ACKNOWLEDGEMENT

INFLATION

According to Crowther, “Inflation is a state in which the value of money is falling i.e prices are
rising ”

How to Measure Inflation

If the price level in the current year is ‘P1’ & in the previous year is ‘Po’,

then inflation for the current year is

Inflation = P1-Po X 100

Po

TYPES OF INFLATION

Inflation is often classified on three different criteria. Firstly, one might distinguish between
various types of inflation on the basis of speed at which the general price level rises .Secondly,
one way distinguishes between open and suppressed inflation. Finally, as we find in the modern
macroeconomic theory, inflation is classified on the basis of the factors, which induce it.

On the criterion of the rate at which the general price level rises, we have the following types of
inflation

1. Creeping Inflation

2. Walking Inflation

3. Running Inflation

4. Galloping or Hyper-Inflation

5. Cost-Push Inflation

6. Demand-Pull Inflation

7. Built-in Inflation

8. Chronic Inflation

9. Core Inflation

10. Headline inflation

11. Stealth Inflation

12. Assets inflation

CAUSES OF INFLATION

For controlling the rates of the commodity we must know why these rates are rising i.e inflating
which means what are the reasons and causes behind inflation.

There are various factors that cause inflation in the economy which are as follows:

a) MONETARY FACTORS

b) NON-MONETARY FACTORS

c) STRUCTURAL FACTORS

MONETORY FACTORS

1. EXPANSION OF MONEY SUPPLY

This is the basic factor that causes inflation. Due to the increase in expansion of money supply,
there is an increase in the demand of the luxurious commodities. Credit facilities adopted by the
banks are as a result of inflation. Deficit financing is also contribute to the growth of inflation.

2. INCREASE IN THE DISPOSABLE INCOME

When the disposable income of a person increases, the demand for real goods and services also
increases, causing a rise in the price leading inflation.

3. INCREASE IN CONSUMER SPENDING

As the income of the consumer rises, they spend more due to the expenditure consumption or
demonstration effect, which raises the aggregate demand causing inflation.

4. DEVELOPMENT AND NON-DEVELOPMENT EXPENDITURE

The expenditure for the development of huge plants and projects will increase the demand for
factors of production resulting in inflation. On the other hand, the expenditure on non-
development like the defense expenditure will create shortages of consumption goods resulting
inflation.

5. INDIRECT TAXES

Due to high indirect taxes, the sellers increase the price of their products to recover the tax from
the consumers, which indirectly leads to inflation.

6. DEMAND FOR FOREIGN COMMODITIES

When the demand for foreign commodity increases the supply for domestic commodities
decreases which leads to increase in the prices of the commodities.

NON-MONETARY FACTORS

1. RISING POPULATION

As the population of the country increases , demand for the commodity also increases, which
causes inflation. So, rising population is the foremost non-monetary factor resulting to inflation.

2. NATURAL CALAMITIES

Due to the occurrence of the natural calamities like floods, droughts, bad weather, results
in crop failure, which leads to rising prices.

3. SPECULATION AND BLACK MONEY

Speculation, hoarding and black money also causes inflation as such the unearned money is
spent lavishly by people, creating unnecessary demand for goods and services.

4. UNFAIR TRADE PRACTICES BY MONOPOLY HOUSES

The monopoly houses prefer to restrict outputs of their products and raise their prices to enjoy
excess profits leading to inflation.

5. BOTTLENECKS AND SHORTAGES

Bottlenecks i.e. blockages and shortages of various kinds of products destruct the process of
economic development. As a result of which prices tend to rise.

STRUCTURAL FACTORS

1. CAPITAL SHORTAGES

This is due to the slow rate of capital formation in a underdeveloped and developing economy
where vicious circle of poverty exists.
 2. INFRASTRUCTURAL BOTTLENECKS

Power shortages, inefficient transports, underutilization of capacities and resources, are

obstruction to the economic growth of the country which leads to price rise and finally inflation.

3. LIMITED EFFICIENT ENTREPRENEURS

Entrepreneurs do not posses spirit to undertake risky projects. Investments are generally made in
trade and unproductive assets like land, gold etc. Hence when the supply of money increases the
output of real goods and services does not increase which leads to inflation.

4. LACK OF FOREIGN CAPITAL

The unfavorable terms of trade and deficit in balance of payments has further increased the
problems of rising prices.

5. IMPERFECTIONS OF THE MARKET

Immobility of factors, rigid prices, ignorance of market conditions all these does not allow to
utilize the resources properly so the prices rises due to the increase in the supply without increase
in the real output.

MEASURES TO CONTROL INFLATION

These are the following actions taken to control inflation

1) Monetary Measures

2) Fiscal Measures

3) Other Non-monetary Measures

(1) MONETARY MEASURES

(A) Quantitative Methods:

1. Raising the Bank Rate

To control inflation the central bank increases the bank rate. With this the cost of borrowing of
commercial banks from central bank will increase so the commercial banks will charge higher
rate of interest on loans. This discourages borrowings and thereby helps to reduce the money in
circulation.

2. Open Market Operations

During inflation, the central bank sells the bills and securities. These cash reserves of
commercial banks will decrease as they pay central bank for purchasing these securities. Thus
the loan able funds with commercial banks decrease which leads to credit contraction.

3. Variable Reserve Ratio

The commercial banks have to keep certain percentage of their deposits with the central bank in
the form of cash reserve. During inflation, the central bank increases this cash reserve ratio this
will reduce the lending capacity of the banks.

(B) The Qualitative Methods

1. Fixation of Margin Requirements

Commercial banks have to maintain certain fixed margins while granting loans. In inflation
central bank raises the margin to contract credit and reduce the price level.

2. Regulation of Consumer Credit

For purchase of durable consumer goods on installment basis rules regarding payments are fixed.
During inflation and initial payment is increased and the number of installments are reduced.
These results in credit contraction and fall in prices.

3. Control through Directives

Certain directives are issued by central bank to commercial banks and they are asked to follow
them while lending. This keeps in check the volume of money.

4. Rationing of Credit

The central bank regulates the amount and purpose for which credit is granted by commercial
banks.

5. Moral Suasion

This refers to request made by central bank to commercial banks to follow its general monetary
policy.

6. Direct Action

Direct action is taken by central bank against commercial banks if they do not follow the
monetary policy laid by it.

7. Publicity
The central bank undertakes publicity to educate commercial bank and public about the trends in
money market. By undertaking these measures the central bank can control the money supply
and help to curb inflation.

2. FISCAL MEASURES

1. Taxation

The rates of direct and indirect taxes may be raised and new taxes may be imposed. This policy
will reduce the disposable income in the hands of the people and their expenditure.

2. Public Expenditure

During inflation, the government should reduce its expenditure. This would reduce the income in
the hands of some people. Hence the effective demand would decrease.

3. Public Borrowing

The government may resort to voluntary and compulsory borrowing. This policy reduces the
income in the hands of some people. Hence the effective demand would decrease.

4. Over Valuation of Domestic Currency

Over valuation of domestic currency makes exports costlier and there is a fall in the volume of
exports. Imports also become cheaper and there is an increase in money supply causing a fall in
prices.

5. Inducement to Save

The government should induce savings through incentives. This will reduce the supply of money
and purchasing power of the people causing a fall in prices.

6. Public debt management

The public debt should be handled in such a way that there is no increase in the supply of money.
Hence the surplus in the budget should be used to repay the public debts.

3. NON –MONETARY MEASURES/OTHER MEASURES

1. Increase in output

Every country suffering from inflation should take steps to increase the output of scarce goods
and services. The production of essential goods at the cost of luxury goods can also serve as an
anti-inflationary measure.
2. Price control and rationing

Price control must be introduced in respect of essential commodities. Also rationing should be
introduced for equitable distribution of essential commodities. The supply of essential goods can
be undertaken through public distribution system to keep the prices in check.

3. Imports

Imports of food grains and other essential goods which are in short supply should be allowed.

4. Legal action

Legal action should be taken against hoarders and black marketers.

5. Wage-rate

During inflation, the rise in wage rate should be linked to rise in labour productivity. This will
help to control inflation.

6. Check on population growth

It is essential to check the growth of population by adopting effective family planning device .
Above all, an efficient and honest administration and good discipline among people are essential.
The various measures stated above have to be combined in a proper manner depending on the
situation of the country.

MEASURES OF INFLATION

This rate can be calculated for many different price indices, including:
 CONSUMER PRICE INDICES

 COST-OF-LIVING INDICES

 WHOLESALE PRICE INDEX

 PRODUCER PRICE INDICES

 COMMODITY PRICE INDICES

 GDP DEFLATOR

 CAPITAL GOODS PRICE INDEX

 REGIONAL INFLATION

 HISTORICAL INFLATION
Reasons for inflation in India

1.Increase in Demand and fall in supply causes rise in prices.

2. A Growing Economy has to pass through Inflation.

3. Lack of Competition and Advanced Technology (increases cost of

production and rise in price)

4. Defective Monetary and Fiscal Policy (In India its fine)

5. Hoarding (when traders hoard goods with intention to sell later at high

prices)

6. Weak Public Distribution

INFLATION IMPACT ON
Stock market

 Prices of stocks are determined by the net earnings of a company. It depends on how
much profit, the company is likely to make in the long run or the near future. In other
words, the price of stocks are directly proportional to the performance of the company.

 In the event when inflation increases, the company earnings (worth) will also subside.
This will adversely affect the stock prices and eventually the returns.

Interest rate

 An individual borrows USD$500 from a lender to buy a commodity. The borrower also
promises to return USD550, while returning the money a year later. So, the interest paid
by the borrower is the excess USD$50. A year later, the lender gets back USD$550.
 Owing to a rise in inflation, the price of the commodity becomes USD$550, a year later.
This means that the lender did not benefit from the interest paid by the borrower a year
later. This is because, due to inflation there was an increase in the interest rate.
Consequently, the purchasing power of the lender has declined.
 The above instance exemplifies how the lending organizations are affected, when they
loan out money to the general public on a large scale. Increase in inflation means, the
 interest rates are affected and this directly or indirectly impacts the macroeconomic
indicators of the economy of a country.

Exchange rate

 Emerging countries were used to having a fixed type of exchange rate. Every effort was
made to keep the exchange rate fixed because a floating exchange rate was feared to
cause inconvenience in trading.
 If the rate of inflation remains low for a considerable period of time, the value of
currency rises. This occurs due to increase in the purchasing power.
 In the event when a nation is aware of a possible rise in inflation, it can take measures
accordingly. Exchange rates may also be affected by the type of inflation prevailing in
the economy.

Investment

 Emerging countries were used to having a fixed type of exchange rate. Every effort was
made to keep the exchange rate fixed because a floating exchange rate was feared to
cause inconvenience in trading.
 If the rate of inflation remains low for a considerable period of time, the value of
currency rises. This occurs due to increase in the purchasing power.
 In the event when a nation is aware of a possible rise in inflation, it can take measures
accordingly. Exchange rates may also be affected by the type of inflation prevailing in
the economy.

