Balance of payments

1. Meaning

The balance of payments of a country is a systematic record of all its economic

transactions with the outside world in a given year.
It is a statistical record of the character and dimensions of the countrys economic
relationships with the rest of the world. According to Bo Sodersten, The balance of
payments is merely a way of listing receipts and payments in international
transactions for a country. B. J. Cohen says, It shows the countrys trading position,
changes in its net position as foreign lender or borrower, and changes in its official
reserve holding.
2. Structure of Balance of Payments Accounts

The balance of payments account of a country is constructed on the principle of

double-entry bookkeeping. Each transaction is entered on the credit and debit side of
the balance sheet. But balance of payments accounting differs from business
accounting in one respect. In business accounting, debits (-) are shown on the left
side and credits (+) on the right side of the balance sheet. But in balance of payments
accounting, the practice is to show credits on the left side and debits on the right side
of the balance sheet.
When a payment is received from a foreign country, it is a credit transaction while
payment to a foreign country is a debit transaction. The principal items shown on the
credit side (+) are exports of goods and services, unrequited (or transfer) receipts in
the form of gifts, grants, etc. from foreigners, borrowings from abroad, investments
by foreigners in the country, and official sale of reserve assets including gold to
foreign countries and international agencies.

The principal items on the Debit side (-) include imports of goods and services,
transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending to
foreign countries, investments by residents to foreign countries, and official purchase
of reserve assets or gold from foreign countries and international agencies.
These credit and debit items are shown vertically in the balance of payments account
of a country according to the principle of double-entry book-keeping.
Horizontally, they are divided into three categories:
The current account, the capital account, and the offcial settlements account or the
Official reserve assets account.
The balance of payments account of a country is constructed in Table 1.

1. Current Accounting:
The current account of a country consists of all transactions relating to trade in goods
and services and unilateral (or unrequited) transfers. Service transactions include
costs of travel and transportation, insurance, income and payments of foreign
investments, etc. Transfer payments relate to gifts, foreign aid, pensions, and private

remittances, charitable donations etc. received from foreign individuals and

governments to foreigners.
In the current account, merchandise exports and imports are the most important
items. Exports are shown as a positive item and are calculated f.o.b. (free on board)
which means that costs of transportation, insurance, etc are excluded. On the other
side, imports are shown as a negative item and are calculated c.i.f. which means that
costs, insurance and freight are included.
The difference between exports and imports of a country is its balance of visible trade
or merchandise trade or simply balance of trade. If visible exports exceed visible
imports, the balance of trade is favourable. In the opposite case when imports exceed
exports, it is unfavourable.
It is, however, services and transfer payments or invisible items of the current
account that reflect the true picture of the balance of payments account. The balance
of exports and imports of services and transfer payments is called the balance of
invisible trade. The invisible items along with the visible items determine the actual
current account position. If exports of goods and services exceed imports of goods
and services, the balance of payments is said to be favourable. In the opposite case, it
is unfavourable.
In the current account, the exports of goods and services and the receipts of transfer
payments (unrequited receipts) are entered as credits (+) because they represent
receipts from foreigners. On the other hand, the imports of goods and services and
grant of transfer payments to foreigners are entered as debits (-) because they
represent payments to foreigners. The net value of these visible and invisible trade
balances is the balance on current account.
2. Capital Account:
The capital account of a country consists of its transactions in financial assets in the
form of short-term and long-term lendings and borrowings, and private and official

investments. In other words, the capital account shows international flow of loans
and investments, and represents a change in the countrys foreign assets and
liabilities.
Long-term capital transactions relate to international capital movements with
maturity of one year or more and include direct investments like building of a foreign
plant, portfolio investment like the purchase of foreign bonds and stocks, and
international loans. On the other hand, short-term international capital transactions
are for a period ranging between three months and less than one year.
There are two types of transactions in the capital accountprivate and government.
Private transactions include all types of investment: direct, portfolio and short-term.
Government transactions consist of loans to and from foreign official agencies.
In the capital account, borrowings from foreign countries and direct investment by
foreign countries represent capital inflows. They are positive items or credits because
these are receipts from foreigners. On the other hand, lending to foreign countries
and direct investments in foreign countries represent capital outflows. They are
negative items or debits because they are payments to foreigners. The net value of the
balances of short-term and long-term direct and portfolio investments is the balance
on capital account.
Sodersten and Reed refer to the external wealth account of a country which shows
the stocks of foreign assets held by the country (positive item) and of domestic assets
held by foreign investors (liabilities or negative item). The net value of a countrys
assets and liabilities is its balance of indebtedness. If its assets are more than its
liabilities, then it is a net creditor. If its liabilities are more than its assets, then it is a
net debtor.
Basic Balance:
The sum of current account and capital account is known as the basic balance.
3. The Official Settlements Account:

The official settlements account or official reserve assets account is, in fact, a part of
the capital account. But the U.K. and U.S. balance of payments accounts show it as a
separate account. The official settlements account measures the change in nations
liquidity and non-liquid liabilities to foreign official holders and the change in a
nations official reserve assets during the year. The official reserve assets of a country
include its gold stock, holdings of its convertible foreign currencies and SDRs, and its
net position in the IMF. It shows transactions in a countrys net official reserve
assets.
Errors and Omissions:
Errors and omissions is a balancing item so that total credits and debits of the three
accounts must equal in accordance with the principles of double entry book-keeping
so that the balance of payments of a country always balances in the accounting sense.
3. Is Balance of Payments Always in Equilibrium?

Balance of payments always balances means that the algebraic sum of the net credit
and debit balances of current account, capital account and official settlements
account must equal zero. Balance of payments is written as.
B = Rf -Pf
B =where, represents balance of payments,
Rf receipts from foreigners,
Pf payments made to foreigners.
When = Rf-- Pf = 0, the balance of payments is in equilibrium.
When Rf Rf > 0, it implies receipts from foreigners exceed payments made to
foreigners and there is surplus in the balance of payments. On the other hand, when
Rf - Pf < 0 or Rf < Pf - there is deficit in the balance of payments as the payments made
to foreigners exceed receipts from foreigners.

If net foreign lending and investment abroad are taken, a flexible exchange rate
creates an excess of exports over imports. The domestic currency depreciates in
terms of other currencies.
The export becomes cheaper relatively to imports. It can be shown in
equation form:
X + = M + If
Where X represents exports, M imports, 1, foreign investment, foreign borrowing
or X-M= If -B
or (X-M)-(If -B) = 0
The equation shows the balance of payments in equilibrium. Any positive balance in
its current account is exactly offset by negative balance on its capital account and vice
versa. In the accounting sense, the balance of payments always balances. This can be
shown with the help of the following equation:
C + S + T= C + I + G + (X-M)
or Y=C + I + G + (X M) [. Y = + S + T]
where represents consumption expenditure, S domestic saving, T tax receipts, I
investment expenditures, G government expenditures, X exports of goods and
services, and M imports of goods and services.
In the above equation
+ S + T is GNI or national income (Y), and
+ I + G =A,
where A is called absorption.
In the accounting sense, total domestic expenditures ( + I + G) must equal current
income (C + S + T) that is A = Y. Moreover, domestic saving (Sd) must equal

domestic investment (7d). Similarly, an export surplus on current account (X > M)

must be offset by an excess of domestic savings over investment (Sd > Id). Thus the
balance of payments always balances in the accounting sense, according to the basic
principle of accounting.
In the accounting system, the inflow and outflow of a transaction are recorded on the
credit and debit sides respectively. Therefore, credit and debit sides always balance.
If there is a deficit in the current account, it is offset by a matching surplus in the
capital account by borrowings from abroad or/and withdrawing out of its gold and
foreign exchange reserves, and vice versa. Thus, the balance of payments always
balances in this sense also.
4. Measuring Deficit or Surplus in Balance of Payments

If the balance of payments always balances, then why does a deficit or surplus arise
in the balance of payment of a country? It is only when all items in the balance of
payments are included that there is no possibility of a deficit or surplus. But if some
items are excluded from a countrys balance of payments and then a balance is
struck, it may show a deficit or surplus.
There are three ways of measuring deficit or surplus in the balance of
payments:
First, there is the basic balance which includes the current account balance and the
long-term capital account balance.
Second, there is the net liquidity balance which includes the basic balance and the
short-term private non-liquid capital balance, allocation of SDRs, and errors and
omissions.
Third, there is the official settlements balance which includes the total net liquid
balance and short-term private liquid capital balance.

