Question

On 12th March 2020, the RBI released the Q3FY19 Balance of Payments data that showed that the country's current account deficit (CAD) narrowed sharply to $1.4 billion, or 0.2 per cent of GDP, for the December 2019 quarter.

i) What is Balance of Payments (BOP) and how will the above-mentioned current account deficit get “balanced”? What happens if the BOP does not balance?
ii) What is ‘impossible trinity’? Explain, in the case of full capital mobility, why is it impossible to simultaneously conduct monetary policy and maintain a fixed exchange rate?

Answer 1

Answer to Part 1)

Countries exchange goods and services to be able to meed domestic demand which cannot be fulfilled by local production. For example, countries like India, do not have sufficient resources to be able to meet the energy demand for petroleum products as a result of which they require the same from countries such as Saudi Arabia which may be rich in the same. At the same time, the country has abundance of low cost labor force, which it uses to produce Information and Technology services which are sold worldwide by major tech companies in the country.

The end result of this import and export is Balance of Payment which happens if a country has imports exceeding exports or exports exceeding imports. A balanced approach is when both match i.e the payment obligations for a country to other countries matches the net receipts which it gets from those countries as well. A positive balance of payment takes place, when the payments we need to make to others is lesser than the receipts which we have i.e we receive payments up and over our obligations.

On the contrary, a negative balance of payment takes place when our payment obligations towards other countries exceed our receipts.

The following are three components or sub parts of balance of payments:-

1) Current Account wherein the the differences in exports and imports is calculated.

2) Capital Account which measures the capital investments in fixed assets etc which other countries make in our country v/s the capital expenditure we make in other countries.

3) Financial Account which measures the obligations in terms of portfolio based investments which people from other countries make in our country V/s the ones which our residents make in other countries.

The difference between the net receipts and the obligations towards these three accounts helps in deciding the balance of payment for a country.

Now, here in the case study we are looking at a current account deficit for the country. Which means that the imports into the country far outweigh the exports and their value. The value of the deficit is 1.4 Billion $ Now, this current account deficit is either financed using the receipts which the government has towards capital expenditure from other countries or by supplying additional currency thus devaluing the currency and providing the same to meet up with foreign obligations.

The net effect of this is as follows:-

Foreign Investors do not prefer investing into countries with a higher current account deficit as when these countries finance their deficit, often it leads to depletion in the value of the currency itself which limits the returns and makes it a risky proposition to invest further. Further, as the value of the currency goes down due to the government printing more currency, the net result is that exports bring in lesser cash for the country while imports become expensive. The currency depreciates in value and more currency needs to be given than it was earlier.

For example, if the currency devalues by 10 percent, for imports we would have to give 10% extra than we previously would and for exports we would get 10% lesser than we used to earlier.

2)  

The impossible Trinity is a hypothetical concept which was developed and stated, that a country cannot maintain a fixed exchange rate, monetary policy and free flow of capital at the same time.

A fixed system of exchange rate is one wherein the amount of money which we give for purchasing a foreign currency remains the same over a period of time. A floating exchange rate changes as per demand and supply and this is what is followed by most countries today.

The reason why it is impossible to attain the same is that a fixed exchange rate is possible only when demand and supply remain stable. During a recession for example, when a monetary policy is applied, the supply of money in the economy is increased by the government at that point of time there is ambiguity and demand and supply change. Therefore, it is not possible to maintain a fixed exchange rate in a system wherein the monetary policy requires changes to be made.

When a central bank administers decisions wherein the demand and supply of currency is not stable, the exchange rate cannot remain stable.

Please feel free to ask your doubts in the comments section.