INTERNATIONAL BUSINESS

1 a) Differences between Domestic Business and International BusinessANS:

S.NoInternational BusinessDomestic Business

1.It is extension of Domestic Business and Marketing Principles remain same.The Domestic Business Follow the marketing Principles

2.Difference is customs, cultural factorsNo such difference. In a large countries languages likeIndia, we have many languages.

3.Conduct and selling procedure changesSelling Procedures remain unaltered

4.Working environment and management practices change to suit local conditions.No such changes are necessary

5.Will have to face restrictions in trade practices, licenses and government rules.These have little or no impact on Domestic trade.

6.Long Distances and hence more transaction time.Short Distances, quick business is possible.

7.Currency, interest rates, taxation, inflation and economy have impact on trade.Currency, interest rates, taxation, inflation and economy have little or no impact on Domestic Trade.

8.MNCs have perfected principles, procedures and practices at international levelNo such experience or exposure.

9.MNCs take advantage of location economies wherever cheaper resources available.No such advantage once plant is built it cannot be easily shifted.

10.Large companies enjoy benefits of experience curveIt is possible to get this benefit through collaborators.

11.High Volume cost advantage.Cost Advantage by automation, new methods etc.

12.Global StandardizationNo such advantage

13.Global business seeks to create new values and global brand image.No such advantage

14.Can Shift production bases to different countries whenever there are problems in taxes or marketsNo such advantage and get competition from some spurious or SSI Unit who get patronage of Government.

b) Features of Comparative Cost theory of international businessANS:Comparative Costs Theory:The principle of comparative costs is based on the differences in production costs of similar commodities in different countries. Production costs differ in countries because of geographical division of labour and specialisation in production. Due to differences in climate, natural resources, geographical situation and efficiency of labour, a country can produce one commodity at a lower cost than the other.In this way, each country specialises in the production of that commodity in which its comparative cost of production is the least. Therefore, when a country enters into trade with some other country, it will export those commodities in which its comparative production costs are less, and will import those commodities in which its comparative production costs are high.This is the basis of international trade, according to Ricardo. It follows that each country will specialise in the production of those commodities in which it has greater comparative advantage or least comparative disadvantage. Thus a country will export those commodities in which its comparative advantage is the greatest, and import those commodities in which its comparative disadvantage is the least.

2 b) Measures to correct disequilibrium in Balance of PaymentsANS:Measures To Correct Deficit in the Balance of Payment BoPSolution 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.The monetary methods for correcting disequilibrium in the balance of payment are as follows :-1. DeflationDeflation 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 DepreciationExchange 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 :-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. DevaluationDevaluation 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 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. Ifboth 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 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 ControlIt 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. TariffsTariffs 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 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. QuotasUnder the quota system, the government may fix and permit the maximum quantity or value of a commodity to be imported during a 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, and5. import licensing.3. Export PromotionThe government can adopt export promotion measures to correct disequilibrium in the balance of payments. This includes substitutes, tax 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 SubstitutionA 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.

3 a) Difference between Fixed vs. Flexible Exchange Rate System! ANS:There may be variety of exchange rate systems (types) in the foreign exchange market. Its two broad types or systems are Fixed Exchange Rate and Flexible Exchange Rate as explained below.In between these two extreme rates, there are some hybrid systems like Crawling Peg, Managed Floating . Broadly when government decides the conversion rate, it is called fixed exchange rate. On the other hand, when market forces determine the rate, it is called floating exchange rate.(a) Fixed Exchange Rate System: Fixed exchange rate is the rate which is officially fixed by the government or monetary authority and not determined by market forces. Only a very small deviation from this fixed value is possible. In this system, foreign central banks stand ready to buy and sell their currencies at a fixed price. A typical kind of this system was used under Gold Standard System in which each country committed itself to convert freely its currency into gold at a fixed price. In other words, value of each currency was defined in terms of gold and, therefore, exchange rate was fixed according to the gold value of currencies that have to be exchanged. This was called mint par value of exchange. Later on Fixed Exchange Rate System prevailed in the world under an agreement reached in July 1994. The advantages and disadvantages of this system are as under: Merits: (i) It ensures stability in exchange rate which encourages foreign trade, (ii) It contributes to the coordination of macro policies of countries in an interdependent world economy, (iii) Fixed exchange rate ensures that major economic disturbances in the member countries do not occur, (iv) It prevents capital outflow, (v) Fixed exchange rates are more conducive to expansion of world trade because it prevents risk and uncertainty in transactions, (vi) It prevents speculation in foreign exchange market. Demerits: (i) Fear of devaluation. In a situation of excess demand, central bank uses its reserves to maintain foreign exchange rate. But when reserves are exhausted and excess demand still persists, government is compelled to devalue domestic currency. If speculators believe that exchange rate cannot be held for long, they buy foreign exchange in massive amount causing deficit in balance of payment. This may lead to larger devaluation. This is the main flaw or demerit of fixed exchange rate system, (ii) Benefits of free markets are deprived; (iii) There is always possibility of under-valuation or over-valuation.(b) Flexible (Floating) Exchange Rate System: The system of exchange rate in which rate of exchange is determined by forces of demand and supply of foreign exchange market is called Flexible Exchange Rate System. Here, value of currency is allowed to fluctuate or adjust freely according to change in demand and supply of foreign exchange. There is no official intervention in foreign exchange market. Under this system, the central bank, without intervention, allows the exchange rate to adjust so as to equate the supply and demand for foreign currency In India, it is flexible exchange rate which is being determined. The foreign exchange market is busy at all times by changes in the exchange rate. Advantages and disadvantages of this system are listed below: Merits: (i) Deficit or surplus in BOP is automatically corrected, (ii) There is no need for government to hold any foreign exchange reserve, (iii) It helps in optimum resource allocation, (iv) It frees the government from problem of BOP Demerits: (i) It encourages speculation leading to fluctuations in foreign exchange rate, (ii) Wide fluctuation in exchange rate hampers foreign trade and capital movement between countries, (iii) It generates inflationary pressure when prices of imports go up due to depreciation of currency. Managed Floating: This refers to a system of gradual adjustments in the exchange rate deliberately made by a central bank to influence the value of its own currency in relation to other currencies. This is done to save its own currency from short-term volatility in exchange rate caused by economic shocks and speculation. Thus, central bank intervenes to smoothen out ups and downs in the exchange rate of home currency to its own advantage. When central bank manipulates floating exchange rate to disadvantage of other countries, it is termed as dirty floating. However, central banks have no fixed times for intervention but have a set of rules and guidelines for this purpose.(c) Distinction between Fixed Exchange Rate and Flexible Exchange Rate [AOS; D09]: Fixed exchange rate is the rate which is officially fixed in terms of gold or any other currency by the government. It does not change with change in demand and supply of foreign currency. As against it, flexible exchange rate is the rate which, like price of a commodity, is determined by forces of demand and supply in the foreign exchange market. It changes according to change in demand and supply of foreign currency. There is no government intervention.

