10. Mrunal » [Economic Survey Ch6] Balance of Payments, Forex Reserves, Currency Exchange, NEER, REER » Print

8/12/2019 10. Mrunal [Economic Survey Ch6] Balance of Payments, Forex Reserves, Currency Exchange, NEER, REER P

1/14


2/14

4/25/13 Mrunal [Economic Survey Ch6] Balance of Payments, Forex Reserves, Currency Exchange, NEER, REER Print

mrunal .org/2013/04/economic-survey-ch6-balance-of-payments- forex- reserves-cur rency-exchange-neer -reer .html /pr int/ 2

on Indian investors FDI, FII in USA etc.)

3. Transfer (gift, remittances from NRI to their

families etc. always positive for India

because of large Diaspora abroad.)

2. External commercial

borrowing, external

assistance etc.

Note: current account can be calculated using Visible and invisibles, that was

explained in old article on current account deficit click me.

Since we want to track the flow of cash, so, whenever American invest in India

(via FDI, FII, ADR etc) we add it as (+), and

when Indians invest in USA (via FDI, FII, IDR etc.) we add it as (-) and then get

the final figure for Foreign investment.

Same goes for everything in balance of payment (remittances, External

commercial borrowing whatever.)

In short, BoP= we are tracking the incoming and outgoing money.

For India, current account has been in deficit (negative number) and capital

account has been in surplus (positive number).

The BoP accounting system is similar to double entry book-keeping.Therefore theoretically, balance in current account and balance in capital

account should be same (ignoring the +/- signs).

In other words, if there is deficit in current account, there has to be equal surplus

in capital account. Why?

Why BoP = 0 in theory?

Assume there are only two countries India (rupees) and USA (dollars). And there

are no forex agents or middlemen, taxation, regulation, cricketers, politicians,saah-bahu serials nothing

Now Indian importer buys Apple6 phones worth 10 billion US$ from American

exporter. Since there is no forex agent, the Indian importer will pay 500 billion

Indian rupees to that American exporter. (assuming 1$=50 Rs.) Means that much

Rupee currency is gone from Indian system via current account.

But that American exporter has no use of Indian rupees! He lives in USA, he

cannot even buy a burger from local McDonalds shop using Indian rupees. So

what can he do?

1. He can import something else from India (e.g. raw material, steel and

plastic for further production of Apple6) = our rupee currency comes backto India via current account.

2. He can invest that Indian currency to setup some factory or joint venture

in India (=our rupee currency comes back to India via capital account)

3. He can buy some shares or bonds in India. Again our rupee currency comes

back.

4. He can find a 2ndAmerican 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
http://mrunal.org/2012/05/economy-current-account-deficit-how-to.html


3/14



desperation of that 2ndAmerican 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 ofhis 500 billion Rupees by exchanging it with that American importers

dollar

Or the apple exporter will find some NRI living in USA. This NRI wants to

send money (dollar earned by working in USA) to his family back in India,

(preferably in Indian currency ) so this NRI will be willing to exchange his

dollar savings with that Apple exporters rupees.

There are many other possibilities and combinations but the point is, in

BoP, whatever currency goes out of the country, will come back to the

country.

Convertibility

Suppose you want to import a dell computer from USA. And American exporter

accepts only payments dollars.

If you can easily convert your rupee into dollars, that means Rupee is fully

convertible. And rupee is fully convertible as far as Current account transactions

are concerned (e.g. import, export, interest, dividends).

But rupee is partially convertible for capital account transection. (In crude terms


4/14



it means, if an Indian wants to buy assets abroad or invest via FDI/FII OR borrow

via External commericial borrowing (ECB) he cannot do it beyond the limits

prescribed by RBI. (And vice versa e.g. American wants to convert his dollars to

rupees to invest in India, then also RBIs limits have to be followed).

RBI gets power to do ^this, via FERA and FEMA Acts.

1973: Foreign Exchange Regulations Act, 1973 (FERA).