If the total debits are more than total credits in the current and capital accounts,
including errors and omissions, the net debit balance measures the deficit in the
balance of payments of a country. This deficit can be settled with an equal amount of
net credit balance in the official settlements account.
On the contrary, if total credits are more than total debits in the current and capital
accounts, including errors and omissions, the net debit balance measures the surplus
in the balance of payments of a country. This surplus can be settled with an equal
amount of net debit balance in the official settlements account.
The relationship between these balances is summarised in Table 2 below.
TABLE 2:
Trade balance.. a
Transfer payments balance b Autonomous
Current Account Balance (= a + b) Items
Long-term capital balance d
Basic Balance.. e (= + d)
Short-term private non-liquid capital
Balance.. f
Allocation of SDRs g Accommodating
Errors and omissions.. h Items
Net Liquidity Balance i (= e + f + g + h)
Short-term private liquid capital balance j
Official Settlements Balance.. k (= i + j)

Autonomous and Accommodating Items:

Each balance would give different figure of the deficit. The items that are included in
a particular balance are placed above the line and those excluded are put below the
line. Items that are put above the line are called autonomous items. Items that are
placed below the line are called settlement or accommodating or compensatory or
induced items.
All transactions in the current and capital accounts are autonomous items because
they are undertaken for business or profit motives and are independent of balance of
payments considerations. According to Sodersten and Reed, Transactions are said
to be autonomous if their value is determined independently of the balance of
payments. Whether there is BOP deficit or surplus depends on the balance of
autonomous items. If autonomous receipts are less than autonomous payments, BOP
is in deficit and vice versa.
Accommodating items on the other hand are determined by the net consequences of
the autonomous items, according to Sodersten and Reed. They are in the official
reserve account. They are compensating (induced or accommodating) short-term
capital transactions which are meant to correct disequilibrium in the autonomous
items of balance of payments.
But it is difficult to determine which item is compensatory and which is autonomous.
For instance, in the table given above, the main difference in the three balances is
their treatment of short-term capital movements which are responsible for deficit in
the balance of payments.
The basic balance places short-term private non-liquid capital movements below the
line while the net liquid balance puts them above the line. Similarly, the net liquid
balance places short-term private liquid capital movements below the line and the
official settlements balance puts them above the line. Thus, as pointed out by
Sodersten and Reed, Essentially the distinction between autonomous and

accommodating items lies in the motives underlying a transaction, which are almost
impossible to determine.
Conclusion:
The above analysis is based on the assumption of fixed exchange rates. Thus a deficit
(or surplus in the balance of payments is possible under a system of fixed exchange
rates. But under freely floating exchange rates, there can in principle be no deficit (or
surplus) in the balance of payments.
The country can prevent a deficit or (surplus) by depreciating (or appreciating) its
currency. Further, balance of payments always balances in an ex-post accounting
sense, according to the basic principle of accounting. Lastly, such a balance of
payments can be in equilibrium only if there are no compensating transactions.
5. Balance of Trade and Balance of Payments

The balance of payments of a country is a systematic record of its receipts and

payments in international transactions in a given year. Each transaction is entered
on the credit and debit side of the balance sheet (see Table 1).
The principal items on the credit side are:
(1) Visible exports which relate to the goods exported for which the country receives
payments.
(2) Invisible exports which refer to the services rendered by the country to other
countries.
Such services consist of banking, insurance, shipping, and other services rendered in
the form of technical know-how, etc., money spent by tourists and students visiting
the country for travel and education, etc.
(3) Transfer receipts in the form of gifts received from foreigners.

(4) Borrowings from abroad and investments by foreigners in the country.

(5) The official sale of reserve assets including gold to foreign countries and
international institutions.
The principal items on the debit side are:
(1) Visible imports relating to goods imported for which the country makes payments
to foreign countries.
(2) Invisible imports in the form of payments made by the home country for services
rendered by foreign countries. These include all items referred to under (2) In the
above para.
(3) Transfer payments to foreigners in the form of gifts, etc.
(4) Loans to foreign countries, investments by residents in foreign countries, and
debt repayments to foreign countries.
(5) Official purchase of reserve assets or gold from foreign countries and
international institutions.
If the total receipts from foreigners on the credit side exceed the total payments to
foreigners on the debit side, the balance of payments is said to be favourable. On the
other hand, if the total payments to foreigners exceed the total receipts from
foreigners, the balance of payments is unfavourable.
The balance of trade is the difference between the value of goods and services
exported and imported. In contains the first two items of the balance of payments
account on the credit and the debit side. This is known as balance of payment on
current account. Some writers define the balance of trade as the difference between
the value of merchandise exports and imports. Prof. Meade regards this way of
defining the balance of trade as wrong and of minor economic significance from the
point of view of the national income of the country.

In equation form, the balance of payments of Y = C + I+G + (X-M) which includes all
transactions which give rise to or exhaust national income. In the equation, Prefers
to national income, C to consumption expenditure, I to investment expenditure, G to
government expenditure, X to exports of goods and services and M to imports of
goods and services. The expression (X M) denotes the balance of trade. If the
difference between X and M is zero, the balance of trade balances. If X is greater than
M, the balance of trade is favourable, or there is surplus balance of trade. On the
other hand, if X is less than M, the balance of trade is in deficit or is unfavourable.
6. Disequilibrium in Balance of Payments

Disequilibrium in the BOP of a country may be either a deficit or a surplus. A deficit

or surplus in BOP of a country appears when its autonomous receipts (credits) do not
match its autonomous payments (debits). If autonomous credit receipts exceed
autonomous debit payments, there is a surplus in the BOP and the disequilibrium is
said to be favourable. On the other hand, if autonomous debit payments exceed
autonomous credit receipts, there is a deficit in the BOP and the disequilibrium is
said to be unfavourable or adverse.
Causes of Disequilibrium:
There are many factors that may lead to a BOP deficit or surplus:
1. Temporary Changes (or Disequilibrium):
There may be a temporary disequilibrium caused by random variations in trade,
seasonal fluctuations, the effects of weather on agricultural production, etc. Deficits
or surpluses arising from such temporary causes are expected to correct themselves
within a short time.
2. Fundamental Disequilibrium:
Fundamental disequilibrium refers to a persistent and long-run BOP disequilibrium
of a country. It is a chronic BOP deficit, according to IMF.

It is caused by such dynamic factors as: (1) Changes in consumer tastes within
the country or abroad which reduce the countrys exports and increase its imports.
(2) Continuous fall in the countrys foreign exchange reserves due to supply
inelasticitys of exports and excessive demand for foreign goods and services. (3)
Excessive capital outflows due to massive imports of capital goods, raw materials,
essential consumer goods, technology and external indebtedness. (4) Low
competitive strength in world markets which adversely affects exports. (5)
Inflationary pressures within the economy which make exports dearer.
3. Structural Changes (or Disequilibrium):
Structural changes bring about disequilibrium in BOP over the long run.
They may result from the following factors:
(a) Technological changes in methods of production of products in domestic
industries or in the industries of other countries. They lead to changes in costs, prices
and quality of products.
(b) Import restrictions of all kinds bring about disequilibrium in BOP.
(c) Deficit in BOP also arises when a country suffers from deficiency of resources
which it is required to import from other countries.
(d) Disequilibrium in BOP may also be caused by changes in the supply or direction
of long-term capital flows. More and regular flow of long-term capital may lead to
BOP surplus, while an irregular and short supply of capital brings BOP deficit.
4. Changes in Exchange Rates:
Changes in foreign exchange rate in the form of overvaluation or undervaluation of
foreign currency lead to BOP disequilibrium. When the value of currency is higher in
relation to other currencies, it is said to be overvalued. Opposite is the case of an
undervalued currency. Overvaluation of the domestic currency makes foreign goods
cheaper and exports dearer in foreign countries. As a result, the country imports
more and exports less of goods. There is also outflow of capital. This leads to

unfavourable BOP. On the contrary, undervaluation of the currency makes BOP

favourable for the country by encouraging exports and inflow of capital and reducing
imports.
5. Cyclical Fluctuations (or Disequilibrium):
Cyclical fluctuations in business activity also lead to BOP disequilibrium. When there
is depression in a country, volumes of both exports and imports fall drastically in
relation to other countries. But the fall in exports may be more than that of imports
due to decline in domestic production. Therefore, there is an adverse BOP situation.
On the other hand, when there is boom in a country in relation to other countries,
both exports and imports may increase. But there can be either a surplus or deficit in
BOP situation depending upon whether the country exports more than imports or
imports more than exports. In both the cases, there will be disequilibrium in BOP.
6. Changes in National Income:
Another cause is the change in the countrys national income. If the national income
of a country increases, it will lead to an increase in imports thereby creating a deficit
in its balance of payments, other things remaining the same. If the country is already
at full employment level, an increase in income will lead to inflationary rise in prices
which may increase its imports and thus bring disequilibrium in the balance of
payments.
7. Price Changes:
Inflation or deflation is another cause of disequilibrium in the balance of payments.
If there is inflation in the country, prices of exports increase. As a result, exports fall.
At the same time, the demand for imports increase. Thus increase in export prices
leading to decline in exports and rise in imports results in adverse balance of
payments.
8. Stage of Economic Development:
A countrys balance of payments also depends on its stage of economic development.
If a country is developing, it will have a deficit in its balance of payments because it

