International Economics

II
Module I
Contents
Balance of payment
BOP Accounting principles and Double entry book keeping
Credits and Debits
Components of BOP
BALANCE OF PAYMENTS

 The balance of payments accounts are an integral part of the national income
accounts for an open economy.
 The balance of payments of a country is a systematic record of all its economic
transactions with the outside world in a given year.
 In other words, balance of payments is a summary statement in which all
transaction of the residents of the nation with the residents of all other nations
are recorded during a particular period of time, usually a calendar year.
 The balance of payments is a way of listing receipts and payments in
international transactions for a country.
 They record all transactions between residents of the country concerned and
those of other countries, where residents are broadly interpreted as all
individuals, business, and governments and their agencies.
Features of BOP

 It is a systematic record of all economic transactions between one country

and the rest of the world.
 It includes all transactions , visible as well as invisible.
 It relates to a period of time . Generally ,it is an annual statement.
 It adopts double- entry book keeping system.
 It has two sides : credit side and Debit side
 Receipts are recorded on the credit side and payments on the debit side.
Balance of Trade

 The difference between a country’s imports and exports. Balance of trade is

the largest component of a country’s balance of payments
 Debit items include imports , foreign aid , domestic spending abroad and
domestic investments abroad.
 Credit items include exports , foreign spending in the domestic economy and
foreign investments in the domestic economy.
 When exports are greater than imports then the BOT is favourable and if
imports are greater than exports then BOT is unfavourable.
BOP/BOT

BOP BOT
1. It is a broad item 1. it is a narrow item
2. It includes all transactions related 2. It includes only visible items
to visible,invisible and capital 3. It can be favourable or unfavourable
transfers 4. BOT= Net earnings on Exports-Net
3. It is always balance itself payments for imports
4. BOP=Current account+Capital 5. Following are main factors which
account+ or – Balance item affect BOT
5. Following are the main factors • Cost of production
which affect BOP • Availability of raw materials
• Conditions of foreign lenders • Exchange rate
• Economic policy of Govt. • Prices of goods manufactured at
• All the factors of BOT home
Importance of Balance of Payments

 BOP records all the transactions that create demand for and supply of a
currency
 Judge economic and financial status of a country in the short term.
 BOP may confirm trend in economy’s international trade and exchange rate of
the currency. This may also indicate change or reversal in the trend.
 This may indicate policy shift of the monetary authority (RBI)of the country.
 BOP may confirm trend in economy’s international trade and exchange rate of
the currency
BOP Accounting Principles and Double
Entry Book Keeping
 The arrangement of international transactions into a balance of payments
account requires that each transaction be entered as a credit or a debit.
 A credit transaction is one that results in a receipt of a payment from
foreigners.
 A debit transaction is one that leads to a payment to foreigners.
 While credit transactions are entered with a positive sign and debit
transactions are entered with a negative sign in the nation’s BOP accounts
according to BOP accounting principles
Credits and Debits

 The export of goods and services, unilateral transfers (gifts) received from
foreigners, and capital inflows are entered as credits (+) because they involve
the receipt from foreigners.
 On the other hand, the import of goods and services, unilateral transfers or
gifts made to foreigners, and capital outflows involve payments to foreigners
and are entered as debits (-) in the nation’s balance of payments.
 Financial inflows can take either of two forms: an increase in foreign assets in
the nation or a reduction in the nation’s assets abroad.
 Financial outflows can take the form of either an increase in the nation’s
assets abroad or a reduction in foreign assets in the nation because both
involve a payment to foreigners
Double-Entry Book keeping

 In recording a nation's international transactions, the accounting procedure is

known as book keeping . This means that each international transaction is
recorded twice, once as a credit and once as a debit of an equal amount.
 In theory, the balance of payment is kept in standard double - entry book -
keeping under which each international transaction undertaken by residents
of a country results in a debit and a credit of equal size.
 For example, an export would be entered in a country's balance of payments
as a credit, the corresponding debit show the manner in which payment is
made.
 Import, on the other hand, would be a debit entry in the country's balance of
payments, the corresponding credit would be to foreign exchange. This would
indicate a reduction in the foreign currency holding of the country's banks.
Components of BOP

 Traditionally there are two basic elements in a perfectly compiled set of a

balance of payments accounts:
 the current account and
 the capital account.
 The current account is subdivided into
 visible and invisible trade and
 The capital account into
 long - term and short - term private transactions and changes in official
reserves.
The current account

 The current account records exports and imports of goods and services and
unilateral transfers.
 Exports, whether of goods or services, are by convention entered as positive
items in the account.
 Imports are entered as negative items. Exports are normally calculated f.o.b.
(free on board, that is usually costs of transportation, insurance etc. are not
included)
 while imports are normally calculated c.i.f. (cost, insurance, freight, that is
costs for transportation, insurance, costs, etc. are included).
 The balance of exports and imports is referred to as the balance of visible
trade or simply the balance of trade.
Current Account

 Invisible trade is a much more heterogeneous category than visible trade.

 Invisibles include factor and non-factor services.
 Trade in shipping, banking and insurance services and payments by residents as tourists abroad are
usually the most important items in invisible account. Apart from that, it includes factor services,
which consist of interest, profits and dividends etc. also. Unilateral transfers of unrequited receipts,
are receipts which the residents of a country receive for free, without having to make any present
or future payments in return.
 Receipts from abroad are entered as positive items, payments to abroad as negative items.
 This kind of receipts usually takes one of two forms: The first, often referred to as private
unrequited transfers, is gifts which domestic residents receive from foreign residents, most notably
when migrant workers sent money back to relatives living in the country in question.
 The second, official unrequited transfers, is the payment of pure aid by governments in developed
countries to government in less developed countries (LDCs).
 Historically, a third form of unilateral transfer has been important reparation payments. Such
payments are compensation payments intended to cover damage or injury inflicted during a war.
Current account

 The net value of the balance of visible trade and of invisible trade and of unilateral
transfers defines the balance on current account.
 Invisible items, along with the visible items, determine the actual current accounts
position that reflect the true picture of the balance of payments account.
 If exports of goods and services exceed imports of goods and services, the balance
of payment is said to be favourable.
 In the opposite case, it is unfavourable.
 In the current account, the exports of good and services and the receipts of transfer
payments are entered as credit because they represent receipts from foreigners.
 On the other hand, the imports of goods and services and transfer payments to
foreigners are entered as debits because they represent payments to foreigners.
The Capital Account

 The capital account records all international transactions that involve a resident of the country
concerned changing either his assets with or his liabilities to a resident of another country.
 Transactions in the capital account reflect a change in a stock - either assets or liabilities. It is
often useful to make distinctions between various forms of capital account transactions.

 Direct investment is the act of purchasing an asset and at the same time acquiring control of
it. The acquisition of a firm residing in one country by a firm in another country is an example.
Such business transactions form the major part of private direct investment in other countries,
multinational corporations being especially important.
 Portfolio investment by contract is the acquisition of an asset that does not give the purchaser
control over it.
 An example is the purchase of shares in a foreign company or of bonds issued by a foreign
government. Loans made to foreign firms or governments come into the same broad category.
Capital Account

 Portfolio investment may also be identified as either private or official,

according to the sector from which they originate. The purchase of an asset in
another country, whether it is direct or portfolio investment, would appear as
a negative item in the capital account for the purchasing firm's country, and
as a positive item in the capital account for the other country.
 The capital outflows appear as a negative item in country's balance of
payment and capital inflows as positive items.
 The net value of the balances of direct and portfolio investment defines the
balance on capital account.
Capital account

 The distinction between short - term and long - term investment is often confusing but
usually relates to the specification of asset rather than to the length of time for which it
is held.
 For example, a firm or individual that holds a bank account in another country and
increases its balance in that account will be engaging in short term investment, even if
its intention is to keep that money in that account for many years.
 On the other hand, an individual buying a long - term government bond in another
country will be making a long - term investment, even if that bond has only one month
to go before maturity.
 The term basic balance refers to the sum of current account balance and the net
balance on long term capital.
 A worsening of the basic balance is termed as an indicator of the deterioration in the
relative state of the economy. A worsening of the basic balance can be an increase in
deficit or a reduction in surplus or even a move from surplus to a deficit.
Errors and Omissions

 Errors and omissions, reflect transactions that have not been recorded for various reasons
and which cannot be entered under a standard heading.
 But balance of payment is constructed as an accounting identity with each transaction
theoretically recorded twice, the sum total of debits and credits should always be equal.
Hence, errors and omissions are also included. But in fact this is rarely the case.
 Errors and omissions reflect the difficulties involved in recording accurately, if at all, a wide
variety of transactions that occur within a given period.
 In some cases there is such a large number of transactions that a sample is taken rather than
recording each transaction, with the inevitable errors that occur when samples are used.
 In some other situations problems may arise when one or other of the parts of transactions
takes more than one year. Dishonesty may also play part, as when goods are smuggled, in
which case the merchandise side of the transaction is unreported although payment will be
made somehow and will be reflected somewhere in the accounts. Similarly, the desire to
avoid taxes may lead to under reporting of some items in order to reduce tax liabilities.
Official Reserves Account

 Finally, there are changes in the reserves of the country.

 Reserves are held in three forms: in foreign currency, as gold and as Special
Deposit Receipts (SDRs) borrowed from the IMF.
 SDRs are a reserve asset created by IMF and allocated from time to time to
member countries.It can be used to settle international payments between
monetary authorities of two different countries.
 The changes in the country's reserves must reflect the net value of all the
other recorded items in the balance of payments. These changes will of
course be recorded accurately, and it is the discrepancy between the changes
in reserves and the net value of the other recorded items that allows to
identify the errors and omissions.
Balance sheet-Format
Credits(Receipts) Debits(Payments)
Current Account
Exports of Goods Imports of Goods
Exports of Services Imports of Services
Unrequited Receipts Unrequited payments

Capital Account
Capital Receipts (Direct investment,portfolio Capital Payments(Direct investment,portfolio
investment,short term investment and long term investment,short term investments and long
investment term investment

Capital Settlement
Official reserve assets(gold,stock,foreign Official reserve liabilities
currency)SDRs borrowed from IMF

Errors and Omissions

Autonomous and Accommodating Flows

 Transactions are said to be autonomous if their value is determined independently of the

balance of payments.
 Accommodating items, on the other hand, are determined by the net consequences of the
autonomous items.
 Accommodating capital inflows are unforeseen capital flows which have to be made to bring
the BOP into equilibrium. An alternative nomenclature is that, items are above the line
(autonomous) or below the line (accommodating).
 Obviously the sum of the accommodating and autonomous items must be zero, since all
entries in the balance of payments accounts must come under one of the two headings.
Whether the balance of payments is in surplus or deficit depends on the balance of the
autonomous items.
 The balance of payments is said to be in surplus if autonomous receipts are greater than
autonomous payments.
 On the other hand, BOP is in deficit if autonomous receipts are less than autonomous
payments.
Autonomous capital flows-items

 These refer to international economic transactions that take place due to some economic
motives like earning income and profit maximization.
 They have nothing to do with foreign exchange payments.since such transactions are
independent of the state of country’s balance of payments.ie.irrespective of whether BOP
is favourable or unfavourable.therefore,they are called autonomous items
 These are generally called “above the line items”in BOP
 Autonomous items which make deficit or surplus in BOP
 BOP is in deficit if the autonomous receipts are less than autonomous payments.
 BOP is in surplus if the autonomous receipts are greater than autonomous payments.
 BOP depends upon the balance of autonomous items.
 When during the year total inflows of foreign exchange on account of autonomous
transactions are less than total outflows on account of such transactions,there is deficit in
BOP
Accommodating capital flows-items

 These refers to transactions that takes place to cover deficit or surplus arising
from autonomous transactions
 These items are also called “below the line” items , because of govt .
financing , official settlements are seen as accommodating items to keep the
BOP
 To meet the deficit , govt . may borrow from abroad or make withdrawals
from foreign exchange reserves.
 The official settlement approach is based on the assumption that monetary
authority is the ultimate financier of any deficit in BOP or the ultimate
recipient of any surplus.
Disequilibrium in the BOP

 A dis equilibrium in the BOP means is the condition of Surplus or Deficit

 A Surplus in the BOP occurs when total receipts exceeds total payments
 BOP=CREDIT>DEBIT
 A Deficit in the BOP occurs when total payments exceeds total receipts
 BOP=CREDIT<DEBIT
Causes of Disequilibrium in the BOP

 Cyclical fluctuations
 Short fall in the exports
 Economic Development
 Rapid increase in population
 Structural changes
 Natural Calamities
 International Capital Movements
Measures to correct disequilibrium in
BOP
1. Monetary measures:
a) Monetary policy :the monetary policy is concerned with money supply and credit
in the economy.The central bank may expand or contract the money supply in
the economy through appropriate measures which will affect the prices.
b) Fiscal policy :Fiscal policy is govt’s policy on income and expenditure.Govt.incurs
development and non-development expenditure.It gets income through
taxationand non-tax sources.Depending upon the situation govts expenditure
may be increased or decreased.
c) Exchange Rate Depreciation :By reducing the value of the domestic currency,govt
can correct the disequilibrium in the BOP in the economy.Exchange rate
depreciation reduces the value of home currency in relation to foreign
currency.As a result,import becomes costlier and export become cheaper.It also
leads to inflationary trends in the country.
Measures

d, Devaluation :Devaluation is lowering the exchange value of the official

currency .When a country devalues its currency,exports become cheaper and
imports become expensive which causes a reduction in the BOP deficit.
e, Deflation :Deflation is the reduction in the quantity of money to reduce prices
and incomes .In the domestic market,when the currency is defated,there is a
decrease in the income of the people.This puts curb on consumption and govt
can increase exports and earn more foreign exchange.
f, Exchange Control:All exporters are directed by the monetary authority to
surrender their foreign exchange earnings,and the total available foreign
exchange is rationed among the licensed importers.The license holder can import
any good but the amount is fixed by monetary authority.
Measures to correct disequilibrium in
BOP
 II.Non-monetary measures
a) Export promotion :To control export promotions the country may adopt measures to
stimulate exports like
1.Export duties may be reduced to boost exports
2. Cash assistance ,subsidies can given to exporters to increase exports
3.Goods meant for exports can be exempted from all types of taxes
b, Import substitutes:steps may be taken to encourage the production of import
substitutes.This will save foreign exchange in the short run by replacing the use of
imports by these import substitutes
c, Import Control :Import may be kept in check through the adoption of a variety of
measures like quotas and tariffs.Under the quota system,the govt fixes the maximum
quantity of goods and services that can be imported during a particular period.
Unit II
Internal and External balance

 Contents
 Expenditure changing and Expenditure switching policies
 Expenditure switching policies
 Devaluation:The Elasticity Approach
 J curve effect
 Devaluation : The Absorption Approach
 Expenditure changing policies
 Monetary policy
 Fiscal policy
 Import function of the nation
 Foreign trade multiplier
 Internal and External balance with expenditure changing and expenditure switching policies
 The Swan Model
 The Assignment problem
Internal and External Balance

 Every nation aims to achieve full employment and price stability within the
domestic economy and equilibrium in the balance of payments.
 The most important economic objectives of a nation are
(a) Internal balance
(b) external balance
(c) reasonable rate of growth
(d) equitable distribution of income.
 As automatic adjustment mechanisms have serious unwanted side effects,
there has been a shift in the emphasis from automatic adjustment
mechanisms to different kinds of adjustment policies. The economist mainly
responsible for this shift is James Meade.
Expenditure changing and Expenditure
Switching Policies
 When there is a deficit or surplus in the balance of payments of a country,
equilibrium is brought about automatically through price and income changes
or by adopting certain policy measures.
 There are two main ways in which a deficit can be cured: expenditure
changing or expenditure - switching policies.
 Monetary policy and fiscal policy are the important expenditure changing
policies
 Expenditure switching policies primarily work by a change in the exchange
rate involving a devaluation or a revaluation of the domestic currency.
Expenditure Switching policies

 Expenditure switching policies refer to a change in exchange rates, namely

devaluation. The traditional approach to the effect of devaluation on the
balance of trade is in terms of elasticities - the elasticity approach.
 The modern approach concerning the effects of devaluation on the balance of
trade is absorption approach.
Devaluation: The Elasticity Approach

 One major way in which devaluation affects a country’s balance of payment is

through changes in the relative prices of goods and services internationally.
 A deficit country may be able to reverse the imbalances by lowering its prices so
that exports are encouraged while imports decline.
 One way of accomplishing this is by adjusting the exchange rate by currency
devaluation.
 The ultimate outcome of a currency devaluation depends on the price elasticity of
demand for a country’s imports and the price elasticity of demand for its exports.
 The immediate effect of devaluation is a change in relative prices. An increase in
import prices leads to a fall in the demand for imports. Exporters can lower their
prices counted in foreign currency and will become more competitive. By how much
they are able to expand exports depends primarily on the foreign demand
elasticities for their goods.
Marshall-Lerner condition

 The traditional approach to the effects of devaluation on the balance of payments is based on
Marshall - Lerner condition for devaluation.
 Marshall - Lerner condition states that the sum of the elasticities of demand for a country’s
exports and of its demand for imports has to be greater than 1 for a devaluation to have a
positive effect on a country’s trade balance. Such a case indicates a stable foreign exchange
market.
 If the sum of these elasticities is less than 1, the foreign exchange market is unstable.
 If the sum of the elasticities of demand for a country’s exports and of its demand for imports is
equal to 1, a change in exchange rate will leave the exchange rate unchanged.
 According to Marshall - Lerner condition, a devaluation will improve the trade balance if ex +
em>1 (the sum of the two elasticities is greater than one).
 Where ex = foreign country’s elasticity of demand for the exports of the country which
devaluates its currency em = devaluing country’s elasticity of demand for imports.
 If ex + em<1,devaluation will lead to a worsening of balance of trade and if
ex+em=1,devaluation will not have any impact on trade.
The elasticity approach

 devaluation will lead to an increase in the price of imports.

