Mrunal (Economic Survey Ch6) Balance of Payments, Forex Reserves, Currency Exchange, NEER, REER Print

6/24/13 Mrunal [Economic Survey Ch6] Balance of Payments, Forex Reserves, Currency Exchange, NEER, REER Print
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[Economic Survey Ch6] Balance of Payments, Forex Reserves, Currency
Exchange, NEER, REER
1. What is Balance of Payment?
2. Why BoP = 0 in theory?
3. Convertibility
4. Rupee-Dollar Exchange rate
5. Building up Foreign Exchange Reserves
6. FOREIGN EXCHANGE RESERVES
7. FOREX Reserve: India vs other
8. Why volatility in rupee?
9. How did rupee recover?
10. Exchange Rate of Other Emerging Economies
11. NEER and REER
12. Why is REER important?
13. External Debt
14. FDI Restrictiveness Index (FRI)
15. FDI: defense offset
16. CHALLENGES AND OUTLOOK
17. Mock Question
What is Balance of Payment?
If you want to see a companys incoming and outgoing cash, youve to check
its account book.
Similarly Balance of Payment (BoP) is the summary / account sheet that
shows the cash flow between India and rest of the world.
BoP is made up of two parts: Current account and capital account. (As per
IMF definition, three parts: Current Account + Capital account+ financial
account).
Without getting into technical details, just a brief over view:
Balance of Payment
Current Account
Capital (and
financial) Account
1. Import, Export (always negative, because
we export less and import more oil n gold,
hence weve trade deficit.)
2. Income from abroad (interest, dividends
paid on Indian investors FDI, FII in USA
1. Foreign investment in
India (FDI, FII, ADR,
direct purchase of land,
assets).
etc.)
3. Transfer (gift, remittances from NRI to
their families etc. always positive for India
because of large Diaspora abroad.)
2. External commercial
borrowing, external
assistance etc.
Note: current account can be calculated using Visible and invisibles, that
was explained in old article on current account deficit click me.
Since we want to track the flow of cash, so, whenever American invest in India
(via FDI, FII, ADR etc) we add it as (+), and
when Indians invest in USA (via FDI, FII, IDR etc.) we add it as (-) and then get
the final figure for Foreign investment.
Same goes for everything in balance of payment (remittances, External
commercial borrowing whatever.)
In short, BoP= we are tracking the incoming and outgoing money.
For India, current account has been in deficit (negative number) and capital
account has been in surplus (positive number).
The BoP accounting system is similar to double entry book-keeping.
Therefore theoretically, balance in current account and balance in capital
account should be same (ignoring the +/- signs).
In other words, if there is deficit in current account, there has to be equal
surplus in capital account. Why?
Why BoP = 0 in theory?
Assume there are only two countries India (rupees) and USA (dollars). And
there are no forex agents or middlemen, taxation, regulation, cricketers,
politicians, saah-bahu serials nothing
Now Indian importer buys Apple6 phones worth 10 billion US$ from
American exporter. Since there is no forex agent, the Indian importer will pay
500 billion Indian rupees to that American exporter. (assuming 1$=50 Rs.)
Means that much Rupee currency is gone from Indian system via current
account.
But that American exporter has no use of Indian rupees! He lives in USA, he
cannot even buy a burger from local McDonalds shop using Indian rupees. So
what can he do?
1. He can import something else from India (e.g. raw material, steel and
plastic for further production of Apple6) = our rupee currency comes
back to India via current account.
2. He can invest that Indian currency to setup some factory or joint
venture in India (=our rupee currency comes back to India via capital
account)
3. He can buy some shares or bonds in India. Again our rupee currency
comes back.
4. He can find a 2
nd
American who wants to import something from India /
wants to invest in India. Apple6 guy can sell his rupee currency to that
third American fellow @Rs.50=1$ or Rs.49=1$ or Rs.99=1$
(depending on the desperation of that 2
nd
American fellow).
In short, if rupee goes out, it has to come back. (same for dollar, from
American point of view).
Therefore, current account + capital account = ZERO (balance of Payment),
atleast in theory.
