MODULE 4

World Monetary and Financial Environment

EXCHANGE RATE
 The exchange rate is defined as "the rate at
which one country's currency may be
converted into another."
 It may fluctuate daily with the changing
market forces of supply and demand of
currencies from one country to another. For
these reasons; when sending or receiving
money internationally, it is important to
understand what determines exchange rates.
 An exchange rate is the value of the currency
of one country expressed in the currency of
another country. An exchange rate
or currency quotation is necessary to
determine the proportions of currency
volume in case of international trade in
goods and services, cash flows, revaluation
of accounts in foreign currency, etc. The cost
basis of the currency is its purchasing power.
 Govern
ment Inflation
Debt

Terms of
Factors Recession
Trade
affecting
Country’ exchang
s e rate
Current
Account Specu
/ Balance
of
lation
Political
Payment Stability
s Interest
&
rate
Performa
nce
What is the real difference?

INTERNATIONAL MONETARY FUND

VS
THE WORLD BANK
PURPOSES OF THE IMF AND THE WORLD BANK

 The International Monetary Fund (IMF) maintains

international monetary cooperation among its members.

 The World Bank aids in the development and

reconstruction of it members.
IMF BRIEFING
 Exchange rate stability, balance of payments
disequilibrium, and growth of international trade

 Currently 190 member countries

 By sharing economic policies the system of buying

and selling currencies would be stable
WORLD BANK BRIEFING
Made up of 5 different organizations:
 International Bank for Reconstruction and
Development (IBRD)
 International Development Association (IDA)
 International Finance Corporation (IFC)
 Multilateral Investment Guarantee Agency (MIGA)
 International Center for the Settlement of Investment
Disputes (ICSID)
 HISTORY BEHIND THE IMF AND WORLD BANK
 After the Great Depression in the 1930s there was a need
for an organization to create a system for exchange rate
stability
 Uncertainty of the value of paper money (no longer used
the gold standard)
 Countries began cheating other countries in trade

 Countries’ economies affected by WW II

 need for reconstruction in well-developed nations
 need for development in the lesser developed nations
BRETTON WOODS CONFERENCE
 1940s proposals for monetary system by Harry Dexter

White (U.S.) and John Keynes (UK)

 establish the value of each currency

 eliminate restrictions and certain practices on trade

 assistance for post-war reconstruction

 Bretton Woods Conference, New Hampshire, July 1944

with delegates of 44 nations

 final negotiations of the IMF and the World Bank took

place
PURPOSES OF THE IMF

Articles of Agreement of the IMF

i) promote international monetary cooperation

ii) expansion and balanced growth of

international trade

iii) promote exchange rate stability

iv) help establish multilateral system of

payments and eliminate foreign exchange

restrictions

v) make resources of the Fund available to

members

vi) Shorten the duration and lessen the degree

of disequilibrium in international balances

of payments
WHERE THE IMF GETS ITS MONEY

 Most comes from the quota subscriptions

 the money each member contributes when joining
the IMF

 General Arrangements to Borrow (1962)

 line of credit set up with several governments and
banks throughout the world
SPECIAL DRAWING RIGHT (SDRS)
 SDR is an invented currency
 its value is based on the worth of the world’s five
major currencies
US Dollar, French Franc, Pound Sterling, Japanese Yen,
Deutsche Mark
 Countries add SDRs to their holdings of foreign
currencies
 keep available for need of payments that must be
made in foreign exchange
ORGANIZATION
 Board of Governors
 Each member country appoints one Governor and and
Alternate Governor
 Executive Board
 24 Executive Directors which are representatives for
the members
 Managing Director
 the chairman of the Executive Board
 Governors spend most of their time dealing with their
own countries
 report their countries’ plans to their representatives
 only meet with entire IMF board once a year
 Executive Board oversees the economic policies of the
members
 holds meetings three times a week
 Managing Director heads the the IMF staff of about 2,600
people
 traditionally held by a European
POWER AMONG THE MEMBERS

