international finance - university of calicut

INTERNATIONAL FINANCE

(ECO4 C12)

IV SEMESTER

MA ECONOMICS

2019 Admission onwards

UNIVERSITY OF CALICUT School of Distance Education

Calicut University- P.O,

Malappuram - 673635, Kerala.

190313

School of Distance Education

International Finance 2

UNIVERSITY OF CALICUT


Study Material

IV SEMESTER

MA ECONOMICS

CORE COURSE: ECO4 C12

INTERNATIONAL FINANCE

Prepared by:

Dr. SHIMA K.M, Assistant Professor of Economics,

SDE, University of Calicut,

Scrutinized by:

Dr. RASEENA K.K,

Asst. Professor of Economics,

Sri. C. Achutha Menon Govt. College,

Thrissur.

DISCLAIMER “The author shall be solely responsible for the

content and views expressed in this book”



ECO4 C12 - INTERNATIONAL FINANCE

(Credit 3)

Module I: Balance of Payments

Balance of payments- Components- Equilibrium and

disequilibrium in BOP- Methods of correcting BOP deficit-

Adjustment Mechanisms-Automatic, price and income

adjustments- Elasticity approach- Marshall-Lerner

condition- Absorption Approach-Monetary approach- J

curve effect- Currency convertibility- Current and capital

account convertibility-The Indian experience-FEMA.

Module II: Exchange Rate and Theories of Exchange

Rate

Exchange rate-Nominal, Real, Effective, NEER, REER-

Exchange rate systems- Relative merits and demerits of

fixed and flexible exchange rates- Hybrid exchange rates-

Purchasing power parity theory-Monetary approach- Asset

market (portfolio balance) model- Exchange rate

overshooting - Exchange rate in India- Indian Rupee and its

fluctuations in international currency market.

Module III: Foreign Exchange Market

Foreign exchange market-Functions-Participants- Stability

of foreign exchange markets-Spot and forward market-

Currency futures and options- Swap market- Foreign

exchange risk- Hedging- Speculation- Stabilizing and de-

stabilizing- Currency arbitrage- Internal and external



balance-( Salvatore) Policy adjustments- Expenditure

changing and expenditure switching policies- Assignment

problem- Swan diagram- Mundell-Fleming model.

Module IV International Capital Flows

Portfolio investment and direct investments- Motives for

capital flows- Effects of international capital flows-

Multinational corporations- Advantages and disadvantages

of MNCs- Foreign investment in India since 1991.

Module V International Monetary System

International monetary system-The gold standard and its

breakdown-Bretton Woods system and its breakdown-

Present international monetary system- European monetary

union-Euro-Optimum currency areas- Currency boards-

Dollarization- Brexit.



ModuleI

Balance of Payments

1.1. Balance of Payments

The balance of payments (BOP), also known as balance of

international payments, summarizes all transactions that a

country’s individuals, companies, and government bodies

complete with individuals, companies, and government

bodies outside the country. These transactions consist of

imports and exports of goods, services, and capital, as well

as transfer payments, such as foreign aid and remittances. It

represents a summation of country’s current demand and

supply of the claims on foreign currencies and of foreign

claims on its currency. It also indicates whether the country

has a surplus or a deficit on trade. When exports exceed

imports, there is a trade surplus and when imports exceed

exports there is a trade deficit.

A country’s balance of payments and its net international

investment position together constitute its international

accounts. The sum of all transactions recorded in the

balance of payments must be zero, as long as the capital

account is defined broadly. The reason is that every credit

appearing in the current account has a corresponding debit

in the capital account, and vice-versa. If a country exports

an item (a current account transaction), it effectively

imports foreign capital when that item is paid for (a capital

account transaction).



Purposes of Calculation of Balance of Payments

Reveals the financial and economic status of a

country.

Can be used as an indicator to determine whether the

country’s currency value is appreciating or depreciating.

Helps the Government to decide on fiscal and trade

policies.