But in reality, RBI or tax authorities never have complete details of all
financial transactions and currency exchange rates keep fluctuating. Hence
there will be statistical discrepancies, errors and omissions and. So, BoP is
expressed as:
Current Account + Capital account + Net errors and omissions = 0 (Balance of
Payment).
In IMF definition, we can express this as
Current Account + Capital account + Financial account + balancing item = 0
Ok then does it mean a country can never have surplus (or deficit) in Balance
of payment?
Well, a country can have TEMPORARY surplus or deficit in BoP. Because,
BoP is calculated on quarterly and yearly basis. There is a good chance, that
American Apple6 exporter may not invest back all those 500 billion Indian
rupees in India within that time-frame.
Secondly, Indian Government may put some FDI/FII restrictions so Apple6
exporter (or that third American guy) cannot re-invest in India even if he wants
to.
But in the long run, system will balance itself. for example
Apple exporter will find some fourth American importer and convince
him to pay Indian exporter in rupee currency and thus apple guy will get
rid of his 500 billion Rupees by exchanging it with that American
importers dollar
Or the apple exporter will find some NRI living in USA. This NRI wants
to send money (dollar earned by working in USA) to his family back in
India, (preferably in Indian currency ) so this NRI will be willing to
exchange his dollar savings with that Apple exporters rupees.
There are many other possibilities and combinations but the point is,
in BoP, whatever currency goes out of the country, will come back to
the country.
Convertibility
Suppose you want to import a dell computer from USA. And American
exporter accepts only payments dollars.
If you can easily convert your rupee into dollars, that means Rupee is fully
convertible. And rupee is fully convertible as far as Current account
transactions are concerned (e.g. import, export, interest, dividends).
But rupee is partially convertible for capital account transection. (In crude
terms it means, if an Indian wants to buy assets abroad or invest via FDI/FII
OR borrow via External commericial borrowing (ECB) he cannot do it beyond
the limits prescribed by RBI. (And vice versa e.g. American wants to convert
his dollars to rupees to invest in India, then also RBIs limits have to be
followed).
RBI gets power to do ^this, via FERA and FEMA Acts.
1973: Foreign Exchange Regulations Act, 1973 (FERA).
1997: Tarapore Committee (of RBI), had recommended that India should have
full capital account convertibility. (Meaning anyone should be allowed to
freely move from local currency into foreign currency and back, without any
restrictions by Government or RBI.)
2002: Government replaced FERA with Foreign Exchange Management Act
(FEMA). Although full capital account convertibility is yet not given.
Full capital account convertibility has both pros and cons. But thatd require
another article. Lets get back to the topic, we are seeing the 6
th
chapter of
Economic Survey: Balance of Payment, exchange rates etc.
Rupee-Dollar Exchange rate
How does Fixed Exchange Rate system work? and how does market based
exchange rate system work? = explained in the Bretton woods article. Click
me
Anyways, lets construct a bogus technically incorrect model to understand
the market based exchange rate system, once again:
Assume following things
There are only two countries in the world India and America.
India has rupee currency. Indian farmers dont grow Onions.
America doesnt have any currency, they trade using onions. The rate
being 1kg onion=Rs.50
First situation: American investor thinks that Indian economy is rising. If we
invest in India (FDI/FII), well make good profit. So theyre more eager to
convert their onions to Indian rupee currency. So theyd even agree to sell 1kg
onions =Rs.45. (and then buy Indian shares/bonds worth Rs.45)
Result =Rupee strengthened against onion (dollar).
During this time, RBI governor also buys 300 billion kilo onions from the
forex and stores these onions in his refrigerator. (Why? Because onions are
selling cheap! And why onions are selling cheap? Because there is surge in
capital investment in India by American investors.)
Ok everything is going nice and smooth. Now add third country to our bogus
model: UAE.
Second situation: UAE has increased crude oil prices, and they dont accept
rupee currency. They also want payment in onions.
1 barrel of crude oil costs 132kg of Onions.
India is eager/desperate for oil, because if we dont have crude oil, we cant
get petrol, diesel= whole economy will collapse.