imports raw materials, machinery, capital equipment, and services associated with
the development process and exports primary products. The country has to pay more
for costly imports and gets less for its cheap exports. This leads to disequilibrium in
its balance of payments.
9. Capital Movements:
Borrowings and lendings or movements of capital by countries also result in
disequilibrium in BOP. A country which gives loans and grants on a large scale to
other countries has a deficit in its BOP on capital account. If it is also importing
more, as is the case with the USA, it will have chronic deficit. On the other hand, a
developing country borrowing large funds from other countries and international
institutions may have a favourable BOP. But such a possibility is remote because
these countries usually import huge quantities of food, raw materials, capital goods,
etc. and export primary products. Such borrowings simply help in reducing BOP
deficit.
10. Political Conditions:
Political condition of a country is another cause of disequilibrium in BOP. Political
instability in a country creates uncertainty among foreign investors which leads to
the outflow of capital and retards its inflow. This causes disequilibrium in BOP of the
country. Disequilibrium in BOP also occurs in the event of war or fear of war with
some other country.
Implications of Disequilibrium:
A disequilibrium in the balance of payments whether a deficit or surplus has
important implications for a country. A deficit in the combined current and capital
accounts is regarded as undesirable for the country. This is because such a deficit has
to be covered by borrowing from abroad or attracting foreign exchange or capital
from abroad. This may require paying high interest rates.
There is also the danger of withdrawing money by foreigners, as happened in the
case of the Asian crisis in the late 1990s. An alternative may be to draw on the

reserves of the country which may also lead to a financial crisis. Moreover, the
reserves of a country being limited, they can be used to pay for BOP deficit upto a
limit.
But the above analysis of a combined current and capital account deficit is not
correct in practice. The reason being that a current account deficit is the same thing
as a capital account surplus. However, it is beneficial for a country to have a current
account deficit even if it equals capital account surplus in BOP.
In the short-run, the country may benefit from a higher level of consumption through
import of goods and consequently a higher standard of living. But the excess of
imports over exports may be financed by foreign investments in the country. These
may lead to increased production, employment and income in the country. In the
long-run, foreign investors may purchase large assets in the country and thus
adversely affect domestic industry as is the case with MNCs (multinational
corporations).
The current account deficit in BOP of a country may have either good or bad effects
depending on the nature of an economy.
Take a country where domestic industries are rapidly growing and it has current
account BOP deficit. These industries offer a high rate of return on their investment.
This would, in return, attract foreign investments. As a result, the country would
have a capital account surplus due to the inflow of capital and a current account
deficit.
This current account deficit is good for the economy. No doubt, the external debt of
the country increases, but this debt is being utilised to finance the rapid growth of
the economy. The real burden of this debt will be very low because it can be repaid
out of higher income in the future.
On the contrary, a country having an inefficient and unproductive domestic industry
will be adversely affected by its current account BOP deficit. The country borrows

from abroad to finance the excess of spending over consumption. To attract foreign
borrowings, the country will have to pay high interest rates.
These will increase the money burden of the debt. The real burden of the debt will
also increase because of the low productive capacity of domestic industries. If the
current consumption is being financed by foreign borrowings, the wealth of the
economy will decline. This, in turn, will lead to either a reduction in domestic
expenditure or a change in government policy so as to control the rising debt.
On the other hand, if foreign borrowings are being used to finance real investment,
the current account BOP deficit will be beneficial for the economy. A higher rate of
return on real investment than the interest on foreign borrowings would increase the
countrys wealth over time through rise in its national income. Thus a current
account BOP deficit is not always undesirable for a country.
7. Measures to Correct Deficit in Balance of Payments

When there is a deficit in the balance of payments of a country, adjustment is

brought about automatically through price and income changes or by adopting
certain policy measures like export promotion, monetary and fiscal policies,
devaluation and direct controls.
We study these as follows:
1. Adjustment through Exchange Depreciation (Price Effect):
Under flexible exchange rates, the disequilibrium in the balance of payments is
automatically solved by the forces of demand and supply for foreign exchange. An
exchange rate is the price of a currency which is determined, like any other
commodity, by demand and supply. The exchange rate varies with varying supply
and demand conditions, but it is always possible to find an equilibrium exchange rate
which clears the foreign exchange market and creates external equilibrium. This is
automatically achieved by depreciation of a countrys currency in case of deficit in its
balance of payments.

Depreciation of a currency means that its relative value decreases. Depreciation has
the effect of encouraging exports and discouraging imports. When exchange
depreciation takes place, foreign prices are translated into domestic prices. Suppose
the dollar depreciates in relation to the pound. It means that the price of dollar falls
in relation to the pound in the foreign exchange market.
This leads to the lowering of the prices of U.S. exports in Britain and raising of the
prices of British imports in the U.S. When import prices are higher in the U.S., the
Americans will purchase less goods from the Britishers. On the other hand, lower
prices of U.S. exports will increase exports and diminish imports, thereby bringing
equilibrium in the balance of payments.
2. Devaluation or Expenditure-Switching Policy:
Devaluation raises the domestic price of imports and reduces the foreign price of
exports of a country devaluing its currency in relation to the currency of another
country. Devaluation is referred to as expenditure switching policy because it
switches expenditure from imported to domestic goods and services. When a country
devalues its currency, the price of foreign currency increases which makes imports
dearer and exports cheaper. This causes expenditures to be switched from foreign to
domestic goods as the countrys exports rise and the country produces more to meet
the domestic and foreign demand for goods with reduction in imports. Consequently,
the balance of payments deficit is eliminated.
3. Direct Controls:
To correct disequilibrium in the balance of payments, government also adopts direct
controls which aim at limiting the volume of imports. The government restricts the
import of undesirable or unimportant items by levying heavy import duties, fixation
of quotas, etc. At the same time, it may allow Imports essential goods duty free or
at lower import duties, or fix liberal import quotas for them.
For instance the government may allow free entry of capital goods, but impose heavy
import duties on luxuries. Import quotas are also fixed and the importers are

required to take licenses from the authorities in order to import certain essential
commodities in fixed quantities.
In these ways, imports are reduced in order to correct an adverse balance of
payments. The government also imposes exchange controls. Exchange controls have
a dual purpose. They restrict imports and also control and regulate the foreign
exchange. With reduction in imports and control of foreign exchange, visible and
invisible imports are reduced. Consequently, an adverse balance of payment is
corrected.
4. Adjustment through Capital Movements
A country can use capital imports to correct a deficit in its balance of payments. A
deficit can be financed by capital inflows. When capital is perfectly mobile within
countries, a small rise in the domestic rate of interest brings a large inflow of capital.
The balance of payments is said to be in equilibrium when the domestic interest rate
equals the world rate. If the domestic interest rate is higher than the world rate, there
will be capital inflows and the balance of payments deficit is corrected.
5. Adjustment through Income Changes:
Given the foreign exchange rate and prices in a country, an increase in the value of
exports, causes an increase in the incomes of all persons associated with the export
industries. These, in turn create demand for other goods and services within the
country. This will raise the incomes of persons engaged in the latter industries and
services. This process will continue and the national income increases by the value of
the multiplier.
6. Stimulation of Exports and Import Substitutes:
A deficit in the balance of payments can also be corrected by encouraging exports.
Exports can e encouraged by producing quality products, by reducing exports
through increased production and productivity, and by better marketing. They can
also be increased by a policy of import substitution it means that the country
produces those goods which it imports.

In the beginning, imports are reduced u in the long run exports of such goods start.
An increase in exports causes the national income to rise by many times through the
operation of the foreign trade multiplier. The foreign trade multiplier expresses the
change in income caused by a change in exports. Ultimately, the deficit in the balance
of payments is removed when exports rise faster than imports.
7. Expenditure-Reducing policies:
A deficit in the balance of payments implies an excess of expenditure over income. To
correct it expenditure and income should be brought into equality. For this
expenditure reducing monetary and fiscal policies are used. A contractionary or tight
monetary policy relates to cut in interest rates to reduce money supply and a
contractionary fiscal policy relates to reduction in government expenditure and or
increase in taxes.
Thus expenditure reducing policies reduce aggregate demand through higher taxes
and interest rates, thereby reducing expenditure and output. The reduction in
expenditure and output, in turn, reduces the domestic price level. This gives rise to
switching of expenditure from foreign to domestic goods. Consequently, the
countrys imports are reduced and the balance of payments deficit is corrected

