Balance of Payments:

Introduction:

A systematic accounting record of the country’s economic transactions with the rest of the
world.

It is a record of all the factors which create demand for and supply of a country’s currency.

Definition:

The BoP of a country is a systematic accounting record of all economic transactions during a
given period of time between the residents of the country and residents of foreign countries.

Residents of foreign countries means nonresidents, foreigners, or rest of the world.

Clarifications of the above definition:

1. Economic transactions means the transfer of economic value from one economic agent to
another. Economic agents are individuals, businesses, governments, etc.

Transfer may be requited transfer or an unrequited transfer. RT are the transfers wherein
the transferee (receiver) gives something of equivalent economic value to the transferor
(giver). URT are the transfers wherein the transferee (receiver) does not give something of
equivalent economic value to the transferor (giver). These are unilateral gifts (one sided
gifts).

Types of economic transfers:

1. One real and one financial transfer

 2. Two real transfers.
3. Two financial transfers.
4. One real transfer. A Unilateral gift in kind.
5. One financial transfer. A Unilateral financial gift.

2. “Residents” does not mean “citizens”. As regards to individuals, residents are those
individuals whose general center of interest can be said to rest in the given economy. The
consume goods and services, participate in productive processes or otherwise carry out
economic activities within the territory of the country on other than a temporary basis.
As regards non-individuals, certain conventions have been evolved. For example,
governments and non-profit bodies serving resident individuals are the residents of the
respective countries. According to the IMF, unincorporated branches of the multinational
companies are considered to be residents of countries where they operate; though they are
not a separate legal entity from the parent located abroad. International organizations like
UN, World Bank, etc. are not considered to be residents of any national economy even
though their offices may be located within the territories of any number of countries.

Accounting Principles:

The BoP is subject to all the rules of double entry book-keeping. For every transaction two
entries must be made, one credit and one debit, and leaving aside errors and omissions, the
total of credits must exactly match the total of debits.

1. All transactions which lead to immediate or prospective payment from RoW to the country
in question should be recorded as credit entries in the BoP of that country. The payment
themselves should be recorded as the offsetting debit entries. All transactions which result
in actual or prospective payment from the country in question to the RoW should be
recorded as debits and the corresponding payments as credits.
 An increase in the foreign assets must be recorded as debit entry. A decrease in the foreign
assets or an increase in foreign liabilities must be recorded as credit entry.
2. A transaction which leads to increase in demand or decrease in supply of foreign exchange
is to be recorded as a debit entry. A transaction which leads to decrease in demand or
increase in supply of foreign exchange is to be recorded as a credit entry.
An increase in foreign assets or a decrease in foreign liabilities uses up foreign exchange and
therefore reduces the supply of the foreign exchange, therefore it is a debit entry.
A decrease in foreign assets or an increase in foreign liabilities is a source of foreign
exchange and therefore increases the supply of the foreign exchange, therefore it is a credit
entry.

Valuation:

Cross-country comparison of BoP data would be meaningful only when ta common pricing
system is used by all the countries. The IMF recommends the use of “market price”. Market
price means the price paid by a willing buyer to a willing seller, where the buyer and the seller
are independent parties and the transaction is governed solely by commercial considerations.

Another aspect of valuation is choice between FOB and CIF. IMF recommends the use of FOB as
the CIF includes the value of transportation and insurance in addition to the value of the goods.
In India’s BoP statistics, exports are recorded at FOB and imports are recorded at CIF value.

Another difficulty in valuation relates to the translation of foreign currency into the domestic
currency. Theoretically, it should be done at the exchange rate prevailing at the time of the
transaction. In practice, for transactions during a particular month, the average exchange rate
for the month is used.

Components of the BoP:

1. The current account

 It records the imports and exports of goods and services and unilateral transfers of
goods and services.
2. The capital account
It records transactions leading to changes in the foreign assets and liabilities of the
country.
3. The reserve account
It also records transactions related to assets and liabilities. However, it only records
reserve asses. These are the assets which the monetary authority of the country uses to
settle the deficits and surpluses that arise on the other two accounts taken together.

International Monetary System:

Firms having worldwide transactions in goods, services, and finances require an efficient
multilateral financial system for efficient operations. There is a need of world monetary and
financial organization that facilitates the transfer of funds between parties, conversion of
national currencies into one another, acquisition and liquidation of financial assets, and the
international credit creation. The international monetary system is an important constituent of
the global financial system.

Discussion topics:

Exchange rate regimes

International liquidity

IMF (Evolution, role, and functioning)

The adjustment process

Currency blocks and unions such as Economic and Monetary Union.

Exchange rate regimes

An exchange rate is the value of one currency in terms of another currency.

The term “exchange rate regime” refers to the mechanism, procedures, and institutional
framework for determining exchange rates at a point in time and changes in them over time,
including the factors which induce the changes.

A large number of exchange rate regimes are possible. It can be perfectly fixed or rigid
exchange rate, perfectly flexible or floating exchange rate, or hybrid exchange rate with varying
degrees of limited flexibility.

Gold standards and the Bretton Woods system:

The Gold Standard:

The Gold standard is the oldest system and it lasted till the First World War. It had broadly 3
versions. In the version called “Gold Specie Standards”, the actual currency in circulation
consisted of gold coins with the fixed gold content. In the version called “Gold Bullion
Standard”, the basis of money remains a fixed weight of gold but the currency in circulation
consisted of paper notes with the monetary authorities, i.e. the central bank of the country
standing ready to convert on demand, unlimited amounts of paper currency into gold and vice
versa, at a fixed conversion ratio. Under the “Gold Exchange Standard”, the authorities stand
ready to convert, at a fixed rate, the paper currency issued by them into paper currency of
another country which is operating a Gold Specie or Gold Bullion standard. Thus, if rupees are
freely convertible into dollars and dollars in turn into gold, then rupees can be said to be on a
gold-exchange standards.

The exchange rate between any pair of currency will be determined by their respective
exchange rates against gold. This is called “Mint parity” rate of exchange.

Under true gold standards, the monetary authorities must obey the following 3 rules:
1. They must fix once-and-for-all the rate of conversion of the paper money issued by them
into gold.
2. There must be free flows of gold between countries on gold standards.
3. The money supply in the country must be tied to the amount of gold the monetary
authorities have in reserve. If the amount of gold increases or decreases, the money supply
must increase or decrease respectively.

The gold regime imposes very rigid discipline on the policy makers. During the Great Depression
the gold standard was finally abandoned.

The Bretton Woods System:

The Bretton Woods Agreement was negotiated in July 1944 by delegates from 44 countries at
the United Nations Monetary and Financial Conference held in Bretton Woods, New
Hampshire. Thus, the name “Bretton Woods Agreement.

Approximately 730 delegates representing 44 countries met in Bretton Woods in July 1944 with
the principal goals of creating an efficient foreign exchange system, preventing competitive
devaluations of currencies, and promoting international economic growth. The Bretton Woods
System created two important organizations—the International Monetary Fund (IMF) and the
World Bank. While the Bretton Woods System was dissolved in the 1970s, both the IMF and
World Bank have remained strong pillars for the exchange of international currencies.

Though the Bretton Woods conference itself took place over just three weeks, the preparations
for it had been going on for several years. The primary designers of the Bretton Woods System
were the famous British economist John Maynard Keynes and American Chief International
Economist of the U.S. Treasury Department Harry Dexter White. Keynes’ hope was to establish
a powerful global central bank to be called the “Clearing Union” and issue a new international
reserve currency called the “Bancor”. White’s plan envisioned a more modest lending fund and
a greater role for the U.S. dollar, rather than the creation of a new currency. In the end, the
adopted plan took ideas from both, leaning more toward White’s plan.
In 1958 that the Bretton Woods System became fully functional. Once implemented, its
provisions called for the U.S. dollar to be pegged to the value of gold. Moreover, all other
currencies in the system were then pegged to the U.S. dollar’s value. The exchange rate applied
at the time set the price of gold at $35 an ounce.