 The effect of this price increase will depend on the elasticity of demand for imports.
 The larger the elasticity the greater will be the fall in the volume of imports.
 The value of the demand elasticity of imports depends on what type goods the devaluing country imports.
 If a country primarily imports necessities, raw materials and goods needed as inputs for its industries, the
demand elasticity of imports may be very low and a devaluation may not be a very efficient means of
correcting a deficit.
 When the exporters receive more for every unit of foreign currency they earn, they can lower their prices
quoted in foreign currency. When they lower their prices they will be able to sell more. By how much the
quantity exported increases depends on the demand elasticity confronting the country’s exports.
 Again, it depends to a large extent on the type of goods the country exports as well as the market
conditions. If a country exports raw materials and if it is the sole or main supplier of the product, the
foreign demand elasticity for its exports may be low.
 If a country exports industrial goods in close competition with suppliers from other industrial countries,
the demand elasticity for its products will be probably high.
The elasticity approach

 devaluation should be used only as a last resort as it has some side effects.
 Devaluation can have an inflationary impact on the economy as it makes
import goods more expensive and the increase in import prices.
 However, the effects of devaluation on the price level depend on the type of
economic policy accompanying devaluation.
 Another consideration is the effect of devaluation on income distribution and
it is expected to lead to a redistribution of income away from the labour class
to the non -labour class.
 A devaluation should result in a reallocation of resources away from the
sector producing non traded goods and into export and import competing
sectors.
J curve effect

 A nation’s balance of trade may actually worsen soon after a devaluation and it may
improve later on. This is due to the tendency of the domestic currency price of imports
to rise faster than the export prices soon after devaluation.
 Later, the quantity of export rises and the quantity of import falls and export prices
catch up with import prices.
 Thus, the initial deterioration in the nation’s trade balance is halted and then reversed.
 This short term deterioration in balance of trade is due to inelastic demand.
 When demand becomes more price elastic, BOT improves in the long run. This tendency
of a nation’s balance of trade to first deteriorate before improving as result of a
devaluation or depreciation in the nation’s currency is known as J- curve effect.
 nation’s trade balance is plotted on the vertical axis and time is plotted on the
horizontal axis. The response of the trade balance to a devaluation looks like J. Here,
it is assumed that the original trade balance is zero.
J-curve effect
Devaluation: The Absorption Approach

 Apart from the traditional approach, absorption approach is an alternative approach to

the effects of devaluation formulated in macro terms.
 It was first developed by Sidney Alexander.
 A devaluation affects a country’s national income also. The larger the trade relative to
national income, lesser accurate will be the predictions of the elasticity approach.
 To appreciate the interaction between the price and income effects, assume that a
country devalues its currency to correct a payments deficit. The rise in export income
and the fall in import expenditures will stimulate domestic spending and income
according to the multiplier process.
 The opposite will occur in the foreign country. The rise in domestic income leads to an
increase in imports by way of the increase in marginal propensity to imports. This means
that the initial price effect of devaluation, which is positive, is counteracted by a
negative income effect. The trade will either improve or worsen depending on the
relative strength of these two opposing forces.
Absorption Approach

 The devaluation of currency will increase the net exports of the country.
 However,an increase in net exports will also increase income(Y),thereby
increasing consumption(C) and investment(I)
 The trade balance or balance of payment will improve only when the increase
in income is more than the increase in domestic expenditure(C+I)
 Y>C+I
 If Y>C+I –Trade balance will improve
 Y=C+I No change in the trade balance
 Y<C+I Trade balance will worsen
Absorption Approach

 From the Gross Domestic product (GDP) equation

 Y=C+I+G+(X-M)
 Rearranging the equation,we get
 X-M=Y-(C+I+G)
 Assume that government spending is constant in the short run,denote that X-
M as B and C+I as A
 Therefore B=Y-A
 Where B is the net exports or balance of trade(BOT) Y is the income and A is
the domestic expenditure
Contd.

 A devaluation on trade balance depend first on how devaluation affects the real income or
output (Y), second on the marginal propensity to absorb (c) and third on the effect of
devaluation on direct absorption (D). All these ultimately depend on whether there are idle
resources (unemployment) in the economy.
 If there are unemployed resources when the country devalues, then production can expand
in the short run.
 The expansionary process is expected to start by an increase in exports giving rise to an
increase in national income via the multiplier process. By how much exports will expand
depends greatly on whether export prices in the devaluing country rise and on the capacity
and willingness of the rest of the world to absorb exports from the devaluating country.
 The net effect of the recovery or the increase in income on the balance of trade does not
comprise the total amount of increase in production but, rather, the difference between
this and the induced increase in total absorption.
Expenditure changing policies

 Expenditure reducing policies can be divided into two broad categories: monetary policy and fiscal policy.
 Monetary policies today are in principle the same as under the gold standard, though the spectrum of
policies is now broader.
 Fiscal policy was hardly used for this purpose before the 1930’s. It has become an important policy
weapon in connection with the growth of government expenditure which has occurred in most countries
since the second world war.
 Monetary Policy Changes in interest rates and open - market operations are today the most important
instrument for monetary policy. To cure a deficit, the natural thing to do is to raise interest rates and sell
bonds.
 The primary effect of an increase in interest rates is on investment. As it becomes more expensive to
borrow money and the availability of credit becomes more scarce, producers borrow and invest less.
 If the country is in a boom period, the result of an increase in interest rates depends to a large extent on
the expectations of producers. If they expect the interest rate to fall after some time, they may
postpone investments. In such a case the increase in interest may have a considerable impact and
through multiplier effects lead to a reduction in the national income or at least act as a brake in an
inflationary situation.
Monetary policy

 The standard means of regulating the supply of money and influencing the availability of credit is
through open - market operations.
 In open - market operations, the central bank sells or buys bonds and securities.
 If it sells bonds, bond prices will be decreased and the effective interest yield will be increased.
 If the central bank wants to tighten the money supply, it sells bonds and other securities to
commercial banks, insurance companies, households, etc.
 Commercial banks and other buyers of bonds will have to pay for them with liquid money. The
liquidity to the banking system falls and the availability of credit decreases.
 The sale of bonds will also lead to a fall in their price and to an upward pressure on interest rates.
The decrease in availability of credit, together with an increase in discounts, can have a negative
influence on investment. Producers may now simply find it impossible to borrow money. An increase
in interest rate and a decrease in the availability of credit can affect investment.
 A decrease in investment will, through a multiplier effect lead to a decrease in income and to a fall
in imports. Similarly, policies that curtail consumption will also lead to a decrease in imports. Thus,
a tighter monetary policy is one way of implementing a policy of expenditure reduction.
Fiscal Policy

 Fiscal policy can also be used to reduce expenditure.

 One form of expenditure reducing policy is to cut government expenditure. A
decrease in public consumption will, of course, also lead to a fall in total
income. A decrease in public investment produces much the same effect on
national income as does a fall in private investment and leads to a fall in
national income and imports.
 Fiscal policy can, therefore, be viewed as an efficient means of
implementing an expenditure reducing policy.
 It may be difficult for government to increase taxes and keep expenditures
constant, or to decrease expenditures keeping taxes constant. However if it
does so, total expenditures will definitely decrease and imports will fall.
Import function of the Nation

 The imports of a country depend on its level of income. For given prices of
imported goods and tastes of consumers, the higher the level of income, the
greater will be its imports.
 The relationship between imports and level of income of a country is called
the import function and is written as:
 M = f(Y)
 where M stands for imports and Y stands for income of a country.
 Following Figure shows an import function, where on the X axis the level of
national income and Y-axis imports of a country are measured.
Import function of the Nation
Contd.

 There are two concepts of propensity to import which should be understood.

 APM and
 MPM
 First, average propensity to import is defined as the proportion or
percentage of national income spent on imports, that is, it is rupee value of
imports divided by national income or M/Y.
 The marginal propensity to import means change in import as a result of
increase in national incomes and is expressed as ΔM/ΔY where ΔM is the
change in value of imports and ΔY is the increase in national income.
Foreign Trade Multiplier

 In a closed economy equilibrium level of national income is determined at the level where intended
saving equals intended investment (S = I).
 Saving represents leakage or withdrawal of some money from the income flow, while investment is
the injection of some money in to the income stream.
 The level of national income is in equilibrium when leakage from the income stream in the form of
savings is equal to the injection of investment expenditure.
 In an open economy, the role of foreign trade, that is, exports considered. Imports by consumers of a
country represent the expenditure on imported goods by the residents of the country and leads to
the leakage of some income from domestic economy.
 Therefore, in addition to saving, imports are other form of leakage that occur in an open economy.
On the other hand, exports represent expenditure by the people of foreign countries on the goods
produced in the domestic economy and are, like domestic investment, injection into the income
stream of an open economy.
 Therefore, equilibrium level of national income in an open economy is determined at the level at
which total leakage, that is, savings plus imports (S + M) equal total injection, that is, domestic
investment plus exports (I + X) into the income stream.
Contd.

 Thus, in an open economy, national income is in equilibrium at the level at which S + M = I + X When a
change in any of the above four variables occurs, then the change on the left side of the above equation
must equal the change on the right side if the new equilibrium is to be achieved.
 Hence, ΔS + ΔM = ΔI + ΔX …(1)
 Now, introduced changes in saving, ΔS = s. ΔY
 Where s = marginal propensity to save and ΔY= change in national income.
 Similarly introduced change in imports, ΔM = m. ΔY where m = marginal propensity to import.
 ΔI + ΔX = s. ΔY + m. ΔY
 ΔI + ΔX = (s+ m) ΔY
 ΔY = 1/s+m ( ΔI + ΔX)
 Where 1/s+m is the foreign trade multiplier
 So, the foreign trade multiplier is equal to the reciprocal of marginal propensity to save (s) plus marginal
propensity to import (m).
 Smaller the values of marginal propensity to save (s) and marginal propensity to import (m) the greater
the value of foreign trade multiplier.
Graphic representation of foreign trade
multiplier

 where S + M is the saving plus import function curve and Xo is the export curve
which is constant and it has assumed to be an autonomous variable which is
independent of the level of income.
 Let us assume that there is no investment and the equilibrium level of national
income will be determined by consumption and exports.
 where S + M=X0, investment being zero. Suppose there is autonomous increase in
exports so that export curve shifts upward from X increases to Y1.
 Thus, increase in exports (ΔX) has led to the increase in income (ΔY) equal to Y Y0
which is much greater than change in exports (ΔX).
 The expression ΔY/ΔX represents the foreign trade multiplier whose value depends
on the slope of which is equal to the reciprocal of the sum of marginal propensity to
save and marginal propensity to import (1/s + m).
Contd.
Contd.

 Thus, increase in exports (ΔX) has led to the increase in income (ΔY) equal to
Y Y0 which is much greater than change in exports (ΔX). The expression
ΔY/ΔX represents the foreign trade multiplier whose value depends on the
slope of which is equal to the reciprocal of the sum of marginal propensity to
save and marginal propensity to import (1/s + m).
Working of the Foreign Trade Multiplier

 The foreign trade multiplier works in the same way as keyne’s investment multiplier.When there is
increase in exports ,it will cause the increase in income of the exporters and those employed in
the export industries.They will save some of the increase in their incomes and will spend a good
part of the increase in their incomes on consumer goods,both domestic and imported ones.
 Expenditure on imports represents leakage from the income stream as far as domestic economy is
concerned.But the increased expenditure on domestic goods as a result of increase in exports will
go on increasing incomes in various successive rounds of spending till the multiplier fully works
itself out.
 the exporters may meet the demand for exported goods by selling their inventories and enjoy
higher incomes. But in the next periods, they will make efforts to increase the production of
exported goods and employ more workers. This will generate new income and employment in the
export industries. But the working of multiplier does not stop here.
 Those employed in export industries will spend a good part of their increased incomes on goods
produced by other industries and in this way increases in income, production and employment will
spread in the whole of the domestic economy.

The Foreign Trade Multiplier: With both
Exports and Domestic Investment
 In an open economy when there is positive investment the level of equilibrium in
national income is reached when sum of domestic investment and net exports
equals saving.
 Thus, in an open economy the condition for the equilibrium level of national
income is: Id + Xn = S …(1)
 where Id is domestic investment, Xn is net exports and S is the saving
 Net exports (Xn) is the net of exports over imports, that is, Xn = X – M
Substituting X – M for Xn in equation (1) we get
 Id + (X – M) = S
 or Id + X = S + M
 In the case when there is positive domestic investment the determination of the
equilibrium level of national income is graphically shown in figure.
Contd.

 The curve id represents domestic investment which remains constant.

 S is an increasing function of income.
 Over the domestic investment curve(Id) we have added the exports(X) of the economy to get
Id+X curve.
 To the saving function curve we have added the import function curve to obtain the
aggregate of saving and import functions curve (S+M)
 in the figure Id+Xequals S+M at point E and thus the equilibrium level of national income Yo
is determined.Yo level of income saving(S) and domestic investment(Id) are also equal.
 Thus at equilibrium income Yo
 Id+X=S+M
 And Id= S
 At Yo equilibrium income
 X=M
Contd.
Foreign trade multiplier with exports
and domestic investment
 The equality of exports (X) with imports (M) implies that there is equilibrium
in the balance on the current account. However, it is important to note that it
is not necessary that at equilibrium level of national income exports (X) equal
imports (M).This equilibrium in the current account balance along with
equilibrium of saving and domestic investment occurs only when e equal to
imports at the equilibrium level of income determined by the equality of
saving and domestic investment.
 In figure at equilibrium income Y investment, imports are equal to DE.
 If exports happen to b current account balance will also occur. However, this
is not necessary because exports may be greater or less than the imports DE. –
Internal and External balance with Expenditure
Changing and Expenditure Switching Policies

 The most important economic objectives of a nation include

 (a) Internal balance which refers to full employment with price stability and (b) the
external balance or balance of payments equilibrium. Here, we examine how a nation
achieves internal and external balance with expenditure switching and expenditure
changing policies.
 It was Harry G. Johnson who pointed towards the range of policy instruments for bringing
about both internal and external balance the called them expenditure reducing or internal
policies and expenditure switching or external policies.
 A deficit in the balance of payments implies an excess of expenditure over income. To
correct it, expenditure and income should be brought into equality.
 Expenditure - reducing policies aim at reducing aggregate demand through higher taxes
and interest rates thereby reducing expenditure and output. The reduction in expenditure
and output in turn, reduces the domestic price level. This gives rise to switching of
expenditure from foreign to domestic goods. Consequently, the country’s imports are
reduced.
Contd.

 Expenditure switching policies aim at increasing the demand for domestic goods and to
change expenditure from imported goods to domestic goods. Such expenditure - switching
increases domestic output.
 Johnson distinguished between two types of expenditure switching policies.
 The first is devaluation which, by making the country’s goods relatively cheaper compared
with imported goods, tends to switch both domestic and foreign expenditure on domestic
goods.
 The second is the use of direct controls to restrict imports. To achieve both objectives of
internal and external balance simultaneously, a judicious combination of expenditure -
reducing and expenditure switching instruments is needed.
 So expenditure - switching policy of devaluation must be accompanied by expenditure
reducing policies of tighter fiscal and monetary controls to maintain full employment and
balance of payments equilibrium. In order to attain simultaneously the two targets of
internal and external balance, the relationship between policy instruments are discussed in
terms of Trevor Swan's model
Swan model

 The model is based on the assumption that (1) there are no trade restrictions
(2) there are not capital movements (BOP = BOT) and (3) there is no inflation
until full employment is reached.
Swan model

 the horizontal axis measures real domestic expenditure/absorption and the

vertical axis measures the exchange rate.
 An increase in R refers to devaluation and a decrease in R refers to revaluation.
 YY is the internal balance curve which represents a situation of full employment
and stable prices. It represents the various combinations of exchange rates and
real domestic expenditure that result in internal balance.
 The YY curve is negatively sloped which shows that an increase in domestic
absorption must be balanced by a decrease in the exchange rate of the country
to reduce its trade balance in order to maintain full employment with price
stability.
 Obviously, points to the right (above) the YY curve relate to inflation or over full
employment, and points to the left (below) of the curve refer to recession or
unemployment.
Contd.

 The EE curve shows various combinations of exchange rate and domestic

expenditure that result in external balance. It represents the external
balance where exports equal imports, in the absence of capital movements.
So, external balance occurs when net exports equal zero.
 This curve slopes upwards from left to right which shows that for the
economy to remain in external balance devaluation must be balanced by an
increase in domestic expenditure (Devaluation will improve the country’s
trade balance by encouraging exports and discouraging imports, and the
increase in real domestic expenditure will increase the country’s imports
sufficiently).
 Obviously, points above the EE curve refer to a surplus and points below the
cure relate to a deficit in the balance of payments.
Contd.

 The point where the EE curve intersects the YY curve represents the point of
bliss where the economy is simultaneously in internal and external balance. F is
such a point in figure. where the exchange rate and real domestic expenditure
are in equilibrium.
 If the economy is not at point F, it is in disequilibrium. According to Swan, the
two curves of internal balance and external balance divide disequilibrium
situation into four zones of external and internal imbalances.
 The four zones of disequilibrium are:
 Zone I Unemployment and surplus in the balance of payments.
 Zone II Inflation and surplus in the balance of payments.
 Zone III Inflation and deficit in the balance of payments.
 Zone IV Unemployment and deficit in the balance of payments.
Policy Measures

 A country at point C’ has equilibrium in the balance of payments and unemployment

(or recession). Such a situation requires expansion of the domestic economy through
increase in domestic expenditure. This will reduce net exports. In order to counteract
this tendency, devaluation should be combines with increase in domestic expenditure.
If unemployment and a deficit in the balance of payments exist simultaneously, as at
point C in fourth, there should be increase in domestic expenditure as well as
exchange rate. If exchange rate alone is increased, nation can reach only C’ (external
balance) or C” (internal balance), but cannot achieve both internal and external
balance simultaneously.
 Similarly, by increasing domestic absorption only, nations can reach J (internal balance
only) where there is no external balance. It the nation is on point J on YY, if there is
devaluation alone, the nation can reach S on EE. However, there will be inflation.
 Hence, we can see that two policies are simultaneously required to achieve the two
goals. That is a combination of expenditure switching and expenditure reducing
policies are essential to achieve both internal and external balance.
The Assignment Problem

 When the economy follows only one policy or both expenditure - switching and
domestic expenditure policies simultaneously to achieve one target (say,
internal balance), it moves away from the other target (say, external balance).
 If the policy makers follow a ‘piecemeal’ approach to policy making with the
use of just one policy instrument to obtain each target, then they may move
away from rather then towards the ultimate goal of simultaneously attaining
their targets. This is known as assignment problem. Assume that the two
instruments are exchange rate (to achieve external balance) and fiscal policy
(to achieve internal balance), whether this is the correct assignment depends
on the relative impact of two instruments on the two targets.
 Economists like Mundell suggested that fiscal policy can be used to bring about
internal balance and monetary policy to obtain external balance. This will lead
to convergence on the policy goal of simultaneous balance.
Module II
foreign Exchange
 Contents
 Meaning and Functions of Foreign Exchange
 Determination of Exchange Rate
 Equilibrium in Foreign Exchange Rate
 Spot and forward Exchange rates
 Arbitrage
 Different foreign exchange regimes
 Fixed exchange rate
 Floating Exchange rate
 Flexible Exchange rate
 European Snake(Snake in the Tunnel)
Meaning of Foreign Exchange

 The foreign exchange market is the market in which individuals, firms, and
banks buy and sell foreign currencies or foreign exchange.
 The foreign exchange market for any currency comprises of all the locations
where the currency is bought and sold for other currencies.
 Different monetary centers (for eg. London, Paris, Zurich, Frankfurt,
Singapore, Hong Kong, Tokyo, and New York) in which these currencies are
bought and sold are connected electronically and are in constant contact with
one another, thus, forming a single international foreign exchange market.
Functions of Foreign Exchange Market

 The various functions of the Foreign Exchange Market are as follows:

 Transfer Function: The basic and the most obvious function of the foreign
exchange market is to transfer the funds or the foreign currencies from one
country to another for settling their payments. The market basically converts
one’s currency to another.
 Credit Function: The FOREX provides short-term credit to the importers in
order to facilitate the smooth flow of goods and services from various
countries. The importer can use his own credit to finance foreign purchases.
 Hedging Function: The third function of a foreign exchange market is to hedge
the foreign exchange risks. The parties in the foreign exchange are often afraid
of the fluctuations in the exchange rates, which means the price of one
currency in terms of another currency. This might result in a gain or loss to the
party concerned.
Features of Foreign Exchange Market

