Open Economy

Macroeconomy

Resources

Mankiw (2006), Macroeconomics: Chapters 5, 12

Blanchard ((2007),
), Macroeconomics: Chapters
p
18,, 19,, 20,, 21

DSouza (2008), Macroeconomics: Chapters 5, 11

Sikdar (2006), Principles of Macroeconomics: Chapter 7

Multinational
l
l Business Finance: Eiteman, S
Stonehill,
h ll Moffett
ff
and
d Pandey
d
((Tenth
h
Edition), 2007: Chapters 3

Multinational Financial Management: Shapiro (7th Edition), 2003: Chapter 5

I t
International
ti
l Financial
Fi
i l Management:
M
t Apte
A t (Fourth
(F
th Edition),
Editi ) 2006:
2006 Chapter
Ch t 4

International Finance: Levi (Third Edition), 1996: Chapters 5 and 6

Foreign Exchange International Finance Risk Management: AV Rajwade (Third

Edition) 2000: Chapter 1
Edition),
2

The Exchange Rate

An exchange
h
rate is,
i simply,
i
l the
h price
i off one
nations currency in terms of another currency, often
termed the reference currency.

Example:

The rupee/dollar exchange rate is just the number of rupees

that one dollar will buy.
buy

If a dollar will buy 40 rupees, the exchange rate would be

expressed as Rs.40/$.

Since exchange rate is a price, like the price of any

commodity, it is also determined by the forces of
demand and supply in foreign exchange markets
3

Deriving a Currencys Supply Curve

The supply
Th
l curve off a currency shows
h
the
h amount off that
h
currency supplied on the horizontal axis and the price of the
currency, given by the exchange rate, on the vertical axis

The supply curve of a currency derives from a country

countrys
s
demand for imports.

This is because when paying for imports that are invoiced in

foreign currency, the countrys
country s residents must sell their
currency for the needed foreign exchange; and when imports
are invoiced in domestic currency, the foreign recipient of the
currency sells it.

In either
h case, imports result
l in the
h countrys
currency being
b
supplied

The amount of currency supplied = the value of imports

Deriving a Currencys Demand Curve

The d
Th
demand
d curve for
f a currency shows
h
the
h value
l
off the
h
currency that is demanded at each possible exchange rate.

Because the need to buy a countrys currency stems from the

need
d to
t pay for
f the
th countrys
t exports,
t the
th currencys
demand
d
d
curve is derived from the countrys export supply curve, which
shows the quantity of exports at each price of exports

The amount of currency demanded = the value of exports

Equilibrium Exchange Rate

Exchange rate ($/Re)
SRs.

e1

The equilibrium exchange rate is

that at which the quantity of
currency supplied equals the
quantity demanded.

e0
e2
DRs.

Q0

Demand and supply of rupees

I t
Interpret
t exchange
h
rates
t e1 and
d e2
6

Factors Affecting exchange Rates

Quick Thinking!
Suppose India exports textiles and imports wheat from US.
What will happen to equilibrium exchange rate
rate, if

the world price of textile increases?

the world price of wheat increases?
if India
Indias
s terms of trade improves?

Hints

Increase in world price of textiles increases the value of exports at

each exchange rate, which shifts the demand curve for rupees to
the right and result in an increase in the value of rupees
Increase in world price of wheat increases the value of imports at
each exchange rate, which shifts the supply curve for rupees to the
right and result in a decrease in the value of rupees
7

Factors Affecting exchange Rates

What happens if Indias terms of trade improve?

The price of a countrys exports relative to the price of its

imports is called the country
countrys
s terms of trade
A countrys terms of trade is said to improve when the price
of exports increases relative to the price of its imports, in
our example textile prices increase more than wheat prices
Rupee will appreciate in value as a result of improvement in
Indias terms of trade.

Think!

What will happen

pp
if India has a g
good wheat harvest?
8

Balance of Payments Accounting

As with the price of any commodity, the price of a countrys

currency depend on the supply and demand for that currency.

Any
y factor increasing
g the demand for currency
y will,, ceteris
paribus, increase the foreign exchange value of the currency,
that is, cause the currency to appreciate.

Any
y factor increasing
g the supply
pp y for currency
y will,, ceteris
paribus, decrease the foreign exchange value of the currency,
that is, cause the currency to depreciate

Clearly, then, there is considerable interest in maintaining a

record of the factors behind the supply of and demand for a
countrys currency. This record is maintained in the balanceof-payments account.

Balance of Payments Accounting

The Balance of Payments is the statistical record of a
countrys international transactions over a certain period of
time.
Observations:
1)

When we say a countrys balance of payments we are referring to

the ttransactions
ansactions of its citizens
citi ens and government
go e nment

2)

Examples of international transactions include import and export of

goods and services and cross-border investments in businesses,
b k accounts, bonds,
bank
b d stocks
k and
d reall estate.

