Many interesting comments appeared on my previous blog post, Mythbusting:
Current account deficit edition, and I thought it made sense
to respond to all of them in this post.
Ambarish: I don’t think there has been a sudden rise in rupee
trading outside India. It was always there; we weren’t seeing it. As
Jayanth Varma has emphasised, we used to think the NDF market was in
Singapore. But the BIS data on rupee trading shows significant rupee
trading at many places worldwide, not just in Singapore. Overall, the
picture is roughly one with $20 billion of onshore trading a day and
another $20 billion of offshore trading, giving an overall market size
of $40 billion a day.
One can think of many good reasons for domestic and overseas
economic agents to do INR trading outside India. E.g. foreigners are,
presently, not permitted to trade on the onshore currency futures.
Given that gross flows across the Indian border, on the BOP, are now
at $1.3 trillion a year, it is not surprising that there is a lot of
rupee trading going on. Until big changes to the capital controls take
place, I believe there will be an increasing shift of INR trading away
Neeraj: I agree with you that capital controls can potentially
change the situation significantly. So one can think at two
levels. First, for a given set of capital controls, a central bank can
float as in not trading. That gives you a float, but yes, the price
that comes out of this is distorted because there are capital
controls. As an example, the government can have non-interference in
the domestic market for DRAM chips, but the domestic price can itself
be distorted through quantitative restrictions or customs duties on
DRAM chips. So even though the government is not manipulating the
domestic price by directly trading in the market (as it does with
foodgrain or currency) the observed price is a distorted one. Then
comes the second level where you have full convertibility. Once again,
here the central bank could choose to trade in the market or it could
choose to not trade in the market. Only when there are no capital
controls + no trading by the central bank do you get to the true
floating rate and the market’s price.
Durga: Modulo the issue raised by Neeraj and touched upon above, I
think we’re a fairly flexible rate today. If INR trading globally is
$40 billion, then RBI trading of anything less than $2 billion per day
would have a negligible impact on the price. RBI has to either hit the
market with very big trades (over $2 billion a day, i.e. over $40
billion a month, i.e. Chinese style currency manipulation) or RBI has
to sit back and accept the price. Small trades are pointless, and
actually make you wonder what the strategy there is.
That said, the rupee is still a small currency. India is a GDP of
only $1.25 trillion and there are a lot of restrictions on
cross-border commerce. So there is a long way to go before the INR
becomes a serious international currency. It does not, hence, surprise
me to see that the spreads on the INR are much worse than those seen
for the big international currencies.
However, what I talked about in the blog post — that when a
central bank stops trading on the currency market, the CAD = capital
flows — is not an equilibrium condition. It is an accounting
identity. It requires nothing about market microstructure on the
currency market, or about the capital controls, in order to hold. As
long as RBI trading on the currency market is zero, CAD will be
exactly equal to capital flows.
Finally, Anonymous, you ask: Is there a point where the CAD becomes
so big that it becomes dangerous? We should think in two parts.
First, in a place like the US, there has been a lot of concern that
the imbalance (= the very large CAD) is too big in the sense that
under reasonable assumptions, the US is not going to be able to
service all the capital coming into the country. After all, all the
equity / debt capital that comes into (say) India today inexorably
requires that at future dates, dividends and coupon payments and debt
repayment have to happen in dollars, which will require purchases of
foreign exchange by residents. In order to service the borrowing of
the US today, substantial exports growth will be required, which is
unlikely. Hence, when this borrowing of today is to be repaid in the
future, a huge dollar depreciation will have to take place.
As long as there is an environment of high growth in exports of
goods and services, there is no problem. If, hypothetically, you see a
country with a big CAD but you also have a WEAK pace of exports growth
then you know that at future dates, there will be pressure on the
currency which will give sharp depreciations. Odds are, the financial
system will see that and these fears will translate into a
depreciation right away! Conversely, if you see capital inflows going
into investments which will bolster growth of exports of goods and
services, then you feel comfortable that there is no problem.
