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 Section A
Balance of Payments
Answer 1

i. Understanding Balance of Payments :

The balance of payments accounts of country can be best compared to being a record of the
value of all transactions that take place between the residents of one country with the
residents of other countries in the world in a specific period of time, the Balance of payments
can be best viewed as a statistical summary of international transactions, where each
transaction can be very carefully identified as the exchange or ownership of something that
has economic value and can be very well defined in monetary terms. As identified by many
economic scholars, researchers and known economists these transfers are characteristics of
being of the following nature:

• These could be goods that are tangible and can be identified as goods/ commodities or
products.

• These could even be services that consist of tangible commodities that are being
produced, transferred with simultaneous consumption.

• Income which can be best represented under services and finally

• These could take the form of financial claims on, and liabilities to, in context to the rest of
the world these may even include changes that occur within a country’s reserve assets that
are being held by the central monetary authorities.

The balance of accounts can be best identified and studied in two distinct parts which are then
further studied in sub parts, the two main parts of a balance of account for a country are:

1. The Current Account: the current account of the balance of payments accounts can be
looked at measuring and reporting the flow of funds that come across the country as trade

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 of goods, services and other sources of income inflows into the economy, economists
study the current account as further three sub parts which are:

 The balance of trade in goods: this is best addressed as the “visible trade balance”
or the “merchandise account balance” or even “the balance of trade”, the primary
objective of this account is to evaluate the revenue received from exports from the
economy minus the expenses born by the country for the imports. This accounts
for all trades in the country; furthermore the researcher identifies the following
relationship.

When Exports are greater than imports it’s a condition of surplus

When Exports are less than imports it’s can be identified as a deficit

 The balance of trade in services: this is also known as “invisible balance”, the
“service balance” or the “net balance”, this area of balance of accounts looks into
areas like banking, insurance and tourism. Balance of services can be best
represented as the sum of revenue received from the exports of services minus the
expenditure borne by the country on the import of any service.

 The third aspect of the current account is the Net income flows, this can further be
classified and studied as below:

o Net investment incomes, which are nothing but the measure of monetary
movement of profits, interest etc in and out of any country at any specific
point of time.

o Net transfer of money, these can be best represented as foreign aid or

grants, these do not reflect any actual exchange of goods or services, but
represent a payment that has been made between two countries.

2. The capital accounts: the capital accounts for any balance of accounts for a country
measures the buying and selling of assets between two countries, where the assets can be
very broadly classified and studied as any element that can be owned and has a specific
value associated with it, this may include land, real estate etc. The primary reason and the
significance of the existence of the capital accounts is that is often used by economists to
measure the net change that has occurred over a period of time in foreign and domestic

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 ownership of the country. The researcher during the investigation in the area of research
identifies the following:

If all other associated accounts reflect an increase then it is reported that there is a surplus
in the official reserve account.

If a decrease is reported then a deficit is reported in the official reserve account.

However if a net change is report there is believed to be a balance of accounts, the

existence of net change is never achievable due to the fact there are numerous
transactions that need to be accounted for, which calls for the introduction of a balancing
item best identified as the “net errors” that ensures the existence of net change.

ii. How USA ran a current account deficit for almost 30 years:

As the illustration below reflects the quarterly data from the US current account balance as a
percentage of GDP starting from the period 1973, there is a strong trend that reflects that the
deficits has shown a significant increase since the 1992, the other element of consideration in
this illustration is that this period when considered under the RER index has experienced a
significant gyrations.

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As reflected in the financial health of the US, it has come to the notice that the net FDIs flows
from the period marked from 2002, has had a steep fall and have at time been reported to be
negative, furthermore the researcher adds that during the years 2003-2004, the growing US
current account deficits were very difficultly managed and financed through the net fixed
income and to be more specific through the official foreign purchase if government securities.

As the illustration above is reflective of the fact that the net investment position (NIP) for the
US economy as a percentage of GDP has been falling drastically, where at one point of time
the net US international liabilities reached as high as 29% of the total GDP. Furthermore as
reported in financial reports it has to come to notice that 70% of the gross foreign assets that
are under the control of US are held in different curries, and 95% of the gross liabilities for
the US economy is formed by varied foreign currencies, which gives rise to something that
can be best addressed by the “valuation effects”.