Provides important information to analyze and

understand the economic dealings of a country with other

countries

1.1.1. Components of Balance of Payments

The main components of balance of payments can be

discussed under following heads:

a) Current Account

Current account refers to an account which records all the

transactions relating to export and import of goods and

services and unilateral transfers during a given period of

time. Current account contains the receipts and payments

relating to all the transactions of visible items, invisible

items and unilateral transfers. The main components of

Current Account are:

i) Export and Import of Goods (Merchandise

Transactions or Visible Trade): A major part of transactions

in foreign trade is in the form of export and import of

goods (visible items). Payment for import of goods is

written on the negative side (debit items) and receipt from

exports is shown on the positive side (credit items). Balance



of these visible exports and imports is known as balance of

trade (or trade balance).

ii) Export and Import of Services (Invisible Trade): It

includes a large variety of non- factor services (known as

invisible items) sold and purchased by the residents of a

country, to and from the rest of the world. Payments are

either received or made to the other countries for use of

these services. The services are generally of three kinds: a)

shipping b) Banking c) Insurance

iii) Unilateral or Unrequited Transfers to and from

abroad (One sided Transactions): Unilateral transfers

include gifts, donations, personal remittances and other

‘one-way’ transactions. These refer to those receipts and

payments, which take place without any service in return.

Receipt of unilateral transfers from rest of the world is

shown on the credit side and unilateral transfers to rest of the

world on the debit side.

iv) Income receipts and payments to and from abroad:

The Income receipts and payments to and from abroad

include investment income in the form of interest, rent and

profits.

b) Capital Account

Capital account of BOP records all those transactions,

between the residents of a country and the rest of the world,

which cause a change in the assets or liabilities of the

residents of the country or its government. It is related to

claims and liabilities of financial nature. The main

components of capital accounts are as follows:

i. Borrowing and lending to and from abroad: It



includes all transactions relating to borrowings from abroad

by private sector, government, etc. the receipts of such loans

and repayment of loans by foreigners are recorded on the

positive (credit) side. On the other hand the transactions of

lending to abroad by private sector and government. These

lending abroad and repayment of loans to abroad is recorded

as negative or debit item.

ii. Investments to and from abroad: It includes the

investments by rest of the world in shares of Indian

companies, real estate in India, etc. Such investments from

abroad are recorded on the positive (credit) side as they bring

in foreign exchange. On the other hand investments made by

Indian residents in shares of foreign companies, real estate

abroad, etc. are recorded on the negative (debit) side as they

lead to outflow of foreign exchange.

iii. Change in Foreign Exchange Reserves: The

foreign exchange reserves are the financial assets of the

government held in the central bank. A change in reserves

serves as the financing item in India’s BOP. So, any

withdrawal from the reserves is recorded on the positive

(credit) side and any addition to these reserves is

recorded on the negative (debit) side. It must be noted that

‘change in reserves’ is recorded in the BOP account and not

‘reserves’.

1.1.2. Components of Balance of Payments in

case of India

A. CURRENT ACCOUNT

1. Export, 2. Imports, 3. Trade Balance, 4. Invisibles

(net) a) Service , b) Income, c) Transfers 5. Goods and

Service Balance, 6. Current account balance



B. CAPITAL ACCOUNT

1. External Assistance (net), 2. External Commercial

Borrowings, 3. Short term Debt, 4. Banking Capital, 5.

Foreign Investment a) FDI (net) b) Portfolio (net), 6.

Other Flows (net).

C. CAPITAL ACCOUNT BALANCE :Errors and

Omissions

D. OVERALL BALANCE

E. RESERVE

1.2. Relative Importance of Current account

and Capital Account

Current Account records all the actual transactions of

goods and services which affect the income, output and

employment of a country. So, it shows the net income

generated in the foreign sector. In the current account,

receipts from export of goods, services and unilateral

receipts are entered as credit or positive items and payments

for import of goods, services and unilateral payments are

entered as debit or negative items. The net value of credit

and debit balances is the balance on current account. The

surplus in current account arises when credit items are more

than debit items. It indicates net inflow of foreign exchange.

On the other hand deficit in current account arises when

debit items are more than credit items. It indicates net

outflow of foreign exchange.

In case of capital account, the transactions, which lead

to inflow of foreign exchange like receipt of loan from

abroad, sale of assets or shares in foreign countries are

recorded on the credit or positive side of capital account.



Similarly, transactions, which lead to outflow of foreign

exchange like repayment of loans, purchase of assets or

shares in foreign countries, are recorded on the debit or

negative side. The net value of credit and debit balances is

the balance on capital account. The surplus in capital

account arises when credit items are more than debit items.