3)

Since the balance of payments is recorded over a certain period of

time (i.e., a quarter or a year), it has the same time dimension as
national income accounting
10

Balance of Payments Accounting

4)

Any transaction that results in a receipt from foreigners will

be recorded as a credit, with a positive sign, in Indias
balance of payments; whereas any transaction that gives rise
to a payment to foreigners
f
i
will
ill be
b recorded
d d as a debit,
d bi with
iha
negative sign.

5)

The plus sign and minus sign indicate respectively the

earning and spending of foreign exchange by the country.

6)

A debit records a transaction increasing assets or reducing

li biliti
liabilities;
a credit
dit records
d a transaction
t
ti
reducing
d i
assets
t or
increasing liabilities

11

Balance of Payments Accounting

Example 1:

Suppose that an Indian manufacturer sells $20

million
illi
worth
h off gems and
d jewellery
j
ll
to US.
US

Then, the exports by the Indian manufacturer will be

recorded as a credit (+) in India
Indias
s BOP account

We can think of the export of the gems and

jewellery as resulting in a demand for rupees and
supply of foreign exchange.

12

Balance of Payments Accounting

Example 2:

Suppose that an Indian wholesaler purchases $10

million worth of jeans from a US manufacturer

In this case, imports by Indian wholesaler will be

recorded as a debit (-).

We can think of the import of jeans by Indian

manufacturer as resulting in a supply of rupees and
demand for foreign exchange.

13

Balance of Payments Accounting

If the imports from India are more than its exports,

then this means that the supply of rupees is likely
to exceed the demand in the foreign exchange
market. One can thus infer that the Indian rupees
would be under pressure to depreciate against other
currencies.
currencies

On the other hand, if India exports more than it

imports then the rupees would likely to appreciate
imports,
appreciate.

14

Components of the Balance of Payments

The balance of payments accounts are those that

record all transactions between the residents of a
country and residents of all foreign
g nations

They are composed of the following:

The Current Account

The Capital Account

Statistical Discrepancy / Errors and Omissions

The Official Reserves Account

15

Components of the Balance of Payments

The Current Account: Under this are included imports and

exports of goods and services and unilateral transfers of goods
and services.

The Capital Account: Under this are grouped transactions

leading to changes in foreign financial assets and liabilities of
the country.

The Official Reserves Account: In this category only "reserve

assets" are included. These are the assets which the monetary
authority of the country uses to settle the deficits and
surpluses that arise on the other two categories take together

Statistical Discrepancy: Theres going to be some omissions

and misrecorded transactionsso we use a plug figure to get
things to balance
16

Merchandise Trade

Merchandise
M
h di trade
d should
h ld cover all
ll transactions
i
relating
l i
to
movable goods, where the ownership of goods changes from
residents to non-residents (exports) and from non-residents to
residents (imports).

Exports are the credit entries; while imports are the debit
entries

The difference between the total of credits and debits appears

in the "Net" column. This is the Balance on Merchandise Trade

The valuation should be on f.o.b. basis so that international

freight and insurance are treated as distinct services and not
merged
d with
ith the
th value
l
off the
th goods
d themselves.
th
l
[FOB is
i Free
F
on Board and means that the charges become yours at the
origination. The seller will load it on the truck and then it's
yours.]
17

Invisibles

The invisibles account includes services such as transportation

and insurance, income payments and receipts for factor
services - labour and capital - and unilateral transfers, such as
f
foreign
i
aid
id

Credits under invisibles consist of services rendered by

residents to non
non-residents,
residents, income earned by residents from
their ownership of foreign financial assets (interest, dividends),
income earned from the use, by non-residents, of non-financial
assets such as p
patents and copyrights
py g
owned by
y residents, and
cash and in-kind gifts received by residents from non-residents

Debits consist of same items with the roles of residents and

non residents reversed
non-residents
18

The Current Account

The net balance between the credit end debit

entries under the heads merchandise, nonmonetary g
gold movements and invisibles taken
together is the Current Account Balance.

The net balance is taken as deficit if negative

(debits exceed credits)
credits), a surplus if positive (credits
exceed debits).

19

The Capital Account

The capital account consists of three major subgroups.

The first relates to foreign investments in India either in the

form of direct investments e.g., Ford Motor Co. starting a car
plant in India or portfolio investments such as purchase of
Indian companies stock by foreign institutional investors, or
subscriptions by non-resident investors to GDR and ADR issues
b IIndian
by
di
companies.
i

Loans comprise external assistance, commercial borrowings

and short term loans (repayable within one year). External
assistance is borrowings
b
ffrom multilateral
l l
l organizations llike
k
World Bank and from bilateral sources, mainly on concessional
terms.

