Balance of Payment

Submitted from,
Muhammad Faisal (5854) Mir Waqas Mansab (5886) Abdul Rauf Balaparia (5863) Muhammad Saad Bashir (5869) Muhammad Danish Bashir (6462)

Submitted to,

Sir Raghib Zafar.

Lecturer

Acknowledgement

I should like to acknowledge the lecturer Sir Raghib Zafar of Macro Economics (who deserves all of the credit and none of the blame!). And of my group members who guide me and made many valuable suggestions. Also of others, who advised me on point of my detail.

Table of Content
Introduction to Balance of Payment. Balance of Payment (BOP) theory.
o Limitations or Demerits of BOP theory

Pakistans Balance of Payment

o Historical perspective. o Future Evolution.

Balance of Payment Internationally.

o Overall balance of payments deficit or surplus.

o Overall balance of Payment and its significance. Mini case: Mexicos Balance of Payment problem.
o Suggested Solution to Mexicos Balance-of-Payments Problem Key

Opinions.
o Frederic Bastiat o Jane Haldimand Marcet

o Don Boudreaux Comments Conclusion. Recommendations. References.

BALANCE of PAYMENT
Introduction:The measurement of all international economic transactions between the residents of a country and foreign residents is called the Balance of Payments (BOP) The IMF is the primary source of similar statistics worldwide Multinational businesses use various BOP measures to gauge the growth and health of specific types of trade or financial transactions by country and regions of the world against the home country Monetary and fiscal policy must take the BOP into account at the national level Businesses need BOP data to anticipate changes in host countrys economic policies driven by BOP events BOP data may be important for the following reasons o BOP is important indicator of pressure on a countrys exchange rate, thus potential to either gain or lose if firm is trading with that country or currency o Changes in a countrys BOP may signal imposition (or removal) of controls over payments, dividends, interest, etc o BOP helps to forecast a countrys market potential, especially in the short run

Balance of Payment (BOP) Theory:BOP is yet another important theory of exchange rate determination. It is also known as General Equilibrium Theory. According to this theory, when there is free market situation, the exchange rates are determined by the market forces i.e. demand for and supply of the foreign exchange. This theory is based on simple market mechanism in which the price of any commodity is determined. Under this theory the external CF values domestic currency depends on the demand for and the supply of the currency. The Nation's overall Balance of Payments (BOP) can either be in surplus or in deficits. When the nation's BOP is in deficits, the exchange rate depreciates, and when BOP is in surplus, there will be healthy foreign exchange reserves, leading to the appreciation of the home currency. Under deficits in the BOP, residents of a country in question demands foreign currency, excessively leading to excess demand for foreign currency in terms of home currency. However,

under surplus BOP situation there is an excess demand for home currency from foreigners than the actual supply of home currency. Due to this price of home currency in terms of concerned foreign currency rises, i.e. exchange rate improves or appreciates. Thus according to this theory the exchange rate is basically determined by the demand for and the supply of foreign currency in concerned nations. The BOP theory of exchange rate determination is more satisfaction is more satisfactory than the PPP (Purchasing Power Parity Theory) theory of exchange rate determination. It is because BOP theory recognizes the significance of all items in the BOP rather than few items selected under the PPP theory. The BOP theory is like the general equilibrium theory, under which market fares determines the value of the commodity. According to this theory, when there is free market situation, the exchange rates are determined by the market forces i.e. demand for and supply of the foreign exchange. This theory is based on simple market mechanism in which the price of any commodity is determined. Under this theory the external values cf domestic currency depends on the demand for and the supply of the currency. The Nation's overall Balance of Payments (BOP) can either be in surplus or in deficits. When the nation's BOP is in deficits, the exchange rate depreciates, and when BOP is in surplus, there will be healthy foreign exchange reserves, leading to the appreciation of the home currency. Under deficits in the BOP, residents of a country in question demands foreign currency, excessively leading to excess demand for foreign currency in terms of home currency. However, under surplus BOP situation there is an excess demand for home currency from foreigners than the actual supply of home currency. Due to this price of home currency in terms of concerned foreign currency rises, i.e. exchange rate improves or appreciates. Thus according to this theory the exchange rate is basically determined by the demand for and the supply of foreign currency in concerned nations. The BOP theory of exchange rate determination is more satisfaction is more satisfactory than the PPP (Purchasing Power Parity Theory) theory of exchange rate determination. It is because BOP theory recognizes the significance of all items in the BOP rather than few items selected under the PPP theory. The BOP theory is like the general equilibrium theory, under which market fares determines the value of the commodity. According to this theory the BOP disequilibrium can be corrected by adjusting the exchange rate in either direction i.e. devaluation or revaluation. However, this theory has a drawback like it ignores the impact of exchange rate on the BOP. Limitations or Demerits of BOP Theory:Although BOP theory is superior to the PPP theory, still it is not free from demerits. The BOP theory is based on the unrealistic assumption such as perfect competition in foreign exchange market. Also BOP theory ignores the link between domestic price