1. High Liquidity
The foreign exchange market is the most easily liquefiable financial market in the whole world.
This involves the trading of various currencies worldwide. The traders in this market are free to
buy or sell the currencies anytime as per their own choice.
2. Market Transparency
There is much clarity in this market. The traders in the foreign exchange market have full access
to all market data and information. This will help to monitor different countries’ currency price
fluctuations through the real-time portfolio.
3. Dynamic Market
The foreign exchange market is a dynamic market structure. In these markets, the currency
values change every second and hour.
4. Operates 24 Hours
The Foreign exchange markets function 24 hours a day. This provides the traders the possibility to
trade at any time.
Participants of Foreign Exchange Market

 Central Bank: The central bank takes care of the exchange rate of the currency of
their respective country to ensure that the fluctuations happen within the desired
limit and this participant keeps control over the money supply in the market.
 Commercial Banks: Commercial banks are the channel of forex transactions, which
facilitates international trade and exchange to its customers. The commercial banks
also provide foreign investments.
 Traditional Users: The traditional users consist of foreign tourists, the companies
who carry out business operations across the globe.
 Traders and Speculators: The traders and the speculators are the opportunity
seekers who look forward to making a profit through trading on short-term market
trends.
 Brokers: Brokers are considered to be the financial experts who act as a sure
intermediary between the dealers and the investors by providing the best quotations.
Demand and Supply of foreign exchange

 The demand for foreign currencies arises when tourists visit another country
and need to exchange their national currency for the currency of the country
they are visiting or when a domestic firm wants to import from other nations
or when an individual or firm wants to invest abroad and so on.
 A nation’s supply of foreign currencies arises from foreign tourist
expenditures in the nation, from export earnings, from receiving foreign
investments, and so on.
 A nation’s commercial banks operate as clearing houses for the foreign
exchange demanded and supplied in the course of foreign exchange
transactions by the nation’s residents
Determination of Foreign Exchange Rate

 Exchange rate can be defined in two ways:

(1) the amount of the foreign currency that may be bought for one unit of the
domestic currency
(2) the cost of domestic currency of purchasing one unit of the foreign currency.
 The rate of foreign exchange as the price of one unit of foreign currency
expressed in terms of the units of the home currency.
 Like the determination of price of a commodity in a free commodity market,
the foreign exchange rate is also determined in the free foreign exchange
market by the demand for the supply of foreign money
 Foreign exchange rate is determined by the forces of demand for foreign
exchange and supply of foreign exchange.
Determination of Exchange Rate

 Under flexible exchange rate system, like the price of any other commodity,
the dollar price of euro (R) is determined by the intersection of market
demand and supply curves for euro. In the figure, the vertical axis measures
the dollar price of Euro and the horizontal axis measures the quantity of
euros.
Demand for Foreign Exchange

 The demand for foreign exchange arising from the imports of goods and
services has the same foreign exchange rate elasticity as the elasticity of
demand for the imported goods and services with respect to their prices
expressed in terms of the home currency.
 So far the demand for foreign exchange has been regarded as wholly arising
from the imports of goods and services.
 Although the imports of goods and services constitute the single largest
component of the total demand for foreign exchange, it is not the only source
of demand for foreign exchange.
 Foreign loans and investments and outward unilateral transfers are also
sources of the autonomous demand for foreign exchange.
Supply of Foreign Exchange

 The supply schedule or curve of foreign exchange shows the different amounts of foreign
exchange that are available at different rates of foreign exchange in the foreign exchange
market.
 The source of supply of foreign exchange appearing on the credit side of the international
balance of payments of a country is the exports of goods and services, capital inflows and inward
unilateral transfer receipts.
 These sources of supply of foreign exchange depend largely on the decisions of foreigners. The
total amount of different goods and services which a country can export and, the total amount
of foreign exchange which it can acquire through exports depends on the amount of different
goods and services which the residents of foreign countries are willing to import from a
particular country.
 The amounts of capital inflows and unilateral transfer receipts depend on the decisions of the
foreign investors to invest in any given country.
 Thus, ceteris paribus, a country’s exports-which are imports of other countries-are a function of
the foreign exchange rates because these together with their domestic prices determine the
prices of exports expressed in terms of the foreign currencies.
Contd.

 The negatively sloping DD demand curve shows that elasticity of the demand for
foreign exchange is less than infinity and greater than zero.
 The demand for foreign exchange arising from the imports of goods and services
has the same foreign exchange rate elasticity as the elasticity of demand for the
imported goods and services with respect to their prices expressed in terms of
the home currency.

 The supply curve of foreign exchange is positively sloped from left to right if the
elasticity of foreign demand for the country's exports and, therefore, for its
currency is greater than unity. It will be vertical if the elasticity of foreign
demand for the country's exports is unity while it will be backward bending if
the elasticity of foreign demand for the country's exports is less than unity.
Equilibrium Foreign Exchange Rate

 The equilibrium foreign exchange rate in the foreign exchange market is

determined at the point of intersection of the supply and demand curves for
foreign exchange
 When there is excess demand for foreign currency there will be a rise in the
rate of foreign exchange while an excess supply situation will manifest itself
through a fall in the rate of foreign exchange.
 Thus, a rise or a fall in the foreign exchange rate in the foreign exchange
market shows the presence of disequilibrium in the market.
 The equilibrating movements in the foreign exchange rate may, however, be
obstructed by government through exchange control or exchange pegging.
Spot and Forward Foreign Exchange
Rates
 The spot rate of foreign exchange is the rate or price expressed in terms of the home
currency which is payable for spot delivery of specified type of foreign exchange.
 The forward rate of foreign exchange is the rate or price at which a transaction can
be consummated at some specified time in future.
 The spot transactions in which the buyer buys and seller sells ‘on the spot’ are
conducted in the spot foreign exchange market. In the spot transaction, the seller of
foreign exchange has to deliver the foreign exchange sold by him ‘on the spot’ (within
two days).
 In the forward foreign exchange market the seller agrees to sell and the buyer agrees
to buy a certain stated amount of foreign exchange at some specified future date at a
price agreed upon in advance. Usually the forward contracts are made on the three-
month basis.
 The spot and forward foreign exchange markets are intimately linked through interest
arbitrage, hedging and speculation.
Arbitrage

 Arbitrage refers to the purchase of a currency where it is cheaper for

immediate resale at a place where it is more expensive in order to make a
profit.
 Arbitrage is the act of simultaneously buying a currency in one market and
selling it in another at a small margin of profit.
 It is the mechanism by which the two markets, physically separate, are
unified into a single market in economic sense. A single market is a place
where the buyers and sellers of a commodity trade at an identical price.
Arbitrage results in one price and one market where there are two markets
and the costs of buying in one and selling in the other market are small.
 An arbitrageur is one who generally buys at a lower price and sells at a higher
price in a situation where both prices are known to him.
Arbitrage

 Arbitrage is conducted by a few large institutions which are mostly banks and
possess the necessary capital and connections for prompt purchase and sale
of foreign exchange on a large scale and which can afford to obtain a very
small rate of profit.
 In the real world, however, arbitrage operations are not limited to two
currencies or two centers only.
 In fact, there may be more than two currencies and more than two financial
centers involved in an arbitrage operation.
 When two currencies and two monetary centers are involved in arbitrage, we
have two point arbitrage.
 When 3 currencies and three monetary centers are involved, we have
triangular or three point arbitrage.
Different Foreign Exchange Regimes

 There are three important exchange rate systems

(1) fixed (pegged) exchange rate system
(2) flexible exchange rate system
(3) floating exchange rate system

 Fixed exchange rate system had been tried by the IMF during 1947- 1971 and
then this system was abandoned. After 1971, the world’s exchange rate
became a flexible or a floating one. The exchange rate that is followed by the
IMF now is known as ‘managed floating system, or ‘managed flexibility’.
Fixed Exchange Rate system

 A fixed exchange rate is an exchange rate that does not fluctuate.

 Government or the central monetary authority intervenes in the foreign
exchange market so that exchange rates are kept fixed at a stable rate.
 Under fixed exchange rate system, the monetary authority ties the
currency’s official exchange rate to another country’s currency or to the price
of gold.
 The rate at which the currency is fixed is called par value. This par value is
allowed to move in a narrow range or ‘band’ of ± 1 per cent.
Floating Exchange rate system

 A regime where the value of the currency in relation to others is allowed to

freely fluctuate subject to market forces.
 Under floating exchange rate the government fixes the range of foreign
exchange rate with in which exchange rate is allowed to fluctuate according
to demand and supply of foreign currency in the market.
 Under the managed exchange rate, floating exchange rates are ‘managed’
partially.
 Exchange rates are determined mainly by market forces, but central bank
intervenes to stabilize fluctuations in exchange rates so as to bring ‘orderly’
conditions in the market or to maintain the desired exchange rate values.
Flexible Exchange rate system

 Under flexible exchange rate system, the exchange rate is determined by

market forces of demand and supply of foreign exchange.
 Government does not intervene and the market forces determine the
exchange rate.
 In fact, automatic variations in exchange rates consequent upon a change in
market forces are the essence of freely fluctuating exchange rates.
European Snake (Snake in the tunnel)

 The snake in the tunnel was the first attempt at European monetary cooperation in the
1970s, aiming at limiting fluctuations between different European currencies. It was an
attempt at creating a single currency band for the European Economic Community
(EEC), essentially pegging all the EEC currencies to one another.
 Snake in the tunnel is an expression for an agreement by a group of countries in a
flexible exchange rate system to intervene in the foreign exchange market to hold their
currencies closer to each other than the generally permitted maximum deviation.The
general limit is the tunnel.
 This system was operated by some European countries before the adoption of the
European Monetary System in 1979.
 The snake in the tunnel was a system of European monetary cooperation in the 1970’s
which aimed at limiting the fluctuations between different European currencies.
 It attempted to create a single currency band for EEC essentially pegging all the EEC
currencies to one another.
Snake in the tunnel
Contd.

 The tunnel collapsed in 1973 when the US dollar floated freely

 The snake proved unsustainable, with several currencies leaving and in some
cases re-joining. Ultimately, from January 1974 onwards, the snake was no
longer contained within the tunnel, and only the countries of the mark zone –
Germany, Denmark and the three Benelux countries – remained within the
system.
 The monetary agreement of 23 August 1971, signed by Belgium, Luxembourg
and the Netherlands, was suspended in 1976. Reduced to a mere skeleton,
the snake was in terminal decline. By 1977, it had become a Deutsche Mark
zone with just the Belgian and Luxembourg franc, the Dutch guilder and the
Danish krone tracking it. The Werner plan was abandoned. The nine Member
States of the EEC then decided to let all their currencies float in relation to
the dollar.
Unit 4
Theories of Foreign Exchange
 Contents
 Mint Parity Theory
 Price-Specie –Flow adjustment mechanism
 Purchasing power parity Theory
 Balance of Payments Theory
 Monetary approach under Fixed Exchange Rates
 Monetary approach under Flexible Exchange Rates
 Monetary approach to Exchange Rate Determination
 Mundell Fleming Model
Mint parity Theory

 The theory explaining the determination of foreign exchange rate under the
gold standard is known as the Mint Parity theory of foreign exchange rate.
 The theory associated with the working of the international gold standard.
 The central bank of a country was ready to buy and sell gold at specific price.
 First, let us examine Mint parity theory and purchasing power parity theory
before examining monetary approach to exchange rate determination and
BOP theory.
Mint Parity Theory

 The mint parity theory explains the determination of foreign exchange rate between the currency
units of the gold standard countries.
 When the two countries are on the gold standard, their currency units are either made of gold of
specified purity and weight or are freely convertible into gold of given purity at fixed rate.
 Under the gold standard, countries maintain the value of their currencies in a fixed relationship to the
value of gold by committing themselves to buy and sell gold at fixed prices.
 The foreign exchange rate determined on the basis of the gold contents of the two currency units.
 The exchange rate between two gold standard countries’ currencies will fluctuate within the narrow
limits around the fixed mint parity.
 By mint parity it is meant that the foreign exchange rate is determined on the weight-to-weight basis
of the metallic contents of the two money units, allowance being given to the purity of the metallic
contents.
 The mint parity theory of foreign exchange rate is applicable only when the countries are on the same
metallic standard which in practice has taken the form of either the gold or the silver standard.
 Mint parity theory has been considered as the earliest theory of foreign exchange.
Price-Specie-FIow Adjustment
Mechanism
 The price-specie-flow mechanism was first developed by David Hume in the
eighteenth century.
 The price-specie-flow mechanism under the international gold standard
occupied a prominent place in the classical explanation of the determination
of foreign exchange rate.
 The market rate of foreign exchange can differ from the equilibrium rate of
foreign exchange either by falling below it or by rising above it. This will
happen when a country’s balance of payments is in disequilibrium, i.e., when
it is either adverse due to the excess of total imports over total exports or
surplus due to the total exports exceeding the total imports.
 In such a situation, equilibrium in the international balance of payments
position of a country is restored through the automatic mechanism of gold
flows.
Contd.

 The price-specie-flow mechanism was first developed by David Hume in the

eighteenth century
 At the time it was regarded as a revolutionary notion as it led to destroy the
mercantilist view that an increase in exports leading to gold imports was desirable.
 Hume insisted that gold inflows would reverse themselves because the rise in prices
that followed the gold inflows will increase the country’s imports and decrease- her
exports.
 When a country is faced with an adverse balance of payments, equilibrium in the
balance of payments of that country is brought about through a long chain of
causation and counter causation. The excess of imports over exports reflected in
the adverse balance of trade of the country causes gold outflows from that country
and gold inflows in the country enjoying the favorable balance of trade
 This explain how trade balances can be automatically adjusted under gold standard.
Purchasing Power Parity Theory

 The purchasing power parity theory of foreign exchange rate determination

was developed by Sweedish economist Gustav Cassel at the end of World War
I as a means of measuring departure from ‘equilibrium’.
 Gustav Cassel suggested the purchasing power parity as the appropriate level
at which the foreign exchange rate should be set.
 This rate was calculated by measuring the relative departures or deviations of
price levels from some chosen base period in which the balance of payments
of concerned countries had been in equilibrium.
 According to the theory, the equilibrium rate of foreign exchange between
two inconvertible currencies is determined by the ratio of their respective
purchasing powers.
ppp theory

 Currencies are used for purchasing goods and services

 Value of a currency(money )depends upon the quantity of goods and services
that can be purchased by the currency.
 Thus,the value of money is its purchasing power
 Exchange rate is also determined on the basis of this purchasing power.
 Exchange rate is the expression of one currency in terms of another
 INR60=1$
 Puchasing power of currency changes due to inflation or deflation
 When there is inflation,price level increases,quantity of goods that can be
purchased by one unit of currency declines.,thus the purchasing power also
declines vice versa.
PPP theory

 The rate of exchange tends to be established at the point of equality between

the purchasing powers of the two currencies.
 On the other hand, if prices doubled in both the countries the purchasing
power parity rate of foreign exchange would remain unchanged. The theory
has two versions: absolute and relative.
 According to the absolute version, the equilibrium exchange rate between
two currencies is equal to the ratio of the price levels in the two nations.
 R = P /P∗ where R = exchange rate, P = general price level in home P* =
general price level in the foreign nation.
 That is the purchasing power of two currencies must be at parity. Otherwise,
it will lead to commodity arbitrage. This version of PPP completely disregards
capital account.
Relative version of PPP

 This version postulates that a change in exchange rate should be proportional

to the relative change in the price levels in the two nations over the same
period.
 R1 = P1/P0/ P1∗/P0∗× 𝑅𝑂 where
 R1 = exchange rate for period 1,
 R0 – exchange rate for base period.
 Relative purchasing power parity theory is an economic theory that states
that exchange rates and inflation prices(price levels)in two countries should
equal out over time.
Balance of Payments Theory

 The balance of payments theory holds that the foreign exchange rate is
determined by autonomous factors which are unrelated to the internal prices
and the money supply.
 According to this theory BOP position of a country determines the foreign
exchange rate.
 The forces of demand and supply are determined by various items in the balance
of payment theory
 Hence, a deficit balance of payments leads to a depreciation of the rate of
foreign exchange while a surplus balance of payments, by strengthening the
foreign exchange, causes an appreciation of the rate of foreign exchange.
 An adverse international balance of payments of a country shows a situation in
which the demand for foreign exchange (currency) exceeds its supply at a given
rate of foreign exchange.
BOP Theory

 if the international balance of payments of a country is favourable it means that there is

greater demand for the domestic currency in the foreign exchange market that can be met
by the available supply at any given rate of foreign exchange.
 Consequently, price of the unit of home currency in terms of foreign currency rises, i.e., fee
rate of exchange moves in favour of the home currency.
 Consequently, a unit of home Currency begins to command more units of the foreign
currency. There is appreciation of domestic currency.
 The theory asserts that the balance of payments position is determined mainly by factors
that are independent of changes in the rate of foreign exchange.
 independent factors that influence the foreign exchange rate consist of autonomous
payments like the reparation payments and payment of interest on foreign loans etc.
 Besides these autonomous payments, the demand for imports, particularly for essential raw
materials, may be perfectly price-inelastic and, therefore, insensitive to changes in the
foreign exchange rate.
Merits of BOP

(1) Firstly, it is compatible with the general theory of value. Like the price of any
commodity, the rate of foreign exchange should also be determined by the supply
of and the demand for foreign exchange.
(2) Secondly, it brings the determination of the foreign exchange rate within the
purview of the general equilibrium theory.
(3) Thirdly, the theory emphasizes that there are many significant forces,
besides those of exports of goods and services, which influence the supply of and
the demand for foreign exchange and, thereby, influence the equilibrium foreign
exchange rate.
(4) Fourthly, the theory explains that disequilibrium in the balance of payments
of a country can be corrected by making appropriate adjustment in the foreign
exchange rate. i.e., either by devaluing or by revaluing the currency unit of the
country.
Limitations of BOP Theory

 (1) The main defect of the theory is that it ignores that the balance of trade
depends upon the relationship between the domestic and foreign prices.
 (2) The second criticism of the theory is that it treats the demand for many
imported raw materials as perfectly price-inelastic and consequently
independent of changes in prices and foreign exchange rate. It is worthwhile
to remember that perfectly inelastic demand for a good is a very rare
phenomenon.
Monetary Approach under Fixed
Exchange Rates
 The monetary approach postulates that the demand for nominal money balances
is positively related to the level of nominal national income and is stable in the
long run.
 The equation for the demand for money can be written as: Md = kPY Where Md =
quantity demanded of nominal money balances k= desired ratio of nominal
money balances to nominal national income P= domestic price level Y = real
output .PY is the nominal national income or output (GDP).
 This is assumed to be or to tend toward full employment in the long run.
 The symbol k is the desired ratio of nominal money balances to nominal national
income; k is also equal to 1/V, where V is the velocity of circulation of money or
the number of times a dollar turns over in the economy during a year. With V and
k depending on institutional factors and assumed to be constant, Md is a stable
and positive function of the domestic price level and real national income.
Contd.