20

The Capital Account

Banking capital covers the assets and liabilities of

commercial banks, non resident deposit accounts
and other financial institutions.
institutions

The total capital account consists of these three

major groups and two other minor groups shown
under

Rupee debt Service - includes principal repayments on account

of civilian and non-civilian debt in respect of Rupee Payment Area

(RPA) and interest payment thereof

Other capital
p
includes any
y capital
p
transaction not included in the
above
21

Statistical Discrepancy

While conceptually and arithmetically the net difference

between current and capital accounts must compensate the
movement in reserves, in practice this is not often so because
off errors and
d omissions
i i
in
i the
h reported
d data.
d

For instance, information on payments for imports not passing

tthrough
oug the
t e banking
ba
g channels
c a e s is
s obtained
obta ed from
o other
ot e sources,
sou ces,
primarily government records. The timing of recording for each
leg of the transaction may also vary.

The balance of payments statistics of a country will therefore

generally include a compensating term statistical discrepancy
or errors and omissions.

22

The Official Reserve Account

Official
Offi
i l reserves assets include
i l d gold,
ld foreign
f
i
currencies,
i
SDRs,
SDR reserve
positions in the IMF

The balance on current account and capital account together will result
in the countrys
y reserves of foreign
g exchange
g going
g
g up
p or down
correspondingly

A current account deficit may be combined with a higher capital

account surplus and therefore reflect as an addition to the countrys
reserves of foreign exchange.
exchange

Thus, we may write the BOP identity

BCA + BKA + BRA = 0 or BCA + BKA = - BRA

where BCA = Balance on Current Account

BKA = Balance on Current Account
BRA = Balance on the Reserves Account

23

Indias Balance of Payments Data

Credits

Debits

Current Account
1

Exports

Imports

Invisibles
Balance on Current Account

$104,780
($156,334)
$91,481

($50,539)
($10,612)

Capital Account
4

Direct Investment

Portfolio Investment

6
7

Other Investments
Balance on Capital Account
Statistical Discrepancies
Overall Balance

Official Reserve Account

$8,520

($2,787)

$68,115

($55,626)

$62,665

($56,194)

$24,693
$971

$336,532
($15 052)
($15,052)

24

Indias Balance of Payments Data

Credits

Debits

Current Account
1

Exports

Imports

Invisibles
Balance on Current Account

$104,780
($156,334)
$91,481

($50,539)
($10,612)

Capital Account
4

Direct Investment

Portfolio Investment

6
7

Other Investments
Balance on Capital Account
Statistical Discrepancies
Overall Balance

Official Reserve Account

$8,520

($2,787)

$68,115

($55,626)

$62,665

($56,194)

$24,693
$971

$336,532

In 2005-06, India
imported more
than it exported,
thus running a
current account
deficit of $10,612
million.

($15 052)
($15,052)

25

Indias Balance of Payments Data

Credits

Debits

Current Account
1

Exports

Imports

Invisibles
Balance on Current Account

$104,780
($156,334)
$91,481

($50,539)
($10,612)

Capital Account
4

Direct Investment

Portfolio Investment

6
7

Other Investments
Balance on Capital Account
Statistical Discrepancies
Overall Balance

Official Reserve Account

$8,520

($2,787)

$68,115

($55,626)

$62,665

($56,194)

During
D
i the
h same
year, India attracted
net investment of
$24 693 million
$24,693
clearly the rest of
the world found
India to be a good
place to invest.

$24,693
$971

$336,532
($15 052)
($15,052)

26

Indias Balance of Payments Data

Credits

Debits

Current Account
1

Exports

Imports

Invisibles
Balance on Current Account

$104,780
($156,334)
$91,481

($50,539)
($10,612)

Capital Account
4

Direct Investment

Portfolio Investment

6
7

Other Investments
Balance on Capital Account
Statistical Discrepancies
Overall Balance

Official Reserve Account

$8,520

($2,787)

$68,115

($55,626)

$62,665

($56,194)

Under a pure
flexible exchange
rate regime, these
numbers would
balance each other
out.

$24,693
$971

$336,532
($15 052)
($15,052)

27

Indias Balance of Payments Data

Credits

Debits

Current Account
1

Exports

Imports

Invisibles
Balance on Current Account

$104,780
($156,334)
$91,481

($50,539)
($10,612)

Capital Account
4

Direct Investment

Portfolio Investment

6
7

$8,520

($2,787)

$68,115

($55,626)

Other Investments
Balance on Capital Account

$62,665

($56,194)

Statistical Discrepancies
Overall Balance

$971

Official Reserve Account

In the real
world, there
is a statistical
discrepancy.

