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Forex Market

  1. 1. 2021 Forex Market (FX Market) Classroom Deliberations CA. Dr. Prithvi Ranjan Parhi 1 CA Dr Prithvi Ranjan Parhi
  2. 2. 703- INTERNATIONAL TRADE AND BUSINESS MODULE- I International Trade: Concept, Importance, Benefits of International Trade, international Marking vs. Domestic Marking (differences). Theory of International Trade: theory of comparative Cost, factor proportion Theory. MODULE-II Multinational corporations (MNCs): Definition, Role of MNCs in International marking. International Trade barriers: Meaning, tariff and non-Tariff Barriers, Impact of Non-tariff barriers. MODULE-III Organizational and Agreements: WTO (Functions, Principle, agreements), IMF (Purposes, Facilities Provided by IMF), World Bank (Purpose, Principle, Policies). MODULE-IV Foreign Trade of India: Organizational Setup (Autonomous Bodies, Attached and subordinate offices), Major Export and Imports, Concept of Export House, EXIM Policy (2002-2007) of India (Features and Objectives of the Policy). MODULE-V Foreign Exchange market: Concept, Functions, Methods of international Payment, concept of Balance of Payment, Concept of Fixed and Flexible Exchange Rate and Convertibility of Rupee. CA Dr Prithvi Ranjan Parhi 2
  3. 3. Meaning of Forex • Importing country pays money to exporting countries in return of goods either in domestic currency or in hard currency. • This currency which facilitates the payment to complete the transaction is called Foreign Exchange. • So foreign exchange is the money in one country for money or credit of goods or services in another country. • Foreign exchange includes: Foreign currency, Foreign cheques and foreign drafts. 3 CA Dr Prithvi Ranjan Parhi
  4. 4. Foreign Exchange Market • Foreign Exchange is bought and sold in FOREX market. • FOREX market is a physical, online and institutional structure through which money of one country is exchanged for that of other country- at a rate determined either mutually or by market forces. • Foreign exchange transactions are completed either physically or on-line. 4 CA Dr Prithvi Ranjan Parhi
  5. 5. Nature of FOREX market • Widespread Geographically(All countries, All geographical areas) • All Time Operation (24*7*365days market, working hours differ globally) • Two Levels: Wholesale market(Interbank market), Retail Market(Client Market) • Size of the market: The volume of foreign exchange traded in the market is very very large.(Trillions of dollar a day) 5 CA Dr Prithvi Ranjan Parhi
  6. 6. Participants in FOREX Market • Bank & Non bank FOREX Dealers (operate both in interbank(Wholesale) & Client(Retail ) Market. They act as market maker. (Bid rate, Ask rate & Bid-Ask Spread) • Individuals, Firms conducting personal, commercial and investment transactions- importers, exporter, international portfolio investors, MNCs,Tourists etc. 6 CA Dr Prithvi Ranjan Parhi
  7. 7. ------Participants in FOREX Market • Forex Brokers/Agents-trade on behalf of their principals in lieu of commission. • Speculators-to earn profit by trading in forex. • Arbitragers-To earn profit from simultaneous buying and selling in different markets. • Central banks and treasuries-to acquire and spend forex reserves and to influence the price in the market. 7 CA Dr Prithvi Ranjan Parhi
  8. 8. Market Participants
  9. 9. Functions of Forex Market  The Foreign Exchange Market provides: –The physical and institutional structure through which the money of one country is exchanged for that of another country –The determination rate of exchange between currencies CA Dr Prithvi Ranjan Parhi 9
  10. 10. Structure of Forex Market
  11. 11. Exchange Rate Determination • Exchange rate is the price paid in the home currency for a unit of foreign currency. • Exchange rate can be quoted in two ways: Direct Quote, Indirect Quote. • Exchange rate in a free market is determined by the demand for and supply of foreign currency of a particular market. • The equilibrium exchange rate is the rate at which demand for foreign exchange and supply of foreign exchange are equal. 11 CA Dr Prithvi Ranjan Parhi
