Balance of Payments — Current Account and Capital Account
›Current Account = Trade in goods + Services + Factor income + Transfers
›Trade deficit = M > X (visible trade: merchandise imports exceed exports)
›Capital Account records asset and liability changes: FDI, FII, external debt, reserve changes
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The **Balance of Payments (BoP)** is a systematic record of all economic transactions between residents of a country and the rest of the world during a given period. The BoP has two main accounts: the Current Account and the Capital Account. As per the new accounting standards specified by the International Monetary Fund (IMF) in the sixth edition of the Balance of Payments and International Investment Position Manual (BPM6), the BoP can also be classified into three accounts: current account, financial account, and capital account; however, the Reserve Bank of India continues to publish data using the older classification.
**Current Account:** Records transactions related to the flow of goods, services, and income.
- **Trade in Goods (Visible Trade):** Exports and imports of merchandise. The difference is the **trade balance** or **merchandise balance**. If imports exceed exports, there is a trade deficit (M > X).
- **Trade in Services (Invisible Trade):** Software services, tourism, banking, insurance, transport.
- **Factor Income:** Wages earned by residents abroad, profits from foreign investment, interest receipts and payments.
- **Transfer Payments:** Remittances, pensions, official aid — one-directional flows.
**Current Account Balance (CAB):** The sum of trade balance + services balance + factor income + transfers. A **current account deficit** means a country is spending more on foreign trade than it earns from it — it must be financed by capital inflows. A surplus current account means that the nation is a lender to other countries, while a deficit current account means that the nation is a borrower from other countries.
**Capital Account:** Records transactions involving changes in ownership of foreign assets and liabilities.
- **Foreign Direct Investment (FDI):** Long-term investment in productive capacity abroad.
- **Portfolio Investment (FII/FPI):** Purchase of shares and bonds in foreign stock markets.
- **External Borrowings:** Loans taken from foreign banks and governments.
- **Change in Reserves:** Increases or decreases in the central bank's foreign exchange reserves.
**BoP Identity:** By accounting convention, the sum of the current account and capital account must be zero (BoP always balances). A current account deficit is automatically financed by a capital account surplus (net capital inflow).
Current Account + Capital Account + Change in Reserves = 0
**Autonomous vs. Accommodating Transactions:** Autonomous transactions take place due to normal economic motivations (trade, investment). Accommodating transactions are those undertaken to cover a deficit or surplus in the autonomous items — primarily changes in official reserves. A true BoP "disequilibrium" refers to a sustained deficit in autonomous transactions requiring official reserve drawdown.
All key facts
›Current Account = Trade in goods + Services + Factor income + Transfers
›Trade deficit = M > X (visible trade: merchandise imports exceed exports)
›Capital Account records asset and liability changes: FDI, FII, external debt, reserve changes
›BoP always balances in accounting terms: CAB + Capital Account + Reserve changes = 0
›A current account deficit is financed by capital inflows or drawdown of foreign reserves
›Remittances from abroad are part of the current account (transfer payments)
›FDI is long-term capital; FII (portfolio investment) is short-term and more volatile
›As per IMF's BPM6 accounting standards, the Balance of Payments can be classified into three accounts: current account, financial account, and capital account; however, the Reserve Bank of India continues to publish data using the older classification.
›Trade in services, a component of the Current Account, includes both factor income and non-factor income transactions.
›Non-factor income in the current account's services trade represents the net sale of service products such as shipping, banking, tourism, and software services.
›Transfer payments, which are receipts residents get 'for free' without providing goods or services, consist of gifts, remittances, and grants, provided by government or private citizens living abroad.
›A surplus current account signifies that the nation is a lender to other countries, while a deficit current account indicates the nation is a borrower.
›The Balance on Current Account is composed of two main elements: Balance of Trade (BOT) and Balance on Invisibles.
›In the Balance of Trade (BOT), the export of goods is recorded as a credit item, and the import of goods is recorded as a debit item.
›Net Invisibles refers to the difference between the value of exports and imports of invisibles, which include services, transfers, and income flows between countries.
