The document summarizes the key aspects of a country's balance of payments (BOP), including: 1) The BOP records all economic transactions between a country's residents and the rest of the world in a given period, usually one year. It has both a current account and a capital/financial account. 2) A BOP deficit can put pressure on a country's exchange rate and signals the need for corrective measures. 3) Measures to correct a deficit include reducing imports through monetary steps like devaluation or non-monetary steps like tariffs and quotas.

1. BALANCE OF PAYMENT AND
EXCHANGE RATE
Submitted To:
Prof. Shrikant Iyenger
Submitted By:
Piyush Gaur
Krutarth Gandhi
Nishidh Shah
Pratyancha Suryavanshi
Sonal Nagpal
BALANCE OF PAYMENTS
1

2. The balance of payments of a country is a systematic record of all
economic transactions between the residents of a country and the rest
of the world. It presents a classified record of all receipts on account of
goods exported, services rendered and capital received by residents
and payments made by theme on account of goods imported and
services received from the capital transferred to non-residents or
foreigners.
- Reserve Bank of India
The above definition can be summed up as following: - Balance of
Payments is the summary of all the transactions between the residents
of one country and rest of the world for a given period of time, usually
one year.
What is Balance of Payments?
The BOP is a statistical record of the flow of all of the payments
between the residents of a country and the rest of the world in a given
year.
Transactions are recorded on the basis of double entry bookkeeping –
by definition it has to balance.
- Every “source” must have a “use”.
The two main components are:
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3. - Current Account
- Capital/Financial Account
Importance of BOP
The BOP is an important indicator of pressure on a country’s foreign
exchange rate.
The BOP helps to forecast a country’s market potential, especially in the
short run.
Changes in a country’s BOP may signal the imposition or removal of
controls over payment of dividends and interest, license fees, royalty
fees, or other cash disbursements to foreign firms or investors.
Contents of BOP
 Current account
 Capital account
 Financial account
 Net errors and omissions account
 Reserves and related items
Current account (CA)
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4. This is record of a country’s trade in goods and services in the current
period.
CA = Exports (X) – Imports (M)
It is divided into 4 sub-categories:
 Goods trade
 Services trade
 Income
 Current transfers
 The sum of the four sub-categories = CA balance
Current Account Deficit ( % of GDP)
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5. Current Account Convertibility
In India, In Current Account can be converted into Foreign Currency
(E.g. $) or Vice-versa.
It is Freely permitted in India by Reserve Bank of India.
Capital account (KA)
This includes all short- and long-term transactions pertaining to
financial assets.
KA = Capital Inflow (cr) – Capital outflow (dr)
The two main components:
 Capital account.
 Financial account (direct, portfolio, other).
KA balance = Sum of capital account and financial account.
Capital Account Convertibility
In India, Partial Capital Account convertibility is there, i.e. up to
$200,000 is allowed by Reserve bank of India.
Up to $500 million the bank need not to take permission from RBI for
Foreign Loan.
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6. Capital Account Balance (in US $ Bn)
What Financial account includes?
 Net foreign direct investment
 Net portfolio investment
 Other financial items
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7. Net Foreign Investment in India (in US $ Bn)
Net errors and omissions account includes Missing data such as illegal
transfers.
Official Reserves
Records the purchase or sale of official reserve assets by the central
bank.
These assets include
 Commercial paper, Treasury bills and bonds
 Foreign currency
 Money deposited with the IMF
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8. This account shows the change in foreign exchange reserves held by the
central bank.
Since the BOP must balance
CA + KA + ∆RFX = 0
CA + KA = – ∆RFX
For floating rate regime countries, such as the U.S., official reserves are
relatively unimportant.