Money

 Store of value of money is affected. This occurs due to inflation, when the purchasing
power of money is impacted. This in turn diminishes money's role as store of value.
 Another important effect of inflation on money is that it becomes difficult to judge the
performance of a company.
 Inflation makes the value of money weak. This is because with every passing day, the
value of money decreases(while inflation prevails). Since cost of all commodities
escalate, the standard of living of the common man gets affected. While the cost of goods
increases, the salaries remain the same. So, outgoing money exceeds the inflow to keep
up with inflation.

Globalization

 Domestic inflation is impacted by many global factors. Owing to trade expansion there
might be domestic inflation. This happens because trade expansion depends to a large
extent on cost of goods, which are imported. Another factor, which is taken into
consideration is competitive pressure brought forth by globalization. The cost of some
goods are internationally integrated. Pressures created for utilizing resources in
economies of foreign countries could influence domestic inflation.
  Few economists feel that globalization does not affect the rate of inflation. This is
because the changes, which globalization has brought forth affect relative costs of
services and goods. On the other hand, there are yet others, who feel inflation is after all
the change in the overall price level. This can be determined by monetary policies. This
(monetary policies affecting inflation) holds true for long term commitments. With regard
to short or medium run commitments, it may not hold true.

PURCHASING POWER PARITY

Purchasing power parity (PPP) is a theory which states that exchange rates between currencies
are in equilibrium when their purchasing power is the same in each of the two countries. This
means that the exchange rate between two countries should equal the ratio of the two countries'
price level of a fixed basket of goods and services. When a country's domestic price level is
increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in
order to return to PPP.

The basis for PPP is the "law of one price". In the absence of transportation and other transaction
costs, competitive markets will equalize the price of an identical good in two countries when the
prices are expressed in the same currency. For example, a particular TV set that sells for 750
Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the
exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in
Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in
Vancouver. If this process (called "arbitrage") is carried out at a large scale, the US consumers
buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian
goods more costly to them. This process continues until the goods have again the same price.
There are three caveats with this law of one price. (1) As mentioned above, transportation costs,
barriers to trade, and other transaction costs, can be significant. (2) There must be competitive
markets for the goods and services in both countries. (3) The law of one price only applies to
tradeable goods; immobile goods such as houses, and many services that are local, are of course
not traded between countries

Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP.
Absolute PPP was described in the previous paragraph; it refers to the equalization of price
levels across countries. Put formally, the exchange rate between Canada and the United States
ECAD/USD is equal to the price level in Canada PCAN divided by the price level in the United States
PUSA. Assume that the price level ratio PCAD/PUSD implies a PPP exchange rate of 1.3 CAD per 1
USD. If today's exchange rate ECAD/USD is 1.5 CAD per 1 USD, PPP theory implies that the CAD
will appreciate (get stronger) against the USD, and the USD will in turn depreciate (get weaker)
against the CAD.

Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition
states that the rate of appreciation of a currency is equal to the difference in inflation rates
between the foreign and the home country. For example, if Canada has an inflation rate of 1%
and the US has an inflation rate of 3%, the US Dollar will depreciate against the Canadian Dollar
by 2% per year. This proposition holds well empirically especially when the inflation differences
are large.

No. Exchange rate movements in the short term are news-driven. Announcements about interest
rate changes, changes in perception of the growth path of economies and the like are all factors
that drive exchange rates in the short run. PPP, by comparison, describes the long run behaviour
of exchange rates. The economic forces behind PPP will eventually equalize the purchasing
power of currencies. This can take many years, however. A time horizon of 4-10 years would be
typical.

The simplest way to calculate purchasing power parity between two countries is to compare the
price of a "standard" good that is in fact identical across countries. Every year The Economist
magazine publishes a light-hearted version of PPP: its "Hamburger Index" that compares the
price of a McDonald's hamburger around the world. More sophisticated versions of PPP look at a
large number of goods and services. One of the key problems is that people in different countries
consumer very different sets of goods and services, making it difficult to compare the purchasing
power between countries.

The following two charts compare the PPP of a currency with its actual exchange rate relative to
the US Dollar and relative to the Canadian Dollar, respectively. The charts are updated
periodically to reflect the current exchange rate. It is also updated once a year to reflect new
estimates of PPP. The PPP estimates are taken from studies carried out by the Organization of
Economic Cooperation and Development (OECD) and others; however, they should not be taken
as "definitive". Different methods of calculation will arrive at different PPP rates.

The currencies listed below are compared to the US Dollar. A green bar indicated that the local
currency is overvalued by the percentage figure shown on the axis; the currency is thus expected
to depreciate against the US Dollar in the long run. A red bar indicates undervaluation of the
local currency; the currency is thus expected to appreciate against the US Dollar in the long run.
The currencies listed below are compared to the Canadian Dollar. A green bar indicated that the
local currency is overvalued by the percentage figure shown on the axis; the currency is thus
expected to depreciate against the Canadian Dollar in the long run. A red bar indicates
undervaluation of the local currency; the currency is thus expected to appreciate against the
Canadian Dollar in the long run.
The currencies listed below are compared to the European Euro. A green bar indicated that the
local currency is overvalued by the percentage figure shown on the axis; the currency is thus
expected to depreciate against the Euro in the long run. A red bar indicates undervaluation of the
local currency; the currency is thus expected to appreciate against the Euro in the long run.

The International Fisher Effect

The International Fisher Effect is the international counterpart of the Fisher Effect. It can be seen
as a combination of the generalized version of the Fisher Effect and the relative version of the
Purchasing Power Parity. The generalized version of the Fisher Effect states that the real interest
rates across countries will be equal due to the possibility of arbitrage. If the real rate is equal
between different countries, it follows that the differences in their observed nominal rates must
arise from differences in expected inflation. The relative version of the Purchasing Power Parity
implies that inflation differential will be offset by exchange rate changes. Recall equation 2.1 and
equation 2.4:

By combining these two equations we get the International fisher relation:

The International Fisher Effect proposes that the changes in the spot rate of exchange between
two currencies will be equal to the differences in their nominal interest rates (Demirag &
Goddard 1994, 76). For example, a rise in the Swedish inflation rate relatively to the US will
cause a depreciation of the Swedish krona relative to the US dollar (i.e. PPP). The nominal
interest rate in Sweden will also rise relative to the US nominal interest rate (i.e. Fisher Effect).

