Balance of payment, current account, capital account, rupee recovery, forex reserves - sschub

Posted on May 04, 2013
sschub - Many times you when reading newspaper, you will face keywords like BoP, Current account, capital account, rupee weakens, India's foreign reserves etc. but only few of us have basic knowledge about these terms. So this article will help you to understands all these what and how.ok so lets move.

What is Balance of Payment?

  • Suppose you are going to get a company’s incoming and outgoing cash details, you’ve to check its account book.
  • Similarly Balance of Payment (BoP) is the account sheet (summary)  that tells the cash flow between India and rest of the world.
  • BoP =  Current account + capital account. (As per IMF definition, three parts: Current Account + Capital account + financial account).
  • so just know a brief overview:
What is Current account
  1. Import, Export (always negative, because we export less and import more oil n gold, hence we’ve trade deficit.)
  2. Income from abroad (interest, dividends paid on Indian investor’s FDI, FII in USA etc.)
  3. Transfer (gift, remittances from NRI to their families etc. always positive for India because of large Diaspora abroad.)
What is Capital account (+ financial account)
  1. Foreign investment in India (FDI, FII, ADR, direct purchase of land, assets).
  2. External commercial borrowing, external assistance etc.

  • Since we want to track the flow of cash, so, whenever American invest in India (via FDI, FII, ADR etc) we add it as (plus), and
  • when Indians invest in USA (via FDI, FII, IDR etc.) we add it as (minus) 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?

How Rupee-dollar convertibility works

  • 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

  • Let’s create 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 is conclusion of above?

  1. 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.
  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.

How Foreign Exchange Reserves build up

  • 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
  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 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

Why our rupee is volatile ?

  • 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?

Cause#1: import-export

  • 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.

Cause#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 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.

Cause#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.

Cause#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).

Cause#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 to recover rupee ?

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 =>
  • 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 =>
  • 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.
In this way we have an idea how RBI and Govt recovers rupee against foreign currency.

Not only Our rupee weakens

  • 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.
For more Economy articles click here Economy

Categories: