Balance of Payments and Forex Important Questions
1. If the US dollar becomes costlier in terms of the Indian rupee, it is good as well as bad for domestic growth. How?
Ans. (i) It is good because of the purchasing power of the US dollar in the Indian market increases. Accordingly, demand for domestic goods is expected to rise. Implying a rise in exports and therefore, a rise in GDP.
(ii) It is bad because imports of essential capital goods ( critical for growth) become expensive. It inflates CAD ( current account deficit) and borrowings from the rest of the world.
2. When the foreign exchange rate in a country is on the rise, what impact is it likely to have on exports and imports, and how?
Ans. A unit of the domestic currency will now buy fewer goods from the rest of the world while a unit of foreign currency can now buy more goods in the domestic economy. Goods produced in the domestic economy become cheaper to buyers abroad while foreign goods become relatively expensive to the domestic buyers. As a result, exports are expected to rise and imports are expected to fall.
3. “Trade deficit must exist if a country is facing a situation of Current Account Deficit”. Defend or refute the statement, with a valid argument.
Ans. The given statement is refuted as the Current Account Deficit (CAD) is a broader concept. CAD occurs when the foreign exchange payments on account of visible, invisible, and current transfers are in excess of the receipts of visible, Invisibles, and current transfers.
4. Why demand curve of foreign exchange is downward sloping?
When the price of foreign currency rises, its demand falls. Explain why?
Ans. The demand curve of foreign exchange slopes downwards due to the inverse relationship between demand for foreign exchange and the foreign exchange rate.
In the given fig. Demand for foreign exchange (USD) and the rate of foreign exchange are shown on the horizontal axis and vertical axis respectively. The demand curve is downward sloping. It means that less foreign exchange is demanded as the exchange rate increases. This is due to the fact that a rise in the price of foreign exchange increases the rupee cost of foreign goods, which makes them more expensive. As a result, imports decline. Thus, demand for foreign exchange decreases.
5. Why supply curve of foreign exchange is upward sloping?
Ans. The supply curve of foreign exchange slopes upwards due to the positive relationship between the supply for foreign exchange and the foreign exchange rate.
In fig, supply for foreign exchange (USD) and rate of foreign exchange are shown on the horizontal axis and vertical axis respectively. The supply curve is upward sloping which means that more foreign exchange is supplied as the exchange rate increases. This is due to the fact that domestic goods become cheaper to foreigners since the rupee is depreciating in value. The demand for our exports should, therefore, increase as the exchange rate increases. The increased demand for our exports will translate into a greater supply of foreign exchange. Thus, the supply of foreign exchange increases as the exchange rate increases.
6. Balance of payments always balances. Explain why?
Ans. Since the balance of payment is based upon a system of double-entry book-keeping, the total debits must equal total credits. This is because two aspects of each transaction recorded are equal in amount but appear on opposite sides of the balance of payments account. In this accounting sense, balances of payments for a country must always balance. The debit side shows the use of total foreign exchange acquired in a particular period. The credit side shows the sources from which the foreign exchange is acquired during a particular period. Against every credit entry, there is an offsetting debit entry & vise-versa, so the receipts and payments on these two sides must be equal. Hence the two sides must necessarily balance. If X imports from Y, Y would also import from X. Hence there would be debit and credit entries in the balance of payments of both the countries X & Y. The individual items in the balance of payments may not balance. But the total credits of the country must be equal to its total debts. If there is any deficit in any individual account, it would be covered by a surplus in other accounts, if there is any difference between total debits and total credits, it would be settled under ‘errors & omissions. Hence in the accounting sense, the balance of payments of a country always balances.
7. Balance of payments always balances. Does it mean a situation of zero net financial obligation for a country?
Ans. It is only in the accounting sense that balance of payment is always balanced. From a practical point of view, it should not be interpreted as a situation of zero net financial obligation for a country. A negative balance on the current is equated with a positive balance in the capital account. But the positive balance in the capital account may have been achieved through loans from the rest of the world. All loans are financial obligations to the rest of the world.
8. Recently Government of India has doubled the import duty on gold. What impact is it likely to have on the foreign exchange rates and how?
