Year: 2020

Valuation of Future

When you trade a futures contract, you agree either to buy or to sell the asset underlying the futures contract on a specified date in the future. The price at which the contract is traded is not pre-set, but is determined by market forces.

It is possible to calculate a theoretical fair value for a futures contract.

The fair value of a futures contract should approximately equal the current value of the underlying shares or index, plus an amount referred to as the ‘cost of carry’.

The cost of carry reflects the cost of holding the underlying shares over the life of the futures contract, less the amount the shareholder would receive in dividends on those shares during that time. Because the buyer of the futures contract pays only a small percentage of the contract value at the time of the transaction, they do not directly incur this funding cost.

For example, assume that:

• The S&P/ASX 200 Index is trading at 5000 points
• There are 120 days until maturity of the June futures contract
• Interest rates are currently at 7% p.a.
• The average dividend yield on stocks in the S&P/ASX200 Index is 4% p.a.

The theoretical fair value of the June ASX Mini 200 Future can be calculated as:

Fair value = current level of S&P/ASX200 + cost of carry

= 5000 + (5000 X (7% – 4%) X 120/365)

= 5049.5 points

As maturity approaches, the prices of the futures contract and the underlying asset tend to converge. The trader’s profit or loss depends on how far the price of the futures contract at maturity is above or below the price at which the contract was initially traded.

The full value of the futures contract is not paid or received when the contract is established instead both buyer and seller pay a small initial margin. The traded price is the basis on which profit or loss is calculated at maturity or on closing out the position if this takes place before maturity.

Valuation of Swaps

A wide variety of swaps are utilized in the over-the-counter (OTC) market in order to hedge risks, including interest rate swaps, credit default swaps, asset swaps, and currency swaps. In general, swaps are derivative contracts through which two private parties usually businesses and financial institutions exchange the cash flows or liabilities from two different financial instruments.

A plain vanilla swap is the simplest type of swap in the market, often used to hedge floating interest rate exposure. Interest rate swaps are a type of plain vanilla swap. Interest rate swaps convert floating interest payments into fixed interest payments (and vice versa).

Two parties may decide to enter into an interest rate swap for a variety of different reasons, including the desire to change the nature of the assets or liabilities in order to protect against anticipated adverse interest rate movements. Like most derivative instruments, plain vanilla swaps have zero value at the initiation. This value changes over time, however, due to changes in factors affecting the value of the underlying rates. And like all derivatives, swaps are zero-sum instruments, so any positive value increase to one party is a loss to the other.

How Is the Fixed Rate Determined?

The value of the swap at the initiation date will be zero to both parties. For this statement to be true, the values of the cash flow streams that the swap parties are going to exchange should be equal. This concept is illustrated with a hypothetical example in which the value of the fixed leg and floating leg of the swap will be V_fix and V_fl respectively. Thus, at initiation:

V_{fix} = V_{fl}Vfix​=Vfl​

Notional amounts are not exchanged in interest rate swaps because these amounts are equal; it does not make sense to exchange them. If it is assumed that parties also decide to exchange the notional amount at the end of the period, the process will be similar to an exchange of a fixed rate bond to a floating rate bond with the same notional amount. Therefore such swap contracts can be valued in terms of fixed-rate and floating-rate bonds.

There are many ways in which investment managers and investors can use swaps, forwards, futures, and volatility derivatives. The typical applications of these derivatives involve modifying investment positions for hedging purposes or for taking directional bets, creating or replicating desired payoffs, implementing asset allocation and portfolio rebalancing decisions, and even inferring current market expectations. The following table shows some common uses of these derivatives in portfolio management and the types of derivatives used by investors and portfolio managers.

Derivatives

Derivatives are securities whose value is determined by an underlying asset on which it is based. Therefore the underlying asset determines the price and if the price of the asset changes, the derivative changes along with it. A few examples of derivatives are futures, forwards, options and swaps. The purpose of these securities is to give producers and manufacturers the possibility to hedge risks. By using derivatives both parties agree on a sale at a specified price at a later date. In each derivative certain aspects are documented such as the relation between the derivative, type of underlying asset and the market in which they are traded. It is essential to understand the strengths and weaknesses of each derivative to employ them to their fullest potential.

Futures

Futures are exchange organized contracts which determine the size, delivery time and price of a commodity. Futures can easily be traded because they are standardized by an exchange. Per commodity traded there are different aspects specified in a futures contract. First of all is the quality of a commodity. For a commodity to be traded on the exchange, it must meet the set requirements. Second is the size of a single contract. The size determines the units of a commodity that is traded per contract. Thirdly is the delivery date, which determines on which date or in which month the commodity must be delivered. Thanks to the standardization of futures commodities can easily be traded and give manufacturers access to large amounts of raw materials. They can buy their materials on the exchange and don’t need to worry about the producer or take on contracts with multiple suppliers.

Forwards

Forwards and futures are very similar as they are contracts which give access to a commodity at a determined price and time somewhere in the future. A forward distinguish itself from a future that it is traded between two parties directly without using an exchange. The absence of the exchange results in negotiable terms on delivery, size and price of the contract. In contrary to futures, forwards are usually executed on maturity because they are mostly use as insurance against adverse price movement and actual delivery of the commodity takes place. Whereas futures are widely employed by speculators who hope to gain profit by selling the contracts at a higher price and futures are therefore closed prior to maturity.

Swaps

A swap is an agreement between two parties to exchange cash flows on a determined date or in many cases multiple dates. Typically, one party agrees to pay a fixed rate while the other party pays a floating rate. For example, when trading commodities the first party, an airline company relying of kerosene, agrees to pay a fixed price for a pre-determined quantity of this commodity. The other party, a bank, agrees to pay the sport price for the commodity. Hereby the airline company is insured of a price it will pay for its commodity. A rise in the price of the commodity is in this case paid by the bank. Should the price fall the difference will be paid to the bank.

Caps, floors and collars

Cap and floor options can be used as an insurance against negative price movements. When two parties agree on a swap contract, both parties take a risk on the price movement of the underlying commodity. To reduce this risk they can also agree on a cap or floor option. This is similar to a swap, because two parties agree to exchange cash flows. The difference is the usage of a maximum or minimum price. With a cap option, a cash flow will only occur when the spot price rises above the cap price. When the price remains under the cap price a company will buy the commodity for the sport price. When the spot price rises above the cap price, the difference between the spot and cap price will be paid by the other party.

A floor option works similar to a cap option, because the exchange of cash flows only takes place when a condition is met. The only difference is that a cash flow now only takes place when the spot price drops below the floor price.

A collar option is a combination of both a cap and floor option. It sets a maximum and a minimum price. When the spot price remains between these two prices, the commodity will be bought for the current market price. Should the spot price rise or drop outside these boundaries, an exchange of cash flows will occur.

Swaptions

A swaption is a combination of a regular swap and an option. It gives a holder the right to enter a swap with another party at a given time in the future. Parties usually agree on a swaption when there are uncertainties about the price movements in the future. Just like with options, the swaption will only be executed if the price is more favorable then the spot price. If the sport price upon the maturity date is more favorable, the swaption will expire. In this situation a company will agree on a new swap, based on the current market prices.

Options

Options are a form of derivatives, which gives holders the right, but not the obligation to buy or sell an underlying asset at a pre-determined price, somewhere in the future. When you take an option to buy an asset it is called a ‘call’ and when you obtain the right to sell an asset it is called a ‘put’. To determine whether it is profitable to exercise an option, the current market price (spot price) and the price in the option (strike price) need to be compared. By comparing both prices, a choice can be made to either exercise the option or let it expire. When exercising an option there are three positions on which the holder can find themselves.

The first is in the money (ITM), where the strike price is more favorable than the spot price and thus it will be advantageous to exercise the option.

The second is at the money (ATM) in which the strike and spot price are equal and so no advantage can be gained.

The third is out the money (OTM), where the strike price is higher than the spot price. In this case it is better to let the option expire and buy the commodity at the current market price.

There are two ways of settling an option between two parties.