›In the context of the Capital Account, an asset is any form in which wealth can be held, such as money, stocks, bonds, or Government debt.
›On the capital account, the purchase of assets is recorded as a debit item (foreign exchange outflow), while the sale of assets is recorded as a credit item (foreign exchange inflow).
›Components of the Capital Account include External Assistance (net), External Commercial Borrowings (net), Short-term Debt, Banking Capital (net) (including Non-resident Deposits), Foreign Investments (net) (comprising FDI and Portfolio investment), and Other Flows (net).
›In a Balance of Payments equilibrium where there are no reserve movements, a current account deficit is financed entirely by a capital account surplus.
›An official reserve sale occurs when the Reserve Bank sells foreign exchange to cover a BoP deficit; a decrease in official reserves is termed an overall balance of payments deficit, and an increase is a surplus.
›Monetary authorities are considered the ultimate financiers of any BoP deficit or the recipients of any surplus.
›Official reserve transactions are more relevant under a fixed exchange rate regime compared to floating exchange rates.
›Autonomous transactions, made for reasons other than bridging a BoP gap (e.g., profit), are termed ‘above the line’ items in the Balance of Payments.
›Accommodating transactions, determined by the BoP gap and its net consequences, are termed ‘below the line’ items; official reserve transactions are an example of an accommodating item.
›Errors and Omissions is a third element of the Balance of Payments, reflecting inaccuracies in recording international transactions.
›Before 1993, India followed a "Fixed and Adjustable" exchange rate system, where the rupee's value was fixed against major currencies and adjusted (devalued/revalued) as needed based on economic situations.
›India consistently devalued its currency until 1993, leading the exchange rate to change from $1 = Rs. 1 in 1947 to $1 = Rs. 31 by 1993, primarily due to adverse Balance of Payment situations and higher domestic inflation.
›Currency devaluation is undertaken by a country to correct an adverse Balance of Payment situation, making its exports cheaper and imports costlier.
exchange rates
Balance of Trade (BOT)
›Balance of Trade (BOT) is the difference between the value of exports and value of imports of **goods** of a country in a given period of time (NCERT Class 12 — Introductory Microeconomics, ch06-open-economy.md, p. 87).
›It is also known as Trade Balance (NCERT Class 12 — Introductory Microeconomics, ch06-open-economy.md, p. 87).
›Export of goods is entered as a credit item in BOT (NCERT Class 12 — Introductory Microeconomics, ch06-open-economy.md, p. 87).
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The Balance of Trade (BOT), also known as Trade Balance, represents the difference between the monetary value of a country's exports and imports of goods over a specified period, typically a year. It is a crucial component of the current account within the overall Balance of Payments (BoP) framework.
When a country exports goods, the value of these exports is recorded as a credit item in the Balance of Trade. Conversely, when a country imports goods, the value of these imports is entered as a debit item. The BOT is considered to be in balance when the value of goods exported equals the value of goods imported.
A "Surplus BOT" or "Trade surplus" occurs when a country exports more goods than it imports, indicating a net inflow of foreign currency from trade in goods. Conversely, a "Deficit BOT" or "Trade deficit" arises when a country imports more goods than it exports, signifying a net outflow of foreign currency due to trade in goods. The Balance of Trade specifically focuses on tangible goods, distinguishing it from the Balance on Invisibles, which accounts for services, transfers, and income flows.
All key facts
›Balance of Trade (BOT) is the difference between the value of exports and value of imports of **goods** of a country in a given period of time (NCERT Class 12 — Introductory Microeconomics, ch06-open-economy.md, p. 87).
›It is also known as Trade Balance (NCERT Class 12 — Introductory Microeconomics, ch06-open-economy.md, p. 87).
›Export of goods is entered as a credit item in BOT (NCERT Class 12 — Introductory Microeconomics, ch06-open-economy.md, p. 87).
›Import of goods is entered as a debit item in BOT (NCERT Class 12 — Introductory Microeconomics, ch06-open-economy.md, p. 87).