 Size of the quotas determine voting power

 IMF decides on the quota for each member
 richer countries have larger quota
 US having largest economy provides 18% of the total
quota (about $35 billion)
 US has largest voting power (18% or 26,5000)
 A BIT MORE ON QUOTAS
 Each member of the IMF is assigned a quota, based broadly
on its relative size in the world economy, which determines its
maximum contribution to the IMF’s financial resources.
 Upon joining the IMF, a country normally pays up to one-
quarter of its quota in the form of widely accepted foreign
currencies (such as the U.S. dollar, euro, yen, or pound
sterling) or Special Drawing Rights (SDRs).
 The remaining three-quarters are paid in the country’s own
currency.
 Quotas are reviewed every 5 years by the IMF
 Quotas also determine how much each member can borrow
WHEN IS A COUNTRY IN NEED ?
 A country that had not taken in enough foreign currency
to pay the other countries for what they have bought
 spends more money than it takes in
 IMF will lend foreign exchange to that member
 hoping to stabilize its currency which will strengthen
its trade
HOW MUCH MONEY A MEMBER CAN
BORROW FROM THE IMF
 25% of the country’s quota can be used

 If this is not sufficient, then members can

borrow up to 3 times the amount of its quota
 present plans for reform to Executive Directors

 If these plans are sufficient for the Executive

Directors, the IMF grants the member a loan
WORLD BANK

Made up of 5 different organizations

 International Bank for Reconstruction and
Development (IBRD)
 International Development Association (IDA)
 International Finance Corporation (IFC)
 Multilateral Investment Guarantee Agency
(MIGA)
 International Center for the Settlement of
Investment Disputes (ICSID)
INTERNATIONAL BANK FOR RECONSTRUCTION
AND DEVELOPMENT (IBRD)
 Founded in 1944 at the Bretton Woods Conference
 to finance the reconstruction of countries affected
by WWII
 help with development of impoverished nations
 World Bank’s central institution
 189 member countries
IBRD CONTINUED
 Lends to countries with relatively high per capita
incomes
 Money is used for:
 development projects (i.e. highways, schools)
 programs to help governments change the way they
manage their economies
 Provides technical assistance in projects
INTERNATIONAL DEVELOPMENT ASSOCIATION
(IDA)

 Established in 1960
 assist the poorest developing countries
 lends to countries with annual per capita incomes of
about $800 or less
 It’s loans are knows as “credits”
 174 members
 INTERNATIONAL FINANCE
CORPORATION(IFC)

 Established in 1956 to reduce poverty and improve people's

lives in an environmentally and socially responsible manner
(186 members)

 finances private sector investments, mobilizes capital in

international financial markets, and provides technical
assistance and advice to governments and businesses

 provides both loan and equity finance for business ventures in

developing countries
MULTILATERAL INVESTMENT GUARANTEE
AGENCY
 Established in 1988

 helps developing countries attract foreign investment

 provides investment marketing services and legal
advisory services to its members

 182 members
INTERNATIONAL CENTER FOR THE
SETTLEMENT OF INVESTMENT DISPUTES

 Established in 1966 to promote increased flow of

international investment

 Provides facilities for the reconciliation of disputes

between governments and foreign investors

 163 countries (signatory and contracting states); 154

countries (contracting states only)
WHERE THE IBRD GETS ITS MONEY

 through the sale of its bonds in international capital

markets
 Members’ subscriptions to its capital stock
 only 10% of the subscriptions is used by the Bank
 “Callable Capital”
 portion of the subscriptions that the Bank borrows
 the Bank charges a rate of interest rate on its loans to
pay this back
WHERE THE IDA GETS ITS MONEY

 Mostly from governments’ voluntary

contributions

 Replenishments

 additional contributions which are needed every

few years
DIFFERENCES BETWEEN THE IBRD AND
THE IDA

 IBRD charges an interest rate on loans

 loans must be repaid within 15-20 years with a 5
year grace period

 IDA does not charge an interest rate, only a 0.75%

service charge
 repayment period is 30-45 years with a 10 grace
period
 ASIAN CRISIS
 Financial crisis broke out in Asia in 1997
 large declines in currencies, stock markets, and
other asset prices

 affected emerging markets outside of Asia

 IMF arranged programs of economic stabilization and

reform with Indonesia, Korea, and Thailand
IMF’S ACTIONS

 Temporary tightening of monetary policy

 correct the weaknesses in the financial system
 remove features of the economy that were
impediments to growth
 assist in reopening lines of external financing
 maintaining a sound fiscal policy
 International Monetary
World Bank
Fund
 oversees the international monetary  seeks to promote the economic

system development of the world's poorer

 promotes exchange stability and countries

orderly exchange relations among its  assists developing countries through

member countries long-term financing of development

 assists all members--both industrial projects and programs

and developing countries--that find  provides to the poorest developing

themselves in temporary balance of countries whose per capita GNP is less
payments difficulties by providing than $865 a year special financial
short- to medium-term credits assistance through the International