• The first way is to physically deliver the underlying commodity.
• The other way is to cash settle the option. In this way the difference between the spot and strike price is paid to the holder of the option upon exercising of the option. An option has a few advantages over other derivatives.

The most important advantage is that an option is not binding, in the way is does not obligate one to buy a commodity. It gives you the right to buy it and so when the price of the option is higher than the current market price you can just let the option expire and buy at the spot price. The only loss made, will be the premium which is the cost for maintaining the option. Another advantage is the usefulness of options as a hedging tool. Options offer the tools to successfully hedge price movements with a small investment risk.

The late Per Jacobsson said, “By liquidity, I understand the supply of credit in national currencies as needed to finance and provide the means of payment for trade and production.”

International liquidity consists essentially in the resources available to national monetary authorities to finance potential balance of payments deficit…it may consist in the possession of assets like gold, foreign exchange and in the ability to borrow internationally.

Thus, in its international setting, liquidity includes all those assets including SDRs which are generally acceptable without loss of value for settling international debts.

It may include the following:

Gold stocks with the Central Banks and with the IMF; foreign exchange reserves of countries ; drawing rights of member countries with IMF; credit arrangements between countries ; country’s capacity to borrow in the money markets of another country ; accumulation facilities (these arise when a foreign country accepts payments of debts in debtor’s currency like Sterling balances accumulated during World War II ; Euro-Dollars SDRs etc.

Corresponding to domestic liquidity which is a function of income, rate of interest and aggregate value of assets; we may spell out international liquidity of a country in the following function:

LI = LI (Exps, i diff, Gm, $, £—sterling, IME dr It, Deffd payts, sht-term, Credits Sarr). where, LI stands for international liquidity (LI to the right is a functional notation); i diff = interest differential Gm = monetary gold; Exps = export surplus; dr It = drawing limit; Deffd payts = deferred payments arrangements with foreign countries; Sht term = Short term ; Credit Sarr = Credit arrangements or Swars.

The IMF distinguishes between unconditional liquidity and conditional liquidity. The former consists of gold, foreign exchange reserves and credit facilities (gold reserve tranche position in the Fund) which member countries could use automatically without any questions being asked concerning balance of payments outlook and monetary policies. Conditional liquidity implies credit facilities which are not automatic, i.e., which can be used only if the potential lender (for example, the IMF) has received assurance concerning the monetary and BOP outlook of the borrowing country or its ability to repay credit in time.

Problem in International Liquidity

There is no agreement amongst the economists about the true nature of the problem of international liquidity. Some economists feel that the problem is quantitative that is, inadequacy of the means of international payments. Others feel that the problem is qualitative in nature and pertains to the form and composition of international reserves for liquidity purposes.

There are others who present the problem of international liquidity in a different way the claim that the problem is more of confidence, which arises due to lack of adjustment on account of fixed exchange rates (as had been the case under Bretton Woods System till 1976).

They feel that had there been greater adjustment in the exchange values of the currencies according to the conditions prevailing in the market or had there been flexible exchange rates helping quick adjustments, there would have been no problem of international liquidity.

So the problem according to them, is one of adjustment. It may be true that a part of the problem of international liquidity (that is, providing the means of international payments) may be that of confidence and adjustment but mainly the problem is of inadequacy of reserves to cope with the expanding requirements of international trade. It has been found that the growth in the liquidity has not kept pace with the growth in the world trade.

During the 1970s through 1980s, the world trade almost doubled in a decade or so but the world reserves increased by hardly 25 per cent to 30 per cent in a decade and even this increase was unevenly distributed not only amongst developed countries but also between developed and underdeveloped countries, thereby causing a serious shortage of international liquidity.

The average annual increase in world trade in past decade 1970-80 was about 8 to 10 per cent while the annual average percentage change in reserves was hardly 3V2 per cent between 1970-80. The ratio of reserves to imports which is generally taken as an approximate indicator of the adequacy of reserves, has markedly declined thereby suggesting the inadequacy of not only the present volume but also the rate of growth of international reserves.

International monetary system Or arrangements, based on gold or gold exchange standard or dollar and sterling as international reserves, could no longer inspire confidence and provide for increased quantum of international liquidity on account of expanding world trade.

Apart from this, most baffling has been the problem as to the form, the new international reserve asset should take. Opinions differed in the past amongst leading countries as to the true nature and form of the new international reserve asset.

It is rather difficult to determine as to what will constitute the adequate level of international liquidity under the dynamic conditions of expanding world trade and growth in developing economies. It is said that the quantum of international money needed by the world depends on the size of international trade, that is, more trade will require more money to finance it. But, this is not true because trade is not financed normally by reserves.

International reserves finance not the volume of international trade but the balance of payments deficits. The amount or the quantity of international reserves needed, therefore, varies with the size of the swings in the balance of payments.

It may, therefore, be said that in a sense the aggregate needs of international liquidity are in one way related to factors like world trade, capital movements and imbalances in BOP. But their adequacy is also affected by psychological attitudes towards what is minimum or desired levels of natural reserves, by reserve movements and by the use of available credit facilities. Because other influencing factors cannot be quantified growth in imports seems to be the most relevant indicator of the need for reserves.

According to Triffin, “The ratio of gross reserves to annual imports is the first and admittedly rough approach to the appraisal of reserve adequacy”. But it is not easy to determine the correct ratio of gross reserves to annual imports. It will, thus, be seen that the factors which determine the adequacy of international liquidity are, in practice, not precisely measurable.

It is not simply a matter of arithmetical relationship. Broadly speaking, the question of adequacy of liquidity—national or international—is a matter of judgment, depending on the economic circumstances prevailing in a country, on the time and on the purpose for which the reserves are to be used. We may conclude that a country will regard its liquidity or reserves as adequate when, in its opinion, the level of liquidity or reserves are sufficient to meet unforeseen deficits in its balance of payments without adopting restrictive policies affecting economic growth and international trade.

Importance of International Liquidity

The importance of international liquidity lies in providing means by which disequilibrium in the BOP of different countries participating in international trade is settled, As such, it helps in the smooth flow of international trade by facilitating the availability of international means of payment. It make be understood that these means or reserves are used to finance deficits in the BOPs.

These reserve are not used to finance the inflows or outflows of trade. Changes in the balance of payments  temporary deficits and surplus must be met by transfers of gold, convertible currencies or international borrowing facilities.

All these go to constitute international liquidity. The greater the stock of these items of international liquidity held by any country and by countries in the aggregate, the less will the need for changes in exchange rates.

In a world, in which there are considerable fluctuations in economic activities, accompanied by a growing demand for stability, the importance of international liquidity reserves lies in serving as a buffer, giving each country some leeway for the regulation of its national income and employment and providing it with a means to soften the impact of economic fluctuations arising on account of international trade and transactions.

A greater world holding of international liquidity reserves becomes necessary to maintain stable exchange rates over the whole business cycle than to meet any seasonal or short-run fluctuations. It is in this sense that adequacy or otherwise of foreign liquid reserves is an important determinant of the levels of world trade and economic activity. If there are enough or sufficient international liquid reserves, specially with those countries which are likely to incur deficits there will be less worry or panic for adjustment.

On the other hand, if there is too little international liquidity in the world, deficit countries will have no or little time to adjust and they will be forced to impose restrictions on trade and capital movements. As a result the world growth in international trade will be hampered and the prices of primary products will fall, turning the terms of trade in an unfavorable manner for developing economies. Easy access to international liquidity reserves makes it possible for the swings in the balance of payments to be financed, otherwise, the world trade may be strangled for want of international liquidity.

It implies not only sufficient quantity but the right composition and distribution of international liquid reserves. In other words, stability of reserves (in monetary system) has to be provided in terms of scale, composition and distribution, scale refers to the supply of liquid funds to the system as a whole ; while distribution applies to the distribution of liquid reserves amongst countries. Composition implies the currency composition of reserve holdings.

Regarding scale the major limitation is its inability to adjust the supply of reserves in a manner which exerts a stabilizing influence on the world economy. Again, the compositional problem inherent in multi-currency reserve system with floating exchange rates has to be looked into. The distributional problems have to be sorted out to the extent to which some countries have easier, less costly, access to international credits or reserves than do other countries in similar circumstances.

