The Balancing Act The current account should be balanced against the combined capital and financial accounts; however, as mentioned above, this rarely happens. We should also note that, with fluctuating exchange rates, the change in the value of money can add to BOP discrepancies. If a country has a fixed asset abroad, this borrowed amount is marked as a capital account outflow. However, the sale of that fixed asset would be considered a current account inflow (earnings from investments). The current account deficit would thus be funded. When a country has a current account deficit that is financed by the capital account, the country is actually foregoing capital assets for more goods and services. If a country is borrowing money to fund its current account deficit, this would appear as an inflow of foreign capital in the BOP. Overall balance of payment = Balance of current account + Balance of capital account + unilateral transfer account +Statistical discrepancy. Statistical discrepancy arises from on account of difficulties involved in collecting data, differences in approach to collect data from time to time, etc. Liberalizing the Accounts The rise of global financial transactions and trade in the late-20th century spurred BOP and macroeconomic liberalization in many developing nations. With the advent of the emerging market economic boom, developing countries were urged to lift restrictions on capital- and financial-account transactions to take advantage of these capital inflows.Some economists believe that the liberalization of BOP restrictions eventually lead to financial crises in emerging market nations, such as the Asian financial crisis. Many of these countries had restrictive macroeconomic policies, by which regulations prevented foreign ownership of financial and non-financial assets. The regulations also limited the transfer of funds abroad. With capital and financial account liberalization, capital markets began to grow, not only allowing a more transparent and sophisticated market for investors but also giving rise to foreign direct investment (FDI). For example, investments in the form of a new power station would bring a country greater exposure to new technologies and efficiency, eventually increasing the nation's overall gross domestic product (GDP) by allowing for greater volumes of production. Liberalization can also facilitate less risk by allowing greater diversification in various markets. Types of Balance of Payment Account The balance of payment is the difference between exports (of goods plus services plus capital transfers) less imports (of goods plus services plus capital transfers). It shows that balance of 51 CU IDOL SELF LEARNING MATERIAL (SLM)
payment is a wider term and the balance of trade is its part. Balance of Payment is further classified into favourable and unfavourable. Favourable Balance of Payments Excess of goods and services exported plus capital transferred to abroad over the goods and services imported and capital transfers from abroad is known as favourable balance of payments. Unfavourable Balance of Payments Excess of goods and services imported plus capital transfers from abroad over the goods and services exported plus capital transfers to abroad, i.e., rest of world, is known as unfavourable balance of payments. 3.3 DISEQUILIBRIA IN BOP Though the credit and debit are written balanced in the balance of payment account, it may not remain balanced always. Very often, debit exceeds credit or the credit exceeds debit causing an imbalance in the balance of payment account. Such an imbalance is called the disequilibrium. Disequilibrium may take place either in the form of deficit or in the form of surplus. Disequilibrium of Deficit arises when our receipts from the foreigners fall below our payment to foreigners. It arises when the effective demand for foreign exchange of the country exceeds its supply at a given rate of exchange. This is called an 'unfavourable balance'. Disequilibrium of Surplus arises when the receipts of the country exceed its payments. Such a situation arises when the effective demand for foreign exchange is less than its supply. Such a surplus disequilibrium is termed as 'favourable balance'. Causes of Disequilibrium in Balance of Payment Population Growth Most countries experience an increase in the population and in some like India and China the population is not only large but increases at a faster rate. To meet their needs, imports become essential and the quantity of imports may increase as population increases. Development Programmes Developing countries which have embarked upon planned development programmes require importing capital goods, some raw materials which are not available at home and highly skilled and specialized manpower. Since development is a continuous process, imports of these items continue for the long time landing these countries in a balance of payment deficit. Demonstration Effect 52 CU IDOL SELF LEARNING MATERIAL (SLM)
When the people in the less developed countries imitate the consumption pattern of the people in the developed countries, their import will increase. Their export may remain constant or decline causing disequilibrium in the balance of payments. Natural Factors Natural calamities such as the failure of rains or the coming floods may easily cause disequilibrium in the balance of payments by adversely affecting agriculture and industrial production in the country. The exports may decline while the imports may go up causing a discrepancy in the country's balance of payments. Cyclical Fluctuations Business fluctuations introduced by the operations of the trade cycles may also cause disequilibrium in the country's balance of payments. For example, if there occurs a business recession in foreign countries, it may easily cause a fall in the exports and exchange earning of the country concerned, resulting in a disequilibrium in the balance of payments. Inflation An increase in income and price level owing to rapid economic development in developing countries, will increase imports and reduce exports causing a deficit in balance of payments. Poor Marketing Strategies The superior marketing of the developed countries have increased their surplus. The poor marketing facilities of the developing countries have pushed them into huge deficits. Flight Of Capital Due to speculative reasons, countries may lose foreign exchange or gold stocks People in developing countries may also shift their capital to developed countries to safeguard against political uncertainties. These capital movements adversely affect the balance of payments position. Globalization Due to globalisation there has been more liberal and open atmosphere for international movement of goods, services and capital. Competition has been increased due to the globalisation of international economic relations. The emerging new global economic order has brought in certain problems for some countries which have resulted in the balance of payments disequilibrium. 3.4 MEASURES TO BRING BACK EQUILIBRIUM IN BOP 53 CU IDOL SELF LEARNING MATERIAL (SLM)
Overall account of BOP is always in equilibrium. This balance or equilibrium is only in accounting sense because deficit or surplus is restored with the help of capital account. In fact, when we talk of disequilibrium, it refers to current account of balance of payment. If autonomous receipts are less than autonomous payments, the balance of payment is in deficit reflecting disequilibrium in balance of payment. 3.4.1 Methods Measures to correct disequilibrium in BOP- Monetary Policy (Deflection) Monetary policy may be devised to correct a deficit in the balance of payments of a country. The deficit occurs because of high import and exports. This is to be reversed.In this regard, the country may adopt deflationary or dear money policy by raising the bank rate and restricting credit.Under deflation, prices fall which makes exports attractive and imports relatively costlier.This eventually leads to a rise in exports and a fall in imports. The policy of money contraction or deflection keeps exchange rates unaffected and tries to correct the deficit in the Balance of payments through domestic changes. However, deflations being in inexpedient, its Side Effects are dangerous to a poor Nation. It creates more unemployment and poverty.Again a developing economy has to adopt an expansionary rather than a contraceptive monetary policy to cater to developmental needs. Exchange Depreciation Exchange depreciation means the decline in the rate of exchange of one country in terms of another. For example the Indian rupee exchanges for 65 Roubles of the Russian currency. If India experiences an adverse Balance of payments with regard to Russia, the Indian demand for Rouble will be rise.Consequently, the price of Rouble in terms of Rupee will be appreciated in its external value.Thus, the rate of exchange of Indian rupee in terms of rouble may change to 1 Rupee = 45 Roubles from 1 equal 45 balls this is known as 1 Rupee = 64 Roubles. This is known as Exchange Depreciation.It is automatic and it helps in correcting a mild adverse balance of payments. This stimulates exports by making the domestic goods cheaper to the foreigners and thereby leading to favourable balance.However, this method is not feasible under the present system of IMF which prescribes the fixed exchange rate system. Devaluation Devaluation of currency is another way that makes exports attractive.The term Devaluation means a reduction in the official rate at which one currency is exchanged for another.It is an alternative to exchange depreciation.Devaluation is undertaken when the currency is found to be unduly overvalued. 54 CU IDOL SELF LEARNING MATERIAL (SLM)
Devaluation makes the Goods cheaper for foreigners. Exports will rise and imports decline.The Success of Devaluation, however, depends on certain following factors- The demand elasticity for the exports must be greater than unity. The elasticity of supply for the imports should be greater than unity. Devaluation should not be exceedingly adverse because it will not do anything. There should not be retaliation from other nations, that is, other nations should not have the corresponding Devaluation that nullifies each other’s gain. Devaluation of the country’s “terms of trade” should not be exceedingly adverse otherwise it will not gain anything from trade. Moreover, these are the following ‘Drawbacks of Devaluation’- It may lead to ‘Inflationary’ tendencies in the internal economy. It is nothing but the acknowledgment of a country’s economic weakness. It puffs up the burden of Debt servicing. It takes considerable time to yield expected results. Its effect is strongly purgative i.e. violent. Exchange Control Restriction on the use of foreign exchange by the central banks is called exchange control. When exchange control is adopted, all the exporters have to surrender their foreign exchange earnings to Central Bank.Under exchange control, the central bank releases foreign exchanges only for essential imports and conserves the rest of the balance. This is the most direct method of curbing imports. Exchange control, in general, deals with the balance of payments disequilibrium by suppressing the deficit that is only a symptom and not the Basic Trouble.Exchange control deals with only the deficit, not its causes, and it may irritate those causes tending to create a more basic disequilibrium.In other words, exchange control can prevent a complete breakdown, but it cannot eliminate a condition of disequilibrium. Thus, exchange control offers no permanent solution to the problem of persistent disequilibrium.It can, at best be justified only as a temporary measure, to gain time while other more fundamental adjustments made to restore equilibrium in the Balance of payments. Fiscal Policy- Import Duties Under this policy, import traffic tariff duties are imposed so as to make the import dearer with an overall aim of checking imports.Imports get reduced and Balance of payments becomes favourable. 55 CU IDOL SELF LEARNING MATERIAL (SLM)
Import Policy Under this mechanism, the government fixes a maximum quantity or value of a commodity to be imported.This in turn reduces and the deficit is reduced and thereby the Balance of payments, the position is improved.This measure has the immediate effect of checking imports as the marginal propensity to import becomes zero once the quota limit is reached. To correct disequilibrium in Balance of payments import quotes are assumed to be better than import duties. The quota has the immediate effect of restricting imports as the marginal prosperity to import become zero, once the quota-limited is reached. Thus, the effect of quotas on quantitative restriction (QR) of imports is explicit. But the Balance of payments effects of import duties and not to certain. Stimulating/Improving Export To correct disequilibrium in the balance of payments, it is necessary that exports should be increased. The government may adopt export programs for this purpose.Export promotion programs include subsidies, tax concession to exporters, marketing facilities, incentives for exporters, reducing export duties, etc.Further, to encourage exports the level of costs in the country may have to be brought down. Thus, may involve cutting down on wages and interest rates and other incomes and also a contraction of currency to bring the prices down. Foreign Loans The government can also secure loans from foreign banks or foreign governments to reduce the deficit in the balance of payments.Since the repayment of these loans is spread over a long period, this helps the government to remove the deficit in the balance of payments.During the currency of the loans, the government takes steps to improve its foreign exchange position. Encouragement to Foreign Investment The government induces the foreigners to make an investment in the country offering them all sorts of investor’s incentives and concessions. This provides the government with extra foreign exchanges which are utilized to reduce the deficit in the Balance of payments.But while inviting the foreign capitalist to invest their capital within the country, the government sees to it that this does not produce any adverse repercussions on the economy. Incentives to Foreign Tourist The government may also encourage foreign tourists to visit the country in increasing numbers of offering them various facilities and constitutional travel. 56 CU IDOL SELF LEARNING MATERIAL (SLM)
