External Sector

Open Economy

  • Before proceeding to study the external sector, it is very important to understand what Open Economy is. An open economy is one that trades with other nations in goods and services and, most often, also in financial assets.
  • Total foreign trade (exports + imports) as a proportion of GDP is a common measure of the degree of openness of an economy.

Note: When goods move across national border, money must move in the opposite direction.

The Balance of Payments (BoP)

The Balance of Payments (BoP) records the transactions in goods, services and assets between resident of a country with the rest of the world for a specific period of time, typically a year.

There are two main accounts in BoP

  • The Current Account; and
  • The Capital Account

Current Account

The current account records exports and imports in Goods and Services and transfer payments

Exports: Sale of Goods and Services by the domestic country to the rest of the world

Imports: Purchase of goods and services by the domestic country to the rest of the world.

Transfer Payments: Transfer Payments are receipts which the residents of a country receive for free without having to make any present or future payments in return. For example- remittances, gifts and grants etc. They could be official or private.

Trade Balance: The balance of exports and imports of gods is referred to as the trade balance.

Trade Surplus: When exports exceed imports, there is a trade surplus.

Trade Deficit: When imports exceed exports there is a trade deficit.

Trade – in- Services:  Trade-in-Services are denoted as invisible trade, because they are not seen to cross national borders. It includes- factor income, net investment income and net non-factor income.

  • Factor Income: net income from compensation of employees
  • Net Investment Income: it includes the interests, profits, and dividends on our assets abroad minus the income foreigners earn on assets they won in India.
  • Net non-factor Income: net income from shipping, banking, insurance, tourism and software services

Current Account Balance: By adding trade-in-services, net transfers and trade balance, we get Current Account Balance.

  • Current Account Deficit: If the Current Account Balance is a negative number, it is Current Account Deficit.
  • Current Account Surplus: If the Current Account Balance is a positive number, it is current Account Surplus.

Capital Account

The Capital Account records all international purchases and sales as assets such as money, stocks, bonds etc.

  • Credit: Any transactions resulting in a payment to foreigners is entered as debit and is given a negative sign.
  • Debit: Any transactions resulting in a receipt from foreigners is entered as a credit and is given a positive sign.

Balance of Payment Surplus & Deficit

Like an individual who spends more than her income must finance the difference by selling assets or by borrowing – A country that has a deficit in its Current Account (spending more abroad than it receives from sales to the rest of the world) must finance it by selling assets or by borrowing abroad.

Thus, any Current Account Deficit is of necessarily financed by a net Capital inflow. Alternatively, the country could engage in official reserve transactions running down its reserves of foreign exchange, in case of a deficit by selling foreign currency in the foreign exchange market.

  • The decrease in official reserves is called the overall Balance of Payment Deficit. In the same way-
  • The increase in official reserves is called the Balance of Payment Surplus.

From this we may conclude that the monetary authorities are the ultimate financers of any deficit in the BoP or the recipients of any surplus.

Note I: The BoP surplus or deficit is obtained after adding the Current and Capital Account Balances.

Note II: A country is said to be in balance of payment equilibrium when the sum of its Current Account and its non-reserve Capital Account equals to Zero, so that the Current Account Balance is financed entirely by international lending without reserve movements.

Note III: The official reserve transactions are more relevant under a regime of pegged exchange rates than when exchange rates are floating.

The Foreign Exchange Market

A demand for foreign exchange would be supplied in the foreign exchange market- the markets in which national currencies are traded for one another. The major participants in this market are commercial banks, foreign exchange brokers, other authorized dealers and the monetary authorities.

Note: although the participants themselves may have their own trading centers, the market itself is worldwide. There is close and continues contact between the trading centers and the participants deal in more than one market.

Exchange Rate

The price of one currency in terms of other is known as exchange rate. It may be defined in two ways such as:

  • The amount of domestic currency required buying one unit of foreign currency; for example- Exchange Rate of Rs 50 means it costs Rs 50 to buy one unit of foreign currency.
  • The cost in foreign currency of purchasing one unit of domestic currency; for example, it cost 2 cents to buy a rupee

Nominal Exchange Rate

  • The number of units of domestic currency one must give up to get a unit of foreign currency; the price of foreign currency in terms of domestic currency. This is also termed as – Bilateral Nominal Exchange Rate.
  • Bilateral in the sense that they are exchange rates for one currency against another and they are nominal because, they quote the exchange rate in money term. For example- so many rupees per dollar of per pound

Real Exchange Rate

The relative price of foreign goods in terms of domestic goods is termed as Real Exchange Rate.