 The demand for money is a related, inversely, to the interest rate (i) or opportunity cost of
holding inactive money balances rather than interest-bearing securities.
 Thus, Md is directly related to PY and inversely related to i.
 We assume that Md is related only to PY (the nation’s nominal GDP). On the other hand, the
nation’s supply of money is given by
 Ms = m(D+F) Where Ms= the nation’s total money supply m= money multiplier D= domestic
component of the nation’s monetary base F = International or foreign component of the
nation’s monetary base
 The domestic component of the nation’s monetary base (D) is the domestic credit created by
the nation’s monetary authorities or the domestic assets backing the nation’s money supply
and (F) refers to the international reserves of the nation, which can be increased or decreased
through balance of payments surpluses or deficits.
 D+F is called the monetary base of the nation, or the high-powered money. Under a fractional
reserve banking system, each new dollar of D or F deposited in any commercial bank results in
an increase in the nation’s money supply by a multiple of $1.
Contd.

 To conclude a surplus in the nation’s balance of payments results from an

excess in the stock of money demanded that is not satisfied by domestic
monetary authorities.
 A deficit in the nation’s balance of payments results from an excess in the
stock of money supplied that is not eliminated or corrected by the nation’s
monetary authorities.
 The nation’s balance of payments surplus or deficit is temporary and self-
correcting in the long run.
 That is, after the excess demand for or supply of money is eliminated through
an inflow or outflow of funds, the balance of payments surplus or deficit is
corrected and the international flow of money dries up and comes to an end.
Monetary Approach under Flexible
Exchange Rates
 under a flexible exchange rate system, the balance of payments disequilibrium are
immediately corrected by automatic changes in exchange rates without any international
flow of money or reserves.
 under a flexible exchange rate system, the nation retains dominant control over its
money supply and monetary policy.
 Adjustment takes place as a result of the change in domestic prices that accompanies the
change in the exchange rate.
 A deficit in the balance of payments leads to an automatic depreciation of the nation’s
currency. This causes prices and the demand for money to rise sufficiently to absorb the
excess supply of money and automatically eliminate the balance of payments deficit.
 A surplus in the balance of payments (results from an excess demand for money)
automatically leads to an appreciation of the nation’s currency. This tends to reduce
domestic prices, thus eliminating the excess demand for money and the balance of
payments surplus.
Contd.

 With flexible exchange rates, the rest of the world is to some extent shielded
from the monetary excesses of some nations.
 The nations with excessive money growth and depreciating currencies will
now transmit inflationary pressures to the rest of the world primarily through
their increased imports rather than directly through the export of money or
reserves. This will take some time to occur and will depend on how much
slack exists in the world economy and on structural conditions abroad.
The Determination of a Floating Exchange Rate :
Keynesian Framework A fixed price model with
perfectly immobile capital
 Floating exchange rates insulate the domestic economy from changes in
income elsewhere.
 With fixed prices and no capital mobility, the level of real income and the
exchange rate are jointly determined by equilibrium in the goods market and
in the balance of payments.
Contd.

 The curve GM shows the combinations of real income (Y) and the exchange rate (e) that give
equilibrium in the goods market. GM has a positive slope.
 Starting from an equilibrium position, an increase in output, and so in real income, will lead to
an excess supply of goods.
 In order to eliminate excess supply the country must increase its exports and/or reduce its
imports. This requires that its exchange rate must depreciate. BP must also be positively sloped.
 An increase in real income leads to a deficit in the balance of payments, and this must be offset
by a depreciation of the exchange rate. As the marginal propensity to save and/or the marginal
tax rate are positive, the BP must however be flatter than the GM curve.
 An increase in income will in this case lead to an excess supply in the goods market that is larger
than the deficit in the balance of payments. It follows that the depreciation of the exchange
rate needed to restore equilibrium in the goods market must be greater than that needed to
restore balance of payments equilibrium. The general equilibrium of the economy is then at
point E, the intersection of GM and BP. A floating exchange rate will always bring about this
equilibrium.
Contd.

 This model may be used to give us some insight into the effects of
government policy on the exchange rate when there is no capital mobility.
Suppose that the government attempts to expand the economy, by either
fiscal or monetary means. This will shift the GM line to the right. The
economy must however remain in balance of payments equilibrium, and so
the new equilibrium must still be on BP. Since GM is steeper than BP, the
exchange rate must depreciate.
Mundell Fleming Model: A fixed price
model with capital mobility
 If there is international capital mobility, we must consider the capital account
in the balance of payments and then the effect of the domestic interest rate
must be brought into the analysis.
 We may do this by extending the familiar closed economy IS-LM model into
the IS-LM-BP or Mundell-Fleming model.
 first derive the IS and LM schedules for an open economy, and shall then
discuss the derivation of the BP(balance of payments) schedule under
different assumptions about the degree of capital mobility.
The IS schedule for a small open
economy
 The IS schedule shows those combinations of real income and the real rate of
interest that give equilibrium in the goods market. Foreign incomes and
interest rates are assumed to be given.
 I+G+X= S+M
 Savings (S) and imports (M) are increasing functions of real income (Y) but are
independent of the rate of interest (r).
 The relationship between S+M and Y is shown in the south-east quadrant of
the figure.
 IS schedule has its familiar negative slope. As in the closed economy model,
the IS schedule will be shifted to the right by an increase in the government
budget deficit.
Contd.
The LM schedule for a small open
economy
 L1+L2= Ms
The BP schedule for a small economy
 The BP schedule shows those combinations of real income and the real
interest rate that give equilibrium in the balance of payments for a given
exchange rate.
 Under the assumptions of the Keynesian model, imports (M) are an increasing
function of income, and exports (X), are exogenously determined. It follows
that the current-account balance, (X-M), is a decreasing function of income.
LM schedule
BP Equilibrium

 The flow model of the capital account states that the flow of capital is an
increasing function of the domestic interest rate and a decreasing function of the
foreign interest rate.
 The rate of interest giving balance in the capital account is r0. A higher interest
rate, such as r1, will lead to a surplus on the capital account (a net inflow), and a
lower rate of interest, say r2, will lead to a capital-account deficit (a net outflow).
 The 45° line in the south-west quadrant, which must obviously pass through the
point defined by a zero balance on both current and capital accounts.
 Balance of payments equilibrium requires a domestic interest rate, r1, that must
be higher than r0.
 The BP schedule must be positively sloped. To maintain overall equilibrium there
must be a corresponding capital outflow, and this requires that the interest rate be
lower than r0, at r2.
Contd.
Equilibrium

 The BP schedule may be steeper or flatter than the LM schedule. The degree
of capital mobility between countries determines the slope of the BP
schedule. The more highly mobile is capital, the less would be the slope of
the capital-account schedule in the north-east quadrant, and the flatter
would be the BP schedule. In the limiting case where the capital is perfectly
mobile, the BP schedule would be horizontal. At the other extreme, where
capital is perfectly immobile, the BP schedule would be vertical, since
changes in the domestic interest rate could have no direct effect on the
balance of payments.
Unit V
open Economy Macro Economic Policies
 Contents
 Impact of monetary policy in Mundell Fleming Model
 Impact of Fiscal expansion in Mundell Fleming Model
 Macro Economic policies under pegged exchange rate system
Impact of Monetary Policy

 The effect of monetary expansion on the Mundell- Fleming model under

three assumptions regarding capital mobility:
 (1) capital cannot move at all
 (2) capital is perfectly mobile
 (3) Limited mobility of capital.
Case I
Capital is not mobile
 As we have assumed perfect immobility of capital between countries, BP
schedule is vertical.
 As shown in the figure , E1 is the initial equilibrium with Y1 as the equilibrium
level of income and r1 rate of interest. When there is monetary expansion
and capital is completely immobile, there is a shift in the LM schedule to the
right. The new equilibrium is given by the intersection of LM2 with IS1. This
leads to BOP deficit and, as there is floating exchange rate, there will be
depreciation of exchange rate. This will shift the IS and BP schedule to the
right. As capital is immobile, BP curve is vertical. E2 is the final equilibrium
where LM2 and IS2 intersect with each other. Rate of interest falls to r2 and
output increases to Y2.
Contd.
Case 2
Capital is perfectly mobile
 Monetary expansion shifts the LM curve to schedule to LM2. This will lead to a
deficit in BOP. There will be decrease in interest rate.
 The BOP deficit leads to a depreciation which in turn shifts the IS curve to
the right. At the same time fall in interest rate leads to an outflow of capital.
Finally, IS schedule intersects with new LM schedule at the original rate of
interest. The country has current account surplus balanced by a capital
inflow.
Monetary expansion with perfect capital
mobility
Case III
Limited Capital Mobility
 With limited capital mobility, BP schedule is positively sloped. Monetary
expansion leads to fall in interest rate and to an increase in income. Both
leads to deficit in balance of payment and to a depreciation in exchange rate.
This leads to an increase in current account shifting the IS schedule to the
right and in a rightward movement of the BP schedule. The movement of the
IS schedule amplifies the effect of initial monetary expansion on income while
at the same time partially offsetting the initial fall in the rate of interest.
Monetary expansion with limited capital
mobility
 In the final equilibrium, income is higher than the monetary expansion and
the domestic rate of interest is lower. Lower interest rate leads to an out flow
of capital. Exchange rate depreciates and produces a current account surplus.
It is important remember that the more mobile the capital is, the flatter the
BP schedule is and the greater will be the effect of a monetary expansion on
the level of income, and smaller will be the effect on rate of interest.
Impact of Fiscal expansion in the
Mundell-Fleming model
 Let us examine the effect of fiscal expansion on the Mundell- Fleming model
under three assumptions regarding capital mobility:
 (1) capital cannot move at all
 (2) capital is perfectly mobile
 (3) Limited mobility of capital.
Case 1
Capital is Immobile
 First, let us examine the case when capital cannot move between countries. A
fiscal expansion will shift the IS schedule to the right. The original LM curve is
the LM1, and the initial equilibrium is at E1, with output Y1 and interest rate
r1
 In the case when the capital is perfectly immobile, the BP schedule is
vertical. The initial fiscal expansion shifts the IS schedule to the right. The
short-run equilibrium would be at the intersection of IS2 and LM1, which
implies a balance of payments deficit. The currency would therefore
depreciate, which will shift the IS curve further to the right as well as shifting
the BP schedule in that direction. The final equilibrium will be at a point such
as E2, with a higher income than before and a higher rate of interest (since
the money supply is unchanged while the demand for money has increased
with increased income).
Case II
Capital is perfectly mobile
 The original LM curve is the LM1, and the initial equilibrium is at E1, with
output Y1 and interest rate r1. When capital is perfectly mobile, however, a
fiscal expansion can have no long run effect.
 The initial shift to the right in the IS schedule implies a temporary equilibrium
at the intersection of IS2 and LM1. There will be an increase in the inflow of
capital that will outweigh the effects of the fiscal expansion on the current
account balance, and this will lead to appreciation of the exchange rate, and
a shift to the left of the IS schedule. Since neither the LM nor the BP schedule
will move following a fiscal expansion, the initial and final equilibria must be
the same. The IS schedule will shift back to IS1, and the fiscal expansion will
have been ineffective.
Case III
Limited capital mobility
 A fiscal expansion is effective in increasing income when there is no capital
mobility, it is totally ineffective when capital is perfectly mobile. Indeed, in
the former case the initial effect of the fiscal expansion is amplified by the
consequent depreciation of the currency and the improvement in the current
account that it brings about. In the latter case the inflow of capital brought
out by the short-term increase in the domestic interest rate leads to an
appreciation of the exchange rate, and so to the worsening of the current
account that exactly offsets the initial expansionary effect. The contrast
between these two extreme cases suggests that in the intermediate case the
degree of capital mobility will play a crucial part in determining the effects
of a fiscal expansion. The assumption is that capital has limited mobility.
Hence, the BP schedule is steeper than the LM schedule. The initial
equilibrium is again at the intersection of LM1, IS1 and BP1, giving an
equilibrium income of Y1, and the target level of income is Y2.
Contd.
 A fiscal expansion will shift the IS schedule to the right, say to IS2. If nothing
else changed then there would be an increase in income coupled with a fall in
the rate of interest. The net effect must be a balance of payments deficit,
shown by the intersection of IS2 and LM1 being to the right of BP1. This must
always be the case if the BP schedule is steeper than LM. The exchange rate
must therefore depreciate, which shifts the IS schedule yet further to the
right and the BP schedule in the same direction. Given that the government
chooses the appropriate fiscal expansion, the new equilibrium will be at the
target income Y2, determined by the intersection of IS3, BP2, and LM1. Both
income and the domestic rate of interest have increased, and the
depreciation in the exchange rate has amplified the income effect of the
initial fiscal expansion. There is a deficit on the current account, balanced by
an inflow of capital
Macro Economics Policies under fired
and pegged exchange rate system
 Under fixed exchange rate system (eg. Gold standard), as the exchange rate is fixed BOP
adjustment must either come about through the automatic working of the economic
system or must be brought about by the government. Under pegged exchange rate system
also, so long as there is no change in par value, authorities can take action to reinforce
the automatic mechanisms. However, under pegged exchange rate system the par value
of currency is a policy variable and BOP is a policy target. There are three instruments
that government can use to achieve equilibrium in BOP: changing the par value, fiscal
policy and monetary Policy Elasticity and absorption approaches examine whether
devaluation will improve BOP or not. Swan diagram explains how fiscal policy can be
combined with exchange rate adjustments to achieve both internal and external balance.
Governments are often unwilling to use exchange rate changes as a policy instrument
under pegged exchange rate system. So they combine fiscal and monetary policies to
achieve targets. The effect of all policies depend very much on three factors. Whether
there are unemployed resources, whether the authorities sterilize the effect of their
operations on the foreign exchange market and the extent to which capital is mobile
between countries.
MODULE III
INTERNATIONAL MONETARY SYSTEM
 International Monetary Fund (IMF) is an international organization that
oversees the global financial system by observing exchange rates and balance
of payments as well as offering financial and technical assistance. Its
headquarters are located in Washington D.C, USA.
 IMF was conceived in July 1944, when the representatives of 44 countries
met in Bretton Woods with a goal to stabilize exchange rates and supervise
the reconstruction of the world’s international payment system. Countries
contributed to a pool which could be borrowed from, on a temporary basis, by
countries with payment imbalances.
 The IMF was formally organized on December 27, 1945, when the first 29
countries signed its Articles of Agreement. The creation of IMF has been
considered as a landmark in the history of world economic cooperation.
Origin of IMF

 The origin of the IMF can be traced to the period of the breakdown of Gold
standard. Competitive exchange rate depreciations, exchange controls,
import and export regulations and bilateral trade pacts were the order of the
day. During the Second World War, there were plans for the construction of an
international institution for the establishment of monetary order. At the
Bretton Woods Conference held in 1944, delegates from 44 nations negotiated
an agreement on the structure and operation of the international monetary
system. The Articles of Agreement of the IMF provided the basis of the
international monetary system. Although IMF came into official existence on
27 December 1945, it started its financial operations on 1 March 1947. As of
now IMF has 189 member countries. India is one of the founder- members of
IMF.
Objectives of IMF

 1. To promote international monetary cooperation through a permanent institution which provides

the machinery for consolation and collaboration on international monetary problems.
 2. To facilitate the expansion and balanced growth of international trade, and to contribute
thereby to the promotion and maintenance of high levels of employment and real income and to
the development of the productive resources of all members as primary objective of economic
policy.
 3. To promote exchange stability, to maintain orderly exchange arrangements among members,
and to avoid competitive exchange depreciation.
 4. To assist in the establishment of a multilateral system of payments in respect of current
transactions between members and in the elimination of foreign exchange restrictions which
hamper the growth of world trade.
 5. To give confidence to members by making the general resources of the Fund temporarily
available to them under adequate safeguards thus, providing them with the opportunity to correct
maladjustments in their balance of payments, without resorting to measures destructive of
national or international prosperity.
 6. To shorten the duration and lesson the degree of disequilibrium in the BOP of members.
Functions of IMF

 The principal function of the IMF is to supervise the international monetary system.
Several functions are derived from the principal function. Secondary functions are the
following: granting of credit to member countries in the midst of temporary balance of
payments deficits, surveillance over the monetary and exchange rate policy of
member countries, issuing policy recommendations. So we can classify the functions of
the IMF may be combined into three: Regulatory, financial, and consultative:
 Regulatory Function: The Fund functions as the guardian of a code of rules set by its
Articles of Agreement (AOA). It provides orderly adjustment of exchange rate.
 Financial Function: It functions as an agency of providing resources to meet short
term and medium term BOP disequilibrium faced by the member countries. That is the
fund functions as a short term credit institution. It is reservoir of currencies of all
member nations.
 Consultative Function: It functions as a centre for international cooperation and a
source of counsel and technical assistance to its members.
Organisation and financial structure of
IMF
 IMF is run by Board of Governors, Executive Board and international staff.
Every member country delegates a representative to the Board of Governors.
It meets once a year and takes decision on fundamental matters such as
electing new members or changing quotas. The Executive Board is entrusted
with the management of day-to-day policy decisions. The Board comprises 24
executive directors who supervise the implementation of policies set by the
member governments. IMF is headed by the Managing Director who is elected
by the Executive Board for a 5 year term of office. Rights and obligations,
i.e., the balance of Powers in the Fund is determined by a system of quotas.
Quotas are decided by a vote of the Board of Governors. Quotas or
subscriptions roughly reflect the importance of members in the world
economy. It is the quota on which payment obligation, credit facilities, and
voting rights of members are determined.
Financial Structure

 The capital or the resources of the Fund come from two sources: (i)
Subscription or quota of the member nations and (ii) Borrowings. Each
member country is required to subscribe an amount equivalent to its quota.
As soon as a country joins the Fund, it is assigned a quota which is expressed
in Special Drawing Rights (SDRs). Payment obligations, voting rights of
members and the credit facilities are fixed on the basis of quota. The Fund is
authorised to borrow in special circumstances if its own resources prove to be
insufficient. It sells gold to member countries to replenish currency holdings.
It is entitled to borrow even from international capital market. The Articles of
Agreement permit the Fund to borrow from the private capital market also.
Special Drawing Rights (SDRs)

 The Special Drawing Rights (SDRs) as an international reserve asset or reserve money in the
international monetary system was established in 1969 with the objective of alleviating the
problem of international liquidity. The IMF has two accounts of operation - the General
Account and the Special Drawing Account. The former account uses national currencies to
conduct all business of the fund, while the second account is transacted by the SDRs. The
SDR is defined as a composite of five currencies—the Dollar, Mark, Franc, Yen and Pound
 The SDRs are allocated to the member countries in proportion to their quota subscriptions.
Only the members can participate in SDR facility. SDRs often called paper gold, is just a book
entry in the Special Drawing Account of the IMF. Whenever such paper gold is allocated, it
gets a credit entry in the name of the participating countries in the account. It is to be
noted that SDRs, once allocated to a member, are owned by it and operated by it to
overcome BOP deficits. Since its inception, there have been only four allocation to SDRs -
the first in 1970, and the last in 2008-09—mainly to the developing countries. The Special
Drawing Rights (SDRs) as an international reserve asset or reserve money in the international
monetary system was established in 1969 with the objective of alleviating the problem of
international liquidity.
Lending and Loan Conditionalities of IMF

 The IMF Articles of Agreement clearly state that the resources of the Fund are to be used to give
temporary assistance to members in financing BOP deficit on current account. Of course, the
financial assistance provided by the Fund is loan. The following technique is employed: If a country
buys foreign currencies from the IMF in return for the equivalent in the domestic currency. This, in
legal and technical terms, is called a ‘drawing’ on the Fund. The technique, therefore, suggests that
the IMF does not lend, but sells the required currency to the members on certain terms. This unique
financial structure of the Fund clearly suggests that the Fund’s resources are meant to cover short
run gaps in BOP.
 The IMF loan usually lasts between 18 months and 3 years. If the borrowing nation demonstrate that
reasonable efforts have been taken to overcome its financial difficulties, the country will receive the
first ‘credit tranche’ of the loan. This is 25% of a members quota. A member is entitled to draw an
amount not exceeding 25 % of its quota. The first 25 percent is called the ‘gold tranche’ or ‘reserve
tranche’ and this can easily be drawn by countries with BOP problems. This 25 percent of the quota is
the members’ own reserves and, therefore, no conditions are attached to such drawings. This may be
called ‘ordinary, drawing rights; even the Fund cannot deny its use. However, no interest for the first
credit tranche is required to be paid though such drawings are subject to repayment within 3-5 years
period. The later series of ‘credit tranches’ will be available subject to the IMF approval and hence,
‘conditional’.
Borrowing methods used by the Fund are

 (i) Stand-by Arrangements: This method of borrowing has become the most normal form of assistance
by the Fund. Under this form of borrowing, a member state obtains the assurance of the Fund that,
usually over 12-18 months, requests for drawings of foreign exchange to meet short- term BOP
problems up to a certain amount will be allowed if the country concerned wishes. However, the
stand-by arrangements can be extended up to 3 years while repayments are required to be made
within 3-5 years of each drawing.
 (ii) Extended Fund Facility (EFF): Stand-by arrangements to stabilise a member’s BOP run usually for
a period of 12-18 months. Developing countries suffer from chronic BOP problems which could not be
remedied in the short run. Such protracted BOP difficulties experienced by the LDCs were the result
of structural imbalances in production and trade. It then necessitated an adjustment programme and
redemption scheme of longer duration.
 (iii) Compensatory Financing Facility (CFF): Apart from the ordinary drawing rights, there are some
‘special finances’ windows to assist the developing countries to tide over BOP difficulties. CFF,
introduced in 1963, is one such special drawing provision. Its name was changed to Compensatory and
Contingency Financing Facility (CCFF) in 1980, but the ‘contingency’ was dropped in 2000. Under it,
members were allowed to draw up to 25% of its quota when CFF was introduced. It can now draw up
to 45 p.c. Since the mid- 1990s, this has been the least-used facility.
Contd.