  12. 12. Exchange Rate Determination Demand for Foreign Exchange • Import of goods and services • Investment in Foreign Countries(FDI Outward) • Payment made by Indian Govt to other foreign Govt (interest, loan etc) • Other type of outflow of foreign capital like giving donations etc 12 CA Dr Prithvi Ranjan Parhi
  13. 13. Exchange Rate Determination Supply of Foreign Exchange • Country’s exports of goods and services to foreign countries • Inflow of Foreign Capital • Payment made by the foreign governments to Indian governments for settling their transactions • Other type of inflow of foreign capital like Remittances by NRI, Donations received 13 CA Dr Prithvi Ranjan Parhi
  14. 14. 14 Exchange Rate Drivers International Trade Speculation Balance of Payment Intervention by Central Bank Economic Fundamentals Political Stability Interest rate Parity Inflation rate Self fulfilling prophesy © CA. Prithvi R Parhi, M Com, FCA,DISA(ICAI) 5:54 PM © CA. Prithvi R Parhi
  15. 15. 15 What drives Xch rate ? • Currency is a commodity ~ Forces of demand & supply determine the price of a commodity. Factors that drive exchange rates are; 1. International Trade : Demand & supply of currencies emanates from import & export of goods & services, raising money from global market. 2. Speculation : Players in Forex market wait to seize opportunities to buy or sell foreign currency. Thrust of movement of rates comes more from speculators than from international trade. This may have stabilizing/ dis-stabilizing effect. 3. Balance of Payment : Healthy BoP leads to strengthening of the currency, Levered BoP would lead to weakening of the currency. A very adverse BoP would mean the country have to buy foreign currency to meet its obligation which would lead to greater demand for foreign currency , pushing its price up. This would mean weakening domestic Currency. 4. Intervention by Central Bank : Central bank of the country would be interested in some kind of stability in the exchange rate.~ If INR strengthens it would be adverse for the exporter & if INR weakens it would be adverse for the importer. RBI may step in to keep the currency rate within a certain zone.~ Pure floating rate / Dirty floating rate. © CA. Prithvi R Parhi, M Com, FCA,DISA(ICAI) 5:54 PM © CA. Prithvi R Parhi
  16. 16. 16 What drives Xch rate ? 5. Economic Fundamentals : Country blessed with rich natural resources would automatically benefit from a net surplus on its current account. Further it would attract long term capital investment from overseas. Hence on account of advantageous fundamentals, the currency of such country going to be strong. 6. Political Stability : Uncertain political stability or an uncertain economic future would weaken countries currency since international investors would not be showing interest in investing in these countries. 7. Interest rate Parity : According to IRPT, a high interest rate ( in real terms) in one country would lead to depreciation in the currency of that country. 8. Inflation rate : According to IRPT, if inflation is higher in 1 country than another, the former currency will tend to weaken against the other country’s currency. 9. Self fulfilling prophesy : Expectations of the players in the market also drives the exchange rate. © CA. Prithvi R Parhi, M Com, FCA,DISA(ICAI) 5:54 PM © CA. Prithvi R Parhi
  17. 17. 17 Thanks © CA. Prithvi R Parhi 5:54 PM
  18. 18. Exchange Rate Regimes • Commodity Specie Standard • Gold Standard • The Bretton Woods System of Exchange Rates • Exchange Rate Regimes Since 1973 a. Floating Rate System b.Pegging of Currency c.Crawling Peg d.Target-zone Arrangements 18 CA Dr Prithvi Ranjan Parhi
  19. 19. Commodity Specie Standard • Initially the exchange rates were determined on the basis of the value of metal contained in the coins of two countries. • This system was referred as the commodity specie standard. • With the introduction of paper currency this system ceased to exist. 19 CA Dr Prithvi Ranjan Parhi
  20. 20. Gold Standard • Gold Standard was prevalent between 1870s and 1914,which was suspended during the great world war. • However it was readopted, but was finally abandoned by 1930s. • Gold Standard was initially adopted by Britain. Later ,Germany, Japan,USA and other countries adopted Gold Standard. 20 CA Dr Prithvi Ranjan Parhi
