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# 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),
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## The Exchange Rate

An exchange h rate is, i simply, i l the h price i of f 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
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## Deriving a Currencys Supply Curve

The supply Th l curve of f a currency shows h the h amount of f 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 of f 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 e0 e2 DRs.

The equilibrium exchange rate is that at which the quantity of currency supplied equals the quantity demanded.

Q0

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## 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? 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
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Hints

## 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!

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## 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 t transactions ansactions of its citizens citi ens and government go e nment 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 real l estate. 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
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2)

3)

## 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. The plus sign and minus sign indicate respectively the earning and spending of foreign exchange by the country. 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

5)

6)

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## Balance of Payments Accounting

Example 1:

Suppose that an Indian manufacturer sells \$20 million illi worth h of f 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.

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## 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.

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## 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.

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## 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

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## 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
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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 of f 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.]
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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
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## 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).

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## 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 I by Indian di companies. i Loans comprise external assistance, commercial borrowings and short term loans (repayable within one year). External assistance is borrowings b f from multilateral l l l organizations l like k World Bank and from bilateral sources, mainly on concessional terms.

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## 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
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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 of f errors and d omissions i i in i the h reported d data. d For instance, information on payments for imports not passing through t 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.

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## 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

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## Indias Balance of Payments Data

Credits Current Account 1 2 3 Exports Imports Invisibles Balance on Current Account Direct Investment Portfolio Investment Other Investments Balance on Capital Account Statistical Discrepancies Overall Balance \$91,481 \$104,780 (\$156,334) (\$50,539) (\$10,612) \$8,520 \$68,115 \$62,665 \$24,693
\$971

Debits

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## Indias Balance of Payments Data

Credits Current Account 1 2 3 Exports Imports Invisibles Balance on Current Account Direct Investment Portfolio Investment Other Investments Balance on Capital Account Statistical Discrepancies Overall Balance \$91,481 \$104,780 (\$156,334) (\$50,539) (\$10,612) \$8,520 \$68,115 \$62,665 \$24,693
\$971

Debits

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

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

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## Indias Balance of Payments Data

Credits Current Account 1 2 3 Exports Imports Invisibles Balance on Current Account Direct Investment Portfolio Investment Other Investments Balance on Capital Account Statistical Discrepancies Overall Balance \$91,481 \$104,780 (\$156,334) (\$50,539) (\$10,612) \$8,520 \$68,115 \$62,665 \$24,693
\$971

Debits

## Capital Account 4 5 6 7 (\$2,787) (\$55,626) (\$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.

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## Indias Balance of Payments Data

Credits Current Account 1 2 3 Exports Imports Invisibles Balance on Current Account Direct Investment Portfolio Investment Other Investments Balance on Capital Account Statistical Discrepancies Overall Balance \$91,481 \$104,780 (\$156,334) (\$50,539) (\$10,612) \$8,520 \$68,115 \$62,665 \$24,693
\$971

Debits

## Capital Account 4 5 6 7 (\$2,787) (\$55,626) (\$56,194)

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

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## Indias Balance of Payments Data

Credits Current Account 1 2 3 Exports Imports Invisibles Balance on Current Account Direct Investment Portfolio Investment Other Investments Balance on Capital Account Statistical Discrepancies Overall Balance \$91,481 \$104,780 (\$156,334) (\$50,539) (\$10,612) \$8,520 \$68,115 \$62,665 \$24,693 \$971 \$336,532 (\$15 052) (\$15,052) (\$2,787) (\$55,626) (\$56,194) Debits

Capital Account 4 5 6 7

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## Indias Balance of Payments Data

Credits Current Account 1 2 3 Exports Imports Invisibles Balance on Current Account Direct Investment Portfolio Investment Other Investments Balance on Capital Account Statistical Discrepancies Overall Balance \$91,481 \$104,780 (\$156,334) (\$50,539) (\$10,612) \$8,520 \$68,115 \$62,665 \$24,693
\$971

Debits

BCA + BKA = BRA

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

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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).

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Convertibility of Rupee

Indian I 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
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## 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 i in 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

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## 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.

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## 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
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## 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

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## 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

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## Widening Current Account Deficit

Indias di inflation i fl i spurted d 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 commodity yp prices. 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 g government has to make p provisions for waiving g agricultural loans, and other rural development and welfare schemes launched in the recent past.

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## 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 during g AprilAugust 2007. Huge g trade deficit has p put downward p pressure on rupee. p

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## 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

In th I the recent t global l b l financial fi i l crisis, i i the th spread d 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.

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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.

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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, and d with ith the th US economy in i trouble, t bl prospects t elsewhere l h looked l k d at t 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.
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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.
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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 y year, 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.
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## International Crude Oil Prices and Indias Foreign Exchange Reserves

Month Average Crude Price (US dollars / bbl)
89.9 90.8 101.8 108.8 122.6 131 5 131.5 132.8

## FOREX Reserves (in billions of US dollar) )

293.2 301.2 309.7 314.2 314.6 312 1 312.1 306.2

January 2008 February 2008 March 2008 April 2008 May 2008 June 2008 July 2008

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## 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
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## 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 hl lower than th huge h reserves, which hi h even increased i d since i FDI inflows i fl continued to be robust.
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## 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
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## 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 goal l of fk keeping i the th exchange h rate t at t 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.
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## 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.
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## 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

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## The Impossible Trinity

A nation ti cannot t 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.

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## 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)

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## 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 p political 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 size e 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* +

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## 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*). 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.

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## U.S. Cents per Mexic can Peso

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

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

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35

## U.S. Cents per Mexican Peso U

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

In the I th week k 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

## 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)

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## Understanding the Peso Crisis

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

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.

During 1994, political instability caused an increase in Mexicos risk premium ( ): peasant uprising in Chiapas region in Mexico

## 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)

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## 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 i increase 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 countrys s currency in the foreign exchange market.

Mexicos central bank had repeatedly promised foreign investors that it would not allow the peso pesos s 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 A August 17 17, 1994 December 1, 1994 December 15, 15 1994 \$28 billion \$17 billi billion \$ 9 billion \$ 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.)

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## Understanding the Peso Crisis

During 1994, Mexicos central bank hid the fact that its reserves were being depleted. Why Mexico Mexicos s central bank didn didnt t 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

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The Disaster

## (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 and d pull ll their th i capital it l out t of f 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%.

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## 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.
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