3 B) Capital account convertibilityCapital account convertibility is a feature of a nation's financial regime that centers on the ability to conduct transactions of local financial assets into foreign financial assets freely and at country determined exchange rates.[1] It is sometimes referred to as capital asset liberation or CAC.In layman's terms, full capital account convertibility allows local currency to be exchanged for foreign currency without any restriction on the amount.[citation needed] This is so local merchants can easily conduct transnational business without needing foreign currency exchanges to handle small transactions.[citation needed] CAC is mostly a guideline to changes of ownership in foreign or domestic financial assets and liabilities. Tangentially, it covers and extends the framework of the creation and liquidation of claims on, or by the rest of the world, on local asset and currency markets.[2]CAC was first coined as a theory by the Reserve Bank of India in 1997 by the Tarapore Committee, in an effort to find fiscal and economic policies that would enable developing Third World countries transition to globalized market economies.[3] However, it had been practiced, although without formal thought or organization of policy or restriction, since the very early 1990s. Article VIII of the IMFs Articles of Agreement is agreed by most economists to have been the basis for CAC, although it notably failed to anticipate problems with the concept in regard to outflows of currency.However, before the formalization of CAC, there were problems with the theory. Free flow of assets was required to work in both directions. Although CAC freely enabled investment in the country, it also enabled quick liquidation and removal of capital assets from the country, both domestic and foreign. It also exposed domestic creditors to overseas credit risks, fluctuations in fiscal policy, and manipulation.[4]As a result, there were severe disruptions that helped to contribute to the East Asian crisis of the mid 1990s. In Malaysia, for example, there were heavy losses in overseas investments of at least one bank, in the magnitude of hundreds of millions of dollars. These were not realized and identified until a reform system strengthened regulatory and accounting controls.[5] This led to the Tarapore Committee meeting which formalized CAC as utilizing a mixture of free asset allocation and stringent controls.[4]CAC has 5 basic statements designed as points of action:[6] All types of liquid capital assets must be able to be exchanged freely, between any two nations in the world, with standardized exchange rates. The amounts must be a significant amount (in excess of $500,000). Capital inflows should be invested in semi-liquid assets, to prevent churning and excessive outflow. Institutional investors should not use CAC to manipulate fiscal policy or exchange rates. Excessive inflows and outflows should be buffered by national banks to provide collateral.ApplicationIn most traditional theories of international trade, the reasoning for capital account convertibility was so that foreign investors could invest without barriers. Prior to its implementation, foreign investment was hindered by uneven exchange rates due to corrupt officials, local businessmen had no convenient way to handle large cash transactions, and national banks were disassociated from fiscal exchange policy and incurred high costs in supplying hard-currency loans for those few local companies that wished to do business abroad.Due to the low exchange rates and lower costs associated with Third World nations, this was expected to spur domestic capital, which would lead to welfare gains, and in turn lead to higher GDP growth. The tradeoff for such growth was seen as a lack of sustainable internal GNP growth and a decrease in domestic capital investments.[7]When CAC is used with the proper restraints, this is exactly what happens. The entire outsourcing movement with jobs and factories going overseas is a direct result of the foreign investment aspect of CAC. The Tarapore Committee's recommendation of tying liquid assets to static assets (i.e., investing in long term government bonds, etc.) was seen by many economists as directly responsible for stabilizing the idea of capital account liberalization.ControversyDespite changes in wording over the years, and additional safeguards, there is still criticism of CAC by some economists. American economists, in particular, find the restriction on inflows to Third World countries being invested in improvements as negative, since they would rather see such transactions put to direct use in growing capital.[4][2]

4 A) DevaluationDevaluation on modern monetary policy is a reduction in the value of a currency with respect to those goods, services or other monetary units with which that currency can be exchanged. "Devaluation" means official lowering of the value of a country's currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference currency. In contrast, depreciation is used to describe a decrease in a currency's value (relative to other major currency benchmarks) due to market forces, not government or central bank policy actions. Under the second system central banks maintain the rates up or down by buying or selling foreign currency, usually but not always USD. The opposite of devaluation is called revaluation.Depreciation and devaluation are sometimes incorrectly used interchangeably, but they always refer to values in terms of other currencies. Inflation, on the other hand, refers to the value of the currency in goods and services (related to its purchasing power). Altering the face value of a currency without reducing its exchange rate is a redenomination, not a devaluation or revaluation.Devaluation is most often used in a situation where a currency has a defined value relative to the baseline. Historically, early currencies were typically coins struck from gold or silver by an issuing authority which certified the weight and purity of the precious metal. A government in need of money and short on precious metals might abruptly lower[clarify]the weight or purity of the coins without any announcement, or else decree that the new coins have equal value to the old, thus devaluing the currency.Later, with the issuing of paper currency as opposed to coins, governments decreed them to be redeemable for gold or silver (a gold standard). Again, a government short on gold or silver might devalue by abruptly decreeing a reduction in the currency's redemption value, reducing the value of everyone's holdings.Present day currencies are usually fiat currencies with variable market value. Some countries hold floating exchange rates while others maintain fixed exchange rate policies against the United States dollar or other major currencies. These fixed rates are usually maintained by a combination of legally enforced capital controls or through government trading of foreign currency reserves to manipulate the money supply. Under fixed exchange rates, persistent capital outflows or trade deficits may lead countries to lower or abandon their fixed rate policy, resulting in a devaluation (as persistent surpluses and capital inflows may lead them towards revaluation).In an open market, the perception that a devaluation is imminent may lead speculators to sell the currency in exchange for the country's foreign reserves, increasing pressure on the issuing country to make an actual devaluation. When speculators buy out all of the foreign reserves, a balance of payments crisis occurs. Economists Paul Krugman and Maurice Obstfeld present a theoretical model in which they state that the balance of payments crisis occurs when the real exchange rate (exchange rate adjusted for relative price differences between countries) is equal to the nominal exchange rate (the stated rate).[1] In practice, the onset of crisis has typically occurred after the real exchange rate has depreciated below the nominal rate. The reason for this is that speculators do not have perfect information; they sometimes find out that a country is low on foreign reserves well after the real exchange rate has fallen. In these circumstances, the currency value will fall very far very rapidly. This is what occurred during the 1994 economic crisis in Mexico.Generally, a steady process of inflation is not considered a devaluation, although if a currency has a high level of inflation, its value will naturally fall against gold or foreign currencies. Especially where a country deliberately prints money (often a cause of hyperinflation) to cover a persistent budget deficit without borrowing, this may be considered a devaluation.In some cases, a country may revalue its currency higher (the opposite of devaluation) in response to positive economic conditions, to lower inflation, or to please investors and trading partners. This would imply that existing currency increased in value, as opposed to the case with redenomination where a country issues a new currency to replace an old currency that had declined excessively in value (such as Turkey and Romania in 2005, Argentina in 1992, Russia in 1998, Germany in 1923, or Bizone/Trizone in 1948).4 B) Export Incentives

The Government of India has framed several schemes to promote exports and to obtain foreign exchange. These schemes grants incentive and other benefits. The few important export incentives, from the point of view of indirect taxes are briefed below:Free Trade Zones (FTZ)Several FTZs have been established at various places in India like Kandla, Noida, Cochin, etc. No excise duties are payable on goods manufactured in these zones provided they are made for export purpose. Goods being brought in these zones from different parts of the country are brought without the payment of any excise duty. Moreover, no customs duties are payable on imported raw material and components used in the manufacture of such goods being exported. If entire production is not sold outside the country, the unit has the provision of selling 25% of their production in India. On such sale, the excise duty is payable at 50% of basic plus additional customs or normal excise duty payable if the goods were produced elsewhere in India, whichever is higher.Electronic Hardware Technology Park / Software Technology ParksThis scheme is just like FTZ scheme, but it is restricted to units in the electronics and computer hardware and software sector. Advance Licence / Duty Exemption Entitlement Scheme (DEEC)In this scheme advance licence, either quantity based (Qbal) or value based (Vabal), is given to an exporter against which the raw materials and other components may be imported without payment of customs duty provided the manufactured goods are exported. These licences are transferable in the open market at a price. Export Promotion Capital Goods Scheme (EPCG)According to this scheme, a domestic manufacturer can import machinery and plant without paying customs duty or settling at a concessional rate of customs duty. But his undertakings should be as mentioned below: Customs Duty Rate Export Obligation Time 10% 4 times exports (on FOB basis) of CIF value of machinery. 5 years Nil in case CIF value is Rs200mn or more. 6 times exports (on FOB basis) of CIF value of machinery or 5 times exports on (NFE) basis of CIF value of machinery. 8 years Nil in case CIF value is Rs50mn or more for agriculture, aquaculture, animal husbandry, floriculture, horticulture, poultry and sericulture. 6 times exports (on FOB basis) of CIF value of machinery or 5 times exports on (NFE) basis of CIF value of machinery. 8 years

Note:- NFE stands for net foreign earnings. CIF stands for cost plus insurance plus freight cost of the machinery. FOB stands for Free on Board i.e. export value excluding cost of freight and insurance.