Development Association (IDA)

THE INTERNATIONAL MONETARY FUND AND THE WORLD BANK AT A

GLANCE
 International Monetary Fund World Bank

 supplements the currency reserves of its  encourages private enterprises in

members through the allocation of SDRs
developing countries through its
(special drawing rights); to date SDR 21.4
affiliate, the International Finance
billion has been issued to member
Corporation (IFC)
countries in proportion to their quotas  acquires most of its financial
 draws its financial resources principally resources by borrowing on the
from the quota subscriptions of its international bond market
member countries  has an authorized capital of $184
 has at its disposal fully paid-in quotas billion, of which members pay in
now totaling SDR 145 billion (about $215 about 10 percent
billion)  has a staff of 7,000 drawn from 180
 has a staff of 2,300 drawn from 182 member countries
member
THE countries
INTERNATIONAL MONETARY FUND AND THE WORLD BANK AT A
GLANCE
 OVERVIEW : IMF

 Membership: 190 countries

 Headquarters: Washington, D.C.

 Executive Board: 24 Directors each representing

a single country or a group of countries

 Staff: Approximately 2,600 from 147 countries

REGIONAL DEVELOPMENT BANKS
 The regional development banks (RDBs) are multilateral

financial institutions that provide financial and technical

assistance for development in low- and middle-income

countries within their regions.

 Finance is allocated through low-interest loans and

grants for a range of development sectors such as

health and education, infrastructure, public

administration, financial and private-sector

development, agriculture, and environmental and

natural resource management.

 The regional development banks consist of several
regional institutions that have functions similar to the
World Bank group's activities, but with particular focus
on a specific region. Shareholders usually consist of
the regional countries plus the major donor countries.
SOME EX.

 African Development Bank (AfDB)

 Asian Development Bank (ADB)
 European Bank for Reconstruction and
Development (EBRD)
 Inter-American Development Bank (IDB)
 AFRICAN DEVELOPMENT BANK

 The African Development Bank Group (AfDB) is a multilateral

development finance institution.

 established to contribute to the economic development and social

progress of African countries.

 The AfDB was founded in 1964

 comprises three entities: The African Development Bank, the African

Development Fund and the Nigeria Trust Fund.

 mission : to fight poverty and improve living conditions on the

continent through promoting the investment of public and private

capital in projects and programs that are likely to contribute to the

economic and social development of the region.

 The AfDB is a financial provider to African governments and private

AFDB :
 Formation:10 September1964
 Type: International organization

 Legal status: Treaty

 Purpose: Regional development

 Headquarters: Abidjan, Ivory Coast

 Membership: 78 countries

 President: Akinwumi Adesina

 Main organ: Board of Executive

ASIAN DEVELOPMENT BANK

 The Asian Development Bank (ADB) is a regional

development bank.

 Established on: 19 December 1966

 Headquartered : Ortigas Center located in

Mandaluyong, Metro Manila, Philippines

 President : Takehiko Nakao

 maintains 31 field offices around the world

 Aim : to promote social and economic
development in Asia.
 From 31 members at its establishment, ADB now
has 67 members, of which 48 are from within Asia
and the Pacific and 19 outside.
 The ADB was modeled closely on the World Bank,
and has a similar weighted voting system where
votes are distributed in proportion with members'
capital subscriptions.
EUROPEAN BANK FOR RECONSTRUCTION
AND DEVELOPMENT (EBRD)
 The European Bank for Reconstruction and Development (EBRD) is

an international financial institution founded in 1991.

 The EBRD uses investment as a tool to build market economies.

 Initially focused on the countries of the former Eastern Bloc

 It expanded to support development in 30 countries from central Europe

to central Asia.