$24,693
$336,532
($15 052)
($15,052)

28

Indias Balance of Payments Data

Credits

Debits

Current Account
1

Exports

Imports

Invisibles
Balance on Current Account

$104,780
($156,334)
$91,481

($50,539)
($10,612)

Including that,
the balance of
payments identity
should hold:
BCA + BKA = BRA

Capital Account
4

Direct Investment

Portfolio Investment

6
7

Other Investments
Balance on Capital Account
Statistical Discrepancies
Overall Balance

Official Reserve Account

$8,520

($2,787)

$68,115

($55,626)

$62,665

($56,194)

$24,693
$971

$336,532
($15 052)
($15,052)

($10,612) + $24,693 + $971 = ($15,052)

29

Summary

A surplus in the BOP implies that the demand for the countrys
currency exceeded the supply and that the government should
allow the currency value to increase in value or intervene and
accumulate
l
additional
ddi i
l foreign
f
i
currency reserves in
i the
h Official
Offi i l
Reserves Account (by selling domestic currency for foreign
exchange)

A deficit in the BOP implies an excess supply of the countrys

currency on world markets, and the government should then
either
ith allow
ll
the
th currency to
t depreciate
d
i t or expend
d its
it official
ffi i l
reserves to support its value (by buying domestic currency
with its reserve of foreign currency).

30

Convertibility of Rupee

IIndian
di
rupee is
i fully
f ll convertible
ibl on current account. This
Thi
means that there are virtually no restrictions now on the
purchase and sale of foreign exchange for trade in goods and
services.

However, trade in assets (International Lending and

Borrowing), particularly by residents, is still very carefully
regulated by exchange controls. This means the rupee is not
convertible on capital account.
account

Capital account convertibility (CAC) refers to the freedom to convert

local financial assets into foreign financial assets and vice versa at
market determined rates of exchange (the first Tarapore Committee
on Capital Account Convertibility appointed in February 1997 )

There exists a restricted capital account convertibility now - by

which any Indian entity (individual, company or otherwise) can
invest or acquire assets outside India or a foreign entity remit
funds for investment or acquisition of assets with specified
`cap' on such investments and for specific purpose
31

India: Rupee Depreciation During 2008-09

During 2008-09, the Indian rupee generally depreciated.

Rupee moved in the range of Rs.39.89 (end March 2008) 49.96 (as
on October 24) per US dollar,
dollar falling over 21% during the period,
period
being the second-worst performing currency in Asia after the Korean
won.

Depreciation
D
i ti
iin rupee reflects
fl t FII outflows,
tfl
bearish
b
i h stock
t k market
k t
condition, high inflation and higher crude oil prices, that generate
higher demand for dollars.

The rupees fall was also aided by the dollars rise against the pound
and euro the pound fell to a six-year low against dollar on October
24

32

India: Rupee Depreciation During 2008-09

When the
Wh
th rupee was appreciating
i ti
in
i 2007-08,
2007 08 it was widely
id l
believed that the upturn was here to stay.

When the tide turned, it was a rude awakening.

India continues to be a net importer of goods, especially capital

goods and key industrial inputs. A costlier rupee raises project
costs and affects the rate of investment
investment, which impacts
economic growth.

Given this, if we want to have a view on Indias g

growth story,
y it
becomes necessary to understand the moves being made by the
rupee.

33

India: Rupee Depreciation During 2008-09

Since 1993, Indias currency regime is said to be a managed

float

There is a currency market and the exchange rate is not visibly

administratively determined. The rupee was marketdetermined in the sense that it was now convertible on current
account and the RBI was no longer fixing buy and sell quotes.

However, the RBI actively trades on the market, with the stated
goal of containing volatility, and influencing the exchange rate

Distinction between the de jure currency regime as claimed by

a central bank and the de facto currency regime that is
actually
actua
y in operation
ope at o has
as been
bee established
estab s ed in literature.
te atu e
34

India: Rupee Depreciation During 2008-09

Exchange rate pegging can adversely affect internal

economic balance the idea of impossible trinity
[Mundell 1961]

Once the capital account is open, and the exchange

rate is fixed,
fixed monetary policy is solely driven by the
need to uphold the fixed exchange rate

35

India: Rupee Depreciation During 2008-09

Possible Causes for Rupee Depreciation:
(i) Widening Current Account Deficit
(ii) Net Capital Outflows
((iii)) Resilient Dollar
(iv) Forced Depreciation

36

Widening Current Account Deficit

Indias
di inflation
i fl i spurtedd to double
d bl digits
di i in
i June 08 higher
hi h
than the rate of economic growth on the back of high crude oil
and commodityy pprices.

At the same time, the governments decisions to raise subsidies

rather than p
pass on the high
g global
g
prices
p
of crude oil and
fertilizers have dramatically increased the fiscal deficit.