Special Drawing Rights, often referred to as SDRs, are an interest-bearing international reserve asset used by the International Monetary Fund (IMF). The SDR is based on a basket of currencies and comes with the currency code, XDR, which it may also be referred to by. The SDR serves as the unit of account for the IMF for internal accounting purposes.

SDRs are also used as a supplementary foreign exchange reserve for countries who are IMF members. As of October 2016, the basket of currencies used to value the XDR consists of the US dollar, the euro, the Chinese yuan, the Japanese yen, and the British pound sterling.

 What is the Purpose of Special Drawing Rights?

Special drawing rights were originally introduced in 1969 by the IMF. At this time, the main purpose of creating SDRs was for use as a supplementary foreign exchange reserve. This was due to a lack of US dollars and gold, which at the time were the main assets held in foreign exchange reserves. At that time, the SDR was the equivalent of one US dollar, or 0.888671 grams of gold, and was intended to be used in the context of the Bretton Woods fixed exchange rate system. After this system fell apart in 1973, the SDR was instead defined by a basket of major currencies.

SDRs still serve their original purpose as a supplement to foreign currency reserves, however, less so after 1973. When the US dollar is weak or becomes less attractive, countries may prefer special drawing rights.

One of the main purposes of SDRs is as a unit of account for internal accounting purposes by the IMF. Holding this basket of major currencies helps the IMF manage the exchange rate volatility of any single currency.

Countries have also pegged their currency to the XDR as a way to increase transparency.

How do Special Drawing Rights Work?

SDRs are allocated to each of the countries that are IMF members. The amount of SDRs that are allocated to each country is based on their individual IMF quotas. IMF quotas are based broadly on the relative economic position of the country in the world economy. The quota is essentially a country’s financial commitment to the IMF and its voting power. The IMF determines whether there is a need for a new allocation of SDRs in the global economy every five years. In 2009, in response to the financial crisis, the IMF allocated the largest amount of SDRs since its inception.

SDRs can be traded for freely usable currencies between IMF members through voluntary trading agreements. These agreements are facilitated by the IMF and can be done to adjust reserves or meet balance of payments needs. It is important to understand that SDRs are neither a currency nor a financial claim on the IMF. SDRs are a potential claim of IMF members on freely usable currencies.

When SDRs are initially allocated to an IMF member country, the member is given two positions. The two positions are the “SDR holdings” and the “SDR allocations.” Countries receive interest on their holdings and pay interest based on their allocations position. The interest amount for both positions is based on the SDR interest rate. The two positions’ values start out the same. Therefore, the interest received and interest paid cancel each other out.

When a country trades SDRs for freely usable currencies, their holdings decrease and their foreign exchange reserves increase. This causes the holdings to fall below the allocations. When this happens, the interest payments associated with the two positions do not cancel each other out. The country will pay more interest than it receives. Alternatively, if a country trades freely usable currencies for SDRs, their holdings can increase above their allocations position. The country will then receive more interest than it pays out.

How are the SDR Value and SDR interest rate (SDRi) Calculated?

The SDR is defined using a basket of major currencies. The currencies are chosen based on how important and widely traded they are in international exchange markets. Every five years, the IMF executive board reviews which currencies should be included in the SDR basket. This is done to ensure that the SDR is relevant and useful as a foreign exchange reserve. As of October 2016, the basket consists of:

• 73% US dollar
• 93% euro
• 92% Chinese yuan
• 33% Japanese yen
• 09% British pound sterling

The value of the SDR is determined daily and based on fluctuations in the value of the currencies in the basket. There is also an associated SDR interest rate (SDRi), which is determined on a weekly basis. The SDRi is also based on the currencies held in the SDR basket. This rate is determined by a weighted average, based on short-term government debt instruments associated with each of the basket currencies.

International Portfolio Management, also known as International Portfolio Management or Foreign Portfolio Management, refers to grouping of investment assets from international or foreign markets rather than from the domestic ones. The asset grouping in GPM mainly focuses on securities. The most common examples of International Portfolio Management are:

• Share purchase of a foreign company
• Buying bonds that are issued by a foreign government
• Acquiring assets in a foreign firm

Factors Affecting International Portfolio Investment

International Portfolio Management (GPM) requires an acute understanding of the market in which investment is to be made. The major financial factors of the foreign country are the factors affecting GPM. The following are the most important factors that influence GPM decisions.

1. Tax Rates

Tax rates on dividends and interest earned is a major influencer of GPM. Investors usually choose to invest in a country where the applied taxes on the interest earned or dividend acquired is low. Investors normally calculate the potential after-tax earnings they will secure from an investment made in foreign securities.

2. Interest Rates

High interest rates are always a big attraction for investors. Money usually flows to countries that have high interest rates. However, the local currencies must not weaken for long-term as well.

3. Exchange Rates

When investors invest in securities in an international country, their return is mostly affected by −

• The apparent change in the value of the security.
• The fluctuations in the value of currency in which security is managed.

Investors usually shift their investment when the value of currency in a nation they invest weakens more than anticipated.

Modes of International Portfolio Management

Foreign securities or depository receipts can be bought directly from a particular country’s stock exchange. Two concepts are important here which can be categorized as Portfolio Equity and Portfolio Bonds. These are supposed to be the best modes of GPM. A brief explanation is provided hereunder.

1. Portfolio Equity

Portfolio equity includes net inflows from equity securities other than those recorded as direct investment and including shares, stocks, depository receipts (American or international), and direct purchases of shares in local stock markets by foreign investors.

2. Portfolio Bonds

Bonds are normally medium to long-term investments. Investment in Portfolio Bond might be appropriate for you if:

• You have additional funds to invest.
• You seek income, growth potential, or a combination of the two.
• You don’t mind locking your investment for five years, ideally longer.
• You are ready to take some risk with your money.
• You are a taxpayer of basic, higher, or additional-rate category.

3. International Mutual Funds

International mutual funds can be a preferred mode if the Investor wants to buy the shares of an internationally diversified mutual fund. In fact, it is helpful if there are open-ended mutual funds available for investment.

4. Closed-end Country Funds

Closed-end funds invest in internationals securities against the portfolio. This is helpful because the interest rates may be higher, making it more profitable to earn money in that particular country. It is an indirect way of investing in a international economy. However, in such investments, the investor does not have ample scope for reaping the benefits of diversification, because the systematic risks are not reducible to that extent.

Drawbacks of International Portfolio Management

International Portfolio Management has its share of drawbacks too. The most important ones are listed below.

1. Unfavorable Exchange Rate Movement

Investors are unable to ignore the probability of exchange rate changes in a foreign country. This is beyond the control of the investors. These changes greatly influence the total value of foreign portfolio and the earnings from the investment. The weakening of currency reduces the value of securities as well.

2. Frictions in International Financial Market

There may be various kinds of market frictions in a foreign economy. These frictions may result from Governmental control, changing tax laws, and explicit or implicit transaction costs. The fact is governments actively seek to administer international financial flows. To do this, they use different forms of control mechanisms such as taxes on international flows of FDI and applied restrictions on the outflow of funds.

3. Manipulation of Security Prices

Government and powerful brokers can influence the security prices. Governments can heavily influence the prices by modifying their monetary and fiscal policies. Moreover, public sector institutions and banks swallow a big share of securities traded on stock exchanges.

4. Unequal Access to Information

Wide cross-cultural differences may be a barrier to GPM. It is difficult to disseminate and acquire the information by the international investors beforehand. If information is tough to obtain, it is difficult to act rationally and in a prudent manner.

Benefits of Portfolio capital flows

Foreign portfolio investment is a type of investment that an investor has abroad. A foreign portfolio investment can include a variety of different assets held in foreign countries, including bonds, stocks, and cash equivalents. They can be managed by finance professionals or directly held by an investor.

Most foreign portfolio investments are passively held by the investor. Though their liquidity does depend on the volatility of the foreign market in which they are held, foreign portfolio investments can be very liquid.