 Headquartered in London

 President: Sir Suma Chakrabarti

 The EBRD is owned by 65 countries and two EU institutions. Despite its

public sector shareholders, it invests mainly in private enterprises,

together with commercial partners.

INTER-AMERICAN DEVELOPMENT
BANK
 The Inter-American Development Bank
(IADB or IDB or BID) is the largest source of development
financing for Latin America and the Caribbean.
 Established in 1959
 Headquarters: Washington, D.C. United States
 Membership : 48 countries
 IDB supports Latin American and Caribbean economic
development, social development and regional integration
by lending to governments and government agencies,
including State corporations.
Founded Name HQ

IDB: Interamerican
1959 Washington
Development Bank

CABEI : Central
1960 American Bank for Tegucigalpa
Economic Integration

CEB Council of
1956 Europe Development Paris
Bank

BOAD Banque ouest-

africaine de
1973 développement Lomé
West African
Development Bank
 AFDB : African
1964 Abidjan
Development Bank

IsDB :Islamic
1973 Jeddah
Development Bank Group

ADB Asian Development

1966 Manila
Bank

CAF - Development Bank

1970 Caracas
of Latin America

EBRD European Bank for

1991 Reconstruction and London
Development
 MEANING : BOP
 Balance of payments refers to the recording
of all economic transactions of a given
country with rest of the world. Each country
has got to enter into economic transactions
with other countries of the world. As a result
of such transactions, it receives payments to
other countries. Balance of Payments is a
statement of accounts of these receipts and
payments.
 A Balance of Payment Account is a
systematic record of all economic
transactions between residents of a
country and the rest of the world carried
out in a specific period of time.
 It represents a summation of country’s
current demand and supply of the claims
on foreign currencies and of foreign claims
on its currency.
BALANCE OF PAYMENT :
DEFINITIONS

 According to Kindle Berger, "The

balance of payments of a country is a
systematic record of all economic
transactions between the residents of
the reporting country and residents of
foreign countries during a given period
of time".
 In words of Benham

“Balance of payments of a country is

record of the monetary transactions over
a period of time with the rest of the
world”.
 BOP account, like a typical business
account, is based on double entry
system which contains two sides—Credit
side and Debit side. Any transaction
which brings in foreign exchange
(currency) is recorded on credit side
whereas any transaction that causes a
country to lose foreign exchange is
recorded on debit side.
FEATURES

 It is a systematic record of all economic

transactions between residents of one
country and rest of the world.
 It includes all transactions in goods (visible
items), services (invisible) and assets (flow of
capital) during a period of time.
 It is constructed on double entry system of
accounting. Thus, every international
transaction will result in credit entry and
debit entry of equal size.
 All economic transactions that are carried out
with the rest of world are either credited or
debited.
 In accounting sense total debit will always be
equal to total credits, i.e., balance of payments
will always be in equilibrium. But in economic
sense, if receipts are larger than payments,
there is surplus in BOP Similarly, if payments
are larger than receipts, there is deficit in BOP
 IMPORTANCE
 It serves as an indicator of the changing international

economic or financial position of a country.

 It helps in formulation of a country’s monetary, fiscal and

trade policies.

 It helps in determining the influence of foreign trade &

transactions on the level of national income of a country.

 It is useful to banks, firms, financial institutions and

individuals which are directly or indirectly involved in

international trade and finance.

 It is an economic barometer of nation’s progress vis à

vis rest of the world.

 There are two main accounts in the BOP –
the current account and the capital account.

 Current Account: The current account

records exports and imports in goods, trade
in services and transfer payments.
 Capital Account: The capital account records
all international purchases and sales of
assets such as money, stocks, bonds, etc. It
includes foreign investments and loans.
 ACCOUNT OVERVIEW
Current Account
Capital Account
 Merchandise trade
 exports
Changes in assets abroad, net
 imports other govt. assets
 Trade Balance
private assets
 Services
All changes, net
 military trans. (net)
 other services, net Changes in foreign assets in the US,
 Service Balance
net foreign private assets
 Balance on goods & services
All changes, net
 Investment income, net Unilateral transfers
 government grants Changes in holdings of official
 govt. pensions, and
international reserves, net
 other transfers
 Private remittances and Statistical discrepancy
 other transfers
 All transfers, net
Balance on capital account