This increases the foreign exchange earnings of the country with the help of which the deficit in the Balance of payments can be reduced. Automatic Measures The disequilibrium in the balance of payments may automatically disappear after sometime when certain forces came into operation in the country. For example – The disequilibrium in the Balance of payments of a country under the gold standard was automatically corrected through the inflow and outflow of gold. If the balance of payments was unfavourable there was an outflow of gold from the country causing a contraction in the volume of currency and credit, and ultimately a fall in the domestic price level. This encouraged exports, while it discouraged imports. The equilibrium in the BOP was automatically restored after some time. Similarly, the equilibrium in the Balance of payments of a country on the paper standard was automatically corrected through fluctuations in its rate of exchange. For example – If the country’s BOP was unfavourable, the demand for foreign exchange exceeded its supply, and consequently, the exchange value of its currency went down. The fall in its exchange value encouraged exports while it discouraged imports. The Equilibrium in the BOP was automatically restored after the lapse of some time. The opposite process worked when the Balance of payments of the nation turned favourable. The automatic measures discussed above did not produce the desired results in a short period. Nor were they effective in dealing with a serious and fundamental disequilibrium in the BOP. Miscellaneous Measures These include developing import-substituting Industries, postponing debt payments, check on inflation, check on smuggling, etc. All these may help in correcting disequilibrium in the Balance of payments. To sum up, some of the deficit in the balance of payments is not a desirable phenomenon for a nation. The methods mentioned above aim at reducing imports and stimulating exports. Of these, the trade measures are better and effective. It produces immediate results. The Government of a nation may use this method in combination with other methods to eliminate or reduce a chronic deficit in the Balance of payments. Recent Data Trend India's current account balance posted a marginal surplus of USD 0.6 billion (0.1% of GDP) in the Jan-Mar quarter 2020, as against a deficit of USD 4.7 billion in Jan-Mar 2019 and USD 57 CU IDOL SELF LEARNING MATERIAL (SLM)
2.6 billion in the previous quarter. It is noteworthy that this is the first quarterly current account surplus since the Jan-Mar quarter of 2007. It is primarily on account of lower trade deficit at USD 35 billion and a rise in net invisible receipts (which includes services, primary and secondary income) at USD 35.6 billion. The lower trade deficit is a result of the sharp decline in demand at both the national and international levels following the implementation of COVID-19 lockdowns and a fall in global crude oil prices since the beginning of this year. In the financial account, net foreign direct investment at USD 12 billion was higher than USD 6.4 billion in Jan-March quarter 2019. On the portfolio investment side, there was a net outflow of USD 13.7 billion compared to USD 9.4 billion inflow the same quarter last year on account of money being pulled out from both debt and equity markets. A surplus at both current and capital account has resulted in a forex reserve accretion of USD 18.8 billion in the Jan-Mar quarter 2020. Generally, a current account surplus is a piece of welcome news; however, in the current scenario, it is a major worry for the Indian economy as it reflects a drop in economic activity. Given that the imports collapsed more than the exports and overall trade balance posted a surplus in the month of April and May, the current account will likely remain in surplus in the June quarter. Overview The Balance of Payments (BoP) records all economic transactions between residents of a country and the rest of the world. The BoP account mainly consists of the current account and the capital account. The current account includes the transaction of goods, services, primary income, and secondary income between the residents and the rest of the world. The current account balance is largely driven by the movement of goods and services. The capital account comprises credit and debit transactions under non-produced non-financial assets and capital transfers between residents and non-residents. Thus, acquisitions and disposals of non-produced non-financial assets, such as land sold to embassies and sales of leases and licenses, as well as transfers which are capital in nature, are recorded under this account. Key Features of India’s BoP in Q2 of 2020-21 India’s current account surplus moderated to US$ 15.5 billion (2.4 per cent of GDP) in Q2 of 2020-21 from US$ 19.2 billion (3.8 per cent of GDP) in Q1 of 2020-21; a deficit of US$ 7.6 billion (1.1 per cent of GDP) was recorded a year ago [i.e. Q2 of 2019-20]. The narrowing of the current account surplus in Q2 of 2020-21 was on account of a rise in the merchandise trade deficit to US$ 14.8 billion from US$ 10.8 billion in the preceding quarter. 58 CU IDOL SELF LEARNING MATERIAL (SLM)
Net services receipts increased both sequentially and on a year-on-year basis, primarily on the back of higher net earnings from computer services. Private transfer receipts, mainly representing remittances by Indians employed overseas, declined on a y-o-y basis but improved sequentially by 12 per cent to US$ 20.4 billion in Q2 2020-21. Net outgo from the primary income account, primarily reflecting net overseas investment income payments, increased to US$ 9.3 billion from US$ 8.8 billion a year ago. In the financial account, net foreign direct investment recorded robust inflow of US$ 24.6 billion as compared with US$ 7.3 billion in Q2 of 2019-20. Net foreign portfolio investment was US$ 7.0 billion as compared with US$ 2.5 billion in Q2 of 2019-20, largely reflecting net purchases in the equity market. With repayments exceeding fresh disbursals, external commercial borrowings to India recorded net outflow of US$ 4.1 billion in Q2 of 2020-21 as against an inflow of US$ 3.1 billion a year ago. Net accretions to non-resident deposits moderated to US$ 1.9 billion from US$ 2.3 billion in Q2 of 2019-20. There was an accretion of US$ 31.6 billion to the foreign exchange reserves (on a BoP basis) as compared with that of US$ 5.1 billion in Q2 of 2019-20 BoP during April-September 2020-21 (H1 of 2020-21) India recorded a current account surplus of 3.1 per cent of GDP in H1of 2020-21 as against a deficit of 1.6 per cent in H1 of 2019-20 on the back of a sharp contraction in the trade deficit. Net invisible receipts were lower in H1 of 2020-21, mainly due to decline in net private transfer receipts. Net FDI inflows at US$ 23.8 billion in H1of 2020-21 were higher than US$ 21.3 billion in H1of 2019-20. Portfolio investment recorded a net inflow of US$ 7.6 billion in H1of 2020-21, almost at the same level as a year ago. In H1 of 2020-21, there was an accretion of US$ 51.4 billion to the foreign exchange reserves (on a BoP basis). 3.5 SUMMARY Balance of Payment (BOP) is a statement which records all the monetary transactions made between residents of a country and the rest of the world during any 59 CU IDOL SELF LEARNING MATERIAL (SLM)
given period. This statement includes all the transactions made by/to individuals, corporate and the government and helps in monitoring the flow of funds to develop the economy. When all the elements are correctly included in the BOP, it should sum up to zero in a perfect scenario. This means the inflows and outflows of funds should balance out. However, this does not ideally happen in most cases. A BOP statement of a country indicates whether the country has a surplus or a deficit of funds i.e. when a country’s export is more than its import, its BOP is said to be in surplus. On the other hand, the BOP deficit indicates that a country’s imports are more than its exports. The balance of payments (BOP) is the record of all international financial transactions made by the residents of a country. There are three main categories of the BOP: the current account, the capital account, and the financial account. The current account is used to mark the inflow and outflow of goods and services into a country. The current account records imports and exports of goods and services and unilateral transfers. Balance-of-payments accounts usually differentiate between trades in goods and trade in services. The balance of exports and imports of the former is referred to as the balance of visible trade or as the balance of merchandise trade. The capital account is where all international capital transfers are recorded. In the financial account, international monetary flows related to investment in business, real estate, bonds, and stocks are documented. The current account should be balanced versus the combined capital and financial accounts, leaving the BOP at zero, but this rarely occurs. When exchange control is adopted, all the exporters have to surrender their foreign exchange earnings to Central Bank.Under exchange control, the central bank releases foreign exchanges only for essential imports and conserves the rest of the balance. Under fiscal policy, import traffic tariff duties are imposed so as to make the import dearer with an overall aim of checking imports. Imports get reduced and Balance of payments becomes favourable. The basic balance is defined as the sum of the current account balance and the net balance on long-term capital, which were then seen as the most stable elements in the balance of payments, and so placed 'above the line'. A worsening of the basic balance 60 CU IDOL SELF LEARNING MATERIAL (SLM)
(an increase in a deficit or a reduction in a surplus, or even a move from surplus to deficit) was seen as indicating deterioration in the (relative) state of the economy. Trisections 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. 3.6 KEYWORDS Balance of payment - The balance of payments is a statistical summary of the transactions of a given economy with the rest of the world. Current Account – The current account covers international transactions in goods, services, income, and current transfers. Capital Account – the capital account covers international capital transfers and the acquisition/disposal of non-produced, nonfinancial assets. Financial Account – the financial account deals with transactions involving financial claims on, or liabilities to, the rest of the world, including international purchases of securities, such as stocks and bonds Preferential trade arrangements (PTAs) - This is the term used in the WTO for trade preferences, such as lower or zero tariffs, which a member may offer to a trade partner unilaterally. These include the Generalized System of Preferences schemes, under which developed countries grant preferential tariffs to imports from developing countries. They also include non-reciprocal preferential schemes granted through a waiver by the General Council, meaning the member has been exempted from applying the most favoured nation (MFN) principle Conversion procedures- Both systems employ consistent procedures for converting transactions denominated in a variety of currencies or units of account into the unit of account (usually the domestic currency) adopted for compiling the balance of payments statement or the national accounts. There also is concordance between the two systems on conversion procedures used in constructing balance sheet accounts. Ad valorem (According to value) - A tax imposed on imports by the customs authority of a country based on the value of the goods. Advance Against Documents - A loan made on the security of the documents covering the shipment. Advising Bank- A bank, operating in the exporter’scountry, which handles the letter of credit for a foreign bank by notifying the export firm that the credit has been opened in its favour. The advising bank informs the exporter of the conditions of the letter of credit without necessarily bearing responsibility for payment. 61 CU IDOL SELF LEARNING MATERIAL (SLM)
(APEC) Asia Pacific Economic Cooperation- APEC was established in 1989 to further enhance economic growth and prosperity for the region and to strengthen the Asia-Pacific community. Since its inception, APEC has worked to reduce tariffs and other trade barriers across the Asia-Pacific region, creating efficient domestic economies and dramatically increasing exports. It also works to create an environment for the safe and efficient movement of goods, services and people across borders in the region through policy alignment and economic and technical cooperation. Financial Capital- The value of financial assets, which is an asset whose value arises not from its physical embodiment (as would a building or a piece of land or capital equipment) but from a contractual relationship: stocks, bonds, bank deposits, currency, etc. This is opposite to real assets such as buildings and capital equipment. Capital Flows- A net flow of capital, real and/or financial, from (into) a country, in the form of reduced holdings of domestic assets by foreigners and/ or increased purchases of foreign assets by domestic residents. Capital inflows (outflows) are recorded as negative (positive), or a debit, in the balance on capital account. International Reserves- The assets denominated in foreign currency, plus gold, held by a central bank, sometimes for the purpose of intervening in the exchange market to influence or peg the exchange rate. Usually includes foreign currencies themselves (especially US dollars), other assets denominated in foreign currencies, gold, and a small amount of SDRs. Trade Balance- The trade balance is the net sum of a country's exports and imports of goods without taking into account all financial transfers, investments and other financial components. A country's trade balance is positive (meaning that it registers a surplus) if the value of exports exceeds the value of imports. 3.7 LEARNING ACTIVITY 1. If inflation is higher in country A than in country B, and the exchange rate between the two countries is fixed. What is likely to happen to the trade balance between the two countries? ___________________________________________________________________________ ___________________________________________________________________________ 2. If India exports goods worth Rs 20 crore and imports goods worth Rs 30 crore, what will happen to balance of trade? ___________________________________________________________________________ ___________________________________________________________________________ 62 CU IDOL SELF LEARNING MATERIAL (SLM)