So India would agree to buy 1kg onion even for Rs.55 (from American or
forex agent or whoever is willing to sell his onions). Then India can give that
onions to some Sheikh of UAE and import crude oil.
Third situation: The Sheikh of UAE gets even greedier, he demands 200kg
onions for 1 barrel of crude oil. Now 1kg onion sells for Rs.59, Because
those with onion surplus (vendors) know that India likes it or not, itll have to
buy onions to pay for the crude oil!
Thus, Rupee has weakened against onion (Dollar.)
If such situation continues, then there will be huge inflation in India (because
crude oil expensive=petrol/diesel expensive = transport expensive=
milk/vegetables and everything else transported using petrol/diesel becomes
expensive.)
Now RBI governor decides to become the hero and save the fall of rupee
against onion. So, He loads a few tonnes of onions in his truck and drive it to
the forex market.
Result: onion supply has increased, price should go down.
Now onions get little cheaper: 1kg onion =53 Rs.
Thus RBIs intervention in the forex market has led to recovery of rupee.
Ok so what do we get from this story?
1. RBIs intervention to buy Foreign exchange during surge in capital
investment= leads to build-up of (foreign exchange) reserves, which provides
self-insurance against external vulnerability of rupee.
2. When RBI sells its foreign exchange reserves, it stems (halts) the fall of
rupee.
3. Higher foreign exchange reserve levels restore investor confidence and may
lead to an increase in foreign direct and indirect investment flows= boost in
growth and helps bridge the current account deficit.
Building up Foreign Exchange Reserves
Prior to 1991, India followed License-quota-inspector (and suitcase) raj and
import substitution strategy. (Beautifully explained class 11 NCERT
textbook.)
During that era, foreign companies couldnt invest in India.
Imported products such as radio / camera/ wristwatches attracted heavy
custom duty. (And that led to rise of smugglers and mafias, and the Bollywood
movies that romanticized their criminal lives.)
On the other hand, thanks to the license-quota-inspector (and suitcase) raj, the
private Indian companies werent big or efficient enough to compete in
international market so export was also low.
Result: during that time incoming money (via export, investment) was very
low. Hence RBI couldnt build up huge forex reserve. (when onion supply is
low, its prices will be high)
Ultimately in 1991, the Forex reverses of India were about to exhaust.
Finally India had to pledge its gold to IMF and get loans.
Then India had to open up its economy for private and foreign sector
investment. Remove the license-quota-inspector raj etc. to boost the
incoming flow of dollars and other foreign currencies..all those LPG
reforms. (Although suitcase raj still continues, because the Mohans in the
system are blinded by totally awesome people like A.Raja.)
fast-forward: now weve a trillion dollar economy, our software and
automobile companies are globally recognized blah blah blah.
But the lesson learnt: RBI should have good foreign exchange reserve.
Hence post LPG reforms, RBI has been buying dollars, pound yen etc. from
the currency market, whenever FII/FDI inflow is high. Because during such
situation, the foreign investors are more eager to get their dollars converted
to rupee currency hence rupee is trading at higher rate e.g. 1$=Rs.49
But after global financial crisis, RBI has stopped building forex reserves
actively.
Nowadays RBI intervenes in the forex market, only to stop the excess
volatility (fluctuation) in rupee exchange rate.
However, there was a sharp decline in rupee in 2011-12. Then RBI had to sell
foreign exchange worth 20 billion dollars. (so demand of foreign currency
would decrease and rupee would stop).
Similarly in 2012 also RBI had to sell its foreign exchange reserve worth 3
billion dollars to prevent the fall of rupee. (in June 2012, Rupee had became
very weak: 1$=around 57 Rupees. Thanks to RBI and Governments
interventions, it came back to the normal 53-54 level at the end of 2012.)
FOREIGN EXCHANGE RESERVES
Indias foreign exchange reserves is made up of
1. Foreign currency assets (FCA) (US dollar, euro, pound sterling, Canadian
dollar, Australian dollar and Japanese yen etc.)