Balance on current account

BALANCE OF PAYMENTS
Current Account Capital Account

Trade in Goods Foreign

Investment(FDI, FII,
(BOT = Ex – Im)
Equities etc)
Factor Trade in
Services(compensation External Assistance
investment income i.e.,
dividends, profit, Commercial
interest etc.) Borrowing
Non factor trade in
Services(shipping, IMF
banking, software )
Private Transfer NR Deposits
Payment(gifts,
remittance, grants) Rupee debt Service
Official Transfer
Payment(gifts, Other Flows
remittance, grants)
 Note: The IMF accounting standards of
the BOP statement divides international
transactions into three accounts: the
current account, the capital account and the
financial account, where the current account
should be balanced by capital account and
financial account transactions. But, in
countries like India the financial account is
included in the capital account itself.
 A buys a graphing calculator from B for
$50. (Debit A $50, Import; Credit B $50,
Export.) (NOTE: dollar amounts equal and
one is positive and one negative. This is
always true in every transaction.)
 B downloads a movie from A for $5.
(Debit B $5, Import; Credit A $5, Export.)
 A immigrants send $100 back to B
relatives. (Debit A $100, Transfer to the
World; Credit B $100, Transfer from the
World. This is a unilateral transfer or a
gift.)
 A corporations pay $20 dividends to B
stockholders. (Debit A $20, investment
income paid; Credit B $20, investment
income received.)
 The A government sells $75 in bonds to B.
(Debit B Capital Outflow, $75; Credit A,
Capital Inflow, $75. Here, financial capital is
leaving B and entering A as investment.)
 Rogue B’s investors buy A’s junk bonds for
$15. (Debit B Capital Outflow, $15; Credit A,
Capital Inflow, $15. Here, financial capital is
leaving B and entering A as investment.)
 A investors receive interest payments
from B Government of $10. (Debit B,
$10 Investment Income Paid; Credit A
$10, Investment Income Received.)
 A businesses borrow $65 from B Banks.
 (Debit B $65, capital outflow; Credit A
$65, capital inflow.)
 Trade
balance Capital a/c
Current account

Structure of BOP

Error and Foreign

Omission Exchange
Reserves
 ERRORS AND OMISSION

 According to double entry book – keeping

concept for every credit, there exists a

matching debit and thus, there must be a

balance in BOP as well.

 In reality BOP may not balance. Once various

types of international financial flows are

recorded, the statistical discrepancy, referred

to as errors and omissions, is also recorded.

 The statistical discrepancy occurs due to complications
associated with collecting balance of payments data. You
can find different sources of data which occasionally
differ in their approach. For instance, merchandise is
shipped in March, however the payments are received in
April. If statistics are compiled on the 31st March, the
numbers will differ. The errors and omissions amount is
equal to the amount required to balance both the sides.
It is useful to keep in mind that whenever past figures
for the BOP are adjusted as time passes by, the figures
for ‘net errors and omissions’ get smaller and smaller as
the errors are located and fixed.
FOREIGN EXCHANGE RESERVES

 Foreign exchange reserves exhibits the

reserves that are kept in the form of
foreign currencies. If the overall balance
is surplus, it is moved to the official
reserves account which raises the foreign
exchange reserves. It may be in form of
dollar, pound, gold and Special Drawing
Rights (SDRs).
MEANING OF DISEQUILIBRIUM IN
BALANCE OF PAYMENTS
 A country’s balance of payments is in
disequilibrium when there is no perfect
equality between the demand and
supply for foreign exchange.
 DISEQUILIBRIUM IN BOP

 A country’s balance of payments is said to be

in disequilibrium when its receipts (credits)
are not equal to its payments (debits).
 DISEQUILIBRIUM IN BOP → RECEIPTS ≠ PAYMENTS

