Q 3) Refer to Charts 1 & 2 and answer the question below:

1) What according to you is the relationship between REER, Forex Reserves and Capital
inflows? Explain with reference to India and China.
(5 Marks)

reer ,neer and

Capital flow.pdf

2) Would you say that the Indian Rupee and Chinese Renminbi are undervalued or
overvalued? Justify your answer in the context of inferences from the charts.
Indian Currency:
A wider measure of the value of a currency such as the Indian rupee is its real
effective exchange rate (REER). This is a measure of the value of a currency
against the currencies of major trading partners, and adjusted for inflation. The
REER is commonly used to measure trade competitiveness, so an increase in the
REER implies that exports become more expensive while imports become cheaper.
There are several ways to measure the REER, which is why different agencies
come up with different estimates. The most convenient one to use is the estimate of
the Reserve Bank of India since the central bank has traditionally used its 36-
country REER as a lodestone to understand whether the rupee is overvalued or
undervalued. India has been battling an overvalued rupee in recent years, and the
REER has corrected only after episodes of sharp rupee depreciation. Critics of the
REER say it is only an analytical tool, since most of Indian trade is billed in dollars
while corporate borrowing is also in terms of specific currencies.
The third way to look at the valuation of any currency is through its real exchange
rate. Goods will usually sell at the same price across the world because of
international trade. However, not everything can be traded across borders,
especially services such as medical care or haircuts. They tend to be cheaper in
emerging markets such as India, so a dollar goes a longer way in Mumbai than in
New York. That is the basic intuition behind the famous Big Mac index, with
hamburger prices being used to guess whether currencies are overvalued or
undervalued.
The menu of prices can be extended beyond hamburgers. A comparison of all
prices— traded and non-traded—is done through purchasing power parity (PPP)
adjustments. The idea of PPP is well known. What is less known is that it can be
used to assess whether a currency is out of alignment based on international price
comparisons, using what is known as the Balassa-Samuelson effect on how price
levels in any country depend on its average income level. Services are cheaper in
poorer countries, and their prices rise as wages go up with development.

Chiniese Currency

Why is the value of China’s currency a political issue?

China’s rapid economic rise has left its economic welfare increasingly
intertwined with that of other countries. China has boasted a trade
surplus with the United States since 1985, which has contributed to the US’
current account deficit. Additionally, China holds large amounts of US and
other foreign securities as part of its strategy to manage the RMB’s value.
The EU’s trade deficit with China more than doubled in real terms between
2002 and 2006, and reached a record high of €184.8 billion in 2018,
sparking concern over China’s exchange rate policy across the continent.

As a result of these economic linkages, the RMB’s value relative to the

dollar and the euro has been the subject of extensive political debate in the
US and the EU. Critics have accused China of intervening in its currency
markets to put itself at a competitive advantage. For years, the US has
called for an appreciation of the RMB’s value against the dollar on the
presumption that this would boost US exports to China and aid American
companies that directly compete with Chinese firms.

Many are apprehensive that China’s ownership of American debt affords

the Chinese economic leverage over the United States. This worry stems
from a misunderstanding of sovereign debt. Learn more here.
 EXPLORE MORE  

While China’s alleged currency manipulation has been a source of political

clamoring for decades, countries have typically shied away from outright
labeling China as a currency manipulator. In 2009, former European
Commission President Jose Manuel Barroso urged China to revalue the
RMB, stating, “major imbalances because of trade or because of currencies
can create problems in the future if they are not fully addressed.” In 2017,
US President Donald Trump turned away from earlier claims that China
was the “grand champion” of currency manipulation, but kept China on
a currency monitoring list created under the Obama Administration in 2016.

Amid ongoing US-China trade tensions, the US Treasury Department

formally designated China a currency manipulator in August 2019. The
move came in response to what the Trump administration called China’s
attempts to “gain an unfair competitive advantage in international trade.” At
that time, President Trump also stated that China’s gradual depreciation of
the RMB is aimed at offsetting the cost of US tariffs on Chinese goods.