1997: Tarapore Committee (of RBI), had recommended that India should have

full capital account convertibility. (Meaning anyone should be allowed to freelymove from local currency into foreign currency and back, without any

restrictions by Government or RBI.)

2002: Government replaced FERA with Foreign Exchange Management Act

(FEMA). Although full capital account convertibility is yet not given.

Full capital account convertibility has both pros and cons. But thatd require

another article. Lets get back to the topic, we are seeing the 6thchapter of

Economic Survey: Balance of Payment, exchange rates etc.

Rupee-Dollar Exchange rateHow does Fixed Exchange Rate systemwork? and how does market based exchange

rate system work? = explained in the Bretton woods article. Click me

Anyways, lets construct a bogus technically incorrect model to understand the

market based exchange rate system, once again:

Assume following things

There are only two countries in the world India and America.

India has rupee currency. Indian farmers dont grow Onions.

America doesnt have any currency, they trade using onions. The rate being

1kg onion=Rs.50First si tuation: American investor thinks that Indian economy is rising. If we

invest in India (FDI/FII), well make good profit. So theyre more eager to

convert their onions to Indian rupee currency. So theyd even agree to sell 1kg

onions =Rs.45. (and then buy Indian shares/bonds worth Rs.45)

Result =Rupee strengthenedagainst onion (dollar).

During this time, RBI governor also buys 300 billion kilo onions from the forex

and stores these onions in his refrigerator. (Why? Because onions are selling

cheap! And why onions are selling cheap? Because there is surge in capital

investment in India by American investors.)

Ok everything is going nice and smooth. Now add third country to our bogus

model: UAE.

Second situation: UAE has increased crude oil prices, and they dont accept

rupee currency. They also want payment in onions.

1 barrel of crude oil costs 132kg of Onions.

India is eager/desperate for oil, because if we dont have crude oil, we cant get

petrol, diesel= whole economy will collapse.

So India would agree to buy 1kg onion even for Rs.55 (from American or forex

agent or whoever is willing to sell his onions). Then India can give that onions to
http://mrunal.org/2012/05/bretton-woods.html#25http://mrunal.org/2012/05/bretton-woods.html#108


5/14



some Sheikh of UAE and import crude oil.

Third situation: The Sheikh of UAE gets even greedier, he demands 200kg

onions for 1 barrel of crude oil. Now 1kg onion sells for Rs.59, Because those

with onion surplus (vendors) know that India likes it or not, itll have to buy

onions to pay for the crude oil!

Thus, Rupee has weakenedagainst onion (Dollar.)

If such situation continues, then there will be huge inflation in India (because

crude oil expensive=petrol/diesel expensive = transport expensive=milk/vegetables and everything else transported using petrol/diesel becomes

expensive.)

Now RBI governor decides to become the hero and save the fall of rupee against

onion. So, He loads a few tonnes of onions in his truck and drive it to the forex

market.

Result: onion supply has increased, price should go down.

Now onions get little cheaper: 1kg onion =53 Rs.

Thus RBIs intervention in the forex market has led to recovery of rupee.

Ok so what do we get from this story?

1. RBIs intervention to buy Foreign exchange during surge in capital investment=

leads to build-up of (foreign exchange) reserves, which provides self-insurance

against external vulnerability of rupee.

2. When RBI sells its foreign exchange reserves, it stems (halts) the fall of rupee.

3. Higher foreign exchange reserve levels restore investor confidence and may lead

to an increase in foreign direct and indirect investment flows= boost in growth

and helps bridge the current account deficit.

Building up Foreign Exchange Reserves

Prior to 1991, India followed License-quota-inspector (and suitcase) raj and

import substitution strategy. (Beautifully explained class 11 NCERT textbook.)

During that era, foreign companies couldnt invest in India.

Imported products such as radio / camera/ wristwatches attracted heavy custom

duty. (And that led to rise of smugglers and mafias, and the Bollywood movies

that romanticized their criminal lives.)

On the other hand, thanks to the license-quota-inspector (and suitcase) raj, the

private Indian companies werent big or efficient enough to compete ininternational market so export was also low.

