with interbank transactions. About 50% of all forex transactions are interbank trades.

Some large investors do carry out their forex trades through their bank, but most of banks’ forex
trade falls under the category of interbank trade. Top level banks from all countries participate
actively in this market.

Governments

Governments also have a share in forex trade and they use this to maintain a positive trend in the
economy through various strategies. A government does not usually participate directly in trades
but does this through central banks. The monetary policy to be followed is usually implemented
in various ways by the central bank. One of these ways is through forex trading.

The forex reserves of a country are also maintained by judicious forex trading by central banks.
Proper maintenance of forex reserves is critical to keep the import markets active. Import
processes, in turn, need to be facilitated in a disruption free manner to keep businesses and
industries active and to maintain production levels.

Some countries, where the domestic currency depends on or is linked to a predominantly used
global currency like the US dollar, buy and sell currency through the central bank. This helps
keep the value of the domestic currency steady.

Individual Investors

Executing forex trades has been made very easy through the use of computers and the internet.
This has brought in a huge number of individual investors looking to make profits in this market.
And this number is all set to grow as investors show lesser interest in equity investments after the
stock market crash in 2008.
 Foreign Exchange Rate
MEANING
An exchange rate is the rate at which one currency will be exchanged for another. It is also
regarded as the value of one country’s currency in relation to another currency. Exchange rates
are determined in the foreign exchange market, which is open to a wide range of different types
of buyers and sellers
DEFINITION
According to Brigham & Houston, “An exchange rate specifies the number of units of a given
currency that can be purchased with one unit of another”.
IMPORTANCE OF FOREIGN EXCHANGE RATE
1. Value of money is not the same everywhere. The value of money is worth more when
trading to a country with money of a lower exchange rate.
2. It determines the value of foreign investment. A volatile exchange rate discourages
foreign investment, as does a high, stable one. A low, stable exchange rate, however,
encourages foreign investment, but at the price of the low-valued currency's economy.
3. It plays vital role in a country’s level of trade, which is critical to most every free market
economy in the world. For this reason,exchange rates are among the most analyzed and
governmentally manipulated economic measures.
4. Exchange rates have impact on real return of an investor’s portfolio.
5. Exchange rates determines the level of imports & exports.
A higher currency makes a country’s exports more expensive & imports cheaper in
foreign markets and vice versa.
6. Numerous factors determine exchange rates and all are related to the trading relationship
between two countries.
TYPES OF FOREIGN EXCHANGE RATES

In the foreign exchange market, at a particular time, there exists, not one unique exchange rate,
but a variety of rates, depending upon the credit instruments used in the transfer function. Major
types of exchange rates are as follows:

1. Fixed Exchange Rate System (or Pegged Exchange Rate System):Fixed exchange rate
system refers to a system in which exchange rate for a currency is fixed by the
government.

The basic purpose of adopting this system is to ensure stability in foreign trade and
capital movements.To achieve stability, government undertakes to buy foreign currency
when the exchange rate becomes weaker and sell foreign currency when the rate of
exchange gets stronger. For this, government has to maintain large reserves of foreign
currencies to maintain the exchange rate at the level fixed by it.
 Under this system, each country keeps value of its currency fixed in terms of some
‘External Standard’. This external standard can be gold, silver, other precious metal,
another country’s currency or even some internationally agreed unit of account.When
value of domestic currency is tied to the value of another currency, it is known as
‘Pegging’.When value of a currency is fixed in terms of some other currency or in terms
of gold, it is known as ‘Parity value’ of currency.

2. Flexible exchange rate system(‘Floating Exchange Rate’.): refers to a system in which

exchange rate is determined by forces of demand and supply of different currencies in the
foreign exchange market.

The value of currency is allowed to fluctuate freely according to changes in demand and
supply of foreign exchange.There is no official (Government) intervention in the foreign
exchange market.

The exchange rate is determined by the market, i.e. through interactions of thousands of
banks, firms and other institutions seeking to buy and sell currency for purposes of
making transactions in foreign exchange.