Deemed ExportsThe Indian suppliers are entitled for the following benefits in respect of deemed exports: Refund of excise duty paid on final products Duty drawback Imports under DEEC scheme Special import licenses based on value of deemed exports

The following categories are treated as deemed exports for seller if the goods are manufactured in India: Supply of goods against duty free licences under DEEC scheme Supply of goods to a 100 % EOU or a unit in a free trade zone or a unit in a software technology park or a unit in a hardware technology park Supply of goods to holders of licence under the EPCG scheme Supply of goods to projects financed by multilateral or bilateral agencies or funds notified by the Finance Ministry under international competitive bidding or under limited tender systems in accordance with the procedures of those agencies or funds where legal agreements provide for tender evaluation without including customs duty Supply of capital goods and spares upto 10% of the FOR value to fertilizer plants under international competitive bidding Supply of goods to any project or purpose in respect of which the Ministry of Finance permits by notification the import of goods at zero customs duty along with benefits of deemed exports to domestic supplies Supply of goods to power, oil and gas sectors in respect of which the Ministry of Finance permits by notification benefits of deemed exports to domestic supplies

Manufacture Under BondThis scheme furnishes a bond with the manufacturer of adequate amount to undertake the export of his production. Against this the manufacturer is allowed to import goods without paying any customs duty, even if he obtain it from the domestic market without excise duty. The production is made under the supervision of customs or excise authority.Duty DrawbackIt means the rebate of duty chargeable on imported material or excisable material used in the manufacturing of goods in and is exported. The exporter may claim drawback or refund of excise and customs duties being paid by his suppliers. The final exporter can claim the drawback on material used for the manufacture of export products. In case of re-import of goods the drawback can be claimed.

The following are Drawbacks: Customs paid on imported inputs plus excise duty paid on indigenous imports. Duty paid on packing material.

Drawback is not allowed on inputs obtained without payment of customs or excise duty. In part payment of customs and excise duty, rebate or refund can be claimed only on the paid part.

In case of re-export of goods, it should be done within 2 years from the date of payment of duty when they were imported. 98% of the duty is allowable as drawback, only after inspection. If the goods imported are used before its re-export, the drawback will be allowed as at reduced percent.

5 A) IMF QuotasQuota subscriptions are a central component of the IMFs financial resources. Each member country of the IMF is assigned a quota, based broadly on its relative position in the world economy. A member countrys quota determines its maximum financial commitment to the IMF, its voting power, and has a bearing on its access to IMF financing.When a country joins the IMF, it is assigned an initial quota in the same range as the quotas of existing members of broadly comparable economic size and characteristics. The IMF uses a quota formula to help assess a members relative position. The current quota formula is a weighted average of GDP (weight of 50percent), openness (30percent), economic variability (15percent), and international reserves (5percent). For this purpose, GDP is measured through a blend of GDPbased on market exchange rates (weight of 60percent)and on PPP exchange rates (40percent). The formula also includes a compression factor that reduces the dispersion in calculated quota shares across members. Quotas are denominated in Special Drawing Rights (SDRs), the IMFs unit of account. The largest member of the IMF is the United States, with a current quota of SDR42.1billion (about $58billion), and the smallest member is Tuvalu, with a current quota of SDR1.8million (about $2.47million).Quotas play several key roles in the IMFA member's quota determines that countrys financial and organizational relationship with the IMF, including:

Subscriptions. A member's quota subscription determines the maximum amount of financial resources the member is obliged to provide to the IMF. A member must pay its subscription in full upon joining the Fund: up to 25percent must be paid in SDRs or widely accepted currencies (such as the U.S. dollar, the euro, the yen, or the pound sterling), while the rest is paid in the member's own currency.

Voting power. The quota largely determines a member's voting power in IMF decisions. Each IMF members votes are comprised of basic votes plus one additional vote for each SDR100,000 of quota. The 2008 reform fixed the number of basic votes at 5.502percent of total votes. The current number of basic votes represents close to a tripling of the number prior to the implementation of the 2008 reforms.

Access to financing. The amount of financing a member can obtain from the IMF (its access limit) is based on its quota. For example, under Stand-By and Extended Arrangements, a member can borrow up to 200percent of its quota annually and 600percent cumulatively. However, access may be higher in exceptional circumstances.How quota reviews workThe IMF's Board of Governors conducts general quota reviews at regular intervals (usually every five years). Any changes in quotas must be approved by an 85percent majority of the total voting power, and a members quota cannot be changed without its consent. There are two main issues addressed in a general quota review: the size of an overall increase and the distribution of the increase among the members. First, a general quota review allows the IMF to assess the adequacy of quotas both in terms of members balance of payments financing needs and in terms of its own ability to help meet those needs. Second, a general review allows for increases in members quotas to reflect changes in their relative positions in the world economy. Ad hoc increases outside general reviews do not occur often, but the increases in quotas for 54 member countries approved under the 2008Reform are a recent example. Doubling of quotas and major realignment of quota sharesOn December 15, 2010, the Board of Governors, the Funds highest decision-making body, completed the 14th General Review of Quotas, which involved a package of far-reaching reforms of the Funds quotas and governance. Once the reform package is approved by member countries (it includes an amendment to the Articles of Agreement that requires acceptance by three-fifths of the members having 85percent of the total voting power) and implemented, there will be an unprecedented 100percent increase in total quotas and a major realignment of quota shares. This will better reflect the changing relative weights of the IMFs member countries in the global economy. The reform package builds onearlier reforms from 2008, which became effective on March3,2011. These strengthened the representation of dynamic economiesmany of which are emerging market countriesthrough ad hoc quota increases for 54member countries. They also enhanced the voice and participation of low-income countries through a near tripling of basic votes.Building on the 2008 reforms, the 14thGeneral Review of Quotas will: double quotas from approximately SDR 238.5billion to approximately SDR477billion (close to $655billion at current exchange rates), shift more than 6percent of quota shares from over-represented to under-represented member countries, shift more than 6percent of quota shares to dynamic emerging market and developing countries (EMDCs), significantly realign quota shares. China will become the thirdlargest member country in the IMF, and there will be four EMDCs (Brazil, China, India, and Russia) among the 10largest shareholders in the Fund, and preserve the quota and voting share of the poorest member countries. This group of countries is defined as those eligible for the low-income Poverty Reduction and Growth Trust (PRGT) and whose per capita income fell below $1,135 in 2008 (the threshold set by the International Development Association) or twice that amount for small countries. A comprehensive review of the current quota formula was completed in January 2013, when the Executive Board submitted its report to the Board of Governors. The outcome of this review will form a basis for the Executive Board to agree on a new quota formula as part of the 15thReview. Work on the 15th Review has been delayed, pending implementation of the 2010Reforms. In February 2015, the Board of Governors adopted a resolution calling for the completion of the 15th Review by December 15, 2015the deadline under the Articles of Agreement.1/ This review was conducted outside the five-year cycle. 5 B) International Bank for Reconstruction and Development