Factors contributing to the balance of payments crisis

When faced with the balance of payments crisis; an easy option for the government or
the central bank is to de-value the currency to push up exports and reduce imports but
then, devaluation may or may not lead to a significant expansion in exports but
enhances the real value of foreign debt
By Hussain H. Zaidi
A balance of payments (BoP) crisis refers to a sharp change in official foreign reserves.
A BoP crisis is faced only by an open economy one that trades with other economies.
Closed economies do not face a BoP crisis. The BoP crisis may be induced by factors
external to an economy or it may be internally generated.
Externally induced crises can be sparked by a variety of factors. These are discussed as
under:
(1) A major cause of a BoP crisis is demand shock, which refers to a significant change in
demand for a product or products. In the context of a BoP crisis, aggregate demand may
significantly fall in the major export markets of a country leading to a slump in its export
earnings. Such a possibility is greater in case of countries with a narrow export market
base as well as a narrow export product base. Pakistan is particularly vulnerable to such
a problem as only the USA and the 27-member European Union account for 55 per cent
of its global exports. Besides, the textile sector accounts for 60 per cent of the countrys
total exports.
(2) Price shocks can also induce a BoP crisis. Price shocks refer to drastic changes in the
level of prices. The prices may be import or export prices. For instance, the prices of
major imports like oil may escalate resulting in deterioration of terms of trade. This
happened to Pakistan during the financial year 2007-08 when the current account deficit
surged to $14.01 billion from $6.87 billion in the preceding year mainly due to a record
increase in international oil prices. Alternately, prices of exports may plunge thus
reducing export earnings. Countries which mainly export primary commodities are more
likely to face this problem, as their prices tend to be volatile in the global market.
(3) A BoP crisis in one country may be occasioned by devaluation of the currency by
another country. In order to arrest its deteriorating trade balance, a country may resort
to devaluation making its exports cheaper, and thus more competitive, and imports
expensive, and thus less competitive. Consequently it may export more and import less
at the expense of its trading partners.
(4) A countrys major trading partner may have an undervalued currency, which elevates
the price competitiveness of the latters exports. The current account problems of the
USA may in part be attributed to the fact that China, one of its major trading partners,
has an undervalued currency.
(5) A BoP crisis may be occasioned by reputation externalities. This happens when a
BoP or a financial crisis in one country adversely affects investors perceptions about
common structural conditions obtaining in other countries and likely policy response to
such vulnerabilities. This happened in many emerging markets after the East Asian crisis
of the late 1990s.
(6) The next cause of a BoP crisis is hike in interest rates. It is customary for developing
countries to borrow from developed countries and multilateral institutions. A swell in the
interest rate of loans adds to the debt burden and enlarges the cost of debt servicing,
consequently putting pressure on foreign exchange reserves.

(7) Countries which rely a lot on foreign remittances may fall into a BoP crisis if these
remittances drop significantly. Pakistans economy is open to such a shock, because
remittances form an important component of the current account balance.
(8) Finally, unpaid import bills or loans by foreigners may also cause a BoP crisis. This
form of BoP crisis is the counterpart of a domestic financial crisis caused by bad debt.
Having outlined the main external factors responsible for BoP crises, lets look at the
internal causes of such crises.
(a) Arguably, the most fundamental internal cause of a BoP crisis is expansionary
policies. Expansionary fiscal or monetary policies adopted to stimulate the economy may
cause aggregate demand to grow at a pace higher than domestic supply. The gap
between aggregate demand and domestic supply is filled by imports. The result is that
imports grow more quickly than exports. Current account deficit goes up, which has to
be financed through either falling foreign exchange reserves or capital inflows. Capital
inflows, however, may not be forthcoming owing to lack of trust in the countrys financial
situation.
When faced with such a situation, an easy option for the government or the central bank
is to de-value the currency to push up exports and reduce imports. Devaluation may or
may not lead to a significant expansion in exports. But, devaluation enhances the real
value of foreign debt. If devaluation leads to a significant increase in exports, it may
offset the rise in the value of foreign debt. On the other hand, if exports do not go up
significantly, the country may face foreign exchange problems. Great care therefore,
needs to be taken while pursuing expansionary policies. Stimulation of the aggregate
demand must match domestic supply capacity.
(b) Fiscal deficit may also underlie a BoP crisis. To finance its fiscal deficit, the
government resorts to borrowing either from the central bank or from foreigners.
Borrowing from the central bank causes inflation. Inflation is bad for trade, because it
distorts prices. In particular, inflation heightens the input cost of exportable goods and
makes them less price competitive. Again, this is happening in case of Pakistan as the
fiscal deficit is largely being financed by printing money.
(c) The next factor is capital flight. A real or perceived financial crisis may induce foreign
and domestic investors to take their money out of the country, as happened to many
East Asian economies in late 1990s. This may give rise to a BoP crisis if the country does
not have enough foreign reserves to cover these outflows and has other obligations like
debt-servicing.
(d) In case the exchange rate is fixed to a relatively stable currency and expansionary
monetary policies start causing inflation, exchange rate appreciates in real terms. The
result is that exports become expensive and thus less competitive, while imports become
cheaper. Balance of trade deteriorates and a BoP crisis may ensue.
(e) If a country follows protectionist policies, such as higher tariffs or quantitative
restrictions, the final prices of imports in the domestic market shoot up. If these imports
are used in final exportable goods, exports become less competitive. The result may be a
drastic fall in foreign exchange earnings, hence deteriorating the balance of trade. Such
problems are more likely to be faced by developing countries than by developed
countries. This is for two reasons: one, in case of developing countries, there exists on
aggregate a big gap between applied and bound tariffs so applied tariffs are likely to
fluctuate. Two, as opposed to developed countries, in case of developing countries,
customs duties or tariffs are a principal source of revenue. Therefore, tariffs are enlarged
to generate more revenue.

(f) Weaknesses of domestic financial systems also contribute to the eruption of a BoP
crisis. Foreign capital plays a major role in economic development. Nonetheless, in many
cases capital inflows have been volatile. Extensive capital flows have been followed
abruptly by equally massive capital outflows. Countries with weak and in transparent
financial system are particularly vulnerable to this problem, as happened in case of the
East Asian crisis. This brings home the need for a strong financial system to cope with
volatile capital flows. It may be mentioned that though Article 8 of the IMF prevents
members from putting restrictions on current account, restrictions may be placed on
capital account. A related factor is liberalisation of the financial sector. Liberalisation of
the financial sector may be necessary to attract foreign investment. However, there is
the need for sequencing the liberalisation of financial markets.

Bop crises causes

Economic factors
Huge development expenditure owing to which there are large scale imports
Business cycles in terms of recession, depression, recovery and boom High rate of
inflation running up to large scale imports of essential goods Decline of import
substitutes which would necessitate and increase in imports Change in cost
structure of trading partners
Political factors
Political Instability leading to decline in FDI and FII Populism policies which may
encourage imports
Social factors
Change in tastes and preferences leading to demand changes Cross border
prejudices which may lead to expensive sources of imports

Letter of credit
A letter of credit - sometime known as 'documentary credit' - is basically a guarantee
from a bank that a particular seller will receive a payment due from a particular
buyer. The bank guarantees that the seller will receive a specified amount of money
within a specified time. In return for guaranteeing the payment, the bank will require
that strict terms are met. It will want to receive certain documents - for example
shipping confirmation - as proof.
A letter of credit is an obligation of the bank that opens the letter of credit (the issuing
bank) to pay the agreed amount to the seller on behalf of the buyer, upon receipt of
the documents specified in the letter of credit.
Why use a letter of credit?
Letters of credit are most commonly used when a buyer in one country
purchases goods from a seller in another country. The seller may ask the
buyer to provide a letter of credit to guarantee payment for the goods.
The main advantage of using a letter of credit is that it can give security
to both the seller and the buyer.
Advantages for sellers
By asking for an appropriate letter of credit a seller is reassured that they
will receive their money in full and on time. A letter of credit is one of the
most secure methods of payment for exporters as long as they meet all
the terms and conditions. The risk of non-payment is transferred from the
seller to the bank (or banks).
Advantages for buyers
When a buyer uses a letter of credit they get a guarantee that the seller
will honour their side of the deal and provide documentary proof of this.
Other things to consider
It's important to be aware of the additional costs involved in using a letter
of credit. Banks make charges for providing them, so it's sensible to
weigh up the costs against the security benefits.
If you're an exporter you should be aware that you'll only receive
payment if you keep to the strict terms of the letter of credit. You'll need
to give documentary proof that you have supplied exactly what you
contracted to supply. Using a letter of credit can sometimes cause delays
and other administrative problems.

When to use a letter of credit

Although letters of credit can be useful, it's often best to avoid using one for a transaction.
They can sometimes result in expensive delays, bureaucracy and unexpected costs. As a
general rule you should probably only consider opening a letter of credit as an importer if:

your supplier insists on it

national exchange controls require it
Exporters - deciding whether to ask for a letter of credit
Think carefully about whether or not you need to ask an overseas customer for a letter of
credit. Some important things to consider include:

Legal matters - does the country you're exporting to require one?

Costs - does the value of the order justify the bank charges and extra costs involved, and who
pays these costs?
The customer's creditworthiness - do they have a track record with you?
Risks associated with the country you're exporting to - is it politically stable with a good
reputation as an international trading partner?
Normal trading practices - is it standard practice for exporters to use letters of credit when
trading with that country, and/or in that particular commodity?
Available advice and guidance - banks may recommend using of a letter of credit in certain
trading situations regardless of other factors, while credit insurers sometimes insist on it.
Give some thought to alternative arrangements, such as credit insurance, export factoring or
cash in advance terms.

If you do decide that a letter of credit is the best option you'll need to consider which type of
letter to use. A 'confirmed and irrevocable' letter of credit is the most secure type.
It's wise to have a clear policy in your business about when to consider using a letter of
credit. Reviewing your policy on a regular basis will help you avoid using them unnecessarily
and possibly putting off would-be customers.

Types of letter of credit

There are five commonly used types of letter of credit. Each has different features and some
are more secure than others. The most common types are:

irrevocable
revocable
unconfirmed
confirmed
transferable
Other types include:

standby
revolving
back-to-back
Sometimes a letter of credit may combine two types, such as 'confirmed' and 'irrevocable'.