  21. 21. -------Gold Standard • In this system Central Bank was maintaining official parity between its currency and gold and as such needed an adequate stock of gold reserves. • Banknotes were exchanged for gold on demand. • The price of gold was officially set at which it was bought and sold. 21 CA Dr Prithvi Ranjan Parhi
  22. 22. -------Gold Standard • Gold standard allowed free flow of gold among countries and for automatic adjustment in exchange rate and in balance of payments. • In this case Deficit in balance of trade led to outflow of gold and vice versa. • The fixed supply of gold led to the demise of gold standard. 22 CA Dr Prithvi Ranjan Parhi
  23. 23. The Bretton woods system of Exchange Rates • The collapse of gold standard led to the conduct of the Bretton Woods conference in July 1944 and the establishment of IMF in 1945 and evolution of a new system of exchange rate, which is known as Bretton woods system of exchange rate. • Bretton Woods system represented a fixed parity system with adjustable pegs. • Under this system each country was to fix the par value of its currency in term of gold or US dollar. • The monetary authorities were allowed to make adjustment to the extend +/-1% of fixed par value. • This system could bring about stability in exchange rate ,it could not sustain for long time. 23 CA Dr Prithvi Ranjan Parhi
  24. 24. Exchange Rate Regimes Since 1973 • In the wake of collapse of Bretton woods system of exchange rate the committee appointed by IMF suggested four options for exchange rate. • These suggestions were accepted by IMF and incorporated in its 2nd amendment to the Article of agreement. • These options are:1.Floating rate system 2.Pegging of Currency 3.Crowling Peg 4.Target- Zone Arrangement 24 CA Dr Prithvi Ranjan Parhi
  25. 25. -----Exchange Rate Regimes Since 1973 Floating Rate System: • Market forces determine the exchange rate of currencies under floating rate system. Pegging of Currencies: • Here developing countries pegs its currencies either to a strong currency or to a currency of a country with which it has a large share of trade. • Pegging system provide for fixed exchange rate between two currencies. However, the exchange rate float with respect to other currencies. 25 CA Dr Prithvi Ranjan Parhi
  26. 26. -----Exchange Rate Regimes Since 1973 Crawling Peg: • It is a hybrid of fixed rate and floating rate. • Here, the exchange rate of a currency with which it is pegged is stable in the short run ,but it changes gradually over a period of time in order to reflect the changes in the market. • This system has the advantages of stability and flexibility. 26 CA Dr Prithvi Ranjan Parhi
  27. 27. -----Exchange Rate Regimes Since 1973 Target-Zone Arrangement: • Under this system the exchange rates are fixed with respect to the currencies of the countries of a particular zone and the exchange rate float with respect to countries outside the zone. • Example: Eastern Caribbean Currency Union, Central African Economic and Monetary community and Western African Economic and Monetary Union. 27 CA Dr Prithvi Ranjan Parhi
  28. 28. Fixed/Pegged Exchange Rate • A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime where a currency's value is fixed against either the value of another single currency, to a basket of other currencies, or to another measure of value, such as gold. • In a fixed exchange-rate system, a country’s central bank typically uses an open market mechanism and is committed at all times to buy and/or sell its currency at a fixed price in order to maintain its pegged ratio. 28 CA Dr Prithvi Ranjan Parhi
  29. 29. List of Counties Having Fixed Exchange Rate(Peg to USD) Country Region Currency Name Code Peg Rate Rate Since Bahrain Middle East Dollar BHD 0.376 2001 Cuba Central America Convertible Peso CUC 1.000 2011 Dijibouti Africa Franc DJF 177.721 1973 Eritrea Africa Nakfa ERN 15.000 2005 Hong Kong Asia Dollar HKD 7.75-7.85 1998 Jordan Middle East Dinar JOD 0.709 1995 Lebanon Middle East Pound LBP 1507.5 1997 Oman Middle East Rial OMR 0.3845 1986 Panama Central America Balboa PAB 1.000 1904 Qatar Middle East Riyal QAR 3.64 2001 Saudi Arabia Middle East Riyal SAR 3.75 2003 United Arab Emirates Middle East Dirham AED 3.6725 1997 Venezuela South AmericaBolivar VEB 6.3 2013 29 CA Dr Prithvi Ranjan Parhi