The International Bank for Reconstruction and Development (IBRD) is an international financial institution that offers loans to middle-income developing countries. The IBRD is the first of five member institutions that compose the World Bank Group and is headquartered in Washington, D.C., United States. It was established in 1944 with the mission of financing the reconstruction of European nations devastated by World War II. The IBRD and its concessional lending arm, the International Development Association, are collectively known as the World Bank as they share the same leadership and staff.[1][2][3] Following the reconstruction of Europe, the Bank's mandate expanded to advancing worldwide economic development and eradicating poverty. The IBRD provides commercial-grade or concessional financing to sovereign states to fund projects that seek to improve transportation and infrastructure, education, domestic policy, environmental consciousness, energy investments, healthcare, access to food and potable water, and access to improved sanitation.The IBRD is owned and governed by its member states, but has its own executive leadership and staff which conduct its normal business operations. The Bank's member governments are shareholders which contribute paid-in capital and have the right to vote on its matters. In addition to contributions from its member nations, the IBRD acquires most of its capital by borrowing on international capital markets through bond issues. In 2011, it raised $29 billion USD in capital from bond issues made in 26 different currencies. The Bank offers a number of financial services and products, including flexible loans, grants, risk guarantees, financial derivatives, and catastrophic risk financing. It reported lending commitments of $26.7 billion made to 132 projects in 2011.Assignment2 1 a) Arguments in favour:The main arguments in support of protection can be briefly summarised as follows: i. The Infant Industry Argument. There are many industries in a country that are in their infancy, but have a potential to grow. In the short-term, these industries may be too small to gain economies of scale. Without protection, these infant industries will not survive competition from abroad. Protection will allow such industries to grow and become more efficient.ii. Protection is required to prevent the establishment of a foreign- based monopoly so as to prevent mis-utilisation of resources.iii. Protection is required to prevent dumping and other unfair trade practices by foreign producers.iv. Trade restrictions are imposed to reduce the influence of trade on consumer tastes. Some restrictions on trade may be justified in order to reduce producer sovereignty of the MNCs.v. Protection helps to reduce reliance on goods with little dynamic potential. Many countries have traditionally exported primary commodities. The world demand for these commodities is income inelastic and thus grows relatively slowly. In such cases, free trade is not an engine of growth.vi. Protection is required to spread the risks of fluctuating markets. Greater diversity and greater self-sufficiency can reduce these risks.vii. Trade restrictions also help a country to improve its terms of trade by exploiting its market power.viii. Protection is required to take account of externalities. Free trade tends to reflect private costs ignoring the associated externalities. Trade restrictions could be designed to deflect these externalities.ix. Restrictions are required to prevent the import of harmful goods.Arguments against Protection Protection, however, imposes cost on a nation also. This can be summarised as follows: i. Protection to achieve some objective may be at a very high opportunity cost. Other things being equal, there will be a net loss in welfare from restricting trade. Due to this reason, any gain in government revenue or profits to firms would be outweighed by a loss in consumers surplus.ii. Restricting trade is unlikely to be a first-bed solution to the problem, since it involves costs of side-effect.iii. Restricting trade may have adverse world multiplier effects.iv. Protection may encourage retaliation.v. Protection may allow inefficient firms to remain inefficient.vi. Restrictions may involve considerable bureaucracy and possibly even corruption.

1 B) Non-Tariff Barriers to TradeNon-Tariff Barriers (NTBs) refer to restrictions that result from prohibitions, conditions, or specific market requirements that make importation or exportation of products difficult and/or costly. NTBs also include unjustified and/or improper application of Non-Tariff Measures (NTMs) such as sanitary and phytosanitary (SPS) measures and other technical barriers to Trade (TBT). NTBs arise from different measures taken by governments and authorities in the form of government laws, regulations, policies, conditions, restrictions or specific requirements, and private sector business practices, or prohibitions that protect the domestic industries from foreign competition. Examples of Non-Tariff BarriersNon-Tariff Barriers to trade can arise from: Import bans General or product-specific quotas Complex/discriminatory Rules of Origin Quality conditions imposed by the importing country on the exporting countries Unjustified Sanitary and Phyto-sanitary conditions Unreasonable/unjustified packaging, labelling, product standards Complex regulatory environment Determination of eligibility of an exporting country by the importing country Determination of eligibility of an exporting establishment (firm, company) by the importing country. Additional trade documents like Certificate of Origin, Certificate of Authenticity etc Occupational safety and health regulation Employment law Import licenses State subsidies, procurement, trading, state ownership Export subsidies Fixation of a minimum import price Product classification Quota shares Multiplicity and Controls of Foreign exchange market Inadequate infrastructure "Buy national" policy Over-valued currency Restrictive licenses Seasonal import regimes Corrupt and/or lengthy customs procedures2 a) Difference between Balance of Trade and Balance of PaymentsBasis of DifferenceBalance of Trade (BOT)

Balance of Payment (BOP)

1. Definition

Balance of trade may be defined as difference between export and import of goods and services.

Balance of payment is flow of cash between domestic country and all other foreign countries. It includes not only import and export of goods and services but also includes financial capital transfer.

2. Formula

BOT = Net Earning on Export - Net payment for imports

BOP = BOT + (Net Earning on foreign investment - payment made to foreign investors) + Cash Transfer + Capital Account +or - Balancing Itemor BOP = Current Account + Capital Account + or - Balancing item ( Errors and omissions)

3. Favourable or Unfavourable

If export is more than import, at that time, BOT will be favourable. If import is more than export, at that time, BOT will be unfavourable.

Balance of Payment will be favourable, if you have surplus in current account for paying your all past loans in your capital account.Balance of payment will be unfavourable, if you have current account deficit and you took more loan from foreigners. After this, you have to pay high interest on extra loan and this will make your BOP unfavourable.

4. Solution of Unfavourable ProblemTo Buy goods and services from domestic country.To stop taking of loan from foreign countries.

5. Factors

Following are main factors which affect BOTa) cost of productionb) availability of raw materialsc) Exchange rated) Prices of goods manufactured at homeFollowing are main factors which affect BOPa) Conditions of foreign lenders. b) Economic policy of Govt. c) all the factors of BOT

6. Meaning of Debit and Credit

If you see RBI' Overall balance of payment report, it shows debit and credit of current account. Credit means total export of different goods and services and debit means total import of goods and services in current account. Credit means to receipt and earning both current and capital account and debit means total outflow of cash both current and capital account and difference between debit and credit will be net balance of payment.

2 b) Reasons for disequilibrium in Balance of PaymentsANS: Causes of DisequilibriumVarious causes of disequilibrium in the balance of payments or adverse balance of payments are as follows:1. Development Schemes:The main reason for adverse balance of payments in the developing countries is the huge investment in development schemes in these countries. The propensity to import of the developing countries increases for want of capital for industrialization. The exports, on the other hand, may not increase because these countries are traditionally primary producing countries. Moreover the volume of exports may fall because newly created domestic industries may need them. All this leads to structural changes in the balance of payment resulting in structural disequilibrium.2. Price-Cost Structure:Changes in price-cost structure of export industries affect the volume of exports and create disequilibrium in the balance of payments. Increase in prices due to higher wages, higher cost of raw materials, etc. reduces exports and makes the balance of payments unfavorable.3. Changes in Foreign Exchange Rates:Changes in the rate of exchange is another cause of disequilibrium in the balance of payments. An increase in the external value of money makes imports cheaper and exports dearer; thus, imports increase and exports fall and balance of payments become unfavourable. Similarly, a reduction in the external value of money leads to a reduction in imports and an increase in exports.4. Fall in Export Demand:There has been a considerable decline in (he export demand for the primary goods of the underdeveloped countries as a result of the large increase in the domestic production of foodstuffs raw materials and substitutes in the rich countries. Similarly, the advanced countries also find a fall in their export demand because of loss of colonial markets. However, the deficit in the balance of payment due to the fall in export demand is more persistent in the underdeveloped countries than in the advanced countries.5. Demonstration Effect:According to Nurkse, the people in the less developed countries tend to follow the consumption patterns of the developed countries. As a result of this demonstration effect, the imports of the less developed countries will increase and create disequilibrium in the balance of payments.6. International Borrowing and Lending:International borrowing and lending is another reason for the disequilibrium in the balance of payments. The borrowing country tends to have unfavourable balance of payments, while the lending country tends to have favourable balance of payments.7. Cyclical Fluctuations:Cyclical fluctuations cause cyclical disequilibrium in the balance of payments. During depression, the incomes of the people in foreign countries fall. As a result, the exports of these countries tend to decline which, in turn, produces disequilibrium in the home country's balance of payment.8. Newly Independent Countries:The newly independent countries, in order to develop international relations, incur huge amounts of expenditure on the establishment of embassies, missions, etc. in other countries. This adversely affectsthe balance of payments position.9. Population Explosion:Another important reason for adverse balance of payments in the poor countries is population explosion. Rapid growth of population in countries like India increases imports and decreases the capacity to export.10. Natural factors:Natural calamities, such as droughts, floods, etc., adversely affect the production in the country. As a result, the exports fall, the imports increase and the country experiences deficit in its balance of payments.3 a) Government of India Policy on Exchange Rate Determination ANS: An exchange-rate regime is the way an authority manages its currency in relation to other currencies and the foreign exchange market. Between the two limits of fixed and freely floating exchange regimes, there can be several other types of regimes. In their operational objective, it is closely related to monetary policy of the country with both depending on common factors of influence and impact.The exchange rate regime has a big impact on world trade and financial flows. The volume of such transactions and the speed at which they are growing makes the exchange rate regime a central piece of any national economic policy framework.

