Relation of BOP with the exchange rate

Relation of BOP with the exchange rate

Subject: Economy

Section: External Sector

Context: exchange rate and BOP

India’s BoP is a ledger of its transactions with the rest of the world. It shows how much money went out of the country and how much money came into the country through international transactions.

These transactions could be:

• Trade (export or import) of goods (such as cars, gadgets, or raw materials) or services (such as an Indian company selling computer software to someone in the US or an American firm providing banking services to some Indians).
• Investments — such as an Indian buying some land in the US or an American firm investing in the Indian stock exchanges — and
• Exchange of loans and aids between Indian and other countries of the world.

The relationship between balance of payments and exchange rates under a floating-rate exchange system will be driven by the supply and demand for the country’s currency and all transactions taking place with other countries.

• Suppose there is surplus in balance of payments-It means money inflows are greater than the money outflows due to the net positive international transactions.

Example-Let initial exchange rate be Rs. 40 = $1. An increase in demand for India’s exportables means an increase in the demand for Indian rupee relative to the demand of the US$ and decrease in the supply of the Indian rupee relative to the supply of the US$  . Consequently, the dollar depreci­ates while the Indian rupee appreciates.

• Suppose there is deficit in balance of payments-It means money outflows are greater than the money inflows due to the net negative international transactions.

Example-Let initial exchange rate be Rs. 40 = $1. An increase in demand for India’s importables means an increase in the demand for the US$ relative to the demand of the Indian rupee and decrease in the supply of the US $ relative to the supply of the Indian rupee. Consequently, the dollar appreci­ates while the Indian rupee depreciates.

BOP always balances in accounting sense:

The BOP figures are published in a single column with positive (credit) and negative (debit) signs. Since payments side of the account enumerates all the uses which are made up of the total foreign purchasing power acquired by this country in a given period, and since the receipts of the accounts enumerate all the sources from which foreign purchasing power is acquired by the same country in the same period, the two sides must balance. The entries in the account should, therefore, add up to zero.

In reality, total receipts may diverge from total payments because of: (i) the difficulty of collecting accurate trade information; (ii) the difference in the timing between the two sides of the balance; and (iii) a change in the exchange rates, etc.

Because of such measurement problems, resources are made to ‘balancing items’ that intend to eliminate errors in measurement. The purpose of incorporating this item in the BOP account is to adjust the difference between the sums of the credit and the sums of the debit items in the BOP accounts so that they add up to zero by construc­tion. Hence the proposition ‘the BOP always balances’. It is a truism. It only suggests that the two sides of the accounts must always show the same total. It implies only equality. In this book-keeping sense, BOP always balances.

Example-The net result of a current account deficit (of $ 26.6 billion) and a capital account surplus (of $ 90.1 billion) is that a total of 63.5 billion US dollars have entered the Indian economy — and the BoP accounts — during April and December 2021. The only way to balance the BoP is for some authority to take these excess dollars out of the equation. That authority is the RBI and it takes out these dollars and keeps it with itself as the forex reserves.

RBI management of exchange rate through forex exchange 

In March 1992, Liberalised Exchange Rate Management System (LERMS) involving the dual exchange rate was instituted. A unified single market-determined exchange rate system based on the demand for and supply of foreign exchange replaced the LERMS effective March 1, 1993.

The Reserve Bank’s exchange rate policy focuses on ensuring orderly conditions in the foreign exchange market. For this purpose, it closely monitors the developments in the financial markets at home and abroad. When necessary, it intervenes in the market by buying or selling foreign currencies. The market operations are undertaken either directly or through public sector banks.

In addition to the traditional instruments like forward and swap contracts, the Reserve Bank has facilitated increased availability of derivative instruments in the foreign exchange market. It has allowed trading in Rupee-foreign currency swaps, foreign currency-Rupee options, cross-currency options, interest rate swaps and currency swaps, forward rate agreements and currency futures.

The central bank can also influence the value of the rupee by way of monetary policy. RBI can tweak the repo rate (the rate at which RBI lends to banks) and the liquidity ratio (the portion of money banks are required to invest in government bonds) to control rupee.

RBI can raise the repo rate, which leads to a rise in interest rates, bond yields and return on debt papers, drawing more investor money to chase better returns if the same is low in other markets. On the other hand, higher interest rates stem money circulation in the economy, leaving more money in the hands of the RBI to manage the currency demand-supply situation.

The Reserve Bank’s exchange rate policy focuses on ensuring orderly conditions in the foreign exchange market. For this purpose, it closely monitors the developments in the financial markets at home and abroad. Consider the various steps taken by the RBI to prevent depreciation of Indian rupee

1. Selling of forex
2. Buying of forex
3. Sterilization
4. Currency swap agreement
5. Rise in repo rate