Open Economy (India)

Open Economy

Open economy is one where buying and selling of good & services & capital assets take place between residents (including individuals or enterprises) of an economy and the rest of the world. The act of selling goods or services to rest of the world is called exporting. The act of buying goods or services from rest of the world is called importing. A record of all transactions made between residents and the rest of the world during a specified period of time is called Bill of Payments (BOP). BOP compares the 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 (called deficit), and vice versa (called surplus).

BOP for any economy has following heads:

• Current Account: It capture the currency value of goods & services exported & imported, income (interest, dividends, compensation), unilateral transfers (gifts, remittances etc) in the economy.
• Capital Account: It includes foreign investment (including FDI, FII), loans (ECB, external assistance, short-term loans), banking capital (non-residents deposits), other capital (to account for export / import done but money is yet to come or go... e.g., leads & lags in export receipts)
• Errors and Omissions
• Overall Balance: It is the aggregate figures after adding up all the current and capital accounts adjusting for errors & omissions.
• Money Movements: Deficit in overall balance leads to credit entry the money movement whereas surplus leads to debit entry. Loan financed from IMF to handle the deficit scenarios are also entered as credit item in BOP.

General Notes on BOP

• Any transaction that brings in foreign exchange to the country, e.g. exports, FII and so on is Credit item whereas, any transaction that takes out foreign exchange from the country, e.g. imports is Debit item.  
• Role of International Monetary Fund (IMF) is to help countries to avoid the default of the country due to higher deficit situation in their economy. It is not in interest of the country as well as for the rest of the world to let a country default.
• India does not go to IMF to borrow money to compensate for deficits -- as they have foreign exchange reserves. And the reserves are higher than deficits. For a country which has no foreign exchange reserves would require to finance the deficit by borrowing money from IMF.
• Surplus in current account of a country is it's own money e.g. China has current account surplus. And kind of protected any disturbance in economy of rest of the world. Whereas, Surplus in capital account indicate higher foreign investment and there is a risk of money going back overnight if due to some extreme reason foreign investor decide to so.

Current and capital account convertibility

Current Account Convertibility means practically there are no restrictions on exports and imports
of goods and services. It means "the freedom to convert one currency into other internationally accepted currencies, wherein the exporters and importers where allowed a free conversion of rupee.

Capital Account Convertibility means practically there are no restrictions on inflow and outflow
of fund. It means that rupee can now be freely convertible into any foreign currencies for acquisition of assets like shares, properties and assets abroad. Further, the banks can accept deposits in any currency. The firm can freely invest in the country or take out the investment from the economy. India is not fully capital account convertible.. still few sectors are regulated - liberal compared to earlier though. This also upto some extent to shield India from Lehman Brother crises..

Remittance to foreign countries from india is restricted by RBI. for import of machines you are remitting abroad means it is capital account convertibility. if you remit money to your son or relative living abroad means current account convertibilty.

 

Foreign Exchange

Foreign exchange rate is not directly related to the health of the economy, rather it is function of the demand and supply of the currency. When demand of dollar is greater than supply of dollar, Rupees per dollar rate increases and vice versa.
 

D_$ ↑  >   S_$   ↓        →                 Rs / $  ↑

D_$ ↓  <   S_$   ↑        →                 Rs / $  ↓

Notes:
1. Increase in export from India result into increase in dollar supply

2. Increase in import to India result into increase in dollar demand
3. Higher Rupees per dollar exchange rate is export friendly

 Examples:
1. US recession, export from India goes down, and so leads to decrease in supply of dollar, and in turn, leading to increase in Rupees per dollar rate.
2. FII pumping in money in India cause increase in supply of dollar and go resulted into decrease in Rupees per dollar rate
3.  Capital flight (i.e. when FII takes out the money), it result into higher demand for dollar and so cause increase in Rupees per dollar exchange rate
4. Increase in the current account deficit, due to higher import with same level of export, would lead to higher Rupees per dollar exchange rate.

Whether is it good to have higher (or lower) foreign exchange rate?

Developing countries requires more import and so it make sense to have lower exchange rate.. Eg. import of oil will be costy. The inflation rate will increase in the country due to higher cost paid for import.

Whereas in export oriented economy, it make sense to have higher exchange rate.. China keep the fix exchange rate higher than the maket determined rate.

Why RBI did not intervene when exchange rate were raising from 45 to 55 RS / Dollar?

RBI could have supplied the dollar to bring the rupees from 55 to 50.. but this does not assuret that dollar supply will pick up to ensure that it stay at 50. RBI would then require to continue intervention to maintain the Rs at 50 and which is very difficult to do. Such things are possible to China to do as they have current account surplus whereas India has current account deficit.

Impossible trinity

1. Convertible capital account -> free foreign trade

2. Pegged currency -> Government can maintain target foreign exhange rate
3. Independent monetary policy -> Government can apply monetary policy effective

These three are different to maintain simulataneously.

E.g. 2007 India:

FII money coming in -> supply dollar -> exchange rate going up (but fixed by goverment --- pegging) -> RBI supply dollar  -> inflation up -> interest rate up -> external commerical borrowing (convertible capital account) -> dollar supply up (back to square one)

So, 1, 2, 3 are impossible to maintain simulataneiously... So, after 2007, RBI never tried to peg the currency.. [RBI could have stopped ECB as alternative].

Why lehman brother crisis did not affect India so much? This is due to restriction of RBI on Indian banks to lend money on short-term to foreign investor.. India is not fully capital account convertible.

Professor viewpoint is that India should have target foreign exchange rate (pegged). Then for this, out of other twos something to be compomised. Proferssor views is that it is better to compromise capital account covertible compared to Independent monetary policy.