Revocable Letters of Credit

A revocable letter of credit allows alterations, modifications and

cancellations at any time without the consent of the exporter or
beneficiary of the terms explained in the letter of credit. Because of
the risk to the exporter, are not normally accepted
Irrevocable Letter Of Credit (ILOC) is a letter of credit type which can not be cancelled or
amended by the issuing bank without the agreement of the parties of the letter of credit
transaction. For example, issuing bank has no power to modify letter of credit terms if
beneficiary does not find them acceptable. In other words, every amendmend at least
requires beneficiary's acceptance in order to be effective. Irrevocable letters of credit give
much more payment security to the beneficiaries than revocable letters of credit because of
the reasons explained above. As a result irrevocable letters of credit are the types of LCs
that dominantly seen on the market place.

The most popular of the documentary credit forms is the irrevocable

letter of credit. This one needs the consent of exporter, importer and
issuing bank in order to be modified or cancelled. It is appealing to
exporters because they payment for the merchandise is according to
what the letter of credit established and cannot be amended.
Therefore an importer cannot decide not to pay, or to pay later.
Irrevocable letters of credit cannot be altered unilaterally.

Unconfirmed Letters of Credit

Unconfirmed Letters of Credit can be described as a letter of credit, which has not been
guaranteed or confirmed by any bank other than the bank that opened it. In these types of
credits, the only bank that undertakes to honor a complying presentation is the issuing
bank.
Confirmed Letters of Credit
It would be easier to understand the confirmed letters of credit if we start from the
definition of the confirmation.
Confirmation means a definite undertaking of the confirming bank, in addition to that of the
issuing bank, to honor or negotiate a complying presentation.
If a letter of credit's payment undertaking is guaranteed by a second bank, in addition to the
bank originally issuing the credit this kind of credit is called confirmed letter of credit. The
confirming bank agrees to pay or accept drafts against the credit even if the issuer refuses
to do so. Only irrevocable credits can be confirmed.
Transferable letters of credit
A transferable letter of credit can be passed from one 'beneficiary' (person
receiving payment) to others. They're commonly used when
intermediaries are involved in a transaction. For a letter of credit to be transferred,
the transfer needs to be indicated in the terms of the letter of credit. Before the transfer, the
exporter must contact in writing with the bank for the disbursement of funds. The bank that
makes the transfer, whether or not letter of credit has been confirmed, is required to make the
transfer only to a point and how it is specifically expressed in the letter of credit.
A transferable letter of credit may carry many specific risks to the holder. For one, when a
bank receives one of those letters, neither the bank nor the buyer knows the supplier properly.

Clean Letters of Credit :

Below two different definitions of clean letters of credit are given.
A letter of credit payable upon presentation of the draft, without any supporting document
being required.(www.businessdictionary.com)
L/C that does not require any document other than a written demand for payment by its
beneficiary. In effect, a draft.(www.intracen.org)
Clean letters of credit are issued only by the request of the highest credit standing
companies. It is suitable for variety commercial situations where no movement of goods is
expected. Historically these types of credits have been used in traveler's letters of credit.
Today direct pay standby letter of credit can be given as an example of clean letters of
credit.
Back-to-Back Letters of Credit
Arrangement in which one irrevocable letter of credit serves as the collateral for another;
the advising bank of the first letter of credit becomes the issuing bank of the second L/C.
Unlike transferable letters of credit, there are two separate letter of credits exist in back-toback letter of credit transactions.

Advance Payment (Red Clause) Letters of Credit

Letter of credit that carries a provision (traditionally written or typed in red ink) which
allows a seller to draw up to a fixed sum from the advising or paying-bank, in advance of the
shipment or before presenting the prescribed documents.

General Risks in Letters of Credit:

Country Risk: (Political Risk)
The first risk factor that can be mentioned in the general risks group is the country risk or
the political risk. Let us assume that we are an exporter located in a country X and we have a
customer from the country Y. Our customer, which is from the country Y, opened a L/C in
favor of us. We have checked the L/C conditions and they seem workable. We have
produced and shipped the order as per the L/C and transmit the required documents to the
issuing bank before the expiry date. The issuing bank found our presentation complying and
informed us that they will be honoring our payment claim at the maturity date. However,
before the maturity date due Country Y has changed its export regime, which makes it
impossible for the issuing bank to honor our presentation. This illustrative is a good example
of a country risks. Other examples of country risks are mass riots, civil war, boycott,
sovereign risk and transfer risk.
Fraud Risk:
As we have described before all conditions stated in a letter of credit must be connected to
a document, otherwise banks will disregard such a condition. In addition, banks deal with
only documents but not goods, services or performance to which the documents may
relate. This feature of the letters of credit is the source of the fraud risk at the same time. As
an example, a beneficiary of a certain letter of credit transaction can prepare fake
documents, which looks complying on their face, to make the presentation to the issuing
bank. As the documents are complying on their face, the issuing bank may honor the
presentation and in this case, the applicant must pay to the issuing bank for the goods it will
never be receiving. Beneficiaries of L/Cs bear also fraud risks. This happens if an applicant

issues a counterfeit letter of credit. In this case, the beneficiary never receives its payment
for the goods it has shipped.
Risks to the Applicant:
In a letter of credit transaction, main risk factors for the applicants are non-delivery, goods
received with inferior quality, exchange rate risk and the issuing bank's bankruptcy risk.
Risks to the Beneficiary:
In a letter of credit transaction, main risk factors for the beneficiaries are unable to comply
with letter of credit conditions, counterfeit L/C, issuing bank's failure risk and issuing bank's
country risk.
Risks to the Banks:
Every bank in a L/C transaction bears risks more or less. The risk amount increases as
responsibility of the bank increases.

Definition
Foreign direct investment (FDI) is an investment in a business by an investor from another
country for which the foreign investor has control over the company purchased.
The Organization of Economic Cooperation and Development (OECD) defines control as
owning 10% or more of the business. Businesses that make foreign direct investments are often
called multinational corporations (MNCs) or multinational enterprises (MNEs). A MNE may
make a direct investment by creating a new foreign enterprise, which is called a greenfield
investment, or by the acquisition of a foreign firm, either called an acquisition or brownfield
investment.

Advantages and Disadvantages: A Matter of Perspective

In the context of foreign direct investment, advantages and disadvantages are often a matter of
perspective. An FDI may provide some great advantages for the MNE but not for the foreign
country where the investment is made. On the other hand, sometimes the deal can work out
better for the foreign country depending upon how the investment pans out. Ideally, there should
be numerous advantages for both the MNE and the foreign country, which is often a developing
country. We'll examine the advantages and disadvantages from both perspectives.

Advantages for MNEs

Access to markets. FDI can be an effective way for you to enter into a foreign market.
Some countries may extremely limit foreign company access to their domestic markets.
Acquiring or starting a business in the market is a means for you to gain access.
Access to resources. FDI is also an effective way for you to acquire important natural
resources, such as precious metals and fossil fuels. Oil companies, for example, often
make tremendous FDIs to develop oil fields.
Reduces cost of production. FDI is a means for you to reduce your cost of production if
the labor market is cheaper and the regulations are less restrictive in the target foreign
market. For example, it's a well-known fact that the shoe and clothing industries have
been able to drastically reduce their costs of production by moving operations to
developing countries.

Advantages to Foreign Countries

Source of external capital and increased revenue. FDI can be a tremendous source of
external capital for a developing country, which can lead to economic development.

For example, if a large factory is constructed in a small developing country, the country will
typically have to utilize at least some local labor, equipment and materials to construct it. This will
result in new jobs and foreign money being pumped into the economy. Once the factory is
constructed, the factory will have to hire local employees and will probably utilize a least some
local materials and services. This will create further jobs and maybe even some new businesses.
These new jobs mean that locals have more money to spend, thereby creating even more jobs.
Additionally, tax revenue is generated from the products and activities of the factory, taxes
imposed on factory employee income and purchases, and taxes on the income and purchases
now possible because of the added economic activity created by the factory. Developing
governments can use this capital infusion and revenue from economic growth to create and
improve its physical and economic infrastructure such as building roads, communication
systems, educational institutions and subsidizing the creation of new domestic industries.

Development of new industries. Remember that a MNE doesn't necessary own all of
the foreign entity. Sometimes a local firm can develop a strategic alliance with a foreign
investor to help develop a new industry in the developing country. The developing
country gets to establish a new industry and market, and the MNE gets access to a new
market through its partnership with the local firm.
Learning. This is more of an indirect advantage. FDI exposes national and local
governments, local businesses and citizens to new business practices, management
techniques, economic concepts, and technology that will help them develop local
businesses and industries.