2. gold,
3. special drawing rights (SDRs) of IMF
4. Reserve tranche position (RTP) in the International Monetary Fund (IMF)
The level of forex reserve is expressed in US dollars. Hence Indias forex reserve
declines when US dollar appreciates against major international currencies and vice
versa.
RBI gains Foreign exchange reserves by
buying foreign currency (via intervention in the foreign exchange market
Funding from the International Bank for Reconstruction and Development
(IBRD), Asian Development Bank (ADB), International Development
Association (IDA) etc.
aid receipts,
interest receipts
FOREX Reserve: India vs other
Country wide- China has the largest forex reserve (3300+ billion USD). India
is 8
th
position (close to 300 Billion USD).
Countries with largest Forex reserves
1. China
2. Japan
3. Russia
4. Switzerland
5. Brazil
6. South Korea
7. Hong Kong
8. India
Why volatility in rupee?
Volatility = Variation in something over the given time.
if today SENSEX is 12000 points, tomorrow it goes up by 200 points and day
after it goes down by 300 points etc..they we say market is volatile.
If morning shifts SSC paper is too easy but evening shifts SSC paper is too
damn difficult then we can say SSC paper is volatile.
Similarly, if there is too much fluctuation in Dollar to rupee exchange rate,
we say rupee is volatile.
In 2012, the rupee has experienced unusually high volatility. Why?
#1: import-export
Demand for Indian goods and services has declined due to Euro-zone crisis +
America hasnt fully recovered.
On the other hand, cost of import= very high due to oil and heavy gold import
(due to high inflation).
Similarly high inflation = raw material / services become costly for the
export. If he raises the prices, then his export product becomes less
competitive than Cheap China made stuff.
#2: FII
In the total foreign investment in India, majority comes from FII (and not
from FDI).
FII money is hot, it leaves quickly whenever FII investors feels that Indias
market is not giving good returns and or some other xyz countrys market is
giving better returns.
There are week-to-week variation in such FII inflows and outflows. Hence it
leads to changes in rupee-dollar exchange rate.
#3: Dollar is strengthened
US treasury bonds are consider the safest investment. During the peak of
Eurozone, Greece crisis, the big investors started pulling out money from
Europe and investing it in US treasury bonds. = demand of dollar increased.
So other currencies would automatically weaken against dollar.
#4: policy paralysis
For past few years, Indian Government was lazy regarding environmental
project clearances, land acquisition, FDI in retail, pension, insurance etc. that
has led to foreign investors losing faith in Indian economy= slowdown in FII
inflows. (besides Government did not allow more FDI in pension / insurance /
retail etc. so FDI inflow did not increase either).
#5: Risk On / Risk off
From the earlier article on debt vs equity, Government bonds = safer than
equities (shares). But when an investment is safe= it doesnt offer good
returns.
When foreign investors feel confident, they display risk on behavior =they
invest more in equities, particularly in developing countries. (which are risky
but offer more profit).
But when foreign investors are not feeling confident, they display risk off
behavior, = they usually fall back to investing in US treasury bonds or gold.
In India, majority of foreign investment comes from FII (and not FDI)
and FII investors are more prone to displaying this risk-on/risk-off behavior.
They plug in their money quickly, they pull out their money quickly. Thus,
Indian rupees exchange rate becomes volatile against Dollar.
Therefore, Indian Government needs to inspire and sustain the confidence of
foreign investors, to prevent the fall of rupee. RBI intervention in forex
market, cannot help beyond a level.
How did rupee recover?
Rupee is weakening against dollar, it means demand of rupee is less than the demand
for dollars. So how did RBI and Government fix it?
RBI Govt.
During 2012, RBI sold around 3 billion dollars
from its forex reserves.
Oct-12, Rupee recovers, 1$=around 51 rupees.
RBI allowed Indian banks to give more interest
on Foreign Currency Non-Resident (FCNR)
bank accounts. (thus attracting more NRIs to
save their dollars in Indian banks).
Govt. allowed FIIs
to invest more
money in govt.and
corporate bonds.
Govt. eased the FDI
policy for pension,
insurance, aviation,
multi-brand retail
etc.