›BOT is in balance when exports of goods are equal to imports of goods (NCERT Class 12 — Introductory Microeconomics, ch06-open-economy.md, p. 87).
›A Surplus BOT (Trade surplus) arises if a country exports more goods than it imports (NCERT Class 12 — Introductory Microeconomics, ch06-open-economy.md, p. 87).
›A Deficit BOT (Trade deficit) arises if a country imports more goods than it exports (NCERT Class 12 — Introductory Microeconomics, ch06-open-economy.md, p. 87).
›The Balance of Trade is a component of the Balance on Current Account, alongside the Balance on Invisibles (NCERT Class 12 — Introductory Macroeconomics, ch06-open-economy.md, p. 87).
Exchange Rates — Nominal, Real, Fixed vs Flexible, and PPP
›Exchange rate = price of foreign currency in domestic currency (e.g., INR per USD)
›Real exchange rate = e × (P_f / P): measures competitiveness of domestic goods internationally
›PPP: real exchange rate = 1; goods cost the same internationally when converted at market rates
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The **exchange rate** is the price of one currency in terms of another. The foreign exchange market is a market where national currencies are traded for one another. The major participants in this market are commercial banks, foreign exchange brokers, other authorised dealers, and the monetary authorities.
**Nominal Exchange Rate:** The price of foreign currency in terms of domestic currency. It may be defined in one of two ways:
1. The amount of domestic currency required to buy one unit of foreign currency (e.g., how many rupees per dollar — the standard convention in India).
2. The amount of foreign currency required to buy one unit of domestic currency.
Since there is symmetry between the two currencies, the exchange rate may be defined in either way. The bilateral nominal exchange rate between two currencies quotes the rate in money terms.
**Real Exchange Rate:** The ratio of foreign to domestic prices, measured in the same currency. It captures how expensive foreign goods are relative to domestic goods.
Real Exchange Rate = e × (P_f / P)
where P and P_f are the price levels at home and abroad respectively, and e is the rupee price of foreign exchange (the nominal exchange rate). The numerator expresses prices abroad measured in rupees, the denominator gives the domestic price level measured in rupees, so the real exchange rate measures prices abroad relative to those at home. If the real exchange rate equals one, currencies are at **Purchasing Power Parity (PPP)**.
**Purchasing Power Parity (PPP):** If the real exchange rate is equal to one, currencies are at PPP — goods cost the same in both countries when measured in the same currency. The Law of One Price holds. If a country has higher inflation than another, its exchange rate should be depreciating (nominal depreciation offsets higher domestic inflation to maintain PPP). The PPP theory is used to make long-run predictions about exchange rates in a flexible exchange rate system.
**Fixed vs Flexible Exchange Rate Systems:**
- **Fixed Exchange Rate (Bretton Woods System):** The central bank pegs the exchange rate at a declared value and buys/sells foreign exchange reserves to maintain that rate. Provides stability but requires large reserve holdings and limits monetary policy autonomy. In this system, governments intervene to maintain the specified rate, and may buy or sell foreign currency to manage excess supply or demand at the fixed rate. This system is prone to "speculative attacks" if the public loses confidence in the government's ability to maintain the fixed rate.
- **Flexible (Floating) Exchange Rate:** The exchange rate is determined by market forces (demand and supply of foreign exchange). Allows automatic adjustment of BoP imbalances but can be volatile. In a completely flexible system, central banks do not intervene. This system offers governments more flexibility and monetary policy independence, as they do not need to maintain large foreign exchange reserves. Exchange rate movements are also influenced by factors like speculation, interest rate differentials, and domestic income changes.
- **Managed Float (Dirty Float):** Most countries including India operate a managed float — the exchange rate is primarily market-determined but the RBI intervenes to prevent excessive volatility. This system is also called "dirty floating," and under it, official reserve transactions are generally not equal to zero.
**Currency Depreciation vs Devaluation:**
- **Depreciation:** A fall in the exchange rate under a floating system (market-driven). It implies the price of foreign currency in terms of domestic currency has increased.