Even with such huge deficits the US economy has continued to exist over 30years now, to
this many authors and economic scholars have made arguments stating that even through
there is worsening of the current account balance which is primarily due to increase in
investment it is very much different from the problems that arise from decline in national
savings. Some researchers like Corden (1994) add to the literature by mentioning that such
huge deficits don’t really matter as long as they have come across as a result of higher private
sector investments. The reason of the US still existing even after the deficits is that since the
early 1970s the US has been the only country that is primarily in manufacturing and has

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 operated with an excess of more than 5% deficit, this is owing to the unique position that the
US enjoys in the international financial system, where the US owned assets have huge
demands, thus allowing the US economy to run its economy with growing deficits.

iii. BoP and exchange rate of a country against other countries and the available tools for the
government to control exchange rates volatility:

In addition to the different theories and models that are widely used by economist and
financial scholars to determine the exchange rate and the associated volatility for any country
it is also very important to have a sound understanding and working knowledge of how the
complexities of international policies, political economical standing along with societal and
economic infrastructures influence and affect the exchange rate markets.

Exchange rates can be viewed, studied and understood from a balance of payment approach,
the relationship that defines the relationship between balance of payments and the exchange
rates can be best identified as the equation below

(X – M) + (CI – CO) + (FI – FO) + FXB = BOP

Where X = exports of goods and services, M = imports of goods and services, CI = capital
inflows, CO = capital outflows, FI = financial inflows, FO = financial outflows and FXB =
official monetary reserves.

This can be further studied under the following sub headings:

 Countries with fixed exchange rates:

o Under this system it is the responsibility of the government to ensure that the BoP
is nearest to zero.

o To bring BoP to zero the country needs to get involved in the exchange rate
market to either buy or sell domestic currency.

o The country has to maintain a foreign exchange reserve balance to ensure it can
participate in the exchange rate market.

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  Countries with floating exchange rates:

o The government of such countries have no responsibility to peg its foreign

exchange rates

o The fact that current and capital account balances do not sum to zero will
automatically (in theory) alter the exchange rate in the direction necessary to
obtain a BOP near zero.

Answer 2

i. Understanding Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) of exchange
rates:

Purchasing Power Parity, or PPP, is a theory which states that, when two currencies are in
equilibrium, their exchange rate should be such, that either one of them retains its purchasing
power when converted into the other It is not difficult to realize that PPP is derived from the law
of one price. It essentially implies that any freely traded good should be priced the same,
everywhere, when measured in the same currency. The main theory behind PPP is simply that the
law of one price should hold for all identical products which can be purchased in either one of the
two countries. As such, the purchasing power of each currency, as measured by its ability to
purchase any of these products, should always be the same. Therefore, according to PPP,
exchange rates are defined by the difference in purchasing powers (or prices) between currencies.
Likewise, PPP predicts that when the purchasing power of one currency increases (or prices in
that currency decreases) relative to another currency, the exchange rate for these currencies
should change accordingly.

Interest rate parity or IRP is the other main theory behind exchange rate fluctuation. It
establishes a relationship between interest rates and the expected evolution in exchange rates for
two different currencies. IRP is normally stated as: two currencies are in equilibrium when the
expected rates of return on deposits of these two currencies measured in the same currency are
equal.

ii. Calculating the future exchange rate of £:

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 Section B
Regulations
Answer 1

i. Rationale for regulating banks and financial markets, identifying the different types of
regulations and the discussing the limitations of regulations:

Globalisation and internationalisation along with the developments made in the field of
information technology has transformed global economies, integrating financial markets and
gradually but consistently transforming the market into one single seamless trading ground.
One of the areas that have been very heavily regulated has been the international banking and
financial sector. As many economist and financial scholars argue and agree the reason for this
sector being so heavily regulated has been the recent events of financial disasters like Enron,
WorldCom etc. These events have challenged a brought the integrity of the entire industry
into question.

The three key developments that have transformed today’s financial markets have very
prominently been identified as:

• The falling or diminishing of the numerous barriers that existed in the international
flow of capital, owing to globalisation the flow of capital across borders has increased
significantly across-borders initiating more financial transactions.

• The second development can very prominently be marked by the functional

integration of hitherto discrete areas that have had an increased volume of financial
activities leading to the growing emergence of financial conglomerates that have
further integrated traditional banking practices with the securities operations and
numerous other non-banks initiatives.