Advantages of Foreign Direct Investment

Foreign direct investment has many advantages for both the investor and the
recipient. One of the primary benefits is that it allows money to freely go to whatever
business has the best prospects for growth anywhere in the world. That's because
investors aggressively seek the best return for their money with the least risk. This
motive is color-blind, doesn't care about religion or form of government.
This gives well-run businesses -- regardless of race, color or creed -- a competitive
advantage. It reduces (but, of course, doesn't eliminate) the effects of politics,
cronyism and bribery. As a result, the smartest money goes to the best businesses
all over the world, bringing these goods and services to market faster than if
unrestricted FDI weren't available.
Investors receive additional benefits. Their risk is reduced because they
can diversify their holdings outside of a specific country, industry or political system.
Diversification always increases return without increasing risk.
Businesses benefit by receiving management, accounting or legal guidance in
keeping with the best practices practiced by their lenders. They can also incorporate
the latest technology, innovations in operational practices, and new financing tools
that they might not otherwise be aware of. By adopting these practices, they
enhance their employees' lifestyles, helping to create a better standard of living for
the recipient country. In addition, since the best companies get rewarded with these
benefits, local governments have less influence, and aren't as able to pursue poor
economic policies.
The standard of living in the recipient country is also improved by higher tax revenue
from the company that received the foreign direct investment. However, sometimes
countries neutralize that increased revenue by offering tax incentives to attract the
FDI in the first place.
Another advantage of FDI is that it can offset the volatility created by "hot money."
Short-term lenders and currency traders can create an asset bubble in a country by
investing lots of money in a short period of time, then selling their investments just as
quickly. This can create a boom-bust cycle that can wreak economies and political
regimes. Foreign direct investment takes longer to set up, and has a more
permanent footprint in a country.

In recent years, FDI has been used more as a market entry strategy for investors, rather
than an investment strategy. Despite the decline in trade barriers, FDI growth has increased at
a higher rate than the level of world trade as businesses attempt to circumvent protectionist

measures through direct investments. With globalization, the horizons and limits have been
extended and companies now see the world economy as their market.
Additionally for investors, FDI provides the benefits of reduced cost through the realization of scale
economies, and coordination advantages, especially for integrated supply chains. The preference
for a direct investment approach rather than licensing and franchising can also been viewed in
terms of strategic control, where management rights allows for technological know-how and
intellectual property to be kept in-house.
In recent years, FDI has been used more as a market entry strategy for investors, rather
than an investment strategy. Despite the decline in trade barriers, FDI growth has increased at
a higher rate than the level of world trade as businesses attempt to circumvent protectionist
measures through direct investments. With globalization, the horizons and limits have been
extended and companies now see the world economy as their market.
Additionally for investors, FDI provides the benefits of reduced cost through the realization of scale
economies, and coordination advantages, especially for integrated supply chains. The preference
for a direct investment approach rather than licensing and franchising can also been viewed in
terms of strategic control, where management rights allows for technological know-how and
intellectual property to be kept in-house.

Summary
1. FDI is an investment that a parent company makes in a foreign
country. On the contrary, FII is an investment made by an investor
in the markets of a foreign nation.
2. FII can enter the stock market easily and also withdraw from it
easily. But FDI cannot enter and exit that easily.
3. Foreign Direct Investment targets a specific enterprise. The FII
increasing capital availability in general.
4. The Foreign Direct Investment is considered to be more stable
than Foreign Institutional Investor
5) While the FDI flows into the primary market, the FII flows into
secondary market. While FIIs are short-term investments, the FDIs
are long term.
The Foreign Direct Investment is considered to be more stable than
Foreign Institutional Investor. FDI not only brings in capital but
also helps in good governance practises and better management
skills and even technology transfer. Though the Foreign
Institutional Investor helps in promoting good governance and
improving accounting, it does not come out with any other benefits
of the FDI.

FDI (Foreign Direct Investment) is when a foreign company invests in India directly by setting up
a wholly owned subsidiary or getting into a joint venture, and conducting their business in India.
IBM India is a wholly owned subsidiary of IBM, and is a good example of FDI where a foreign
company has set up a subsidiary in India and is conducting its business through that company.
Whats amazing about IBM is that, it is now the largest Indian IT company in India. It is serving
Indian customers, and a large domestic market that was not tapped by the Indian players
themselves.
Foreign companies partnering with Indian companies to set up joint ventures is more typical
andStarbucks partnering with Tata Global Beverages Limited is a recent example of FDI
through joint venture, but there are several others in the insurance, telecom, food industry etc.
FII is when foreign investors invest in the shares of a company that is listed in India, or in bonds
offered by an Indian company. So, if a foreign investor buys shares in Infosys then that qualifies
as FII Investment.
It is easy to see why you would prefer FDI to FII investments. FDI investments are more stable
because companies like IBM set up offices, hire employees, and have a long term plan for the
country. IBM cant just pull out a few million dollars from India overnight, which is what FII
investors do from time to time and that leads to market crashes.
In India, attracting FII has been easier than FDI because of the policy uncertainty and procedural
delays. An RBI study has the following par

Unit 3 foreign exchange risk management

Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial
risk that exists when a financial transaction is denominated in a currency other than that of the base
currency of the company. Foreign exchange risk also exists when the foreign subsidiary of a firm
maintains financial statements in a currency other than the reporting currency of the consolidated
entity. The risk is that there may be an adverse movement in the exchange rate of the denomination
currency in relation to the base currency before the date when the transaction is
completed.[1][2] Investors and businesses exporting or importing goods and services or making foreign
investments have an exchange rate risk which can have severe financial consequences; but steps
can be taken to manage (i.e., reduce) the risk.

In the present era of increasing globalization and heightened currency

volatility, changes in exchange rates have a substantial influence on
companies operations and profitability. Exchange rate volatility affects not just
multinationals and large corporations, but small and medium-sized enterprises
as well, even those who only operate in their home country. While
understanding and managing exchange rate risk is a subject of obvious

importance to business owners, investors should be familiar with it as well

because of the huge impact it can have on their investments.
Many firms are exposed to foreign exchange risk - i.e. their wealth is affected by
movements in exchange rates - and will seek to manage their risk exposure.

Why manage your foreign exchange risk?

Changes in exchange rates induce changes in the value of a firms assets, liabilities
and cash flows, especially when these are denominated in a foreign currency.
Therefore, fluctuations in the currency markets have an impact on your outgoing
import payments and incoming export funds
Your foreign exchange risk is influenced by many factors such as length of exposure
and currency volatility
By managing the risk, you could maximize profits or minimize the risk
Where do these foreign exchange exposures come from?
Trade Drawdown and Repayment of Import/Export Foreign Currency Loans and
payments of Import/Export Bills denominated in foreign currencies
Inward and Outward Remittances denominated in foreign currencies
Overseas Dividends, e.g. repatriating overseas profit home and Overseas Operating
Expenses, e.g. paying overseas employees salary expenses
Overseas Assets, e.g. surplus cash balances of overseas subsidiaries and Overseas
Liabilities, e.g. foreign currency borrowing
Types of foreign exchange risk

Transaction exposure This arises from the effect that exchange rate
fluctuations have on a companys obligations to make or receive
payments denominated in foreign currency in future. This type of
exposure is short-term to medium-term in nature.
This is the risk of an exchange rate changing between the transaction date
and the subsequent settlement date, i.e. it is the gain or loss arising on
conversion.
This type of risk is primarily associated with imports and exports. If a company
exports goods on credit then it has a figure for debtors in its accounts. The
amount it will finally receive depends on the foreign exchange movement from
the transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of a company,
most companies choose to hedge against such exposure. Measuring and
monitoring transaction risk is normally an important component oftreasury risk
management.

The degree of exposure is dependent on:

(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.
(c) The anticipated volatility of the exchange rates during the hedge period.
The corporate risk management policy should state what degree of exposure
is acceptable. This will probably be dependent on whether the Treasury
Department is been established as a cost or profit centre.

Translation exposure This exposure arises from the effect of

currency fluctuations on a companys consolidated financial statements,
particularly when it has foreign subsidiaries. This type of exposure is
medium-term to long-term.
A firm's translation exposure is the extent to which its financial reporting is affected by
exchange rate movements. As all firms generally must prepare consolidated financial
statements for reporting purposes, the consolidation process for multinationals entails
translating foreign assets and liabilities or the financial statements of foreign
subsidiary|subsidiaries from foreign to domestic currency.While translation exposure may not
affect a firm's cash flows, it could have a significant impact on a firm's reported earnings and
therefore its stock price.Translation exposure is distinguished from transaction risk as a result
of income and losses from various types of risk having different accounting treatments.
The financial statements of overseas subsidiaries are usually translated into the home currency in order that they
can be consolidated into the group's financial statements. Note that this is purely a paper-based exercise - it is
the translation not the conversion of real money from one currency to another.
The reported performance of an overseas subsidiary in home-based currency terms can be severely distorted if
there has been a significant foreign exchange movement.
If initially the exchange rate is given by $/1.00 and an American subsidiary is worth $500,000, then the UK
parent company will anticipate a balance sheet value of 500,000 for the subsidiary. A depreciation of the US
dollar to $/2.00 would result in only 250,000 being translated.
Unless managers believe that the company's share price will fall as a result of showing a translation exposure
loss in the company's accounts, translation exposure will not normally be hedged. The company's share price, in
an efficient market, should only react to exposure that is likely to have an impact on cash flows.