So, Real Exchange Rate = the ratio of foreign to domestic prices, measures in the same currency. It is defined as:

Real Exchange Rate = cPf (Price abroad in rupee) / P (in rupees)

Here, P = Domestic Price level

Pf = Foreign Price level and

E = the nominal exchange rate

Purchasing Power Parity

If the real exchange rate is equal to one, currencies are at Purchasing Power Parity. This means that goods cost the same in two countries when measures in the same currency.

Example: If a pen costs $4 in the USA, and the nominal exchange rate is Rs 50 per US dollar then with a real exchange rate of 1 it should cost = ePf = 50×4 = Rs 200 in India.

If the Real Exchange Rate rising above 1, -this means that goods abroad have become more expensive than goods at home.

Note: The Real Exchange Rate is often taken as measure of a country’s International Competitiveness.

Since a country interacts with many countries, we may want to see the movement of the domestic currency relative to all other currencies in a single number than by looking at bilateral rates. That is, we would want an index for the exchange rate against other currencies, just as we use a Price Index to show how the Price of goods, in general has changed. This is calculated as the Nominal Effective Exchange Rate.

Nominal Effective Exchange Rate (NEER)

NEER is a multi-lateral rate representing the price of a representative basket of foreign currencies, each weighted by its importance to the domestic country in the international trade. (The average of exports and imports shares is taken as an indicator of this.)

Real Effective Exchange Rate (REER)

The REER is calculated as the weighted average of the Real Exchange Rates of all its trade partners. The weights being shares of the respective countries in its foreign trade. It is interpreted as: the quantity of domestic goods required to purchase one unit of a given basket of foreign goods.

Determination of Exchange Rate

To understand the economic principles that lie behind exchange rate determination, we study the major exchange rate regimes that have characterized the international monetary system. There has been a move from a regime of commitment of fixed-price convertibility to one without commitments where residents enjoy greater freedom to convert domestic currencies into freedom to convert domestic currency into foreign currencies but do not enjoy a price guarantee.

Flexible Exchange Rate

In a system of flexible exchange rates (also known as floating exchange rates), the exchange rate is determined by the forces of market demand and supply. In a completely flexible system, the central banks follow a simple set of rules – they do nothing to directly affect the level of the exchange rate, in other words they do not intervene in the foreign exchange market (and therefore, there are no official reserve transactions).

The link between the balance of payments accounts and the transactions in the foreign exchange market is evident when we recognised that all expenditures by domestic residents on foreign goods, services and assets and all foreign transfer payments (debits in the BoP accounts) also represent demand for foreign exchange. The Indian resident buying a Japanese car pays for it in rupees but the Japanese exporter will expect to be paid in yen. So, rupees must be exchanged for yen in the foreign exchange market. Conversely, all exports by domestic residents reflect equal earnings of foreign exchange. For instance, Indian exporters will expect to be paid in rupees and, to buy our goods, foreigners must sell their currency and buy rupees. Total credits in the BoP accounts are then equal to the supply of foreign exchange. Another reason for the demand for foreign exchange is for speculative purposes

Purchasing Power Parity (PPP) theory and Exchange Rate

The Purchasing Power Parity (PPP) theory is used to make long-run predictions about exchange rates in a flexible exchange rate system. According to the theory, as long as there are no barriers to trade like tariffs (taxes on trade) and quotas (quantitative limits on imports), exchange rates should eventually adjust so that the same product costs the same whether measured in rupees in India, or dollars in the US, yen in Japan and so on, except for differences in transportation. Over the long run, therefore, exchange rates between any two national currencies adjust to reflect differences in the price levels in the two countries.

For Example: If a shirt costs $8 in the US and Rs 400 in India, the rupee-dollar exchange rate should be Rs 50. To see why, at any rate higher than Rs 50, say Rs 60, it costs Rs 480 per shirt in the US but only Rs 400 in India. In that case, all foreign customers would buy shirts from India. Similarly, any exchange rate below Rs 50 per dollar will send all the shirt business to the US. Next, we suppose that prices in India rise by 20 per cent while prices in the US rise by 50 per cent. Indian shirts would now cost Rs 480 per shirt while American shirts cost $12 per shirt. For these two prices to be equivalent, $12 must be worth Rs 480, or one dollar must be worth Rs 40. The dollar, therefore, has depreciated.

Therefore, according to the PPP theory, differences in the domestic inflation and foreign inflation are a major cause of adjustment in exchange rates. If one country has higher inflation than another, its exchange rate should be depreciating.