It indicates net inflow of capital. On the other hand, the

deficit in capital account arises when debit items are more

than credit items. It indicates net outflow of capital, further

current account and capital account, there is one more

element in BOP, known as ‘Errors and Omissions’. It is the

balancing item, which reflects the inability to record all

international transactions accurately.

1.2.1.Current Account Deficit

The current account records exports and imports in

goods and services and transfer payments. It represents a

country’s transactions with the rest of the world and, like the

capital account, is a component of a country’s Balance of

Payments (BOP). There is a deficit in Current Account if the

value of the goods and services imported exceeds the value

of those exported.

Major components are: Goods, Services, and Net

earnings on overseas investments (such as interests and

dividend) and net transfer of payments over a period of time,

such as remittances. It is measured as a percentage of Gross

Domestic Product (GDP). The formulae for calculating

Current Account Balance is:

Current Account Balance = Trade gap + Net current

transfers + Net income abroad. Trade gap = Exports –

Imports



A country with rising CAD shows that it has become

uncompetitive, and investors may not be willing to invest

there. In India, the Current Account Deficit could be

reduced by boosting exports and curbing non-essential

imports such as gold, mobiles, and electronics. Current

Account Deficit and Fiscal Deficit (also known as "budget

deficit" is a situation when a nation's expenditure exceeds its

revenues) are together known as twin deficits and both often

reinforce each other, i.e., a high fiscal deficit leads to higher

CAD and vice versa.

According to the data released by the Reserve Bank of

India (RBI), the Current Account Deficit (CAD) of the

country came down to 2% of GDP in the first quarter of the

April 2019- June 2019 from 2.3% of GDP, reported during

the same period in the previous year (2018). According to

the RBI, the CAD declined on a year-on-year basis, because

of a number of factors such as:

a) Invisible Account: Higher invisible receipts at

$31.9 billion as compared with $29.9 billion a year ago. For

e.g., rise in net earnings from travel, financial services, and

telecommunications, computer and information services.

b)Trade Visible: Trade deficit has been lower recently,

due to lower crude oil prices and also due to the declining

demand. C) Rising Private transfers (Remittances).

1.2.2. Capital Account Deficit

A capital account deficit is a very infrequent

occurrence. It implies that there is a net outflow of

investment capital, as domestic institutions and individuals

increase their holdings of assets valued in foreign exchange.

China, the world’s largest export, experienced a temporary



capital account deficit of US $71.4 billion in the first quarter

of 2012-13. This is largely because of investors pulling out

short-term funds amid the global economic downturn.

Earlier, China ran massive surpluses on both accounts. This

was possible due to a high level of government intervention.

The influx of foreign funds put pressure on the yuan to

appreciate. To combat this pressure, the People’s Bank of

China bought up most of the foreign currency that entered

the country, leading to a swelling of the nation’s foreign

exchange reserves. This allowed it to maintain a surplus in

its capital account.

1.3.Balance of Payment: India

Strong BoP: The BoP is going to be strong on the back

of significant improvement in exports and a fall in

imports. The exports in July 2020 is at about 91%

export level of July 2019 figures. Imports are still at

about 70-71% level as of July 2019.

Trade Surplus in June 2020: India’s trade has turned

surplus for the first time in 18 years as imports dropped

by 47.59% in June 2020 as compared to June 2019. The

country posted a trade surplus of USD 0.79 billion in

June 2020.

Domestic Manufacturing Being Boosted: The

government is taking steps to support and promote

domestic manufacturing and industry. It has increased

curbs on imports of products and parts, especially from

China, as part of its ‘Atmanirbhar' Initiative. The

government also reviewed all Free-Trade Agreements

(FTA) done between 2009 and 2011 and found most of



them to be asymmetrical. FTAs done earlier have

permitted foreign goods to come easily into the country.

But Indian goods have not been allowed reciprocal

entry. E.g. European countries have opposed technical

standards imposed by India on import of tyres, even as

they have restricted export of tyres from India.

Change in Mode of Manufacturing: The government has

also asked firms investing in the country to stop having

an “assembly workshop” approach that has typically

characterised Indian manufacturing.