In Fig. 21.2, as one moves from point A on the left to point B on the right, both the frequency of intervention by domestic monetary authorities and required level of international reserves tend to be lower.Under a pure fixed-exchange-rate regime (point A), authorities intervene so that the value of the domestic currency vis-a-vis the currency of another country, say the US Dollar, is maintained at a constant rate. Under a freely floating exchange-rate regime, authorities do not intervene in the market for foreign exchange and there is minimal need for international reserves.Exchange Rate System in India: India was among the original members of the IMF when it started functioning in 1946. As such, India was obliged to adopt the Bretton Woods system of exchange rate determination. This system is known as the par value system of pegged exchange rate system. Under this system, each member country of the IMF was required to define the value of its currency in terms of gold or the US dollar and maintain (or peg) the market value of its currency within per cent of the defined (par) value.The Bretton Woods system collapsed in 1971. Consequently, the rupee was pegged to pound sterling for four years after which it was initially linked to the basket of 14 currencies but later reduced to 5 currencies of Indias major trading partners.This system continued through the 1980s; through the exchange rate was allowed to fluctuate in a wider margin and to depreciate modestly with a view to maintaining competitiveness. However, the need for adjusting exchange rate became precipitous in the face of external payments crisis of 1991.As a part of the overall macro-economic stabilisation programme, the exchange rate of the rupee was devalued in two stages by 18 per cent in terms of the US dollar in July 1991. With that, India entered into a new phase of exchange rate management.Objectives of Exchange Rate Management: The main objectives of Indias exchange rate policy is to ensure that the economic fundamentals are truly reflected in the external value of the rupee.Subject to this predominant objective, the conduct of exchange policy is guided by the following: i. Reduce volatility in exchange rates, ensuring that the market correction of exchange rates is effected in an orderly and calibrated manner;ii. Help maintain an adequate level of foreign exchange reserves;iii. Prevent the emergence of destabilisation by speculative activities; andiv. Help eliminate market constraints so as to assist the development of a healthy foreign exchange market.Exchange Rate Reforms: Exchange rate reforms have proceeded gradually beginning with a two- stage cumulative devaluation of rupee by about 20 per cent effected in July 1991. Subsequently, the Liberalised Exchange Rate Management System (LERMS) was introduced in 1992, which was later replaced by the Unified Exchange Rate System (UERS) in 1993. The net result was an effective devaluation of the rupee by around 35 per cent in nominal terms and 25 per cent in real terms between July 1991 and March 1993.Features of the Current Regime: The principal features of the current exchange rate regime in India can be briefly stated as follows: i. The rates of exchange are determined in the market.ii. The freely floating exchange rate regime continues to operate within the framework of exchange control.iii. Current receipts are surrendered (or deposited) to the banking system, which in turn, meets the demand for foreign exchange.iv. RBI can intervene in the market to modulate the volatility and sharp depreciation of the rupee. It effects transactions at a rate of exchange, which could change within a margin of 5 per cent of the prevailing market rate.v. The US dollar is the principal currency for the RBI transactions.vi. The RBI also announces a Reference Rate based on the quotations of select banks on Bombay at twelve noon every day. The Reference Rate is applicable to SDR transactions and transactions routed through the Asia Clearing Union.In short, the India rupee has matured to a regime of the floating exchange rate from the earlier versions of a managed float.Convertibility on Current Account: The current regime of the exchange rate has been accompanied by full Convertibility on current account with effect from August 20, 1994. Accordingly, several provisions like remittances for service, education, basic travel, gift remittances, donation, and provisions of the Exchange Earners Foreign Currency Account (EEFCA) were relaxed.In a further move, announced in 1997, the RBI liberalised the existing regulations in regard to payments for various kinds of feasibility studies, legal services, postal imports and purchases of designs and drawings. With this, India acquired a status called as the IMF Article VIII Status.By attaining the Article VIII status, India has reached a position by which it can instill confidence among the international investor community, paving the way for further inflow of foreign capital. Further, India is also committed to allowing free outflow of current account payments (like interest) even if there is a serious foreign exchange crisis.Notwithstanding the above, the government still retains many controls on current account.Among these, the following may be specifically mentioned: i. Repatriation of export proceeds within six months;ii. Caps on the amounts spent on the purchase of services abroad;iii. Restrictions on the repatriation of interest on rupee debt;iv. Dividend-balancing for FDI in some consumer goods industries;v. Restrictions on the repatriation of interest on NRI deposits;vi. The rupee is not allowed to be officially used as international means of payment. Indian banks are not permitted to offer two- way quotes to NRIs or-non-resident banks.With the help of these controls, the governments can significantly alter the flow of foreign exchange and the exchange rate of rupee. Additionally, the RBI can influence the exchange rate through direct purchase and sale of foreign exchange in the market.Convertibility on Capital Account: Drawing on the experience of the past decade and a half, the extent and timing of capital account liberalisation is sequenced with other reforms like strengthening of banking systems, fiscal consolidation, market development and integration, trade liberalisation, etc. all of which are in tune with the changing domestic and external economic environment.A hierarchy is thus established in the sources and types of capital flows. The priority has been to liberalise inflows relative to outflows, but all outflows associated with inflows have been totally freed. Among the type of inflows, FDI is preferred for its stability, while short-term external debt is avoided. A differentiation is made between Corporates, individuals and banks.For outflows, the hierarchy for liberalisation has corporate at the top, followed by financial intermediaries and individuals. Restrictions have been eased for corporate Seeking investments and acquisitions abroad, which strengthen their global presence. Banks and financial intermediaries are considered a source of greater volatility as their assets are relatively illiquid and their liabilities are demandable.They are thus susceptible to self-fulfilling crisis of confidence leading to contagion effect. In view of this, liberalisation for outflows in this sector has been tied to financial sector reforms. For individuals, residents are treated differently from nonresidents, and non-resident Indians are accorded a well-defined intermediate status between residents and non-residents.Intervention by RBI: The current exchange rate regime, introduced in 1993, the RBI has been, actively intervening in the foreign exchange market with the objective of maintaining the real effective exchange rate (REER) stable.The RBI uses two types of intervention in this regard: i. Direct Intervention: It refers to purchases and sales in international currency (i.e. US dollars and euro) both on the spot and also in forward markets.ii. Indirect Intervention: It refers to the use of reserve requirements and interest rate flexibility to smoothen temporary mismatches between demand and supply of foreign currency.Intervention by the RBI has raised a question as to whether or not there should be an exchange rate band within, which the central bank should allow the currency to fluctuate. The Tarapore Committee in its report on Capital Account Convertibility had, while suggesting transparency in the exchange rate policy of the central bank, recommended a band within which it would allow the currency to move.The RBI has been, in contrast, saying that there cannot be such rigidities in exchange rate policy, and, therefore, the bank should have the right to intervene at its discretion. Such interventions are considered necessary till the rupee is made fully convertible.3 b) Exchange Rate Determination under Balance of Payment Approach