3. Spot rate(cable rate or telegraphic transfer rate):it is the rate at which foreign exchange is
made available on the spot. It is also known as cable rate or telegraphic transfer rate
because at this rate cable or telegraphic sale and purchase of foreign exchange can be
arranged immediately. Spot rate is the day-to-day rate of exchange.
The spot rate is quoted differently for buyers and sellers. For example, $ 1 = Rs 15.50 for
buyers and $ 1 = Rs 15.30 for the seller. This difference is due to the transport charges,
insurance charges, dealer's commission, etc. These costs are to be born by the buyers.
4. Forward rate: is the rate at which the future contract for foreign currency is made. The
forward exchange rate is settled now but the actual sale and purchase of foreign exchange
occurs in future. The forward rate is quoted at a premium or discount over the spot rate.
5. Long rate:Long rate of exchange is the rate at which a bank purchases or sells foreign
currency bills which are payable at a fixed future date. The basis of the long rate of
exchange is the interest on the delayed payment.
The long rate of exchange is calculated by adding premium to the spot rate of exchange
in the case of credit purchase of foreign exchange and deducting premium from the spot
rate in the case of credit sale.
If the spot rate is £1 = $ 2.80 and the rate of interest is 6%, then on 30 days bill, $ 0.014
will be added per pound in case of credit purchase and deducted in case of credit sale of
dollars.
6. Multiple Rates:refer to a system in which a country adopts more than one rate of exchange
for its currency. Different exchange rates are fixed for importers, exporters, and for different
countries.
7. Two-Tier Rate System:is a form of multiple exchange rate system in which a country
maintains two rates, a higher rate for commercial transactions and a lower rate for capital
transactions
ADVANTAGES OF FIXED EXCHANGE RATES

The main arguments advanced in favor of the system of fixed or stable exchange rates are as
follows:

1. Promotes International Trade:Fixed or stable exchange rates ensure certainty about the
foreign payments and inspire confidence among the importers and exporters. This helps to
promote international trade.
2. Necessary for Small Nations:Fixed exchange rates are even more essential for the smaller
nations like the U.K., Denmark, Belgium, in whose economies foreign trade plays a dominant
role. Fluctuating exchange rates will seriously affect the process of economic growth in these
economies.
3. Promotes International Investment:Fixed exchange rates promote international investments.
If the exchange rates are fluctuating, the lenders and investors will not be prepared to lend for
long-term investments.
4. Removes Speculation:Fixed exchange rates eliminate the speculative activities in the
international transactions. There is no possibility of panic flight of capital from one country to
another in the system of fixed exchange rates.
5. Necessary for Small Nations:Fixed exchange rates arc even more essential for the smaller
nations like the U.K., Denmark, Belgium, in whose economies foreign trade plays a dominant
role. Fluctuating exchange rates will seriously disturb the process of economic growth of these
economies.
6. Necessary for Developing Countries:Fixed exchanges rates are necessary and desirable for
the developing countries for carrying out planned development efforts. Fluctuating rates disturb
the smooth process of economic development and restrict the inflow of foreign capital.
7. Suitable for Currency Area:A fixed or stable exchange rate system is most suitable to a
world of currency areas, such as the sterling area. If the exchange rates of the countries in the
common currency area are flexible, the fluctuations in the leading country, like England (whose
currency dominates), will also disturb the exchange rates of the whole area.
8. Economic Stabilization:Fixed foreign exchange rate ensures internal economic stabilization
and checks unwarranted changes in the prices within the economy. In a system of flexible
exchange rates, the liquidity preference is high because the businessmen will like to enjoy wind
fall gains from the fluctuating exchange rates. This tends to Increase price and hoarding activities
in country.
9. Not Permanently Fixed:Under the fixed exchange rate system, the exchange rate does not
remain fixed or is permanently frozen. Rather the rate is changed at the appropriate time to
correct the fundamental disequilibrium in the balance of payments.
10. Other Arguments:Besides, the fixed exchange rate system is also beneficial on account of
the following reasons.

(i) It ensures orderly growth of world's money and capital markets and regularises the
international capital movements.

(ii) It ensures smooth functioning of the international monetary system. That is why, IMF has
adopted pegged or fixed exchange rate system.

(iii) It encourages multilateral trade through regional cooperation of different countries.

(iv) In modern times when economic transactions and relations among nations have become too
vast and complex, it is more useful to follow a fixed exchange rate system.

DISADVANTAGES OF FIXED EXCHANGE RATES

The system of fixed exchange rates has been criticized on the following grounds:

1. Outmoded System:Fixed exchange rate system worked successfully under the favorable
conditions of gold standard during 19th century when

(a) the countries permitted the balance of payments to influence the domestic economic policy;

(b) there was coordination of monetary policies of the trading countries;

(c) the central banks primarily aimed at maintaining the external value of the currency in their
respective countries; and

(d) the prices were more flexible. Since all these conditions are absent today, the smooth
functioning of the fixed exchange rate system is not possible.

2. Discourage Foreign Investment:Fixed exchange rates are not permanently fixed or rigid.
Therefore, such a system discourages long-term foreign investment which is considered available
under the really fixed exchange rate system.
3. Monetary Dependence:Under the fixed exchange rate system, a country is deprived of its
monetary independence. It requires a country to pursue a policy of monetary expansion or
contraction in order to maintain stability in its rate of exchange.
4. Cost-Price Relationship not Reflected:The fixed exchange rate system does not reflect the
true cost-price relationship between the currencies of the countries. No two countries follow the
same economic policies. Therefore the cost-price relationship between them go on changing. If
the exchange rate is to reflect the changing cost-price relationship between the countries, it must
be flexible.
5. Not a Genuinely Fixed System:The system of fixed exchange rates provides neither the
expectation of permanently stable rates as found in the gold standard system, nor the continuous
and sensitive adjustment of a freely fluctuating exchange rate.
6. Difficulties of IMF System:The system of fixed or pegged exchange rates, as followed by the
International Monetary Fund (IMF), is in reality a system of managed flexibility.

It involves certain difficulties, such as deciding as to

(a) when to change the external value of the currency,

(b) what should be acceptable criteria for devaluation; and

(c) how much devaluation is needed to reestablish equilibrium in the balance of payments of the
devaluing country.

Advantage of Flexible Exchange Rates

Flexible exchange rate system is claimed to have the following advantages:

1. Independent Monetary Policy:

Under flexible exchange rate system, a country is free to adopt an independent policy to conduct
properly the domestic economic affairs. The monetary policy of a country is not limited or
affected by the economic conditions of other countries.

2. Shock Absorber:

A fluctuating exchange rate system protects the domestic economy from the shocks produced by
the disturbances generated in other countries. Thus, it acts as a shock absorber and saves the
internal economy from the disturbing effects from abroad.

3. Promotes Economic Development:

The flexible exchange rate system promotes economic development and helps to achieve full
employment in the country. The exchange rates can be changed in accordance with the
requirements of the monetary policy of the country to achieve the planned national objectives.

4. Solutions to Balance of Payment Problems:

The system of flexible exchange rates automatically removes the disequilibrium in the balance of
payments. When, there is deficit in the balance of payments, the external value of a country's
currency falls. As a result, exports are encouraged, and imports are discouraged thereby,
establishing equilibrium in the balance of payment.

5. Promotes International Trade:

The system of flexible exchange rates does not permit exchange control and promotes free trade.
Restrictions on international trade are removed and there is free movement of capital and money
between countries.

6. Increase in International Liquidity:

The system of flexible exchange rates eliminates the need for official foreign exchange reserves,
if the individual governments do not employ stabilization funds to influence the rate. Thus, the
problem of international liquidity is automatically solved. In fact, the present shortage of
international liquidity is due to pegging the exchange rates and the intervention of the IMF
authorities to prevent fluctuations in the rates beyond a narrow limit.

7. Market Forces at Work:

Under the flexible exchange rate system, the foreign exchange rates are determined by the
market forces of demand and supply. Market is cleared off automatically through changes in
exchange rates and the possibility of scarcity or surplus of any currency does not exist.

8. International Trade not Promoted by Fixed Rates:

The argument that fixed exchange rates promotes international trade is not supported by
historical facts of inter-war or post-war period. On the other hand under the flexible exchange
rate system, the trend of the rate of exchange is generally assessed through the forward market,
and the traders are protected from financial losses arising from fluctuating exchange rates. This
helps in promoting international trade.

9. International Investment not Promoted by Fixed Rates:

The argument that long-term international investments are encouraged under fixed exchange rate
system is not valid. Both the lenders and borrowers cannot expect the exchange rate to remain
stable over a very long-period.

10. Fixed Rates not Necessary for currency Area:

This stable exchange rates are not necessary for any system of currency areas. The sterling block
functioned smoothly during the thirties in spite of the fluctuating rates of the member countries.

11. Speculation not Prevented by Fixed Rates:

The main weakness of the stable exchange rate system is that in spite of the strict exchange
control, currency speculation is encouraged. This destroys the stability in the exchange value of
the home currency and makes devaluation of the currency inevitable. For instance, the pound had
to be devalued in 1949 mainly because of such speculation.

Disadvantage of Flexible Exchange Rates

The following are the main drawbacks of the system of flexible exchange rates :

1. Low Elasticities:

The elasticities in the international markets are too low for exchange rate, variations to operate
successfully in bringing about automatic equilibrating adjustments. When import and export
elasticities are very low, the exchange market becomes unstable. Hence, the depreciation of the
weak currency would simply tend to worsen the balance of payments deficit further.

2. Unstable conditions:

Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to
reduce the volume of international trade and foreign investment. Long-term foreign investments
arc greatly reduced because of higher risks involved.

3. Adverse Effect on Economic Structure:

The system of flexible exchange rates has serious repercussion on the economic structure of the
economy. Fluctuating exchange rates cause changes in the price of imported and exported goods
which, in turn, destabilise the economy of the country.

4. Unnecessary Capital Movements:
The system of fluctuating exchange rates leads to unnecessary international capital movements.
By encouraging speculative activities, such a system causes large-scale capital outflows and
inflows, thus, seriously disturbing the economy of the country.

5. Depression Effects of Capital Movements:

Speculative capital movements caused by fluctuating exchange rates may lead to the problem of
extremely high liquidity preference. In a situation of high liquidity preference, people tend to
hoard currency, interest rates rise, investment falls and there is large-scale unemployment in the
economy.

6. Inflationary Effect:

Flexible exchange rate system involves greater possibility of inflationary effect of exchange
depreciation on domestic price level of a country. Inflationary rise in prices leads to further
depreciation of the external value of the currency.

7. Factor Immobility:

The immobility of various factors of production deprives the flexible exchange rate system of its
advantages arising from the adoption of monetary and other policies for maintaining internal
stability. Such policies produce desirable effects on production and employment only when
supply of factors of production is elastic.

8. Failure of Flexible Rate System:

Experience of the flexible exchange rate system adopted between the two world wars has shown
that it was a flop.

FACTORS AFFECTING FOREIGN EXCHANGE RATE

A country's foreign exchange rate provides a window to its economic stability, which is why it is
constantly watched and analyzed. If you are thinking of sending or receiving money from
overseas, you need to keep a keen eye on the currency exchange rates.

It may fluctuate daily with the changing market forces of supply and demand of currencies from
one country to another. For these reasons, it is important to understand what determines
exchange rates.

1. Inflation Rates
Changes in market inflation cause changes in currency exchange rates. A country with a lower
inflation rate than another's will see an appreciation in the value of its currency. The prices of
goods and services increase at a slower rate where the inflation is low. A country with a
consistently lower inflation rate exhibits a rising currency value while a country with higher
inflation typically sees depreciation in its currency and is usually accompanied by higher interest
rates
 

2. Interest Rates
Changes in interest rate affect currency value and dollar exchange rate. Forex rates, interest rates,
and inflation are all correlated. Increases in interest rates cause a country's currency to appreciate
because higher interest rates provide higher rates to lenders, thereby attracting more foreign
capital, which causes a rise in exchange rates
 

3. Country’s Current Account / Balance of Payments

A country’s current account reflects balance of trade and earnings on foreign investment. It
consists of total number of transactions including its exports, imports, debt, etc. A deficit in
current account due to spending more of its currency on importing products than it is earning
through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its
domestic currency.
 

4. Government Debt
Government debt is public debt or national debt owned by the central government. A country
with government debt is less likely to acquire foreign capital, leading to inflation. Foreign
investors will sell their bonds in the open market if the market predicts government debt within a
certain country. As a result, a decrease in the value of its exchange rate will follow.
 

5. Terms of Trade
Related to current accounts and balance of payments, the terms of trade is the ratio of export
prices to import prices. A country's terms of trade improves if its exports prices rise at a greater
rate than its imports prices. This results in higher revenue, which causes a higher demand for the
country's currency and an increase in its currency's value. This results in an appreciation of
exchange rate.
 

6. Political Stability & Performance

A country's political state and economic performance can affect its currency strength. A country
with less risk for political turmoil is more attractive to foreign investors, as a result, drawing
investment away from other countries with more political and economic stability. Increase in
foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country
with sound financial and trade policy does not give any room for uncertainty in value of its
currency. But, a country prone to political confusions may see a depreciation in exchange rates.
 
7. Recession
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances
to acquire foreign capital. As a result, its currency weakens in comparison to that of other
countries, therefore lowering the exchange rate.
 

8. Speculation
If a country's currency value is expected to rise, investors will demand more of that currency in
order to make a profit in the near future. As a result, the value of the currency will rise due to the
increase in demand. With this increase in currency value comes a rise in the exchange rate as
well.
 
Conclusion:
All of these factors determine the foreign exchange rate fluctuations. If you send or receive
money frequently, being up-to-date on these factors will help you better evaluate the optimal
time for international money transfer. To avoid any potential falls in currency exchange rates, opt
for a locked-in exchange rate service, which will guarantee that your currency is exchanged at
the same rate despite any factors that influence an unfavorable fluctuation.

ADR

MEANING OF AMERICAN DEPOSITORY RECEIPT

American Depository Receipt (ADR) is a certified negotiable instrument issued by an American

bank suggesting the number of shares of a foreign company that can be traded in U.S. financial
markets.
American Depository Receipts provide US investors with an opportunity to trade in shares of a
foreign company. When the ADRs did not exist, it was very difficult for an American investor to
trade in shares of foreign companies as they had to go through many rules and regulation. To
ease such hardship faced by American investors, the regulatory body Securities Exchange
Commission (SEC) introduced the concept of ADR which made it easier for an American
investor to trade in shares of foreign companies. American depository receipt fee varies from one
cent to three cents per share depending upon the ADR amount and its timing.

AMERICAN DEPOSITORY RECEIPT EXAMPLE

Volkswagen, a German company trades on New York Stock Exchange. The investor in America
can easily invest into the German company, through the stock exchange. Volkswagen is listed on
the American stock exchange after complying the required laws. On other hand if the shares of
Volkswagen are listed in stock markets of countries other than US then it is termed as GDR.
Advantages of ADRs

American Depositary Receipts have a number of benefits that make them an ideal opportunity
for international investors, including:

 Ease of use: ADRs can be bought and sold just like shares of IBM or Coca-Cola.
 Same broker: You don't need a foreign brokerage account or a new broker; you can use
the same broker that you normally deal with.
 Dollar-based pricing: Prices for ADRs are quoted in U.S. dollars, and dividends are paid
in dollars.
 Standard market hours: ADRs trade during U.S. market hours and are subject to similar
clearing and settlement procedures as American stocks.
 Customization: You can customize your portfolio however you like, depending on which
countries or sectors you are interested in.

Disadvantages of ADRs

By the same token, ADRs have some important limitations and drawbacks, including:

 Limited selection: Not all foreign companies are available as ADRs. For example, Japan's
Toyota Motor has an ADR, but Germany's BMW does not.
 Liquidity: Plenty of companies have ADR programs available, but some may be very
thinly traded.
 Exchange rate risk: While ADRs are priced in dollars, for sake of convenience, your
investment is still exposed to fluctuations in the value of foreign currencies.
 Because ADRs are like stocks, you need to buy enough of them to ensure adequate
diversification. So if you don't have enough investment capital to spread around, say 25
to 30 ADRs (or more), you won't be able to create a truly diversified portfolio on your
own.

Types of ADRs

The following table summarizes the types of American Depositary Receipt programs and the
associated filings required by the SEC.

Type of Program Description

 ADRs traded on the US OTC market, using
existing shares. No contractual relationship with
 Unsponsored
company. Up to four depositary banks can
establish
 ADRs traded on the US OTC market, using
 Sponsored Level I existing shares. Company forms contractual
relationship with single depositary bank
  ADRs listed on a recognized US exchange (NYSE
 Sponsored Level II
or NASDAQ), using existing shares
 ADRs initially placed with US investors and listed
 Sponsored Level
on a recognized US exchange (NYSE or
III
NASDAQ)

BALANCE OF PAYMENT
MEANING
The balance of payments, also known as balance of international payments and abbreviated
B.O.P. or BoP, of a country is the record of all economic transactions between the residents of
the country and of the world in a particular period (over a quarter of a year or more commonly
over a year). These transactions are made by individuals, firms and government bodies. Thus the
balance of payments includes all external visible and non-visible transactions of a country.
DEFINITION
According to Sloman and John , “ Balance of payment is an accounting record of all monetary
transactions between a country and the rest of the world”.

In the words of C. B. Kindleberger; “The balance of payments of a country is a systematic record

of all economic transactions between the residents of the reporting and the residents of the
foreign countries during a given period of time.”

COMPONENTS OF BOP

According to the broad nature of the transactions concerned, the BOP of a country is divided into
two main parts: (i) the current account, and the (ii) capital account. The other part is official
reserve account.

(i) The Current account:

The current account of BOP includes all transaction arising from trade in currently produced
goods and services, from income accruing to capital by one country and invested in another and
from unilateral transfers, both private and official.

