What is Capital Account in the Balance of Payments of a Country?

1. Introduction

In determination of the capital account in the balance of payments of a country there are two crucial variables, namely:

1. The Real Exchange Rate

2. The Real Rate of Interest

The Real Exchange Rate (RER) is critical in influencing the competitiveness of traded goods, since it measures the cost of foreign goods relative to domestic goods in trade transactions. The measure of changes in the RER is thus, useful in explaining the foreign trade behaviour and the changes in national income of a country (see, Ickes, 2004).

The concept of real exchange rate rather than the nominal exchange rate tends to be more significant in analysing the trade behaviour under the system of flexible or floating exchange rates.

The question of real exchange rate emerges in solving trade disputes and the new IMF surveillance when one wants to examine whether a country’s currency is fundamentally overvalued or undervalued (Catao, 2007).

2. Nominal Versus Real Exchange Rate

Normal Exchange Rate (ER) refers to the domestic price of buying a foreign currency (the foreign exchange). From India’s point of view, for instance, buying a U.S. dollar costs Rs.40, when the nominal exchange rate is:

1US$ = Rs.40

Nominal exchange rate is, thus, defined as the ratio of the price of one currency in terms o another.

Real Exchange Rate (RER), on the other hand, is measured by considering the price levels o goods (inflation rates) in two related countries, along with the nominal exchange rate, thus:

RER = Real Exchange Rate

P’ = Foreign Inflation Rate Price level in the foreign country, say the U.S.A.

P = Domestic Inflation Rate Domestic price level, say in India.

It follows that:

1. If P* = P, then: RER = ER”

That is to say, the real exchange rate is the same as the nominal exchange rate. The absolute purchasing power parity (PPP) holds in this case.

2. Then, RER > ER*** That means there is an appreciation of the real exchange rate, when (AP’/P’) > (A/V

In other words, when foreign inflation rate is exceeding the domestic inflation rate, the country real exchange rate would appreciate.

3. If P'<P

Then, RER < ER

That means there is a depreciation of the real exchange rate, when (PA/P’) < (AP/P). Other words, when foreign inflation rate is lower than that of the domestic situation, the country real exchange rate would depreciate.

It follows that fundamentally when the real exchange rate (RER) diverges from the nominal exchange rate (ER), the currencies encounter with pressure to change. For an undervalued currency (when RER > ER), the pressure is to depreciate. For an overvalued currency (when RER < ER), the pressure is to appreciate.

An issue in trade disputes arises when the government policies obstruct normal equilibration process of exchange rate.

For all practical purposes, to measure the real exchange rate, the relative price level (P’/P) is measured in verms of an index number, usually, the consumer price index (CPI), or GDP deflator with a bench-mark.

Thus, RER index numbers for the two respective countries are worked out in a series with a base year.

If the RER indices between countries remain unchanged over a period of time, it implies that the relative purchasing power parity (PPP) holds good.

The following formula is conventionally used to measure the real exchange rate index. Thus:

Where,

RER = Real Exchange Rate is measured as an index number in terms of 100.

ER = Nominal Exchange Rate measured as the domestic currency units per unit of foreign currency.

t = Current year

o = Base year.

In economic analysis, thus, there are several measures used, such as:

1. Nominal exchange rate

2. Normal Bilateral Exchange Rate (relative to one another specific country’s currency)

3. Normal effective exchange rate

4. Real Exchange Rate

5. Real Bilateral Exchange Rate

6. Real Effective Exchange Rate (taken as a weighted average relative a number of other countries’ currencies).

3. Determinants of the RER

What causes changes in the RER? There are two major factors to be considered here.

Demand:

A change in export demand for the concerned country; say India. When the world demands the Indian goods has an increase, its demand curve of expandable shifts to the right.

Against the given supply, S curve, when demand for Indian goods increases, the demand shifts from D to D_p the original equilibrium exchange rate changes from R to R_r This is because current exchange rate when there is an excess demand for the Indian goods, the relative price of Indian goods must rise relative to the foreign price, in order to restore the equilibrium.

Thus, when P > P’ in the measure, RER = ‘ , the RER would fall. RER < ER.

means there is a depreciation of the country’s real exchange rate. This implies that, the ex’ value of Indian Rupee (nominal exchange rate ER) has appreciated in real terms, since the pure power of the Rupee has increased relative to foreign goods.

Supply

A change in the supply of Indian exportable. May occur due to technological and man changes. Suppose the Indian output of exports supply tends to rise, there may be an excess of against the demand. That is to say, when increase in foreign demand for Indian exportable is less than the increase in the output supply of exportable, the price of the Indian goods must fall in order to restore the equilibrium.

The real exchange rate tends to appreciates when the country’s productivity growth takes place which is reflected through increase in output and the supply of exportable.

A rise in the real exchange rate or its appreciation causes a positive effect on the country’s balance of payments.

Appreciation of RER, thus, serves as a mechanism of BOP adjustment to deal with the current account deficit (CAD).

4. Real Effective Exchange Rate

The Real Effective Exchange Rate (REER) is derived by the weighted average of the bilateral real exchange rates (RERs) between the concerned nation and each of its trading partners. Weights are assigned in terms of the respective trade shares of each trading partners.

Suppose, a country has four major trading partners nations: A, B, C, and D. Then, the real effective exchange rate (REER) of a given country (x) is measured as:

Here, a, b, c, and d are referred to the respective country and its trading share (S). RER_a implies the concern country’s real exchange rate in relation to A’s currency. Likewise REE_h refers to real exchange rate against B currency and so on.

The formula can be extended in general for’«’ partners nations to a country, thus:

REER = E RER /N

Where, 27is sum of, N= number of partner countries, n= 1,2, 3, …«.

5. Misalignments :

On an average, a country’s real effective exchange rate may not indicate an overall misalignment – under an overvaluation of the currency – when for some partners it may be over-valued and for some under-valued.

To trace its general misalignment or misevaluation and its extent, a series of the REER needs to be worked out over a period of time. Intensified fluctuations would reflect the nature of misalignment.

Catao (2007), for instance, mentions that REER fluctuations among the advanced nations were within the band of 30 per cent in the past. In the 1980s, however, the U.S. economy had REER fluctuations up to a level of 80 per cent.

All large REER fluctuations, however, cannot be considered to be the cases of misalignment. Many times, factors such as changes in transportation costs, taxes and tariffs may have been responsible for such variations in the REER of a country. Besides, the fluctuations in the prices of non-tradable goals relative to those of tradable goods in the developing economies are causing the variations in the REER.

This is a referred to as the ‘Balassa-Samuelson Effect’. Differences in fiscal policies and measures among the different nations may also cause variations in the REER which cannot be termed as misalignment.

Concluding Remarks

In Open Economy Macroeconomics, misalignments in the RERs are recognised to be a tool to predict future exchange rate shifts. Overvaluation of currencies indicates an early warning of possible currency crashes (Krugman, 1979).

For a sustainable growth and development of the trade and economy, stability of real exchange rate of a country’s currency is important. Unstable and overvalued real exchange rates provide weak incentives to the exports growth (The World Bank, 1984).