CBP Class

Handouts #45 Open Economy Macroeconomics

• Import is leakage from circular flow of income.

• Export is injection in the circular flow.

Balance of Payment (Economic Survey 2013-14)

• 1. Export (of goods)

• 2. Import (of goods)
• 3. Trade Balance (2-1) -195
• 4. Invisibles (Net)
– (a)Non Factor Income (net) (from services) (shipping, banking, insurance, tourism, software services etc)
– (b) Factor Income (net) ( from services) (wages or coe, investment income (interest, profit, rent)
– (c) Pvt Transfers (net) (receipts for free ie without any payment) (remittances, gift, aid)
• 5. Current Account Balance (3+4) -88.2
• 6. External Assistance (net)
• 7. Commercial Borrowing (net)
• 8. Short Term Debt
• 9. Banking Capital of which
– NRI Deposits (net)
• 10. Foreign Investment (net)
– (i) FDI (net)
– (ii) Portfolio
• 11. Other Flows (net)
• 12. Capital Account total (net) (sale and purchase of assets like money, stocks, bonds) 89.3
*(payment to foreigner is debit, receipt is credit)
• 13. Errors and Omissions 2.7
• 14. Balance of Payments (5+12+13) 3.8
• 15. Reserve Use (- is increase) -3.8
• BOP Surplus and Deficit
• Current Account Deficit is financed by a net capital inflow
• The decrease (increase) in official reserves is called the overall bop deficit (surplus)
• BOP is in equilibrium when sum of its current account and its non reserve capital account is zero so that the
current account balance is financed entirely by international lending without reserve movement.
• Autonomous and Accommodating Transactions: Transactions made independently of the state of BOP (for
instance due to profit motive) are called Autonomous. These are above the line items in BOP. BOP is in surplus
(deficit) if autonomous receipts are greater (less) than autonomous payments.
• Accommodating Transactions (below the line) are determined by net consequences of autonomous items ie
whether BoP is surplus or deficit. The official reserve transactions are seen as the accommodating item in the BOP
(all other being autonomous)
• Error and Ommissions constitute the third element in the BoP (apart from current and capital accounts) which is a
balancing item reflecting inability to record all international transactions accurately.
•
• The Foreign Exchange Market
• The forex market is one in which national currencies are traded.
• Exchange Rate: Price of one currency in terms of other, usually as the amount of domestic currency required to
buy one unit of foreign currency. This is bilateral nominal Exchange Rate as it is quoted in money terms.
• Real Exchange Rate: Ratio of foreign to domestic prices , measured in same currency ie e*p(f)/p
• p(f) is foreign price, p is domestic price, e is nominal exchange rate.
• If Real exchange rate is equal to 1 then currencies are at purchasing power parity ie goods cost same in two
countries. If real exchange is greater than one then foreign goods are more expensive than domestic. Hence real
exchange gives measure of country’s competitiveness.
• If we want index for the exchange rate against other currencies, this is calculated as Nominal Effective Exchange
Rate (NEER), which is a multilateral rate representing the price of a representative basket of foreign currencies,
each weighted by the importance to the domestic country in international trade (indicated by average of export
and import shares)
• Real Effective Exchange Rate (REER) is weighted average of the real exchange rates of all trade partners, the
weights being the shares of the respective countries in its foreign trade.
 OPEN ECONOMY III

• India’s Balance of Payments

• BOP is a double entry record of all economic transactions between the ‘residents’ of a country and the rest
of the world carried out in a specific period of time.
• Double entry accounting is closed with the help of
– Purchases and repurchases from the IMF
– Allocation of IMF SDRs
– Own Reserve
• Current Account: India presents imports on c.i.f basis (cost, insurance, and freight basis) while the exports
are presented on f.o.b basis (free on board basis) ie without including freight and insurance costs.
• High earnings from invisibles especially software exports and private remittances are main new
contributors to improvement in the balance of payments situation in recent years.
• Capital Account: Both FII and NRI fair weather friends. Short term Debt is frequently hot money which
moves across countries in search of high returns.
• FPI include: 1. FII and 2. GDR & ADR