Benefits of Bretton Woods Currency Pegging

The Bretton Woods System included 44 countries. These countries were brought together to
help regulate and promote international trade across borders. As with the benefits of all
currency pegging regimes, currency pegs are expected to provide currency stabilization for
trade of goods and services as well as financing.

All of the countries in the Bretton Woods System agreed to a fixed peg against the U.S. dollar
with diversions of only 1% allowed. Countries were required to monitor and maintain their
currency pegs which they achieved primarily by using their currency to buy or sell U.S. dollars as
needed. The Bretton Woods System, therefore, minimized international currency exchange rate
volatility which helped international trade relations. More stability in foreign currency exchange
was also a factor for the successful support of loans and grants internationally from the World
Bank.

The outcome of the conference was the “Bretton Woods System” and birth of two supra-
national institutions called “IMF” and “World Bank”.

The exchange rate regime that was put in place had following features:
The US government undertook to convert the US dollar freely into gold at a fixed parity of $35
per ounce.

Other member countries of the IMF agreed to fix the parity of their currencies against the dollar
with variation within 1% on either side of the central parity being permissible. If the exchange
rate hit either side of the limit, the monetary authorities of the country were obliged to defend
it by buying or selling dollars against their domestic currency to any extent required to keep the
exchange rate within the limits.

In return for undertaking this obligation, the member countries were entitled to have access to
credit facilities from the IMF to carry out their intervention in the currency markets.

The Bretton Woods system was an adjustable peg system. Here, the parity of the currency
against the dollar could be changed in the face of a fundamental disequilibrium. A fundamental
disequilibrium is when at the given exchange rate, the country repeatedly faces BoP
disequilibrium and has to constantly intervene and sell foreign exchange (persistent deficit) or
buy foreign exchange (persistent surplus) against its own currency. The situation of persistent
deficit requires devaluation of the home currency.

Changes upto 10%in either direction could be made without the consent of the IMF while larger
changes could be affected consulting the IMF and obtaining their approval. However, this
degree of freedom was not available to US. US monetary authorities had to maintain the gold
value of dollar.

Current exchange rate regime:

IMF classifies member countries into 7 categories according to the exchange rate regime they
have adopted.

1. Exchange Arrangements with no Separate Legal Tender:

 Under this regime either a country adopts currency of another country as its legal tender or
a group of countries share a common currency. For ex., Ecuador and Panama have adopted
USD as their legal tender. Another example is the European Union in which 12 member
countries have Euro as their currency.
A country adopting such a regime cannot have an independent monetary policy since its
money supply is tied to the money supply of the country whose currency it has adopted or
controlled by a common central bank which regulates monetary policy in all member
countries belonging to the currency union.

2. Currency Board Arrangements

In this regime there is a legislative commitment to exchange the domestic currency against
a specified foreign currency at a fixed rate coupled with restrictions on the monetary
authority to ensure that this commitment will be honored. A country with Currency Board
Arrangements cannot have an independent monetary policy.

3. Conventional Fixed Peg Arrangements:

Here the country pegs its currency to another or to a basket of currencies with a band of
variation not exceeding +- 1% around the central parity.

4. Pegged Exchange Rates within Horizontal Bands:

Here there is a peg but variation is permitted within wider bands. It can be interpreted as a
sort of compromise between a fixed peg and a floating exchange rate.

5. Crawling Peg:
It is a variant of a limited flexibility regime. The currency is pegged to another currency or a
basket of currencies but the peg is periodically adjustable.

6. Managed Floating with no Pre-announced Path for the Exchange Rate:

 Here the central bank influences the exchange rate by means of active intervention in the
foreign exchange market, without any commitment to maintain the exchange rate at any
particular level.

7. Independently floating:
Here the exchange rate is market determined with the central bank intervening only to
moderate the speed of change and to prevent excessive fluctuations but not attempting to
maintain it at any particular level.