India’s Foreign Currency Reserve (in $ Bn)
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9. India’s Overall Balance Of Payment (April-Sept 2010 USD $ Million)
Item Credit Debit Net
A.CURRENT
ACCOUNT
I. MERCHANDISE 110,518 177,457 -66,939
II.INVISIBLES 87,982 48,924 39,058
Total Current
Account (I+II) 198,500 226,381 -27,881
B. CAPITAL
ACCOUNT
1. Foreign
Investment 120,179 91,042 29,137
2.Loans 50,110 34,394 15,716
3. Banking Capital 33,735 32,901 834
4. Rupee Debt
Service - 17 -17
5. Other Capital 3,756 12,765 -9,009
Total Capital
Account (1to5) 207,780 171,119 36,661
C. Errors &
Omissions - 1,750 -1,750
D. Overall Balance 406,280 399,250 7,030
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10. Total Current
Account, Capital
Account and Errors
& Omissions
E. Monetary
Movements - 7,030 -7,030
BOP Trends and 1991 crisis
Protectionist Policies
 The main objective of the Second Five Year Plan (1956-57 to 1960-
61) was to attain self reliance through industrialization.
 Heavy capital goods were imported but other imports were
severely restricted to shut off competition in order to promote
domestic industries.
 The high degree of protection to Indian industries led to
inefficiency and poor quality products due to lack of competition.
The high cost of production further eroded our competitive
strength.
 Rising petroleum products demand, the two oil shocks, harvest
failure, all put severe strain on the economy. The BOP situation
remained weak throughout the 1980s, till it reached the crisis
situation in 1990-91; When India was on the verge of defaulting
due to heavy debt burden and constantly widening trade deficit.
External Debt
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11.  India had to resort to large scale foreign borrowings for its
developmental efforts in the field of basic social and industrial
infrastructure
 Government of India resorted to heavy foreign borrowings to
correct the BOP situation in the short run out of panicky.
 By the Seventh Five Year Plan, the debt service obligations rose
sharply because of harder average terms of external debt,
involving commercial borrowing, repayments to the IMF and a fall
in concessional aid flow.
Exchange rate
 The instability of the exchange value of the rupee was another
problem. The constant devaluations (to promote exports) raised
the amount of external debt
 India followed a strongly inward looking policy, laying stress on
import substitution.
 Ideally, imports should be financed by export earnings. But
because there was export pessimism, the deficit was financed
either by the invisible earnings or by foreign aid or depletion of
valuable foreign exchange reserve.
 Much import constraint to check trade deficit was also not
possible because India’s imports were mainly ‘maintenance
imports’. On one hand import reduction was not possible and on
the other exports suffered due to the recession in the 1980s.
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12.  India’s BOP was thus beset with several problems. The process of
liberalization began from the mid 1980s. Restriction on certain
imports were removed, particularly those which were used as
inputs for export production. But by then the situation was
already bad and all the mismanagement ultimately led to the
1990-91 BOP crisis.
Components of the trade
 Imports -bulk imports: petroleum, crude oil products, bulk
consumption goods, other bulk items.
-non bulk imports: capital goods, mainly export related items
 Exports -agriculture and allied products, ores and minerals,
manufactured goods, mineral fuels.
Specialization and Trade
 Absolute Advantage: Where one country can produce goods with
fewer resources than others.
 Comparative Advantage: Where one country can produce the
goods with low opportunity costs – It sacrifices its less resources
in production.
India’s Foreign Trade Major Export Destinations
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13. India’s Foreign Trade Major Import Commodities
Export, Import & Trade Deficit (in $ Bn)
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14. Invisibles Inflow & Outflow in India
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15. Invisibles (in $ Bn)
How to correct the Balance of Payment ?
Solution to correct balance of payment disequilibrium lies in earning
more foreign exchange through additional exports or reducing imports.
Quantitative changes in exports and imports require policy changes.
Such policy measures are in the form of monetary, fiscal and non-
monetary measures.