• Finally the greatest contributor to the banking and financial sector has come across
through innovation and the introduction of numerous financial instruments and
vehicles that have facilitated financial integration and development.

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These developments in the financial markets have undoubted increased the efficiency of the
global financial markets making them more open and progressive however with these
developments there has been immense growing pressure on the regulators, who have to
ensure that there is uniformity and stability in the entire financial system. The integration of
financial markets have related and co-related the entire global system by close links and
degree of dependence, which has numerous advantages, however this integration poses the
biggest threat of the transmission of financial shocks from economy to another, like in the
case of recent financial crisis that originated from the US mortgage market and exponentially
spread across borders growing in intensity eventually leading to the downfall the global
financial and banking system. This fact calls for stronger banking regulations and reforms
like BASEL II, Sox, and MiFID etc that ensure that financial institutes and markets are in
line with the global financial growth, reducing the possibility of any irregularities and
abnormalities in the market.

The case for regulating financial institutions can be made on three broad grounds. First, there
is the consumer protection argument. This is based on the view that depositors and investors
cannot be expected to assess the riskiness of financial institutions they place their money
with, nor to monitor effectively the standard of service provided by such institutions. The
consumer protection rationale gives rise to three categories of regulation: first, compensation
schemes designed to reimburse all or part of losses suffered through the insolvency of
financial institutions; secondly, regulation in the form of capital adequacy requirements and
other rules aimed at preventing insolvency; and, finally, conduct of business or market
practice rules intended to ensure that users of financial services are treated fairly

The globalisation of banking and securities markets adds a new dimension to the regulatory
problem. Globalisation in this context means three things: the cross-border delivery of
financial services to foreign residents; the penetration of foreign financial markets by
branches and subsidiaries of multinational institutions; and transactions between banks and
investment firms from different countries that give rise to inter-jurisdictional counterparty
risk. Banking and securities regulators are presented with a number of formidable difficulties
associated with globalisation. Systemic risk may be increased through contagious financial
disorders originating in poorly regulated financial centres; depositors, investors and
counterparties may be exposed to foreign jurisdiction risks which they are not in a position to

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 monitor or control; and the co-existence of uneven national regulations and global markets
may severely distort competition between financial institutions.

Answer 2

i. Evolution and changes in the UK banking and financial services industry post the “Big
Bang” in 1986

The Bank of England has a longstanding interest in the structure of the financial system.
System structure can affect financial stability through influencing the cost and availability of
the financial services on which households and businesses depend. The basic services
provided by the financial system are relatively timeless, but the structure of the system that
provides them continues to evolve. While new products and players have emerged over the
past 50 years, UK banks have become ever larger and more central to the provision of the full
range of financial services. Post-crisis, public-policy attention has been focused on the
potential costs of this evolution. In particular, the emergence of large, highly interconnected
universal banks has transformed the financial network, increasing the likelihood of system-
wide contagion in the event of an individual bank’s distress. To the extent that these banks
are ‘too important to fail’, private incentives are distorted and resources misallocated
(Haldane (2010). Acknowledging this, efforts are under way both domestically and
internationally to address the risks associated with too important to fail institutions.

At the end of the 1950s, around 100 banks provided information to the Radcliffe Committee,
which had been established to review the workings of the UK monetary system. Of these, the
16 London and Scottish clearing banks held around £8.3 billion in assets, amounting to 85%
of total UK banking assets and more than 30% of UK GDP

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Consolidation of UK Banking sector 1960 to 2010
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Deposit-taking and lending services by the clearing banks in their 1960 and 2010 forms
Building societies, 1960–2010

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UK banks’ sources of earnings

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Sizes of the UK and US banking systems

Assets of UK financial subsectors

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References:
• P. Krugman, M. Obstfeld, “International Economics: Theory and Policy”, Pearson, 2005

• M. Obstfeld, K. Rogoff, “Foundations of International Macroeconomics”, The MIT Press,

1998

• Paul Krugman, “Exchange Rates”, The Concise Encyclopedia of Economics,

http://www.econlib.org/library/Enc/ExchangeRates.html

• M. Chinn, G. Meredith, “Testing Uncovered Interest Parity at Short and Long Run
During the Post Bretton Woods Era”, NBER Working Paper no.11077

• V. Bhatt, A. Virmani, “Global Integration of India’s Money Market: Interest Rate Parity
in India”, Indian Council for Research on International Economics Relations, 2005

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