- What is Balance of Payment?
- Why BoP = 0 in theory?
- Rupee-Dollar Exchange rate
- Building up Foreign Exchange Reserves
- FOREIGN EXCHANGE RESERVES
- FOREX Reserve: India vs other
- Why volatility in rupee?
- How did rupee recover?
- Exchange Rate of Other Emerging Economies
- NEER and REER
- Why is REER important?
- External Debt
- FDI Restrictiveness Index (FRI)
- FDI: defense offset
- CHALLENGES AND OUTLOOK
- Mock Question
What is Balance of Payment?
- If you want to see a company’s incoming and outgoing cash, you’ve 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|
Capital (and financial) Account
- 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$=50 Rs.) Means that much Rupee currency is “gone” from Indian system via current account.
- But that American exporter has no use of Indian rupees! He lives in USA, he cannot even buy a burger from local McDonalds shop using Indian rupees. So what can he do?
- He can import something else from India (e.g. raw material, steel and plastic for further production of Apple6) = our rupee currency comes back to India via current account.
- He can “invest” that Indian currency to setup some factory or joint venture in India (=our rupee currency comes back to India via capital account)
- He can buy some shares or bonds in India. Again our rupee currency comes back.
- He can find a 2nd American who wants to import something from India / wants to invest in India. Apple6 guy can sell his rupee currency to that third American fellow @Rs.50=1$ or Rs.49=1$ or Rs.99=1$ (depending on the desperation of that 2nd 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 importer’s 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 exporter’s 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.
- 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 RBI’s 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 that’d require another article. Let’s get back to the topic, we are seeing the 6th 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, let’s 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 don’t grow Onions.
- America doesn’t 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), we’ll make good profit. So they’re more eager to convert their onions to Indian rupee currency. So they’d 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 don’t 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 don’t have crude oil, we can’t 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, it’ll 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 RBI’s “intervention” in the forex market has led to “recovery” of rupee.
Ok so what do we get from this story?
- RBI’s 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.
- When RBI sells its foreign exchange reserves, it stems (halts) the fall of rupee.
- 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 couldn’t 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 weren’t 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 couldn’t 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 we’ve 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 Government’s interventions, it came back to the normal 53-54 level at the end of 2012.)
FOREIGN EXCHANGE RESERVES
India’s foreign exchange reserves is made up of
- Foreign currency assets (FCA) (US dollar, euro, pound sterling, Canadian dollar, Australian dollar and Japanese yen etc.)
- special drawing rights (SDRs) of IMF
- Reserve tranche position (RTP) in the International Monetary Fund (IMF)
The level of forex reserve is expressed in US dollars. Hence India’s 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 8th position (close to 300 Billion USD).
Countries with largest Forex reserves
- South Korea
- Hong Kong
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 shift’s SSC paper is too easy but evening shift’s 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?
- Demand for Indian goods and services has declined due to Euro-zone crisis + America hasn’t 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.
- 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 India’s market is not giving good returns and or some other xyz country’s 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 doesn’t 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 rupee’s 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?
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 Africa’s 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 dollar…rupee all time low against dollar…and so on.
- Does it mean, Indian rupee is a really bogus weak and fragile currency? Nope.
- Because we don’t trade only with USA.
- We don’t 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 Rupee’s volatility, we’ve 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 doesn’t 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 you’ve to calculate NEER. Then using NEERs, you calculate REER.
|Nominal Effective Exchange Rate||Real Effective Exchange Rate (REER)|
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:
|Here Indian rupee is measured against 6 big currencies viz.
||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.|
|SDR of IMF||84|
- 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, India’s external debt stock = 345 billion (near to 17 lakh crore rupees.)
India’s 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 don’t 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 he’ll have to repay more. This will badly affect not just him but to India’s 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.
- Three top countries from where FDI comes to India: Mauritius, Singapore and UK
- Global Economic Prospects= this report is published by world bank.
- Which of the following, is not a part of Capital account
- External commercial borrowing
- Which of the following is not a part of Current account?
- External commercial borrowing
- Interest, dividends paid on FII
- India has deficit in
- Current account
- Capital account
- India has surplus in
- Current account
- Capital account
- India’s official forex reserve doesn’t include
- Foreign currency assets (FCA) (US dollar, euro, pound sterling, Canadian dollar, Australian dollar and Japanese yen etc.)
- Special drawing rights (SDRs)
- How can RBI build its foreign exchange reserve?
- By Buying foreign currency
- via funding from World Bank, ADB etc.
- Which of the following country has second largest forex reserves in the world?
- Among the countries with largest forex reserves, India ranks
- Rupee will strengthen against dollar when
- Government eases FDI policy
- Government raises the ceiling on FII investment
- Correct statement
- NEER is calculated by RBI
- REER is calculated by Finance ministry
- REER captures
- difference in inflation between India and its trading partners
- external competitiveness of Indian products
- Which of the following currency is not part of REER-6 calculation?
- Hong Kong Dollar
- Japanese Yen
- Pound Sterling
- Canadian Dollar
- Incorrect Match
- S.Korea: won
- Mexico: Peso
- Argentina: Peso
- S.Africa: Baht
- Which of the following is not released by World Bank?
- International Debt Statistics, 2013
- FDI Restrictiveness Index
- Global Economic Prospects
- All of Above
- FDI Restrictiveness Index is released by
- World Bank
- Majority of FDI to India, comes from
- None of above
@garima: as you know that current account includes the liabilities to the government. it includes external commercial borrowings, domestic borrowings, fdi, fii, nri deposits and remitances. As indian diaspora is large and quite rich and also lately fdi and fii have shown interest in the indian economy this capital account happens to be surplus.
@garima: 1 correction it should be only nri deposits not deposits and remitances. Sorry.
oops!! sorry read current as capital account.
Mrunal sir can we get all the economic survey chapters in single file ? it will be easier to study.. thanx
There are some interesting US and India related taxation questions and answers in the community section on http://www.simplyglobal.com. Looks like some of them have been answered by CPAs from US and CAs from India. I have used their daily exchange rate comparison for different banks/companies. I also like the graph on their website that shows the trend of the exchange rate over the last year, as published by Reserve Bank of India.
MRUNAL SIR YOU GAVE THE EXAMPLE OF I PHONE FOR BALANCE OF PAYMENT.BUT I DIDN’T UNDERSTAND ONE THING THAT WHY APPLE 6 EXPORTER WILL ACCEPT PAYMENT IN INR INSTEAD OF DOLLARS??? PLZ RPLY??
the story here is an assumption.
effect of balance of payment disequillibrium
1 c,2 c,3 a,4 b,5 c,6 b,7 c,8 d,9 b,10 a,11 c,12 d,13 b,14 b,15 c,16 c
sir, i could not find the current account deficit page … its not available
This link is not opening..
likewise, there are some other links also. Kindly suggest a solution.
thank you sir…
Link s not opening..mrunal sir can u pls provide alternate link…most of the links are not opening i.e. wrt Old archives of urs…thanks once again
Its wow!! sir g
Sir old articles not opening.. articles were excellent and required for brushing up for pre examination. kindly fix it up at the earliest.
i have doubt in 11th question answer can anyone share
what does “The weighted average of bilateral nominal exchange rates of the home currency in terms of foreign currencies” in the above context regarding NEER means . please someone explain.
You make understand very easily even those thins which are very difficult to understand. Thank you so much.
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..
But practically there exist forex, so India will make payement in terms of Dollar then how will it return back to india to make BOP=0?
Hello Sir, could you please upload the Bretton wood article again ?