I believe that’s a fair description of the present Indian
situation. Over the last 15 years, the gross inflows on the current
account into India (which can be roughly interpreted as the total
revenues from exporting goods and services) grew by 8.1 times, from
$42 billion in 1994-95 to $343 billion in 2009-10. This was an average
annual growth rate of 15%. This is a huge pace of growth, and gives me
confidence that the CAD coming in today will be serviced tomorrow
without large currency depreciation. If, hypothetically, you disagree
with my optimism about future growth in exports of goods and services,
then you would think that this large CAD today increases the odds of
INR depreciation in the future, and you would go short the rupee.
For smaller emerging markets, there is a risk of sudden changes in
international financing conditions, which is rooted in the lack of
information in the hands of foreign investors about the country. Then
a large CAD could mean that if something goes wrong and a lot of
capital leaves the country, then it could yield a large currency
depreciation. I believe this is less and less an issue for the large
emerging markets like India, where problems of asymmetric information
and lack-of-attention in the global community are not a problem.
Join the forum discussion on this post - (1) Posts
In recent months, the current account deficit has risen. The latest data shows:
This has started making many people worried. Is such a `large’ current account deficit a cause for concern?
The right answer
How long should a man’s legs be? Long enough to touch the ground.
The old intuition
Under a fixed exchange rate, where the central bank holds the rate fixed by trading on the market:
- Net capital inflow is an autonomous variable
- All the capital that comes into the country is bought by the central bank (and vice versa), and this has consequences for sterilisation or monetary distortions.
- You can then ask yourself whether the amount of capital coming into the country is “too much” or “too little”.
The new intuition
But all this changes under a floating exchange rate!
As the graph above shows, RBI’s trading on the currency market has been at near-zero values in recent months: we have something that is essentially a floating exchange rate. The rupee is now a fairly big market, and small scale trading by RBI has zero impact on the price: i.e. what we’re seeing is a true market price. Under a floating exchange rate:
- Net capital inflows = Current account deficit, as an accounting identity
- If there is a sudden increase in capital inflows, this yields a rupee appreciation, which tends to increase the current account deficit. Conversely, if there is a sudden capital outflow, this yields a rupee depreciation, which tends to decrease the current account deficit. Through this, there are constant equilibriating forces which bring the two together.
With a floating exchange rate, you curiously look at the current account deficit and wonder that if there is some sudden international crisis (e.g. Lehman’s death) whether there would be a short-run dislocation. For the rest, there is no policy involvement in either the current account deficit or in net capital inflows, both of which are purely market phenomena.
A new angle
In the very short run (e.g. a day), changes in the exchange rate can have little impact upon imports or exports. So if $10 billion suddenly leaves the country in a day, when the rupee depreciates, there can’t be a response from import or exports immediately. The only response that can come about immediately is: from capital flows.
When $10 billion leaves the country, the rupee depreciates, and some investors think that they will score some nice returns by buying short-dated rupee securities. They step in in the breach, thus yielding an equilibrium.
So I will conjecture: A country that has capital controls against short-dated debt flows will have more volatility on the currency market.
Viewing the current account deficit as a capital inflow by Matthew Higgins and Thomas Klitgaard, FRBNY, December 1998.
Previous editions of `Mythbusting’
Mythbusting: Reserves edition, 18 October 2008.
Join the forum discussion on this post - (1) Posts
C. J. Chivers has a story in the New York Times from Uzbekistan which links up to an idea that I have often thought would be a great step forward for India: the interior of every police station in the country should be blanketed with video cameras giving feeds out to the Net. As Robert Kaplan says, underdevelopment is where the police are more dangerous than the criminals. If we think surveillance cameras are important in public places, they are triply important to watch the interiors of police stations. On a related note, see this harrowing story about a journalist in Pakistan. Do we do similarly?
A fascinating fact about insurgencies: while a diverse array of weapons can be in fray, ammunition is quite well standardised. Writing about the guns used by the Taliban, C. J. Chivers points out on the New York Times blog, `for the 24 rifles and machine guns in the locker, produced in multiple nations over many decades, only three types of cartridges are required to feed them‘.
Shobhana Subramanian in the Financial Express on C. B. Bhave. And, Sandeep Singh has a story in the Hindustan Times about Mr. Bhave coming through fine on one attack on him.
Ashok Desai reviews a book in Business World. Also see.
Auditor and Audit Committee Independence in India by Jayati Sarkar and Subrata Sarkar.
Developments on MCX:
- John J. Lothian is a respected observer of the global securities business. He has written a piece about Financial Technologies Group titled You gotta earn it.
- Mobis Philipose in Mint.
- Deepshikha Sikarwar in the Economic Times.
- A story by Deepika D. Thapliyal on NDTV.
An editorial in Business World on the MoF Working Group on Foreign Investment.
Learn R in Bombay.
Gautam Bhardwaj in the Indian Express on using the NPS to solve the problems of EPFO.
Sunil Jain on the difficulties of the data reported by the Indian statistical system.
An editorial in the Business Standard about developments on private container train companies, which reminds me of the conflicts between DoT and private telecom companies in the early 1990s.
Mobis Philipose worries about the apparent turnover numbers that we’re seeing.
An editorial in the Mint on the latest attempt to keep FMC separate from mainstream financial regulation.
Jan Sjunnesson Rao in Education World on the damage that the Right to Education Act is causing.
The Economics of Foodgrain Management in India by Kaushik Basu, DEA Working Paper, September 2010.
A recent paper by Guido Heineck and Bernd Sussmuth finds that the blight of communism runs deep: Using data from the German Socio-Economic Panel, we find that despite twenty years of reunification East Germans are still characterized by a persistent level of social distrust. In comparison to West Germans, they are also less inclined to see others as fair or helpful..
A great interview with Condoleezza Rice on Spiegel Online about the halcyon days of 1989.
The last practical connection with World War I just died away. The legacy of that war, of course, remains with us; everything that came after was attenuated.
David Sanger in the New York Times; Jaswant Singh and Jeffrey N. Wasserstrom on Project Syndicate, on Engaging China. Also see these threats being made against Norway.
Mick Meenan in the New York Times about kabbadi going places.
A great story about the innovative logistics of the Italian army in Ethiopia in 1938.
Greg Mankiw on the high marginal tax rates which are hobbling labour supply in many countries.
China’s Charter 08 is a brilliant and well-crafted document, worthy of a Nobel Peace Prize.
Norman MacLean wrote a great article in Lapham’s Quarterly about his 1928 experiences with violinist, watercolorist, chess player, and physicist: Albert Michelson. They don’t make men like that these days.
Randall Stross in the New York Times on the making of Steve Jobs.
Brad DeLong on Who can replace Larry Summers?.
A great article by Michael Heilemann on binarybonsai: George Lucas Stole Chewbacca, But It’s Okay, which made me think about how copyright, patents and `intellectual property’ fit uneasily into the creative process. As he says: Chewbacca didn’t spring to life out of nowhere, fully formed when Lucas saw his dog in the passenger seat of his car. That’s the soundbite. A single step. The reality is complex and human. From vague names floating around, the kernel of an idea, changing purposes and roles of characters, major restructuring, the design hopping from person to person, scrapping the existing concept and going down a different path, seeing existing things in a different light and having to conform a range of ideas to complement and enrich one another.. Everything is a remix.
At the frontiers of computing is `cloud computing’, where users rent equipment, e.g. by the hour. Amazon’s tariff card for such rental is bad news for developers who built knowledge on Microsoft technologies.
John Taylor has a story about Japanese currency manipulation. Recent research shows that the role of the Yen in global currency arrangements has been waning, and this episode of currency trading by the BoJ will exacerbate this trend.
WordPress database error: [Table './amateure_sswp01/comments' is marked as crashed and should be repaired]
SELECT DISTINCT ID, post_title, post_password, comment_ID, comment_post_ID, comment_author, comment_author_url, comment_content, comment_date_gmt, comment_approved, comment_type, SUBSTRING(comment_content,1,60) AS com_excerpt FROM comments
LEFT OUTER JOIN posts ON (comments.comment_post_ID = posts.ID)
WHERE comment_approved = '1' AND comment_type = '' AND post_password = ''
ORDER BY comment_date_gmt DESC