• India Foreign Exchange Reserves

• Rule of thumb for forex adequacy: The stock of reserves should be equivalent to a few months of imports.
However now recognised that focusing on current account is insufficient as capital account transactions
are more important. Within this short term external debt has gained prominence in determining reserve
adequacy.
• A substantial part of the build of reserves since 1991 has been due to NRI deposits and FII. These are
essentially hot money. However RBI claims that fundamental factors like increased remittances
contributed to the reserves and not necessarily the arbitrage motive of NRI and FII.
• A rise in international interest rates or a rise in dollar value can squeeze the arbitrage window, leading to
reversal of flows.
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• Capital Account Convertibility
• Tarapore Committee on CAC 1997 has defined CAC as the freedom to convert local financial assets into foreign
financial assets and vice versa at market determined rates of exchange.
• RBI has opted for phased and gradual capital account liberalisation. It started off by opting first for current account
liberalisation. Gradually liberalisation of FDI, FPI, External Borrowings, Outflows.
• Current Account Convertibility: When domestic currency allowed to convert into foreign currency for all current
account purposes.
• Capital Account Convertibility: When domestic currency allowed to convert into foreign currency for all capital
account purposes. The Second Committee on CAC chaired by Tarapore gave report in 2006 on which RBI/Govt is
having consultation.

• Foreign Exchange Regulation Act (FERA) 1973

• All non banking foreign branches and subsidiaries with foreign equity exceeding 40 % had to obtain permission to
establish new undertaking, to purchase shares in existing companies , or to acquire wholly or partly any other
company.

• Foreign Exchange Management Act (FEMA) 1999

• Objective is to facilitate external trade and payments and for promoting the orderly development and
maintenance of foreign exchange market in India.

• FERA vs FEMA
• FEMA emphasises ‘exchange management’ whereas FERA emphasised ‘exchange regulation’ or ‘control’.
• Except for dealing in foreign exchange no other provisions of FEMA stipulate obtaining RBI permission. FERA
stipulated RBI permission for most provisions.
• FEMA removes restriction on drawals of forex for purpose of current account transaction.
• Also unlike FERA, violation of FEMA don’t attract criminal proceedings. The contravention will now be treated as
civil offence.
• Hence, FEMA can now be seen as initial step towards CAC.

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• India Foreign Trade 2015-16
• Composition of Imports: POL (Petroleum, Oil and Lubricant) 21.8 %, Non Ferrous Metal ( including Gold and Silver)
11.8%, Electronic Goods 10.5 %
• Composition of Exports: Engineering Goods 23.1%, Gems and Jewellery 15.1%, Petroleum Products 11.6%.
• Direction of Imports: China 16.2 %, USA 5.7%, Saudi Arabia 5.3%, UAE 5.09 % (For 2017 China, UAE, USA)
• Direction of Exports: USA 15.4%, UAE 11.6%, Hong Kong 4.6%, China 3.45%

• Forex Reserves
• Includes foreign currency reserves , gold reserves, SDRs, Reserve Tranche in IMF
• Reserve holding involves a cost like:
– To avoid inflationary pressure spot dollar purchases are converted into forward. This involves cost in form of forward premium.
– OMO also involves cost.
– Dollar is invested in US treasuries with negligible returns owing to lower yields.
• BOP Crisis: When forex reserves not capable of fulfilling the negatively created by the BoP. IMF help is last resort
in such cases.

• Exchange Rate Management:

• Direct: via buying and selling of foreign currency.
• Indirect: through Monetary Policy impact on interest rates.
• Gliding \ Crawling Peg: Peg is allowed to glide smoothly upward or downward.

• Some More Concepts

• India had current account surplus for three consecutive years (2000-03) only such period in Indian economic
history.
• Extended Fund Facility: IMF provided forex to members facing BoP crisis, but on condition of structural reforms.
• Hard Currency: International currency of high faith and need. Eg US dollar.
• Soft Currency: Currency easy available in forex market. Opposite of hard currency. Eg INR in India forex market.
• Hot Currency: Hard currency exiting at fast pace.
• Heated Currency: Domestic currency under pressure or heat of depreciation due to hard currency exit.
• Cheap Currency / Cheap Money : RBI buys bond and release money decreasing interest.
• Dear Currency / Dear Money: RBI sells bonds and collects money increasing interest.
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 Special Economic Zone:
• A designated duty free enclave to be treated as foreign territory only for trade operations and duties and
tariffs. However domestic sales are subject to full custom duty and import policy.
• SEZ Act 2005 concretised this. It provides comprehensive SEZ policy framework which earlier was
contained in foreign trade policy. It also offers tax concessions to units and developers.
• SEZ can be set by either Govt, States or private sector. Objective is to promote exports, investment,
employment. In 2017 206 SEZ operational with 23% share in exports. As per CAG report 53% of land not
put in use yet.