 (iv) Structural Adjustment Facility (SAF) and the Enhanced SAF (ESAF): SAF facility was introduced
in 1986. It was introduced for the benefit of low income countries. It was increasingly realised
that the so-called stringent and inflexible credit arrangements were too inadequate to cope with
the growing debt problems of the poorest members of the Fund. In view of this, SAF was
introduced which stood quite apart from the monetary character of the Fund. Under it, credit
facilities for economic reform programmes are available at a low interest rate of 0.5 % compared
to 6 % for most Fund facilities. Loans are for 10 years with a grace period of five and a half years.
LDCs facing protracted BOP problems can get assistance under SAF provided they agree to
undertake medium-term structural adjustment programmes to foster economic growth and
improve BOP conditions. An extended version of SAF—ESAF—was introduced in 1987. The ESAF has
been replaced by a new facility, called Poverty Reduction and Growth Facility in 1999. (v) Poverty
Reduction and Growth Facility (PRGF): The PRGF that replaced the Enhanced Structural
Adjustment Facility (ESAF) in November 1999 provides concessional lending to help the poorest
member countries with the aim of making poverty reduction and economic growth - the central
objectives of policy programmes. Under this facility, low-income member countries are eligible to
borrow up to 140 % of its quota for a 3-year period. Rate of interest that is charged is only 0.5 %
and repayment period covers 5-10 years, after disbursement of such facility. However, financial
assistance under this facility is, of course, ‘conditional’.
Achievements of the Fund

 IMF acts both as a financing and an adjustment-oriented international institution for the benefit of
its members It has been providing financial assistance to deficit countries to meet their temporary
disequilibrium in BOP. The Fund aims at promoting exchange rate stability. In its early phase, the
Fund made arrangements of avoidance of competitive exchange deprecitation and attempted to
solve the problem of international liquidity. To create international liquidity, SDR allocations were
made to member countries to finance the BOP deficits. The exchange rate stability that the world
witnessed in the IMF era is superior to that in other periods. IMP acts as a forum for discussions of the
economic, fiscal and financial policies of member countries, keeping the BOP problems in mind.
Previously, it has been criticized that the poorest developing countries did not receive adequate
treatment from the Fund. But from 1980s onwards with the advent of debt crisis it decided to divert
its financial resources to these countries. With the collapse of the Soviet Union in 1989, ex-
communist countries became members of the Fund and the Fund is providing assistance to these
countries so as to instill, the principles of market economy. It has decided to finance resources to
combat terrorism and money-laundering. Finally, the IMF has assisted its members in the formulation
of appropriate monetary, fiscal, and trade policies. It has served as an institution for consultation
and guidance in international monetary matters. Even though the fund pursued a conservative credit
policy, of late, IMF has changed its attitude by accepting a more liberal credit Policy. Now the fund
grants developments loans also
Failure of IMF

 Despite these achievements, there are some serious charges against this institution.
Most often, IMF is incapable of taking independent policy decisions. It complies with
the ‘order’ of the superpowers. Further, it has minimal influence over the policy
decisions of the major industrial powers. In these cases, its mandate to exercise
‘firm surveillance’ over some influential members or superpowers is virtually
meaningless. It has been criticized that IMF has no influence over the US deficits or
European interest rates. Secondly, the Fund imposes conditions on the poor
countries while sanctioning loans, sometimes ignoring its central concern—exchange
rate management and the BOP problems. It focuses on the issue of ‘market
principle’. It suggests poor developing countries to cut expenditure, subsidy,
privatisation of state-owned enterprises, etc. If such measures—most popularly
known as structural adjustment programmes—are adopted only then the IMF credit
would be given. Thirdly, the Fund has failed to eliminate foreign exchange
restrictions imposed by its members that hamper the growth of trade. In view of
these, the developing countries are blaming the IMF.
IMF and Developing Countries:

 Activities of IMF in developing world have expanded radically. Today much of

its work goes beyond macroeconomics issues and crisis prevention and
management. It is focusing more on deeper structural issues and by providing
long term development finance, it is significantly involved in efforts to reduce
poverty. The funds vehicle for long term tending to poor countries is its
poverty Reduction and Growth Facility (PRGF). PRGF was formerly known as
Enhanced Structural Adjustment Facility. The change of name shows that
poverty reduction has been emerged as a new goal. Of course, reducing
poverty is an extremely complex process requiring a different mix of policies
and institutions for each country. Moreover, IMF’s use of conditionality in
programmes is for more effective in short term stebilisation situation rather
than in long term growth and poverty.
IBRD

 The International Bank for Reconstitution and Development (popularly known

as World Bank) was set up as a result of the decision taken in Bretton Woods
Conference New Hampshire. The conference was held in July 1944 and
attended by 44 nations. There it was decided to set up two organisations (a)
the I.M.F. and (b) the I.B.R.D., to solve the monetary and financial problems
of the less developed countries likely to be faced in Post-World War II period.
The I.B.R.D. was set up on December 27, 1945 when its Articles of Agreement
was signed by 29 members. At present, 185 countries are its members. If a
country resigns its membership, it is required to pay back all loans with
interest on due dates. If the Bank incurs a financial loss in the year in which a
member resigns, it is required to pay its share of the loss on demand.
Objectives of IBRD

 1. To assist in the reconstruction and development of its member countries by

facilitating the investment of capital for productive purposes, thereby
promoting long term growth of international trade and improvements in
standard of living. It provides long term capital to member nations for
economic development and reconstruction.
 2. To promote private foreign investment by guarantees of and participation in
loans and other investments made by private investors.
 3. When private capital is not available or reasonable terms to make loans for
productive purposes out of its own resources or the funds borrowed by it. It
ensures that development projects are implemented.
 4. To arrange the loans made or guaranteed by it in relation to international
loans through other channels so that more useful and urgent small and large
projects are dealt with first.
Financing Activities of IBRD

 (i) It may lend funds directly, either from its capital funds or from the funds it
borrowed in private investment markets.
 (ii) It may guarantee loans advanced by other or it may participate in such loans.
 (iii) Loans may be advanced to member countries directly or any of their
political sub-divisions or to private business or agricultural enterprises in the
territories of members.
 (iv) It has provided loans to the developing countries for development projects
and programmes because credit rating of many developing countries is poor—
hence they feel difficulties in raising funds in international capital markets. It
provides expertise and financial resources to poor countries to expedite growth.
(v) The World Bank is a vital source to the developing countries, when the
member Government in whose territory the project is located, is not the
borrower, the World Bank asks the member Government for a guarantee.
Characteristics of Bank Loan

 They are meant for infrastructure development in areas like:

 (a) Electric supply
 (b) Power
 (c) Rail
 (d) Roads
 (e) Ports and inland waterways airlines and airports etc.
 (f) Irrigation, water supply, health, education etc.
Subsidiaries of the World Bank

 International Development Association (I.D.A).

 International Finance Corporation (I.F.C.).
 Multilateral Investment Guarantee Agency (MIGA) and
 International Centre for the settlement of Investment Disputes (ICSID) are the
subsidiaries of World Bank.
International Development Association
(IDA)
 This association was set up in 1960. It is an aiding centre for those developing countries who
look up to it for financial assistance. It is an association of donor countries who have come
under the “Aegis” of the World Bank. It offers credit to the eligible developing countries on
extremely favourable terms. The main criteria for the allocation of I.D.A. credit are the per
capita income of the recipient country. Countries which have an annual per capita Gross
National Product (G.N.P.) of less than $ 681 (in 1989) dollars are eligible for I.D.A. credits.
Other parameters taken into consideration are Country’s credit Worthiness, its accessibility
to commercial borrowing its, economic performance, the density of its population and the
existence of viable projects in the borrowing nations. I.D.A. interests free credit are
available to Governments only and may be obtained onpayment of nominal service charges at
0.75% per annum. The period of repayment of loan is 40 years. The purposes for which the
I.D.A. has advanced the credits are agriculture, rural development education, energy,
industrial development and finance, population and nutrition, transportation and tourism,
telecom-munication etc. India has been the largest beneficiary from I.D.A. Since its inception
India’s share is 40% of I.D.A. Funds. India has not been able to utilise this aid fully, both
because of infrastructural difficulties at home and the adverse conditions imposed by donor
countries governing such aid.
Industrial Finance Corporation (IFC)

 This corporation was set up in 1956. It extends credits to private business

enterprises. It provides equity and loan capital for private enterprises in
association with private investors and management, encourages the
development of local capital market and stimulates the international form of
private capital. It supports joint ventures which provide opportunities to
combine domestic knowledge of market and other conditions with the
technical and managerial experience available in the industrial nations. The
corporation has about 200 members. Its paid up capital is about 544 million
dollar and its retained earing were 205 million dollars.
IFC

 The project, for which the corporation advances assistance, must satisfy the
following conditions:
 (i) It should have the prospects of earning profits
 (ii) It should boost the economy of the best country
 (iii) Local investors should be able to participate in the project in the
beginning of the project or later
 (iv) The required funds for the project are not available from private
investors at reasonable terms
 (v) The management should be capable and experienced
 (vi) The sponsor of the project has a substantial holding in the enterprise.
Asian Development Bank

 The Asian Development Bank (ADB) is a regional development bank established in

1966 to promote economic and social development in Asian and Pacific countries
through loans and technical assistance. It is a multilateral development financial
institution owned by 68 members, 48 from the region and 20 from other parts of the
globe. ADB's vision is a region free of poverty. Its mission is to help its developing
member countries reduce poverty and improve the quality of life of their citizens.
The work of the Asian Development Bank (ADB) is aimed at improving the welfare of
the people in Asia and the Pacific, particularly the 1.9 billion who live on less than
$2 a day. Despite many success stories, Asia and the Pacific remains home to two
thirds of the world’s poor.
 The bank was conceived with the vision of creating a financial institution that
Would be "Asian in character" to foster growth and cooperation in a region that back
then was one of the world's poorest ADB raises funds through bond issues on the
world's capital markets, while also utilizing its members’ contributions and earnings
from lending
ADB

 Although by definition the bank is a lender to governments and government

entities, it also provides direct assistance to private enterprises and has also
participated as a liquidity enhancer and best practice enabler in the private
sectors of regional member countries.
 The primary human capital asset of the bank is its staff of professionals,
encompassing academic and/or practical experts in the areas of agriculture,
civil engineering, economics, environment, health, public policy and finance.
Professional staff are drawn from its member countries and given various
incentives to relocate to Manila. It is conceivable that once all of Asia-Pacific
reaches a certain level of living standard the bank will be wound down or
reconfigured to operate as a commercial enterprise.
Organization -ADB

 The highest policy-making body of the bank is the Board of Governors

composed of one representative from each member state. The Board of
Governors, in turn, elect among themselves the 12 members of the Board of
Directors and their deputy. Eight of the 12 members come from regional(Asia-
Pacific) members while the Vest come from non-regional members. The Board
of Governors also elect the bank's President who is the chairperson of the
Board of Directors and manages ADB. The president has a term of office
lasting five years, and may be reelected. Traditionally, and because Japan is
one of the largest shareholders of the bank, the President has always been
Japanese. The current President is Takehiko Nakao. The headquarters of the
Bank is at 6 ADB Avenue, Mandaluyong City, Metro Manila, Philippines, and it
has. representative offices around the world. The bank employs
approximately 2,400 people, coming from 55 of its 67 member countries, and
with more than half of the staff being Filipino.
ADB

 Lending ADB's annual project lending amounts to about US$7 billion per year with
typical lending per project being in the $100 million range. Effectiveness All
projects funded by the Asian Development Bank are evaluated to find out what
results are being achieved, what improvements should be considered, and what is
beings learned. This is achieved through a systematic and impartial, assessment of
policies; strategies, programs, and projects, including their design, implementation,
and results.
 There are two levels of evaluation: self evaluation and independent evaluation. All
projects are self-evaluated by the relevant ADB operations department in a project
completion report. ADB’s project completion reports are publicly disclosed and are
available on ADB's Internet site. Client governments are also required to prepare
their own project completion reports. A proportion of completed projects is also
evaluated by ADB’s Operations Evaluation Department (OED). Since the
establishment of its independence in 2004,OED has reported directly to ADB’s Board
of Directors through the Board's Development effectiveness Committee.
MODULE IV INTERNATIONAL INSTITUTIONS
Unit 7 GATT and WTO

 The General Agreement on Tariffs and Trade (GATT) was the outcome of the
failure of negotiating governments to create the International Trade
Organization (ITO).
 The Bretton Woods Conference had introduced the idea for an organization to
regulate trade as part of a larger plan for economic recovery after World War
II.
 As governments negotiated the ITO, 15 negotiating countries began parallel
negotiations for the GATT as a way to attain early tariff reductions. As Havana
charter for ITO was not translated into practice due to various difficulties and
lack of common agreement, GATT was formed by some 23 major trading
nations, including India. Later, World Trade Organization (WTO) was
established as a successor to GATT in 1995. This unit examines the role and
significance of GATT and WTO.
Origin of GATT

 The GATT was an agreement,not an organization,the countries participating in

the agreement were officially designated as “Contracting parties”,not
members.
 GATT aimed at the removal of discriminating elements in trade among the
participating countries
 The aims of GATT were
1. To reduce tariff rates
2. To reduce and eliminate non-tariff barriers
3. To eliminate the quantitative restrictions
4. To resolve the trade disputes among the contracting parties
GATT

 GATT initiated multilateral negotiations and converted bilateral trade

agreements in to multi lateral trade agreements.
 The first 6 rounds of negotiations concentrated almost exclusively on reducing
tariffs ;while the 7th Round(Tokyo Round 1973-1979) moved on to tackle non-
tariff barriers(NTB’s).
 The 8th round (Uruguay round)sought to broaden the scope of multilateral
trade negotiations by including new areas such as
a) Trade in Services
b) Trade Related aspects of Intellectual properties(TRIP’s)
c) Trade Related Investment Measures(TRIM’s)
GATT: Various Rounds

 Due to the complexity of various issues and conflicts of interests among the
participating countries ,Uruguay Round could not concluded in December 1990
as was originally scheduled.It was concluded on December15,1993 and the
final act was signed at Marrakesh,Morocco in April 1994.
 On January1,1995,GATT was transformed in to World Trade Organisation(WTO)
 The WTO embodies the main provisions of GATT,but role was expanded to
include a mechanism intended to improve GATT’s process for resolving trade
disputes among member nations.
 The headquarter of WTO is located in Geneva
 Its core principle are non-discrimination,reciprocality and domestic
safeguards
Differences between GATT and WTO
WTO
 WTO is a full fledged international
organization with a large
secretariat,headquarters Geneva,Switzerland.
 WTO reverses domestic policies of protection
 WTO has members
 WTO commitments are permanent and binding
to the member countries.WTO approach is rule
based and time bound
 WTO has wider scope than GATT,bringing in to
the multi lateral trading system,trade in
services,intellectual property and investments

The dispute settlement mechanism is based
not on dilatory but automatic.
GATT
 GATT wasbasically a provisional treaty
serviced by an ad hoc secretariat.
 GATT allowed the contracting parties to
retain their domestic laws in certain
sensitive areas(agriculture and textile)
 GATT had only contracting parties
 GATT was applied on a provisional basis
 GATT rules applied only to trade in
merchandise goods.Its scope is narrow
compared to WTO
 There is no Dispute settlement system
World Trade Organization (WTO)

 The World Trade Organization (WTO), is an international organization designed

to supervise and liberalize international trade.
 The WTO came into being on January 1, 1995, and is the successor to the
General Agreement on Tariffs and Trade (GATT), which was created in 1948, and
continued to operate for almost five decades as a de facto international
organization.
 The WTO's stated goal is to improve the welfare of the peoples of its member
countries, specifically by lowering trade barriers and providing a platform for
negotiation of trade. Its main mission is "to ensure that trade flows as smoothly,
predictably and freely as possible".
 This main mission is further specified in certain core functions serving and
safeguarding five fundamental principles, which are the foundation of the
multilateral trading system.
Objectives of WTO

1. To ensure the reduction of tariffs and other barriers to trade

2. To eliminate discriminatory treatment in international trade relations
3. To facilitate higher standards of living,full employment and growing volume of real
income and effective demand,and expanding the production and trade in goods and
services
4. To ensure the developed countries,especially the least developed among them,secure
a share in the growth in international trade commensurate with the needs of their
economic development
5. To facilitate the optimal use of the world resources for sustainable development
6. To develop an integrated ,more viable and durable multilateral trading system
incorporating all the Uruguay Round ‘s trade negotiations
7. To ensure linkages between trade policies,environmental policies and sustainable
development
Functions of WTO

1) To administer and implement the multilateral and plurilateral trade

agreements reached among the member nations
2) To act as a forum for multilateral trade negotiations
3) To resolve trade disputes among members
4) To oversee national trade policies
5) To cooperate with other international institutions like the IMF,World Bank and
its affiliates with a view to achieving greater coherence in global economic
policy setting
Agreements of WTO

 WTO agreement covers the following:

 Multilateral Agreements on Trade in Goods
 General Agreement on Trade in Services
 Agreement on TRIPS
 Rules and Procedures regarding dispute settlement
 Plurilaterals Trade Agreements
 Trade Policy Review Mechanism
 The WTO covers about 60 different agreements which have the status of
international legal texts.
 Member countries must sign and ratify all WTO agreements on accession. A
discussion of some of the most important agreements follows.
Contd.