Economic exposure[edit]
A firm has economic exposure (also known as forecast risk) to the degree that its market value is
influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely
affect the firm's market share position with regards to its competitors, the firm's future cash flows, and
ultimately the firm's value. Economic exposure can affect the present value of future cash flows. Any
transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but

economic exposure can be caused by other business activities and investments which may not be
mere international transactions, such as future cash flows from fixed assets. A shift in exchange rates
that influences the demand for a good in some country would also be an economic exposure for a firm
that sells that good.
Transaction exposure focuses on relatively short-term cash flows effects; economic exposure encompasses
these plus the longer-term affects of changes in exchange rates on the market value of a company. Basically this
means a change in the present value of the future after tax cash flows due to changes in exchange rates.
There are two ways in which a company is exposed to economic risk.
Directly: If your firm's home currency strengthens then foreign competitors are able to gain sales at your
expense because your products have become more expensive (or you have reduced your margins) in the eyes of
customers both abroad and at home.
Indirectly: Even if your home currency does not move vis-a -vis your customer's currency you may lose
competitive position. For example suppose a South African firm is selling into Hong Kong and its main competitor
is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong dollar the South African firm
has lost some competitive position.
Economic risk is difficult to quantify but a favoured strategy to manage it is to diversify internationally, in terms of
sales, location of production facilities, raw materials and financing. Such diversification is likely to significantly
reduce the impact of economic exposure relative to a purely domestic company, and provide much greater
flexibility to react to real exchange rate changes.

Note that economic exposure deals with unexpected changes in exchange

rates - which by definition are impossible to predict - since a companys
management base their budgets and forecasts on certain exchange rate
assumptions, which represents their expected change in currency rates. In
addition, while transaction and translation exposure can be accurately
estimated and therefore hedged, economic exposure is difficult to quantify
precisely and as a result is challenging to hedge.

Hedging transaction risk - the internal techniques

Internal techniques to manage/reduce forex exposure should always be considered before external methods on
cost grounds. Internal techniques include the following:
Invoice in home currency
One easy way is to insist that all foreign customers pay in your home currency and that your company pays for all
imports in your home currency.
However the exchange-rate risk has not gone away, it has just been passed onto the customer. Your customer
may not be too happy with your strategy and simply look for an alternative supplier.
Achievable if you are in a monopoly position, however in a competitive environment this is an unrealistic
approach.
Leading and lagging

If an importer (payment) expects that the currency it is due to pay will depreciate, it may attempt to delay
payment. This may be achieved by agreement or by exceeding credit terms.
If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next three months it
may try to obtain payment immediately. This may be achieved by offering a discount for immediate payment.
The problem lies in guessing which way the exchange rate will move.
Matching
When a company has receipts and payments in the same foreign currency due at the same time, it can simply
match them against each other.
It is then only necessary to deal on the forex markets for the unmatched portion of the total transactions.
An extension of the matching idea is setting up a foreign currency bank account.
Bilateral and multilateral netting and matching tools are discussed in more detail here.
Decide to do nothing?
The company would "win some, lose some".
Theory suggests that, in the long run, gains and losses net off to leave a similar result to that if hedged.
In the short run, however, losses may be significant.
One additional advantage of this policy is the savings in transaction costs.

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Hedging transaction risk - the external techniques

Transaction risk can also be hedged using a range of financial products. These are introduced below with links to
more detailed pages.
Forward contracts
The forward market is where you can buy and sell a currency, at a fixed future date for a predetermined rate, i.e.
the forward rate of exchange. This effectively fixes the future rate.
Forward contracts can be explored in more detail here.
Money market hedges
The basic idea is to avoid future exchange rate uncertainty by making the exchange at today's spot rate instead.
This is achieved by depositing/borrowing the foreign currency until the actual commercial transaction cash flows
occur. This effectively fixes the future rate.
Money market hedges can be explored in more detail here.
Futures contracts
Futures contracts are standard sized, traded hedging instruments.
The aim of a currency futures contract is to fix an exchange rate at some future date, subject to basis risk.

Currency futures can be explored in more detail here.

Options
A currency option is a right, but not an obligation, to buy or sell a currency at an exercise price on a future date. If
there is a favourable movement in rates the company will allow the option to lapse, to take advantage of the
favourable movement. The right will only be exercised to protect against an adverse movement, i.e. the worstcase scenario.
A call option gives the holder the right to buy the underlying currency.
A put option gives the holder the right to sell the underlying currency.
Options are more expensive than the forward contracts and futures but result in an asymmetric risk exposure.
Currency options can be explored in further detail here.
Forex swaps
In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at
the end of the period at an agreed swap rate. The swap rate and amount of currency is agreed between the
parties in advance. Thus it is called a fixed rate/fixed rate swap.
The main objectives of a forex swap are:
To hedge against forex risk, possibly for a longer period than is possible on the forward market.
Access to capital markets, in which it may be impossible to borrow directly.
Forex swaps are especially useful when dealing with countries that have exchange controls and/or volatile
exchange rates.
Forex swaps can be explored in further detail here.
Currency swaps
A currency swap allows the two counter parties to swap interest rate commitments on borrowings in different
currencies.
In effect a currency swap has two elements:
An exchange of principal in different currencies, which are swapped back at the original spot rate - just like a
forex swap.
An exchange of interest rates - the timing of these depends on the individual contract.
The swap of interest rates could be fixed for fixed or fixed for variable.
Currency swaps can be explored in more detail here.

Types of Derivatives and Derivative Market

One of the key features of financial markets are extreme volatility. Prices of foreign
currencies, petroleum and other commodities, equity shares and instruments
fluctuate all the time, and poses a significant risk to those whose businesses are
linked to such fluctuating prices . To reduce this risk, modern finance provides a
method called hedging. Derivatives are widely used for hedging. Of course, some
people use it to speculate as well although in India such speculation is prohibited.
Derivatives are products whose value is derived from one or more basic variables
called underlying assets or base . In simpler form, derivatives are financial security
such as an option or future whose value is derived in part from the value and
characteristics of another an underlying asset. The primary objectives of any
investor are to bring an element of certainty to returns and minimise risks.
Derivatives are contracts that originated from the need to limit risk. For a better
conceptual understanding of different kind of derivatives, you can see this link.
Derivative contracts can be standardized and traded on the stock exchange. Such
derivatives are called exchange-traded derivatives. Or they can be customised as per
the needs of the user by negotiating with the other party involved. Such derivatives
are called over-the-counter (OTC) derivatives.
A Derivative includes :
(a) a security derived from a debt instrument, share, loan, whether secured or
unsecured, risk instrument or contract for differences or any other form of security ;
(b) a contract which derives its value from the prices, or index of prices, of
underlying securities.
Advantages of Derivatives:
1. They help in transferring risks from risk adverse people to risk oriented people.
2. They help in the discovery of future as well as current prices.
3. They catalyze entrepreneurial activity.
4. They increase the volume traded in markets because of participation of risk adverse
people in greater numbers.
5. They increase savings and investment in the long run.

Types of Derivative Instruments:

Derivative contracts are of several types. The most common types are forwards,
futures, options and swap.

Forward Contracts
A forward contract is an agreement between two parties a buyer and a seller to
purchase or sell something at a later date at a price agreed upon today. Forward
contracts, sometimes called forward commitments , are very common in everyone
life. Any type of contractual agreement that calls for the future purchase of a good
or service at a price agreed upon today and without the right of cancellation is a
forward contract.
Future Contracts
A futures contract is an agreement between two parties a buyer and a seller to
buy or sell something at a future date. The contact trades on a futures exchange
and is subject to a daily settlement procedure. Future contracts evolved out of
forward contracts and possess many of the same characteristics. Unlike forward
contracts, futures contracts trade on organized exchanges, called future markets.
Future contacts also differ from forward contacts in that they are subject to a daily
settlement procedure. In the daily settlement, investors who incur losses pay them
every day to investors who make profits.

Options Contracts
Options are of two types calls and puts. Calls give the buyer the right but not the
obligation to buy a given quantity of the underlying asset, at a given price on or
before a given future date. Puts give the buyer the right, but not the obligation to
sell a given quantity of the underlying asset at a given price on or before a given
date.
Swaps
Swaps are private agreements between two parties to exchange cash flows in the
future according to a prearranged formula. They can be regarded as portfolios of
forward contracts. The two commonly used swaps are interest rate swaps and
currency swaps.
1. Interest rate swaps: These involve swapping only the interest related cash flows
between the parties in the same currency.

2. Currency swaps: These entail swapping both principal and interest between the
parties, with the cash flows in one direction being in a different currency than those
in the opposite direction.
SEBI Guidelines:
SEBI has laid the eligibility conditions for Derivative Exchange/Segment and its
Clearing Corporation/House to ensure that Derivative Exchange/Segment and
Clearing Corporation/House provide a transparent trading environment, safety and
integrity and provide facilities for redressal of investor grievances. Some of the
important eligibility conditions are :
1. Derivative trading to take place through an on-line screen based Trading System.
2. The Derivatives Exchange/Segment shall have on-line surveillance capability to
monitor positions, prices, and volumes on a real time basis so as to deter market
manipulation.
3. The Derivatives Exchange/ Segment should have arrangements for dissemination of
information about trades, quantities and quotes on a real time basis through at least
two information vending networks, which are easily accessible to investors across
the country.
4. The Derivatives Exchange/Segment should have arbitration and investor grievances
redressal mechanism operative from all the four areas/regions of the country.
5. The Derivatives Exchange/Segment should have satisfactory system of monitoring
investor complaints and preventing irregularities in trading.
6. The Derivative Segment of the Exchange would have a separate Investor Protection
Fund.
7. The Clearing Corporation/House shall perform full novation, i.e., the Clearing
Corporation/House shall interpose itself between both legs of every trade, becoming
the legal counterparty to both or alternatively should provide an unconditional
guarantee for settlement of all trades.
8. The Clearing Corporation/House shall have the capacity to monitor the overall
position of Members across both derivatives market and the underlying securities
market for those Members who are participating in both.