Govt. offered
subsidies and tax
benefits to
exporters.
Exchange Rate of Other Emerging Economies
In 2012, Rupee wasnot the only currency that weakened against dollar.
The currencies of other emerging economies, such as Brazilian real,
Argentina peso, Russian rouble, and South Africas rand also depreciated
against the US dollar.
It means dollars demand has increased. In the wake of sovereign debt crisis in
the euro zone and due to uncertain global economic environment, more and
more investors are preferring to buy US treasury bonds and other securities in
USA.
NEER and REER
We keep reading bad headlines that rupee weakened against dollarrupee all
time low against dollarand so on.
Does it mean, Indian rupee is a really bogus weak and fragile currency? Nope.
Because we dont trade only with USA.
We dont trade only in terms of Rupee to Dollar exchange.
We also trade with many other countries in many other forms of currency.
Therefore, if we want to objectively measure Rupees volatility, weve to
compare its price fluctuations with multiple currencies (Euro, Yen, Pound
etc.) and not just against single Dollar currency.
Secondly: 1$=Rs.50 or 1$=Rs.40 that alone doesnt decide the demand of
goods and services between India and America. This demand also depends on
the inflation (both in India and in USA.)
NEER and REER index (calculated by RBI), help us here get a clear picture
here.
First youve to calculate NEER. Then using NEERs, you calculate REER.
NEER REER
Nominal Effective Exchange Rate
Real Effective Exchange Rate
(REER)
The weighted average of bilateral nominal
exchange rates of the home currency in
terms of foreign currencies.
weighted average of
nominal exchange
rates, adjusted for
inflation.
Why is REER important?
REER captures inflation differentials between India and its major trading
partners.
REER reflects the degree of external competitiveness of Indian products
REER captures movements in cross-currency exchange rates.
RBI calculates two REER indices:
REER-6 REER-36
Here Indian rupee is measured against 6 big
currencies viz.
1. Dollar
2. Hong Kong dollar
3. Euro
4. Pound sterling
5. Japanese Yen
6. Chinese Renminbi
As the name suggest, 36
currencies.
Now Indian rupees vs. other currencies (Dec. 2012 data)
Just for reference:
1 unit of foreign currency Worth Rs.
Indonesian Rupiah 0.006
S.Korean Won 0.05
Pakistan Rupee 0.56
Yen 0.65
Thailand Baht 1.78
Mexican Peso 4.25
Chinese Renminbi 8
Brazilian Real 26
Turkish LIRA 30
US Dollar 54
Canadian Dollar 55
Euro 71
SDR of IMF 84
Pound 88
External Debt
World Bank has released International Debt Statistics, 2013
It contains the debt numbers for the year 2011.
According to those statistics, in 2011 India was in fourth position in terms of
absolute external debt stock after China, the Russian Federation and Brazil.
At the end of March 2012, Indias external debt stock = 345 billion (near to
17 lakh crore rupees.)
Indias external debt is high because of
Higher NRI deposits (since NRIs are not getting much return on their dollar
savings in American banks, they prefer to invest it in India).
External Commercial borrowings (by Indian corporates)
Corporate borrowers in India and other emerging economies are keen to
borrow in foreign currency (dollar and Euro). Because in US/EU right now the
market is down, not many loan domestic taker businessmen, hence their
banks/ investors dont mind giving loans to foreigners (that is Indian / other
Asian businessmen) at very low interest rate and longer EMIs.
But such borrowings however, are not always helpful, especially in times of
high currency volatility. For example, if Indian businessman had borrowed
loans from USA when 1$=49 rupees but after some years, if 1$=57 rupee,
then hell have to repay more. This will badly affect not just him but to Indias
BoP as well.
FDI Restrictiveness Index (FRI)
Prepared by OECD.
A score of 1 indicates a closed economy and 0 indicates openness.
China is ranked #1 (=it is the most restrictive country)
India is ranked fourth
Foreign Direct Investment (FDI) is preferred to the foreign portfolio
investments primarily because FDI is expected to bring modern technology,
managerial practices and is long term in nature investment.