Monetary Measures for Correcting the BoP ↓
The monetary methods for correcting disequilibrium in the balance of
payment are as follows :-
1. Deflation
15

16. Deflation means falling prices. Deflation has been used as a measure to
correct deficit disequilibrium. A country faces deficit when its imports
exceeds exports.
Deflation is brought through monetary measures like bank rate policy,
open market operations, etc or through fiscal measures like higher
taxation, reduction in public expenditure, etc. Deflation would make
our items cheaper in foreign market resulting a rise in our exports. At
the same time the demands for imports fall due to higher taxation and
reduced income. This would built a favourable atmosphere in the
balance of payment position. However Deflation can be successful
when the exchange rate remains fixed.
2. Exchange Depreciation
Exchange depreciation means decline in the rate of exchange of
domestic currency in terms of foreign currency. This device implies that
a country has adopted a flexible exchange rate policy.
Suppose the rate of exchange between Indian rupee and US dollar is $1
= Rs. 40. If India experiences an adverse balance of payments with
regard to U.S.A, the Indian demand for US dollar will rise. The price of
dollar in terms of rupee will rise. Hence, dollar will appreciate in
external value and rupee will depreciate in external value. The new rate
of exchange may be say $1 = Rs. 50. This means 25% exchange
depreciation of the Indian currency.
Exchange depreciation will stimulate exports and reduce imports
because exports will become cheaper and imports costlier. Hence, a
favourable balance of payments would emerge to pay off the deficit.
Limitations of Exchange Depreciation :-
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17. 1. Exchange depreciation will be successful only if there is no
retaliatory exchange depreciation by other countries.
2. It is not suitable to a country desiring a fixed exchange rate
system.
3. Exchange depreciation raises the prices of imports and reduces
the prices of exports. So the terms of trade will become unfavourable
for the country adopting it.
4. It increases uncertainty & risks involved in foreign trade.
5. It may result in hyper-inflation causing further deficit in balance of
payments.
3. Devaluation
Devaluation refers to deliberate attempt made by monetary authorities
to bring down the value of home currency against foreign currency.
While depreciation is a spontaneous fall due to interactions of market
forces, devaluation is official act enforced by the monetary authority.
Generally the international monetary fund advocates the policy of
devaluation as a corrective measure of disequilibrium for the countries
facing adverse balance of payment position. When India's balance of
payment worsened in 1991, IMF suggested devaluation. Accordingly,
the value of Indian currency has been reduced by 18 to 20% in terms of
various currencies. The 1991 devaluation brought the desired effect.
The very next year the import declined while exports picked up.
When devaluation is effected, the value of home currency goes down
against foreign currency, Let us suppose the exchange rate remains $1
= Rs. 10 before devaluation. Let us suppose, devaluation takes place
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18. which reduces the value of home currency and now the exchange rate
becomes $1 = Rs. 20. After such a change our goods becomes cheap in
foreign market. This is because, after devaluation, dollar is exchanged
for more Indian currencies which push up the demand for exports. At
the same time, imports become costlier as Indians have to pay more
currencies to obtain one dollar. Thus demand for imports is reduced.
Generally devaluation is resorted to where there is serious adverse
balance of payment problem.
Limitations of Devaluation:-
1. Devaluation is successful only when other country does not
retaliate the same. If both the countries go for the same, the effect is
nil.
2. Devaluation is successful only when the demand for exports and
imports is elastic. In case it is inelastic, it may turn the situation
worse.
3. Devaluation, though helps correcting disequilibrium, is considered
to be a weakness for the country.
4. Devaluation may bring inflation in the following conditions :-
i. Devaluation brings the imports down, When imports are
reduced, the domestic supply of such goods must be increased to
the same extent. If not, scarcity of such goods unleash inflationary
trends.
ii. A growing country like India is capital thirsty. Due to non
availability of capital goods in India, we have no option but to
continue imports at higher costs. This will force the industries
depending upon capital goods to push up their prices.
iii. When demand for our export rises, more and more goods
produced in a country would go for exports and thus creating
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19. shortage of such goods at the domestic level. This results in rising
prices and inflation.
iv. Devaluation may not be effective if the deficit arises due to
cyclical or structural changes.