Result: during that time incoming money (via export, investment) was very low.

Hence RBI couldnt build up huge forex reserve. (when onion supply is low, its

prices will be high)

Ultimately in 1991, the Forex reverses of India were about to exhaust.

Finally India had to pledge its gold to IMF and get loans.

Then India had to open up its economy for private and foreign sector investment.

Remove the license-quota-inspector raj etc. to boost the incoming flow of


6/14



dollars and other foreign currencies..all those LPG reforms. (Although

suitcase raj still continues, because the Mohans in the system are blinded by

totally awesome people like A.Raja.)

fast-forward: now weve a trillion dollar economy, our software and automobile

companies are globally recognized blah blah blah.

But the lesson learnt: RBI should have good foreign exchange reserve.

Hence post LPG reforms, RBI has been buying dollars, pound yen etc. from the

currency market, whenever FII/FDI inflow is high. Because during such situation,the foreign investors are more eager to get their dollars converted to rupee

currency hence rupee is trading at higher rate e.g. 1$=Rs.49

But after global financial crisis, RBI has stopped building forex reserves

actively.

Nowadays RBI intervenes in the forex market, only to stop the excess volatility

(fluctuation) in rupee exchange rate.

However, there was a sharp decline in rupee in 2011-12. Then RBI had to sell

foreign exchange worth 20 billion dollars. (so demand of foreign currency

would decrease and rupee would stop).

Similarly in 2012 also RBI had to sell its foreign exchange reserve worth 3billion dollars to prevent the fall of rupee. (in June 2012, Rupee had became

very weak: 1$=around 57 Rupees. Thanks to RBI and Governments

interventions, it came back to the normal 53-54 level at the end of 2012.)

FOREIGN EXCHANGE RESERVES

Indias foreign exchange reserves is made up of

1. Foreign currency assets (FCA) (US dollar, euro, pound sterling, Canadian dollar,Australian dollar and Japanese yen etc.)

2. gold,

3. special drawing rights (SDRs) of IMF

4. Reserve tranche position (RTP) in the International Monetary Fund (IMF)

The level of forex reserve is expressed in US dollars. Hence Indias forex reserve

declines when US dollar appreciates against major international currencies and vice

versa.

RBI gains Foreign exchange reserves by

buying foreign currency (via intervention in the foreign exchange market

Funding from the International Bank for Reconstruction and Development

(IBRD), Asian Development Bank (ADB), International Development

Association (IDA) etc.

aid receipts,

interest receipts

FOREX Reserve: India vs other


7/14



Country wide- China has the largest forex reserve (3300+ billion USD). India is

8thposition (close to 300 Billion USD).

Countries with largest Forex reserves

1. China

2. Japan3. Russia

4. Switzerland

5. Brazil

6. South Korea

7. Hong Kong

8. India

Why volatility in rupee?

Volatility = Variation in something over the given time.

if today SENSEX is 12000 points, tomorrow it goes up by 200 points and day

after it goes down by 300 points etc..they we say market is volatile.

If morning shifts SSC paper is too easy but evening shifts SSC paper is too

damn difficult then we can say SSC paper is volatile.

Similarly, if there is too much fluctuation in Dollar to rupee exchange rate, we

say rupee is volatile.

In 2012, the rupee has experienced unusually high volatility. Why?

#1: import-export

Demand for Indian goods and services has declined due to Euro-zone crisis +

America hasnt fully recovered.

On the other hand, cost of import= very high due to oil and heavy gold import

(due to high inflation).

Similarly high inflation = raw material / services become costly for the export.

If he raises the prices, then his export product becomes less competitive than

Cheap China made stuff.

#2: FII

In the total foreign investment in India, majority comes from FII (and not from

FDI).

FII money is hot, it leaves quickly whenever FII investors feels that Indias

market is not giving good returns and or some other xyz countrys market is

giving better returns.

There are week-to-week variation in such FII inflows and outflows. Hence it


8/14



leads to changes in rupee-dollar exchange rate.