ANS: Exchange Rate DeterminationForeign exchange markets are amoung the largest markets in the world with an annual trading volume in excess of $160 trillionIt is an over-the-counter market, with no central trading location and no set hours of trading.Prices and other terms of trade are determined by computerized negotiation.There are three markets for foreign exchange: Spot market - deals with currency for immediate delivery (within one or two business days) Forward market - involves the future (one, three or six months from today) delivery of foreign currency Currency futures and options market - deals in contract to hedge against future changes in foreign exchange rates.Simple model of spot market exchange rates using supply and demandCurrent Account Factors Changes in relative inflation rates, Changes in tastes, Factors that determine comparative advantage.Capital Account Factors Changes in interest ratesExchange rates can be floating pegged floating pegFloating exchange rates

Exchange rates are also affected by specualation over future currency values. A currency that is considered undervalued brings forth buy orders.The Forward Market for CurrenciesInvestors, businesses and other involved in foreign currency markets may want to guarentee the exchange rate that they will receive at some time in the future.Take out a forward contract in the forward exchange market.If the customer does not know if they will actually need the foreign currency, they can take out an option forward contract.Methods of measureing and quoting forward exchange rates:Outright rate - defines an exchange rate (e.g. 100 = $1)Express the forward rate as a premium or discount from the spot rate, know as the swap rate.Express the forward rate as an annualized percentage rate above or below the current spot rateFunctions of the Forward Exchange MarketCommercial CoveringFor transaction of goods and services that are to be delivered in the future.e.g. U.S. importer of Japanese radios agrees to pay 1 million for the shipment upon receipt in 30 days. if current spot rate is 100 = $1, and stays constant, then will cost importer $10,000Importer faces the risk that the dollar will depreciate.Takes out a 30-day forward contract for the delivery of 1 million at the forward market rate of $.01/ (or 100 = $1). When the 1 million payment is due by the importer, the importer also takes delivery of the 1 million yen as given by the forward contract in exchange for $10,000. The 1 million is then used to pay for the radio shipment.Hedging of an Investment PositionSuppose there is a U.S.-based mutual fund (e.g. The Japan Fund) that purchases Japanese stocks and bonds for (primarily) U.S. investors.The fund manager faces two types of risk: market risk - the value of his or her assets will decline, exchange rate risk - since the assets are denominated in yen, but the value of these assets are reported in dollars, a depreciation of the yen will reduce the NAV of the portfolio even if the yen value of the portfolio remains constant.To reduce exchange rate risk, the fund manager can hedge with currency forwards.Fund manager sells forward contracts of yen.e.g. fear is that the yen will depreciate from 100 = $1 Manager sells forward contracts worth 1 billion ($10m) at exchange rate of 100 = $1.When this forward contract matures, if the spot price of the yen has depreciated to 120 = $1, the fund can buy yen on the spot market and deliver them at the contract price of 100 = $1.Will cost the fund manager $8.3 million to purchase 1 billion and then can sell yen for $10 million. For a profit of $1.7 million on the foreign exchange transaction.If the fund manager sells contracts in an amount that covers both principal and interest or dividends, then the manager has "locked in" their investment return regardless of which way exchange rates go.If instead the yen were to appreciate, the currency trading losses are offset by the increased dollar value of the portfolio due to the yen's appreciation.Speculation on Future Currency PricesSpeculators will buy currency for future delivery if they believe the spot rate will be higher on the delivery date than at the current forward rate (appreciate).Speculators will sell currency forward contracts if they believe the spot rate will be lower on the delivery date than at the current forward rate (depreciate).Covered Interest ArbitrageArises when an investor invests in foreign securities because the interest rate is higher than on comparable domestic securities.Covered Interest Arbitrage - reduce currency risk by using a forward contract.Currency FuturesWhile forward contracts usually result in the actual delivery of the currency, futures contracts in foreign currency are increasingly used. These contracts are typically zeroed out and the currency is not delivered.e.g. you buy one ton of pork belly futures, rather than taking delivery, you zero out the contract by selling an opposite contract before the first contract matures.Note that as currencies appreciate in the spot market, the market value of currency futures also rise along with the market value of the underlying currency.the net rate of return to the investor from any foreign investment is equal to the interest earned plus or minus the forward premium or discount on the price of the foreign currency involved in the transaction.Under normal circumstances, the forward discount or premium on one currency relative to another is directly related to the difference in interest rates between the two countries involved.The currency of a nation with the higher market interest rates normally sells at a forward discount in relation to the currency of the nation with lower interest rates. The currency of a nation with the lower market interest rates normally sells at a forward premium in relation to the currency of the nation with lower interest rates. Interest rate parity exists when the interest rate differential between two nations exactly equals the forward discount or premium of the two currencies.When parity exists, the currency markets are in equilibrium and there is no net flow of capital funds between the two countries seeking a higher return.In this case, the higher return from interest rates abroad is fully offfset by the cost of covering currency risk in the forward exchange market.e.g. Interest rates in the U.S. are 3% higher than in Japan.As a result, the dollar, when in equilibrium, sells at a 3% discount in the forward exchange market. While the yen sells at a 3% premium.In this case, once currency risk is covered, there is no yield benefit for Japanese investors to purchase U.S. securities.Unless, they also expected the prices of these U.S. securities to rise.When interest rate parity does not exist, then there are international net capital flows.**** e.g. Interest rates in the U.S. are 3% higher than in Japan.And the dollar sells at only a 1% discount in the forward exchange market.Money flows from Japan to the U.S. as Japanese investors have a net return of 2% after covering for exchange rate risk.Also the $ appreciates relative to the yen due to the increased demand for dollars. But if the dollar is considered overvalued, then expect it to depreciate back to normal value. Fearing the dollars depreciation, Japanese investors are selling forward contracts on dollar, increasing the discount on these contract and also increasing the premium on contracts to buy yen.Comparing Expected returns on domestic and foreign assetsAssume that the spot exchange rate is 100 = $1 and the expected exchange rate in one year (EXe) is 105 = $1, a 5% increase in the value of the dollar.Assume that the present yield on a one-year 100,000 Japanese government bond equals 5%.If you buy this bond, the cost in dollars is $1,000 that is then converted to yen.After one year, the value of the investment equals 105,000.The expected dollar value of the investment is:105,000/105 = $1,000A general formula to compare total returns from investing $1 in a domestic or foreign asset.Value of $1 investment after one year = EX ( 1 + if ) / EXe where: i = interest rate on the domestic security if = interest rate on the foreign security EX = current exchange rate EXe = expected future exchange ratein this example:(100 = $1)(1.05) / (105 / $1) = $1.00can rewrite the formula so it divides the return into two parts, interest and expected exchange rate change:Value of $1 investment after one year = 1 + if - (change)EXe / EXin our example the expected change in the exchange rate was 5% as the yen depreciated from100 = $1 to 105 = $1Foreign-exchange Market EquilibriumWould a situation in which investors could earn a higher expected rate of return from buying Japanese rather than U.S. assets persist for a long time? The opportunity for traders in the foreign exchange market to make a profit eliminates these opportunities.If a U.S. asset has a higher expected return than a comparable Japanese asset, traders would sell Japanese assets and buy the U.S. assets, increasing the demand for dollars. As a result, the dollar will appreciate relative to the yen to the point at which investors are indifferent between holding U.S. or Japanese assets.