 Agreement on Agriculture (AoA)

 The AoA came into effect with the establishment of the WTO at the beginning of 1995. The AoA has
three central concepts, or pillars domestic support, market access and export subsidies.
 The Agreement specifically aims at curtailing domestic and export subsidies on agricultural goods.It is
laid down that current total aggregate measures of support should not exceed 10 percent of the
annual value of total agricultural product measured at international price.

 The first pillar of the AoA is domestic support.

 The AoA structures domestic support (subsidies) into three categories or "boxes": a Green Box, an
Amber Box and a Blue Box.
 The Green Box contains fixed payments to producers for environmental programmes.
 The Amber Box contains domestic subsidies that governments have agreed to reduce but not to
eliminate.
 The Blue Box contains subsidies which can be increased without limit, so long as payments are linked
to production-limiting programmes.
Contd.

 Market Access:The member nations will cut tariffs on industrial and farm products by an average of
about 37 percent.The USA and European Union will cut tariff between by one half.
 Market access is the second pillar of the AoA, and refers to the reduction of tariff (or non-tariff)
barriers to trade by WTO members.
 The 1995 AoA required tariff reductions of:
 36% average reduction by developed countries, with a minimum per tariff line reduction of 15% over
five years.
 24% average reduction by developing co-untries with a minimum per tariff line reduction of 10% over
nine years.
 Least Developed Countries (LDCs) were exempted from tariff reductions, but they either had to
convert non-tariff barriers to tariffs—a process called tariffication—or "bind" their tariffs, creating a
"ceiling" which could not be increased in future.
 Export subsidies
 "Export subsidies" is the third pillar of tie AoA. The 1995 AoA required developed countries to reduce
export subsidies by at least 35% (by value) or by at least 21% (by volume) over the five years to 2000.
Principles of the trading system

 1. Non-Discrimination: It has two major components: the Most Favoured Nation (MFN) status,
and the national treatment policy. Both are embedded in the main WTO rules on goods,
services, and intellectual property but their precise scope and nature differ across these areas.
 The MFN rule requites that a WTO member must apply the same conditions on all trade with
other WTO members. The means a WTO member has to grant the most favourable conditions
under which it allows trade in a certain product type to all other WTO members.
 2. Reciprocity: It arises because of the MFN rule and a desire to obtain better access to foreign
markets. A related point is that for a nation to negotiate, it is necessary that the gain from
doing so be greater than the gain available from unilateral liberalization. Reciprocal
concessions intend to ensure that such gains will materialize.
 3. Binding and enforceable commitments: The tariff commitments, made by WTO members
in a multilateral trade negotiation and on accession are enumerated in a list of concessions.
These schedules establish "ceiling bindings". A country can change its bindings, but only after
negotiating with its trading partners, which could mean compensating them for loss of trade. If
satisfaction is not obtained, the complaining country may invoke the WTO dispute settlement
procedures.
Contd.

 4. Transparency: The WTO members are required to publish their trade

regulations, to maintain institutions-allowing , for the review of administrative
decisions affecting trade, to respond to requests for information by other
member, and to notify changes in trade policies to the WTO. These internal
transparent requirements are supplemented and facilitated by periodic
country- specific imports through the Trade Policy Review Mechanism (TPRM).
The WTO system tries also to improve predictability and stability, discouraging
the use of quotas and other measures used to set limits on quantities of
imports.
 5. Safety valves: In specific circumstances, governments are able to restrict
trade. There are three types of provisions in this direction: a. articles allowing
for the use of trade measures to attain noneconomical objectives b. articles
aimed at ensuring "fair competition" c. and provisions permitting intervention in
trade for economic reasons.
Structure of WTO

 Highest level: Ministerial Conference.

The top most decision-making body of the WTO is the Ministerial Conference, which has to meets at least every two
years. It is the Supreme governing body which takes ultimate discussions on all matters. All member countries are
members of ministerial conference. The Ministerial Conference can make decisions on all matters under any of the
multilateral trade agreements.
 Second level: General Council
The daily work of the ministerial conference is handled by three groups:
1. the General Council,
2.the Dispute Settlement Body, and
3. the Trade Policy Review Body.
 All three consist of the same membership - representatives of all WTO members - but each meets under different
rules.
 The General Council is the real engine of the WTO which acts on behalf of the ministerial conference. It carries
out the functions of the WTO. It has representatives from all member governments and has the authority to act on
behalf of the ministerial conference which only meets about every two years. The council acts on behalf on the
Ministerial Council on all of the WTO affairs. The Dispute Settlement Body is made up of all member governments,
usually represented by ambassadors or equivalent.
Contd.

 Third Level: Councils for Trade The Councils for Trade work under the General Council. There are three
councils –
1. Council for Trade in Goods,
2. Council for Trade-Related Aspects of Intellectual Property Rights, and
3.Council for Trade in Services — each council works in different fields
 Apart from these three councils, six other bodies report to the General Council reporting on issues such as
trade and development, environmentalism, regional trading arrangements and administrative issues.
1. Council for Trade in Goods - The workings of the General Agreement on Tariffs and Trade (GATT) which
covers international trade in goods, are the responsibility of the Council for Trade in Goods. It is made up of
representatives from all WTO member countries.
2. Council for Trade-Related Aspects of Intellectual Property Rights - Information on intellectual property in the
WTO, news and official records of the activities of the TRIPS Council, and details of the WTO’s work with other
international organizations in the field.
3. Council for Trade in Services - The Council for Trade in Services operates under the guidance of the General
Council and is responsible for overseeing the functioning of the General Agreement on Trade in Services (GATS).
It is open to all WTO members, and can create subsidiary bodies as required.
Contd.

 Fourth level : Subsidiary Bodies .There are subsidiary bodies under each of the
three councils
1. The Goods Council— subsidiary under the Council for Trade in Goods. It has11
committees consisting of all member countries, dealing with specific subjects such as
agriculture, market access, subsidies, anti-dumping measures and so on.
2. The Services Council — subsidiary under the Council for Trade in Services which
deals with financial services, domestic regulations and other specific commitments.
3. Dispute Settlement panels and Appellate Body- subsidiary under the Dispute
Settlement Body to resolve disputes and the Appellate Body to deal with appeals. Other
Committees include
Committees on Trade and Environment, Trade and Development, Regional Trade
Agreements, Balance of Payments Restrictions, Budget, Finance and Administration and
working groups on (a) Trade, debt and finance and (b) Trade and technology transfer.
Evaluation of WTO (Benefits for India)

 Benefits from expansion in trade :Global trade has been growing at a faster rate than
global output.It is estimated by international financial institutions that the
implementation of Uruguay Round package will add between 213 and 274 billion US dollars
annually to world income.
 Benefits from phasing out of MFA : The phasing out of the Multi Fibre Agreement by 2005
is likely to benefit India,as the exports will flood the US and European countries.
 Improved prospects of agricultural exports: India expects relates to the improved
prospects for agricultural products due to reduction in domestic subsidies and barriers to
trade.
 Benefits from multi lateral rules and disciplines:The Uruguay Round Agreement has
strengthened multi lateral rules and disciplines.The most important of these relate to
anti-dumping subsidies and countervailing measures,safeguard dispute settlements.This is
likely to ensure greater security and predictability of the international trading system and
thus create a more favourable environment for India in the new economic world order.
Critical Review of WTO

 First world has not fully opened up:There is extreme inequality within the structure of WTO
and it is this inequalitynthat drives the outcomes rather than any abstract notion of free
trade.
 Issue of huge subsidies:The developed countries are heavily subsidizing their farmers at the
rate of more than one billion dollars per day.Farmers from the developing countries can
never hope to get subsidies from their govt.result is that they are placed in a
disadvantageous position
 Free movement of labour is not allowed:WTO’s ministerial conference have been discussing
the various issues connected with the free movement of capital,goods and services and
technology.This is very important for them as the developed block needs the markets of the
third world countries.when it comes to the labour,silence is the reply from them.
 The promised land is not in sight:The process of free trade is still incomplete in many
ways.tariff peaks still remain in certain areas.The thirld world was led to believe it would be
major access to foreign to foreign territories through global exports.But studies indicate that
only few countries have gained at the cost of many developing countries.
Criticisms

 Tresspassing the sovereignty of nation-states: WTO has been granted powers to

enact international laws on matters that were under national jurisdictions so
far.
 WTO is not environment friendly : WTO agreements mandate the member
nations to implement the clauses and conditions favourable to advanced
countries.USA has not accepted Kyoto protocol.
 Disastrous failure in many countries: According to the UNDP Report ,1997,more
than 100 developing countries have suffered disastrous failures in growth and
deeper and more prolonged cuts in living standards than anything experienced
in the industrial countries even during the great depression of the 1930’s
 Worse than the beginning of the 1980’s:In reality more than 100 countries
income per habitants is lower than what it was some years ago.As a result,160
crore individuals now live worsethan at the beginning of the 1980’s.
Unit 8
UNCTAD and NIEO
 United Nations Conference of Trade and Development (UNCTAD) was created
in 1964 to fulfill a development mission to promote trade and development of
the newly independent developing countries. Its purpose was to facilitate the
integration of these economies into the world economy through a balanced
approach.
 The New International Economic Order (NIEO) was a set of proposals put
forward during the 1970s by some developing countries through the United
Nations Conference on Trade and Development to promote their interests by
improving their terms of trade, increasing development assistance,
developed-country tariff reductions. This unit examines the important
functions of UNCTAD and NIEO.
UNCTAD

 UNCTAD is a permanent intergovernmental body established by the United Nations

General Assembly in 1964. headquarters are located in Geneva, Switzerland, and it has
offices in New York and Addis Ababa.
 UNCTAD is part of the UN Secretariat. It report to the UN General Assembly and the
Economic and Social Council but have its own membership, leadership, and budget. It is
also part of the United Nations Development Group.
 UNCTAD was established to promote development among the so-called under-developed
newly independent countries.
 Its purpose was to facilitate the integration of these economies into the world economy
through a balanced approach.
 Its work can be summed up in 3 words:think,debate,and deliver.
 The first meeting of UNCTAD was held in March 1964 in Geneva and representatives of
about 120 states which were members of UN participated in it. It was a turning point in
the international economic relations.
UNCTAD

 UNCTAD has provided leadership in several areas, highlighting and analysing issues that
often became salient in international policy-making later on.
 Some of its notable successes are the following:
(1) UNCTAD developed the idea of the Generalized System of Preferences (GSP)
(2) UNCTAD pioneered the issue of trade in services, which later became a central feature of
GATT discussions and negotiations
(3) UNCTAD, focused on the issue of tariff escalation focused on South-South trade as early as
in 1960s.
(4) UNCTAD pioneered the analysis of skilled migration, with several studies of the “brain
drain” from developing countries, and organized discussions of proposals to deal with the issue
(5) UNCTAD provided substantial input to commodity agreements as a way of addressing the
persistent problems of earnings instability by countries dependent on one or just a few
primary products.
Functions of UNCTAD

 It promotes international trade all over the world.

 It functions as a forum for intergovernmental deliberations, supported by
discussions with experts and exchanges of experience, aimed at consensus
building.
 It undertakes research, policy analysis and data collection for the debates of
government representatives and experts.
 It provides technical assistance tailored to the specific requirements of
developing countries, with special attention to the needs of the least
developed countries and of economies in transition. When appropriate,
UNCTAD cooperates with other organizations and donor countries in the
delivery of technical assistance.
 It promotes International trade all ones the world.
Major activities of UNCTAD

 It include research and support negotiations for commodity

agreements,technical elaboration of new trade activities designed to assist
developing countries in the areas of trade and capital.
 Basic principles
 UNCTAD’s action program and priorities have been laid down in the various
recommendations adopted by the first conference in 1964
UNCTAD’s efforts

  Comprehend options to address macro-level development challenges

  Achieve beneficial integration into the international trading system
  Diversify economies to make them less dependent on commodities
  Limit their exposure to financial volatility and debt
  Attract investment and make it more development friendly
  Increase access to digital technologies
  Promote entrepreneurship and innovation
  Help local firms move up value chains
  Speed up the flow of goods across borders
  Protect consumers from abuse
  Curb regulations that stifle competition
  Adapt to climate change and use natural resources more effectively
Role of UNCTAD

 Despite the debates and disagreements played a key roll

 The generalized system of preferences
 A maritime shipping code
 Special international programs to help least developed countries and
international aid targets
 During the breakdown of Brettonwood system,oilprice shocks,inflation and
accumulation of debt by developing countries,UNCTAD became a central
forum for debates between the north and south
 Thus UNCTAD organization acts like a bridge between the developing and
developed countries to increase their economy of the country.
New International Economic Order
(NIEO)
 The New International Economic Order (NIEO) was a set of proposals put forward during the
1970s by some developing countries through the United Nations Conference on Trade and
Development to promote their interests by improving their terms of trade, increasing
development assistance, tariff reductions of developed countries.
 The concept of new international economic order was initially projected by Raul Prebisch and
some other economists in the 1950’s and 1960’s. However, the first formal endorsement to it
was received in April 1974, when the United Nations General Assembly committed itself “to
work urgently for the establishment of a new international economic order based on equity,
sovereign equality, common interest and co-operation among all States, irrespective of their
economic and social systems, which shall correct inequalities and redress existing injustices,
make it possible to eliminate the widening gap between the developed and developing
countries and ensure steadily accelerating economic and social development and peace and
justice for present and future generations.”
 This UN commitment recognised the defects of existing economic order was unjust, wicked
and immoral and that there was the necessity to create a new and healthy international
economic order based on justice and co-operation.
What is NIEO ?

 NIEO constitutes a framework for eliminating the existing era of international

economic systems,with all its features and interests of the developed
countries to the detriment of the third world .
 It seeks to end the imbalnces,inequalities in the economic relations between
the under developed and developed worlds.
 Seeks to end the monopolistic controls of the developed countries over
international trade after world war.
Need for NIEO

 Due to the sharp and big changes in the international system of the post war
period
 Weakened position of Europe ,emergence of two super powers ,emergence of
cold war,rise of strong anti imperialist and anti colonialist movements
 The rise of new consciousness among the newly emerged countries of
Asia,Africa and Latin America ,the examples of economic recovery secured by
European countries.
Demand for NIEO

 Restructuring of the existing economic order

 Total recasting of the Bretton woods system
 Increased and definite share in world trade
 Grant of international developmental aid
 Due share in international decision making
 Writing off old debts.
Goals of NIEO

 Lay emphasis on the distribution of world economic resources among the rich
as well as poor.
 Mini income target
 Extent
 Morality
 Common interest
Objectives of NIEO

 Are put in to 4 major heads

 1. Issues Related to Assistance
The foundation for a just world economic order can be laid if there is sympathetic
understanding on the part of developed countries towards the aid requirements of the LDCs.
A greater measure of co-operation from them can assist in the removal of poverty and in the
achievement of balanced regional growth.

 2. Issues Related to Trade

Apart from greater co-operation in the field of aid, the essence of the new
international economic order lies in the improvement of the conditions related to the
international trade such that the less developed countries find progressively expanding
opportunities to enlarge their exports. It can enable them to get hold of export earnings
sufficient to overcome their chronic balance of payments deficits and achieve a steady state
growth.
Objectives

 3. Issues Related to Industrialisation and Technology One of the significant objectives specified by the United
Nations, having an important bearing upon the new international economic order, is a change in approach to
industrialisation and technology. In this regard, the United Nations stressed upon the redeployment of
industrial productive capacity to developing countries. The developed and developing countries should enter
into negotiations about the possible shifting of the industrial capacity of the developed countries to the Third
World.
 4. Social Issues The NIEO has also the objective of dealing with the social issues faced by the international
community through the mutual co-operation of the developed and less developed countries. The social issues
or objectives identified by the United Nations include:
 a. The achievement of a more equitable distribution of income and raising the level of employment,
 b. Provision of health services, education, higher cultural standards and qualifications for the work force;
 c. Integration of women in development, assurance of the well-being of children;
 d. Recognition of the sovereignty of States over natural resources and the right to control their exploitation
and right to their nationalisation;
 e. Provision of compensation for adverse effects on the resources of the states on account of foreign
occupation, colonial domination or apartheid;
 f. Establishment of a system of consultation to promote industrial development, and
North-South Dialogue and NIEO

 The most fundamental requisite of a new international economic order is that the developed and
LDCs should have close and co-operative economic relations among themselves. After the United
Nations General Assembly passed resolution in April 1974 committing itself “to work urgently for
the establishment of a new international economic order”, there was the launching of
negotiations between the developed countries (‘North’) and the less developed countries
(‘South’).
 The main issues in dialogue are as follows:
 (i) Lowering of tariff structure
 (ii) Flow of financial assistance operation.
 (iii) Market access establishment of a NIEO
 (iv) Terms of trade
 (v) Stabilisation of prices of primary products
 (vi) Transfer of technology
 (vii) Problem of international debt burden
Advancement towards NIEO

 The endorsement of the concept of New International Economic Order (NIEO) created
high hopes and expectations among the LDCs. Its economic and social objectives set by
the United Nations created a strong feeling among them that they will get necessary
assistance for the removal of the problems of the impoverished and exploited less
developed regions. It is important to review how far the world has made an advance
towards the goal of establishing a just and exploitation-free new world economic order.
The assessment has to be made on the basis of the following main points concerning
NIEO programme for action:
 1. Development Assistance Target The United Nations has set out one of the objectives
of NIEO as that the advanced countries should progressively expand their development
assistance for the LDCs upto the limit of 0.7 percent of their GNP. Moreover, the goal of
development assistance also specifies that the aid should be untied and be provided on
a long term and continuing basis. It is also stressed that the assistance should be on
easy and concessional terms. By 1981, only Netherlands, Norway, Sweden, Denmark and
France could meet the 0.7 percent GNP target.
Contd.

 Trade Preferences
The LDCs have been demanding preferential access to the markets of the developed
countries. Such a demand from the LDCs was justified on account of the fact that they are at
disadvantage vis-a-vis the advanced countries in the area of manufacturing, in addition, they have
to protect their infant industries. The easier access to the markets of advanced countries is
justified also on the ground that the LDC can thereby rely more on trade than aid. The
tradecreation will be quite beneficial also for the developed countries. In this direction some
progress was achieved in the early 1970’s when the Generalised System of Preferences (GSP) came
into force.
 3. Commodity Stabilisation Funds:
The deteriorating terms of trade for the LDCs and losses in their export earnings have
remained problems of serious concern for them. They insisted that the NIEO should protect them
from continuous erosion in their export earnings through making an appropriate arrangement for
the stabilisation of the prices of primary products. To achieve this objective, they asked for the
institution of commodity stabilisation funds. Such a common fund could be utilised by the LDCs for
financing the buffer stocks operations in the primary commodities.
Contd.