  30. 30. ----------Fixed/Pegged Exchange Rate(Advantages) 1. Promotes International Trade: Fixed or stable exchange rates ensure certainty about the foreign payments and inspire confidence among the importers and exporters. This helps to promote international trade. 2. Necessary for Small Nations: Fixed exchange rates are even more essential for the smaller nations like Denmark, Belgium, in whose economies foreign trade plays a dominant role. Fluctuating exchange rates will seriously affect the process of economic growth in these economies. 3. Promotes International Investment: Fixed exchange rates promote international investments. If the exchange rates are fluctuating, the lenders and investors will not be prepared to lend for long-term investments. 30 CA Dr Prithvi Ranjan Parhi
  31. 31. ----------Fixed/Pegged Exchange Rate(Advantages) 4. Removes Speculation: Fixed exchange rates eliminate the speculative activities in the international transactions. There is no possibility of panic flight of capital from one country to another in the system of fixed exchange rates. 6. Necessary for Developing Countries: Fixed exchanges rates are necessary and desirable for the developing countries for carrying out planned development efforts. Fluctuating rates disturb the smooth process of economic development and restrict the inflow of foreign capital. 31 CA Dr Prithvi Ranjan Parhi
  32. 32. ----------Fixed/Pegged Exchange Rate(Advantages) 7. Suitable for Currency Area: A fixed or stable exchange rate system is most suitable to a world of currency areas, such as the sterling area. If the exchange rates of the countries in the common currency area are flexible, the fluctuations in the leading country, like England (whose currency dominates), will also disturb the exchange rates of the whole area. 8. Economic Stabilization: Fixed foreign exchange rate ensures internal economic stabilization and checks unwarranted changes in the prices within the economy. In a system of flexible exchange rates, the liquidity preference is high because the businessmen will like to enjoy wind fall gains from the fluctuating exchange rates. This tends to Increase price and hoarding activities in country. 9. Not Permanently Fixed: Under the fixed exchange rate system, the exchange rate does not remain fixed or is permanently frozen. Rather the rate is changed at the appropriate time to correct the fundamental disequilibrium in the balance of payments. 32 CA Dr Prithvi Ranjan Parhi
  33. 33. ----------Fixed/Pegged Exchange Rate(Advantages) 10. Other Arguments: Besides, the fixed exchange rate system is also beneficial on account of the following reasons. (i) It ensures orderly growth of world's money and capital markets and regularizes the international capital movements. (ii) It ensures smooth functioning of the international monetary system. That is why, IMF has adopted pegged or fixed exchange rate system. (iii) It encourages multilateral trade through regional cooperation of different countries. (iv) In modern times when economic transactions and relations among nations have become too vast and complex, it is more useful to follow a fixed exchange rate system. 33 CA Dr Prithvi Ranjan Parhi
  34. 34. ----------Fixed/Pegged Exchange Rate(Disadvantages) 1. Outmoded System: Fixed exchange rate system worked successfully under the favorable conditions of gold standard during 19th century when (a) the countries permitted the balance of payments to influence the domestic economic policy; (b) there was coordination of monetary policies of the trading countries; (c) the central banks primarily aimed at maintaining the external value of the currency in their respective countries; and (d) the prices were more flexible. Since all these conditions are absent today, the smooth functioning of the fixed exchange rate system is not possible. 34 CA Dr Prithvi Ranjan Parhi