Ans. With the doubling of the import duty, the commodity is set to cost more now. Since most of the demand for gold is met by imports, with the increased import duty gold is likely to fall. This will reduce the demand for foreign exchange. Other things remaining constant, a reduction in the demand for foreign exchange will lead to (i) a fall in the foreign exchange rate and (ii) a reduction in CAD (current account deficit).
9. ‘Devaluation and depreciation of currency are one and the same thing’. Do you agree? How do they affect the exports of a country?
Ans. Devaluation and depreciation are different terms.
Devaluation is the fall in the value of the domestic currency in relation to foreign currency as planned by the government in a situation when the exchange rate is not determined by the forces of supply and demand but is fixed by the government of different countries.
Depreciation, on the other hand, is the fall in the value of the domestic currency in relation to foreign currency in a situation when the exchange rate is determined by the forces of supply and demand in the international money market.
However, both devaluation and depreciation lead to a fall in the value of the domestic currency in relation to foreign currency. Consequently, domestic goods become cheaper in terms of foreign currency. Accordingly, exports tend to rise (while imports are discouraged).
10. How are NRI deposits significant for us?
Ans. NRI deposits in India are reflected as capital receipts in the BoP accounts. These add to the supply of foreign exchange for the Indian economy. This foreign exchange can be used to offset the current account deficit which usually remains high. In the event of low NRI deposits, we have to depend on commercial borrowings from the rest of the world which lead to the high burden of interest payments.
Also, a constant supply of foreign exchange ( by way of NRI deposits) keeps the exchange rate under check. This facilitates the import of essential goods like crude oil.
11. What are NRI deposits and NRI remittances? What is the difference between the two?
Ans. NRI deposits are foreign currency deposits made in an Indian bank by a non-resident Indian. These deposits can be repatriated by the NRI on maturity along with the interest earned. There are different kinds of schemes offered to NRIs like FCNR (B) or foreign currency non-resident (banks) and non-resident external (rupee accounts or NRE (RA). The flows from such deposits predominantly come from the middle-east Asian countries, where working Indians typically use the money on return to the home.
On the other hand, remittances are foreign currency funds sent by NRIs to their folks in India. These funds are essentially in the name of relatives, mostly immediate family. These are meant for their maintenance and upkeep and hence, can not be repatriated. Such funds come mainly from North America and Europe, besides the Gulf countries.
While NRI deposits can be repatriated on maturity or rolled over, they are essentially investments. From the balance of payments -the country’s external sector balance sheet -perspective, NRI deposits are capital flows and hence, vulnerable to outflows. They have been an important source of foreign exchange in times of crisis.
12. The country needs a huge amount of imports for developmental programmes. Name one step which the central bank can take to make imports cheaper using the foreign exchange market.
Ans. By selling foreign exchange in the international money market from its reserves, the central bank can increase the supply of foreign exchange, leading to a fall in the foreign exchange rate or appreciation of the domestic currency. This will make imports cheaper.
13. Would you always justify the depreciation of the Indian currency as it leads to a rise in exports?
Ans. Of course, depreciation of the currency leads to a rise in exports. Because a unit of foreign currency (say US dollar) is now exchanged for more rupees. But it does not mean that continuous depreciation of our currency is always good. The reason is this: continuous depreciation of the currency would make imports costlier over time. There are certain essential imports (like crude oil) that cannot be cut to any significant extent. Accordingly, continuous depreciation of the currency would lead to higher and higher import bills. Maybe, what we earn by way of additional export receipts are lower than what we lose by way of additional import payments (when there is currency depreciation). Thus, the stability of the exchange rate is always better than the swings in it.
14. (a) Distinguish between appreciation of the home currency and depreciation of the home currency.
(b) What is meant by “current account surplus”?
(c) State any one source of supply of foreign currency for a country.
Ans. (a) The main differences between appreciation of the home currency and depreciation of home currency are as under:
(i) Appreciation of home currency refers to a situation when a home ( domestic) currency appreciates in relation to a foreign currency. On the other hand, depreciation of home currency refers to a situation when the home (domestic) currency depreciates in relation to a foreign currency.
(ii) In case of appreciation of the home currency, fewer rupees are to be paid to buy one US dollar. Because domestic currency (rupee) gains its value in relation to the US dollar. On the other hand, in case of depreciation of the home currency, more rupees are to be paid to buy one US dollar. Because domestic currency (rupee) loses its value in relation to the US dollar.