However, we note that if American prices rise faster than Indian prices and, at the same time, countries erect tariff barriers to keep Indian shirts out (but not American ones), the dollar may not depreciate. Also, there are many goods that are not tradeable and inflation rates for them will not matter. Further, few goods that different countries produce and trade are uniform or identical. Most economists contend that other factors are more important than relative prices for exchange rate determination in the short run. However, in the long run, purchasing power parity plays an important role.

Fixed Exchange Rate

It is also called pegged exchange rate system, in which the exchange rate is pegged at a particular level. Sometimes, a distinction is made between the fixed and pegged exchange rates. It is argued that while the former is fixed, the latter is maintained by the monetary authorities, in that the value at which the exchange rate is pegged (the par value) is a policy variable – it may be changed.

There is a common element between the two systems. Under a fixed exchange rate system, such as the gold standard, adjustment to BoP surpluses or deficits cannot be brought about through changes in the exchange rate. Adjustment must either come about ‘automatically’ through the workings of the economic system (through the mechanism explained by Hume, given below) or be brought about by the government. A pegged exchange rate system may, as long as the exchange rate is not changed, and is not expected to change, display the same characteristics. However, there is another option open to the government – it may change the exchange rate.

A devaluation is said to occur when the exchange rate is increased by social action under a pegged exchange rate system.

The opposite of devaluation is a revaluation. Or, the government may choose to leave the exchange rate unchanged and deal with the BoP problem by the use of monetary and fiscal policy. Most governments change the exchange rate very infrequently. In our analysis, we use the terms fixed and pegged exchange rates interchangeably to denote an exchange rate regime where the exchange rate is set by government decisions and maintained by government actions.

Managed Floating

Without any formal international agreement, the world has moved on to what can be best described as a managed floating exchange rate system. It is a mixture of a flexible exchange rate system (the float part) and a fixed rate system (the managed part). Under this system, also called dirty floating, central banks intervene to buy and sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriate. Official reserve transactions are, therefore, not equal to zero.

History of Exchange Rate Management

The Gold Standard

From around 1870 to the outbreak of the First World War in 1914, the prevailing system was the gold standard which was the epitome of the fixed exchange rate system. All currencies were defined in terms of gold; indeed, some were actually made of gold. Each participant country committed to guarantee the free convertibility of its currency into gold at a fixed price. This meant that residents had, at their disposal, a domestic currency which was freely convertible at a fixed price into another asset (gold) acceptable in international payments. This also made it possible for each currency to be convertible into all others at a fixed price. Exchange rates were determined by its worth in terms of gold (where the currency was made of gold, its actual gold content).

For example, if one unit of say currency A was worth one gram of gold, one unit of currency B was worth two grams of gold, currency B would be worth twice as much as currency A. Economic agents could directly convert one unit of currency B into two units of currency A, without having to first buy gold and then sell it. The rates would fluctuate between an upper and a lower limit, these limits being set by the costs of melting, shipping and recoining between the two Currencies. To maintain the official parity each country needed an adequate stock of gold reserves. All countries on the gold standard had stable exchange rates.

The question arose – would not a country lose all its stock of gold if it imported too much (and had a BoP deficit)? The mercantilistexplanation was that unless the state intervened, through tariffs or quotas or subsidies, on exports, a country would lose its gold and that was considered one of the worst tragedies. David Hume, a noted philosopher writing in 1752, refuted this view and pointed out that if the stock of gold went down, all prices and costs would fall commensurately and no one in the country would be worse off. Also, with cheaper goods at home, imports would fall and exports rise (it is the real exchange rate which will determine competitiveness). The country from which we were importing and making payments in gold would face an increase in prices and costs, so their now expensive exports would fall and their imports of the first country’s now cheap goods would go up. The result of this price specie-flow (precious metals were referred to as ‘specie’ in the eighteenth century) mechanism is normally to improve the BoP of the country losing gold, and worsen that of the country with the favorable trade balance, until equilibrium in international trade is re-established at relative prices that keep imports and exports in balance with no further net gold flow. The equilibrium is stable and self-correcting, requiring no tariffs and state action. Thus, fixed exchange rates were maintained by an automatic equilibrating mechanism.