The current account is usually divided in three subdivisions:

The first of these is called visible account or merchandise account or trade in goods account.
This account records imports and exports of physical goods. The second part of the account is
called invisibles account since it records all exports and imports of services. As these
transactions are not recorded in the customs office unlike merchandise trade we call them
invisible items. There is another flow in current account consists of Investment income and
unrequited transfers. Investment income consists of interest, profit and dividends on bonus and
credits. Unrequited transfers include grants, gifts, pension etc.

(ii) The Capital account:

The capital account shows transactions relating to the international movement of ownership of
financial assets. It refers to cross-border movements in foreign assets like shares, property or
direct acquisitions of companies’ bank loans, governments securities, etc.

In other words, capital account records export and import of capital from and to foreign
countries.

The capital account is divided into two main divisions one is the short term and another is the
long term movements of capital. A short term capital is one which matures in one year or less,
such as bank accounts. A long term capital is one whose maturity period is longer than a year,
such as long term bonds or physical capital. Long term capital account is, again of two
categories: direct investment and portfolio investment. Direct investment refers to expenditure on
fixed capital formation, while portfolio investment refers to the acquisition of financial assets
like bonds, shares etc.

(iii) Statistical discrepancy- errors and omissions: Since BOP always balances in theory; all
debits must be offset by all credits and vice versa. In practice, rarely it happens particularly
because statistics are incomplete as well as imperfect. That is why errors and omissions are
considered so that BOP accounts are kept in balance

(iv) The official reserve account: The category of official reserve account covers the net amount
of transactions by government. This account covers purchases and sales of reserve assets( such
as gold, convertible foreign exchange and special drawing rights) by the central monetary
authority.

THE BALANCE OF PAYMENTS ALWAYS BALANCES

o Goods, services, and resources traded internationally are paid for; thus every
movement of products is offset by a balancing movement of money or some other
financial asset.
 If a U.S. retailer imports $1 million of Japanese televisions, there is a
corresponding or balancing movement of money to the Japanese producer.
o A surplus in the Current account is by definition offset by a deficit in the Capital
account.
 Another way to think of this is that if we export goods and services, then
we import financial assets of the foreigners who purchased those goods
and services.
o Similarly, a deficit in the Current account must be offset by a surplus in the
Capital account.
  In practical terms, if Americans import foreign products, then we export
our financial assets to pay for them.
o While the Current account deficit of recent years has received much media
attention, there is little public awareness that this trade deficit is accompanied by a
surplus in the Capital account.

EQUILIBRIUM OF BALANCE OF PAYMENTS

Meaning: Equilibrium is that state of the balance of payment over the relevant time period
which makes it possible to sustain an open economy without severe unemployment on a
continuing basis.

Whether the Balance of Payments is in equilibrium or not, it can be justified with this help of
the three following test:

(i) Decrease in Foreign Exchange:

If gold continuously flows from the country, it may be assumed that the balance of payments
is in disequilibrium. At present the decrease in foreign exchange reserves of our country
indicate such a situation.

(ii) Increase in Foreign Debts and Loans:

If the amount of foreign debts and loans increase, that indicates the balance of payment of the
country is in disequilibrium i.e., exports are less than imports,

(iii) Decrease in Foreign Exchange Rates:

If the foreign exchange rates of a country decrease, it may be said that the country is
suffering from the disequilibrium in the balance of payments position.

Meaning of Disequilibrium in Balance of Payment

Though the credit and debit are written balanced in the balance of payment account, it may
not remain balanced always. Very often, debit exceeds credit or the credit exceeds debit
causing an imbalance in the balance of payment account. Such an imbalance is called the
disequilibrium. Disequilibrium may take place either in the form of deficit or in the form of
surplus.
 Disequilibrium of Deficit arises when our receipts from the foreigners fall below our
payment to foreigners. It arises when the effective demand for foreign exchange of the
country exceeds its supply at a given rate of exchange. This is called an 'unfavorable
balance'.

Disequilibrium of Surplus arises when the receipts of the country exceed its payments. Such
a situation arises when the effective demand for foreign exchange is less than its supply.
Such a surplus disequilibrium is termed as 'favorable balance'.