4. Exchange Control
It is an extreme step taken by the monetary authority to enjoy
complete control over the exchange dealings. Under such a measure,
the central bank directs all exporters to surrender their foreign
exchange to the central authority. Thus it leads to concentration of
exchange reserves in the hands of central authority. At the same time,
the supply of foreign exchange is restricted only for essential goods. It
can only help controlling situation from turning worse. In short it is only
a temporary measure and not permanent remedy.
Non-Monetary Measures for Correcting the BoP ↓
A deficit country along with Monetary measures may adopt the
following non-monetary measures too which will either restrict imports
or promote exports.
1. Tariffs
Tariffs are duties (taxes) imposed on imports. When tariffs are imposed,
the prices of imports would increase to the extent of tariff. The
increased prices will reduced the demand for imported goods and at
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20. the same time induce domestic producers to produce more of import
substitutes. Non-essential imports can be drastically reduced by
imposing a very high rate of tariff.
Drawbacks of Tariffs :-
1. Tariffs bring equilibrium by reducing the volume of trade.
2. Tariffs obstruct the expansion of world trade and prosperity.
3. Tariffs need not necessarily reduce imports. Hence the effects of
tariff on the balance of payment position are uncertain.
4. Tariffs seek to establish equilibrium without removing the root
causes of disequilibrium.
5. A new or a higher tariff may aggravate the disequilibrium in the
balance of payments of a country already having a surplus.
6. Tariffs to be successful require an efficient & honest
administration which unfortunately is difficult to have in most of the
countries. Corruption among the administrative staff will render
tariffs ineffective.
2. Quotas
Under the quota system, the government may fix and permit the
maximum quantity or value of a commodity to be imported during a
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21. given period. By restricting imports through the quota system, the
deficit is reduced and the balance of payments position is improved.
Types of Quotas :-
1. the tariff or custom quota,
2. the unilateral quota,
3. the bilateral quota,
4. the mixing quota, and
5. import licensing.
6.
Merits of Quotas :-
1. Quotas are more effective than tariffs as they are certain.
2. They are easy to implement.
3. They are more effective even when demand is inelastic, as no
imports are possible above the quotas.
4. More flexible than tariffs as they are subject to administrative
decision. Tariffs on the other hand are subject to legislative sanction.
Demerits of Quotas :-
1. They are not long-run solution as they do not tackle the real cause
for disequilibrium.
2. Under the WTO quotas are discouraged.
3. Implements of quotas is open invitation to corruption.
3. Export Promotion
The government can adopt export promotion measures to correct
disequilibrium in the balance of payments. This includes substitutes, tax
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22. concessions to exporters, marketing facilities, credit and incentives to
exporters, etc.
The government may also help to promote export through exhibition,
trade fairs; conducting marketing research & by providing the required
administrative and diplomatic help to tap the potential markets.
4. Import Substitution
A country may resort to import substitution to reduce the volume of
imports and make it self-reliant. Fiscal and monetary measures may be
adopted to encourage industries producing import substitutes.
Industries which produce import substitutes require special attention in
the form of various concessions, which include tax concession,
technical assistance, subsidies, providing scarce inputs, etc.
Non-monetary methods are more effective than monetary methods
and are normally applicable in correcting an adverse balance of
payments.
Drawbacks of Import Substitution:-
1. Such industries may lose the spirit of competitiveness.
2. Domestic industries enjoying various incentives will develop
vested interests and ask for such concessions all the time.
3. Deliberate promotion of import substitute industries go against
the principle of comparative advantage.
BOP & Macroeconomic Variables
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23. A nation’s balance of payments interacts with nearly all of its key
macroeconomic variables.
Interacts means that the BOP affects and is affected by such key
macroeconomic factors as:
– Gross Domestic Product (GDP)
– Exchange rate
– Interest rates
– Inflation rates
FOREIGN EXCHANGE
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24. Method by which rights to wealth expressed in terms of currency of
one country are converted into rights to wealth in terms of currency of
another country are known as Foreign Exchange.
Prices of foreign currencies expressed in terms of other currencies is
called Foreign Exchange Rate.
Determinants of Exchange Rates:
Exchange rates are determined by the demand for and the supply of
currencies on the foreign exchange market.
The demand and supply of currencies is in turn determined by:
 Relative interest rates
 The demand for imports
 The demand for exports
 Investment opportunities
 Speculative sentiments
 Global trading patterns
 Changes in relative inflation rates
Foreign Exchange Includes:
 A Currency Note
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25.  Travellers Cheque
 Bills of Exchange
 Bank balance in Foreign Currency
FOREIGN EXCHANGE MARKETS
Peculiarities
 Largest financial market in the world.
 No single location, No barriers.
 Open 24 hours a day.
 Indian market timings are 9.00 am to 5.00 pm
 An over the counter market (OTC).
 Exchange rate fluctuate almost every 2/3 seconds.
 Controls/policies of respective countries.
 Effect of other markets-Money,capital,debt.
Sources of Foreign Exchanges
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26.  Export Receipts (Diamond, Pharmacy, Cotton, etc)
 Inward Remittances
(Money sent by NRI through bank to India)
 Borrowings
(Company borrow from Foreign banks)
Application of Foreign Exchanges
 Import Payments
(Gold, Crude Oil, Electronic Goods)
 Outward Remittances
(People send money Abroad)
 Loan Repayments
Players in Foreign Exchange Market
 Central Bank (Reserve Bank of India)
 Authorized Dealers
 Exchange brokers
 Authorized Money Changers
 FEDAI – Foreign Exchange Dealers Association of India
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27. Money Changers in India
 Restricted Money Changers
Can only Buy Foreign Currency
e.g. Hotels
 Full Fledged Money Changers
Can buy & sell Foreign currency
e.g. Thomas Cook
Indirect quotations
INR 1 = USD 0.02225
INR 1 = GBP 0.01419
- Home currency fixed.
- Foreign currency variable .
(Indirect quotations were being used in India till July 1993)
Direct quotations
USD 1 = INR 45.58
GBP 1 = INR 73.70
- Foreign currency fixed
- Home currency variable
(Used in India from August 1993)
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28. Inflation And Foreign Exchange
 High Inflation in India
(5% Average Inflation in India, more than 8% now)
Whereas In developed countries Inflation is below 1%
 Due to High Inflation Interest rate are higher in India
 Foreign Currency is Appreciating & Indian Currency is Depreciating
Fixed Exchange Rate
In a fixed exchange rate system – foreign central banks buy and sell
their currencies at a fixed price in terms of the domestic currency
Prior to 1973, most countries had fixed exchange rates against each
other.
 A fixed exchange rate acts like a price support system
 In order to maintain a fixed exchange rate, the central bank has to
make up for the excess demand or take up the the excess supply
of foreign currency.
 In order to carry out these interventions, it is necessary for the
central bank to hold an inventory of foreign currencies.
 However, if the country persistently runs deficits in the BOP, the
central bank eventually runs out of foreign currencies, and will
not be able to carry out the interventions
28

29.  In such a situation, the central bank will have to ultimately
devalue its currency
Pros and Cons of Fixed Exchange Rate
Argument in favor of fixed exchange rate
 Certainty & Less inflationary
 Promotes money and capital markets
 Helps in the smooth working of the international monetary
system & Prevents monetary shocks
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30. Argument against fixed exchange rate
 Heavy burden on exchange reserve
 Country must have sufficient reserve
 Fails to solve the balance of payment disequilibrium
 Does not prevent real shock
 It is not a long term solution if the underlying economy is
weak
Flexible Exchange Rate
In a flexible exchange rate system, the central bank allows the
exchange rate to adjust to equate the supply and demand for foreign
currency. In effect since 1973
Clean floating – the central bank stands aside completely and allows
the exchange rate to be freely determined in the forex market – official
reserve transactions are zero
 Managed float - the central bank intervenes to buy or sell foreign
currencies periodically in an attempt to influence the exchange
rates
30

31. Pros and Cons of Flexible Exchange Rate
Argument in favor of flexible exchange rate
 Simple operation, smoother, more fluid adjustment
 Brings realism in forex transactions
 Disequilibrium in balance of payment autostabilized
 No need for forex reserve to manage exchange rate
 Prevents real shocks
 Reinforces the effectiveness of monetary policy
Argument against flexible exchange rate
 Exchange rate risk –futures market
 Adverse effect of speculation
 Encourages inflation
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32.  Far from perfect system, but no better system exists
Bretton Woods I
The original Bretton Woods system was the system of fixed exchange
rates that existed from the end of World War II (1946), until its collapse
in 1971.
– John Maynard Keynes was a principle architect of the
Bretton Woods System.
– Global financial system would have fixed exchange rates in
order to prevent the beggar-thy-neighbor policies of
currency devaluations that characterized the 1930’s.
– The dollar could be converted to any other major currency
or gold at a fixed exchange rate.
Role of IBRD & IMF
 IBRD: International Bank For Reconstruction And Development
 Give loans to countries for reconstruction of Infrastructure.
 IMF: International Monetary Fund
 To monitor Exchange rate stability
 Advice country to follow Fixed exchange rate system
 Give loans to countries to overcome BOP problems
By the early 1970s, as the Vietnam War accelerated inflation, the
United States was running not just a balance of payments deficit but
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33. also a trade deficit. The crucial turning point was 1970, which saw U.S.
gold coverage deteriorate from 55% to 22%.
In the first six months of 1971, assets for $22 billion fled the United
States. In response, on August 15, 1971, President Nixon unilaterally
“closed the gold window.”
“Bretton Woods II” is a term coined by three Deutsche Bank
economists — Michael Dooley, Peter Garber, and David Folkers-Landau
— in a series of papers in 2003–2004 to describe the current
international monetary system:
In this system, the United States and the Asian economies have entered
into an implicit contract where the U.S. runs current account deficits
and the Asian countries keep their currencies fixed and undervalued by
buying U.S. government debt.
According to Dooley, Folkert-Landau, and Garber (DFG), this system has
benefits to both parties:
– The U.S. obtains a stable and low-cost source of funding for
its current account and budget deficits, and can easily
reduce taxes, and increase government spending at the
same time.
– For the Asian countries, the undervalued currency creates
export-led development strategy that produces economic
and employment growth to keep the lid on potentially
explosive pressures rising large pools of surplus labor.
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34. US-China Currency Issue
 China have trade surplus with USA & World.
 Chinese central bank maintained currency exchange fixed ($ =
8.28 Yuan)
YEAR China Foreign CurrencyChina Trade Surplus (in $)
Reserve (in $)
2006 1.06 Trillion 178 Billion
2007 1.5 Trillion 268 Billion
2008 1.9 Trillion 297 Billion
2009 2.39 Trillion 198 Billion
2010 2.64 Trillion 184.7 Billion
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35. US Trade with China
Steps Taken by China to avoid Manipulation in its Currency
• China Modified its Currency Policy on July 21, 2005.
• Yuan’s Exchange rate become adjustable with respect to Market
Demand & Supply of currency in Basket.
• Basket includes Dollar, Euro & Yen etc. So $ = 8.11 Yuan (2.1%
appreciation)
• Also Yuan can fluctuate by 0.3% on daily basis against basket.
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36. As per some Economist it was argued that:
• China’s Currency is Undervalued by 40%.