level and exchange rate determination. The BOP positions on exchange rate however the exchange rate can also influence the BOP position. Final Conclusion:Thus, despite these demerits; the BOP theory is more satisfactory or superior to the PPP theory of exchange rate determination.

PAKISTANS BALANCE OF PAYMENTS: Historical Perspective:A. 1994-98 (Table I) Exports were stagnant. Structural problems persisted. Import growth led to widening of trade deficit Debt Servicing burden was rising Current account deficit hovered around $ 3-3.5 billion or 4-5% of GDP. Financing was unsustainable as Foreign Current Accounts and FE 45 swaps with banks were used. B. May 1998 aftermath An exogenous shock exposed the weakness of the balance of payments situation and the non-viability of the trade and financing.

Freezing of FCAs, Hub Power Dispute and Political uncertainty eroded the confidence in the economy. Extraordinary restrictive measures had to be put in place which included administrative controls on foreign exchange and introduction of multiple exchange rates. Debt rescheduling and new inflows from IMF, World Bank and Asian Development Bank in January, 1999. Helped build up the reserve situation to comfortable levels by end June, 1999. A unified exchange rate was re-introduced in May, 1999. Underlying structural problems were not attacked during the breathing period to enable the country to exit from rescheduling.
C. Current Situation (Table II) (October 1999 Onwards) Foreign exchange regime was liberalized and all restrictions on foreign investment outflows removed. Stable exchange rate maintained until June, 2000 and the premium over open market rate was stable 4 to 5%. Current account deficit has been reduced from 3.8% to 1.6%. Export growth recovered to 10% in 1999-2000 after a long time. As inflows from international financial institutions almost dried up, purchases from open market enabled the country to meet its payment obligations. $ 1.3 billion of debt relief under Paris Club was eroded by increase in oil prices.

 Since June 2000, rupee has been put on free float and there has been depreciation of almost 12% with greater volatility and fluctuations. In 1999-2000 cash payments of $ 3.6 billion were paid on external debt servicing in addition to rescheduling of debt (Table III). External Cash outflows exceeded inflows during 1999- 2000 despite purchases from the market and exceptional financing putting pressure on foreign reserves. There was a draw down of almost $ 400 million from the reserves by end June 2000 (Table IV). The present government has initiated a number of key structural reforms which had been postponed for a long time. Introduction of agriculture income tax, extension of GST on Retail Trade and Services, aligning prices of gas, petroleum products to international prices, documentation and survey to widen tax base will reduce fiscal deficit and hence further narrow the current account deficit and external borrowing requirements in future. Current account deficit is likely to narrow further in 2000-2001 as exports are projected to rise by 14% and imports by 8%. Exceptional financing requirements are expected to be reduced from 4 billion annually in 1998-99 and 1999-2000 to $ 2.2 billion in 2000-2001. Reserve target for end June 2001 is $ 1.7 billion. Workers remittances are down by $ 400 million, and Foreign Investment by $ 500 million -compared to the pre-1998 trends. If these flows are reinstated, oil prices decline, and export growth is further accelerated the gap between inflows and outflows will narrow and the need for further rescheduling will be reduced. Future Evolution: Efficient import substitution of furnace oil by domestically produced natural gas in thermal power generation and enhanced refinery capacity will lower the import bill for petroleum products and improve the current account deficit. Thus new investment in gas exploration, transmission pipeline and distribution systems will have a large pay off both to the macro economy as well as the investors. The government has therefore identified oil and gas as one of the four priorities sectors for economical revival strategy. Foreign Direct Investment is preferred to debt creating flows as it not only brings capital but also technology and managerial skills. Multinational Corporations help promote competition in the sector by their improved corporate governance standards and practices which have to be emulated by the domestic companies to stay afloat. Profits, Dividends and Remittances account for only a small fraction of our external payments. In 1999-2000 the total payments on this account were only $ 430 million compared to $ 3.6 billion account of external debt servicing obligations. If FDI flows to Pakistan are doubled and payments on account of dividends, profits etc., rise in the same proportion we will have no difficulty in servicing them. Under this scenario, the FDI inflows will lead to a diminution in external