9. The level of initial margin on Index Futures Contracts shall be related to the risk of
loss on the position. The concept of value-at-risk shall be used in calculating
required level of initial margins. The initial margins should be large enough to cover
the one-day loss that can be encountered on the position on 99 per cent of the days.
10. The Clearing Corporation/House shall establish facilities for electronic funds transfer
(EFT) for swift movement of margin payments.
11. In the event of a Member defaulting in meeting its liabilities, the Clearing
Corporation/House shall transfer client positions and assets to another solvent
Member or close-out all open positions.
12. The Clearing Corporation/House should have capabilities to segregate initial margins
deposited by Clearing Members for trades on their own account and on account of
his client. The Clearing Corporation/House shall hold the clients margin money in
trust for the client purposes only and should not allow its diversion for any other
purpose.
13. The Clearing Corporation/House shall have a separate Trade Guarantee Fund for the
trades executed on Derivative Exchange/Segment.
SEBI has specified measures to enhance protection of the rights of
investors in the Derivative Market. These measures are as follows:
1. Investors money has to be kept separate at all levels and is permitted to be used
only against the liability of the Investor and is not available to the trading member
or clearing member or even any other investor.
2. The Trading Member is required to provide every investor with a risk disclosure
document which will disclose the risks associated with the derivatives trading so that
investors can take a conscious decision to trade in derivatives.
3. Investor would get the contract note duly time stamped for receipt of the order and
execution of the order. The order will be executed with the identity of the client and
without client ID order will not be accepted by the system. The investor could also
demand the trade confirmation slip with his ID in support of the contract note. This
will protect him from the risk of price favour, if any, extended by the Member.

4. In the derivative markets all money paid by the Investor towards margins on all
open positions is kept in trust with the Clearing House /Clearing Corporation and in
the event of default of the Trading or Clearing Member the amounts paid by the
client towards margins are segregated and not utilised towards the default of the
member. However, in the event of a default of a member, losses suffered by the
Investor, if any, on settled/closed out position are compensated from the Investor
Protection Fund, as per the

The SEBI, that is, the Securities and the Exchange Board of India, is the national regulatory body
for the securities market, set up under the securities and Exchange Board of India Act, 1992, to
protect the interest of investors in securities and to promote the development of, and to regulate
the securities market and for matters connected therewith and incidental too.
SEBI as the watchdog of the industry has an important and crucial role in the market in ensuring
that the market participants perform their duties in accordance with the regulatory norms. The
Stock Exchange as a responsible Self Regulatory Organization (SRO) functions to regulate the
market and its prices as per the prevalent regulations. SEBI play complimentary roles to enhance
the investor protection and the overall quality of the market.
MISSION OF SEBI
Securities & Exchange Board of India (SEBI) formed under the SEBI Act, 1992 with the prime
objective of :

Protecting the interests of investors in securities,

Promoting the development of, and

Regulating, the securities market and for matters connected therewith or incidental thereto.
Focus being the greater investor protection, SEBI has become a vigilant watchdog
PREAMBLE
The Preamble of the Securities and Exchange Board of India describes the basic functions of the
Securities and Exchange Board of India as to protect the interests of investors in securities and
to promote the development of, and to regulate the securities market and for matters connected
therewith or incidental thereto.[1]

FUNCTIONS AND POWERS OF SEBI

Chapter IV of Act highlights the Powers and Functions of SEBI[2]
REGULATORY FUNCTIONS

1. Regulation of Business in the Stock Exchanges.

2. Registration and Regulation of the Working of Intermediaries and Mutual
Funds, Venture Capital Funds & Collective Investment Schemes.
3. Prohibiting fraudulent and unfair trade practices and insider trading in the
securities market.
4. Investor education and the training of intermediaries.
5. Inspection and inquiries.
6. Regulating substantial acquisition of shares and take-overs.
7. Performing such functions and exercising such powers under the
provisions of the Securities Contracts (Regulation) Act, 1956 as may be
delegated to it by The Central Government;
8. Levying fees or other charges for carrying out the purposes of this section.
DEVELOPMENTAL FUNCTIONS

1. Promoting investors education and training of intermediaries.

2. Conducting research and publishing information useful to all market
participants.
3. Promotion of fair practices and self regulatory organizations.
POWERS OF SEBI

1. Power to call periodical returns from recognized stock exchanges.

2. Power to compel listing of securities by public companies.
3. Power to levy fees or other charges for carrying out the purposes of
regulation.
4. Power to call information or explanation from recognized stock exchanges
or their members.
5. Power to grant approval to byelaws of recognized stock exchanges.
6. Power to control and regulate stock exchanges.
7. Power to direct enquiries to be made in relation to affairs of stock
exchanges or their members.

SEBI is regulator to control Indian capital market. Since its establishment in 1992, it is
doing hard work for protecting the interests of Indianinvestors. SEBI gets education from
past cheating with naive investors of India. Now, SEBI is more strict with those who
commit frauds in capital market.
The role of security exchange board of India (SEBI) in regulating Indian capital market is
very important because government of India can only open or take decision to open
new stock exchange in India after getting advice from SEBI.
If SEBI thinks that it will be against its rules and regulations, SEBI can ban on any stock
exchange to trade in shares and stocks.
Now, we explain role of SEBI in regulating Indian Capital Market more deeply with
following points:
1. Power to make rules for controlling stock exchange :
SEBI has power to make new rules for controlling stock exchange in India. For example,
SEBI fixed the time of trading 9 AM and 5 PM in stock market.
2. To provide license to dealers and brokers :
SEBI has power to provide license to dealers and brokers of capital market. If SEBI sees
that any financial product is of capital nature, then SEBI can also control to that product
and its dealers. One of main example is ULIPs case. SEBI said, " It is just like mutual
funds and all banks and financial and insurance companies who want to issue it, must
take permission from SEBI."
3. To Stop fraud in Capital Market :
SEBI has many powers for stopping fraud in capital market.
It can ban on the trading of those brokers who are involved in fraudulent and unfair
trade practices relating to stock market.
It can impose the penalties on capital market intermediaries if they involve in insider
trading.
4. To Control the Merge, Acquisition and Takeover the companies :
Many big companies in India want to create monopoly in capital market. So, these
companies buy all other companies or deal of merging. SEBI sees whether this merge or
acquisition is for development of business or to harm capital market.

5. To audit the performance of stock market :

SEBI uses his powers to audit the performance of different Indian stock exchange for
bringing transparency in the working of stock exchanges.
6. To make new rules on carry - forward transactions :

Share trading transactions carry forward can not exceed 25% of broker's total
transactions.

90 day limit for carry forward.

7. To create relationship with ICAI :

ICAI is the authority for making new auditors of companies. SEBI creates good
relationship with ICAI for bringing more transparency in the auditing work of company
accounts because audited financial statements are mirror to see the real face of
company and after this investors can decide to invest or not to invest. Moreover,
investors of India can easily trust on audited financial reports. After Satyam Scam, SEBI
is investigating with ICAI, whether CAs are doing their duty by ethical way or not.
8. Introduction of derivative contracts on Volatility Index :
For reducing the risk of investors, SEBI has now been decided to permit Stock
Exchanges to introduce derivative contracts on Volatility Index, subject to the condition
that;
a. The underlying Volatility Index has a track record of at least one year.
b. The Exchange has in place the appropriate risk management framework for such
derivative contracts.
2. Before introduction of such contracts, the Stock Exchanges shall submit the following:
i. Contract specifications
ii. Position and Exercise Limits
iii. Margins

iv. The economic purpose it is intended to serve

v. Likely contribution to market development
vi. The safeguards and the risk protection mechanism adopted by the exchange to
ensure market integrity, protection of investors and smooth and orderly trading.
vii. The infrastructure of the exchange and the surveillance system to effectively monitor
trading in such contracts, and
viii. Details of settlement procedures & systems
ix. Details of back testing of the margin calculation for a period of one year considering a
call and a put option on the underlying with a delta of 0.25 & -0.25 respectively and
actual value of the underlying. Link
9. To Require report of Portfolio Management Activities :
SEBI has also power to require report of portfolio management to check the capital
market performance. Recently, SEBI sent the letter to all Registered Portfolio Managers
of India for demanding report.
10. To educate the investors :
Time to time, SEBI arranges scheduled workshops to educate the investors. On 22 may
2010 SEBI imposed workshop. If you are investor, you can get education through SEBI
leaders by getting update information on this page.