Several crises caused the gold standard to break down periodically. Moreover, world price levels were at the mercy of gold discoveries. This can be explained by looking at the crude Quantity Theory of Money, M = kPY, according to which, if output (GNP) increased at the rate of 4 per cent per year, the gold supply would have to increase by 4 per cent per year to keep prices stable. With mines not producing this much gold, price levels were falling all over the world in the late nineteenth century, giving rise to social unrest. For a period, silver supplemented gold introducing ‘bimetallism’. Also, fractional reserve banking helped to economies on gold. Paper currency was not entirely backed by gold; typically, countries held one-fourth gold against its paper currency.

Another way of economizing on gold was the gold exchange standard which was adopted by many countries which kept their money exchangeable at fixed prices with respect to gold but held little or no gold. Instead of gold, they held the currency of some large country (the United States or the United Kingdom) which was on the gold standard. All these and the discovery of gold in Klondike and South Africa helped keep deflation at bay till 1929. Some economic historians attribute the Great Depression to this shortage of liquidity. During 1914-45, there was no maintained universal system but this period saw both a brief return to the gold standard and a period of flexible exchange rates.

The Bretton Woods System

The Bretton Woods Conference held in 1944 set up the International Monetary Fund (IMF) and the World Bank and reestablished a system of fixed exchange rates. This was different from the international gold standard in the choice of the asset in which national currencies would be convertible. A two-tier system of convertibility was established at the centre of which was the dollar. The US monetary authorities guaranteed the convertibility of the dollar into gold at the fixed price of $35 per ounce of gold. The second-tier of the system was the commitment of monetary authority of each IMF member participating in the system to convert their currency into dollars at a fixed price. The latter was called the official exchange rate. For instance, if French francs could be exchanged for dollars at roughly 5 francs per dollar, the dollars could then be exchanged for gold at $35 per ounce, which fixed the value of the franc at 175 francs per ounce of gold (5 francs per dollar times 35 dollars per ounce).

A change in exchange rates was to be permitted only in case of a ‘fundamental disequilibrium’ in a nation’s BoP – which came to mean a chronic deficit in the BoP of sizeable proportions.

Such an elaborate system of convertibility was necessary because the distribution of gold reserves across countries was uneven with the US having almost 70 per cent of the official world gold reserves. Thus, a credible gold convertibility of the other currencies would have required a massive redistribution of the gold stock. Further, it was believed that the existing gold stock would be insufficient to sustain the growing demand for international liquidity. One way to save on gold, then, was a two-tier convertible system, where the key currency would be convertible into gold and the other currencies into the key currency.

In the post-World War II scenario, countries devastated by the war needed enormous resources for reconstruction. Imports went up and their deficits were financed by drawing down their reserves. At that time, the US dollar was the main component in the currency reserves of the rest of the world, and those reserves had been expanding as a consequence of the US running a continued balance of payments deficit (other countries were willing to hold those dollars as a reserve asset because they were committed to maintain convertibility between their currency and the dollar).

The problem was that if the short-run dollar liabilities of the US continued to increase in relation to its holdings of gold, then the belief in the credibility of the US commitment to convert dollars into gold at the fixed price would be eroded. The central banks would thus have an overwhelming incentive to convert the existing dollar holdings into gold, and that would, in turn, force the US to give up its commitment. This was the Triffin Dilemma after Robert Triffin, the main critic of the Bretton Woods system. Triffin suggested that the

IMF should be turned into a ‘deposit bank’ for central banks and a new ‘reserve asset’ be created under the control of the IMF. In 1967, gold was displaced by creating the Special Drawing Rights (SDRs), also known as ‘paper gold’, in the IMF with the intention of increasing the stock of international reserves.

Originally defined in terms of gold, with 35 SDRs being equal to one ounce of gold (the dollar-gold rate of the Bretton Woods system), it has been redefined several times since 1974. At present, it is calculated daily as the weighted sum of the values in dollars of four currencies (euro, dollar, Japanese yen, pound sterling) of the five countries (France, Germany, Japan, the UK and the US). It derives its strength from IMF members being willing to use it as a reserve currency and use it as a means of payment between central banks to exchange for national currencies. The original installments of SDRs were distributed to member countries according to their quota in the Fund (the quota was broadly related to the country’s economic importance as indicated by the value of its international trade).

The breakdown of the Bretton Woods system was preceded by many events, such as the devaluation of the pound in 1967, flight from dollars to gold in 1968 leading to the creation of a two-tiered gold market (with the official rate at $35 per ounce and the private rate market determined), and finally in August 1971, the British demand that US guarantee the gold value of its dollar holdings. This led to the US decision to give up the link between the dollar and gold.