 Disequilibrium in BOP could be in the form of

surplus or deficit in the balance of payments.
SURPLUS IN BOP
 When the receipts (credits) are greater than
payments (debits), the balance of payments
will be in surplus or favourable. In other
words, if total credits are more than total
debits in the current and capital account
(including errors & omissions), the net credit
balance measures the surplus in the nation’s
balance of payments. This surplus is settled
with an equal amount of net debit in the
official reserves account.
DEFICIT IN BOP
 When the autonomous receipts (credits) are
smaller than autonomous payments (debits),
the balance of payments will be in deficit or
unfavorable or adverse. In other words, if total
debits are more than total credits in the
current and capital accounts (including errors
& omissions), the net debit balance measures
the deficit in the nation’s balance of payments.
This deficit is settled with an equal amount of
net credit in the official reserve account
CAUSES OF DISEQUILIBRIUM

 Economic factors

 Social factors

 Political factors
ECONOMIC FACTORS

 The important economic factors are –

 structural changes in the economy,
 changes in exchange rates (overvaluation /
undervaluation),
 Changes in the level of foreign exchange reserves,
 Cyclical fluctuations,
 Inflation / deflation
 Developmental expenditure undertaken by
developing countries, etc.
 Social factors – The social factors may include-
 changes in tastes & preferences due to
demonstration effect,
 population growth rate,
 rate of urbanization, etc.

 Political factors – The political factors may

include –
 political stability / instability in a country,
 war,
 change in diplomatic policy, etc.
MEASURES TO CORRECT DISEQUILIBRIUM IN BOP

 The adjustment measures to correct

disequilibrium in BOP can broadly
divided into two types –
 Automatic
 Policy Induced or Deliberate .
AUTOMATIC ADJUSTMENT

 Under automatic adjustment , as the

name implies, the BOP adjustment
comes about automatically, and it is not
brought about deliberately by
government policy or intervention. The
burden of adjustment is on the economy
and market forces and not on the
government.
 the automatic adjustment in BOP takes
place through changes in prices,
interest rates, income and capital flows.
Thus, under automatic adjustment there
is no government intervention.
However, it is to be noted that
automatic adjustment does not confirm
to reality and has unwanted side
effects.
POLICY INDUCED OR DELIBERATE
MEASURES

 Under policy induced adjustment there is

government intervention in correcting
disequilibrium in BOP.
 Deliberate measures are undertaken by the
government to correct disequilibrium in BOP.
 The government tries to correct disequilibrium
through its policy instruments like – monetary &
fiscal policy, trade policy, devaluation,
exchange controls etc.
 BOP adjustment becomes a matter of
policy.
 The government policies designed to
correct disequilibrium in BOP cannot
neglect the internal problems related to
the economy like unemployment,
inflation, economic growth etc.
 Monetary & Fiscal Policy
 Devaluation
 Exchange Control
 Trade Policy Measures
MONETARY & FISCAL POLICY
(EXPENDITURE – CHANGING POLICIES)

 Monetary policy affects the economy through

changes in money supply and interest rates.
 Fiscal policy affects the economy through
changes in government expenditure and
taxes.
 It is to be noted that the effects of monetary
policy on the BOP situation of a country are
highly predictable, whereas the effects of
fiscal policy on the BOP are less predictable.
DEVALUATION (EXPENDITURE SWITCHING POLICY)

 Devaluation means reduction in the external value of the

country’s currency undertaken by the government officially.
 It is a deliberate action taken by the government deliberately
and legally.
 Devaluation does not change internal purchasing power of a
currency. A country devalues its currency in order to correct
its BOP deficit.
 Devaluation is considered as ‘expenditure switching policy’
because it switches expenditure from imported goods to
domestic goods & services. Thus, when a country with BOP
deficit devalues its currency, the domestic price of its
imports increases and the foreign price of its exports falls.
EXCHANGE CONTROL

 Exchange control also forms a part of

expenditure – switching policy because
they too aim at switching of
expenditure from imported goods and
services to domestic goods and
services.
 Exchange control serves the dual
purpose of restricting imports and
regulating foreign exchange.
TRADE POLICY MEASURES

 Trade policy measures would include

measures which would reduce imports
and promote exports. The important
trade policy measures are –
 Import controls
 Export promotion.
 Import controls - A country may control its imports
by imposing or increasing import duties, restricting
imports through import quotas, licensing,
prohibiting altogether the import of certain non
essential items, etc.
 Export promotion – A country would promote
exports by reducing or abolishing export duties,
providing export subsidies, encouraging production
of exportable, provide monetary, fiscal, physical
and institutional incentives and facilities to
exporters, etc.