3.8 UNIT END QUESTIONS 63 A. Descriptive Questions Short Questions 1. Define balance of payment. 2. List the three elements of capital account? 3. What are the three accounts in BOP? 4. Define exchange control. 5. Explain financial account in short. Long Questions 1. Explain devaluation of currency. 2. What caused disequilibrium in balance of payment? 3. What are the measures to bring back the equilibrium? 4. Explain current and capital account in detail. 5. What is fiscal policy? Explain in depth? B. Multiple Choice Questions 1. Which transactions take place on both current and capital account? a. Autonomous b. Accommodating c. Compensatory d. None of these. 2. Which transactions are dependent of state of BOP? a. Autonomous b. Accommodating c. Compensatory d. None of these. 3. Which of the following is true for Debit side of current account? a. Current receipts b. Current payments c. Current balance d. None of these CU IDOL SELF LEARNING MATERIAL (SLM)
4. Which of the following is true for Credit side of current account? a. Current receipts b. Current payments c. Current balance d. None of these 5. Which of the following is a concept for current account? a. Stock b. Flow c. Real d. None of these Answers 1-a, 2-b, 3-b, 4- a, 5-b 3.9 REFERENCES References Grinblatt, M. and S. Titman (1998). Financial Markets and Corporate Strategy. New York: McGraw-Hill. Madura, J. (1999). International Financial Management. St. Paul: West Publishing Co. Maknkiw, N. G. (1997). Principles of Economics, New York: Dryden Press. Textbooks Shapiro, A. C. (1999). Multinational Financial Management, Upper Saddle River, NJ: Prentice-Hall. Simison, R. L. (1998). Firms Worldwide Should Adopt Ideas of US Management, Panel Tells OECD. The Wall Street Journal. Eiteman, D. K., Stonehill, A.I. and Moffett, M.H. (1998). International Business Finance, New York: Addison-Wesley Publishing Co. Websites https://en.wikipedia.org/wiki/Balance_of_payments https://www.investopedia.com/terms/b/bop.asp#:~:text=The%20balance%20of%20p ayments%20(BOP)%20is%20a%20statement%20of%20all,a%20quarter%20or%20a %20year. 64 CU IDOL SELF LEARNING MATERIAL (SLM)
https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/ap- open-economy-international-trade-and-finance/the-balance-of-payments/a/the- balance-of-payment 65 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 4 – CONVERTIBILITY OF CURRENCIES STRUCTURE 4.0 Learning Objectives 4.1 Introduction 4.2 Convertibility of Currencies 4.2.1 Modes and Methods 4.3 Current Account and Capital Account Convertibility 4.4 Exchange Control 4.4.1 Objectives of Exchange Control 4.4.2 Foreign Exchange Regulation Concerning Exports 4.5 Reasons and Methods 4.6 Summary 4.7 Keywords 4.8 Learning Activity 4.9 Unit End Questions 4.10 Reference 4.0 LEARNING OBJECTIVES After studying this unit, you will be able to: Define convertibility of currencies. Examine the advantages of convertibility. Describe current and capital account convertibility. 4.1 INTRODUCTION Currencies are used to buy goods and services both at home and abroad and their value is determined in many ways. Currencies are scare commodities subject to the laws of supply and demand. And the demand for foreign exchange is derived (indirect) demand. Currencies are of two broad types, convertible and inconvertible. The status of a country’s currency depends on its balance of payments position. If a country’s balance of payment (BOP) account shows a deficit most of the time then its currency is likely to depreciate in terms of other currencies. Most of its trading partners will be reluctant to accept its currency 66 CU IDOL SELF LEARNING MATERIAL (SLM)
in exchange for goods, services or financial assets.The currency of such a country is called an inconvertible currency. In contrast, it a country’s BOP position is strong, then the external value of the country’s currency is likely to remain stable Therefore most of its trading partners will be willing to accept the currency of the country. Such a currency is called a convertible currency. For example, the US dollar is a convertible currency. Definition Any currency, which can be freely converted into another currency in the foreign exchange market, is called a convertible currency. Currency convertibility is of two types: partial and full. If a currency is convertible on current account only it is called a partially convertible currency. But if it is convertible on capital account also it is called a fully convertible currency. IMF Rules on Convertibility Just as the general acceptability of national currency eliminates the costs of barter within a single economy, the use of national currencies in international trade makes the world economy function more efficiently. To promote efficient multilateral trade, the IMF Articles of Agreement urged members to make their national currency convertible as soon as possible. A convertible currency is one that may be freely exchanged for foreign currencies. The US and Canadian dollars became convertible in 1945 This means, for example, that a Canadian resident who acquired US dollars could use them to make purchases in the United States, could sell them in the foreign exchange market for Canadian dollars, or could sell them to the Bank of Canada, which then had the right to sell them to the Federal Reserve (at the fixed dollar/gold exchange rate) in return for gold. General inconvertibility would make international trade extremely difficult. A French citizen might be unwilling to sell goods to a German in return for inconvertible DM because these DM would then be usable only subject to restrictions imposed by the German government. With no market in inconvertible francs, the Germans would be unable to obtain French currency to pay for the French goods. The only way of trading would, therefore, be through barter i.e. the direct exchange of goods for goods. The IMF Articles called for convertibility on current account transactions only. Countries were explicitly allowed to restrict capital account transactions provided they permitted the free use of their currencies for transactions entering the current account. The experience of 1918-39 had led policymakers to view private capital moments as a factor leading to economic instability, and they feared that speculative movements of ‘hot money’ across national borders might sabotage their goal of free trade based on fixed exchange rates. By insisting on convertibility for current account transactions only, the IMF hoped to facilitate free trade while avoiding the possibility that private capital flows might tighten the external constraints faced by policymakers. 67 CU IDOL SELF LEARNING MATERIAL (SLM)
Most countries in Europe did not restore convertibility until the end of 1958, with Japan doing this in 1964 Germany also allowed substantial capital account convertibility, although the IMF Articles did not require this. Prior to that date, a European Payments Union had functioned as a clearing house for inconvertible European currencies, performing some of the functions of a foreign exchange market and thus facilitating intra-European trade. Britain had made an early ‘dash for convertibility’ in 1947 but had retreated in the face of large foreign reserve losses. The early convertibility of the US dollar, together with its special position in the Bretton Woods System, made it the post-world war period’s (1945) key currency. Because dollars were freely convertible, much international trade was done through dollars and importers and exporters held dollar balances for transactions. In effect, the dollar became international money, a universal medium of exchange, and a unit of account and a store of value. Also contributing to the dollar’s dominance was the strength of the American economy relative to the devastated economies of Europe and Japan. Dollars were attractive because they could be used to purchase badly needed goods and services that only the United States was in a position to supply. Central banks naturally found it advantageous to hold their international reserves in the form of interest-bearing dollar assets. Implications of Convertibility If a currency is convertible on current (trade) account it will be accepted in payment for all goods and services. But if a currency is convertible on capital account also it can be used to repay a country’s external debt. The Indian Rupee was made partially convertible in July 1991 when the Government of India announced its new economic policy. A new exchange rate system was introduced—the Liberalised Exchange Rate Mechanism System (LERMS). The rupee was linked to six major currencies of the world, viz., US dollar, British pound, German mark, French franc, Swiss franc and Japanese yen. Now the rupee floats in the foreign exchange market in response to changes in the rates of exchange between the rupee and these six strong (hard) currencies. Now that rupee has been made a partially convertible currency, we can pay for imports in rupees and thus save foreign exchange and avoid borrowing to finance a current account deficit. However, from the point of view of a country’s BOP, what is more important is capital account convertibility. Advantages of Currency Convertibility Convertibility of a currency has several advantages which we discuss briefly: Encouragement to exports An important advantage of currency convertibility is that it encourages exports by increasing their profitability. With convertibility profitability of exports increases 68 CU IDOL SELF LEARNING MATERIAL (SLM)
because market foreign exchange rate is higher than the previous officially fixed exchange rate. This implies that from given exports, exporters can get more rupees against foreign exchange (e.g. US dollars) earned from exports. Currency convertibility especially encourages those exports which have low import-intensity. Encouragement to import substitution Since free or market determined exchange rate is higher than the previous officially fixed exchange rate, imports become more expensive after convertibility of a currency. This discourages imports and gives boost to import substitution. Incentive to send remittances from abroad Thirdly, rupee convertibility provided greater incentives to send remittances of foreign exchange by Indian workers living abroad and by NRI. Further, it makes illegal remittance such ‘hawala money’ and smuggling of gold less attractive. A self balancing mechanism Another important merit of currency convertibility lies in its self-balancing mechanism. When balance of payments is in deficit due to over-valued exchange rate, under currency convertibility, the currency of the country depreciates which gives boost to exports by lowering their prices on the one hand and discourages imports by raising their prices on the other. In this way, deficit in balance of payments get automatically corrected without intervention by the Government or its Central bank. The opposite happens when balance of payments is in surplus due to the under-valued exchange rate. Specialisation in accordance with comparative advantage Another merit of currency convertibility ensures production pattern of different trading countries in accordance with their comparative advantage and resource endowment. It is only when there is currency convertibility that market exchange rate truly reflects the purchasing powers of their currencies which is based on the prices and costs of goods found in different countries. Since prices in competitive environment reflect that prices of those goods are lower in which the country has a comparative advantage, this will encourage exports. On the other hand, a country will tend to import those goods in the production of which it has a comparative disadvantage. Thus, currency convertibility ensures specialisation and international trade on the basis of comparative advantage from which all countries derive benefit. Integration of World Economy Finally, currency convertibility gives boost to the integration of the world economy. As under currency convertibility there is easy access to foreign exchange, it greatly helps the 69 CU IDOL SELF LEARNING MATERIAL (SLM)
growth of trade and capital flows between the countries. The expansion in trade and capital flows between countries will ensure rapid economic growth in the economies of the world. In fact, currency convertibility is said to be a prerequisite for the success of globalisation. 4.2 CONVERTIBILITY OF CURRENCIES Currency convertibility is the ease with which a country's currency can be converted into gold or another currency. Currency convertibility is important for international commerce as globally sourced goods must be paid for in an agreed-upon currency that may not be the buyer's domestic currency.When a country has poor currency convertibility, meaning it is difficult to swap it for another currency or store of value, it poses a risk and barrier to trade with foreign countries who have no need for the domestic currency. Understanding Currency Convertibility A convertible currency is any nation's legal tender that can be easily bought or sold on the foreign exchange market with little to no restrictions. A convertible currency is a highly liquid instrument as compared with currencies that are tightly controlled by a government's central bank or other regulating authority. A convertible currency is sometimes referred to as a hard currency. Currencies such as the South Korean won and Chinese Yuan are known as partially convertible currencies. A partially convertible currency is the legal tender of a country that is traded in low volumes in the global foreign exchange market. The governments of these countries place capital controls that limit the amount of currency that can exit or enter the country. Nearly all countries have currencies that are at some level at least partially convertible. However, currencies such as the Brazilian real, Argentineanpeso and Chilean peso are considered non-convertible because it is virtually impossible to convert them into another legal tender, except in limited amounts on the black market. A blocked currency is a currency that can’t freely be converted to other currencies on the forex markets as a result of exchange controls. Such money is mainly used for domestic transactions alone and does not freely exchange with other currencies, often due to government restrictions at home or abroad. Convertibility and Geo-Political Considerations There tends to be a correlation between a country's economy and the convertibility of its currency. The stronger an economy is on the global scale, the more likely its currency will be easily converted into other major currencies. Government constraints may result in a currency with a low convertibility. For example, a government with low reserves of hard foreign currency usually restricts currency convertibility because that government would otherwise 70 CU IDOL SELF LEARNING MATERIAL (SLM)