Besides the ggovernment has to make pprovisions for waivingg

agricultural loans, and other rural development and welfare
schemes launched in the recent past.

37

Widening Current Account Deficit

The
h larger
l
fiscal
fi l deficits
d fi i translated
l d into
i
larger
l
current account
deficit, with marginal or zero crowding out of private
investment.

Merchandise trade deficit during April-August 2008 widened

to US $ 49.3 billion from US $ 34.6 billion duringg AprilAugust 2007.

Huge
g trade deficit has pput downward ppressure on rupee.
p

38

Net Capital Outflows

The most obvious reason behind the recent rupee depreciation is the global financial crisis
and the ensuing massive unwinding of foreign portfolio investors (US $ 7.3 billion during
2008-09, up to October 10) to fund their domestic liquidity requirements. This was in
contrast to net FII inflows (US $ 18.9 billion) during the corresponding period of 2007-08.

As and when FIIs are attracted to the market by expectations of a price increase that tend
to be automatically realised, the inflow of foreign capital generates an appreciation of the
rupee.
p

It is worthwhile to note that during 2007-08 rupee has appreciated vis--vis the dollar by
more than 10% This increased the return earned in foreign exchange, when rupee assets
are sold and the revenue converted into dollars.
dollars

The investments turn even more attractive triggering an investment spiral that would imply
a sharper fall when any correction begins.

If any set of developments encourages an unusually high outflow of FII capital from the
market, it can impact adversely on the value of the rupee and set off speculation in the
currency that can in special circumstances result in a currency crisis
39

Net Capital Outflows

IIn th
the recentt global
l b l financial
fi
i l crisis,
i i the
th spreadd between
b t
three-month
th
th LIBOR and
d
the 90-day US treasury bill attained unprecedented values rising sharply from
1.24 percentage points on 11/09/2008 (failure of Lehman Brothers) to a peak of
percentage
g points
p
on October 10.
4.58 p

Prior to financial crisis, it was cheaper for Indian multinationals (both financial
and non-financial) to establish global treasury operations in London primarily for
fund raising
raising.

When LIBOR rose sharply reflecting the rise in credit risk in London the rates
at which Indian firm borrowed went up.

Indian firms who were borrowing in London found themselves structurally short
of dollars. They responded by borrowing in Indian short-term money market,
converting funds into dollars, using the proceeds to meet external debt obligations.

Increased both the demand for domestic liquidity and that for foreign exchange,
exerting downward pressure on the rupee exchange rate.

40

Resilient Dollar

With aggregate demand for US goods falling and interest

rates falling at the same time, a depreciation of dollar would
seem to be a foregone conclusion.

Yet that is not what happened: between end-March 2008

and October 14, 2008, US dollar appreciated by 15% against
the Euro, 13.1% against the Pound sterling, 2.7% against
J
Japanese
yen, 26.3%
26 3% against
i t Korean
K
won and
d 19.4%
19 4%
against Indian rupee

The unexpected strengthening of the dollar weakened the

demand for US products further at a time when
manufacturing output was contracting sharply.

41

Resilient Dollar

The
h dollars
d ll
appreciation
i i can be
b explained
l i d as follows:
f ll

The US has been the worlds most dynamic economy since 1990s,
andd with
ith the
th US economy in
i trouble,
t bl prospects
t elsewhere
l
h looked
l k d att
least as bleak. US financial markets continue to be of crucial
importance to the rest of the world: More than $4 trillion of reserves
are held
h ld in
i US currency
With global financial crisis, there is a flight to safety and investors all over the
world are buying US treasury bills even at near zero interest rates. Thus there is a
huge demand by US dollar and it is appreciating against all floating currencies.

Researchers have found that a lack of financial development at home makes

foreigners keener to invest in America. What attracts them is the size, liquidity,
efficiency and transparency of its financial markets compared with what is on
offer in their domestic markets.
42

Forced Depreciation

Many argue that the rupee depreciation against US dollar during 2008-09 was
engineered by RBI through its faulty exchange rate management policy during
2007-08.

After the cut in the interest rates in the US since mid-2007, there has been a
sharp increase in interest rate differentials with India. This could be expected to
lead to a sharp inflow of capital into India and a rupee appreciation.

February 2008 saw the US dollar weaken against world currencies. But this is
not what happened in India the month saw Indian rupee to depreciate.

If the depreciation of rupee had been due to an outflow of capital putting

pressure on the rupee to depreciate, there would have been either no change in
the foreign exchange reserves held by RBI or foreign exchange reserves would
have declined as the RBI fought off the sudden pressure to ensure a smooth
rupee.
43

Forced Depreciation

However, data from RBI suggested quite the opposite. There has been a sharp
increase in the foreign exchange reserves of the RBI. In the month of February,
reserves increased by 11.7 billion dollars. This suggests that RBI was going all
the way to pushing the rupee to depreciate.