- **Devaluation:** A deliberate policy reduction in the fixed exchange rate by the central bank. It occurs when a government action increases the exchange rate, making domestic currency cheaper.
- **Appreciation/Revaluation:** The opposite movements. Appreciation in a flexible regime means the price of domestic currency in terms of foreign currency increases. Revaluation is when the government decreases the exchange rate in a fixed system, making domestic currency costlier.
All key facts
›Exchange rate = price of foreign currency in domestic currency (e.g., INR per USD)
›Real exchange rate = e × (P_f / P): measures competitiveness of domestic goods internationally
›PPP: real exchange rate = 1; goods cost the same internationally when converted at market rates
›If domestic inflation > foreign inflation, domestic currency should depreciate to maintain PPP
›Fixed rate system: central bank pegs rate, holds large reserves, loses monetary policy independence
›Flexible rate: market determines rate, automatic BoP adjustment, but volatile
›India operates managed float: RBI intervenes to smooth volatility
›Depreciation (market) vs Devaluation (policy decision) — both = fall in domestic currency value
›The foreign exchange rate links currencies of different countries and enables comparison of international costs and prices.
›Demand for foreign exchange arises from purchasing foreign goods and services, sending gifts abroad, and purchasing foreign financial assets.
›Supply of foreign exchange comes from a country's exports, foreigners sending gifts or making transfers, and foreigners buying domestic assets.
›In a completely flexible exchange rate system, central banks do not intervene in the foreign exchange market.
Rupee Devaluation (1966)
›**Timing:** The rupee was devalued in the mid-1960s, specifically associated with the year 1966 (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›**Extent of Devaluation:** The rupee was nominally devalued to 36.5% (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›**Economic Context:** Occurred during a "most vulnerable time" for the Indian economy, characterized by high inflation, low foreign exchange balance, and low food stocks threatening famine (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
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The Rupee Devaluation of 1966 occurred during a period of extreme vulnerability for the Indian economy, marked by high inflation, critically low foreign exchange reserves, and food scarcity threatening famine conditions. This economic distress was exacerbated by two successive monsoon failures in 1965 and 1966, a rising inflation rate (12% from 1965-1968), and increased defence expenditure due to the 1962 (China) and 1965 (Pakistan) wars, leading to a significant fiscal deficit.
Amidst this crisis, external agencies, specifically the US, World Bank, and IMF, exerted pressure on India to liberalize its trade and industrial controls, devalue the Rupee, and adopt a new agricultural policy. Consequently, under Indira Gandhi's government in the mid-1960s, the Rupee was nominally devalued by 36.5%, and initial trade liberalization measures were undertaken. However, these policies quickly became associated with an ongoing recession in industry, persistent inflation, and a failure of exports to increase. These perceived failures, partly attributed to exogenous factors like a major drought in 1966-67 and the inadequate implementation of the policies, coupled with resentment against the "arm twisting" by external agencies, led to a reversal back towards earlier policies of control and state intervention after 1967.
All key facts
›**Timing:** The rupee was devalued in the mid-1960s, specifically associated with the year 1966 (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›**Extent of Devaluation:** The rupee was nominally devalued to 36.5% (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›**Economic Context:** Occurred during a "most vulnerable time" for the Indian economy, characterized by high inflation, low foreign exchange balance, and low food stocks threatening famine (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›**Contributing Factors to Economic Vulnerability:**
›Two successive monsoon failures in 1965 and 1966 (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›Inflation rate rose to 12% from 1965 to 1968, with food prices rising 20% (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›Massive increase in defence expenditure due to the 1962 (China) and 1965 (Pakistan) wars, resulting in a consolidated fiscal deficit of 7.3% of GDP in 1966-67 (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›Foreign exchange reserves were about $340 million during 1964-65, enough to cover less than two months of imports (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›**External Pressure:** The US, World Bank, and IMF wanted India to devalue the Rupee, liberalize trade and industrial controls, and adopt a new agricultural policy (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›**Government Action:** The devaluation was initiated by Indira Gandhi (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
Autonomous and Accommodating Transactions (BoP)
›Autonomous transactions are international economic transactions made for reasons other than bridging a BoP gap, meaning they are independent of the BoP's state (page 89).