#3: Dollar is strengthened

US treasury bonds are consider the safest investment. During the peak of

Eurozone, Greece crisis, the big investors started pulling out money from

Europe and investing it in US treasury bonds. = demand of dollar increased. So

other currencies would automatically weaken against dollar.

#4: policy paralysis

For past few years, Indian Government was lazy regarding environmental project

clearances, land acquisition, FDI in retail, pension, insurance etc. that has led to

foreign investors losing faith in Indian economy= slowdown in FII inflows.

(besides Government did not allow more FDI in pension / insurance / retail etc.

so FDI inflow did not increase either).

#5: Risk On / Risk off

From the earlier article on debt vs equity, Government bonds = safer than

equities (shares). But when an investment is safe= it doesnt offer good returns.

When foreign investors feel confident, they display risk on behavior =they

invest more in equities, particularly in developing countries. (which are risky but

offer more profit).

But when foreign investors are not feeling confident, they display risk off

behavior, = they usually fall back to investing in US treasury bonds or gold.

In India, majority of foreign investment comes from FII (and not FDI)

and FII investors are more prone to displaying this risk-on/risk-offbehavior.

They plug in their money quickly, they pull out their money quickly. Thus, Indian

rupees exchange rate becomes volatile against Dollar.

Therefore, Indian Government needs to inspire and sustain the confidence of

foreign investors, to prevent the fall of rupee. RBI intervention in forex market,

cannot help beyond a level.

How did rupee recover?

Rupee is weakening against dollar, it means demand of rupee is less than the demandfor dollars. So how did RBI and Government fix it?

RBI Govt.

During 2012, RBI sold around 3 billion dollars

Govt. allowed FIIs to

invest more money in

govt.and corporate


9/14



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).

bonds.

Govt. eased the FDI

policy for pension,

insurance, aviation,

multi-brand retail etc.

Govt. offered

subsidies and tax

benefits to exporters.

Exchange Rate of Other Emerging Economies

In 2012, Rupee wasnot the only currency that weakened against dollar.

The currencies of other emerging economies, such as Brazilian real, Argentina

peso, Russian rouble, and South Africas rand also depreciated against the US

dollar.

It means dollars demand has increased. In the wake of sovereign debt crisis in

the euro zone and due to uncertain global economic environment, more and

more investors are preferring to buy US treasury bonds and other securities in

USA.

NEER and REER

We keep reading bad headlines that rupee weakened against dollarrupee all

time low against dollarand so on.

Does it mean, Indian rupee is a really bogus weak and fragile currency? Nope.

Because we dont trade only with USA.We dont trade only in terms of Rupee to Dollar exchange.

We also trade with many other countries in many other forms of currency.

Therefore, if we want to objectively measure Rupees volatility, weve to

compare its price fluctuations with multiple currencies (Euro, Yen, Pound etc.)

and not just against single Dollar currency.

Secondly: 1$=Rs.50 or 1$=Rs.40 that alone doesnt decide the demand of goods

and services between India and America. This demand also depends on the

inflation (both in India and in USA.)

NEER and REER index (calculated by RBI), help us here get a clear picture here.First youve to calculate NEER. Then using NEERs, you calculate REER.

NEER REER

Nominal Effective Exchange RateReal Effective Exchange Rate

(REER)

The weighted average of bilateralnominal

exchange rates of the home currency in terms

of foreign currencies.

weighted average of

nominal exchange rates,

adjusted for inflation.


10/14



Why is REER important?

REER captures inflation differentials between India and its major trading

partners.

REER reflects the degree of external competitiveness of Indian products

REER captures movements in cross-currency exchange rates.

RBI calculates two REER indices:

REER-6 REER-36

Here Indian rupee is measured against 6 big

currencies viz.

1. Dollar

2. Hong Kong dollar

3. Euro4. Pound sterling

5. Japanese Yen

6. Chinese Renminbi

As the name suggest, 36

currencies.