There are many benefits to having a foreign portfolio investment. It offers investors a way to diversify their holdings, and benefit from international investment diversification.

Benefits and costs of portfolio capital flows have been a subject of severe controversy. Private foreign portfolio investment in stocks, equities and bonds has been made by foreign investors in order to get higher return or higher interest on their investment and also to diversify their portfolio in order to reduce risk. Thus, Prof. Todaro rightly writes, “From the investor’s point of view, investing in the stock markets of emerging countries permits them to increase their returns while diversifying their risks.”

In the early 1990s the return on the portfolio investment in the so called ’emerging’ developing countries was quite high, for instance it was 39 per cent during 1988-93 in Latin America which is main recipient of portfolio capital flows. But the high returns were marred by high volatility of stock markets of these countries.

Benefit from Exchange Rate

International currency exchange rates keep changing. Sometimes the currency of the investor’s home country may be strong, and sometimes it may be weak. There are times when a stronger currency in the foreign country where an investor has a portfolio may benefit the investor.

Access to a Bigger Market

Home markets in the United States have become very competitive, as there are many businesses offering similar services. Foreign markets, however, offer a less competitive and sometimes larger market.

Liquidity

Where foreign portfolio investments are very liquid, they can be bought and sold quickly and easily. Higher liquidity means greater buying power for investors, as it gives them access to a ready stream of cash. That means that investors holding foreign portfolio investments are better-positioned to act quickly when good purchase opportunities arise.

The International Financial Market is the place where financial wealth is traded between individuals (and between countries). It can be seen as a wide set of rules and institutions where assets are traded between agents in surplus and agents in deficit and where institutions lay down the rules.

In present business scenario, international trade activities have increased at great pace which augmented the importance of global finance market. Global finance market mainly focuses on lending and borrowing in foreign currencies to finance the foreign trade transactions. Global finance market operate outside the domain, directive and legislature framework of a country. The numerous components of global finance market include euro currency market, export credit facility, International bond market, and institutional finance. Global finance market is dominated by issues and investors in bond. The choice of currency has important role in the area of global finance market. The most chosen currencies for global finance market is US dollars, pond, sterling, Japanese yen. The contributors in global finance market are multinationals, corporate enterprises, and government.

Forms of International Financial Markets

1. The Foreign Exchange Market

Foreign exchange market is not necessarily a physical place, but it is established network of buyer and seller through the latest technology like e-wire, internet, in addition to the postal communication system, through which a currency of one country is converted into the currency of another country. The exchanges of currency from one to another happen to satisfy the need of goods, commodities and services, in addition to invest in financial assets.

Such market is also known as Euro Currency Market. The banks who are involved in euro currency market are generally large sized commercial banks, also known as Euro Banks. Euro banks are involved in acceptance and lend the funds in currencies of the country of the globe, based on need of the citizens of the country where they are operating.

2. Euro Loan or Credit Market

The e-wired or physical market place, where the lending of funds in foreign currency is done for the period of one year or more years is known as Euro credit or Euro Loans market. Euro credit market basically supports the need of corporate, government public sectors, and Non-Government Organisations (NGOs) to operate globally, and to provide their goods, commodities, and services overseas.

3. Euro Bond Market

Euro bond market is a market in which bonds are issued in different currencies other than the currency of the home country in which they are issued. Such bonds are supporting tools for the international firms, government bodies and NGOs to raise capital for long term investment. Euro bonds are normally issued in the currency of the; issuer’s home currency in other country’s capital market.

Major Global Finance Markets

1. The US financial market

It is biggest and most versatile financial market around the globe. It offers wide range of funding options and is characterized by some of the sophisticated and innovative financial institutions. The dominant place of the Dollar in the international financial field makes it more significant. The financial system of US finance market include the network of commercial banks, domestic and foreign international banks, non-bank financial institution, insurance companies, pension funds, mutual funds, savings, and loan associations. Three authorities such as comptroller of currency the Federal Reserve board and the federal deposit insurance corporations regulate the commercial banks in the US (Gurusamy, 2009).

2. Euro market is composed of Euro dollar bond, FRNs, NIFs.

Euro dollar bond accounts for large share of euro bond issues. Syndicated euro loans are available which borrows in developing countries for frequent access (Gurusamy, 2009). The main factor that makes the Eurocurrency market so attractive to both depositors and borrowers is its lack of government regulation. This allows banks to offer higher interest rates on Eurocurrency deposits than on deposits made in the home currency, making Eurocurrency deposits attractive to those who have cash to deposit. The lack of regulation also allows banks to charge borrowers a lower interest rate for Eurocurrency borrowings than for borrowings in the home currency, making Eurocurrency loans attractive for those who want to borrow money. In other words, the spread between the Eurocurrency deposit rate and the Eurocurrency lending rate is less than the spread between the domestic deposit and lending rate. The Eurocurrency market has two disadvantages. First, when depositors use a regulated banking system, they know that the probability of a bank failure that would cause them to lose their deposits is very low. Regulation maintains the liquidity of the banking system.

In an unregulated system such as the Eurocurrency market, the probability of a bank failure that would cause depositors to lose their money is greater (although in absolute terms, still low). Thus, the lower interest rate received on home-country deposits reflects the costs of insuring against bank failure. Some depositors are more comfortable with the security of such a system and are willing to pay the price. Second, borrowing funds internationally can expose a company to foreign exchange risk. For example, consider a US company that uses the Eurocurrency market to borrow euro-pounds, perhaps because it can pay a lower interest rate on euro-pound loans than on dollar loans. Imagine, however, that the British pound subsequently appreciates against the dollar. This would increase the dollar cost of repaying the euro-pound loan and thus the company’s cost of capital. This possibility can be insured against by using the forward exchange market but the forward exchange market does not offer perfect insurance. Consequently, many companies borrow funds in their domestic currency to avoid foreign exchange risk, even though the Eurocurrency markets may offer more attractive interest rates.

3. Japanese market

Japanese financial system was integrated with the international market since 1970s. The main components of Japan’s financial system are much the same as those of other major industrialized nations: a commercial banking system, which accepted deposits, extended loans to businesses, and dealt in foreign exchange; specialized government-owned financial institutions, which funded various sectors of the domestic economy; securities companies, which provided brokerage services, underwrote corporate and government securities, and dealt in securities markets; capital markets, which offered the means to finance public and private debt and to sell residual corporate ownership; and money markets, which offered banks a source of liquidity and provided the Bank of Japan with a tool to implement monetary policy. Ministry of finance closely monitors the Japanese financial system.

Japan’s securities markets increased their volume of dealings rapidly during the late 1980s, led by Japan’s rapidly expanding securities firms. There were three categories of securities companies in Japan, the first consisting of the “Big Four” securities houses (among the six largest such firms in the world): Nomura, Daiwa, Nikko, and Yamaichi. The Big Four played a key role in international financial transactions and were members of the New York Stock Exchange. Nomura was the world’s largest single securities firm; its net capital, in excess of US$10 billion in 1986, exceeded that of Merrill Lynch, Salomon Brothers, and Shearson Lehman combined. In 1986, Nomura became the first Japanese member of the London Stock Exchange. Nomura and Daiwa were primary dealers in the United States Treasury bond market. The second tier of securities firms contained ten medium-sized firms. The third tier consisted of all the smaller securities firms registered in Japan. Many of these smaller firms were affiliates of the Big Four, while some were affiliated with banks. In 1986 eighty-three of the smaller firms were members of the Tokyo Securities and Stock Exchange. Japan’s securities firms derived most of their income from brokerage fees, equity and bond trading, underwriting, and dealing. Other services included the administration of trusts. In the late 1980s, a number of foreign securities firms, including Salomon Brothers and Merrill Lynch, became players in Japan’s financial world.