›A common reason for autonomous transactions is to earn profit (page 89).
›Autonomous transactions are known as 'above the line' items in the Balance of Payments (page 89).
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International economic transactions are classified into two main categories within the Balance of Payments (BoP): autonomous and accommodating transactions.
Autonomous transactions are those international economic transactions that are undertaken for reasons other than to simply cover a deficit or utilize a surplus in the balance of payments. These transactions are independent of the state of the BoP, often driven by motives such as earning profit. They are referred to as 'above the line' items in the BoP. The overall balance of payments is considered to be in surplus if autonomous receipts exceed autonomous payments, and in deficit if autonomous receipts are less than autonomous payments.
Accommodating transactions, in contrast, are specifically carried out to bridge the gap created by autonomous transactions in the BoP. Their magnitude and direction are determined by whether there is a deficit or surplus resulting from the autonomous transactions. These are termed 'below the line' items. Official reserve transactions, which are undertaken by monetary authorities to finance any deficit or absorb any surplus in the balance of payments, are considered the primary accommodating item.
All key facts
›Autonomous transactions are international economic transactions made for reasons other than bridging a BoP gap, meaning they are independent of the BoP's state (page 89).
›A common reason for autonomous transactions is to earn profit (page 89).
›Autonomous transactions are known as 'above the line' items in the Balance of Payments (page 89).
›The Balance of Payments shows a surplus if autonomous receipts are greater than autonomous payments, and a deficit if they are less (page 89).
›Accommodating transactions are determined by the existing deficit or surplus in the Balance of Payments (page 89).
›These transactions are influenced by the net consequences of autonomous transactions (page 89).
›Accommodating transactions are referred to as 'below the line' items (page 89).
›Official reserve transactions are considered an accommodating item because they bridge the BoP gap (page 89).
Balance of Payments Crisis (1991)
›The crisis occurred in **1991** (p. 39).
›It was an **economic crisis related to external debt and balance of payments** (p. 39).
›The government was **unable to make repayments on its borrowings from abroad** (p. 39).
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In 1991, India experienced a severe economic crisis primarily related to its balance of payments. This crisis stemmed from the inefficient management of the Indian economy during the 1980s, where government expenditure significantly outpaced its revenue, leading to unsustainable levels of borrowing. The government struggled to repay its foreign debt, and the foreign exchange reserves plummeted to a critically low level, insufficient to finance imports for even a fortnight. Compounding this, prices of essential goods rose sharply, and there was inadequate foreign exchange to cover interest payments to international lenders. Consequently, India found itself in a situation where no country or international financial institution was willing to extend further credit.
To manage this dire situation, India approached the International Bank for Reconstruction and Development (IBRD), commonly known as the World Bank, and the International Monetary Fund (IMF), securing a loan of $7 billion. However, this assistance came with stringent conditions, requiring India to liberalise and open its economy. These conditionalities included removing restrictions on the private sector, reducing the government's role in various economic areas, and eliminating trade barriers with other countries. In response, India agreed to these terms and introduced the New Economic Policy (NEP), which encompassed wide-ranging economic reforms classified into short-term stabilisation measures and long-term structural reforms. As an immediate measure, the rupee was devalued against foreign currencies to address the crisis.
All key facts
›The crisis occurred in **1991** (p. 39).
›It was an **economic crisis related to external debt and balance of payments** (p. 39).
›The government was **unable to make repayments on its borrowings from abroad** (p. 39).
›Foreign exchange reserves dropped to levels **not sufficient for even a fortnight** of imports (p. 39).
›The crisis was exacerbated by **rising prices of essential goods** (p. 39).
›The origin of the crisis is traced to the **inefficient management of the Indian economy in the 1980s** (p. 39).
›Government expenditure consistently **exceeded its revenue**, making borrowings unsustainable (p. 40).