Now Indian rupees vs. other currencies (Dec. 2012 data)

Just for reference:

1 unit of foreign currencyWorth Rs.Indonesian Rupiah 0.006

S.Korean Won 0.05

Pakistan Rupee 0.56

Yen 0.65

Thailand Baht 1.78

Mexican Peso 4.25

Chinese Renminbi 8

Brazilian Real 26

Turkish LIRA 30US Dollar 54

Canadian Dollar 55

Euro 71

SDR of IMF 84

Pound 88

External Debt


11/14


12/14



/domestic players. E.g. FDI in multibrand retail, mandates that foreign company

must buy 30 percent of the from small-scale industries.)

Such offset policy soften the balance of payments impact and/or develop local

technical capability.

Recently Government revised the offsets policy for defense sector.

But still, it has shown no visible direct or indirect benefits h on the domestic

Indian defence industry.

CHALLENGES AND OUTLOOK

while capital inflows in India, were sufficient to finance the CAD safely.

But majority of the capital flows are via FII (hence volatile)= this has led to

financial fragility and is reflected in rupee exchange rate volatility.

We cannot significantly increase our exports in the short run because they are

dependent upon the recovery and growth of partner countries (US, EU). And this

may take time.

Therefore our main focus has to be on curbing imports, mainly by making oil

prices more market determined (=expensive), and curbing imports of gold.

We should put greater emphasis on FDI including opening up sectors further.

Finally, external commercial borrowing needs to be monitored carefully.

Misc. facts

Three top countries from where FDI comes to India: Mauritius, Singapore and

UK

Global Economic Prospects= this report is published by world bank.

Mock Question

1. Which of the following, is not a part of Capital account

a. FDI

b. FII

c. Remittances

d. External commercial borrowing

2. Which of the following is not a part of Current account?

a. Import

b. Export

c. External commercial borrowing

d. Interest, dividends paid on FII

3. India has deficit in

a. Current account

b. Capital account

c. Both

d. None

4. India has surplus in


13/14



a. Current account

b. Capital account

c. Both

d. None

5. Indias official forex reserve doesnt include

a. Foreign currency assets (FCA) (US dollar, euro, pound sterling, Canadian

dollar, Australian dollar and Japanese yen etc.)

b. Goldc. Silver

d. Special drawing rights (SDRs)

6. How can RBI build its foreign exchange reserve?

a. By Buying foreign currency

b. via funding from World Bank, ADB etc.

c. Both

d. None

7. Which of the following country has second largest forex reserves in the world?

a. India

b. Francec. Japan

d. USA

8. Among the countries with largest forex reserves, India ranks

a. second

b. third

c. fifth

d. eighth

9. Rupee will strengthen against dollar when

a. Government eases FDI policyb. Government raises the ceiling on FII investment

c. Both

d. None

10. Correct statement

a. NEER is calculated by RBI

b. REER is calculated by Finance ministry

c. both

d. none

11. REER captures

a. difference in inflation between India and its trading partnersb. external competitiveness of Indian products

c. Both

d. none

12. Which of the following currency is not part of REER-6 calculation?

a. Hong Kong Dollar

b. Japanese Yen

c. Pound Sterling

d. Canadian Dollar


14/14


13. Incorrect Match

a. S.Korea: won

b. Mexico: Peso

c. Argentina: Peso

d. S.Africa: Baht

14. Which of the following is not released by World Bank?

a. International Debt Statistics, 2013

b. FDI Restrictiveness Indexc. Global Economic Prospects

d. All of Above

15. FDI Restrictiveness Index is released by

a. IMF

b. ADB

c. OECD

d. World Bank

16. Majority of FDI to India, comes from

a. Mauritius

b. Germanyc. USA

d. None of above

Article printed from Mrunal: http://mrunal.org

URL to article: http://mrunal.org/2013/04/economic-survey-ch6-balance-of-

payments-forex-reserves-currency-exchange-neer-reer.html
http://mrunal.org/

Documents

10. Mrunal » [Economic Survey Ch6] Balance of Payments, Forex Reserves, Currency Exchange, NEER, REER » Print