But why? One possible answer is that too much money was coming in trying to
take advantage of one way bet and interest rate differentials with respect to the
US.

However, an artificial depreciation of the rupee is a step in the wrong direction

As an example,
p during
g the first few months this yyear, in an environment of rising
g
oil prices and a higher import and subsidiary bill, RBI started buying dollars
aggressively to engineer a depreciation. Apart from the fact that a rupee
depreciation is inflationary, the current account deficit position worsened,
putting further downward pressure on rupee.
44

International Crude Oil Prices and Indias

Foreign Exchange Reserves
Month

Average Crude Price

(US dollars / bbl)

FOREX Reserves
(in billions of US
dollar))

January 2008

89.9

293.2

February 2008

90.8

301.2

March 2008

101.8

309.7

April 2008

108.8

314.2

May 2008

122.6

314.6

June 2008

131 5
131.5

312 1
312.1

July 2008

132.8

306.2

Source: RBI, IMF and World Bank

45

What is Wrong with Sharp Rupee

Depreciation?
Weaker rupee has three important effects:
(i) On the real sector: Makes exports cheaper, imports dearer increase net export
component of aggregate demand and therefore output.
(ii) On inflation: A lot of things that we import are priced in US dollars, and a rupee
depreciation would worsen inflation. In addition, many domestic products, like
steel,
t l are priced
i d by
b import
i
t parity
it pricing
i i where
h the
th global
l b l price
i is
i multiplied
lti li d by
b
the rupee-dollar exchange rate to arrive at the price purely used in domestic
transactions. Through these two channels, the rupee depreciation might kick up
inflation in India.
India
(iii) On Indian firms: A weakening rupee has pushed up the foreign exchange
liabilities of Indian companies. When the rupee depreciates, the value of foreign
currency liability denominated in rupee terms increases. Also firms who felt there
was a one-way bet on the rupee, and were betting on a rupee appreciation will be
46
adversely affected

RBI Intervention in Foreign Exchange

Market
Should RBI intervene? Against:

Recall the idea of impossible trinity. In the

present system, RBI is mandated with numerous
objectives managing public debt, exchange rate,
banking regulation and finding a balance between
growth and inflation. These tasks often come in
conflict with each other.

Exchange rate rigidity forces the real economy to

adjust since the currency market was prevented
from adjusted by the Central bank.
bank
47

RBI Intervention in Foreign Exchange

Market
For:

In favour of reducing volatility or smoothing the change. If the rupee-dollar

rate has to go from Rs.45 per dollar to Rs.50 per dollar, it is argued that instead
of letting the market do this within a few days, the central bank must steadily
trade on the market to spread this change over a period of (say) three months.

The above argument gains further strength since,

since one element of current
financial crisis is that Indian firms are structurally short of dollars. Thus at
present RBI needs to infuse dollar liquidity.

Many economists argue that while RBI intervention slowed the depreciation, it
initially abstained from the large-scale sale of dollars that could have moderated
the depreciation. Such a sale was feasible given that initially outflows were
much
h llower than
th huge
h
reserves, which
hi h even increased
i
d since
i
FDI inflows
i fl
continued to be robust.
48

Fixed Versus Floating Exchange Rates

In a system of floating exchange rates, e is set by market

forces and is allowed to fluctuate in response to changing
economic conditions
conditions. In other words,
words the exchange rate e
adjusts to achieve simultaneous equilibrium in the goods
market and money market.

In contrast, under fixed exchange rates, the central bank trades

domestic for foreign currency at a predetermined price. Under
a fixed
fi d exchange
h
rate,
t the
th central
t l bank
b k announces a value
l for
f
the exchange rate and stands ready to buy and sell the
domestic currency to keep the exchange rate at its announced
level
49

Fixed exchange rates

Under fixed exchange rates, the central bank stands ready to

buy or sell the domestic currency for foreign currency at a
predetermined rate.

For example, suppose the RBI has announced that it was going to
fix the exchange rate at 0.022 dollar per rupee. It would then stand
ready to give Re. 1 in exchange for 0.022 dollars or to give 0.022
dollars in exchange for Re. 1 to carry out this policy, RBI needs to
maintain a reserve of rupees (which it can print) and a reserve of
dollar (which it must have purchased previously).

A fixed exchange rate dedicates a countrys monetary policy to

th single
the
i l goall off k
keeping
i
the
th exchange
h
rate
t att the
th announced
d
level. The central bank is committed to allow the money supply
to adjust to whatever level necessary to ensure that the
equilibrium exchange rate in foreign exchange market equals
the announced exchange rate.
50

Floating vs. fixed exchange rates

Argument for floating rates:

allows monetary policy to be used to pursue other goals (stable

growth, low inflation).