borrowing and hence our debt servicing would consequently decline. The investors will get a remunerative return on their investment which they Can remit abroad without much difficulty while the country is able to reduce Its dependence on foreign loans and the conditionalitys associated with them. In fact, foreign investors will remit only if they are able to generate positive earnings for the economy unlike the external creditors who have to be paid fixed charges irrespective of the fact whether their loan has created positive cash flow or not. Pakistan has suffered in the past due to perception of poor governance and reneging of contracts. This government has taken actions to introduce transparency, predictability, rule of law and accountability in the system. Even the worst critics of this government do recognize that the overall governance has improved although a lot of reforms are either underway or planned to strengthen judiciary, police, civil service and other institutions. In Oil and Gas Sector, the government has moved out of running commercial operations and decided to privatize all publicly owned assets in this sector. Foreign Investors have a great opportunity to own these assets, make them operationally and financially efficient and earn profits. Pakistan is open for foreign investors and as you can see the measures being taken by the government will further strengthen the balance of payments situation in the future. This should provide comfort to the potential investors about the security, return and transferability of their investment.

BALANCE OF PAYMENT INTERNATIONALLY:Japans continuous current account surpluses may have reflected a weak yen and high Competitiveness of Japanese industries. Massive capital exports by Japan prevented yen from appreciating more than it did. At the same time, foreigners exports to Japan were hampered by closed nature of Japanese markets. Continuous current account surpluses disrupt free trade by promoting protectionist sentiment in the deficit country. It is not desirable especially when it is brought about by the mercantilist policies.

Overall balance of payments deficit or surplus:A country can run an overall BOP deficit or surplus by engaging in the official reserve transactions. For example, an overall BOP deficit can be supported by drawing down the central banks reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the central banks reserve holdings.

Overall balance of Payment and its significance:The overall BOP is determined by computing the cumulative balance of payments including the current account, capital account, and the statistical discrepancies. The overall BOP is significant because it indicates a countrys international payment gap that must be financed by the governments official reserve transactions.

MINI CASE: MEXICOS BALANCE OF PAYMENTS PROBLEM:Recently, Mexico experienced large-scale trade deficits, depletion of foreign reserve holdings and a major currency devaluation in December 1994, followed by the decision to freely float the peso. These events also brought about a severe recession and higher unemployment in Mexico. Since the devaluation, however, the trade balance has improved. Investigate the Mexican experiences in detail and write a report on the subject. In the report, you may: (a) Document the trend in Mexicos key economic indicators, such as the balance of payments, the exchange rate, and foreign reserve holdings, during the period 1994.1 through 1995.12.; (b) Investigate the causes of Mexicos balance of payments difficulties prior to the peso devaluation; (c) Discuss what policy actions might have prevented or mitigated the balance of payments problem and the subsequent collapse of the peso; and (d) Derive lessons from the Mexican experience that may be useful for other developing countries. Suggested Solution to Mexicos Balance-of-Payments Problem To solve this case, it is useful to review Chapter 2, especially the section on the Mexican peso crisis. Despite the fact that Mexico had experienced continuous trade deficits until December 1994, the countrys currency was not allowed to depreciate for political reasons. The Mexican government did not want the peso devaluation before the Presidential election held in 1994. If the Mexican peso had been allowed to gradually depreciate against the major currencies, the peso crisis could have been revented. The key lessons that can be derived from the peso crisis are: First, Mexico depended too much on short-term foreign portfolio capital (which is easily reversible) for its economic growth. The country perhaps should have saved more domestically and depended more on long-term foreign capital. This can be a valuable lesson for many developing countries. Second, the lack of reliable economic information was another contributing factor to the peso crisis. The Salinas administration was reluctant to fully Disclose the true state of the Mexican economy. If investors had known that Mexico was experiencing serious trade deficits and rapid depletion of foreign exchange reserves, the peso might have been gradually depreciating, rather than suddenly collapsed as it did. The transparent disclosure of economic data can help prevent the peso-type crisis. Third, it is important to safeguard the world financial system from the peso-type crisis. To this end, a multinational safety net needs to be in place to contain the phenotype crisis in the early stage.

OPINIONS:Frederic Bastiat:-

According to the theory of the balance of trade, France has a quite simple means of doubling her capital at any moment. It suffices merely to pass its products through the customhouse, and then throw them into the sea. In that case the exports will equal the amount of her capital; imports will be nonexistent and even impossible, and we shall gain all that the ocean has swallowed up. "You're just joking," the protectionists will say. "We couldn't possibly have been saying anything so absurd." Indeed you have, and, what is more, you are acting upon these absurd ideas and imposing them on your fellow citizens, at least as far as you can. The truth is that we should reverse the principle of the balance of trade and calculate the national profit from foreign trade in terms of the excess of imports over exports. This excess, minus expenses, constitutes the real profit.

Jane Haldimand Marcet:One evening, when John returned from his work, he found his daughter Patty showing off a new silk gown to her mother. It was a present which her lover had just given her, for the approaching wedding day. Patty's eyes, which had seldom beheld any thing so beautiful, shone with delight, as her mother admired it; and her father gave her a hearty kiss, and said she would be as smart a bride as had ever been married in the village. "Ay, and it is a French silk, too, mother," exclaimed Patty."Why, as for that," replied her mother, "I don't see the more merit in its being French; and I did not think, Patty, you were such a silly girl as to have all that nonsense in your head. No, indeed, it is bad enough for the great ladyfolks to make such a fuss about French finery, so that they can't wear a bit of honest English riband. I don't like your gown a bit the better for being French. No; and I should have thought that your husband, that is to be, might have given you an English silk instead."...

Don Boudreaux on Globalization and Trade Deficits:Don Boudreaux, of George Mason University, talks about the ideas in his book, Globalization. He discusses comparative advantage, the winners and losers from trade, trade deficits, and inequality with EconTalk host Russ Roberts.

Comments:Beggars are never given choices... Leaders made us beggars, they have 'kashkool' in their hands and now they're' Begging in front of IMF, US, Saudi, China, Friends of Pakistan, Iran, Germany, NATO ...! AO ...!

CONCLUSION:Pakistan's payments problems have been chronic since the 1970s, with the cost of oil imports primarily responsible for the trade imbalance. The growth of exports and of remittances from Pakistanis working abroad (mostly in the Middle East) helped Pakistan to keep the payments deficit in check. Since the oil sector boom began subsiding in the early 1980s, however, remittances declined. Remittances from overseas workers peaked at $2.9 billion in 1982/83, and then dropped to $1.4 billion by 1997/98 and $1 billion from 1999 to 2001. This trend especially accelerated during the Gulf War, when nearly 80,000 Pakistanis in Kuwait and Iraq lost their jobs. Only about 25% of these jobs had been regained a year after the end of the conflict. Increased imports and softer demand for Pakistan's textiles and apparel in major markets also caused the current account deficit to further increase. The balance of payments position weakened in 1995/96 as imports grew by 16% and exports by only 6%. The rupee was devalued by 11% during 1995 and 1996 to encourage exports. Nevertheless, foreign reserves fell to around $800 million by mid-1997. By 2000, foreign debt equaled 100% of GDP. The government took steps in the early 2000s to liberalize and deregulate the exchange and payments regime. Pakistan moved to a dual exchange rate system in 2000. An increase in liquid foreign exchange reserves in 2001 was due in part to outright purchases from the kerb market and inflows from international financial institutions. Export growth in 2000/01 was primarily due to higher exports of primary commodities such as rice, raw cotton, and fish, and other manufactures such as leather, carpets, sporting goods, and surgical instruments. Imports increased in 2000/01 primarily due to higher imports of petroleum and petroleum products, and machinery.

RECOMMENDATIONS: Pakistan must increase its production so that Surplus can be exported. Pakistan doesnt need to enter IMF & World Bank Programs. New Water Reservoirs need to be made. Pro Active Export Policy and better marketing of Surplus goods. Electricity crises need to be solved urgently so that open mills and factories give more production and closed units open again. Pakistan needs a leadership with competence, very strong nerves, clear Pakistan needs a leadership with competence, very strong nerves, clear understanding of the issues and psyche of the other side of the table, ability understanding of the issues and psyche of the other side of the table, ability to negotiate with the super powers and come out with a most suitable to negotiate with the super powers and come out with a most suitable package.

REFRENCES:
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