  35. 35. ----------Fixed/Pegged Exchange Rate(Disadvantages) 2. Discourage Foreign Investment: Fixed exchange rates are not permanently fixed or rigid. Therefore, such a system discourages long-term foreign investment which is considered available under the really fixed exchange rate system. 3. Monetary Dependence: Under the fixed exchange rate system, a country is deprived of its monetary independence. It requires a country to pursue a policy of monetary expansion or contraction in order to maintain stability in its rate of exchange. 4. Cost-Price Relationship not Reflected: The fixed exchange rate system does not reflect the true cost-price relationship between the currencies of the countries. No two countries follow the same economic policies. Therefore the cost-price relationship between them go on changing. If the exchange rate is to reflect the changing cost-price relationship between the countries, it must be flexible. 35 CA Dr Prithvi Ranjan Parhi
  36. 36. ----------Fixed/Pegged Exchange Rate(Disadvantages) 5. Not a Genuinely Fixed System: The system of fixed exchange rates provides neither the expectation of permanently stable rates as found in the gold standard system, nor the continuous and sensitive adjustment of a freely fluctuating exchange rate. 6. Difficulties of IMF System: The system of fixed or pegged exchange rates, as followed by the International Monetary Fund (IMF), is in reality a system of managed flexibility. It involves certain difficulties, such as deciding as to (a) when to change the external value of the currency, (b) what should be acceptable criteria for devaluation; and (c) how much devaluation is needed to reestablish equilibrium in the balance of payments of the devaluing country. 36 CA Dr Prithvi Ranjan Parhi
  37. 37. ----------Fixed/Pegged Exchange Rate(Disadvantages) 7.Inflationary Nature A common element with all fixed or pegged foreign exchange regimes is the need to maintain the fixed exchange rate. This requires large amounts of reserves as the country's government or central bank is constantly buying or selling the domestic currency. The problem with huge currency reserves is that the massive amount of funds or capital that is being created can create unwanted economic side effect – namely higher inflation. The more currency reserves there are, the wider the monetary supply– causing prices to rise. 37 CA Dr Prithvi Ranjan Parhi
  38. 38. Floating/Flexible Exchange Rate • Under the flexible exchange rate system, exchange rate between different currencies, like the prices of commodities are freely determined by market forces, that is, by demand and supply forces. • With the change in economic conditions underlying demand and supply, the exchange rate will automatically change without any intervention by the Government. • That is why it is called flexible or variable exchange rate system. • This is also called Free Float of currency. • Example: US Dollar, Euro,Japanese Yen 38 CA Dr Prithvi Ranjan Parhi
  39. 39. -------Floating/Flexible Exchange Rate(Advantages) 1. No need for international management of exchange rates: Unlike fixed exchange rates based on a metallic standard, floating exchange rates don’t require an international manager such as the International Monetary Fund to look over current account imbalances. Under the floating system, if a country has large current account deficits, its currency depreciates. 2. No need for frequent central bank intervention: Central banks frequently must intervene in foreign exchange markets under the fixed exchange rate regime to protect the gold parity, but such is not the case under the floating regime. Here there’s no parity to uphold. 39 CA Dr Prithvi Ranjan Parhi
  40. 40. -------Floating/Flexible Exchange Rate(Advantages) 3.No need for elaborate capital flow restrictions: It is difficult to keep the parity intact in a fixed exchange rate regime while portfolio flows are moving in and out of the country. In a floating exchange rate regime, the macroeconomic fundamentals of countries affect the exchange rate in international markets, which, in turn, affect portfolio flows between countries. Therefore, floating exchange rate regimes enhance market efficiency. 40 CA Dr Prithvi Ranjan Parhi