›Foreign exchange reserves were **also not sufficient to pay interest** to international lenders (p. 40).
›No country or international funder was **willing to lend to India** (p. 40).
›India approached the **International Bank for Reconstruction and Development (IBRD)**, also known as the World Bank, and the **International Monetary Fund (IMF)** (p. 40).
›India received **$7 billion as a loan** to manage the crisis (p. 40).
›Conditionalities for the loan included **liberalising and opening up the economy**, removing restrictions on the private sector, reducing the government's role, and removing trade restrictions (p. 40).
›Depreciation implies that the price of foreign currency (e.g., dollar) in terms of domestic currency (e.g., rupees) has increased.
›Appreciation in a flexible regime means the price of domestic currency (e.g., rupees) in terms of foreign currency (e.g., dollars) increases.
›Exchange rates can be affected by speculation, where people hold foreign exchange expecting gains from currency appreciation.
›Interest rate differentials between countries are important short-run determinants of exchange rate movements; a rise in domestic interest rates can lead to an appreciation of the domestic currency.
›An increase in domestic income often leads to increased imports, which shifts the demand curve for foreign exchange to the right, causing depreciation of the domestic currency.
›The Purchasing Power Parity (PPP) theory is used to make long-run predictions about exchange rates in a flexible exchange rate system, suggesting exchange rates adjust to reflect differences in price levels over the long run.
›Under a fixed exchange rate system, if the government fixes a rate higher than the market equilibrium, the RBI intervenes by purchasing the excess supply of foreign currency to maintain the rate.
›Conversely, if the government fixes a rate lower than market equilibrium, it would have to sell foreign currency from its reserves to meet the excess demand.
›Devaluation occurs in a fixed exchange rate system when government action increases the exchange rate, making the domestic currency cheaper.
›Revaluation occurs in a fixed exchange rate system when the government decreases the exchange rate, making the domestic currency costlier.
›Fixed exchange rate systems are prone to "speculative attacks," where public doubt about the government's ability to maintain the fixed rate leads to aggressive currency buying/selling, forcing devaluation.
›Flexible exchange rate systems offer governments greater flexibility, eliminate the need for large foreign exchange reserves, automatically address BoP imbalances, and provide independence in monetary policy.
›The managed floating system is also known as "dirty floating."
›Under a managed floating system, official reserve transactions are not equal to zero because central banks intervene to moderate exchange rate movements.
›In 1991, the rupee was devalued against foreign currencies as an immediate measure to resolve the balance of payments crisis.
›The 1991 rupee devaluation led to an increase in the inflow of foreign exchange.
›The 1991 foreign exchange reforms aimed to free the determination of the rupee's value from government control.
›Post-1991 reforms, exchange rates in India are more often determined by the market forces of demand and supply of foreign exchange.
›India's foreign exchange reserves increased significantly from about US $6 billion in 1990-91 to about US $646 billion in 2023-24.
›India is currently one of the largest foreign exchange reserve holders in the world.
›**Immediate Perceived Outcomes:** The devaluation was associated with a continuing recession in industry, persistent inflation, and failure of exports to pick up (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›**Factors Influencing Perceived Failure:** Exogenous factors like the major drought of 1966-67 and the inadequate manner in which policies were initiated (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›**Policy Reversal:** The perceived failure and resentment at "arm twisting" by external agencies led to a reversal to earlier policies of control and state intervention after 1967 (Vivek Singh — Indian Economy, ch06-indian-economy-1947-2014.md).
›India agreed to these conditionalities and announced the **New Economic Policy (NEP)** (p. 40).
›The NEP consisted of **stabilisation measures** (short-term, to correct balance of payments weaknesses and control inflation) and **structural reform measures** (long-term, to improve efficiency and international competitiveness) (p. 40).
›As an immediate measure to resolve the crisis in 1991, the **rupee was devalued against foreign currencies** (p. 42).
›In September 1991, the **Narasimha Rao government scrapped the Monopolies and Restrictive Trade Practices (MRTP) Act** (p. 213).