Japanese insurance companies became important frontrunners in international finance in the late 1980s. More than 90% of the population owned life insurance and the amount held per person was at least 50% greater than in the United States. Many Japanese used insurance companies as savings vehicles. Insurance companies’ assets grew at a rate of more than 20% per year in the late 1980s, reaching nearly US$694 billion in 1988. The life insurance companies moved heavily into foreign investments as deregulation allowed them to do so and as their resources increased through the spread of fully funded pension funds. These assets permitted the companies to become major players in international money markets. Nippon Life Insurance Company, the world’s largest insurance firm, was reportedly the biggest single holder of United States Treasury securities in 1989. The Tokyo Securities and Stock Exchange became the largest in the world in 1988, in terms of the combined market value of outstanding shares and capitalization, while the Osaka Stock Exchange ranked third after those of Tokyo and New York. Although there are eight stock exchanges in Japan, the Tokyo Securities and Stock Exchange represented 83% of the nation’s total equity in 1988. Of the 1,848 publicly traded domestic companies in Japan at the end of 1986, about 80% were listed on the Tokyo Securities and Stock Exchange.

4. German market

The Deutshe mark denominated German market. It occupies an important place in the entire gamut of euro market. Since 1985, Germanys’ financial system was attuned to world financial order marked by liberalization and deregulation. Universal banking is popular in Germany.

5. Swiss financial market

It is well developed banking system especially for the foreign investors who made the Swiss market global player in global financial market (Gurusamy, 2009). Presently, an estimated one-third of all worldwide offshore funds (funds held outside their country of origin) are kept in banks within Switzerland. Banking in Switzerland is regulated by the Swiss Financial Market Supervisory Authority (FINMA). FINMA is responsible for supervision of Swiss banks, stock exchanges and insurance companies. FINMA is functionally and institutionally independent from the central federal administration and reports directly to the Swiss parliament.

6. Australian market

Australian dollar became very popular in the offshore market on the issue of bonds. The Australian bonds are popular in American market. Financial markets in Australia expanded very speedily in the 1980s, following deregulation. They have continued to grow in the 1990s, but at a pace more in line with world financial markets. Relative to the size of the economy, Australian financial markets are large by international standards, and well developed. While Australia ranks around fourteenth in the world in terms of GDP, many of its financial markets rank more highly. By turnover, the foreign exchange market. Directed mainly at meeting the needs of the domestic economy, in contrast to markets in London, Singapore and Hong Kong, where most of the trading is international, rather than related to the domestic economy. The dominant participants in Australian markets are banks, especially in foreign exchange and derivatives. As a consequence, supervision of the banking system carries with it the supervision of a large part of the activity in financial markets. The Australian foreign exchange market has grown powerfully since the early 1980s, in terms of trading in both Australian dollars and other currencies. There were two phases of growth. Between 1985 and 1990, the market grew very rapidly, with average daily turnover rising from a little over $A5 billion to $A44 billion, an average annual increase of around 50 per cent. Growth stopped at the start of the 1990s as the financial system experienced a period of consolidation, but turnover picked up at a moderate pace from 1992. By 1995, turnover had reached around $A50 billion per day, an average annual increase of around 3 per cent during the five-year period.

Many factors have contributed to this growth. The deregulation of Australian markets, specifically the floating of the exchange rate and the removal of exchange controls was the major factor in the mid to late 1980s. Following that burst in activity, the expansion of the Australian foreign exchange market has been driven largely by the growth in global foreign exchange trading.

It has been observed that Australia has become progressively integrated into the global foreign exchange market, helping to bridge the time gap between the close of the New York market and the opening of the major Asian markets of Tokyo, Hong Kong and Singapore. In global context, the Australian foreign exchange market accounts for around 2.5 per cent of world turnover, ranking ninth among world trading centres. The UK, US and Japan are the three largest foreign exchange markets; between them they accounted for around 55 per cent of total turnover in April 1995.

7. Indian financial market

Indian financial market is one of the prominent financial markets of the world. It is organized early during the 19th century with the name of SEBI (Security exchange board of India). During the 1960s, there are eight security exchanges in India which has mainly three in Mumbai, Ahmadabad and Kolkata. In spite of these boards there are also boards in other cities also such as Madras, Kanpur, Delhi, Bangalore and Pune. Indian economy had remained steady because of the cost-effective control and after 1991 generally when the liberalization has been started in India which made Indian security market boom and helped Indian economy in its growth. There were also many new companies which revolving around many industries segment which are also helping in flourishing the business. After launching NSE (National stock exchange) and OTCIE (Over the counter exchange of India) especially in the mid-1990s which have also helped in the smooth trading and the transparency from the trading of the securities.

Characteristics of financial market in India

• Foreign investment – Foreign debt database which is being composed by BIS, IMF, OCEO, World Bank and investment internationally.
• Insurance
• Loans
• Mutual funds
• Foreign exchange.
• National and international markets relation
• Financial news markets
• Fixed income in sectors – Corporate Bond Prices, Interest details, Money Market, Public sector debts, External debt services, etc.
• Currency indexes, etc.

8. Sterling market

It has significant place in global financial market.

Method 1. Trade Policy Measures: Expanding Exports and Restraining Imports

Trade policy measures to improve the balance of payments refer to the measures adopted to promote exports and reduce imports.

Exports may be encouraged by reducing or abolishing export duties and lowering the interest rate on credit used for financing exports. Exports are also encour­aged by granting subsidies to manufacturers and exporters.

Besides, on export earnings lower in­come tax can be levied to provide incentives to the exporters to produce and export more goods and services. By imposing lower excise duties, prices of exports can be reduced to make them competi­tive in the world markets.

On the other hand, imports may be reduced by imposing or raising tariffs (i.e., import duties) on imports of goods. Imports may also be restricted through imposing import quotas, introducing li­censes for imports. Imports of some inessential items may be totally prohibited.

Before the economic reforms carried out since 1991. India had been following all the above policy measures to promote exports and restrict imports so as to improve its balance of payments position. But they had not achieved full success in their aim to correct balance of payments disequilibrium.

Therefore, India had to face great difficulties with regard to balance of payments. At several occasions it approached IMF to bail it out of the foreign exchange crisis that emerged as a result of huge deficits in the balance of payments. At long last, economic crisis caused by persistent deficits in balance of payments forced India to introduce structural reforms to achieve a long-lasting solution of balance of payments problem.

Method 2. Expenditure-Reducing Policies

The important way to reduce imports and thereby reduce deficit in balance of payments is to adopt monetary and fiscal policies that aim at reducing aggregate expenditure in the economy. The fall in aggregate expenditure or aggregate demand in the economy works to reduce imports and help in solving the balance of payments problem.

The two important tools of reducing aggregate expen­diture are the use of:

• Tight monetary policy and
• Concretionary fiscal policy

(i) Tight Monetary Policy

Tight monetary is often used to check aggregate expenditure or demand by raising the cost of bank credit and restricting the availability of credit. For this bank rate is raised by the Central Bank of the country which leads to higher lending rates charged by the commercial banks. This discourages businessmen to borrow for investment and consumers to borrow for buying durable consumers goods.

This therefore leads to the reduction in investment and consumption expenditure. Besides, availability of credit to lend for investment and consumption purposes is reduced by raising the cash reserve ratio (CRR) of the banks and also undertaking of open market operations (selling Government securities in the open market) by the Central Bank of the country.

This also tends to lower aggregate expenditure or demand which will helps in reducing imports. But there are limitations of the successful use of monetary policy to check imports, espe­cially in a developing country like India. This is because tight monetary policy adversely affects investment increase in which is necessary for accelerating economic growth.

If a developing country is experiencing inflation, tight monetary policy is quite effective in curbing inflation by reducing aggregate demand. This will help in reducing aggregate expenditure and, depending on the income propensity to import, will curtail imports. Besides, tight monetary policy helps to reduce prices or lower the rate of inflation. Lower price level or lower inflation rate will curb the tendency to import, both on the part of businessmen and consumers.

But when a developing country like India is experiencing recession or slowdown in-economic growth along with deficits in balance of payments, use of tight monetary policy that reduces aggre­gate expenditure or demand will not help much as it will adversely affect economic growth and deepen economic recession. Therefore, in a developing country, monetary policy has to be used along with other policies such as a appropriate fiscal policy and trade policy to tackle the problem of disequilibrium in the balance of payments.