Nevertheless, China has long resisted calls from the United States, EU,
and international economic forums to alter the RMB’s exchange rate
regime. China’s leaders have claimed such pressure to be a violation of
Chinese economic sovereignty, insisting that China’s currency policy is a
domestic concern. In August 2019, People’s Bank of China Governor Yi
Gang stated that China would “not use the exchange rate for competitive
purposes and not use the exchange rate as a tool to deal with external
disturbances such as trade disputes.”

If China wants to have a dynamic domestic financial system it has to move

forward toward having a more market-oriented exchange rate regime as
well.
-DANIEL H. ROSEN

Criticisms levied against China are often rooted in misinterpretations of

international economics. All governments that print their own currency can
set their currency’s nominal exchange rate, which represents the value of a
country’s currency relative to foreign currencies. Nominal exchange rates
can be adjusted in pursuit of specific policy goals, such as managing price
stability and addressing employment levels.

In contrast, a currency’s real exchange rate is set by market forces and

determines the actual purchasing power of a currency. Real exchange
rates reflect the amount of goods and services in a domestic economy that
can be exchanged for goods and services in foreign economies. Real
exchange rates ultimately have a greater impact on global trade. While
China fixes its nominal exchange rate, other countries like the United
States also intervene in their domestic markets by setting their interest
rates.

ith assets moving abroad, the PBOC has intervened by purchasing large
amounts of RMB in order to support its value. In 2015 alone, China spent
over $500 billion of its foreign reserves to protect the RMB from getting
shorted by traders. China imposed a number of new rules on overseas
currency transfers in late 2016 and early 2017. China’s state media has
emphasized that these rules should not be considered capital controls, but
instead as measures that target illegal activities, such as money laundering
and terrorism financing. Nonetheless, the improved capital flow
regulations and the increasing international use of the RMB have ultimately
strengthened the currency’s value.

Q4) Refer to the article ‘CAD

widens to USD 14.3 bn or 2.4% in

Q1 on high trade deficit’ and answer

the following questions.

a) Identify the transactions that

will enter the Balance of

Payments statement and say

whether each belongs to the

current account or capital

account of the BOP. (3 Marks)

 b) Comment on the current account and capital account inflows/outflows in terms of

sustainability. (4 Marks)

c) In spite of a current account deficit, there has been an accretion to the foreign exchange

reserves. Give reasons. (3 Marks)

CAD widens to 2.4%; risk to BoP getting elevated - Emkay

Posted in Top Stories| #Special Report #GDP #Emkay Global Financial Services Ltd.
CAD widens to 2.4%; risk to BoP getting elevated
Despite sharp widening in current account deficit (CAD) to a 4 year high of 2.4% of GDP, forex
reserves surged by USD 11.4bn, significantly contributed by short term capital inflows. The
momentum of debt inflows of USD 11.2bn in Q1FY18 was aided by fading of earlier Trumpflation
trade that caused USD weakening and softening domestic inflation & rates inducing expectations
of capital gains. We believe most of these factors will ebb going forward. CAD widened sharply
with rise in merchandise deficit to 6.8% of GDP. We expect external sector vulnerability to
accentuate due to a) spillover effects of expansionary fiscal spending, which will have a multiplier
effect on domestic consumption demand and boost imports, b) continued decline in structural
supports viz. IT exports, remittances and NRI deposits, c) potential global financial market
volatility impact capital flows. Hence, beyond the recent INR/USD appreciation, we believe the
currency will eventually depreciate.
 
CAD widens sharply to 2.4% in Q1FY18
Current account deficit widened to a 4-year high of USD 14.3bn as compared to USD 3.5bn in
Q4FY17, primarily led by widening merchandise deficit. Merchandise deficit widened to 6.8% of
GDP in Q1FY18 from 4.8% in Q4FY17 due to higher commodity & consumption oriented imports
and moderation in exports growth. Imports increased by 27.0% YoY in Q1FY18 (on BoP basis)
primarily due to rise in petroleum, gold, col and electronic goods. Exports expanded much slower
at 10.6%.
Sharp 14.7%YoY rise in invisibles during the quarter is on account of increase in net services
exports. Part of this growth is attributable to slowdown in services imports (business, travel &
transportation). Net services exports grew particularly from travel, construction and other
businesses. Software services declined by 1.5% YoY as compared to 2.8% in Q4FY17.
Remittances improved tad bit to a 3.1% yoy growth, however there it is still significantly lower
than before downdraft of oil prices.
 