  41. 41. -------Floating/Flexible Exchange Rate(Advantages) 4. Greater insulation from other countries’ economic problems: Under a fixed exchange rate regime, countries export their macroeconomic problems to other countries. Suppose that the inflation rate in the U.S. is rising relative to that of the Euro-zone. Under a fixed exchange rate regime, this scenario leads to an increased U.S. demand for European goods, which then increases the Euro-zone’s price level. Under a floating exchange rate system, however, countries are more insulated from other countries’ macroeconomic problems. A rising U.S. inflation instead depreciates the dollar, curbing the U.S. demand for European goods. 41 CA Dr Prithvi Ranjan Parhi
  42. 42. -------Floating/Flexible Exchange Rate(Advantages) 5. Correction of balance of payments deficits - When, there is deficit in the balance of payments, the external value of a country's currency falls. As a result, exports are encouraged, and imports are discouraged thereby, establishing equilibrium in the balance of payment. 6. Eliminates Cost of FOREX reserves-This system eliminates the expenditure of maintenance of official foreign exchange reserve. 42 CA Dr Prithvi Ranjan Parhi
  43. 43. -------Floating/Flexible Exchange Rate(Disadvantages) 1. Unstable conditions: Flexible exchange rates create conditions of instability and uncertainty which, in turn, tend to reduce the volume of international trade and foreign investment. Long-term foreign investments are greatly reduced because of higher risks involved. 2. Adverse Effect on Economic Structure: The system of flexible exchange rates has serious repercussion on the economic structure of the economy. Fluctuating exchange rates cause changes in the price of imported and exported goods which, in turn, destabilize the economy of the country. 43 CA Dr Prithvi Ranjan Parhi
  44. 44. -------Floating/Flexible Exchange Rate(Disadvantages) 3. Unnecessary Capital Movements: The system of fluctuating exchange rates leads to unnecessary international capital movements. By encouraging speculative activities, such a system causes large-scale capital outflows and inflows, thus, seriously disturbing the economy of the country. 4. Depression Effects of Capital Movements: Speculative capital movements caused by fluctuating ex- change rates may lead to the problem of extremely high liquidity preference. In a situation of high liquidity preference, people tend to hoard currency, interest rates rise, investment falls and there is large-scale unemployment in the economy. 44 CA Dr Prithvi Ranjan Parhi
  45. 45. Managed Float/Dirty Float • It is a floating currency exchange rate system which is not controlled entirely by the market forces of demand and supply but at least partially controlled by government intervention that limits depreciation or appreciation of the currency with in a range. • Hence,' Dirty Float' is a system of floating exchange rates in which the government or the country's central bank occasionally intervenes to change the direction of the value of the country's currency. • Example: In 2013, 82 countries and regions used the system, or 43%, according to a survey of 191 countries by the International Monetary Fund. 45 CA Dr Prithvi Ranjan Parhi
  46. 46. Balance of Payment(BOP)
  47. 47. Definition of BOP----------- • BOP is the statistical record of a country’s international transaction over a certain period of time presented in the form of double entry book keeping. • BOP is a statement listing receipts and payments in international transactions of a country.
  48. 48. ---------Definition of BOP • It is a systematic accounting record of all economic transactions during a given period of time between the residents of the country and residents of foreign country. • It is a statement showing a country’s commercial transaction with the rest of the world.
  49. 49. Importance of BOP • BOP provides detailed information concerning the demand and supply of foreign currency.(If Export>Import, Domestic currency will appreciate where as if Import>Export domestic currency will depreciate) • A country’s BOP data may signal its potential as a business partner for the rest of the world.BOP deficit country more likely to impose control on FOREX.BOP surplus country more likely to encourage imports. • BOP data can be used to evaluate the performance of the country in international economic competition.