(ii) Contractionary Fiscal Policy

Appropriate fiscal policy is also an important means of reduc­ing aggregate expenditure. An increase in direct taxes such as income tax will reduce aggregate expenditure. A part of reduction in expenditure may lead to decrease in imports. Increase in indirect taxes such as excise duties and sales tax will also cause reduction in expenditure.

The other fiscal policy measure is to reduce Government expenditure, especially unproductive or non-developmen­tal expenditure. The cut in Government expenditure will not only reduce expenditure directly but also indirectly through the operation of multiplier.

It may be noted that if tight monetary and contractionary fiscal policies succeed in lowing aggregate expenditure which causes reduction in prices or lowering the rate of inflation, they will work in two ways to improve the balance of payments. First, fall in domestic prices or lower rate of inflation will induce people to buy domestic products rather than imported goods. Second, lower domestic prices or lower rate of inflation will stimulate exports. Fall in imports and rise in exports will help in reducing deficit in balance of payments.

However, it may be emphasised again that the method of reducing expenditure through contractionary monetary and fiscal policies is not without limitations. If reduction in aggregate demand lowers investment, this will adversely affect economic growth. Thus, correction in balance of payments may be achieved at the expense of economic growth.

Further, it is not easy to reduce substantially government expenditure and impose heavy taxes as they are likely to affect incentives to work and invest and invite public protest and opposition. We thus see that correcting the balance of payments through contractionary fiscal policy is not an easy matter.

Method 3. Expenditure Switching Policies: Devaluation

A significant method which is quite often used to correct fundamental disequilibrium in balance of payments is the use of expenditure-switching policies. Expenditure switching policies work through changes in relative prices. Prices of imports are increased by making domestically produced goods relatively cheaper. Expenditure switching policies may lower the prices of exports which will encourage exports of a country. In this way by changing relative prices, expenditure-switching poli­cies help in correcting disequilibrium in balance of payments.

The important form of expenditure switching policy is the reduction in foreign exchange rate of the national currency, namely, devaluation. By devaluation we mean reducing the value or exchange rate of a national currency with respect to other foreign currencies. It should be remembered that devaluation is made when a country is under fixed exchange rate system and occasionally decides to lower the exchange rate of its currency to improve its balance of payments.

Under the Bretton Woods System adopted in 1946, fixed exchange rate system was adopted, but to correct fundamen­tal disequilibrium in the balance of payments, the countries were allowed to make devaluation of their currencies with the permission of IMF. Now, Bretton Woods System has been abandoned and most of the countries of the world have floated their currencies and have thus adopted the system of flexible exchange rates as determined by market forces of demand for and supply of them.

However, even in the present flexible exchange rate system, the value of a currency or its exchange rate as determined by demand for and supply of it can fall. Fall in the value of a currency with respect to foreign currencies as determined by demand and supply conditions is described as depreciation.

If a country permits its currency to depreciate without taking effective steps to check it, it will have the same effects as devaluation. Thus, in our analysis we will discuss the effects of fall in value of a currency whether it is brought about through devaluation or depreciation. In July 1991, when India was under Bretton-Woods fixed exchange rate system, it devalued its rupee to the extent of about 20%. (From Rs. 20 per dollar to Rs. 25 per dollar) to correct disequilibrium in the balance of payments.

Now, the question is how devaluation of a currency works to improve balance of payments. As a result of reduction in the exchange rate of a currency with respect to foreign currencies, the prices of goods to be exported fall, whereas prices of imports go up. This encourages exports and discour­ages imports. With exports so stimulated and imports discouraged, the deficit in the balance of payments will tend to be reduced.

Thus policy of devaluation is also referred to as expenditure switching policy since as a result of reduction of imports, people of a country switches their expenditure on imports to the domestically produced goods. It may be noted that as a result of the lowering of prices of exports, export earnings will increase if the demand for a country’s exports is price elastic (i.e., er > 1). And also with the rise in prices of imports the value of imports will fall if a country’s demand for imports is elastic. If demand of a country for imports is inelastic, its expenditure on imports will rise instead of falling due to higher prices of imports.

Devaluation: Marshall Lerner Condition. It is clear from above that whether devaluation or depreciation will lead to the rise in export earnings and reduction in import expenditure depends on the price elasticity of foreign demand for exports and domestic demand for imports.

Marshall and Lerner have developed a condition which states that devaluation will succeed in improving the balance of payments if sum of price elasticity of exports and price elasticity of imports is greater than one. Thus, according to Marshall-Lerner Condition, devaluation improves balance of payments if

ex + em > 1

Where,

ex stands for price elasticity of exports

em stands for price elasticity of imports

If in case of a country ex + em < 1, the devaluation will adversely affect balance of payments position instead of improving it. If ex + em = 1, devaluation will leave the disequilibrium in the balance of payments unchanged.

Income-Absorption Approach to Devaluation

Further, for devaluation to be successful in correcting disequilibrium in the balance of payments a country should have sufficient exportable surplus. If a country does not have adequate amount of goods and services to be exported, fall in their prices due to devaluation or depreciation will be of no avail.

This can be explained through income-absorption approach put forward by Sidney S Alexander. According to this approach, trade balance is the difference between the total output of goods and services produced in a country and its absorption by it.

By absorption of output of goods and services we mean how much of them is used up for consumption and investment in that country. That is, absorption means the sum of con­sumption and investment expenditure on domestically produced goods and services.

Expressing algebraically we have;

B = Y – A

Where:

B = trade balance or exportable surplus

Y = national income or value of output of goods and services produced

A = Absorption or sum of consumption and investment expenditure

It follows from above that if expenditure or absorption is less than national product, it will have positive trade balance or exportable surplus. To create this exportable surplus, expenditure on domestically produced consumer and investment goods should be reduced or national product must be raised sufficiently.

To sum up, it follows from above that for devaluation or depreciation to be successful in correcting disequilibrium in the balance of payments, the sum of price elasticities of demand for a country s exports and imports should be high (that is, greater than one) and secondly it should have sufficient exportable surplus. The devaluation will also not be successful in the achievement of its aim if other countries retaliate and make similar devaluation in their currencies and thus competitive devaluation of the exchange rate may start.

After Independence India devalued its currency three times, first in 1949, the second in June 1966 and third in July 1991 to correct the disequilibrium in the balance of payments. The devalua­tion of June 1966 was not successful for some time to reduce deficit in the balance of payments.

This is because the demand for bulk of our traditional exports was not very elastic and also we could not reduce our imports despite their higher prices. However devaluation of July 1991 proved quite successful as after it our exports grew at a rapid rate for some years and growth of imports remained within safe limits.

Method 4. Exchange Control

Finally, there is the method of exchange control. We know that deflation is dangerous; devalu­ation has a temporary effect and may provoke others also to devalue. Devaluation also hits the prestige of a country. These methods are, therefore, avoided and instead foreign exchange is controlled by the government.

Under it, all the exporters are ordered to surrender their foreign exchange to the central bank of a country and it is then rationed out among the licensed importers. None else is allowed to import goods without a licence. The balance of payments is thus rectified by keeping the imports within limits.

After the Second War World a new international institution’ International Monetary Fund (IMF)’ was set up for maintaining equilibrium in the balance of payments of member countries for a short term. Member countries borrow from it for a short period to maintain equilibrium in the balance of payments. IMF also advises member countries how to correct fundamental disequilibrium in the balance of Payments when it does arise. It may, however, be mentioned here that no country now needs to be forced into deflation (and so depression) to root out the causes underlying disequilib­rium as had to be done under the gold standard. On the contrary, the IMF provides a mechanism by which changes in the rates of foreign exchange can be made in an orderly fashion.

Conclusion

In short, correction of disequilibrium calls for a judicious combination of the following methods:

• Monetary and fiscal changes affecting income and prices in the country
• Exchange rate adjustment, i.e., devaluation or appreciation of the home currency;
• Trade restrictions, i.e., tariffs, quotas, etc.
• Capital movement, i. e., borrowing or lending aboard
• Exchange control

No reliance can be placed on any single tool. There is room for more than one approach and for more than one device. But the application of the tools depends on the nature of the disequilibrium.