The concept is illustrated in the above graph. The y-axis measures the current exchange rate (EX) The x-axis is the expected rate of return, in dollar terms from investing in a U.S. or Japanese asset. for U.S. assets, the expected rate of return, R, equals the U.S. interest rate i the expected rate of return on foreign assets in dollar terms, Rf , equals if - (change)EXe / EX.For Japanese assets, the expected rate of return, Rf equals the Japanese interest rate if less the expected appreciation of the dollar.R is a vertical line because the return on U.S. assets is the same regardless of the exchange rate. Assume a U.S. interest rate of 5%To graph Rf against the exchange rate, we must first specify the expected future yen/dollar exchange rate.This is done by calculating the dollar's expected rate of appreciation, a component of Rf .If the current yen/dollar spot rate exceeds that expected future exchange rate, investors believe that the dollar is unually strong and it will eventually depreciate.For a given expected exchange rate, a graph of Rf against the current exchange rate slopes upward; as the yen/dollar exchange rate rises, the dollar's expected rate of appreciation falls, pushing up Rf .the more the yen depreciates, the less we expect it to depreciate in the future.e.g assume that the future yen/dollar exchange rate is expected to be 100 and that Japanese interest rates are 5%.a. If the current exchange rate is also 100/$1, no dollar appreciation is expected and Rf equals the 5% Japanese interest rate.b. If the current exchange rate is 105/$1, the dollar is expected to depreciate back to 100/$1 (for a decrease of 4.8%) and Rf equals the 5% Japanese interest rate plus the appreciation of the yen of 4.8% for a total of 9.8%.c. If the current exchange rate is 97/$1, the dollar is expected to appreciate back to 100/$1 (for an increase of 3.1%) and Rf equals the 5% Japanese interest rate minus the depreciation of the yen of 3.1% for a total of 1.9%.connecting these three points yields the Rf line.The equilibrium exchange rate is the one that equates R and Rf . In this case it is 100/$1Suppose the exchange rate is 97/$1. The dollar is expected to appreciate by 3.1%Since the rate of return on Japanese assets is 1.9%, investors switch to U.S. assets.The increased demand for dollars leads to a dollar appreciation. The appreciation of the dollar continues as long as the relative yield on U.S. assets is higher. Finally the yields are in equilibrium at 100/$1.Interest Rate ParityThe exchange rate market condition described here is known as the interest rate parity condition.Given identical characteristics regarding risk, liquidity, time to maturity, etc, domestic and foreign assets should have identical nominal returns.Any difference in the nominal rate of return between identical assets in two countries reflects expected currency appreciation or depreciation.When the domestic interest rate is higher than the foreign interest rate, the domestic currency is expected to depreciate.Equilibrium condition is: Expected return on domestic asset - Expected return on foreign asseti = if - (change)EXe / EXThis does not imply that nominal interest rates are the same throughout the world. Rather that expected nominal returns on comparable domestic and foreign assets are the same.In real terms, the real interest rate parity condition is:i + r = (1 + rf)(EXr / EXer )Expected real return on domestic investment = expected real return on foreign investment.Exchange Rate Fluctutations Changes in domestic real interest rates

The expected return on domestic bonds depends on the interest rate i.That interest rate is the sum of the expected real rate of interest and the expected rate of inflationHolding expected inflation constant, an increase in the domestic interest rate increases the expected rate of return on domestic assets, shifting the R curve to the right.The increased demand for dollars leads to an appreciation of the dollar.Changes in domestic expected inflation

Hold foreign real rate of return Rf constantIf domestic inflatonary expectations increase, then domestic currency loses purchasing power, causing it to depreciate.Two things happen:1. The higher domestic nominal interest rate shifts the expected rate of return to the right (foreign investors will not be affected by the domestic inflation increase but have the benefits of higher return on assets). As a result, the current exchange rate rises.2. An increase in expected inflation reduces expected appreciation of the domestic currency, so the expected foreign rate of return shifts to the right, increasing the attractiveness of foreign assets to consumers.Although the two effects work in opposite directions, we can usually expect the domestic currency to depreciate with higher inflation.Changes in foreign interest rates

An increase in the foreign real interest rate shifts the foreign expected rate of return from Rf0 to Rf1 because at any exchange rate, the foreign rate of return increases.Currency depreciates as money moves abroad.Changes in the Expected Future Exchange Rate

If the expected future exchange rate increases, expected appreciation of the domestic currency rises.Since an appreciation of the domestic currency is good for the value of domestic assets, investors increase their demand for the domestic currency. And the expected rate of return on the foreign assets falls due to the relative depreciation of that currency shift inward the return on foreign assets.Resulting in an increase in the actual exchange rate.Currency Premiums in Foreign-Exchange MarketsThe interest rate parity condition is based on the assumption that domestic and foreign assets with similar attributes are perfect substitutes.But if we allow for imperfect substitutability, we can modify the equation to allow for a currency premium where investors have a preference for the financial assets denominated in one currency over the other.i = if - (change)EXe / EX - hf,dFor example, assume that the one year T-bill rate in the U.S. is 8% and the one-year government bond rate in Germany is 5%.Also assume that investors expect the dollar to depreciate against the mark by 4% over the coming year.The one-year mark/dollar currency premium is8% = 5% - ( -4%) - hf,d, or hf,d= 1%This implies that investors require a 1% higher expected rate of return on the German bond relative to the U.S. T-bill to make the two financial assets equally attractive.If hf,dis positive, it implies that investors prefer the domestic currency asset.In this case, investors will not buy a foreign bond if the expected rate of return just equals that of a domestic bond.Investors require an additional incentive to buy the foreign asset, the currency premium in the form of a higher yield on foreign assets.The size of the currency premium depends on: investors aversion to currency risks, differences in liquidity in markets information about foreign investment opportunities investors' belief that one currency is more stable or safer than another.

Traditional view of exchange rates results in adjustments to international trade in goods. Other approaches include the capital account as a determinent of exchange rates.Explore the role of financial assets.