not be in a position to intervene in the foreign exchange (forex) market (i.e., to revalue, devalue) in order to support their own currency if and when necessary. Countries with a currency that has poor convertibility are at a global trade disadvantage because transactions don't run as smoothly as those with good convertibility. This reality will deter other countries from trading with them. Poor currency convertibility can contribute to slower economic growth as global trade opportunities are missed. There are ways to trade in foreign currencies which do not exchange internationally or whose trade is severely limited or legally restricted in the domestic market. Non-deliverable forward contracts (NDFs) can give a trader, for instance, indirect exposure to the Chinese renminbi, Indian rupee, South Korean won, new Taiwan dollar, and Brazilian real and other inconvertible currencies. Currency Convertibility and Capital Controls Good currency convertibility requires a readily available supply of the physical currency which is why some countries impose capital controls on money leaving its country. As economies slump into recession investors will often seek investment offshore or convert their money into one of the safe-haven currencies. To combat this and ensure money doesn't flood out of the country, some governments put controls in place to reduce capital flight during trying economic times. Capital controls are most prevalent in emerging market countries due to the higher uncertainty in their economic outlook. In the wake of the 1997 Asian financial crisis, many countries in the region imposed tight capital controls to reduce the threat of a run on their currency. More recently, Greece imposed capital controls in June 2015 to slow the capital outflows during the Greek Debt Crisis and these stayed in place until 2018. Those controls limited how much money could be withdrawn from the banking system. The interesting thing about the Greek controls is that the country is an EU member and uses the euro, so the capital controls did not actually affect the currency convertibility as Greece is just one part of the economies underlying the euro. When looking at currency convertibility, there are three different categories- fully convertible, partially convertible, and non-convertible. Fully Convertible Currency that is fully or freely convertible can be traded without any conditions or limits. Generally, fully convertible currencies come from more stable or wealthy countries. All major currencies (the US dollar, the euro, the Japanese yen, pound sterling, and the Swiss franc) are fully convertible currencies. In addition to the majors, there are a few minor and exotic currencies that are freely convertible. The Canadian dollar, Australian dollar, Danish krone, New Zealand dollar, and 71 CU IDOL SELF LEARNING MATERIAL (SLM)
Norwegian krone are all minor currencies that are fully convertible. Examples of fully convertible exotic currencies are; the Hong Kong dollar, Indian rupee, and Bahraini dinar. There are many benefits to a fully convertible currency, if an economy can support it. Freely convertible currency can create more business and employment opportunities for foreigners, increase tourism (and with it, local economies), and gives the world easy access to that country’s market. Fully convertible currencies are also a sign of stability and maturity in a country’s economy. However, there are a few potential drawbacks to having a fully convertible currency. Namely, there is a risk of foreign debt and a potential lack of competitiveness in the international markets. Partially Convertible A partially convertible currency is a currency that can be traded only with restrictions and controls imposed by the government that issues it. In general, partially convertible currencies come from countries with less stable economies. An increase in the price of foreign imports or a capital flight on currency reserves could easily destabilize an already fragile economy. Therefore, limits are imposed – thus making a currency partially convertible. All partially convertible currencies are exotic currencies. Some examples include; the Chinese Yuan, South African rand, and Malaysian ringgit. Rules to exchanging partially convertible currencies vary – some countries impose restrictions on where you can take the money (for example, Indonesian rupiahs must stay on- shore), others can only be converted in-country (like Philippine pesos). In many cases, documented proof is required either to show foreign currency buying is for a legitimate reason or have foreign exchange transactions registered with the central bank. Other common restrictions are limits on how much foreign currency you can have and how much domestic currency you can take out of the country. Non-Convertible Non-convertible currencies or “blocked currencies” are, as the name suggests, not at all traded on the foreign exchange market. Currency is blocked by the issuing government, usually to protect the country’s extremely fragile economy. The only way to exchange non-convertible currency is on the black market, making business in countries with non-convertible currency both risky and difficult. Often, non-convertible currencies are exotic. An example of a blocked currency is the Venezuelan Bolivar. 4.2.1 Modes and Methods In international transactions currencies of different countries are used. Some of the world’s currencies are accepted in all types of transactions throughout the world. These are called convertible currencies. Examples are US dollar, Swiss franc, French franc, British pound, 72 CU IDOL SELF LEARNING MATERIAL (SLM)
Germany marc and so on. Other currencies are called inconvertible currencies because these are not accepted by all countries in all types of transactions. The international status of a country’s currency depends on two things- The country’s balance of payments position and The confidence of the rest of the world in the country’s currency (which depends largely on the stability of the currency in recent past). Currency convertibility is of two types- on current account and on capital account. If a currency is convertible only on current account it is called a partly convertible currency. Such a currency is accepted for all current transactions such as exports of goods and services and unilateral payments and receipts. However, if a currency is convertible on capital account also it is called a fully convertible currency. Such a currency can be used to repay the external debt. For example if rupee becomes a fully convertible currency India will be in a position to repay her external debt in rupees rather than in foreign exchange. Capital account convertibility is also likely to encourage greater inflow of financial capital from the rest of the world and thus improve the country’s balance of payments position. IMF Rules on Convertibility Just as the general acceptability of national currency eliminates the costs of barter within a single economy, the use of national currencies in international trade makes the world economy function more efficiently. To promote efficient multilateral trade, the IMF Articles of Agreement urged members to make their national currencies convertible as soon as possible. A convertible currency is one that may be freely exchanged for foreign currencies. The US and Canadian dollars became convertible in 1945. This meant, for example, that a Canadian resident who acquired US dollars could use them to make purchases in the United States, could sell them in the foreign exchange market for Canadian dollars, or could sell them to the Bank of Canada, which then had the right to sell them to the Federal Reserve (at the fixed dollar/gold exchange rate) in return for gold. General inconvertibility would make international trade extremely difficult. A French citizen might be unwilling to sell goods to a German in return for inconvertible DM because these DM would then be usable only subject to restrictions imposed by the German government. With no market in inconvertible francs, the Germans would be unable to obtain French currency to pay for the French goods. The only way of trading would therefore be through barter, the direct exchange of goods for goods. 73 CU IDOL SELF LEARNING MATERIAL (SLM)
The IMF articles called for convertibility on current account transactions only Countries were explicitly allowed to restrict capital account transactions provided they permitted the free use of their currencies for transactions entering the current account. The experience of 1918-39 had led policymakers to view private capital movements as a factor leading to economic instability, and they feared that speculative movements of “hot money” across national borders might sabotage their goal of free trade based on fixed exchange rates. By insisting on convertibility for current account transactions only, the IMF hoped to facilitate free trade while avoiding the possibility that private capital flows might tighten the external constraints faced by policymakers. Most countries in Europe did not restore convertibility until the end of 1958, with Japan following in 1964. Germany also allowed substantial capital account convertibility, although this was not required by the IMF articles Prior to that date, a European Payments Union had functioned as a clearing house for inconvertible European currencies, performing some of the functions of a foreign exchange market and thus facilitating intra-European trade. Britain had made an early ‘dash for convertibility in 1947 but had retreated in the face of large foreign reserve losses. The early convertibility of the U.S. dollar, together with its special position in the Bretton Woods System, made it the post-war world’s key currency because dollars were freely convertible, much international trade was done through dollars and importers and exporters held dollar balances for transactions. In effect, the dollar became an international money — a universal medium of exchange, unit of account and store of value. Also contributing to the dollar’s dominance was the strength of the American economy relative to the devastated economies of Europe and Japan: Dollars were attractive because they could be used to purchase badly needed goods and services that only the United States was in a position to supply. Central banks naturally found it advantageous to hold their international reserves in the form of interest-bearing dollar assets. 4.3 CURRENT ACCOUNT AND CAPITAL ACCOUNT CONVERTIBILITY A currency may be convertible on current account (that is, exports and imports of merchandise and invisibles) only. A currency may be convertible on both current and capital accounts. We have explained above the convertibility of a currency on current account only. By capital account convertibility we mean that in respect of capital flows, that is, flows of portfolio capital, direct investment flows, flows of borrowed funds and dividends and interest payable on them, a currency is freely convertible into foreign exchange and vice-versa at market determined exchange rate. 74 CU IDOL SELF LEARNING MATERIAL (SLM)
Thus, by convertibility of rupee on capital account means those who bring in foreign exchange for purchasing stocks, bonds in Indian stock markets or for direct investment in power projects, highways steel plants etc. can get them freely converted into rupees without taking any permission from the government. Likewise, the dividends, capital gains, interest received on purchased stock, equity etc. profits earned on direct investment get the rupees converted into US dollars, Pound Sterlings at market determined exchange rate between these currencies and repatriate them. Since capital convertibility is risky and makes foreign exchange rate more volatile, is intro- duced only some time after the introduction of convertibility on current account when exchange rate of currency of a country is relatively stable, deficit in balance of payments is well under control and enough foreign exchange reserves are available with the Central Bank. Benefits of Capital Account Convertibility The Tarapore Committee mentioned the following benefits of capital account convertibility to India- Availability of large funds to supplement domestic resources and thereby promote economic growth. Improved access to international financial markets and reduction in cost of capital. Incentive for Indians to acquire and hold international securities and assets, and Improvement of the financial system in the context of global competition. Accordingly, the Tarapore Committee recommended the adoption of capital account convertibility. Under the system of capital account convertibility proposed by this committee the following features are worth mentioning: Indian companies would be allowed to issue foreign currency denominated bonds to local investors, to invest in such bonds and deposits, to issue Global Deposit Receipts (GDRs) without RBI or Government approval to go in for external commercial borrowings within certain limits, etc. Indian residents would be permitted to have foreign currency denominated deposits with banks in India, to make financial capital transfers to other countries within certain limits, to take loans from non-relatives and others up to a ceiling of $ 1 million, etc. Indian banks would be allowed to borrow from overseas markets for short-term and long- term upto certain limits, to invest in overseas money markets, to accept deposits and extend loans denominated in foreign currency. Such facilities would be available to financial institutions and financial intermediaries also. 75 CU IDOL SELF LEARNING MATERIAL (SLM)