Arguments for fixed rates:

avoids uncertainty and volatility, making international transactions

easier.
easier
Proponents of the fixed exchange rate regime argue that when
future exchange rates are uncertain, businesses tend to shun
foreign trade
trade. Since countries cannot fully benefit from international
trade under exchange rate uncertainty, resources will be allocated
sub-optimally on a global basis
However, to the extent that firms can hedge exchange risk by
means of currency forward or options contracts, uncertain exchange
rates do not necessarily hamper international trade.
51

Attributes of the Ideal Currency

If the ideal currency existed in todays world, it

would possess three attributes:

A stable / fixed exchange rate

An independent monetary policy

Financial market integration with rest of the world / Free

capital movement

52

The Impossible Trinity

A nation
ti
cannott have
h
free capital flows,
independent
y policy,
p
y, and
monetary
a fixed exchange
rate simultaneously.
A nation must
choose one side of
this triangle and
give up the opposite
corner.

Independent
monetary
policy

Free capital
flows

Fixed
exchange
rate

53

The Impossible Trinity

The point is that you can't have it all: A country must pick two out of three. It
can fix its exchange rate without emasculating its central bank, but only by
maintaining controls on capital flows (like China today); it can leave capital
movement free but retain monetary autonomy,
autonomy but only by letting the exchange
rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and
stabilize the currency, but only by abandoning any ability to adjust interest rates
to fight inflation or recession (like Argentina today, or for that matter most of
Europe).
)
---- Paul Krugman (1999)

54

The Chinese Currency Controversy

1995-2005: China fixed its exchange rate at 8

8.28
28 yuan per dollar,
dollar and
restricted capital flows.

The pegging remained until July 2005, the time that the Chinese
central bank decided to peg the yuan to a basket of currenciescurrencies the
U.S. dollar, the euro and the Japanese yen being some of the
currencies included in the basket. As announced then, the central bank
of China was allowing
g the value of its currency
y to be partially
p
y
determined by supply and demand. The value of the Chinese currency
has been rising since then, even though the appreciation is not enough
in the eyes of its competitors such as the U.S. and Europe.

This appreciation of the yuan is indeed lower than what it could have
been. The pegged yuan is now on a managed float system in which
the central bank of China intervenes in order to change the direction of
its value.
value Chinas competitors and some analysts think that Chinas
intervention is too manipulative arguing that the managed float is a
little too dirty. U.S. producers complained that Chinas cheap
55
yuan gave Chinese producers an unfair advantage.

The Chinese Currency Controversy

H
How
Chi
China k
keeps yuan undervalued?
d
l d?

To maintain this peg, China's central bank first intervenes in world

currency markets to buy dollars in amounts roughly equal to its trade
surplus with the United States (more than $200 billion a year). To
prevent what is effectively an increase in China's money supply from
getting into its economy and causing inflation, China's central bank
then "sterilizes"
sterilizes these dollar purchases by selling bonds to Chinese
investors (primarily commercial banks).

China first sells its sterilization bonds at relatively high interest rates
(typically around 4 percent) and then uses the revenue to buy U.S.
US
Treasury bonds that are paying less than 2 percent interest. In this
way, China loses money on much of its U.S. bond investments while
helping to finance the U.S. trade and budget deficits and keeping U.S.
interest rates low. China is willing to endure these losses because it
views them as a small price to pay for creating new jobs in Chinese
export industries, albeit at the expense of American workers.
56

Interest Rate Differentials

Two reasons why r may differ from r*

country risk: The risk that the countrys borrowers will default on their loan
repayments
p y
because of ppolitical or economic turmoil. Lenders require
q
a higher
g
interest rate to compensate them for this risk
expected exchange rate changes: If a countrys exchange rate is expected to
fall, then its borrowers must pay a higher interest rate to compensate lenders
for the expected currency depreciation.

Thus a countrys interest rate equals the world interest rate plus a risk
premium
premi
m (whose
( hose si
sizee depends on in
investors
estors perceptions of the political &
economic risk of holding that countrys assets and on the expected rate of
depreciation or appreciation of the countrys currency, i.e., r = r* +

57

Interest Rate Differentials

If prospective lenders expect the countrys currency to depreciate, or if they

perceive that the countrys assets are especially risky, then they will demand that
borrowers in that country pay them a higher interest rate (over and above r*).

An increase in country risk or an expected depreciation makes holding the

countrys currency less attractive. The increase in the risk premium causes
foreign investors to sell some of their holdings of assets and pull their loanable
loanable
funds out of the country. The capital outflow causes an increase in the supply of
domestic currency in the foreign exchange market, which causes the fall in the
exchange
g rate.