Preliminary data released by the government showed

that India's trade deficit in goods widened to USD 14.11

billion in March 2021 from USD 9.98 billion during

March 2020. Merchandise Exports: India’s merchandise

exports in March 2021 were USD 34.0 billion as

compared to USD

21.49 billion in March 2020, an increase of 58.23%. For

the first time ever in a month, Indian exports crossed

USD 34 billion in March 2021. Merchandise Imports:

India’s merchandise imports were USD 48.12 billion as

compared to USD 31.47 billion in March 2020, an

increase of 52.89%. India is thus a net importer in March

2021, with a trade deficit of USD 14.11 billion. Reasons

for Increased Imports: Relaxation in lockdown policy

and start of economic activities are the main reasons for

increase in demand for the goods and the import. Also

the rise in global trade has made the global supply chain

active and the commerce is taking place. Oil import has

increased due to opening up of the transportation

sector.



1.4.Equilibrium and Disequilibrium of Balance of

Payments

It has already been stated about that the balance of

payments must always balance. It will be balanced only

when the total of credit items will exactly be equal to the

total of debit items which really happens. As such, there

must be either a deficit or a surplus in the current account.

The deficit or surplus so created is met by transferring to

capital account.

Equilibrium is that state of the balance of payment over the

relevant time period which makes it possible to sustain an

open economy without severe unemployment on a

continuing basis. Whether the Balance of Payments is in

equilibrium or not, it can be justified with this help of the

three following test:

(i) Decrease in Foreign Exchange: If gold continuously

flows from the country, it may be assumed that the balance

of payments is in disequilibrium. At present the decrease in

foreign exchange reserves of our country indicate such a

situation.

(ii) Increase in Foreign Debts and Loans: If the amount of

foreign debts and loans increase, that indicates the balance

of payment of the country is in disequilibrium i.e., exports

are less than imports,

(iii) Decrease in Foreign Exchange Rates: If the foreign

exchange rates of a country decrease, it may be said that the

country is suffering from the disequilibrium in the balance

of payments position.



1.4.1. Causes of Disequilibrium of Balance of Payments

Disequilibrium in the balance of payments is a result of

many factors, e.g. the prices of goods and services, national

incomes at home or abroad, the rate of interest, the supply

of money, the state of technology, tastes, the distribution of

incomes etc. Now, if any of the above factors change

without a corresponding change in other factors there must

be a case of disequilibrium in the balance of payment

position. We know that the exports and imports of a country

are influenced by a number of factors. It is hardly possible

that equilibrium in balance of trade of a country is possible

at fixed exchange rate over a long period of time. The

balance of payments is quite disturbed by the factors which

affect and change imports and exports continuously. The

reasons for the cause of disequilibrium in the balance of

payments are noted below:

(a) Domestic Inflation: The greater bulk of balance of

payments difficulties are the result of domestic inflation and

the same can be corrected by disinflation i.e., eliminating

the inflationary gap and reducing demand to the level of

full employment. It is possible by increasing exports and

reducing imports. Similarly halting of inflation and

correction of exchange rate may also help in this regard.

(b) Technological Changes: It is quite known that every

change in technology brings some comparative advantages

which the other country tries to adjust, but the adjustment

process itself brings a deficit in balance of payments. Thus,

the innovation, whatever form it is, invites disequilibrium.

So, a new equilibrium requires either to reduce exports or to

increase imports.



(c) Short Supply: Disequilibrium of balance of payment

arises due to a fall in supply. For example, due to industrial

strike the sugar production of India fall which affect the

supply and as a result there is a corresponding shortfall in

exports and consequently increases the amount of imports which is the result of disequilibrium.

(d) Fall in Demand or Structural Disequilibrium:

Disequilibrium also arises out of a fall in demand of the

export product. For example, if the demand of the Indian

jute product decreases in the world due to a change in taste

or what so ever, the resources which are engaged in jute

production must be shifted to other lines of activity. In such

a situation, we are to restrict our imports and our resources

must be diverted into another export line product. If the

same is not possible, there must be a structural

disequilibrium in balance of payment position.

(e) The deficit in current account due to the loss of

service incomes creates disequilibrium position which may

arise through the bankruptcy of direct investment abroad or

nationalization etc.