All-India financial institutions which fulfil certain regulatory and prudential requirements would be allowed to participate in foreign exchange market along with authorised dealers (ADs) who are, at present, banks. In a later stage, certain select NBFCs would also be permitted to act as ADs in foreign exchange market. Banks and financial institutions would be allowed to operate in domestic and international markets and they would also be allowed to buy and sell gold freely and offer gold denominated deposits and loans. Preconditions for Capital Account Convertibility The Tarapore Committee recommended that, before adopting capital account convertibility (CAC), India should fulfil three crucial pre-conditions- Fiscal deficit should be reduced to 3.5 per cent. The Government should also set up a Consolidated Sinking Fund (CSF) to reduce Government debt. The Governments should fix the annual inflation target between 3 to 5 per cent. This was called mandated inflation target — and give foil freedom to RBI to use monetary weapons to achieve the inflation target. The Indian financial sector should be strengthened. For this, interest rates should be folly deregulated, gross non-paying assets (NPAs) should be reduced to 5 per cent, the average effective CRR should be reduced to 3 per cent and weak banks should either be liquidated or be merged with other strong banks. Apart from these three essential pre-conditions, the Tarapore Committee also recommended that- RBI should have a monitoring exchange rate band of 5 per cent around Real Effective Exchange Rate (REER) and should intervene only when the RER is outside the band: The size of the current account deficit should be within manageable limits and the debt service ratio should be gradually reduced from the present 25 per cent to 20 per cent of the export earnings. To meet import and debt service payments, forex reserves should be adequate and range between $ 22 billion and $ 32 billion; The Government should remove all restrictions on the movement of gold. It was generally agreed that foil convertibility of the rupee, both on current account and capital account was a welcome measure and is necessary for closer integration of the Indian economy with the global economy. The major difficulty with the Tarapore Committee recommendation was that it would like the current account convertibility to be achieved in a 3 year period – 1998 to 2000. The period 76 CU IDOL SELF LEARNING MATERIAL (SLM)
was too short and the pre-conditions and the macroeconomic indicators could not be achieved in such short period. Basically, the Committee failed to appreciate the political instability in the country at that time, and the complete absence of political will and vision to carry forward the process of economic reforms and economic liberalisation. The outbreak of Asian financial crisis at this time was also responsible for shelving the recommendation of Tarapore Committee. The second Tarapore Committee had drawn up a roadmap for 2011 as the target date for fuller capital convertibility of rupee and mentioned that the conditions were quite favourable. These conditions were Strong fundamentals of the Indian economy A good amount of foreign exchange reserves of $ 165 million that existed in 2006. More liberalized use of foreign exchange already in place. A financial system better geared to deal with external capital flows The fuller capital convertibility of rupee seemed to be desirable at the end of 2006 when the committee submitted its report. However, economic events, especially global financial crisis of 2007-09, roughly about a sea change in the economic situation. The Indian economy would have been greatly affected by the global financial crisis if we had implemented the recommendations of Tarapore Committee recommendation. We could not have coped with the extent of capital outflows that took place during 2008-09. Problems It may be noted that convertibility of currency can give rise to some problems. Firstly, since market determined exchange rate is generally higher than the previous officially fixed exchange rate, prices of essential imports rise which may generate cost-push inflation in the economy. Secondly, if current account convertibility is not properly managed and monitored, market exchange rate may lead to the depreciation of domestic currency. If a currency depreciates heavily, the confidence in it is shaken and no one will accept it in its transactions. As a result, trade and capital flows in the country are adversely affected. Thirdly, convertibility of a currency sometimes makes it highly volatile. Further, operations by speculators make it more volatile. Further, operations by speculators make it more volatile and unstable. When due to speculative activity, a currency depreciates and confidence in it is shaken there is capital flight from the country as it happened in 1997-98 in case of South East Asian economies such as Thailand, Malaysia, Indonesia, Singapore and South Korea. This adversely affects economic growth of the economy. In the context of heavy depreciation of the currency not only there is capital flight but inflow of capital in the economy is 77 CU IDOL SELF LEARNING MATERIAL (SLM)
discouraged as due to depreciation of the currency profitability of investment in an economy is adversely affected. 4.4 EXCHANGE CONTROL Exchange controls are government-imposed limitations on the purchase and/or sale of currencies. These controls allow countries to better stabilize their economies by limiting in- flows and out-flows of currency, which can create exchange rate volatility. Not every nation may employ the measures, at least legitimately; the 14th article of the International Monetary Fund's Articles of Agreement allows only countries with so-called transitional economies to employ exchange controls. Understanding Exchange Controls Many western European countries implemented exchange controls in the years immediately following World War II. The measures were gradually phased out, however, as the post-war economies on the continent steadily strengthened; the United Kingdom, for example, removed the last of its restrictions in October 1979. Countries with weak and/or developing economies generally use foreign exchange controls to limit speculation against their currencies. They often simultaneously introduce capital controls, which limit the amount of foreign investment in the country. Exchange controls can be enforced in a few common ways. A government may ban the use of a particular foreign currency and prohibit locals from possessing it. Alternatively, they can impose fixed exchange rates to discourage speculation, restrict any or all foreign exchange to a government-approved exchanger, or limit the amount of currency that can be imported to or exported from the country. Exchange Controls in Iceland Iceland offers a recent notable example of the use of exchange controls during a financial crisis. A small country of about 334,000 people, Iceland saw its economy collapse in 2008. Its fishing-based economy had gradually been turned into essentially a giant hedge fund by its three largest banks whose assets measured 14 times that of the country's entire economic output. The country benefited initially from a huge inflow of capital, taking advantage of the high- interest rates paid by the banks. However, when the crisis happened, investors needing cash pulled their money out of Iceland, causing the local currency, the krona, to plummet. The banks also collapsed, and the economy received a rescue package from the IMF. Lifting the Exchange Controls Under the exchange controls, investors who held high-yield offshore krona accounts were not able to bring the money back into the country. In March 2017, the Central Bank lifted most of the exchange controls on the krona, allowing the cross-border movement of Icelandic and 78 CU IDOL SELF LEARNING MATERIAL (SLM)
foreign currency once again. However, the Central Bank also imposed new reserve requirements and updated its foreign exchange rules to control the flow of hot money into the nation’s economy. In an effort to settle disputes with foreign investors who had been unable to liquidate their Icelandic holdings while the exchange controls were in place, the Central Bank offered to buy their currency holdings at an exchange rate discounted about 20 percent from the normal exchange rate at the time. Icelandic lawmakers also required foreign holders of krona- denominated government bonds to sell them back to Iceland at a discounted rate, or have their profits impounded in low-interest accounts indefinitely upon the bonds’ maturity. Countries with History of Exchange Controls United Kingdom – until 1979 South Korea – 1985 to 1989 Egypt – until 1995 Argentina – 2011 to 2015; and Fiji, Mexico, Peru, Finland, Chile, Zimbabwe, among others Factors that Lead Governments to Impose Exchange Controls The justification and motivation for the imposition of foreign exchange controls vary from country to country and their respective economic situations. Below are some of the justifications- Capital flight at unprecedented levels, mainly due to speculative pressure on the local currency, fear, and extremely low confidence levels. A marked decline in exports resulting in a Balance of Payments (BOP) deficit Adverse shifts in terms of trade War/conflict budgeting. The BOP may be in disequilibrium due to war, drought, etc. Economic development and reconstruction 4.4.1 Objectives of Exchange Control Below are the objectives of exchange control - Restore the balance of payments equilibrium The main objective of introducing exchange control regulations is to correct the balance of payments equilibrium. The BOP needs realignment when it is sliding to the deficit side due to greater imports than exports. Hence, controls are put in place to manage the dwindling foreign exchange reserves by limiting imports to essentials items and encouraging exports through currency devaluation. 79 CU IDOL SELF LEARNING MATERIAL (SLM)
Protect the value of the national currency Governments may defend their currency’s value at a certain desired level through participating in the foreign exchange market. The control of foreign exchange trading is the government’s way to manage the exchange rate at the desired level, which can be at an overvalued or undervalued rate. The government can create a fund to defend currency volatility to stay in the desired range or get it fixed at a certain rate to meet its objectives. An example is an import- dependent country that may choose to maintain an overvalued exchange rate to make imports cheaper and ensure price stability. Prevent capital flight The government may observe increased trends of capital flight as residents and non- residents start making amplified foreign currency transfers out of the country. It can be due to changes in economic and political policies in the country, such as high taxes, low interest rates, increased political risk, pandemics, and so on. The government may resort to an exchange control regime where restrictions on outside payments are introduced to mitigate capital flight. Protect local industry The government may resort to exchange control to protect the domestic industry from competition by foreign players that may be more efficient in terms of cost and production. It is usually done by encouraging exports from the local industry, import substitution, and restricting imports from foreign companies through import quotas and tariff duties. Build foreign exchange reserves The government may intend to increase foreign exchange reserves to meet several objectives, such as stabilize local currency whenever needed, paying off foreign liabilities, and providing import cover. Apart from the above there may be certain other objectives of exchange control To earn revenue in the form of difference between selling and purchasing rates of foreign exchange; To stabilize the exchange rates; To make imports of preferable goods possible by making the necessary foreign exchange available; and To pay off foreign liabilities with the help of available foreign exchange resources. There may be five types of Exchange Control- 80 CU IDOL SELF LEARNING MATERIAL (SLM)
Mild System of Exchange Control Under mild system of exchange control, also known as exchange pegging, the Government intervenes in maintaining the rate of exchange at a particular level. Under this system, the Government maintains on ‘Exchange Equalization Fund’ in foreign currencies. The British Exchange Equalization Account and U.S. Exchange Stabilisation Fund were two examples of mild control. In case the demand for dollar goes up and as a result the value of pound falls, the U.K. Government would sell dollars for pounds and thus restrict the fall in the value of pound by increasing the supply of dollars. Fully Fledged System of Exchange Control Under this system, the Government does not only Peg the Rate of Exchange but have complete control over the entire foreign exchange transactions. All receipts from exports and other transactions are surrendered to the control authority i.e., Reserve Bank of India. The available supply of foreign exchange is then allocated to different buyers of foreign exchanges on the basis of certain pre-determined criteria. In this way the Government is the sole dealer in foreign exchange. Compensating Arrangement A compensating arrangement of the character of the old fashioned barter deal. An example would be the sale by India of cotton goods of a particular value to Pakistan, the latter agreeing to supply raw cotton of the same value to India at a mutually agreed exchange rate. Imports thus compensate for exports, leaving no balance requiring settlement in foreign exchange. Clearing Agreement A clearing agreement consists of an understanding by two or more countries to buy and sell goods and services to each other, at mutually agreed exchange rates against payments made by buyers entirely in their own currency. The balance of outstanding claims are settled as between the central banks at the end of stipulated periods either by transfers of gold or of an acceptable third currency, or the balance might be allowed to accumulate for another period, pending an arrangement whereby the creditor country works of the balance by extra purchases from the other country. Payments Arrangements In a payments arrangement the usual procedure of making foreign payments through the exchange market is left intact. But each country agrees to establish a method of control whereby its citizens are forced to purchase goods and services from the other country in 81 CU IDOL SELF LEARNING MATERIAL (SLM)