Large inflow in portfolio flows boosts capital account surplus
Capital account balance surges to USD 25.4bn i.e. 4.2% of GDP primarily due to sharp increase
in net FII inflows to the tune of USD 11.9bn in Q1. This has been largely from surge in net FII
debt inflows to USD 11.2bn, with possibility of narrowing interest rate differentials the risk of
reversal in flows in likely in the H2FY18. As expected, commercial borrowings resulted in an
outflow for the 8th consecutive quarter to the extent of USD 1.8bn. Concomitant decline in ECB
flows and domestic credit growth is a reflection of continued weakness in domestic investment
activities over the past 18-24 months. In our view, continued sluggishness in investments and
relative rise in global interest rates will extend the slackness in ECB flows.
 
Outlook: CAD to widen with rising commodity prices
The combination of recovery in domestic consumption, rising global commodity prices and muted
services exports is likely to expand India’s CAD to 1.5-1.8% of GDP in FY18 compared to 0.7%
in FY17. Cyclical revival in growth in advanced economies can have a positive influence on
India’s exports of goods and services, but we believe it can be blunted by protectionist measures.
In this context, tightening of global financial condition arising from rate normalization in advanced
economies, backed by their cyclical recoveries, could impose fund flow pressures in emerging
economies, including India. The import coverage remaining comfortable at 11 months from a low
of 6.6 months in Sep’13, primarily contributed by sharp influx in portfolio flows. Risk of reversal is
likely to increase the vulnerability of external position and is likely to exert pressure on the
currency. 
 

ndia’s current account gap in Q4 widens more

than forecast on oil woes
The shortfall was $13bn in January-March, or 1.9% of
gross domestic product, the RBI announced on
Wednesday.
June 13, 2018 19:22 IST | India Infoline News Service

India’s current account deficit

widened more than forecast last
quarter and may extend the rupee’s
fall with the US Federal Reserve
predicted to increase interest rates
this week.

Key Points
 The shortfall was $13bn in
January-March, or 1.9% of gross domestic product, the Reserve Bank of India
said in a statement in Mumbai on Wednesday
 That gap was wider than a median $12.4bn deficit projected in a Bloomberg
survey of 16 economists
 The current account gap is narrower than the previous quarter’s $13.7bn
deficit, or 2.1% of GDP, and higher than $2.6bn recorded in the same period last
year
In Detail
 Net services receipts increased to $20.2bn, higher than the previous year’s
$18.5bn, mainly on the back of higher earnings from software services and
travel, the RBI has said
 Remittances were at $18.1bn, up 15.1% from the previous year; while net
foreign direct investments rose to $6.4bn from $5bn a year ago
 The goods trade deficit widened to $41.6bn from a gap of $29.7bn in the
previous year
 Net portfolio investments recorded an inflow of $2.3bn compared with
$10.8bn last year

Big Picture
The trade deficit was at nearly $41.6bn in the period January-March compared with
$44.1bn in the October-December period. Non-crude oil import growth slowed even
as crude oil imports rose. Crude oil prices averaged US$67.5 a barrel in the January-
March quarter, up from $63.5 in the previous quarter, according to Teresa John,
economist at Nirmal Bang Equities Pvt.

"Our estimates are for a 10 basis point rise in the current account deficit for a $10
rise in the price of crude," said Shashank Mendiratta, an economist at ANZ Banking
Group.

While India needs steady inflows to help bridge the deficit, foreign investors turned
net sellers of bonds while inflows into the stock markets have slowed. India’s foreign
exchange reserves have fallen in the past seven weeks as the central bank has stepped
in to support the rupee, which is the second-worst major Asian currency this year.

Expectations of more rate hikes by the Federal Reserve could weigh on the high-
yielding rupee and a larger current account gap could hurt sentiment.

"All the fundamentals are stacked against the rupee, whether, it’s inflation, fiscal
deficit, or current account,” Mendiratta said, adding, “So that should keep the
pressure on the rupee.”