4 a) Objectives of Special Economic ZonesANS:Special Economic Zones (SEZs) are specially earmarked geographical zones, which can be developed by a private sector or public sector developer or in a public private partnership (PPP) model.In these zones, units function under rules and regulations different from those under which other units in the country operate. The units in the SEZs have to be net foreign-exchange earners but they are not subjected to pre-determined value addition or asked to fulfill minimum export performance requirements. Approved industrial units, banks, insurance, etc., can be located here.SEZs in India are modified versions of the earlier export processing zones. The policy to set up SEZs, first introduced in April 2000, got a legal validity with the SEZ Act passed in 2005. The Act came into force on February 9, 2006.A state can have more than one SEZ with freedom to the manufacturing unit to establish in any SEZ in any state. State governments will have to attract industry by framing bold policies and providing world-class external infrastructure to the zone.The SEZ Act includes India specific rules which provide for drastic simplification of procedures and single window clearance on matters relating to Central and state governments along with income-tax exemptions for 15 years. They also provide for setting up multi-product and product-specific zones while also making provisions for services sector SEZs.It was clarified that there would be no relaxation of labour laws in these zones though some states had sought relaxation of these provisions. Other laws of the land would also prevail, but for the purposes of customs duty levies, the zones would be treated as foreign territory.Objectives of SEZs: In an era of intense competition for markets and investment, SEZs attract export-oriented foreign direct investment and develop industrial skills and resources to successfully compete in the international economy.They can promote foreign trade.They can create employment.They can develop relatively less developed areas, and thus reduce disparities in socio-economic development, besides accelerating industrialisation and urbanisation.Why Opt for SEZs: The SEZs provide facilities to help support production units which can match the international level in quality. The SEZ exports can reach a staggering high, boosting a countrys exports tremendously. They promote economic activity through backward and forward linkages with domestic economies and aid in development of technological and learning spillovers. They are one way of ensuring infrastructure and other facilities come up across the countrya difficult thing to ensure otherwise.The world-class infrastructure set up will cut down the cost of conducting business and render the industry competitive globally. The infrastructure will include electricity availability at competitive rates, capital availability at internationally benchmarked rates, good transport links to check shipment delays and flexible labour laws.The SEZs are duty-free enclaves and deemed foreign territories where trade operations, duties and tariffs are concerned. The exemptions given to SEZs mean that infrastructure facilities are available at lower cost. SEZs are also seen as good attractions of FDI.Objections to SEZs: In spite of the advantages of SEZs, objections have been raised against the utility of SEZs. Economists argue that they attract investment by extending lopsided incentives rather than creating competitive conditions. The SEZs cannot operate to a countrys advantage without certain necessary conditions. Proper location, incentives, policies, linkage between them and the domestic sector and sufficient trained human capital are all necessary to prop up the SEZs.There should also be the back-up of accurate identification of markets, multi-market strategy and other factors. It is also feared that as the policy inside the SEZs is quite attractive, investors may relocate their operations here to benefit from the facilities.So the incentives to firms may put a fiscal burden on the taxpayer. The costs of maintaining zone privilegesdirect and indirectwould lead to pockets of prosperity and the economy as a whole in the true sense would not benefit.Special tariff zones that are being created go against canons of public finance that advocate uniformity. There is also the question whether the selectivity inherent in the SEZ policy might slow down action on the more difficult work of improving infrastructure for the whole country. Critics also fear that SEZs would come up in those states with a strong tradition of manufacturing and exports: this would only aggravate regional, disparities.The National Association of Software and Service Companies (NASSCOM) has said that the SEZ scheme favours big companies and not small ones.Apprehensions have been expressed on misuse of the scheme and relocation of existing industries into SEZs. However, experience has shown that these apprehensions are ill-founded and fresh investments and employments have been flowing into the SEZs.The benefits derived from multiplier effect of the investments and additional economic activity in the SEZs along with the employment generated is estimated to far outweigh the revenue losses on account of tax exemptions given to the SEZs. These SEZs are freshly developed industrial clusters and are not relocated from elsewhere.Concerns have also been expressed regarding acquisition of agricultural land for setting up SEZs.4 b) Gold StandardANS: The gold standard was a domestic standard regulating the quantity and growth rate of a countrys money supply. Because new production of gold would add only a small fraction to the accumulated stock, and because the authorities guaranteed free convertibility of gold into nongold money, the gold standard ensured that the money supply, and hence the price level, would not vary much. But periodic surges in the worlds gold stock, such as the gold discoveries in Australia and California around 1850, caused price levels to be very unstable in the short run.The gold standard was also an international standard determining the value of a countrys currency in terms of other countries currencies. Because adherents to the standard maintained a fixed price for gold, rates of exchange between currencies tied to gold were necessarily fixed. For example, the United States fixed the price of gold at $20.67 per ounce, and Britain fixed the price at 3 17s. 10 per ounce. Therefore, the exchange rate between dollars and poundsthe par exchange ratenecessarily equaled $4.867 per pound.Because exchange rates were fixed, the gold standard caused price levels around the world to move together. This comovement occurred mainly through an automatic balance-of-payments adjustment process called the price-specie-flow mechanism. Here is how the mechanism worked. Suppose that a technological innovation brought about faster real economic growth in the United States. Because the supply of money (gold) essentially was fixed in the short run, U.S. prices fell. Prices of U.S. exports then fell relative to the prices of imports. This caused the British to demand more U.S. exports and Americans to demand fewer imports. A U.S. balance-of-payments surplus was created, causing gold (specie) to flow from the United Kingdom to the United States. The gold inflow increased the U.S. money supply, reversing the initial fall in prices. In the United Kingdom, the gold outflow reduced the money supply and, hence, lowered the price level. The net result was balanced prices among countries.The fixed exchange rate also caused both monetary and nonmonetary (real) shocks to be transmitted via flows of gold and capital between countries. Therefore, a shock in one country affected the domestic money supply, expenditure, price level, and real income in another country.The California gold discovery in 1848 is an example of a monetary shock. The newly produced gold increased the U.S. money supply, which then raised domestic expenditures, nominal income, and, ultimately, the price level. The rise in the domestic price level made U.S. exports more expensive, causing a deficit in the U.S. balance of payments. For Americas trading partners, the same forces necessarily produced a balance-of-trade surplus. The U.S. trade deficit was financed by a gold (specie) outflow to its trading partners, reducing the monetary gold stock in the United States. In the trading partners, the money supply increased, raising domestic expenditures, nominal incomes, and, ultimately, the price level. Depending on the relative share of the U.S. monetary gold stock in the world total, world prices and income rose. Although the initial effect of the gold discovery was to increase real output (because wages and prices did not immediately increase), eventually the full effect was on the price level alone.For the gold standard to work fully, central banks, where they existed, were supposed to play by the rules of the game. In other words, they were supposed to raise their discount ratesthe interest rate at which the central bank lends money to member banksto speed a gold inflow, and to lower their discount rates to facilitate a gold outflow. Thus, if a country was running a balance-of-payments deficit, the rules of the game required it to allow a gold outflow until the ratio of its price level to that of its principal trading partners was restored to the par exchange rate.The exemplar of central bank behavior was the Bank of England, which played by the rules over much of the period between 1870 and 1914. Whenever Great Britain faced a balance-of-payments deficit and the Bank of England saw its gold reserves declining, it raised its bank rate (discount rate). By causing other interest rates in the United Kingdom to rise as well, the rise in the bank rate was supposed to cause the holdings of inventories and other investment expenditures to decrease. These reductions would then cause a reduction in overall domestic spending and a fall in the price level. At the same time, the rise in the bank rate would stem any short-term capital outflow and attract short-term funds from abroad.Most other countries on the gold standardnotably France and Belgiumdid not follow the rules of the game. They never allowed interest rates to rise enough to decrease the domestic price level. Also, many countries frequently broke the rules by sterilizationshielding the domestic money supply from external disequilibrium by buying or selling domestic securities. If, for example, Frances central bank wished to prevent an inflow of gold from increasing the nations money supply, it would sell securities for gold, thus reducing the amount of gold circulating.Yet the central bankers breaches of the rules must be put into perspective. Although exchange rates in principal countries frequently deviated from par, governments rarely debased their currencies or otherwise manipulated the gold standard to support domestic economic activity. Suspension of convertibility in England (1797-1821, 1914-1925) and the United States (1862-1879) did occur in wartime emergencies. But, as promised, convertibility at the original parity was resumed after the emergency passed. These resumptions fortified the credibility of the gold standard rule5 A) Sources of International LiquidityANS: International LiquidityThe concept of international liquidity is associated with international payments. These payments arise out of international trade in goods and services and also in connection with capital movements between one country and another. International liquidity refers to the generally accepted official means of settling imbalances in international payments.In other words, the term 'international liquidity' embraces all those assets which are internationally acceptable without loss of value in discharge of debts (on external accounts).In its simplest form, international liquidity comprises of all reserves that are available to the monetary authorities of different countries for meeting their international disbursement. In short, the term 'international liquidity' connotes the world supply of reserves of gold and currencies which are freely usable internationally, such as dollars and sterling, plus facilities for borrowing these. Thus, international liquidity comprises two elements, viz., owned reserves and borrowing facilities.Under the present international monetary order, among the member countries of the IMF, the chief components of international liquidity structure are taken to be:1. Gold reserves with the national monetary authorities - central banks and with the IMF.2. Dollar reserves of countries other than the U.S.A.3. -Sterling reserves of countries other than U.K.It should be noted that items (2) and (3) are regarded as 'key currencies' of the world and their reserves held by member countries constitute the respective liabilities of the U.S. and U.K. More recently Swiss francs and German marks also have been regarded as 'key currencies.4. IMF tranche position which represents the 'drawing potential' of the IMF members; and5. Credit arrangements (bilateral and multilateral credit) between countries such as 'swap agreements' and the 'Ten' of the Paris Club.Of all these components, however gold and key currencies like dollar today entail greater significance in determining the international liquidity of the world.However, it is difficult to measure international liquidity and assess its adequacy. This depends on gold and the foreign exchange holdings of a country, and also on the country's ability to borrow from other countries and from international organisations. Thus, it is not easy to determine the adequacy of international liquidity whose c