There are, we have said, three types of disequilibrium:

• Cyclical disequilibrium,
• Secular disequilibrium,
• Structural disequilibrium (at the goods and the factor level)

It is more appropri­ate that fiscal measures should be used to correct cyclical disequilibrium in the balance of payments. To correct structural disequilibrium adjustment in exchange rate should be avoided. Capital movements are needed to offset deep-seated forces in secular disequilibrium.

The main methods of desirable adjustment are, therefore, monetary and fiscal policies which directly affect income, and exchange depreciation (that is, devaluation) which affects prices in the first instance. Devaluation or depreciation of exchange rate can also have income effect through price effects. Monetary and fiscal policies affect relative prices also.

Overall account of BOP is always in equilibrium. This balance or equilibrium is only in accounting sense because deficit or surplus is restored with the help of capital account.

In fact, when we talk of disequilibrium, it refers to current account of balance of payment. If autonomous receipts are less than autonomous payments, the balance of payment is in deficit reflecting disequilibrium in balance of payment.

Causes of disequilibrium in BOP

There are several factors which cause disequilibrium in the BOP indicating either surplus or deficit.

Such causes for disequilibrium in BOP are listed below:

(i) Economic Factors

• Imbalance between exports and imports. (It is the main cause of disequilibrium in BOR)
• Large scale development expenditure which causes large imports
• High domestic prices which lead to imports
• Cyclical fluctuations (like recession or depression) in general business activity
• New sources of supply and new substitutes.

(ii) Political Factors

Experience shows that political instability and disturbances cause large capital outflows and hinder Inflows of foreign capital.

(iii) Social Factors

Changes in fashions, tastes and preferences of the people bring disequilibrium in BOP by influencing imports and exports

High population growth in poor countries adversely affects their BOP because it increases the needs of the countries for imports and decreases their capacity to export.

Other Causes of Disequilibrium in the Balance Payments

Cause 1. Cyclical Disequilibrium

Cyclical disequilibrium is caused by the fluctuations in the economic activity or what are known as trade cycles.

During the periods of prosperity, prices of goods fall and incomes of the people go down. These changes in incomes of the people and prices of goods affect exports and imports of goods and thereby influence the balance of payments.

“If prices rise in pros­perity and decline in depression, a country with a price elasticity for imports greater than unity will experience a tendency for a decline in the value of imports in prosperity, while those for which imports price elasticity is less than one will experience a tendency for increase. These tendencies may be overshadowed by the effects of income changes, of course. Conversely, as prices decline in depression, the elastic demand will bring about an increase in imports, the inelastic demand a decrease.”

Cause 2. Secular or Long-Run Disequilibrium

Secular (long-run) disequilibrium in balance of payments occur because of long-run and deep-seated changes in an economy as it develops from one stage of growth to another. The current account in the balance of payments follows a varying pattern from one stage to another. In the initial stages of development, domestic investment exceeds domestic savings and imports exceed exports. Disequilibrium arises due to lack of sufficient funds available to finance the import surplus, or the import surplus is not covered by available capital from abroad.

Then comes a stage of growth when domestic savings tend to exceed domestic investment and export outrun imports. Disequilibrium may result because the long-term capital outflow falls short of the surplus savings or because surplus savings exceed the amount of investment opportunities abroad. At a still later stage of growth domestic savings tend to equal domestic investment and long- term capital movements are , on balance, zero.

Thus we see that a secular disequilibrium will occur when either the long-term capital move­ments get out of adjustment with deep-seated factors affecting savings and investment, or planned savings and investment change without an offsetting change in the movement of long-term capital. If investment adjusted itself readily to the amount of domestic savings plus foreign capital there could be no tendency for secular disequilibrium.

The balance-of-payments position will be in equilibrium, if the international capital flow falls into line with the requirements of domestic investment minus domestic savings. There is a tendency to secular disequilibrium, because of domestic savings and domestic investment are independent of the foreign capital flow and are of different magnitudes.

There is a strong tendency for underdevel­oped countries to over-invest and/or under save. The underdeveloped countries are investing larger than their domestic savings and exports allow them because they are eager to accelerate the rate of economic growth. This tendency to over-invest causes a secular disequilibrium in the balance of payments.

Cause 3. Technological Disequilibrium

Technological disequilibrium in the balance of payments is caused by various technological changes. Technological changes involve inventions or innovations of new goods or new techniques of production. These technological changes affect the demand for goods and productive factors which in turn influence the various items in the balance of payments.

Each technological change implies a new comparative advantage to which a country adjusts to. The innovation leads to increased exports if it is a new good and export-biased innovation. The innova­tion may lead to decline in imports if it is import-biased. This will create a disequilibrium. A new equilibrium will require either increased imports or reduced exports.

Cause 4. Structural Disequilibrium

Let us see how the structural type of disequilibrium is caused. “Struc­tural disequilibrium at the goods level occurs, when a change in demand or supply of exports alters a previously existing equilibrium, or when a change occurs in the basic circumstances under which income is earned or spent abroad, in both cases without the requisite parallel changes elsewhere in the economy.”

Suppose demand in foreign countries for Indian handicrafts falls. The resources engaged in the production of these handicrafts must shift to some other line or the country must restrict imports, otherwise the country will experience a structural disequilibrium. A change in supply may also cause a structural disequilibrium. Suppose Indian jute crop falls because of the change in the shift in the crop-pattern, Indian jute exports will fall and a disequilibrium will be created.

Apart from goods, a loss of service income may also upset the balance-of-payments position on current account. Besides, the loss of income may arise because foreign investment has proved a failure or it has been confiscated or nationalised, e.g. nationalisation of Anglo-Iranian Company in Iran. A war also produces structural changes which may affect not only goods but also factors of production.

A deficit arising from a structural change can be filled by increased production or decreased expenditure, which in turn affect international transactions in increased exports or decreased imports. Actually, it is not so easy because the resources are relatively immobile and expenditure not readily compressible. Under such circumstances, more drastic steps are called for to correct a serious disequilibrium.

“Structural disequilibrium at the factor level results from factor prices which fail to reflect accurately factor endowments … i.e., when factor prices, out or line with factor endowments, distort the structure of production from the allocation of resources which appropriate factor prices would have indicated.” If, for instance, the price of labour is too high, it will be used more sparingly and the country will import highly capital-intensive equipment and machinery. This will lead to disequi­librium in the balance of payments on the one hand and unemployment of labour on the other.

Measures to correct disequilibrium in BOP

Sustained or prolonged deficit has to be settled by short term loans or depletion of capital reserve of foreign exchange and gold.

Following remedial measures are recommended:

(i) Export promotion

Exports should be encouraged by granting various bounties to manufacturers and exporters. At the same time, imports should be discouraged by undertaking import substitution and imposing reasonable tariffs.

(ii) Import

Restrictions and Import Substitution are other measures of correcting disequilibrium.

(iii) Reducing inflation

Inflation (continuous rise in prices) discourages exports and encourages imports. Therefore, government should check inflation and lower the prices in the country.

(iv) Exchange control

Government should control foreign exchange by ordering all exporters to surrender their foreign exchange to the central bank and then ration out among licensed importers.

(v) Devaluation of domestic currency

It means fall in the external (exchange) value of domestic currency in terms of a unit of foreign exchange which makes domestic goods cheaper for the foreigners. Devaluation is done by a government order when a country has adopted a fixed exchange rate system. Care should be taken that devaluation should not cause rise in internal price level.

(vi) Depreciation

Like devaluation, depreciation leads to fall in external purchasing power of home currency. Depreciation occurs in a free market system wherein demand for foreign exchange far exceeds the supply of foreign exchange in foreign exchange market of a country (Mind, devaluation is done in fixed exchange rate system.)

The balance of payments is the record of all international trade and financial transactions made by a country’s residents.

The balance of payments has three components the current account, the financial account, and the capital account. Current accounts measure international trade, net income on investments, and direct payments. The financial account describes the change in international ownership of assets. The capital account includes any other financial transactions that don’t affect the nation’s economic output.