(b) Current account surplus occurs when receipt of foreign exchange on account of the export of visible and invisible items of trade is greater than the payment of foreign exchange on account of the import of these items.
(c) Purchases of domestic goods by foreigners.
15. Explain the reason for the inverse relationship between the price of a foreign currency and its demand.
Ans. There is an inverse relationship between the price of a foreign currency and its demand. The reasons for this inverse relationship are as under:
(i) When a foreign currency (say US dollar) becomes cheaper (in relation to the domestic exchange), we get more dollars per unit of our currency. Accordingly, imports become lucrative. This raises demand for foreign currency.
(ii) When foreign currency becomes cheaper and purchasing power of domestic currency increases in the international money market, domestic investors will be induced to make a greater investment in the rest of the world. Accordingly, demand for foreign currency rises.
(iii) When foreign currency becomes cheaper, Indians will find it less expensive to travel abroad. Accordingly, demand for foreign currency will rise.
The opposite will happen in case foreign currency becomes expensive.
16. When the price of a foreign currency falls, the supply of that foreign currency also falls. Why?
Ans. A fall in the price of a foreign currency causes a fall in its supply, owing to the following reasons:
(i) Now domestic currency becomes dearer in relation to the foreign currency. Accordingly, foreign investors will make lesser investments in the domestic economy. Both FDI and FII will fall. Implying, a fall in the influx of foreign currency from the rest of the world.
(ii) Now domestic exports will fall because one unit of the foreign currency buys fewer goods in the domestic market. Accordingly, the supply of foreign currency (or influx of foreign currency into the domestic economy) will fall.
(iii) Fall in the price of a foreign currency (say US dollar) would mean fewer Indian rupees per US dollar. Accordingly, NRIs would make fewer transfers to their home country. Implying, a fall in the supply of foreign currency into the domestic economy.
(iv) Fall in the price of a foreign currency would lead to lesser purchases by the non-residents in the domestic market. Accordingly, the supply of foreign currency will fall.
17. How is external commercial borrowing different from external commercial assistance?
Ans. External commercial borrowing refers to loans received from or given to the rest of the world at the market rate of interest. External assistance refers to loans received from or given to the rest of the world at the concessional rate of interest.
18. “Indian Rupee (f) plunged to all-time low off 74.48 against the US Dollar($).”
-The Economic Times
In the light of the above report, discuss the impact of the situation on Indian imports.
Ans. This is a situation of depreciation of the Indian Rupee.
Depreciation of the Indian Rupee is the fall in the value of Indian currency (rupee) in relation to foreign currency (US dollar) in a situation when the exchange rate is determined by the forces of supply and demand in the international money market. It implies that more rupees are now required to buy a unit of foreign currency (say one US dollar) Or, that one US dollar is now exchanged for more rupees. More rupees are now required to buy goods worth one US dollar in the US market. As a result, imports are likely to fall.
19. Define “Trade Surplus”. How is it different from “Current Account Surplus”?
Ans. Trade surplus refers to an excess value of export of visible (goods) over the value of import of visible (goods) in the balance of payments of a country.
Trade Surplus: Export of goods > Import of goods
The current account includes receipts and payments of foreign exchange on account of all items of exports and imports (visible as well as Invisibles). Current account surplus occurs when the foreign exchange receipts are in excess of the foreign exchange payments relating to visible as well as invisible items of trade.
20. Is improvement in the exchange rate of the country’s currency always beneficial?
Ans. Improvement in the exchange rate of a country’s currency (say Indian rupee vis-a-vis US dollar) implies that fewer rupees are to be paid for a dollar than before. It points to the relative strength of the Indian rupee in the international market. However, for a developing country like India, it is not also always desired. It would mean that the US now can buy fewer Indian goods for a dollar, than before, which might cut US demand for the Indian goods. Accordingly, our exports might fall which a developing country like India can least afford. However, it may be mentioned that when the Indian rupee becomes stronger in relation to the US dollar, our import bill (on account of essential imports like crude oil) tends to fall. Accordingly, our CAD (Current Account Deficit) is reduced, lowering the need for borrowing in the international money market. In case CAD mounts up, our credit rating takes a hit which sends a wrong signal to the international investors in the Indian markets.