amounts equal to the latter’s purchase from the first country. Another type of payments agreement is one designed to collect past debts. Conditions Necessitating Foreign Exchange Control The exchange control device is not effective in all cases. Only in selective cases, this measure of curbing imports is effective.The following are conditions where exchange control can be resorted- The exchange control is necessary and should be adopted to check the flight of capital. This is especially important when a country’s currency is under speculative pressure. In such cases tariffs and quotas would not be effective. Exchange control being direct method would successfully present the flight of capital of hot money. Exchange control is effective only when the balance of payment is disturbed due to some temporary reasons such as fear of war, failure of crops or some other reasons. But if there are some other underlying reasons, exchange control device would not be fruitful. Exchange Control is necessary when the country wants to discriminate between various sources of supply. Country may allow foreign exchange liberally for imports from soft currency area and imports from hard currency areas will be subject to light import control. This practice was adopted after Second World War due to acute dollar shortage. Even in India, many import licenses were given for use in rupee currency areas only, i.e., countries with which India had rupee-trade arrangements. Thus in above cases, the exchange control is adopted. In such cases quotas and tariffs do not help in restoring balance of payment equilibrium. 4.4.2 Foreign Exchange Regulation Concerning Exports Foreign exchange, as defined under Foreign Exchange Regulation Act. 1973 is foreign currency and includes - All deposits, credit and balances payable in foreign currency Any drafts, traveller’s cheques, letters of credit and bills of exchange expressed or drawn in Indian currency but payable in any foreign currency and, Any instrument payable at the option of the drawee or holder thereof or any other party thereto, either in Indian currency or foreign currency or partly in one and partly in the - Foreign exchange accrues out of foreign exchange transactions. The regulation and control of foreign exchange implies, therefore, regulation and control of foreign exchange transactions. Foreign Exchange Transactions A foreign exchange transaction is ultimately the purchase or sale of one national currency against another arising out of import or export of goods and services, foreign remittances and 82 CU IDOL SELF LEARNING MATERIAL (SLM)
foreign travel both inward and outward, etc. The goods refer to raw materials, intermediary or finished products capital goods, etc., comprising the visible items of a country's foreign trade. Services refer to shipping, air travel, insurance, banking, supply of technical know-how, consultancy, transfer of capital by way of lending and or investment, interest on such capital and dividends on such investment, tourists income and expenses, cost of Indian students abroad and of foreign students in India, gifts and donations, remittances, etc., which taken together comprise the invisible items of a country's foreign trade. A foreign exchange transaction is thus transfer of purchasing power, i.e. acquisition or parting with the right to wealth in a foreign country. As you must know that the foreign exchange is precious for a country. Hence, government regulates and controls the foreign exchange transactions. Exchange Control Exchange control means official intervention with the foreign exchange of a country. It is a system of rationing foreign exchange among competing demands for it, affected by controlling the receipts and payments thereof. The control of receipts aims at centralizing the country's means of external payments in a common pool in the hands of its monetary authorities. Reserve Bank of India is the monetary authority in India. It facilitates judicious use of foreign exchange. The control of payments aims at restraining the demand for foreign exchange broadly in consonance with the national interests within the limits of available resources. Foreign Exchange Regulation Concerning Exports Export of goods is the most important foreign exchange earner for the country and the law provides that foreign exchange in payment of exported goods must be realized in full with utmost promptness. Exporters are required to give a declaration for almost all exports to realize export proceeds within the prescribed period. The amended FERA (Foreign Exchange and Regulation Act, 1993) allows import and export of gold and silver under the provisions of export - import policy of the Government of India. The bringing in or taking out of personal Jewellery by travellers would be regulated by custom act and Baggage rules. Import and export of any Indian currency or foreign exchange is prohibited except with the general or special permission of the Reserve Bank. Exchange control procedures envisage ensuring that no foreign exchange arising out of exports from India is lost. The important provisions include declaration of exports on prescribed forms, realization of export proceeds in permitted methods, permitted currencies prescribed period and prescribed manner. Let us discuss them in detail. Prohibition of Export of all goods either directly or indirectly to any place outside India other than Nepal and Bhutan is prohibited unless the exporter furnishes to the prescribed authority a declaration in the prescribed form. It should be supported by such evidences as may be prescribed or so specified and true in all material particulars. The prohibition shall not apply to the export of- Trade samples supplied free of payment. 83 CU IDOL SELF LEARNING MATERIAL (SLM)
Personal effects of travellers, whether accompanied or unaccompanied. Ship's store, trans-shipment cargo and goods shipped under the orders of the Central Government in this behalf of or the military, naval or air force authorities in India for military, naval or air force requirements. Goods dispatched by air freight and accompanied by a declaration by the sender that they are not more than ten thousand rupees in value and that dispatch does not involve any transaction in foreign exchange. Goods dispatched by air freight and covered by a certificate issued by an authorised dealer that their export does not involve any transaction in foreign exchange. Goods export of which in the opinion of Reserve Bank does not involve any transaction in foreign exchange. Export Declaration Every exporter must make a true declaration in the prescribed form. The declaration is mandatory and includes- i) The full export value of the goods ii) The full export value of the goods is not ascertainable at the time of export, the value which the exporter, having regard to the prevailing market conditions, expects to receive on the sale of goods in the overseas market. The declaration should be supported by an affirmation by the exporters to realize the required export proceeds. Exporter's affirmation has been made. Mandatory that the full export value declared is the same as contracted with the foreign importer. Any other invoicing or over invoicing may attract penal provisions under the FERA act. Permitted Methods Export payment must be received in a currency appropriate to the country of final place of destination of the goods as declared on GR. etc. Reserve Rank has granted permission for receiving payments for exports directly by exporters from their buyers in certain conditions. Authorized dealers should receive remittance from foreign countries (other than Nepal and Exchange Control Regulations Bhutan) or obtain reimbursement from their branches and correspondents in these countries against payments due for exports from India. The other payments receivables should also confirm these methods of payment indicated below- All countries other than member countries in the Asian Clearing Union (except Nepal), Bangladesh, Myanmar Islamic, Republic of Iran, Pakistan and Srilanka. Payment may be received in rupees from the account of a bank situated in any country in this group or payment may be received in any permitted currency. 84 CU IDOL SELF LEARNING MATERIAL (SLM)
Member countries in the Asian Clearing Union (except Nepal), Bangladesh, Myanmar Islamic, Republic of Iran, Pakistan and Srilanka: payment may be received for all eligible current transactions of debit to the ACU (Asian Clearing Union) dollar account in India of a bank of the participating country in which the other party to the transaction is resident, or by credit to the ACU dollar account of the authorized dealer maintained with the correspondent bank in the other participating country. In other cases payment may be received in any permitted currency. Permitted Currencies The payment in foreign trade may be received in a foreign currency which is freely convertible. A freely convertible currency is permitted by the rules and regulations of the country concerned to be converted into major reserve currencies like U.S Dollar, Pound Sterling and for which a fairly active market exists for dealings against the major currencies. Authorized dealer may maintain balances and positions in any permitted currency. Prescribed Period The amount representing the full export value of the goods exported shall be realized and be paid to the authorized dealer when it is due. The amount should be realized either on the due date for the payment or within six months from the date of shipment of the goods whichever is earlier. The period is extended to fifteen months where the goods are exported to a warehouse established outside India with the permission of the Reserve Bank. For exports to CIS countries and other East European countries Reserve Bank may permit realization period upto 12 months. The Reserve Bank may extend the period of six months of twelve months or fifteen months if sufficient and reasonable causes are shown. Prescribed Manner The manners in which the export proceeds are to be realized include: Payment should be received through an authorized dealer except in cases where general specific permission has been granted by Reserve Bank to receive the payment directly. Payment should be received in permitted currency. Payment should be received as per approved methods of payment. 4.5 REASONS AND METHODS Foreign exchange control is the procedure by which a government intervenes in the foreign exchange market, banning or restricting sales and purchases of local currencies by non- residents as well as sales and purchases of foreign currencies by residents. In a context of free trade, the value of currencies fluctuates continuously according to dynamics of demand and supply. In order to limit the volatility of their exchange rate and 85 CU IDOL SELF LEARNING MATERIAL (SLM)
provide greater economic stability to their countries, monetary authorities may implement foreign exchange controls. In the case of weaker economies, the main objective of foreign exchange controls is to avoid speculation with their currencies. Such speculation could otherwise cause significant variations in the exchange rate, potentially triggering capital flows with devastating economic consequences for the country. These are the most common foreign exchange controls: Banning or limiting purchases of foreign currency within the country Banning or restricting the use of foreign currency within the country Setting exchange rates (instead of letting the value of the currency fluctuate according to market forces) Restricting currency exchange to retailers approved by the government Limiting the amount of money that may be imported or exported Currency controls are a challenge for international companies as they hinder their ability to trade in local currencies. These restrictions often entail further processing efforts for the company and increase the costs of FX operations and cross-border payments. Important methods of exchange control are- Intervention It is a commonly adopted mild form of exchange control.Demand and supply forces are allowed to play their role in the market. But the government may intervene with these forces by pegging up or pegging down the exchange rates. Pegging up implies fixation of exchange rate artificially higher than the market rate. Pegging down implies fixing exchange rate artificially lower than the market rate. When the exchange rate is pegged up there is a high demand for foreign exchange and the government has to satisfy it. In the case of pegging down, people demand more local currency and give up their foreign holdings. Naturally, in a less developed economy, under the pressure of balance of payments disequilibrium, to maintain pegging up of exchange rate is a difficult proposition. Exchange Clearing Agreements It is a revolutionary innovation to the international and commercial systems. Under the system, exchange clearing agreements are made between two nations for settling their accounts through their central banks. 86 CU IDOL SELF LEARNING MATERIAL (SLM)
Clearing between individual exporters and importers is not allowed, but done country- wise at an interval of time. Under the system, the importers pay in domestic currency to central bank and exporters get payment through the central bank in the home currency. The main shortcomings of the scheme are: i. It permits only bilateral trade and discourages multilateral trade. ii. It is not based on the sound principle of international trade. iii. It increases the burden of central banks. iv. There may be exploitation of small nations by big nations as the latter are in a strong bargaining position. Blocked Accounts Blocked accounts imply restrictions on the transfer of foreign capital or transfer of funds by foreigners to their home countries. When the policy of blocked accounts is adopted, the central bank deposits assets of foreign nationals in their accounts but they are not allowed to convert these credit balances into their home currencies for some period. This device harms the reputation of the country. It is adopted only during wartime or in grave circumstances. Payment Agreements To overcome the difficulties of delay involved in settling international payments and for the centralisation of payments observed in clearing agreements, the device is defined as payment agreements. Under this scheme, a creditor is paid as soon as information is received by the central bank of the debtor country from the creditor country’s central bank that its debtor has discharged his obligation and vice versa. Payment agreements have the advantage that direct relation between the exporters and importers is maintained. However, payment agreements suffer from two defects - i. The agreements could only be debited or credited for licensed payments. ii. The balances in the accounts could only be used for payment from one partner to another. Gold Policy Exchange control can also be affected by manipulating the buying and selling price of gold. Such a policy affects exchange rates through its effect on the gold points. For example, the Tripartite Agreement of 1936 between the U.K., France and the U.S.A. sought to control exchange rates by fixing the purchase and sale prices of gold at a level at which these parties proposed to fix up the exchange rate. 87 CU IDOL SELF LEARNING MATERIAL (SLM)