The Government has liberalized FDI norms overtime. As a result, only a
handful of sensitive sectors now fall in the prohibited zone and FDI is allowed
fully or partially in the rest of the sectors.
FDI: defense offset
At present, 26% FDI is allowed in Indian defense sector. It also requires
FIPB approval
licensing under Industries (Development & Regulation) Act, 1951
has to follow guidelines on FDI in production of arms & ammunition.
India needs to open up the defense production sector to get access and ensure
transfer of technology.
The existing FDI policy for defence sector provides for offsets policy.
(meaning the foreign company has to buy or outsource some of its work to
local /domestic players. E.g. FDI in multibrand retail, mandates that foreign
company must buy 30 percent of the from small-scale industries.)
Such offset policy soften the balance of payments impact and/or develop local
technical capability.
Recently Government revised the offsets policy for defense sector.
But still, it has shown no visible direct or indirect benefits h on the domestic
Indian defence industry.
CHALLENGES AND OUTLOOK
while capital inflows in India, were sufficient to finance the CAD safely.
But majority of the capital flows are via FII (hence volatile)= this has led to
financial fragility and is reflected in rupee exchange rate volatility.
We cannot significantly increase our exports in the short run because they are
dependent upon the recovery and growth of partner countries (US, EU). And
this may take time.
Therefore our main focus has to be on curbing imports, mainly by making oil
prices more market determined (=expensive), and curbing imports of gold.
We should put greater emphasis on FDI including opening up sectors further.
Finally, external commercial borrowing needs to be monitored carefully.
Misc. facts
Three top countries from where FDI comes to India: Mauritius, Singapore and
UK
Global Economic Prospects= this report is published by world bank.
Mock Question
1. Which of the following, is not a part of Capital account
a. FDI
b. FII
c. Remittances
d. External commercial borrowing
2. Which of the following is not a part of Current account?
a. Import
b. Export
c. External commercial borrowing
d. Interest, dividends paid on FII
3. India has deficit in
a. Current account
b. Capital account
c. Both
d. None
4. India has surplus in
a. Current account
b. Capital account
c. Both
d. None
5. Indias official forex reserve doesnt include
a. Foreign currency assets (FCA) (US dollar, euro, pound sterling,
Canadian dollar, Australian dollar and Japanese yen etc.)
b. Gold
c. Silver
d. Special drawing rights (SDRs)
6. How can RBI build its foreign exchange reserve?
a. By Buying foreign currency
b. via funding from World Bank, ADB etc.
c. Both
d. None
7. Which of the following country has second largest forex reserves in the
world?
a. India
b. France
c. Japan
d. USA
8. Among the countries with largest forex reserves, India ranks
a. second
b. third
c. fifth
d. eighth
9. Rupee will strengthen against dollar when
a. Government eases FDI policy
b. Government raises the ceiling on FII investment
c. Both
d. None
10. Correct statement
a. NEER is calculated by RBI
b. REER is calculated by Finance ministry
c. both
d. none
11. REER captures
a. difference in inflation between India and its trading partners
b. external competitiveness of Indian products
c. Both
d. none
12. Which of the following currency is not part of REER-6 calculation?
a. Hong Kong Dollar
b. Japanese Yen
c. Pound Sterling
d. Canadian Dollar
13. Incorrect Match
a. S.Korea: won
b. Mexico: Peso
c. Argentina: Peso
d. S.Africa: Baht
14. Which of the following is not released by World Bank?
a. International Debt Statistics, 2013
b. FDI Restrictiveness Index
c. Global Economic Prospects
d. All of Above
15. FDI Restrictiveness Index is released by
a. IMF
b. ADB
c. OECD
d. World Bank
16. Majority of FDI to India, comes from
a. Mauritius
b. Germany
c. USA
d. None of above
URL to article: http://mrunal.org/2013/04/economic-survey-ch6-balance-of-
payments-forex-reserves-currency-exchange-neer-reer.html
Posted By Mrunal On 23/04/2013 @ 23:48 In the category Economy

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