a) Define the following:

Balance of trade; balance of invisible transfers; current account balance;

capital account balance and BALANCE OF PAYMENTs.

Ans a) balance of trade

A country's exports minus its imports; the largest component of a country's BALANCE
OF PAYMENTs. Balance of trade figures, also called net exports (NX), are the sum of
the money gained by a given economy by selling exports, minus the cost of buying
imports. They form part of the BALANCE OF PAYMENTs, which also includes other
transactions such as the international investment position.

The figures are usually split into visible and invisible balance figures. The visible balance
represents the physical goods, and invisible represents other forms of trade, e.g. the
service economy.

A positive balance of trade is known as a trade surplus and consists of exporting more (in
financial capital terms) than one imports. A negative balance of trade is known as a trade
deficit or, informally, as a trade gap, and consists of importing more than one exports.
Neither is necessarily dangerous in modern economies, although large trade surpluses or
trade deficits may sometimes be a sign of other economic problems.

Factors that can affect the balance of trade figures include:

Prices of goods manufactured at home (influenced by the responsiveness of supply),
Exchange rates, and
Trade agreements or barriers
other tax, tariff and trade measures

Measuring the BALANCE OF PAYMENTs can be problematic, due to problems with

recording and collecting data. As an illustration of this problem, when official data for all
countries in the world is added up it appears that the world is running a positive
BALANCE OF PAYMENTs with itself. The total reported amount of exports in the
world is greater by a few percent than the total reported amount of imports. This cannot
be true, because all transactions involve an equal credit or debit in the account of each
nation. The discrepancy is widely believed to be explained by transactions intended to
launder money or evade taxes, and other visibility problems.

balance of invisible transfers

invisible balance

1
The invisible balance is that part of the balance of trade figures that refers to services and
commercial money transfer that does not result in the transfer of physical objects.
Examples include consulting services, tourism, and patent license revenues. In countries
with more developed economies, this is a very important part of the figure, as a more
developed economy is liable to import basic goods and food owing to the cheaper costs
of production (especially labour) abroad. In order to get the balance of trade positive, the
invisible balance must be greater than the negative effect of the visible balance.

The Current Account

The current account is used to mark the inflow and outflow of goods and services into a
country. Earnings on investments, both public and private, are also put into the current
account.

Within the current account are credits and debits on the trade of merchandise, which
includes goods such as raw materials and manufactured goods that are bought, sold or
given away (possibly in the form of aid). Services refer to receipts from tourism,
transportation (like the levy that must be paid in Egypt when a ship passes through the
Suez Canal), engineering, business service fees (from lawyers or management consulting,
for example), and royalties from patents and copyrights. When combined, goods and
services together make up a country's balance of trade (BOT). The BOT is typically the
biggest bulk of a country's BALANCE OF PAYMENTs as it makes up total imports and
exports. If a country has a balance of trade deficit, it imports more than it exports, and if
it has a balance of trade surplus, it exports more than it imports.

Receipts from income-generating assets such as stocks (in the form of dividends) are also
recorded in the current account. The last component of the current account is unilateral
transfers. These are credits that are mostly worker's remittances, which are salaries sent
back into the home country of a national working abroad, as well as foreign aid that is
directly received.

The Capital Account

The capital account is where all international capital transfers are recorded. This refers to
the acquisition or disposal of non-financial assets (for example, a physical asset such as
land) and non-produced assets, which are needed for production but have not been
produced, like a mine used for the extraction of diamonds.

The capital account is broken down into the monetary flows branching from debt
forgiveness, the transfer of goods, and financial assets by migrants leaving or entering a
country, the transfer of ownership on fixed assets (assets such as equipment used in the
production process to generate income), the transfer of funds received to the sale or
acquisition of fixed assets, gift and inheritance taxes, death levies, and, finally, uninsured
damage to fixed assets.

2
BALANCE OF PAYMENTs The BALANCE OF PAYMENTs (BOP) is the method
countries use to monitor all international monetary transactions at a specific period of
time. Usually, the BOP is calculated every quarter and every calendar year. All trades
conducted by both the private and public sectors are accounted for in the BOP in order to
determine how much money is going in and out of a country. If a country has received
money, this is known as a credit, and, if a country has paid or given money, the
transaction is counted as a debit. Theoretically, the BOP should be zero, meaning that
assets (credits) and liabilities (debits) should balance. But in practice this is rarely the
case and, thus, the BOP can tell the observer if a country has a deficit or a surplus and
from which part of the economy the discrepancies are stemming.

b) Prepare a write up on the merits and demerits of currency convertibility for a

developing country.