The adjustment of exchange rate to nominal interest differentials between countries can come
about either directly through flow of capital across international money markets, or through some
sort of activity between the goods and money markets, some real cross-border investment
activity or change in trade patterns in the goods market, that all in all still indirectly ensure
nominal interest differentials are still, on average, offset by exchange rate changes (Internet 4).
Investors speculating on the future spot rate interested in making a profit would move capital
from countries with low interest rates to countries with high interest rates. This movement of
capital would ultimately cause a movement in the exchange rate, eliminating all profit
opportunities. The movement in the exchange rate should on average offset the nominal interest
differential. From this follows that the nominal interest rate differential is an unbiased predictor
of future changes in the spot exchange rate. However, nominal interest differentials should not be
seen as a particularly accurate predictor of future changes in spot rate of exchange, it just means
that prediction errors tend to cancel out over time (Shapiro 1998, 172; Demirag & Goddard
1994, 76). The purchase of a foreign asset is not just an investment in a security that pays a
given rate of interest; it is also an investment in a foreign currency, where the return depends on
the appreciation or depreciation of the exchange rate. The International Fisher Effect says that
the return on a foreign investment will be offset by an exchange rate change. Consequently, an
investor that consistently purchases foreign assets will on average earn a similar return as if
investing in purely domestic assets. If the foreign nominal interest rate, rf, is relatively small can
equation 2.6 be approximated by following equation:
We get this approximation of the International Fisher Effect by subtracting 1 from both sides of
equation 2.6 (Shapiro 1998, 171). Equation 2.7 is sometimes called uncovered interest parity.
“Uncovered” refers to the fact that the future spot rate, St+1 is not known with certainty at time t
(Dornbusch, Fisher & Startz 1998, 400). Equation 2.7 is shown graphically in figure

2.3 below.

The vertical axis in figure 2.3 shows the expected change in home currency value of the foreign
currency and the horizontal axis shows the nominal interest rate differential between the same
two currencies for the same time period. If rh > rf we can expect an appreciation of the foreign
currency and if rh < rf we can expect a deprecation of the foreign currency. The parity line shows
all points for which rh – rf = (St+1 – St)/St and consequently shows all equilibrium points
(Shapiro 1998, 171-172).
Empirical evidence
Fisher Effect it has been shown that there is conflicting evidence also for this parity relation.
Aliber and Stickney (1975) calculated the percentage deviation from the Fisher Effect for
thirteen countries, constituting both developed and developing countries for the period 1966-71.
They used the average annual deviation as a measure for long-term validity and the maximum
annual deviation as a measure for short-term validity. They concluded that the International
Fisher Effect holds in the long run because the average annual deviation tended to be zero. The
maximum annual deviation was however too large to support the theory in the short run. Another
study indicating a long-run tendency for interest differentials to offset exchange rate changes
were made by Giddy and Dufey (1975). Robinson and Warburton (1980) disputed the validity of
the International Fisher Effect. They argued that there according to the Fisher Effect the
possibility to earn a higher interest return would be eroded in the medium term by the
appreciation of the currency with the lower interest rate relatively to the currency with the higher
interest rate. In their study they created four filter rules for placing and switching money in three-
month US treasury bills or three- month Eurocurrency deposits. They concluded that superior
returns could be earned and therefore argued that the International Fisher Effect does not hold
empirically. Kane and Rosenthal (1982) studied the Eurocurrency market for six major
currencies during the period 1974 to 1979 and their study gave support to the theory of the
International Fisher Effect.

To sum up: There are contradictory evidences for the existence of an International Fisher Effect.
This might however not come as a surprise given that the evidence for the International Fisher
Effect is considered to be less convincing than the evidences for the Purchasing Power Parity and
the Fisher Effect (Demirag & Goddard 1994, 77).

International Arbitration
International arbitration is a leading method for resolving disputes arising from
international commercial agreements and other international relationships. As
with arbitration generally, international arbitration is a creature of contract, i.e., the
parties' decision to submit disputes to binding resolution by one or
more arbitrators selected by or on behalf of the parties and applying adjudicatory
procedures, usually by including a provision for the arbitration of future disputes in
their contract[1]. The practice of international arbitration has developed so as to
allow parties from different legal and cultural backgrounds to resolve their
disputes, generally without the formalities of their respective legal systems.
Main features of International Arbitration

