This approach holds that balance of trade of a country is determined by the demand-supply position of its ‘entire range of financial instruments’.
Therefore, the corrective measures also lie in tackling those forces which determine the demand for alternative financial assets including money proper.
Elaboration:
This approach tries to remove some of the deficiencies of the monetary approach discussed above. It postulates that, for a wealth holder, domestic money is only one of the several financial assets which he can hold.
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Given the overall liquid purchasing power to be held by an economic unit, it exercises its choice in holding (i) domestic currency, (ii) non-cash domestic financial assets (also termed domestic bonds or securities) and (iii) foreign bonds (or securities).’
The choice between domestic currency and domestic bonds is dependent upon three things, viz., (i) the expected yield from bonds, (ii) their risk of default, and (iii) the expected rate of inflation.
Similarly, choice between domestic and foreign bonds depends, in addition to the factor of domestic inflation, upon the (i) interest rate differential, (ii) the risk differential, and (iii) the risk of variation in exchange rate.
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The exact impact of these influencing factors depends upon the preference-pattern of the asset holders, such as their wealth, income, expectations and so on.
BOP equilibrium is achieved only when there is equilibrium in the financial markets (or portfolio equilibrium). Absence of such equilibrium results in disequilibrium in the BOP also.
By implication, an imbalance in balance of payments can be removed by taking corrective actions in the financial markets including one or more of the following, viz.,
i. The difference in the level of interest rates in the two countries;
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ii. The difference in the expected risk of default associated with the bonds in the two countries; and
iii. The risk of expected variation in exchange rate between currencies of the two countries.
By implication, unless both trading countries cooperate and pursue a coordinated set of financial policies, it may not be possible for one of them to successfully correct its balance of payments.
I should be noted that the portfolio approach ignores the risk of price variation (and therefore, variation in the holding-period yield) of the bonds. This is a serious limitation of this approach.