Main types of disequilibrium in the balance of payments are:

i. Cyclical Disequilibrium
ii. Structural Disequilibrium
iii. Short-run Disequilibrium
iv. Long-run Disequilibrium

i. Cyclical Disequilibrium:

It occurs on account of trade cycles. Depending upon the different phases of trade cycles like
prosperity and depression, demand and other forces vary, causing changes in the terms of trade
as well as growth of trade and accordingly a surplus or deficit will result in the balance of
payments.

ii. Structural Disequilibrium:

It emerges on account of structural changes occurring in some sectors of the economy at home or
abroad which may alter the demand or supply relations of exports or imports or both. Suppose
the foreign demand for India’s jute products declines because of some substitutes, then the
resources employed by India in the production of jute goods will have to be shifted to some other
commodities of export.

iii. Short-run Disequilibrium:

A short-run disequilibrium in a country’s balance of payments will be a temporary one, ‘lasting

for a short period, which may occur once in a while. When a country borrows or lends
internationally, it will have short-run disequilibrium in its balance of payments, as these loans are
usually for a short period or even if they are for a long duration, they are repayable later on;
hence the position will be automatically corrected and poses no serious problem.

iv. Long-run Disequilibrium:

The long-term disequilibrium thus refers to a deep- rooted, persistent deficit or surplus in the
balance of payments of a country. It is secular disequilibrium emerging on account of the
chronologically accumulated short-term disequilibria — deficits or surpluses.

It endangers the exchange stability of the country concerned. Especially, a long-term deficit in
the balance of payments of a country tends to deplete its foreign exchange reserves and the
country may also not be able to raise any more loans from foreigners during such a period of
persistent deficits.

CAUSES OF DISEQUILIBRIUM

Various causes of disequilibrium in the balance of payments or adverse balance of payments are
as follows:

1. Development Schemes:

The main reason for adverse balance of payments in the developing countries is the huge
investment in development schemes in these countries. The propensity to import of the
developing countries increases for want of capital for industrialization. The exports, on the other
hand, may not increase because these countries are traditionally primary producing countries.
Moreover the volume of exports may fall because newly created domestic industries may need
them. All this leads to structural changes in the balance of payment resulting in structural
disequilibrium.

2. Price-Cost Structure:

Changes in price-cost structure of export industries affect the volume of exports and create
disequilibrium in the balance of payments. Increase in prices due to higher wages, higher cost of
raw materials, etc. reduces exports and makes the balance of payments unfavorable.

3. Changes in Foreign Exchange Rates:

Changes in the rate of exchange is another cause of disequilibrium in the balance of payments.
An increase in the external value of money makes imports cheaper and exports dearer; thus,
imports increase and exports fall and balance of payments become unfavourable. Similarly, a
reduction in the external value of money leads to a reduction in imports and an increase in
exports.

4. Fall in Export Demand:

There has been a considerable decline in (he export demand for the primary goods of the
underdeveloped countries as a result of the large increase in the domestic production of
foodstuffs raw materials and substitutes in the rich countries. Similarly, the advanced countries
also find a fall in their export demand because of loss of colonial markets. However, the deficit
in the balance of payment due to the fall in export demand is more persistent in the
underdeveloped countries than in the advanced countries.

5. Demonstration Effect:
According to Nurkse, the people in the less developed countries tend to follow the consumption
patterns of the developed countries. As a result of this demonstration effect, the imports of the
less developed countries will increase and create disequilibrium in the balance of payments.

6. International Borrowing and Lending:

International borrowing and lending is another reason for the disequilibrium in the balance of
payments. The borrowing country tends to have unfavourable balance of payments, while the
lending country tends to have favourable balance of payments.

7. Cyclical Fluctuations:

Cyclical fluctuations cause cyclical disequilibrium in the balance of payments. During

depression, the incomes of the people in foreign countries fall. As a result, the exports of these
countries tend to decline which, in turn, produces disequilibrium in the home country's balance
of payment.

8. Newly Independent Countries:

The newly independent countries, in order to develop international relations, incur huge amounts
of expenditure on the establishment of embassies, missions, etc. in other countries. This
adversely affects the balance of payments position.

9. Population Explosion:

Another important reason for adverse balance of payments in the poor countries is population
explosion. Rapid growth of population in countries like India increases imports and decreases the
capacity to export.

10. Natural factors:

Natural calamities, such as droughts, floods, etc., adversely affect the production in the country.
As a result, the exports fall, the imports increase and the country experiences deficit in its
balance of payments.

MEASURES TO CORRECT DISEQUILIBRIUM IN BALANCE OF PAYMENTS

There are various measures which can be used to correct BOP disequilibrium depending upon
the nature of the disequilibrium. These measures may be automatic as well as deliberate. Further
deliberate measures are in form of monetary, non-monetary or fiscal measures and others
measures. Others measures includes political, social and international measures.