  50. 50. BOP Accounting • BOP is presented in a system of double entry book keeping.(Every credit in the account is balanced by a matching debit and vice versa) • Any transaction that results in a receipt from foreigners will be recorded as credit. • Any transaction that give rise to payment to foreigner will be recorded as debit. • Credit entries give rise to supply of foreign currency(demand for domestic currency),where as debit entries give rise to demand for foreign currency(supply of domestic currency)
  51. 51. Balance of Payment • All types of international transactions can be grouped in to Four heads: 1.Current Account 2.Capital Account 3.Other Account(Error & Omission) 4.Official Reserve Account
  52. 52. Current Account---------- • Current account records the following four categories of transactions: • Merchandise Trade: Represents exports and imports of tangible goods/visibles (Trade balance/Trade deficit/Balance of trade) • Services/Invisibles: It includes payment and receipt for following services:(Transport, Travel, construction, Insurance and pension, financial, telecommunication, computer & IT, personal, cultural & recreational services, other services, charges for use of intellectual property right)
  53. 53. ---------Current Account • Factor Income: It consists largely of payments and receipts of interest, dividend and other income on foreign investments that were previously made. • Unilateral Transfers: it involves unreciprocated payments and receipts. These are only one directional flow.(Foreign Aid, official and Private Grant,Gifts,Remittances etc) • Current Account may show balance or deficit.
  54. 54. Current A/C Balance & Exchange Rate • A Balance in Current A/C---More supply of Foreign Currency----More Demand for Home Currency---Appreciation of Domestic Currency----Affect Positively Imports and Negatively Exports. • A Deficit in Current A/C----More Demand for Foreign Currency---Depreciation of Domestic Currency---Positively affects exports and negatively Imports.
  55. 55. Capital Account---------- • Foreign Direct Investment(Inward/Outward) • Foreign Portfolio Investment (Inward/ Outward) • Loans:(External Assistance, Commercial Borrowing{Lt/Mt},Short term loans) • Banking Capital(Assets & Liabilities) • Rupee Debt Service • Other Capital
  56. 56. ---------Capital Account • Hence current account deals with trade in goods and services, but capital account deals with trade in financial assets and liabilities. • Increase in foreign financial Assets=Debit items • Decrease in foreign financial Assets=Credit items • Increase in Foreign Financial liabilities=Credit items • Decrease in Foreign Financial liabilities=Debit items.
  57. 57. Error & Omission Error and omission are put in BOP due to: • Difficulties involved in collecting BOP data • Different sources of BOP data • Movement of capital may precede or follow the transaction that they are supposed to finance before or after 31st march. • Some figures are based on estimates only • Unrecorded illegal transactions
  58. 58. Deficit Adjustment------- • If the overall balance is found to be in deficit, Central Bank(RBI)arranges capital flows to cover deficit by official borrowing and/or drawing from the IMF. This sort of capital flow is accommodating or compensatory capital flow. This also put in capital account. • Hence capital inflows is of two types: 1.Autonomous Capital flow 2.Accommodating/Compensatory Capital Flow
  59. 59. --------Deficit Adjustment • If overall BOP is negative/deficit and accommodating capital is not sufficient, the official reserve account is debited by the amount of deficit.(It means there will be decrease in official reserve) • If overall BOP is surplus, the surplus amount adds to the official reserve account.(It means there will be increase in official Reserve)
  60. 60. Official Reserve Account • It is held by the central bank of the country. (RBI) • It consists of the following – Gold – Foreign Currency Assets – Special Drawing Rights(SDR) • This account is used for balancing the BOP. • If a country do not have sufficient Official Reserve it leads to BOP crisis and the country goes for policy reforms.
  61. 61. BOP always Balances? • Since the balance of payment is based upon system of double-entry book-keeping, the total debits must equal to total credits. • This is because two aspects of each transaction recorded are equal in amount but appear on opposite sides of the balance of payments account. • In this accounting sense, balances of payments for a country must always balance. • But in economic sense/real sense there may be disequilibrium in BOP.