Ans b ) Convertibility of a currency refers to the freedom to exchange one currency for
another currency or gold at the prevailing rate of exchange. Most businesses – both
foreign and local – have faced severe restrictions in conducting business in India mainly
due to the absence of free convertibility of rupee. This major barrier has forced many
foreign investors to hold back investments or suspend future planned investments in
India. The inconvertibility of rupee has negatively impacted international trade. To
remove these impositions, the Government of India had decided to relax slowly
restrictions imposed on currency convertibility. The process of lifting barriers started
after the commencement of the new trade policy of 1991. Till now, this process has gone
through three phases, discussed below.
EXIMSCRIPS SCHEME
Before the announcement of the new trade policy (1991), the import licensing system
was characterized by undesirable bureaucratic delays. It was also posed with several
problems such as corruption, nepotism, and misuse. To overcome these problems, the
eximscrips scheme was introduced in July 1991. Eximscrips were tradable import
licences that could be used to import a wide range of items, which were earlier
importable against supplementary licences.
To balance above issue, eximscrips were issued for an amount equal to the exports and
were limited by the foreign exchange made available. The government, to meet its needs
and to pay for licensed imports, could utilize 70 percent of the foreign exchange acquired
at the official rate. This scheme was abolished in 1992.

PARTIAL CONVERTIBILITY AND LERMS

In March 1992, eximscrips scheme was replaced with the Liberalized Exchange Rate
Management System (LERMS). Like eximscrips scheme, LERMS also retained all
essential elements such as link between exports and imports. Unlike eximscrips scheme,
complete LERMS is operated through banking system, which helps to eliminate the need
for issuance of eximscrips or import licences.
LERMS is a dual exchange rate arrangement. Under this scheme, 40 percent of the
foreign exchange earnings on current transactions has to be given to the RBI or any

3
authorized dealers at the official exchange rate for official purpose. The remaining 60
percent of foreign exchange can be converted at market rate. The foreign exchange
submitted at the official rate is to be used only to import essential items and the foreign
exchange converted at market rate can be utilized to finance all authorized and approved
transactions.

FULL CONVERTIBILITY ON CURRENT ACCOUNT

De facto, the dual exchange rate is undesirable to exporters and other foreign exchange
earners who have to surrender 40 percent of their foreign earnings at official rate. So, the
government has decided to eliminate, but slowly, the dual exchange rate system. The
government, therefore, made the rupee fully convertible on trade account from March
1993. In March 1994, the government made the rupee fully convertible on current
account, which includes trade in merchandise and trade in invisibles (e.g. services).
Today, the exporters are allowed to convert their entire foreign exchange earnings earned
on current account transactions at the market rate.
In March 1993, the dual exchange rate arrangement was abolished and replaced with
single market determined exchange rate system. Further, the rupee was made floating in
the same year. Under this new arrangement, there is no official exchange rate for the
rupee and the market forces (that is, supply and demand conditions in the foreign
exchange market) purely determine the exchange rate. But, the Reserve Bank of India
(RBI) intervenes, whenever required, to curb excessive speculation and undesirable
conditions in the market.
Despite the rupee being made fully convertible on current account transactions, full
convertibility was far from real. Though FERA was liberalized, some of the provisions of
the Act prohibit the free outflow of foreign currency from the country. In 1999, the
FERA was replaced with the FEMA (Foreign Exchange Management Act). Under this
Act, any person may sell or draw foreign exchange to or from an authorized person when
such sale or drawal is a current account transaction. However, the central government
may, in the public interest and in consultation with RBI, impose reasonable restrictions
for current account transactions.
Currency convertibility is a simple concept. It means residents and non-residents of a
country are able to exchange domestic currency for foreign currency. However, there are
many degrees of convertibility, reflecting the extent to which governments impose
controls on the exchange and use of currency. When convertibility is restricted, financial
risk increases, and so the risk-adjusted interest rate employed to value assets is higher
than it would be with full convertibility. That is because property is held hostage and
subject to a potential ransom through expropriation. As a result investors are willing to
pay less for each dollar of prospective income and the value of property is less than it
would be with full convertibility.

Therefore, investors become justifiably nervous when it seems a government is

considering the imposition of exchange controls. At this point, settled money becomes
"hot" and capital flight occurs. Asset owners liquidate their property and get out while the
getting is good. Contrary to popular wisdom, restrictions on convertibility do not retard
capital flight; they promote it.

4
As we enter the 21st century, globalization (the liberalization of financial and trade
flows) is threatened. Volatile hot money flows are identified as the problem and exchange
controls as the remedy. This prescription, which is based on a wrongheaded diagnosis,
will lead to monetary nationalism and the type of economic chaos the world encountered
after World War I. The only way to avoid such a disaster is for developing countries to
unify their currencies with stronger ones