Automatic measures:

Automatic measures imply free play of market forces of demand and supply. For example, if
there is deficit in BOP account it will lead to an increase in the demand for foreign exchange.
This increase in turn will result in increase in foreign exchange rate and decrease the value of
domestic currency. The depreciation of currency will make exports cheaper and imports dearer.
This mechanism will vanish disequilibrium and restore equilibrium in BOP.
Deliberate measures:

Deliberate measures are of long run in nature. These can be categorized into following groups:

(I)  Monetary Measures: Monetary measures include:

(i)  Deflation: It means a decrease in price level and it can be caused reducing the money supply
in the economy.

There are various measures to decrease money supply. These include tight bank rate policy,
purchasing of government securities in open market etc. Reduced money supply decreases
purchasing power of the people and in turn effective demand. A reduction in effective demand
will lead to a fall in imports. And as we know a country faces deficit when its imports exceeds
export, a fall in imports will restore equilibrium.

(ii) Devaluation: Devaluation means reducing the value of domestic currency deliberately by
monetary authorities. Effect of devaluation is same as it is in case of depreciation, i. e. imports
fall as they become costlier and exports increase as they become cheaper after devaluation. The
only difference is that depreciation is done by market forces and devaluation is brought by
monetary authorities deliberately.

(iii) Exchange rate Policy: The impact of this measure depends on the fact whether country is
adopting fixed exchange rate policy or flexible exchange rate policy. Because it is not suitable to
a country having fixed exchange rate system. Generally exchange rate is depreciated to bring
equilibrium in times of deficit in BOP. Exchange depreciation encourages exports and
discourages imports. Although it has adverse impact on the economy also. For example,
exchange depreciation increases the prices of imports and reduces prices of imports. Hence terms
of trade will turn unfavourable for the country adopting it.

Exchange rate policy also includes regulations regarding conversion of domestic currency
against foreign currency. More liberal the policy of convertibility of currency more will be the
favourable impact on BOP equilibrium. For example, a higher degree of free convertibility of
local currency into foreign currency will positively affect exporters and exports will increase.
This will help in correcting BOP disequilibrium.

(II) Fiscal measures: These measures includes exports promotion and import substitution
measures

(i) Export Promotion Measures :The government encourage those industries which are
producing exportable goods and services by giving them various facilities and incentives. These
facilities are in form of cheap credit facility as well as marketing facilities. The government also
provide tax rebates and subsidies to such industries. Declaration of SEZs and ECZs is the
example of such export promotion measures adopted by countries to correct BOP disequilibrium.

(ii)  Import Substitution Measures: This measure include the following aspects;

(a)   Tariffs: Tariffs are the duties which are imposed on imports. The purpose of imposing
tariffs is to curtail imports as prices of imports increase on account of tariffs. Increased prices of
imports reduce their demand. On the other hand domestic producers get induced to produce
import substitutes. 

(b)   Quotas: A quota means fixing themaximum limit to the quantity of imported items during a
certain time period. The government may fix maximum quantity as well as value of a commodity
to be imported. The quota system reduces imports and as a result deficit in BOP.

(c)    Various Concessions: The government can provide some concessions to the industries
producing import substituting goods. These concessions include tax concessions, technical
assistance, subsidies etc.

(III) Others measures: There are following others measures to correct disequilibrium of balance
of payments. These measures are also known as non economic measures to correct balance of
payments;

(a) Political Measures: There are several political factors that they may correct of
disequilibrium of balance of payments. These factors are; to take independent decision by a
check on political alliances, to save foreign exchange by a check on political and administrative
expenses and change in basic political ideology through socialistic pattern to globolised
economy.

(b) Social Measures: This measure includes change in consumption patterns, tastes and
preferences, fashion and trends etc in the direction of social awareness. These factors may affect
imports and exports of the country.  For a example in India, spread Swadeshi of movement went
a long way in reduce import and correcting the BOP during British rule in India. Today, import
of petroleum product is the major reason of adverse BOP. If the social awareness is spread
among the people to economic use of petroleum product by using public convenience. That
would be positive effect on balance of payments of the nation.

(c) International Measures: These measures includes  new regional, market and international
organizations such as WTO, IMF, SAARC, EU, EEC, NAM, UNCTAD, ASIAN, etc. These
organizations can help solve the crises of the nation. In past, these organizations give the
excellent results to solve the crisis problem.