International arbitration has enjoyed growing popularity with business and other
users over the past 50 years. There are a number of reasons that parties elect to
have their international disputes resolved through arbitration. These include the
desire to avoid the uncertainties and local practices associated with litigation in
national courts, the desire to obtain a quicker, more efficient decision, the relative
enforceability of arbitration agreements and arbitral awards (as contrasted with
forum selection clauses and national court judgments), the commercial expertise of
arbitrators, the parties' freedom to select and design the arbitral procedures,
confidentiality and other benefits.
International arbitration is sometimes described as a hybrid form of dispute
resolution, which permits parties broad flexibility in designing arbitral procedures.
As one example, consider the International Bar Association (IBA)'s Rules on the
Taking of Evidence in International Commercial Arbitration, revised in
2010. These rules adopt neither the common law jurisdictions' broad disclosure
procedures (Discovery), nor follow fully the civil law in eliminating entirely the
ability to engage in some disclosure-related practices. The IBA Rules blend
common and civil systems so that parties may narrowly tailor disclosure to the
agreement's particular subject matter.
David Rivkin, who chaired the committee that drafted the rules, has noted that the
wide adoption of these rules in international arbitration has led in practice to an
unexpected use by common law practitioners to limit disclosure and by civil law
practitioners to expand it. With a possibly more intuitive cause and practical effect,
arbitral tribunals will often read party election of the IBA Rules as an election most
akin to US-style Discovery. This is hardly surprising given the Rules' language and
the IBA's close ties through the years to the American Bar Association (ABA).
Rules of evidence represents just one example of the different practice that applies
to international arbitration, and which distinguishes it from provincial forms of
arbitration rooted in the procedures of a particular legal system. Similarly,
international arbitral practice has given rise to its own non-country-specific
standards of ethical conduct which are believed to apply in international
proceedings and, more to the point, to the arbitrators who are appointed to conduct
them.

Advantage of International Arbitration

For international commercial transactions, parties may face many different choices
when it comes to including a mechanism for resolving disputes arising under their
contract. If they are silent, they will be subject to the courts of wherever a
disaffected party decides to initiate legal proceedings and believes it can obtain
jurisdiction over the other party. This may not sit well with parties that need to
know at the time of entering into their contract that their contractual rights will be
enforced. The alternative to silence is to specify a method of binding dispute
resolution, which can be either litigation before the domestic tribunal of one of the
parties or arbitration. If the parties choose to resolve their disputes in the courts,
however, they may encounter difficulties.
The first is that they may be confined to choosing one or the others' courts, as the
courts of a third country may decline the invitation to devote their resources to
deciding a dispute that does not involve any of that country's citizens, companies,
or national interests. An exception to that rule is New York State, which will not
entertain a forum non conveniens motion when the dispute concerns a contract that
is worth one million dollars or more and in which the parties included a choice-of-
law clause calling for application of New York law. The second, and perhaps more
significant difficulty, is that judicial decisions are not very "portable" in that it is
difficult and sometimes impossible to enforce a court decision in a country other
than the one in which it was rendered.

International Trade Arbitration

In the past twenty years the world of investment arbitration has taken the
commercial world by storm. There are over 2,750 bilateral investment treaties and
almost every one of them has an arbitration provision. Investment arbitration is
now a prominent feature of the arbitration landscape.
Just as BITs have proliferated in recent years, so too have free trade agreements.
There are approximately 380 free trade agreements now in existence, and yet the
question of dispute settlement in the FTA context has rarely featured in the
discussion. Sure, there have been NAFTA Chapter 20 cases, and the occasional ad
hoc dispute–such as the Canadian-U.S. Softwood Lumber dispute. But
international trade arbitration pursuant to FTAs is still in its infancy.
The recent EU-South Korea FTA signed last month may signal a new era of FTA
arbitration. The dispute settlement chapter of this FTA combines features of both
investment arbitration and the WTO DSU.
The procedures are similar to investment arbitration. There are provisions for the
request for arbitration, establishment of an arbitral panel, rules on arbitrator
conduct, rules governing proceedings, evidence gathering and hearings, time
limits for the award, etc. There are a few unique provisions, such as drawing
arbitrators by lot from a roster of fifteen, and adopting the seat of arbitration as
either Seoul or Brussels, depending on which State is the complaining Party. But in
most respects the procedures are familiar to other forms of arbitration involving
States.
When it comes to remedies, however, the FTA arbitration rules are similar to the
WTO. A non-complying State may offer compensation for a violation, or failing
that, be subject to retaliatory countermeasures (i.e., increased tariffs). Those tariff
increases may not exceed the level applied to other WTO members, but will result
in the suspension of duty-free benefits under the FTA. Similar to the WTO,
disputes as to compliance measures or deadlines are subject to further arbitration.
The traditional recognition and enforcement questions under the New York
Convention are irrelevant in this context.
Over 50% of all trade in goods occurs on a preferential basis. Like BITs, FTAs will
continue to proliferate. Sophisticated dispute resolution mechanisms in FTAs are
long overdue. The future portends a new world of international trade arbitration,
and a growing international trade arbitration bar.

Currency Swap:
A simple type of currency swap would be an agreement between two parties to exchange fixed
rate interest payments and the principal on a loan in one currency for fixed rate interest payments
and the principal on a loan in another currency. Note that for such a swap, the uncertainty in the
cash flow is due to uncertainty in the currency exchange rate. In a Dollar/Euro swap, for
example, a US company may receive the Euro payments of the swap while a German company
might receive the dollar payments. Note that the value of the swap to each party will vary as the
USD/Euro exchange rate varies. As a result, the companies are exposed to foreign exchange risk
but if necessary this risk can be hedged by trading in the forward foreign exchange market.

Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps.
However, unlike interest rate swaps, currency swaps can involve the exchange of the principal.

There are three different ways in which currency swaps can exchange loans:

1. The most simple currency swap structure is to exchange the principal only with the
counterparty, at a rate agreed now, at some specified point in the future. Such an
agreement performs a function equivalent to a forward contract or futures. The cost of
finding a counterparty (either directly or through an intermediary), and drawing up an
agreement with them, makes swaps more expensive than alternative derivatives (and thus
rarely used) as a method to fix shorter term forward exchange rates. However for the
longer term future, commonly up to 10 years, where spreads are wider for alternative
derivatives, principal-only currency swaps are often used as a cost-effective way to fix
forward rates. This type of currency swap is also known as an FX-swap.
2. Another currency swap structure is to combine the exchange of loan principal, as above,
with an interest rate swap. In such a swap, interest cash flows are not netted before they
are paid to the counterparty (as they would be in a vanilla interest rate swap because they
are denominated in different currencies. As each party effectively borrows on the other's
behalf, this type of swap is also known as a back-to-back loan.
3. Last here, but certainly not least important, is to swap only interest payment cash flows
on loans of the same size and term. Again, as this is a currency swap, the exchanged cash
flows are in different denominations and so are not netted. An example of such a swap is
the exchange of fixed-rate US Dollar interest payments for floating-rate interest payments
in Euro. This type of swap is also known as a cross-currency interest rate swap, or cross-
currency swap.