The ‘Smithsonian Agreement’ in 1971, which widened the permissible band of movements of the exchange rates to 2.5 per cent above or below the new ‘central rates’ with the hope of reducing pressure on deficit countries, lasted only 14 months. The developed market economies, led by the United Kingdom and soon followed by Switzerland and then Japan, began to adopt floating exchange rates in the early 1970s. In 1976, revision of IMF Articles allowed countries to choose whether to float their currencies or to peg them (to a single currency, a basket of currencies, or to the SDR). There are no rules governing pegged rates and no de facto supervision of floating exchange rates.

The Current Scenario

Many countries currently have fixed exchange rates. Some countries peg their currency to the dollar. The creation of the European Monetary Union in January, 1999, involved permanently fixing the exchange rates between the currencies of the members of the Union and the introduction of a new common currency, the Euro, under the management of the European Central Bank. From January, 2002, actual notes and coins were introduced. So far, 12 of the 25 members of the European Union have adopted the euro.

Some countries pegged their currency to the French franc; most of these are former French colonies in Africa. Others peg to a basket of currencies, with the weights reflecting the composition of their trade. Often smaller countries also decide to fix their exchange rates relative to an important trading partner.

Argentina, for example, adopted the currency board system in 1991. Under this, the exchange rate between the local currency (the peso) and the dollar was fixed by law. The central bank held enough foreign currency to back all the domestic currency and reserves it had issued. In such an arrangement, the country cannot expand the money supply at will. Also, if there is a domestic banking crisis (when banks need to borrow domestic currency) the central bank can no longer act as a lender of last resort. However, following a crisis, Argentina abandoned the currency board and let its currency float in January 2002.

Another arrangement adopted by Equador in 2000 was dollarisation when it abandoned the domestic currency and adopted the US dollar. All prices are quoted in dollar terms and the local currency is no longer used in transactions. Although uncertainty and risk can be avoided, Equador has given the control over its money supply to the Central Bank of the US – the Federal Reserve – which will now be based on economic conditions in the US.

On the whole, the international system is now characterised by a multiple of regimes. Most exchange rates change slightly on a day-to-day basis, and market forces generally determine the basic trends. Even those advocating greater fixity in exchange rates generally propose certain ranges within which governments should keep rates, rather than literally fix them. Also, there has been a virtual elimination of the role for gold. Instead, there is a free market in gold in which the price of gold is determined by its demand and supply coming mainly from jewelers, industrial users, dentists, speculators and ordinary citizens who view gold as a good store of value.

History of Exchange Rate Management in India

India’s exchange rate policy has evolved in line with international and domestic developments. Post-independence, in view of the prevailing Bretton Woods system, the Indian rupee was pegged to the pound sterling due to its historic links with Britain. A major development was the devaluation of the rupee by 36.5 per cent in June, 1966. 

With the breakdown of the Bretton Woods system, and also the declining share of UK in India’s trade, the rupee was delinked from the pound sterling in September 1975. During the period between 1975 to 1992, the exchange rate of the rupee was officially determined by the Reserve Bank within a nominal band of plus or minus 5 per cent of the weighted basket of currencies of India’s major trading partners. The Reserve Bank intervened on a day-to-day basis which resulted in wide changes in the size of reserves. The exchange rate regime of this period can be described as an adjustable nominal peg with a band.

The beginning of 1990s saw significant rise in oil prices and suspension of remittances from the Gulf region in the wake of the Gulf crisis. This, and other domestic and international developments, led to severe balance of payments problems in India. The drying up of access to commercial banks and short-term credit made financing the current account deficit difficult. India’s foreign currency reserves fell rapidly from US $ 3.1 billion in August to US $ 975 million on July 12, 1991 (we may contrast this with the present; as of January 27, 2006, India’s foreign exchange reserves stand at US $ 139.2 billion). Apart from measures like sending gold abroad, curtailing non-essential imports, approaching the IMF and multilateral and bilateral sources, introducing stabilization and structural reforms, there was a two-step devaluation of 18 –19 per cent of the rupee on July 1 and 3, 1991. In march 1992, the Liberalized Exchange Rate Management System (LERMS) involving dual exchange rates was introduced. Under this system, 40 per cent of exchange earnings had to be surrendered at an official rate determined by the Reserve Bank and 60 per cent was to be converted at the market determined rates. The dual rates were converged into one from March 1, 1993; this was an important step towards current account convertibility, which was finally achieved in August 1994 by accepting Article VIII of the Articles of Agreement of the IMF. The exchange rate of the rupee thus became market determined, with the Reserve Bank ensuring orderly conditions in the foreign exchange market through its sales and purchases.


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