1.4.2. Methods of Correcting Disequilibrium in Balance

of Payments

In order to maintain a country’s sound economic condition,

its disequilibrium in balance of payment position (if any)

must be corrected. Naturally, the reasons for creating such a

situation must be removed. Otherwise if the situation

continues for a long, the country will exhaust its foreign

exchange reserves. If such a situation arises the country

concerned will have to depreciate its currency below par.

We describe here, certain measures to correct or improve

the adverse balance of payments position.



(a) Stimulating exports or to check imports: If there

is a declining trend in exports, various steps must be taken

to improve it. In other words, the total cost of the product

must be brought down to encourage export which may

require cutting down of wages and rate of interest etc.

Exports may be also encouraged by granting bounties to

exporters and to manufacturers also. Similarly, imports

must be discouraged by:

(i) Imposing import duty,

(ii) Prohibiting the product totally or

(iii) Adopting quota system,

(iv) Manufacturing the equivalent product within the

country etc.

(b) Depreciate the External Exchange value: by

depreciate the external (exchange) value of the home

currency brings domestic goods cheaper to the foreigner. It

must be remembered in this respect that the rate of exchange

serves as an equilibrating factor between the balance of

payments positions.

(c) To deflate the Currency: If our currency contracts,

no doubt, prices will fall which will check imports and

stimulate exports, although the method of deflation is not

even free from snags. Because, if the prices of the product are

forced to come down while the cost of the same is rigid, these two

do not follow suit. As a result, the country concerned may have to face a serious depression as well as unemployment.

(d) Exchange Control: Under exchange control, all the

exporters are directed to surrender their foreign exchange to



the central bank or to sell it at the official rate to the

government. Then it is rationed out among the licensed

importers i.e., the government will allocate the scarce

foreign exchange among the importers on the basis of some

non-price criteria. No importer is allowed to import goods

without a license. In this way, the balance of payment is to

some extent rectified by reducing the imports.

(e) Devaluation:

The effect of devaluation is almost same like depreciation.

In other words, when a currency is devalued its values are

decreased in terms of foreign currency. It means, the

foreigners can buy more goods than before with the same

amount of currency which no doubt, stimulates exports and

check imports.

Since the imports are discouraged and exports are

encouraged, a time will come when the adverse balance of

payment will be corrected and will turn in our favour. From

the decision made so far, we can draw a conclusion about

the correction of adverse balance of payment position on the

basis of the judicious combination of the following:

(i) Adjustment of exchange rate (i.e.

appreciation/depreciation of the home currency).

(ii) Movement of Capital (i.e., lending/borrowing abroad).

(iii) Fiscal and Monetary changes that affect prices and

incomes.

(iv) Trade restrictions (quotas/tariffs).

Thus, in order to correct the adverse balance of payments no



single method is found suitable. We should try to implement

all the methods stated above although the application of the

factor depends on the nature and type of disequilibrium in

balance of payments, (e.g., exchange rate will play a

significant role in structural disequilibrium).

1.5. Balance of Payments adjustments: Absorption and

Monetary Approaches

1.5.1. Absorption Approaches in adjustment of Balance

of Payments

Sidney S. Alexander pioneered the development of the

absorption to BOP adjustment in his article, “The effects of

Devaluation on the Trade Balance” which appeared in

I.M.F. Staff paper, in the year 1952. The absorption

approach lies in seeing the BOP, not as a relation between

the country’s debits and credits on international account, but

rather as an element in the relation between the aggregate

receipts and expenditures of the economy. The theory

states that if a country has a deficit in its balance of

payments, it means that people are ‘absorbing’ more than

they produce. It implies that domestic expenditure on

consumption and investment is greater than national income.

On the other hand if they have a surplus in the balance of

payments, they are absorbing less. Expenditure on

consumption and investment is less than national income.

The absorption approach stresses the supply side and

implicitly assumes an adequate demand for the nation’s

exports and import substitutes. Here the BOP is defined as

the difference between national income and domestic

expenditure. The analysis can be explained in the following

form



Y = C + Id + G + X-M -------- (1)

Where Y is national income, C is consumption expenditure,

Id total domestic investment, G is autonomous government

expenditure, X represents exports and M imports.