Interest Rate Swap:

Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate
specifications) for another. Because they trade OTC, they are really just contracts set up between
two or more parties, and thus can be customized in any number of ways.

Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an
interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or
manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate
than it would have been able to get without the swap.

Types:
Being OTC instruments interest rate swaps can come in a huge number of varieties and can be
structured to meet the specific needs of the counterparties. By far the most common are fixed-
for-floating, fixed-for-fixed or floating-for-floating. The legs of the swap can be in the same
currency or in different currencies. (A single-currency fixed-for-fixed rate swap is generally not
possible; since the entire cash-flow stream can be predicted at the outset there would be no
reason to maintain a swap contract as the two parties could just settle for the difference between
the present values of the two fixed streams; the only exceptions would be where the notional
amount on one leg is uncertain or other esoteric uncertainty is introduced.

Uses:
Interest rate swaps were originally created to allow multi-national companies to evade exchange
controls. Today, interest rate swaps are used to hedge against or speculate on changes in interest
rates.
Interest rate swaps are also used speculatively by hedge funds or other investors who
expect a change in interest rates or the relationships between them. Traditionally, fixed income
investors who expected rates to fall would purchase cash bonds, whose value increased as rates
fell. Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as
rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.
Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Due to
varying levels of creditworthiness in companies, there is often a positive quality spread
differential which allows both parties to benefit from an interest rate swap.

Risks:
Interest rate swaps expose users to interest rate risk and credit risk.
 Interest rate risk originates from changes in the floating rate. In a plain vanilla fixed-for-
floating swap, the party who pays the floating rate benefits when rates fall. (Note that the
party that pays floating has an interest rate exposure analogous to a long bond position.)
 Credit risk on the swap comes into play if the swap is in the money or not. If one of the
parties is in the money, then that party faces credit risk of possible default by another
party.

COVERED AND UNCOVERED INTEREST RATE PARITY:

Interest rate parity is an economic concept, expressed as a basic algebraic identity that relates
interest rates and exchange rates. The identity is theoretical, and usually follows from
assumptions imposed in economic models. There is evidence to support as well as to refute the
concept.

Interest rate parity is a non-arbitrage condition which says that the returns from borrowing in one
currency, exchanging that currency for another currency and investing in interest-bearing
instruments of the second currency, while simultaneously purchasing futures contracts to convert
the currency back at the end of the holding period, should be equal to the returns from
purchasing and holding similar interest-bearing instruments of the first currency. If the returns
are different, an arbitrage transaction could, in theory, produce a risk-free return.
Looked at differently, interest rate parity says that the spot price and the forward, or futures
price, of a currency incorporate any interest rate differentials between the two currencies
assuming there are no transaction costs or taxes.

Two versions of the identity are commonly presented in academic literature: covered interest rate
parity and uncovered interest rate parity.

Example Uncovered vs. Covered interest parity

Let's assume you wanted to pay for something in Yen in a month's time. There are several ways
to do this.
(a) Buy Yen forward 30 days to lock in the exchange rate. Then you may invest in dollars
for 30 days until you must convert dollars to Yen in a month. This is called covering
because you now have covered yourself and have no exchange rate risk.

(b) Convert spot to Yen today. Invest in a Japanese bond (in Yen) for 30 days (or
otherwise loan out Yen for 30 days) then pay your Yen obligation. Under this model, you
are sure of the interest you will earn, so you may convert fewer dollars to Yen today,
since the Yen will grow via interest. Notice how you have still covered your exchange
risk, because you have simply converted to Yen immediately.

(c) You could also invest the money in dollars and change it for Yen in a month

EXCHANGE RATE:
An exchange rate is the current market price for which one currency can be exchanged for
another.

NOMINAL EXCHANGE RATE:

It is defined as the actual foreign exchange quotation in contrast to the real exchange rate which
can be adjusted for changes in purchasing power.

Mathematical Formulation;

The nominal exchange rate is the price in domestic currency of one unit of a foreign currency.

e X Pi=Pi*
Where:
• e denotes the nominal exchange rate of the domestic currency in terms of the
foreign currency.
• Pi denotes the price of good i in domestic in domestic currency.
• e X Pi is the price of the same good in domestic in foreign currency.
• *Pi denotes the price of the same good in the foreign in foreign currency.
REAL EXCHANGE RATE:

Basically, the real exchange rate can be defined as the nominal exchange rate that
takes the inflation differentials among the countries into account. Its importance
stems from the fact that it can be used as an indicator of competitiveness in the foreign
trade of a country.

The Real Exchange Rate Definitions:

The various definitions of the real exchange rate can mainly be categorized under
two main groups. The first group of definitions is made in line with the purchasing power
parity. The second group of definitions, on the other hand, is based on the distinction between
the tradable and the non-tradable goods.

Purchasing Power Parity:

According to this definition, the real exchange rate can be defined in the long
run as the nominal exchange rate (e) that is adjusted by the ratio of the foreign price
level (Pf) to the domestic price level (P).
BALANCE OF PAYMENTS
A record of all transactions made between one particular country and all other countries during
a specified period of time. BOP compares the dollar difference of the amount of exports and
imports, including all financial exports and imports. A negative balance of payments means that
more money is flowing out of the country than coming in, and vice versa.

