External Sector: Currency Convertibility and Balance of Payment

Currency Convertibility

• Definition: Currency convertibility refers to the ability to exchange a country’s currency for another currency or for gold without restrictions. It allows individuals, businesses, and governments to convert one currency into another freely.
• Types:
  • Fully Convertible Currency:
    • The currency can be exchanged freely into other currencies at market-determined exchange rates without any restrictions or government intervention.
    • Examples: U.S. Dollar (USD), Euro (EUR), British Pound (GBP).
  • Partially Convertible Currency:
    • The currency can be exchanged for other currencies, but there are restrictions on the amount or purpose of exchange (such as for current account transactions but not capital account transactions).
    • Examples: Some emerging market currencies.
  • Non-Convertible Currency:
    • The currency cannot be freely exchanged for foreign currencies due to strict government controls or because the country has an underdeveloped financial system.
    • Examples: North Korean won, Cuban Peso.

Impact of Currency Appreciation and Depreciation

• Revaluation/Appreciation:
  • Exports become expensive.
  • Imports become cheaper.
  • Value of the remittances decreases
  • Overall Inflation decreases
• Devaluation/Depreciation:
  • Exports become cheaper
  • Imports become expensive
  • Increase in aggregate demand
  • Increase in inflation

Balance of Payment

• Balance of Payment (BoP) of a country can be defined as a systematic statement of all economic transactions of a country with the rest of the world during a specific period usually one year.
• It indicates whether the country has a surplus or a deficit on trade.
• Uses:
  • Reveals the financial and economic status of a country.
  • Can be used as an indicator to determine whether the country’s currency value is appreciating or depreciating.
  • Helps the Government to decide on fiscal and trade policies.
  • Provides important information to analyze and understand the economic dealings of a country with other countries.
• Components:
  • Current Account: It shows export and import of visibles (also called merchandise or goods – represent trade balance) and invisibles (also called non-merchandise). Invisibles include services, transfers and income.
  • Capital Account: It shows a capital expenditure and income for a country. It gives a summary of the net flow of both private and public investment into an economy.
  • External Commercial Borrowing (ECB), Foreign Direct Investment, Foreign Portfolio Investment, etc form a part of capital account.
  • Errors and Omissions: Sometimes the balance of payment does not balance. This imbalance is shown in the BoP as errors and omissions. It reflects the country’s inability to record all international transactions accurately.
  • Changes in Foreign Exchange Reserves: Movements in the reserves comprises changes in the foreign currency assets held by the Reserve Bank of India (RBI) and also in Special Drawing Rights (SDR) balances.