Rationing of Foreign Exchange Under the system, all foreign exchange earnings are to be surrendered by exporters to the central bank at a fixed change rate and then allocation is made by the government for imports on a priority basis in fixed amount only. Multiple Exchange Rates The system of multiple exchange rates is adopted to reduce the deficits in the balance of payments. Under the system, different rates of exchange are set up for different exports and imports. It is a rationing by price rather than by quantity. It is better, since it does not directly restrict free trade. The following are the merits of the multiple exchange rates system- i. It is better than devaluation. ii. It encourages exports and proves a disincentive in effect to imports. iii. It helps to adopt discriminations against goods and countries. iv. It helps in encouraging the inflow and minimising the outflow of capital. v. It provides an additional source of revenue to the government. But, the system increases the burden of central bank and may also create a lot of confusion. It is not a very feasible system. The system has the following drawbacks- i. Instead of correcting the balance of payments, it adversely affects the growth of international trade and maximisation of world output and welfare ii. It puts too much arbitrary powers into the hands of the government to influence foreign trade. iii. It creates undue complexities in calculation, due to different exchange rates for different imports and exports which may be changed from time to time, resulting in uncertainty in foreign trade. iv. The system has a formidable administrative problem of effective control. Utmost vigilance has to be maintained against the undervaluation of export invoices and overvaluation of import invoices and care should be taken to see that exporters do not sell their proceeds of foreign exchange in the black market and importers do make specific and proper use of the allotted foreign exchange. Further, the system is also likely to breed corruption. 4.6 SUMMARY 88 CU IDOL SELF LEARNING MATERIAL (SLM)
Currency convertibility refers to how liquid a nation's currency is in terms of exchanging with other global currencies. A convertible currency one that can be easily traded on forex markets with little to no restrictions. A convertible currency (e.g., U.S. dollar, Euro, Japanese Yen, and the British pound) is seen as a reliable store of value, meaning an investor will have no trouble buying and selling the currency. Non-convertible and blocked currencies (e.g. Cuban Pesos or North Korean Won) are not easily exchanged for other monies and are only used for domestic exchange with their respective borders. Currency convertibility, in practice, is a relative concept bound by an outside definition to which few, if any, currencies adhere, that is, the freedom to convert a currency into foreign exchange for any and all purposes at a given rate of exchange. In terms of the ability to conduct international transactions, much progress has been made in terms of current and capital account liberalization. In that respect, convertibility of currencies has been established de jure or de facto to a large extent in many countries. But in essence, it is soft convertibility that prevails, as exchange rate arrangements have moved toward flexibility. Until recently, hard convertibility was characteristic of the currencies in the exchange rate mechanism (ERM) of the European Monetary System, which maintained a virtually fixed link among participating countries. But their convertibility softened when a decision was taken to broaden the margin for most currency fluctuations within the ERM from 2.25 percent to 15 percent. In essence, convertibility of currencies, as liquidity of money, is amenable to many gradations, and in fact, has gone through many of those gradations in the last half century. Most currencies at the outset of the Bretton Woods period were inconvertible, since international transactions were tightly controlled. Indeed, one of the central purposes of the International Monetary Fund was precisely to liberalize the exchange systems of member countries and ensure that a reasonable measure of convertibility was attached to their currencies. Much progress has been made in the international economy at large in lifting exchange restrictions and establishing current account convertibility for many currencies. This progress helped to strengthen the integration of national economies into the world system and thereby tightened the constraints of interdependence. Difficulty or unwillingness to live with the constraints led, inter alia, to the abandonment of the Bretton Woods par value regime in favour of a system of flexible exchange rate arrangements. Hard convertibility was consequently also abandoned, and countries 89 CU IDOL SELF LEARNING MATERIAL (SLM)
entered into a period of soft convertibility of their currencies, the degree of which varied depending on the presence and magnitude of exchange restrictions. The period since the demise of the Bretton Woods system saw also an enormous growth in the scale of capital movements. These capital flows affected currency convertibility in a variety of ways. To the extent that the emergence of capital flows allowed for the financing of current account imbalances, they lessened the degree of exchange rate adjustments that would have been necessary in their absence. Thus, they contributed to a measure of hardening of currency convertibility. Capital flows also were instrumental, together with a trend in governmental policy circles in favour of market prices, in bringing about a de jure or de facto lowering of capital controls. Thus, they also broadened the degree of convertibility by moving currencies toward capital account convertibility. In this respect, reality has surpassed the aims of the code of conduct embedded in the Articles of Agreement, which still contemplate the use of capital controls as an available policy option. In sum, currency convertibility, in its hard modality, is equivalent to domestic price stability as a government aim. The latter will ensure the government’s willingness and ability to maintain the internal value of money. The former amounts to the similar principle in the international domain: the government’s willingness and ability to maintain the external value of money. 4.7 KEYWORDS Authorised Dealers-an Authorised Dealer (AD) is any person specifically authorized by the Reserve Bank under Section 10(1) of FEMA, 1999, to deal in foreign exchange or foreign securities (the list of ADs is available on www.rbi.org.in) and normally includes banks. Exchange Control- The rules and regulations applicable to all transactions involving foreign I exchange is under exchange control. CR Form - A form of declaration for exports by any mode except post to all countries other than Nepal and Bhutan. It is required to be submitted in duplicate to the custom authorities. Permitted Currencies - Currencies approved by the Reserve Bank for maintaining balances and position by the authorised dealers. PP Form - A form of declaration for all postal exports to all countries other than Nepal and Bhutan. It is a declaration by exporter mentioning the details of goods exporting through post office. These details contains the description of goods, value of goods, term of payment, terms of delivery, port of loading, port of discharge, country of destination, shipper details, consignee details etc. etc. 90 CU IDOL SELF LEARNING MATERIAL (SLM)
Softex Form - A form of declaration used to export computer software in non- physical form. Agreement on Textile and Clothing- The World Trade Organization (WTO) Agreement on Textiles and Clothing (the Agreement) provided for the phased liberalization and elimination over the transition period of quotas on textiles and apparel imported from WTO member countries. The Agreement was approved as part of the Uruguay Round Agreements Act and went into effect on January 1, 1995. The Agreement terminated in 2005. Andean Trade Preference Act- ATPA was signed into law in 1991 to provide the beneficiary countries of Bolivia, Colombia, Ecuador and Peru duty-free access to the U.S. market for a wide range of products. The Act expired in December 2001. Barter- Trade in which merchandise is exchanged directly for other merchandise without use of money. Barter is an important means of trade with countries using currency that is not readily convertible. Beneficiary- The person in whose favour a letter of credit is issued or a draft is drawn. Bill of exchange- An unconditional order in writing from one person (the drawer) to another (the drawee), directing the drawee to pay a specified amount to a named drawer at a fixed or determinable future date. Bill of Lading- A document that establishes the terms of a contract between a shipper and a transportation company under which freight is to be moved between specified points for a specified charge. Usually prepared by the shipper on forms issued by the carrier, it serves as a document of title, a contract of carriage, and a receipt for goods. Also see Air waybill, Inland Bill of Lading, Ocean Bill of Lading, and Through Bill of Lading. Cost and Freight- A pricing term indicating that the cost of the goods and freight charges are included in the quoted price.The buyer arranges for and pays insurance. 4.8 LEARNING ACTIVITY 1. Discuss convertibility of Indian rupees in light of the topic convertibility of currencies? ___________________________________________________________________________ ___________________________________________________________________________ 2. Why do people want an alternative currency and specifically crypto currencies like bit coins? 91 CU IDOL SELF LEARNING MATERIAL (SLM)
___________________________________________________________________________ ___________________________________________________________________________ 4.9 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Define currency convertibility. 2. What do you mean by exchange control? 3. What is permitted currency? 4. Define export claim. 5. Explain gold policy with respect to exchange control. Long Questions 1. Describe the broad objectives of exchange control. 2. How foreign Exchange Regulation Act is administered in India? 3. Describe the provisions of foreign exchange regulation concerning exports. 4. What are permitted methods for realization of Export Proceeds? 5. Describe the methods in exchange control. B. Multiple Choice Questions 1. What does Capital account convertibility of the Indian rupee imply? a. That the Indian rupee can be exchanged by authorized dealers for travel b. That the Indian rupee can be exchanged for any major currency for the purpose of trade in goods and services c. That the Indian rupee can be exchanged for any major currency for the purpose of trading in financial assets d. None of these 2. Which of the following is not a benefit of convertibility? a. Convertibility of the rupee will stabilize its exchange value against major currencies of the world. b. It will attract more foreign capital inflow in India c. It will help promote exports d. It will discourage imports to India 92 CU IDOL SELF LEARNING MATERIAL (SLM)
3. Which of the following statements is correct with respect to the convertibility of Indian rupee? a. It is convertible on capital account b. It is convertible on current account c. It is convertible both on current and capital account d. None of these 4. What does full convertibility of the rupee may mean? a. Its free float with other international currencies b. Its direct exchange with any other international currency at any prescribed place inside and outside the country c. It acts just like any other international currency d. Its direct exchange with any other international currency at any prescribed place inside and outside the country, its free float with other international currencies and it acts just like any other international currency. 5. Which of the statements given are correct? a. The Indian rupee is fully convertible In respect of current account transactions. b. The Indian rupee is fully convertible In respect of transaction of gold. c. The Indian rupee is fully convertible In respect of current account transactions and capital account transactions. d. The Indian rupee is fully convertible respect of current account transactions, capital account transactions and gold. Answers 1-c, 2-d, 3-b, 4- d, 5-a 4.10 REFERENCES References Ambler, C.A., and Mesenbourgh, T.L. (1992), EDI-Reporting Standard for the Future. Washington, D.C.: U.S. Department of Commerce. Guitián, M (1996), Concepts and Degrees of Currency Convertibility. International Monetary Fund Varma, S. (2007), Currency Convertibility: Indian and Global Experiences. California: New Century Publications. 93 CU IDOL SELF LEARNING MATERIAL (SLM)
Textbooks Maurice, D.L (2005), International finance (4th ed.), New York: Routledge. Eichengreen, B. (1996). Currency Convertibility, the Gold Standard and Beyond (1st ed.). London: Routledge. Kay, S. (2010). Argentina: The End of Convertibility. Federal Reserve Bank of Atlanta. Websites https://blog.continentalcurrency.ca/currency-convertibility/ https://www.investopedia.com/terms/c/convertibility.asp#:~:text=Currency%20conve rtibility%20is%20the%20ease,be%20the%20buyer's%20domestic%20currency. https://www.yourarticlelibrary.com/economics/foreign-exchange/currency- convertibility-advantage-benefits-and-preconditions-for-capital-account- convertibility/38177 94 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT 5 – TRADE BLOCKS STRUCTURE 5.0 Learning Objectives 5.1 Introduction 5.2 Trade Blocks 5.3 Advantages and Disadvantages of Trade Blocks 5.3.1 Competition and Scale 5.3.2 Trade and Location: The Pattern of Trade 5.3.3 Trade and Location: Convergence or Divergence 5.4 Reasons for Trade Block Formation 5.5 Summary 5.6 Keywords 5.7 Learning Activity 5.8 Unit End Questions 5.9References 5.0 LEARNING OBJECTIVES After studying this unit, you will be able to: Define trade blocks. Analyse advantage and disadvantage of trade blocks. Describe the reason for formation of trade blocks. 5.1 INTRODUCTION There are a variety of ways in which countries can “protect” their domestic economies from competition from abroad. One of them is through trading blocks. There has been a veritable explosion of Regional integration agreements (RIAs) in the last 15 years or so. Nearly every country in the world is either a member of or discussing participation in one or more regional integration arrangements. Such agreements have been concluded among high-income countries, among low-income countries, and, more recently, starting with the North American Free Trade Area (NAFTA) between high-income and developing countries. More than half of world trade now occurs within actual or prospective trading blocs. Why are countries so active in their pursuit of preferential trade agreements? Do such agreements allow countries 95 CU IDOL SELF LEARNING MATERIAL (SLM)