Balance of payments may be used as an indicator of economic and political stability. For

example, if a country has a consistently positive BOP, this could mean that there is significant
foreign investment within that country. It may also mean that the country does not export much
of its currency. This is just another economic indicator of a country's relative value and, along
with all other indicators, should be used with caution. The BOP includes the trade
balance, foreign investments and investments by foreigners.

Since 1974, the two principal divisions on the BOP have been the current account and the capital
account.

The current account shows the net amount a country is earning if it is in surplus, or spending if it

is in deficit. It is the sum of the balance of trade (net earnings on exports – payments for imports)
,factor income (earnings on foreign investments – payments made to foreign investors) and cash
transfers. Its called the current account as it covers transactions in the "here and now" - those
that don't give rise to future claims.

The capital account records the net change in ownership of foreign assets. It includes the reserve
account (the international operations of a nation's central bank), along with loans and
investments between the country and the rest of world (but not the future regular repayments /
dividends that the loans and investments yield, those are earnings and will be recorded in the
current account).

Expressed with the standard meaning for the capital account, the BOP identity is:

CURRENT ACCOUNT

Current account is one of the two primary components of the balance of payments, the other
being the capital account. The current account is the sum of the balance of trade (exports minus
imports of goods and services), net factor income (such as interest and dividends) and
net transfer payments (such as foreign aid).

Under current account of the BoP, transactions are classified into merchandise (exports and
imports) and invisibles. The current account balance is one of two major measures of the nature
of a country's foreign trade (the other being the net capital outflow). A current account surplus
increases a country's net foreign assets by the corresponding amount, and a current account
deficit does the reverse. Both government and private payments are included in the calculation. It
is called the current account because goods and services are generally consumed in the current
period.

Positive net sales abroad generally contribute to a current account surplus; negative net sales
abroad generally contribute to a current account deficit. Because exports generate positive net
sales, and because the trade balance is typically the largest component of the current account, a
current account surplus is usually associated with positive net exports.

CAPITAL ACCOUNT

The net result of public and private international investments flowing in and out of a country. An
account that tracks the movement of funds for investments and loans into and out of a country.
The capital account makes up part of the balance of payments.

TRENDS IN BALANCE OF PAYMENT AND ITS IMPACT ON INDIAN ECONOMY

After three consecutive years of a current account surplus, which exceeded $10.5 billion in 2003-
04, the country experienced a return to a current account deficit amounting to $6.3 billion in
2004-05. 

India’s BoP exhibited considerable resilience during fiscal 2008-09 despite one of the severest
external shocks. The current account balance [ (-) 2.4 per cent of GDP in 2008-09 vis-à-vis (–)
1.3 per cent in 2007-08] remained well within the sustainable limits and there was limited use of
foreign exchange reserves, despite massive decline in net capital flows to US$ 7.2 billion in
2008-09 as against US$ 106.6 billion in 2007-08. As per the latest BoP data for fiscal 2009-10,
exports and imports showed substantial decline during April-September (H1) of 2009-10 vis-à-
vis the corresponding period in 2008-09. There has been improvement in the BoP scenario
during H1 of 2009-10 over H1 of 2008-09, reflected in higher net capital inflows and lower trade
deficit. However, the invisible surplus declined and current account deficit widened vis-a-vis the
corresponding period last year

CURRENT ACCOUNT

Merchandise (exports and imports)

The impact of the global financial crisis was transmitted to India through various external sector
transactions, mainly the trade and financial routes. The transmission of external demand shocks
was much more swift and severe on export growth, which, on a BoP basis, declined from a peak
of 57 per cent in Q1 (April-June 2008) of 2008-09 to (-) 8.4 per cent in Q3 (October – December
2008) and further to (-)20 per cent in Q4 (January – March 2009) of 2008-09–-a fall for the first
time since 2001-02. Import growth, which remained robust till the Q2 (July – September 2008)
of 2008-09, declined by 20.8 per cent in Q3 over Q2 and 20.1 per cent in Q4 over Q3, moving in
tandem with the slowdown in domestic industrial demand and sharp decline in international
crude oil and other primary commodity prices. Thus trade deficit generally expanded in the first
two quarters of 2008-09 due to the combined effect of a high crude oil prices-driven increase in
imports and the collapse in external demand. However, in Q4 of 2008-09, with the pace of
decline in imports outpacing that in exports, trade deficit narrowed down significantly to US$
20.2 billion as compared to US$ 25.3 billion in Q1, US$ 39.1 billion in Q2 and US$ 34.0 billion
in Q3. For the full fiscal 2008-09, however, trade deficit witnessed a marked expansion to US$
118.7 billion (9.7 per cent of GDP) as compared to US$ 91.5 billion (7.4 per cent of GDP) in
2007-08.

India’s current account position during the first half of 2009-10 (April-September) continued to
reflect the impact of the global economic downturn and deceleration in world trade witnessed
since the second half of 2008-09. Growth in exports and imports continued its declining trend
during the first half of 2009-10. On a BoP basis, India’s merchandise exports, which started
falling in October 2008, recorded a decline of 27.0 per cent in H1 (April- September 2009) of
2009 as against a significant increase of 48.1 per cent during the corresponding period of the
previous year.

Similarly, the declining trend in imports, which began during the third quarter of 2008-09, after a
gap of almost seven years, continued during the first half of 2009-10. Import payments, on a BoP
basis, registered a decline of 20.6 per cent during H1 of 2009-10 as compared to robust growth
of 51.0 per cent in the corresponding period of the previous year.