Balance of Payments

The Balance of Payments or Balance of Payments is a statement or record of all monetary and economic transactions made between a country and the rest of the world within a defined period (every quarter or year). These records include transactions made by individuals, companies and the government. Keeping a record of these transactions helps the country to monitor the flow of money and develop policies that would help in building a strong economy.

In a perfect scenario, the Balance of Payments (Balance of Payments) should be zero. That is, the money coming in and the money going out should balance out. But that doesn’t happen in most cases. A country’s Balance of Payments statement correctly indicates whether the country has a surplus or a deficit of funds. A Balance of Payments surplus indicates that a country’s exports are more than its imports. A Balance of Payments deficit, on the other hand, indicates that a country’s imports are more than exports. Both scenarios have short-term and long-term effects on the country’s economy.

Components of Balance of Payments

Now let’s understand the different components of the Balance of Payments. The Balance of Payments consists of three main components current account, capital account, and financial account. As mentioned earlier, the Balance of Payments should be zero. The current account must balance with the combined capital and financial accounts.

1. Current Account

The current account monitors the flow of funds from goods and services trade (import and export) between countries. Now this includes money received or spent on manufactured goods and raw materials. It also includes revenue from tourism, transportation receipts, revenue from specialized services (medicine, law, engineering), and royalties from patents and copyrights. In addition, the current account includes revenue from stocks.

2. Capital Account

The capital account monitors the flow of international capital transactions. These transactions include the purchase or disposal of non-financial assets (for example, land) and non-produced assets. The capital account also includes money received from debt-forgiveness and gift taxes. In addition, the capital account records the flow of the financial assets by migrants leaving or entering a country and the transfer, sale, or purchase of fixed assets.

3. Financial Account

The financial account monitors the flow of funds pertaining to investments in businesses, real estate, and stocks. It also includes government-owned assets such as gold and Special Drawing Rights (SDRs) held with the International Monetary Fund (IMF). In addition, it includes foreign investments and assets held abroad by nationals. Similarly, the financial account includes a record of the assets owned by foreign nationals.

Importance of Balance of Payments

The Balance of Payments statement provides a clear picture of the economic relations between different countries. It is an integral aspect of international financial management. Now that you have understood Balance of Payments and its components, let’s look at why it is important.

To begin with, the Balance of Payments statement provides information pertaining to the demand and supply of the country’s currency. The trade data shows a clear picture of whether the country’s currency is appreciating or depreciating in comparison with other countries. Next, the country’s Balance of Payments determines its potential as a constructive economic partner. In addition, a country’s Balance of Payments indicates its position in international economic growth.

By studying its Balance of Payments statement and its components closely, a country would be able to identify trends that may be beneficial or harmful to the economy and take appropriate measures.

Purchasing Power Parity Theory

The theory aims to determine the adjustments needed to be made in the exchange rates of two currencies to make them at par with the purchasing power of each other. In other words, the expenditure on a similar commodity must be same in both currencies when accounted for exchange rate. The purchasing power of each currency is determined in the process.

Purchasing power parity is used worldwide to compare the income levels in different countries. PPP thus makes it easy to understand and interpret the data of each country.

Example: Let’s say that a pair of shoes costs Rs 2500 in India. Then it should cost $50 in America when the exchange rate is 50 between the dollar and the rupee.

Purchasing power parity theory is based on a market-basket approach to comparing the cost of living between two or more countries. The concept is simple in principle: Compare how much consumers pay for the same types of items in their own currency and use the comparative information to determine the relative costs of living for the economies in question.

For example, suppose a computer costs $1,000 in the United States, and the very same computer can be purchased for £900 in England. The exchange rate between these two currencies is easy to look up: In October 2019, 1 British pound was equivalent to $1.28 in U.S. currency.

In other words, the £900 computer would cost, in dollars, 900 x 1.28, or $1,152. In this (entirely hypothetical) example, a consumer in England is paying about 15 percent more than a consumer in the U.S. for the same item. If that is true across the board for other goods, then the cost of living in England, or its PPP, is 15 percent greater than in the U.S.

Purchasing Power Parity Theory in Practice

While the concept behind purchasing power parity may be straightforward, in practice, it’s difficult to come up with realistic comparisons. The key issue is the wide variability in products and services available in different countries. The computers sold in Britain and in the U.S., though similar, may not be exactly the same – and even if they are, they may not come bundled with the same software, subscriptions, technical assistance packages and so on.

Comparing housing costs from one country to another can also be challenging, especially when lifestyles may differ significantly. An apartment dweller in New York City has a very different living experience than, say, a reindeer herder in Lapland or a villager in rural Nigeria.

To get around these difficulties with PPP theory, international organizations like the United Nations and the World Bank have attempted to standardize market-basket comparisons, making whatever adjustments are needed to account for local differences.

Purchasing Power Parity Theory and GDP

National economies are compared using a metric known as the gross domestic product, or GDP. This measures the value of all the goods and services produced in a country during a year. The size of countries’ economies can be ranked by comparing the size of the GDP of each nation. But it’s not as simple as it sounds.

The key issue, once again, revolves around comparing currencies. The GDP of the United States is measured in dollars; Britain’s, in pounds; China’s in yuan; Japan’s in yen; Germany, France and other EU members’ in Euros; and so on. Before they can be compared, the GDPs need to be converted to a common unit of currency. In international circles, the conversion is usually expressed as dollars.

If the official exchange rates (say, between the U.S. dollar and the Chinese yuan) are used for the conversion, then the ranking of the top five economies in the world (in 2018-2019) looks like this:

• India
• United States
• China
• Japan
• Germany

However, if the PPP of each currency is used to determine conversion rates, as suggested by purchasing PPP theory, then the list takes on a different look:

• China
• United States
• India
• Japan
• Germany

These differences reflect differences in the cost of living in the countries, as indicated in the PPP market-basket calculations. China and India, generally have lower costs of living, so the money circulating in the economies of these countries goes farther, so to speak, than an equivalent amount of cash would go in the economies of the U.S., Germany and Japan.

Interest Rate Theories

Interest rate theories use the inflation rates in determining the exchange rates, unlike the price levels used under the PPP theory.

Fisher Effect theory

Establishing a relationship between the inflation and interest rates, the Fisher Effect (FE) theory states that the nominal interest rate ‘r’ in a country is determined by the real interest rate ‘R’ and the expected inflation rate ‘i’ as follows

(1 + Nominal interest rate) = (1 + Real interest rate)

(1 + Expected inflation rate)

(l + r) = (l + R)( 1 + i)

or r = R + i + Ri

Since, Ri is of negligible value, the preceding equation is generally approximated as

r = R + i

Nominal interest rate = Real interest rate + Expected inflation rate

Real interest rate is used to assess exchange rate movements as it includes interest and inflation rates, both of which affect exchange rates. Given all other parameters constant, there is a high co-relation between differentials in real interest rate and the exchange rate of a currency.

International Fisher Effect theory

The International Fisher Effect (IFE) combines the PPP and the FE to determine the impact of relative changes in nominal interest rates among countries on their foreign exchange values. According to the PPP theory, the exchange rates will move to offset changes in inflation rate differentials.

Thus, a rise in a country’s inflation rate relative to other countries will be associated with a fall in its currency’s exchange value. It would also be associated with a rise in the country’s interest rate relative to foreign interest rates. A combination of these two conditions is known as the IFE, which states that the exchange rate movements are caused by interest rate differentials.

If real interest rates are the same across the country, any difference in nominal interest rates could be attributed to differences in expected inflation. Foreign currencies with relatively high interest rates will depreciate because the high nominal interest rates reflect expected inflation.

The IFE explains that the interest rate differential between any two countries is an unbiased predictor of the future changes in the spot rate of exchange.

Other Determinants of Exchange Rates

In addition to inflation, real income, and interest rates, other market fundamentals that influence the exchange rates include bilateral trade relationships, customer tastes, investment profitability, product availability, productivity changes, and trade policies.