Which Resulted in:
Chinese export to US Cheaper & US export to China Expensive
Also rise in Trade Deficit from $ 30bn in 1994 to $ 260bn in 2007.
1988 Omnibus Trade & Competitiveness Act.
Act requires the Treasury Department to report on exchange rate
policies of Countries which have large Global Current Account Surplus &
Trade Surplus with US.
The aim was to find out, if they manipulate their currencies against
dollar.
And if manipulation found than Treasury is required to negotiate & end
such practices.
China reformed its currency in July 2005 and Treasury made following
observation about China:
• Current Account Surplus has reduced by Chinese Government.
• 2006 – China made progress to make currency more flexible.
• 2007 – Under US law China has no currency manipulation.
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37. • 2007 – China should accelerate the appreciation of RMB’s
effective exchange rate in order to minimize risk.
China Foreign Currency reserve
China has highest foreign currency reserve because of:
• High amount of Export
• And Hot money arrival i.e. foreign funds bought into the country.
• To tackle this the value of RMB should increase.
• In 2008 Foreign Exchange Regulations approach RMB exchange
rate against other fully convertible currencies using floating
system, based on Demand & Supply of Foreign Currency.
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38. Reasons China should let RMB appreciate, in its own interest
1. Overheating of economy
2. Reserves are excessive.
– It gets harder to sterilize the inflow over time.
3. Attaining internal and external balance.
– In a large country like China,
expenditure-switching policy should be the exchange rate.
4. Avoiding future crashes.
Policies to reduce the US CA deficit:
• Reduce the US budget deficit over time,
– thus raising national saving.
– After all, this is where the deficits originated.
• Depreciate the $ more.
– Better to do it in a controlled way
• than in a sudden free-fall.
– The $ already depreciated a lot against the €
• & other currencies
• from 2002 to 2007.
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39. – Who is left?
– The RMB is conspicuous as the one major currency
that is still undervalued against the dollar.
Problems with BW2: People’ Bank of China
U.S. absorbs 80 percent of world’s savings not invested at their home
country.
The large CAD sends billions of dollars abroad, particularly to China.
People’s Bank of China uses the inflow of dollars to purchase assets,
mostly U.S. Treasuries.
Much of the $400 billion fiscal deficit is financed by China.
If China stops purchasing U.S. assets and switches to Japan, Europe, or
other markets, it will cause a fall in the dollar and long-term interest
rates will increase.
Conclusions
 In any case, the new Chinese Exchange Rate Mechanism is a step
to the right direction.
 The United States, in contrast, has not done anything.
 President Bush has not vetoed a single spending bill. The
government spending has increased faster than at any time since
the 1960’s (“the Great Society” welfare programs and Vietnam
War).
39

40.  The massive tax cuts passed in 2001–2003 are set to expire in
2008–2010.
What the China should do?
If China intends to allow a series of small appreciations in the renminbi
then it either has to
1. Keep its interest rates below U.S. rates, so that low interest
rates offset the expected return from renminbi appreciation
over time (currently bank deposit rates in China are capped
at 2.5%, below the 3.5% federal funds rate).
2. Intervene a lot.
3. Or do both.
Either way, this policy prevents independent Chinese monetary policy.
What the U.S. Should Do?
Since these are temporary tax cuts and the likelihood they will be made
permanent is low, basic economic theory tells us that their positive
incentive effects are small.
Since the President and the Congress are unable to control spending,
the simplest way for the U.S. to reduce its fiscal deficit (and, indirectly,
current account deficit) would be to repeal the 2001–2003 tax cuts.
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41. References
• RBI’s Master circular on risk management.
( www.rbi.org.in)
• FEDAI Rules
• www.tradingeconomics.com
• www.chinability.com/Reserves.htm
• International Economics - H G Mannur
• International Financial Management - P G Apte
• Balance of Payments - Paul Madson
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