Topic 4: Balance of Payments and Foreign Exchange

1. Balance of Trade

The balance of trade is the difference between the value of visible exports and visible imports.

• Exports > imports: favourable (surplus).
• Imports > exports: unfavourable (deficit).

Example

Exports = KSh 500 million; imports = KSh 650 million. Balance of trade = 500 - 650 = KSh 150 million deficit.

2. Balance of Payments (BOP)

The balance of payments is a record of all transactions between a country and the rest of the world in a year.

Main Parts

Items

• Credits: money coming in (exports, tourism receipts, remittances, foreign investment).
• Debits: money going out (imports, repayments, payments for services).

3. Causes of BOP Deficit

1. High imports compared to exports.
2. Reliance on a few primary exports with low prices.
3. Inflation making exports costly.
4. Debt repayments.
5. Poor infrastructure and low productivity.
6. Natural disasters or political instability.

Ways of Correcting a Deficit

1. Export promotion and diversification.
2. Import restrictions (tariffs, quotas).
3. Import substitution (producing locally).
4. Currency devaluation or depreciation.
5. Encouraging tourism and foreign investment.
6. Borrowing or drawing from reserves (short-term).
7. Controlling inflation.

4. Foreign Exchange

• Foreign exchange: foreign currencies used for international payments.
• Exchange rate: the price of one currency in terms of another (e.g. KSh per US dollar).

Determination

• Floating: set by demand and supply in the market (Kenya's system).
• Fixed: set by the government.

Effects of Currency Changes

Factors Affecting Exchange Rates

• Demand and supply of the currency
• Inflation and interest rates
• Balance of payments position
• Political stability
• Speculation and capital flows

5. Importance of Foreign Exchange

• Pays for imports.
• Services foreign debts.
• Supports investment and trade.
• A strong reserve gives stability.