58

The Mexican Peso Crisis

U.S. Cents per Mexic
can Peso

35

30

25

20

15

10
7/10/94

8/29/94

10/18/94

12/7/94

1/26/95

3/17/95

Mexicos central bank had maintained a fixed exchange rate with the
U.S. dollar at about 29 cents per peso.

5/6/95

59

The Mexican Peso Crisis

U.S. Cents per Mexican Peso
U

35

30

25

20

15

10
7/10/94

8/29/94

10/18/94

12/7/94

1/26/95

3/17/95

5/6/95

IIn the
th weekk before
b f
Christmas
Ch i t
1994,
1994 the
th central
t l bank
b k abandoned
b d d the
th fixed
fi d
exchange rate, allowing the pesos value to float. In just one week, the peso
lost nearly 40% of its value, and fell further during the following months
60

The Mexican Peso Crisis

U.S. goods more expensive to Mexicans

U.S. firms lost revenue

Mexican assets worth less in dollars

Reduced wealth of millions of U.S. citizens who held Mexican assets

(indirectly through mutual funds and pension funds, which viewed
Mexico very favorably prior to the crisis)

Thus the Peso crisis didnt just hurt Mexico !!

61

Understanding the Peso Crisis

In the early 1990s, Mexico was an attractive place for foreign investment.

During 1994, political instability caused an increase in Mexicos risk premium

( ):
peasant uprising in Chiapas region in Mexico

The passage of NAFTA reduced trade barriers among United States, Canada and
Mexico and made many people confident about the future of the Mexican economy.

assassination of leading presidential candidate Luis Donaldo Colosio

Another factor: The Federal Reserve raised U.S. interest rates several times
during 1994 to prevent U.S. inflation. (r* > 0)

62

Understanding the Peso Crisis

These events put downward pressure on the peso.

peso

We have already seen why an increase in a countrys risk premium causes its
exchange rate to fall (refer to slide 99-100).

One could
O
ld also
l use the
h M-F
M F model
d l to show
h that
h an iincrease in
i r** also
l causes the
h
exchange rate to fall. The intuition is as follows: An increase in foreign interest
rates causes capital outflows: investors shift some of their funds out of the country
to take advantage of higher returns abroad. This capital outflow causes the
exchange rate to fall as it implies an increase in the supply of the country
countryss currency
in the foreign exchange market.

Mexicos central bank had repeatedly promised foreign investors that it would
not allow the peso
pesoss value to fall,
fall so it bought pesos and sold dollars to prop
prop
up the peso exchange rate.

Doing this requires that Mexicos central bank have adequate reserves of dollars

63

Understanding the Peso Crisis

December 1993

$28 billion

A
August
17
17, 1994

$17 billi
billion

December 1, 1994

$ 9 billion

December 15,
15 1994

$ 7 billion

Defending the peso in the face of large capital outflows was draining
the reserves of Mexicos central bank.
(August 17, 1994 was the date of the presidential election.)

64

Understanding the Peso Crisis

During 1994, Mexicos central bank hid the fact that its reserves were being
depleted.
Why Mexico
Mexicoss central bank didn
didntt tell anybody it was running out of reserves?

If people had known that the reserves were dwindling, then they would also have
known that the central bank would soon have to devalue or abandon the fixed
exchange
h
rate
t altogether.
lt th
They
Th would
ld have
h
expected
t d the
th peso to
t fall,
f ll which
hi h would
ld
have caused a further increase in Mexicos risk premium, which would have put even
more downward pressure on Mexicos exchange rate and made it even harder for the
central bank to defend the peso.
p

65

The Disaster

Dec. 20: Mexico devalues the peso by 13%

(fixes e at 25 cents instead of 29 cents)

Investors are SHOCKED! they had no idea Mexico was running out of
reserves.

investors
,
i
t dump
d
their
th i Mexican
M i
assets
t andd pull
ll their
th i capital
it l outt off Mexico
M i

Dec. 22: central banks reserves nearly gone. It abandons the fixed rate and lets
e float.

In a week, e falls another 30%.

66

The Rescue Package

The U
Th
United
i dS
States stepped
d in
i (in
(i its
i own interests)
i
) to help
h l its
i
neighbour to the south

The massive fall in the value of Mexican currency made US goods

expensive resulting in loss of revenue to US firms.
expensive,
firms

To prevent the massive illegal immigration that might follow

government default and economic collapse

To prevent the investor pessimism regarding Mexico from

spreading to other developing countries.

1995: U.S. & IMF set up $50b line of credit to provide loan
guarantees to Mexico
Mexicos
s govt.
govt

This helped restore confidence in Mexico, reduced the risk

premium.

After a hard
Aft
h d recession
i
in
i 1995,
1995 Mexico
M i began
b
a strong
t
recovery from the crisis.
67