to obtain benefits that cannot be achieved through autonomous actions or multilateral cooperation? To understand this, let us look at its definition. A trade block is a type of inter-governmental agreement, often part of a regional inter- governmental organization, where barriers to trade (tariffs and others) are reduced or eliminated among the participating states. Trade blocks can be stand-alone agreements between several states (such as the North American Free Trade Agreement) or part of a regional organization (such as the European Union). Depending on the level of economic integration, trade blocks can be classified as preferential trading areas, free-trade areas, customs unions, common markets, or economic and monetary unions. Trading blocks are usually groups of countries in specific regions that manage and promote trade activities. Trade blocks lead to trade liberalization and trade creation between members, since they are treated favourably in comparison to non-members. While the formation of trade blocs, such as the European Union and NAFTA (North American Free Trade Agreement), has led to trade creation between members, by the same token it is also harder for countries outside the bloc to trade, leading to what is called trade diversion, where a company that otherwise might have got the business in that country is prevented from doing so because of a trading bloc and the barriers in place for non-member countries. The World Trade Organization (WTO) permits the existence of trading blocks, provided that they result in lower protection against outside countries than existed before the creation of the trading blocks. Trade blocks can be of many types- Free Trade Area Members agree to reduce or abolish trade barriers such as tariffs and quotas between themselves. They maintain their own individual tariffs and quotas with respect to non- members. Customs Union Countries that belong to customs unions agree to reduce or abolish trade barriers between themselves and agree to establish common tariffs and quotas with respect to outsiders. Common Market This is a customs union in which the members also agree to reduce restrictions on the movement of factors of production – such as people and finance – as well as reducing barriers on the sale of goods. Economic Union 96 CU IDOL SELF LEARNING MATERIAL (SLM)
A common market which is taken further by agreeing to establish common economic policies on such things as taxation and interest rates and, even, a common currency. 5.2 TRADE BLOCKS There are a variety of ways in which countries can “protect” their domestic economies from competition from abroad. One of them is through trading blocks. A trading block is a type of inter-governmental agreement, often part of a regional inter- governmental organization, where regional barriers to international trade (tariffs and non- tariff barriers) are reduced or eliminated among the participating states, a common currency is sometimes used or taxes on products are increased which have been purchased from outside the trade block allowing trade with each other as easily as possible. The idea is that member countries freely trade with each other, but establish barriers to trade with non-members, which has had a significant impact on the pattern of global trade.International trade agreements can open up new opportunities for exporters. They can also ensure access to competitively priced imports from other countries. While the formation of trade blocks, such as the European Union and NAFTA (North American Free Trade Agreement), has led to trade creation between members, by the same token it is also harder for countries outside the bloc to trade, leading to what is called trade diversion, where a company that otherwise might have got the business in that country is prevented from doing so because of a trading bloc and the barriers in place for non-member countries. Historically the first economic bloc was developed in Germany under the name of German Customs Union in 1834. It was formed on the basis of German Confederation and later on by the German Empire in 1871, a main surge in the trade bloc was noticed in the decade of 60s and 70s and subsequently in 90s during the collusion of communism. Under the rise of global competition approximately 50% of the world trade was taken place from regional blocs. According to the economist Jeffery (1993), there were four common traits shared by the members of successful trade blocs such as geographic proximities, political commitment to the regional organization, similar level of per capita GNP and compatible trading regimes. The member states who are advocating the free trade is opposed to the trade blocs as it is the argument to promote regional blocs against the global free trade (Bernal, 1997). The worldwide economists still argued that whether the regional bloc leads to the fragmented world economy or it is encouraging the stretch of present global multilateral trading system. According to the world economists, trade blocs are basically a trade agreement between the several states which produced the goods and a part of the regional organization (Bernal, 1997). There are the several different categories of trade blocs which are defined based on the level of economic integration such as monetary union, custom union, economic union, preferential trading areas, and common market and free trade areas 97 CU IDOL SELF LEARNING MATERIAL (SLM)
5.3 ADVANTAGES AND DISADVANTAGES OF TRADE BLOCKS Advantages of Trading Blocks Tariff removal leads to trade creation – lower prices for consumers and greater opportunity for exporters. Increased trade enables increased specialization – which gives benefits of economies of scale (lower average costs from increased output) Catch-up effects. Countries joining a rich trading block can benefit from inward investment and increased trade opportunities. Countries in Eastern Europe have made considerable progress in catching up with average income levels in Western Europe. Gravity theory of trade suggests that trade with countries in close proximity is the most important due to lower transport and similar cultural and economic ties. Gives small countries a greater say in global trade agreements Increased competition. The removal of tariffs creates greater choice for consumers. Therefore domestic firms have a greater incentive to cut costs to remain competitive. There is often free movement of labour, e.g. people, across trading blocks. Creates good trading relationships with other countries in the trading block. Disadvantages of Trading Blocks Joining a customs union may lead to increased import tariffs which will lead to trade diversion. For example, when the UK joined the EEC customs union, it required higher import tariffs on imports from former Commonwealth countries. This led to switch in demand towards higher-cost European countries and caused loss of business for Commonwealth countries Increased interdependence on economic performance in other countries in trading block. If Euro zone goes into recession, it will affect all countries in the Euro zone. However, this is almost inevitable even if countries are not formally in a trading block due to a close relationship between trade cycles in different countries. Loss of sovereignty and independence. A trading block needs to make decisions for the whole area. This may go counter to the particular wishes of a country. Increased influence of multinationals. In a bilateral deal between the US and South-East Asian trading block. Free trade may come at the price of allowing free movement of capital. This can have benefits in terms of inward investment. But, can also have costs for higher-cost domestic producers. Free trade can lead to structural unemployment as resources shift from uncompetitive industries to newer industries. Importing and exporting to countries outside the trading bloc can be expensive. 98 CU IDOL SELF LEARNING MATERIAL (SLM)
Countries can often only be part of one trading block, which means they cannot enter others 5.3.1 Competition and Scale The simplebenefits of a trade block are perhaps the scale benefits of having a single big factory serving the regional market. This will almost never be a good idea. Such a factory would be a protected monopoly, and such monopolies are usually inefficient and exploitative. Competition is a vital discipline on private behaviour, yet there is obviously a trade-off between the number of competitors in a market and the average size of factory. More competition means smaller factories, and so within any given market there is a trade-off between competition and scale. Regional integration enlarges the market and so enables both more competition and a larger average scale. Instead of having two national markets, each with three firms producing 100 units, there can be four firms in the regional market, each of which produces 150 units. Both result in increase in competition and scale. Regional integration will be more beneficial but in order to reap these gains, two of the six firms will have to close. Hence, in order for regional integration to secure the gains of competition and scale, the least efficient firms must be allowed to exit. Furthermore, removing tariffs is likely to be insufficient to achieve these gains that depend upon national markets becoming integrated into a single regional market. This will require many other supporting policies of “deep integration” to harmonize product standards and ensure that all firms have real penetration in all the nations within the region. A trade block that succeeds in reaping these competition and scale effects will not only lower the prices of manufactures produced within the region. As a result, importers will be forced to lower their prices so the block will improve its terms of trade. If developing countries want to use trade blocks to improve their terms of trade, they should have collective increase in competition. 5.3.2 Trade and Location: The Pattern of Trade Competition and scale effects accrue to the region as a whole, but trade and location effects are predominantly about transfers between one part of the region and another. The key trade effect is that money, which prior to the trade block accrued to the government as tariff revenue, will now accrue to firms in the partner country. The government loses tariff revenue and the country as a whole loses income. This effect is known as trade diversion. The analysis has to be done block by block. In some circumstances the loss of revenue will be serious, notably where tariffs are high and tariff revenue is a substantial share of total government revenue. For example, in a small, poor country such as Burkina Faso, regional integration will involve a large diversion from government revenue to manufacturing firms in Côte d’Ivoire and Senegal. A price that Burkina Faso might have to pay for the political drive to regionalism might thus be fewer children in primary education. Recent research suggests that there may be a further hidden cost to diversion. 99 CU IDOL SELF LEARNING MATERIAL (SLM)
One by-product of trade is knowledge. Firms learn from their trading partners. Evidence shows that trade has more knowledge benefits the larger is the stock of knowledge of the trading partner, with the stock of knowledge measured by the accumulated investment in research anddevelopment. Hence, if a poor Southern country diverts its trade from a Northern country with a large knowledge stock, to another Southern country with a much smaller knowledge stock, it will reduce its learning. Since within a South-South trade block it is the poorest countries that experience the most diversion, they are the ones liable to suffer the largest reduction in knowledge transfer. The formation of a trade block will cause economic activities to shift location. Potentially, this can create convergence or divergence between the members of the block. A further force for divergence within Southern blocs is industrial agglomeration. Firms within an industry gain from clustering together, and when freed from trade barriers will choose to do so. Trade blocks will thus always increase agglomeration within each industry if they fail to do so it is because they have failed to remove the real barriers to trade. Such forces may or may not cause overall industrial agglomeration. The key issue is whether the big gains from agglomeration are specific to each industry or accrue to industry in general. 5.3.3 Trade and Location: Convergence or Divergence There are numerous trends and tools in the world of economics and finance. Some of them describe opposing forces, such as divergence and convergence. Divergence generally means two things are moving apart while convergence implies that two forces are moving together. In the world of economics, finance, and trading, divergence and convergence are terms used to describe the directional relationship of two trends, prices, or indicators. But as the general definitions imply, these two terms refer to how these relationships move. Divergence When the value of an asset, indicator, or index moves, the related asset, indicator, or index moves in the other direction. This is what is referred to as divergence. Divergence warns that the current price trend may be weakening, and in some cases may lead to the price changing direction. Divergence can be either positive or negative. For example, positive divergence occurs when a stock is nearing a low but its indicators start to rally. This would be a sign of trend reversal, potentially opening up an entry opportunity for the trader. On the other hand, negative divergence happens when prices go higher while the indicator signals a new low.1 When divergence does occur, it does not mean the price will reverse or that a reversal will occur soon. In fact, divergence can last a long time, so acting on it alone could be mean substantial losses if the price does not react as expected. Traders generally don't exclusively rely on divergence in their trading activities. That's because it doesn't provide timely trade signals on its own. 100 CU IDOL SELF LEARNING MATERIAL (SLM)
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