Question

(i). Explain why individuals and companies buy foreign currencies? (3Marks) (ii). Define the concept of 'deficit' in balance of payments. (6Marks) (iii). In what ways is balance of payment account is important to a country like Ghana? (6Marks)

Answer 1

(i) Individuals and companies buy foreign currencies due to the following reasons-

1. Diversification
   You can use currencies to balance your portfolio, particularly if it is heavily focused in U.S. equities. For example, it you believe the dollar will drop in the future, you can buy one or more currencies that you think will rise.
   One difference between stocks and currencies is that stocks move independently of each other while currencies move relative to each other. With currencies, when one is rising, another must be falling.
2. Level Playing Field
   Unlike stocks, the news that drives currency prices is available to everyone on a real-time basis. In theory, there are no "insiders" in the foreign exchange market which operates 24 hours a day around the world. Since currency valuations are driven by actual monetary flows and events that influence a country's economic health, you can do your own analysis of how these events might impact its currency.
3. Global Economic Hedge
   There is a growing fear that current U. S. fiscal and monetary policies will generate inflation and weaken the dollar over time. Growing budget deficits, record low interest rates and the amount of money being created by the Federal Reserve are all reasons for concern, and these developments are being closely tracked by currency traders. The currency market allows you to select currencies based on how you perceive their relative values will change over time. You can bet both ways, either long or short depending on which direction you think a particular currency is headed. You can allocate your risk across the currencies of several countries, allowing you to profit from changing global macroeconomic conditions.
4. Capital Appreciation
   Currencies are akin to commodities and stocks because they offer the potential for capital appreciation. If the value of your currencies rises against the dollar, you will profit. If your currencies fall relative to the dollar, you will lose money.
5. Hedge Against Political and Event Risk
   Currencies can be played against each other based on your tactical assessment of important events going on around the world. Examples are changes in top leadership, interest rate fluctuations, currency revaluations, wars, political upheavals, trading sanctions, new tariffs, monetary policy changes, trade deficits, recessions, tax changes, import restrictions and health-related epidemics.

(ii) Concept of 'deficit' in balance of payments

A balance of payments deficit means the country imports more goods, services, and capital than they export. It must borrow from other countries to pay for its imports.

Key Characteristics-

a) The country imports goods, services and capital more than its exports.

b) It must borrow from other countries to pay for its imports.

c) In a short term, it fuels economic growth.

d) In the long term, it will have to go into debt to pay for its consumption.

It's like taking out a school loan to pay for education. Your expected higher future salary is worth the investment.

In the long-term, the country becomes a net consumer, not a producer, of the world's economic output. It will have to go into debt to pay for consumption instead of investing in future growth. If the deficit continues long enough, the country may have to sell its assets to pay its creditors.These assets include natural resources, land, and commodities.

(iii) BOP account is very important for a country like Ghana because of the following reasons

A major challenge to the Ghanaian economy is the persistence disequilibrium in the balance of payments. This is a general economic phenomenon in most developing countries. Using an annual data set from 1980-2010. This study analyzes the balance of payments for Ghana using a monetary approach with the aid of econometric models. The study shows that the balance of payment disequilibrium in Ghana is not influence only by monetary variables. Out of the four monetary independent variables three were found to be significant. The results also show that domestic credit, GDP growth, and interest rate are found to be significant. Domestic credit and interest rate are negatively related to net foreign assets while GDP growth is positively related. Inflation however is insignificantly related to net foreign assets. However, government expenditure and public debt may influence the balance of payment in Ghana.

The implication for policy is that to correct the disequilibrium in balance of payment, government should give equal attention to other policy levels instead of relying solely on monetary tools to attain stability in the country’s balance of payments account.Despite efforts under the ERP to stabilize the country's balance of payments, Ghana's current account remained in deficit throughout the 1980s and into the early 1990s. Both trade and services deficits continued into the 1990s, given the country's dependence on concessional inflows and IMF funding. The current account deficit fell by US$91 million in 1986 from US$134 million in 1985, but it rose again by US$54 million in 1987. After another recovery in 1988, it was back at US$99 million in 1989 and widened to US$228 million in 1990, US$253 million in 1991, US$378 million in 1992. It was projected to fall to US$190 million in 1994