  62. 62. THANK YOU
  63. 63. Convertibility of a currency • Currency convertibility is the ease with which a country's currency can be converted into gold or another currency. Convertibility is extremely important for international commerce. When a currency is inconvertible, it poses a risk and barrier to trade with foreigners who have no need for the domestic currency. • Government restrictions can often result in a currency with a low convertibility. For example, a government with low reserves of hard foreign currency often restrict currency convertibility because the government would not be in a position to intervene in the foreign exchange market (i.e. revalue, devalue) to support their own currency if and when necessary. 63 CA Dr Prithvi Ranjan Parhi
  64. 64. Convertibility of Rupee • Currency convertibility is of two types: 1.Current Account Convertibility 2.Capital Account Convertibility • Current account convertibility allows free inflows and outflows for all purposes other than for capital purposes. • Capital purpose means dealing the investments in foreign currency and obtaining loans in foreign currency, acquiring any plant and machinery from abroad by making payments in foreign exchange. 64 CA Dr Prithvi Ranjan Parhi
  65. 65. Convertibility of Rupee(Indian Experience) • After the BoP crisis of 1990-91 and change in the central Government, the LERMS was introduced as a first measure towards making foreign exchange a free commodity. • Thus, when LERMs was introduced, there were two exchange rates in India: Official Rate for select items of exports and imports Market Rate for all others. • The Government said that now onwards, anyone who deals in current account means international trade of goods and services will be able to convert them to Indian Rupees as follows: 40 % of the receipts at Official rate 60% of the receipts at Market Rate. • This means that only part of the current account receipts were made convertible at market rates and that is why it was called Partial Convertibility of Rupee on Current Account. 65 CA Dr Prithvi Ranjan Parhi
  66. 66. ------Convertibility of Rupee(Indian Experience) • Encouraged with the success of the LERMS, the government introduced the full convertibility of Rupee in Trade account (means only merchandise trade no service trade)from March 1993 onwards. • With this the dual exchange rate system got automatically abolished and LERMS was now based upon the open market exchange. 66 CA Dr Prithvi Ranjan Parhi
  67. 67. --------Convertibility of Rupee(Indian Experience) • In August 1994, the Government of India declared full convertibility of Rupee on Current account .(Trade and invisibles) • Capital account convertibility (CAC) or a floating exchange rate means the freedom to convert local financial assets into foreign financial assets and vice versa at market determined rates of exchange. • The Committee on Capital Account Convertibility (CAC) or Tarapore Committee was constituted by the Reserve Bank of India for suggesting a roadmap on full convertibility of Rupee on Capital Account. • The committee submitted its report in May 1997. 67 CA Dr Prithvi Ranjan Parhi
  68. 68. --------Convertibility of Rupee(Indian Experience) • However, some partial convertibility of Rupee on Capital Account was introduced later. Today we have Partial convertibility of Rupee on Capital Account. • Reserve Bank of India appointed the second Tarapore committee to set out the framework for fuller Capital Account Convertibility. • The report of this committee was made public by RBI on 1st September 2006. • In this report, the committee suggested 3 phases of adopting the full convertibility of rupee in capital account. – First Phase in 2006-7 – Second phase in 2007-09 – Third Phase by 2011. 68 CA Dr Prithvi Ranjan Parhi
  69. 69. --------Convertibility of Rupee(Indian Experience) Following were some important recommendations of this committee: • The ceiling for External Commercial Borrowings (ECB) should be raised for automatic approval. • NRI should be allowed to invest in capital markets NRI deposits should be given tax benefits. • Improvement of the Banking regulation. • FII (Foreign Institutional Investors) should be prohibited from investing fresh money raised to participatory notes. • Existing PN holders should be given an exit route to phase out completely the PN notes. 69 CA Dr Prithvi Ranjan Parhi
  70. 70. Are We moving towards fuller capital account convertibility? • Though there are certain risks associated with full capital account convertibility, we cannot avoid it for longer period as it may become counter-productive. • But how early are we moving to full capital account convertibility depend on various pre-conditions like low and sustained current account deficit, fiscal-consolidation, controlled inflation, low level of NPAs, resilient financial markets, prudent supervision of financial institutions etc. • Already India is making progress on these fronts. • Today we have Partial convertibility of Rupee on Capital Account and slowly moving towards fuller capital account convertibility. 70 CA Dr Prithvi Ranjan Parhi
  71. 71. THANK YOU 71 CA Dr Prithvi Ranjan Parhi