• FDI Source in India: Mauritius, Cyprus and UAE has been highest due to favourable double tax avoidance
agreement (DTAA). Tax havens also help in round tripping, ie routing of investments by a resident of one
country or firm through other country back to the home country.
• GAAR: General Anti Avoidance Rule to check tax avoidance. It codify doctrine of ‘substance over form’. It
also checks that transactions are at arm’s length.

• India External Debt Stock:

• Structural change in terms of composition.
– Share of concessional debt in total debt has declined and non concessional private debt have surged.
– Rise share of short term debt is worrying. Dependence of private sector on external commercial
borrowing has increased because of lower interest on external commercial borrowing.
– About 85% of borrowing unhedged.
– In 2016, forex reserves cover just 74.2 % of total external debt. This is among lowest in Asia.
• Risk of foreign currency borrowings: Sharp depreciation in local currency would increase debt service
liability resulting in debt overhand and calling for ‘mark to market’.
• Natural Hedge is when forex borrower corporate also have forex earning exports.
• Forex risk calls for hedging but corporate avoid as it comes at a cost.
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• New Foreign Trade Policy (2015-2020):
• Aim to increase India’s export of merchandise and services from $465 bn on 2013 – 14 to $ 900 bn by 2019- 2020
and to raise India’s share in world export from 2% to 3.5%. Two new schemes introduced:
• 1. Merchandise Export from India Scheme (MEIS): has replaced 5 existing schemes, Focus Product Scheme, Market
Linked Focus Products Schemes, Focus Market Schemes, Agriculture Infrastructure Incentives Scrips and Vishesh
Krishi Grameen Udyog Yojana.
• 2. Service Exports from India Scheme: replaces existing Served from India Scheme (SFIS).
• All scrips issued will be transferable. This means scrips issued under export from India can be used for payment of
custom duty, excise duty, and service tax. This benefits service sector as many do not import and were not able to
use the incentives.

• Steps to Promote Trade: e-Filing and e-Payment, single window for customs, 24*7 customs clearance, paperless
environment, training (Niryat Bandhu Scheme: organised at MSME clusters. Niryat Bandhu at your doorsteps is an
online certificate programme in export import business by IIFT.
•
• RTAs by India: With multilateral process at WTO being slow Regional Trade Agreements have assumed greater
significance. RTAs are WTO compliant. India see them as complementing multilateral trade. By 2017 India signed
12 FTA’s (Free TA) and 6 PTAs (Preferential TA), 24 FTAs are under negotiations. Net impact of these is mixed bag.

• Some More Concepts

• Trans-Pacific Partnership: TPP was a new mega-regional agreement between 12 pacific rim countries. USA pulled
out in 2017.
• Transatlantic Trade and Investment Partnership: Between EU and USA and includes investment also. USA dropped
out in 2017.
• Deglobalisation: Recent protectionist trends in form of Brexit and other recent USA initiatives detrimental to
trade.
• National Treatment: Under WTO rules, products once imported into the territory of other member would not be
discriminated vis a vis domestic product.
• BIPA: Bilateral Investment Promotion and Protection Agreement for promoting and protecting investment on
reciprocal basis.

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• World Bank Group
• Consist of 5 closely associated institutions:
• IBRD: International Bank for Reconstruction and Development, Oldest institution of WB, focus was reconstruction of world
war II ravaged countries, now focus on development including human development while lending at low interest.
• IDA: International Development Agency, soft window of WB, long term interest free lending.
• IFC: International Finance Corporation, private arm of WB, lends money to private companies at commercial but relatively
lower interest.
• MIGA: Multilateral Investment Guarantee Agency, provided insurance (guarantees) to private investors for non commercial
risks eg political risks.
• ICSID: International Centre for Settlement of Investment Disputes, is a investment dispute settlement body.

• BRICS Bank
• Called National Development Bank.
• Have a Contingency Reserve Arrangement (CRA) of $100 bn for liquidity protection to member nations during BOP crisis.
• Adopts one nation one vote as against Bretton Woods Institutions (WBG and IMF) which are quota based.

• Asia Infrastructure Investment Bank:

• Providing finance to infrastructure project. Intended to be more of commercial bank, with nations as shareholders, than a
purely development aid institution.