 4. Reform of International Monetary System: One of the major complaints of

the less developed world against the existing international monetary system
has been that it is inadequate to meet their development requirements. They
believed that the IMF and other financial institutions were structured in the
way that could serve essentially the requirements of the advanced countries.
The LDCs continued to press for monetary reforms including the revision of
IMF quotas, change in the basis of quota allocation from the GNP to the per
capita income, linking of Special Drawing Rights to the development needs,
compensatory financing schemes and relaxation of stiff IMF conditionality.
MODULE V TRADE POLICIES IN INDIA
India’s Foreign Trade and Balance of Payment Situation

 Foreign Trade of India during the Pre-independence Period

Before the Second World War, India was forced to export more than its imports in order to meet
the unilateral transfer of payments to Britain in the shape of salaries and pensions of British
officers(civil and military), interest on sterling loans and dividends on British capital invested in
India. During the Second World War, there was a basic change in the nature of India’s international
trade.
 Thus more exports and fewer imports which was the feature of India’s foreign trade helped
the growth of a favourable trade balance.
 The balance of trade was so favourable with Britian-the principal customer of Indian goods-
that even after paying off the sterling debt, India was able to build huge sterling balance
amounting to Rs. 1,733 crores in April, 1946.
 Besides, the war afforded a natural umbrella of protection and this facilitated the growth of
consumer goods industries in India. A vaccum was also created in the countries of the Middle
East and Far East and, consequently, India was able to develop markets for her manufactures in
these countries and import raw materials to feed her growing consumer goods industries.
Contd.

 Pattern of Exports
The value of exports and imports had both been on the increase during 1938-39 to 1947-48. although
exports were consistently higher than imports. The commodity structure of exports also underwent a
change. Whereas the raw material component of exports declined from 45 per cent of total exports in 1938-
39 to 31 percent in export in the pre-war years some wheat, wheat flour, barely and pulses, but with a
rapidly increasing population, the surplus had completely disappeared in the post-independence period.
 Pattern of Imports
The value of imports also moved up steadily. Many factors were responsible for the rise in the value of
imports during the war and the immediate post-war period.
 Firstly, the pent-up demand of the war period pushed up the demand for consumer and capital goods
immediately after the war. During the war, due non-availability of goods, the purchasing power could not
be utilized in procuring the goods demanded. Similarly, arrears of replacement of plant and machinery
had piled up, and as a result, the demand for capital goods also increased. Secondly, price level in India
rose much higher than the corresponding rise in other countries particularly U.K. and U.S.A. This turned
the terms of tirade against India. Consequently, imposts from such countries where initiation had not
been so steep as in India got a fillip. Thirdly, the partition of India and its rising population meant a
rapid exhaustion of food surplusand thus foodgrain imports were undertaken on a large scale.
Foreign Trade since Independence

 divided the post –independence period into seven phases.

 1948-49to 1950-51 –Before Planning :
On the eve of planning, the foreign trade of India showed an excess of imports over
exports. The rise in imports was largely due to (a) increase in demand of the war and
the post-war period as a consequence of various controls and restrictions, (b) the
shortage of food and basic raw materials like jute and cotton as a result of partition,
(c) the rise in the imports of machinery and equipment-or capital goods-to meet the
growing demand for hydro-electric and other projects started during the period.
 1951-52 to 1955-56-The First plan Period
The annual average value of imports during the First Plan Period was Rs.730 crores. In
this way, the average annual deficit worked out to be Rs.108 crores. Trade deficit was
largely due to programmers of industrialization which gathered momentum and pushed
up the imports of capital goods. There was no improvement in exports.
Contd.

 1956-57 to 1960-61-The Second Plan Period

During the Second Plan, a massive programme of industrialization was initiated. This included
the setting up of the steel plants, heavy expansion and renovation of railways and modernization
of many industries, and as a result, the quantum of imports reached a very high level. Besides
this, the maintenance of imports required for a developing economy further increased our
imports. Foodgrains imports had to be resorted to overcome internal shortages and rising prices.
 1961-62 to 1965-666 -The Third Plan Period
The record of exports during the third plan shows that average export earnings worked out to
be Rs.747 crores. As against it, actual annual average imports worked out to be Rs. 1,224 crores.
The increase in the volume of imports during the Third Plan was due to three factors. Firstly, rapid
industrialization necessitated larger imports of machinery, equipment, industrial raw material and
technical know-ho. Secondly, the defense needs had increased following aggression by China and
Pakistan. Finally, large quantity of foodgrains was imported, partly because it was easily available
and partly because of the extensive failure of crops in 1965- 66.
Contd.

 Devaluation of 1966 and the period up to 1973-74

Persistent adverse balance of trade since 1951 and consequent adverse balance of payments,
acute shortage of foreign exchange, extensive borrowing by India from foreign exchange,
extensive borrowing by India from foreign countries and international institutions tike IMF to
overcome balance of payments problems-all these factors induced India to devalue the rupee by
36.5 per cent in June, 1966. Devaluation was resorted to essentially (a) to reduce the volume of
imports, (b) to boost exports, and (c) create a favourable balance of trade and balance of
payments.
 1974-79 – The Fifth plan period
The Fifth Plan Period The hike in oil prices which started in October 1973 seriously affected the
pattern of trade throughout the world and India was no exception. Table 9.6 shows how the value
of imports during the Fifth Plan Period reached very high levels-largely the result of a sharp
increase in the cost of India's major imports viz., petroleum, fertilisers and foodgrains.
Simultaneously, there was a significant improvement in India’s exports as they successively rose
every year during Fifth Plan period. Another interesting point of this period was the re-emergence
of the trade deficit from 1977-78 onwards.
Contd.

 1980 onwards:The Sixth and Seventh Plan Period

On account of further increase in the prices of petroleum products by OPEC, the
import bill shot up during 1979-80 and increased up to 1981-82. Though exports
too continued to rise, the value of exports fell much short of imports. The result
was unprecedented trade deficits. It was this yawning deficit, which forced the
Government to approach the IMF in November, 1981 for a huge loan. The same
situation continued in 1983-84 and the trade deficit further rose to about Rs.
6,061 crores. A review of the data of imports and exports reveals that despite the
fact imports of POL declined during 1980-81 to 1983-84, partly because
international prices of oil showed a downward trend and partly because domestic
production of crude was jacked up by ONGC, the trade deficit was of the order or
Rs. 6,061 crores in 1983-84.
India’s balance of payments

 The balance of payments of India is classified into

 (a) balance of payments on current account, and
 (b) balance of payments on capital account.
 The current account of the balance of payments of India includes three items : (a)
visible trade relating to imports and exports; (b) invisible items, viz., receipts and
payments for such services as shipping, banking, insurance, travel, etc., and (c)
unilateral transfers such as donations. The current account shows whether India
has a favourable balance of payments on capital account shows the implications
of current transactions for the country’s international financial position. For
instance, the surplus and the deficit of the current account are reflected in the
capital account, through changes in the foreign exchange reserves of country,
which are index of the current strength or weakness of a country’s international
payments position, are also included in the capital account.
India’s balance of payments on current
account
 1951-52 to 1955-56-The First Plan Period
During the First Plan Period, the balance of payments was affected by the Korean War boom,
American recession of 1953 and favourable monsoon at home which helped to boost agricultural and
industrial production. While India had been experiencing persistent trade deficit, she had generally a
surplus in net invisibles; accordingly India’s adverse balance of payment during the First Plan was
only Rs. 42 crores. The overall picture during the First Plan was, however, quite satisfactory.
 1956-57 to 1960-61-The Second Plan Period
An important feature of the Second Plan Period was the heavy deficit in the balance of trade
which aggregated to Rs. 2,339 crores. Earnings on account of invisibles and donations from friendly
countries totaled Rs. 614 crores.
 The highly unfavourable balance of payments in the Second Plan was the result of (a) heavy
imports of capital goods to develop heavy and basic industries, (b) the failure of agricultural
production to rise to meet the growing demand for food and raw materials from a rapidly
growing population and expanding industry; (c) the inability of the economy to increase exports;
and (d) the necessity of making minimum ‘maintenance imports’ for a developing economy.
Contd.

 Third Plan and Annual Plans and BOP

The balance on current account was unfavorable during the Third Plan. This was mainly because (a)
imports were expanding faster under the impact of defence and development and to overcome
domestic shortages (import of foodgrains, for example) and (b) exports were extremely sluggish and
failed to match imports. The imbalance in the current account of over Rs. 1,952 crores was financed
by loans from foreign countries, PL 480 and PL 665 funds, loans from the World Bank and withdrawals
from I.M.F. In spite of all these loans, assistance and withdrawals, there was also some depletion of
foreign exchange reserves of the country.
 1969-70 to 1973-74 : The Fourth Plan Period
One of the objectives of the Fourth Plan was self-reliance-i.e,, import substitution of certain critical
commodities (which are of key importance for the Indian economy) on the one side and export
promotion so as to match the rising import bill, on the other. Accordingly, the Government managed
to restrict imports and succeeded in expanding exports. On the import side, restriction of imports
was made possible through good crops in 1968-69 and 1970-71, and consequent significant reduction
of imports of foodgrains. On the export side, vigorous export promotion measures succeeded in
boosting exports of traditional as well as non- traditional items.
Contd.

 1975-76 to 1978-79: Fifth Plan Period

During the Fifth Plan, trade balance was affected by two factors : (a) the value of imports was rapidly mounting
due to the hike in oil prices, and (b) the value of exports was also rising under the impact of promotional
measures. These two factors explained the gradual decline in the deficit in the trade balance and the appearance
of a surplus in the trade balance in 1976-77. But the persistent upward rise in imports and the inadequate
increase in exports due to the relative decline in export prices were responsible for the revival of deficit trade
balance in the last two years of the Fifth Plan Period. Another outstanding feature of this period was the sharp
increase in net invisibles receipts during 1975-76 to 1978-79.
 The main factors responsible for the increase in invisible receipts were :
 (i) stringent measures taken against smuggling and illegal payment transactions;
 (ii) the relative stability in the external value of the rupee at a time when major international currencies
were experiencing sizeable fluctuations;
 (iii) increase in earnings from tourists;
 (iv) the growth of earnings from technical, consultancy and contracting Services; and
 (v) increase in the number of Indian nationals going abroad for employment and larger remittances sent by
them to India. For the first time since planning started, India was in a comfortable position in its external
account.
Contd.

 The Sixth and the Seventh Plan Period

There has been a sea change in the balance of payments position since 1979-80. As against
the surplus balance of payments experiences by the country during the whole of the Fifth
Plan, India started experiencing adverse balance of payments from 1979-80 onwards. For one
thing, trade deficit began to widen from 1978-79. There is a tremendous gap between India’s
imports and exports of merchandise. The disquieting picture was due to the tremendous rate
of growth of imports on the one side and a much lower rate of exports since 1979-80 on the
other. The trade deficit which was more than offset by the flow of funds under net invisibles
during the Fifth Plan Period, could not be so offset since 1979-80.
 1990-91 and Thereafter
For the first time during the last 40 years, net invisibles became negative to the tune of Rs.
435 crores in 1990-91. This was largely the consequence of a net outflow of investment
income of the order of Rs. 6,732 crores in 1990-91 as against Rs. 4,875 crores in 1989-90-as
increase by 38 per cent. Thus, the cushion available through net invisibles to partly neutralise
the trade deficit was removed.
Balance of payment crisis

 Basic aim of the 1985 Export - Import Policy was

a) to facilitate production through easier and quicker access to imported inputs;
b) to strengthen export production base; and
(c) to facilitate technological upgradation. Although the Government has been maintaining that
the policy is neither liberal nor restrictive, but the fact of the matter is that the policy led to a
wave of indiscriminate liberalisation of imports.
 Import liberalisation measures resulted in the emergence of the huge deficit in the balance
of trade. In the name of technological upgradation, there was, therefore, an unfettered
drive for import of capital goods, designs and drawings. All studies on technology transfer
by multi-nationals indicate flat in the: name of technological upgradation, the
multinationals carry on ‘technological dumping' of such technologies which, have been
superseded in developed countries. Consequently, second-hand machinery is dumped in the
name of import of capital goods. It is really this area which led to the growth of foreign
dominance in collusion with Indian big business playing the role of the underpinning of the
world economy.
Contd.

 import liberalisation measures resulted in the emergence of the huge deficit

in the balance of trade. In the name of technological upgradation, there was,
therefore, an unfettered drive for import of capital goods, designs and
drawings. All studies on technology transfer by multi-nationals indicate flat in
the: name of technological upgradation, the multinationals carry on
‘technological dumping' of such technologies which, have been superseded in
developed countries. Consequently, second-hand machinery is dumped in the
name of import of capital goods. It is really this area which led to the growth
of foreign dominance in collusion with Indian big business playing the role of
the underpinning of the world economy.
Balance of payments in the Seventh plan
and thereafter
 During the Seventh plan (1985-86 to 1989-90), trade deficit of the order of Rs. 54,204
crores emerged. Net favourable balance in the invisible account was of the order of Rs.
13,157 crores and thus net balance of payment on current account was Rs. 41,047 crores
Economics identified the following factors. Firstly, despite on encouraging rate of growth
of exports, the pressure on the balance of payments has increased. During the Seventh
Plan (1985-86 to 1989- 90), the annual rate of growth of exports was of the order of 18.7
per cent per annum, but the rate of growth of imports was the order of 16.8 per cent per
annum. Secondly, a major factor responsible for larger inflow of imports was the policy of
import liberalisation. Thirdly, there has been an increase in import-intensity due to the
pattern of industrial development promoted during the Seventh Plan which catered to the
demands thrown up by the upper income groups of the population. During 1980’s as against
the overall industrial growth of 7.7 per cent per annum, the growth rate of consumer
durables segment was of the order of 12.4 per cent per annum.Lastly, the relative steep
depreciation of the rupee vis-a-vis other currencies also led to an increase in the value of
imports. From Rs. 12.82 per dollar at the end of 1987, the rate of exchange depreciated to
Rs. 18.05 at the end of 1989 and was around Rs. 31.36 per dollar in April 1993.
 Balance of payments and the new
economic reforms of 1991
 New economic reforms were initiated in 1991 and an effort was made to step
up exports so that a major part of the import bill is paid for by exports.
Secondly, with a view of bring about technological upgradation, imports were
liberalised. Along with this, in place of debt-creating inflows of capital, non-
debt creating inflows such as foreign direct investment as well as portfolio
investment were encouraged. Another healthy feature of the changing scenario
that foreign reserves have more than doubled during 1993-94, from US$6.4
billion at the end of March 1993 to US$15.1 billion at the end of March 1994.
The large build-up in foreign exchange assets has been made possible by large
inflows of private foreign investments and Non-resident deposits.
 There is no doubt that both international and domestic factors have
contributed to the deterioration in the balance of payments in 1997-98 and this
is reflected by the increase in current account deficit to 1.6 per cent of GDP
and trade deficit rising to 4.9 per cent of GDP in 2004-05.
Contd.

 The situation has further worsened to Rs. 47.49 per US dollar in April 2000. It would be,
therefore, more prudent to adopt a cautious approach in admitting external commercial
borrowing, portfolio investment by foreigners and also larger contributions from NRIs in the
form of bonds. Moreover, the exports of the country must grow faster if the country wants to
save itself from the balance of payments crisis. At the same time, a policy of selective import
liberalisation in priority areas would help to strengthen the fundamentals of the economy.
 The deficit was caused by a burgeoning excess of merchandise imports over exports, which
was left uncompensated by the net surplus in invisibles. While the magnitude of deficit is one
of highest in recent times, it underscored the rising investment demand in the economy. As a
proportion of GDP, the turnaround in the current balance was from a surplus equivalent of 2.3
per cent in 2003-04 to a deficit of 0.4 per cent in 2004-05. For 2005-06 the current account
deficit has shot up to US$9.2 billion. As a consequence, there is a drawn down of our foreign
exchange reserves by US$26.2 billion. Since it is customary to look upon the Chinese
experience as a role model, it may be pointed out that China had current account surplus of
3.8 per cent of GDP in 1997 and has further improved this surplus to 6.1 per cent of GDP in
2005.
India’s current BOP

 India’s current account balance recorded a surplus of US$6.5 billion(0.9%of GDP) in Q1:2021-22
as against a deficit of US$8.1 billion
 The surplus in the current account in Q1:2021-22 was primarily on account of contraction in the
trade deficit to US$41.7 billion in the preceding quarter,and an increase in net services receipts
 Net services receipts increased,both sequentially and on a year-on-year basis,on the back of
robust performance of net exports of computer business services
 Private transfer receipts ,mainly representing remittances by Indians employed
overseas,amounted to US$20.9 billion an increase of 14.8 precent from their level a year ago
 Net outgo from the primary income account,mainly reflecting net overseas investment income
payments,decreased sequentially as well as on a year to year basis.
 Net inflow on account of non-resident deposits decreased to US$ 2.5 billion from US$ 3.0 billion
in Q1:2021
 Net external commercial borrowing to India recorded inflow of US$0.5 billion inQ1:2021-22 as
against an outflow of US$0.6 billion a year ago
Unit 10
Foreign Trade Policies of India
 Composition of Foreign Trade in India
The composition of foreign trade is an important indicator of the pattern of trade
developed by country. By the term composition of trade, we mean the structural
analysis involving the various types and the volume of various items of exports and
imports of the country.
 The country exporting more of primary products, viz., raw materials and importing
finished manufacturing goods and capital goods can be branded as an
underdeveloped country.
 In 1950 the Indian share in the world trade was 1.78% which came down to 0.6% in
1995. It was increased to 2.07% ($779 bn.) of the total world trade in 2015. During
the last 25 years Indian exports have increased by 17 times and imports by 19 times.
India’s share in global merchandise exports has risen from 0.6 percent in early 1990s
to 1.7 percent in 2016, and similarly the share of imports has risen from 0.6 percent
to 2.4 percent during the same period (EXIM Bank, 2017)
Composition of Imports in India

 The import basket of India was mostly consisting of grains, pulses, oils,
machineries, hardware’s, chemicals, drugs, dyes, yarns, paper, non-ferrous
metals, vehicles etc. With the introduction of planning and with its emphasis
on the development of basic, capital goods and engineering industries, the
country had to import a huge quantity of capital equipment’s along with its
spares known as maintenance imports.
 The imports of the country have been broadly divided into four groups:
 (1) Food and live animals chiefly for food;
 (2) Raw materials and intermediate manufactures;
 (3) Capital goods and (4) Other goods.
Composition of Exports in India

 The export basket of the country was mostly consisting of jute, tea and cotton textiles, which
jointly contributed more than 50 per cent of the total exports earning of the country. In 1950-
51, these three commodities contributed about 60 per cent of the total export earnings of the
country.
 The exports of the country have been broadly classified into five groups:
 (1) agriculture and allied products;
 (2) Ores and minerals;
 (3) Manufactured goods;
 (4) Mineral fuels and lubricants;
 (5) others.
 In 1970-71 total value of export was Rs. 1,535 crore and the share of the above five groups was
31.7 per cent, 10.7 per cent, 50.2 per cent, 0.84 per cent and 6.5 per cent respectively. Again
in 2008-2009, the share of these five groups in the country’s export trade changed to 9.2 per
cent, 4.2 per cent, 67.6 per cent, 15.1 per cent and 4.03 per cent respectively.
Exports in India