According to the Directorate General of Commercial Intelligence and Statistics (DGCI&S) data,
oil imports recorded a decline of 45.0 per cent in April-September 2009 as against a significant
rise of 83.0 per cent during April-September 2008. During the same period, non-oil imports
showed a relatively modest decline of 26.3 per cent (as against an increase of 43.8 per cent in
April-September 2008). In absolute terms, oil imports accounted for about 26 per cent of total
imports during April-September 2009 (34.2 per cent in the corresponding period of the previous
year). According to the data released by the Gem & Jewellery Export Promotion Council, total
import of gems and jewellery declined by 12 per cent during April-September 2009 as against an
increase of 33.6 per cent during the corresponding period of the previous year.

Trade deficit, however, remained lower at US$ 58.2 billion during April-September 2009 as
compared to US$ 64.4 billion in April-September 2008 (9.6 per cent decline), mainly on account
of the decline in oil imports. 

Current account

That said, the current account could take a bit of a knock. Exports were up 22.2 per cent in the
first quarter (Q1) of this fiscal from the corresponding period in 2007-08, while imports
increased by 33.3 per cent on account of the spurt in petroleum prices.

With the OECD countries accounting for 40 per cent of India’s export basket, deceleration in
export growth is a distinct possibility.

India’s exports have grown at an average annual rate of 23 per cent (in dollar terms) since 2002-
03; this marks a sharp departure from the annual growth rate of 7.3 per cent between 1995 and
2000, when the East Asian crisis shook the world.

The ongoing turmoil in asset markets is of a bigger order than the 1997 East Asian debacle.

Merchandise export growth could drop below 20 per cent in the third and fourth quarters, given
the impact of a US-led recession, nullifying the impact of a weak rupee. The effect will be felt
more in 2009-10.

The only respite could come from import growth, with oil prices falling steeply from about $120
a barrel in July to $89 at present. Petroleum accounts for a third of India’s total imports of close
to $250 billion.

A minor drop from Q1 import growth rates of 33 per cent is possible, provided oil prices do not
rise again. However, a sudden international political conflict, which cannot be ruled out in a
recession that is comparable to 1907 and 1929, could lead to a rise in oil prices all over again.
Even at current crude prices, import growth may exceed the 2007-08 level of 30 per cent when
oil prices (Indian basket) were ruling at $79.5 a barrel. This is because the rupee is weaker today
than in 2007-08, and is likely to remain so in the absence of a surge in capital flows.

A drop in import growth (oil and non-oil) in quantity terms because of a possible slowdown will
be nullified by the exchange rate.
The trade deficit can be expected to expand by $30 billion, against a rise of $27 billion last year,
to end up at $120 billion.

In 2007-08, the trade deficit of $90 billion was in large measure covered by net inflows of
invisibles (essentially comprising software exports and private transfers), amounting to about
$72.6 billion, leaving a current account deficit of $17.4 billion.

Software exports, which increased by 21 per cent in Q1 of this fiscal over the corresponding
period last year, may not sustain even this modest trend through the year, given the fact that over
a third of these earnings accrue from the financial sector. However, the full effect might be felt in
the third and fourth quarters, and in the next fiscal.

Of the invisibles inflows of $72 billion in 2007-08, $38 billion was from software exports. Even
if remittances buck the recession to grow at about 40 per cent, the current annual rate, the growth
in invisibles will fall below the current level of 36 per cent.

A current account deficit of $25 billion by the end of the year, against $17.4 billion in 2007-08,
cannot be ruled out.

Capital account

Net capital flows could be down to half the levels of 2007-08. There was a net portfolio outflow
of $4.2 billion in this fiscal’s Q1, against a net inflow of $7.4 billion in Q1 of 2007-08. The
ouflow is likely to continue, given the ongoing financial turmoil.

Liberalised guidelines for external commercial borrowings (ECBs) may not bring the desired
inflows, in view of the credit squeeze and hardening interest rates worldwide. Net ECB flows in
April-June this fiscal were $1.6 billion, against $7 billion in April-June 2007-08. Banks might
have retrieved all they could from world markets, by bringing in $1.9 billion in the first quarter
and $14 billion over the last 15 months.

Net capital flows amounted to $108 billion in 2007-08, of which portfolio flows were $29
billion, ECBs were $22.2 billion, foreign direct investment $15.5 billion, banking capital $11.5
billion and short-term trade credits $17.6 billion.

This year’s flows, led by an increase in FDI, will perhaps be closer to 2006-07 levels of $45.7
billion. Apart from the fact that portfolio flows will be negligible, if not negative, and ECBs
lower than 2007-08 levels, short-term debt due for redemption in a year is about $45 billion.
Against a reserves accretion of $92 billion in 2007-08, this year’s increase is likely to be
insignificant, if at all.

Balance of Payment and External Debt of India in 2010

Status of Balance of Payment: India’s Balance of Payment (BoP) has shown significant growth
during fiscal 2008-09 despite of severe slowdown in the world economy. During the fiscal 2009-
10, the net invisibles surplus i.e. invisibles receipts minus invisibles payments stood lower at
US$ 39.6 billion during April-September 2009 registering a sign of overall improvement in
Balance of Payment scenario during the first half of 2009-10 over the corresponding period
2008-09.  The current account deficit increased to US$ 18.6 billion in April-September 2009,
despite lower trade deficit as compared to US$ 15.8 billion in April-September 2008, mainly due
to lower net invisible surplus.

Status of External Debt: During the first half of 2009-10 total external debt increased by US$
18.2 billion i.e. 8.1 per cent to US$ 242.8 billion.  In rupee terms the external debt stands at Rs.
1.166.217 crore. Long-term debt posted an increase of US$ 19.2 billion to stand at US$ 200.4
billion while short-term debt fell by US$ 985 million and stood at US$ 42.4 billion.