 The top eight export sectors - petroleum products, gems and jewellery,
textiles, chemicals and related products, agriculture and allied sector,
transport equipment, base metals and machinery continue to dominate
India’s export basket, accounting for nearly 86.4 per cent of total exports in
2014-15 as compared to 78.1 per cent in 2010-2011.
 The percentage of non traditional goods in total exports has increased the
exports of chemical and engineering goods have shown a high growth rate.
The manufactured goods constitute the bulk of export over 64% in recent
years, followed by crude and petroleum products (including coal) with a 20%
share and agriculture allied with just 13% share (2015).
Foreign Trade Policy of India

 Traditionally, the main objective of the Indian Foreign Trade Policy has been to
protect its market from foreign competition. Upto until the 1980s, India was
not interested in exporting its goods and services abroad and not ready to open
its economy to foreign investments.
 The aim of its economic policy was to ensure the country’s independent
development (the swadeshi principle).
 During the second half of the 1980s, due to recovery in the world economy, the
exports of India grew at a significant rate (17.8 percent).At the end of the
1980s, India was one of the most closed economies in the world.
 Its bilateral trade policy, heavily skewed toward the former communist
countries, was full of grand statements about technology transfer, mutually
advantageous relations and partnership for development to very little purpose.
Exim Policy of India

 In order to maintain the balance of payments and to avoid trade deficit the government of
India has announced a trade policy for imports and exports. After every five years the
government of India reviews the import and export policy in view of the changing
international economic situation.
 The policy relates to promotion of exports and regulation of imports so as to promote
economic growth and overcome trade deficit. Accordingly, the export-and import policies
(EXIM Policy) were announced by the government first in 1985 and then in 1988 which was
again revised in 1990.
 All these policies made necessary provision for extension of import liberalisation measures. All
these policies made necessary provision for import of capital goods and raw materials for
industrialisation, utilisation and liberalisation of REP (Registered Exporters Policy) licences,
liberal import of technology and policy for export and trading houses.
 The government announced its new EXIM policy for 2002-2007 which is mainly a continuation
of the EXIM policy of 1997-2002.The export-import policy for 2002-2007 aims at pushing up
growth of exports to 12 per cent a year as compared to about 1.56 per cent achieved during
the financial year 2001-2002.
Import Policy of India

 Prior to 1991 In the pre-reform period Indian import policy had two constituents:
 a) Import Restrictions:- In the initial phases of development, India had to import
capital equipment, machinery, spare parts, industrial raw material, etc.
 From time to time it had to import food grains too, but because of stagnant
exports, government had to decide to import curtail.
 High import tariffs were used to control import.
 b) Import substitution:- means reducing the dependability on imports, i.e.,
produce goods that we are importing. Two broad objectives of the programme of
import substitution in India were:(i) To save scarce foreign currency for the
import of more important goods; (ii) To achieve self-reliance in the production of
as many as goods as possible.
Foreign Trade Policies of India during the
Pre-reform Period
 Major portion of India’s trade was controlled by the British rulers who exploited the country’s
resources by exporting the goods to England at cheaper rates.
 After independence, Indian government was facing a major problem related to economic development
of the country. At that time growth economy conditions were not very good. This was because it did not
have proper resources for the development, not only in terms of natural resources but also in terms of
financial and industrial development. At that time India’s foreign trade was regulated through
economic planning. During the period of 1949-1970, India’s export has grown at a very slow rate.” In
1950s, India entered into planned development era.
 Due to continuous increasing imports and stagnant exports, policy of import substitution was started in
1960s to cut down on imports. During this period, Indian Government had implemented the policy of
export pessimism and import substitution. During the period of 1971-1991, export performance had
improved. In the late 1960s, Government of India took significant steps like establishment of Indian
Institute of Foreign Trade (IIFT) and others such institutions for the promotion of foreign trade.
 The world economy was also showing rapid growth during 1970s. The growth rate of exports was 15.8
percent in 1970s, which declined to 8 percent in 1980s. The decade of 1970 also witnessed an upsurge
in the imports, resulting in a higher growth rate for imports as compared to exports. The export was
flourishing at the time of 1970s, however, showed a declining trend during the starting of 1980s
Export Policies followed during Pre-
Reform Period
 All these measures can be broadly classified under the following heading:
(a)The duty drawback system, i.e., reimbursing exporters for tariff paid on
imported materials and excise duties paid on inputs;(b) Market development
assistances, i.e., providing cash compensatory support (CCS) to exporters,
and providing grant in aid to Export promotion councils and other
organisations for exploring new export markets;(c) Fiscal concessions for
exports i.e., exempting export earning from income tax partially or fully;(d)
Import policy for exports, i.e., providing imported inputs to export sector at
international prices through Import Entitlement scheme and Import
Replenishment scheme; and(e) Developing Export Processing Zones (EPZs) and
100 per cent Export-Oriented Units (EOUs) for providing necessary open
environment for export production.
Overall View on Export Promotion
Policies:
 During the pre-reform period, the Government of India undertook the some important
export promotion measures which include:
 (i) Cash Compensatory support (CCS);
 (ii) Duty Drawback System;
 (iii) Import Entitlement Scheme for easy access to importable inputs;
 (iv) Advance Licenses and Duty Exemption Scheme;
 (v) Setting up to Export Processing Zones (EPZs) and 100 per cent Export Oriented
Units (EOUs);
 (vi) Subsidies on domestic raw materials;
 (vii) Fiscal Concessions for exports;
 (viii) Export credit and assistance to Export Promotion Councils (EPCs), and(ix)
introducing Blanket Exchange Permit Scheme in June 1987.
Export Policies Followed during the
Reform Period:
 Considering the various problems faced by the exporters and also to raise the volume of exports, the
Government of India introduced new export promotion policies during the reform period in order to
address both production and trading related problems. Moreover, the Government devalued rupee
again by 18 per cent in July 1991 which was expected to boost up the exports.
 Again in May 1993, the Parliamentary Standing Committee on Commerce proposed allocation of
special funds to the State Governments out of the export earning from the units located in those
states to enable the states to develop infrastructure facilities for export promotion. However, with
the onset of liberalisation, the importance of globalisation through trade and taking exports as
engine of growth of the economy has been broadly recognised.
 Export promotion has now been considered as a continuous and sustained effort and in this
direction, specific steps have been taken and achievements have also been recorded in recent years.
 Trade policy reforms such as simplification and streamlining of procedure and additions of items in
the Special Import Licence (SIL) so as to improve premium and incentive to exports have so far
created a freer environment for trade, strengthened production base of export goods and removed
procedural irritants. Imports are also gradually being liberalised to facilitate flow of raw materials
and inputs to the exports sector besides widening and modernising the indigenous production base of
the country.
Import Policies followed during Pre-
Reform Period:
 The import policy of India was formulated as a part of foreign trade policy of
the country. During the post- independence period, the import policy of the
country was formulated at different times in order to attain the following
requirements:
 (a) Limiting the volume of imports to the minimum level in order to conserve
foreign exchange;
 b) Encouraging imports of those items required for industrialisation of the
country and
 (c) Modifying imports for exports promotion. Thus, broadly the import policy
of the country during the pre-reform period has two important constituents,
i.e:(a) Import restrictions and(b) Import substitution.
Import Policies followed during the
Reform Period
 During the reform period (since 1991), the import policies followed in the country
experienced continuous changes in order to make the policy much more rational and open
under the globalisation regime. Over the years, trade policy has undergone fundamental
shifts to correct the earlier anti-export bias and import restrictions through the withdrawal
of quantitative restrictions (QRs), reduction and rationalisation of tariffs, liberalisation in
trade and payments regime and improved access to export incentives by providing duty free
import to meet essential requirements, besides a realistic and market based on exchange
rate.
 Thus the quantitative restrictions were dismantled on imports and the peak rate of customs
duty on imports has also been slashed considerably to 10 per cent. The new trade policy,
2004-09 makes provisions for duty free import of capital goods for agricultural sectors under
Export Promotion Capital Goods (EPCG) scheme in its special focus initiatives. Again, import
of machinery and equipments for Effluent Treatment Plants for leather industry were also
exempted from customs duty. Again under the new Foreign Trade Policy, 2009-14, additional
items were allowed within the existing duty free imports entitlements for some employment
oriented sectors like sports goods ,leather garments, footwear and textile stems.
India’s New Trade Policy 1991

 Free Import and Export : Import of OGL capital goods, non- OGL capital goods and
restricted goods would be allowed without a specific license, provided clearance
was given by the RBI and foreign exchange, because their imports are fully covered
by foreign equity.
 Rationalisation of Tariff Structure: On the recommendation of Chelliah Committee,
import duty was drastically reduced to establish parity in prices of goods produced
domestically and internationally. The 1993-94 Budget reduced the maximum rate of
duty on all goods from 110% to 85%, except for few goods, which was further
reduced to 40% in 1998-99 and further to 35% in 2000-01 Decanalisation: The new
trade policy aimed at progressive decanalisation. The government decontrolled 116
items allowing their exports without any licensing formalities. Another 29 items
were shifted to OGL. It also decanalised 16 export items and 20 import items
including new print, non ferrous metals, natural rubber, intermediate and raw
material for fertilizers. However, eight items (petroleum products, fertilisers, etc.)
remained canalised
Contd.

 Devaluation and Convertibility of Rupee on Current Account: The government

made a twostep downward adjustment of 18-19 per cent in the exchange rate
of the rupee on July 1 and July 3, 1991. This was followed by the introduction
of LERMS i.e., partial convertibility of rupee in 1992-93, full convertibility on
the trade account in 1993-94 and full convertibility on the current account in
August 1994. Substantial capital account liberalisation measures have also
been announced. The exchange rate of the rupee is now market-determined.
Thus, exchange rate policy in India has evolved from the rupee being pegged
to a market related system (since March 1993).
 Trading Houses: The 1991 policy allowed export houses and trading houses to
import a wide range of items. The government also permitted the setting up
of trading houses with 51 per cent foreign equity for the purpose of promoting
exports.
Contd.

 Phased Manufacturing Programme: PMP, according to which organisations were required to

substitute all the imported parts with Indian parts in a specified period, was abolished
Export Oriented Units, (EOUs), Electronic Hardware Parks (EHTP), Software Technology
Parks (STPs) and Bio-Technology Parks (BTPs): The units undertaking to export their entire
production of goods and services may be set up under the Export Oriented Unit (EOU)
Scheme, Electronics Hardware Technology Park (EHTP) Scheme, Software Technology Park
(STP) Scheme or Bio- Technology Park (BTP) Scheme for manufacture of goods, including
repair, remaking, reconditioning, reengineering and rendering of services. Trading units
are not covered under these schemes.
 Free Trade & Warehousing Zones: The Free Trade & Warehousing Zones (FTWZ) shall be a
special category of Special Economic Zones with a focus on trading and warehousing.
 The objective of FTWZ is to create trade-related infrastructure to facilitate the import
and export of goods and services with freedom to carry out trade transactions in free
currency. These Zones would be established in the nearby areas to seaports, airports or
dry ports so as to offer easy access by rail and road.
India’s Foreign Trade Policy 2009-2014

 The Hon’ble Union Commerce & Industry Minister Mr.Anand Sharma

announced the new Foreign Trade Policy 2009 - 2014 in New Delhi on 27th
August, 2009. Various Suggestions of the Federation have been considered in
the New Foreign Trade Policy like - Continuation of DEPB scheme;
Enhancement of incentives under promotional schemes; Benefits to Status
Holders; Zero duty EPCG Scheme; Rationalization of additional export
obligation under EPCG; Additional markets under focus market scheme;
Additional products under Focus Product Scheme; Flexibility in import of
items against Duty Credit Scrips issued under earstwhile in Target Plus/DFCE
Schemes; Removal of Handloom Mark under Focus Product Scheme; Issues
relating to transaction costs; Tangible benefits to town of export excellence;
Technology Fund, etc.
Contd.

 Highlights of the Foreign Trade Policy 2009-2014  Higher Support for Market and Product Diversification. Incentive
schemes have been expanded by way of addition of new products and markets. 26 new markets have been added
under Focus Market Scheme. These include 16 new markets in Latin America and 10 in Asia-Oceania.
  The incentive available under Focus Market Scheme(FMS) has been raised from 2.5% to 3%. The incentive
available under Focus Product Scheme (FPS) has been raised from1.25% to 2%. A large number of products from
various sectors like Engineering products (agricultural machinery, parts of trailers, sewing machines, hand tools,
garden tools, musical instruments, clocks and watches, railway locomotives etc.), Plastic (value added products),
Jute and Sisal products, Technical Textiles, Green Technology products (wind mills, wind turbines, electric operated
vehicles etc.), Project goods, vegetable textiles and certain Electronic itemshave been included for benefits under
FPS.
  Technological Upgradation: To aid technological upgradation of our export sector, EPCG Scheme at Zero Duty has
been introduced. This Scheme will be available for engineering & electronic products, basic chemicals &
pharmaceuticals, apparels & textiles, plastics, handicrafts, chemicals & allied products and leather & leather
products (subject to exclusions of current beneficiaries under Technological Upgradation Fund Schemes (TUFS),
administered by Ministry of Textiles and beneficiaries of Status Holder Incentive Scheme in that particular year).
Jaipur, Srinagar and Anantnag have been recognised as ‘Towns of Export Excellence’ for handicrafts; Kanpur, Dewas
and Ambur have been recognised as ‘Towns of Export Excellence’ for leather products; and Malihabad for
horticultural products.
  EPCG Scheme Relaxations : To increase the life of existing plant and machinery, export obligation on import of
spares, moulds etc. under EPCG Scheme has been reduced to 50% of the normal specific export obligation.
Contd.

 Gems & Jewellery Sector: To neutralize duty incidence on gold Jewellery

exports, it has now been decided to allow Duty Drawback on such exports. A
new facility to allow import on consignment basis of cut & polished diamonds
for the purpose of grading/certification purposes has been introduced. To
promote export of Gems & Jewellery products, the value limits of personal
carriage have been increased from US$ 2 million to US$ 5 million in case of
participation in overseas exhibitions. The limit in case of personal carriage, as
samples, for export promotion tours, has also been increased from US$ 0.1
million to US$ 1 million.  Agriculture Sector : To reduce transaction and
handling costs, a single window system to facilitate export of perishable
agricultural produce has been be allowed re-export of unsold imported raw
hides and skins and semi finished leather from public bonded ware houses,
subject to payment of 50% of the applicable export duty.introduced. Leather
sector shall
Contd.

 Pharmaceutical Sector :Export Obligation Period for advance authorizations

issued with 6-APA as input has been increased from the existing 6 months to
36 months, as is available for other products.  Handloom Sector : To simplify
claims under FPS, requirement of ‘HandloomMark’ for availing benefits under
FPS has been removed.  EOUs will now be allowed to procure finished goods
for consolidation along with their manufactured goods, subject to certain
safeguards.  SEZ in India Export-led economic growth has been an important
part of the economic strategy prescribed to developing countries for their
progress and development especially since the 1970s. The first Export
Processing Zone (EPZ) was set up in Ireland in 1959 and the first EPZ in Asia
was established in India at Kandla in 1965.In later years, the concept EPZ has
gradually been replaced by SEZ. Between 1975 and 2006, the number of Free
Zones has shot up from 79 in 25 countries to 3500 in 130 countries.
India’s Foreign Trade Policy 2015-2020

 On 1st April 2015, the new Foreign Trade Policy (FTP) for the period 2015-20
was announced which replaces the 2009-14 FTP which expired on 31st March
2014. India's Foreign Trade Policy also known as Export Import Policy (EXIM) in
general, aims at developing export potential, improving export performance,
encouraging foreign trade and creating favorable BoP position. The main
objective of the Foreign Trade (Development and Regulation) Act is to provide
the development and regulation of foreign trade by facilitating imports into,
and augmenting exportsfrom India.
Highlights of the present Foreign Trade
Policy 2015-2020
 Commerce Minister announced two new schemes in Foreign Trade Policy 2015-2020Two New
Schemes announced in FTP Are MEIS & SEIS. FTP 2015-20 introduces two new schemes,
namely "Merchandise Exports from India Scheme (MEIS)" and "Services Exports from India
Scheme (SEIS)". These schemes (MEIS and SEIS) replace multiple schemes earlier in place,
each with different conditions for eligibility and usage.
  Merchandize exports from India (MEIS) to promote specific services for specific Markets
Foreign Trade Policy
  For services, all schemes have been replaced by a 'Services Export from India Scheme'(SEIS),
which will benefit all services exporters in India.
  FTP would reduce export obligations by 25% and give boost to domestic manufacturing
  Incentives (MEIS & SEIS) to be available for SEZs also. FTP benefits from both MEIS & SEIS
will be extended to units located in SEZs. – Both MEIS and SEIS firms and service providers
can now get subsidized office spaces in SEZ (Special Economic Zones), along with other
benefits. With a view to boost the Special Economic Zones, Government has decided to
extend both the incentive schemes for export of goods and services to units in SEZs
 e-Commerce of handicrafts, handlooms, books etc., eligible for benefits of MEIS. eCommerce exports up to
Rs.25000 per consignment will get SFIS benefits.  e-Commerce Exports Eligible For Services Exports From India
Scheme. – As part of Digital India vision, mobile apps would be created to ease filing of taxes and stamp duty,
automatic money transfer using Internet Banking have been proposed. > Online procedure to upload digitally
signed document by Chartered Accountant/Company Secretary/Cost Accountant to be developed.
  Agricultural and village industry products to be supported across the globe at rates of 3% and 5% under MEIS.
Higher level of support to be provided to processed and packaged agricultural and food items under MEIS.
  Industrial products to be supported in major markets at rates ranging from 2% to 3%.  Branding campaigns
planned to promote exports in sectors where India has traditional Strength.
  Business services, hotel and restaurants to get rewards scrips under SEIS at 3% and other specified services at
5%.
  Duty credit scrips to be freely transferable and usable for payment of customs duty, excise duty and service tax.
  Debits against scrips would be eligible for CENVAT credit or drawback also.
  Nomenclature of Export House, Star Export House, Trading House, Premier Trading House certificate changed to
1,2,3,4,5 Star Export House. – Some major overhauling of nomenclature and naming have been done. For
instance, Export House, Star Export House, Trading House, Star Trading House, Premier Trading House certificate
has been changed to One, Two, Three, Four, Five Star Export House. The allocation of the status will now be
based on US dollars, instead of Indian Rupees
Contd.

 Reduced Export Obligation (EO) (75%) for domestic procurement under EPCG scheme.
  Inter-ministerial consultations to be held online for issue of various licences.
  No need to repeatedly submit physical copies of documents available on Exporter
Importer Profile.
  Validity period of SCOMET export authorisation extended from present 12 months
to 24 months. Export obligation period for export items related to defence, military
store, aerospace and nuclear energy to be 24 months instead of 18 months
  Calicut Airport, Kerala and Arakonam ICDs(Inland Container Depots), Tamil Nadu
notified as registered ports for import and export.
  Vishakhapatnam and Bhimavarm added as Towns of Export Excellence.
  Certificate from independent chartered engineer for redemption of EPCG
authorisation no longer required.