The sum of (C + Id + G) is the total absorption designated

as A, and the balance of payments (X

– M) is designated as B. Thus Equation (1) becomes

Y = A + B Or B = Y – A ------ (2)

It implies that BOP on current account is the difference

between national income (Y) and total absorption (A). BOP

can be improved by either increasing domestic income or

reducing the absorption. For this purpose, Alexander

advocates devaluation because it acts both ways. First,

devaluation increases exports and reduces imports, thereby

increasing the national income. The additional income so

generated will further increase income via the multiplier

effect. This will lead to an increase in domestic

consumption. Thus the net effect of the increase in national

income on the balance of payments is the difference

between the total increase in income and the induced

increase in absorption, i.e.,

∆B = ∆Y – ∆A ---------------- (3)

Total absorption (∆A) depends on the marginal propensity

to absorb when there is devaluation. This is expressed as ‘a’.

Devaluation also directly affects absorption through the

change in income which we write as D. Thus

∆A = a∆Y + ∆D ----------------- (4)



Substituting equation (4) in (3), we get

∆B = ∆Y – a∆Y – ∆D or ∆B = (1 -a) ∆Y-∆D -------------- (5)

The equation points toward three factors which explain the

effects of devaluation on BOP. They are: (i) the marginal

propensity to absorb ‘a’, (ii) change in income (∆Y), and

change in direct absorption (∆D). It may be noted that since

‘a’ is the marginal propensity (MP) to absorb, (1 – a) is the

propensity to hoard or save. These factors, in turn, are

influenced by the existence of unemployed or idle resources

and fully employed resources in the devaluing country.

A depreciation or a devaluation of the deficit nation’s

currency automatically reduces domestic absorption if it

redistributes income from wages to profits (since profits

earners usually have a higher marginal propensity to save

than wage earners). In addition, the increase in domestic

prices resulting from the depreciation reduces the value of

the real cash balances that the public wants to hold. To

restore the value of real cash balances, the public must

reduce consumption expenditures. Finally, rising domestic

prices push people into higher tax brackets and also reduce

consumption. Since we cannot be certain as to the speed and

size of these automatic effects, contractionary fiscal and

monetary policies may have to be used to cut domestic

absorption adequately.

1.5.2.Monetary Approach in the Adjustment of Balance

of Payment

The monetary approach to the balance of payments is

associated with the names of R. Mundell and H. Johnson.

The other writers who have made contribution to it include

R. Dornbusch, M. Mussa, D. Kemp and J. Frankel. The



basic premise of the approach is the recognition that the

BOP disequilibrium is fundamentally a monetary

phenomenon. It attempts to explain the BOP deficits or

surpluses through demand for and supply of money.

Assumptions of Monetary Approach: This approach rests

upon the following main assumptions:

(i) There is the existence of a single price for identical

products in different countries, after allowing the

transport costs.

(ii) The level of output in a given country is exogenously

determined.

(iii) There is full employment of resources in all the

countries.

(iv) There is no possibility of sterilization of currency

flows under a system of fixed exchange rates on

account of single price assumption.

(v) The demand for money is a direct function of income

and an inverse function of the rate of interest.

(vi) The supply of money is determined by the high

powered money and money multiplier.

(vii) The demand for nominal money balances is stable.

The monetary approach, given the above assumptions,

holds that the excess of money supply over money demand

reflects the balance of payments deficit. The excessive

money holdings are utilised by the people in the purchase of

foreign goods and securities. The excess supply of money

may be offset by the central bank under a system of fixed



exchange rates through the sale of foreign exchange reserves

and the purchase of domestic currency. As the excess supply

conditions in the money market are removed, the balance of

payments equilibrium gets restored. On the opposite, if the

supply of money falls short of the demand for money, the

country will have a balance of payments surplus. In such a

situation, people try to acquire the domestic- currency

through the sale of goods and securities to the foreigners.

For meeting the shortage of domestic currency, the central

bank will buy excess foreign currency in addition to the

purchase of domestic securities. Such measures will remove

the BOP surplus and restore the BOP equilibrium.

The monetary approach to BOP can be expressed through

the following relations: The supply of money (Ms) consists

of domestic component of the nation’s monetary base (H)

and international or foreign component of the nation’s

monetary base (F).

Ms = H + F

The demand for money (MD) is a stable and direct function

of income and inverse function of the rate of interest. The

monetary equilibrium is determined by the equality between

the demand for money and the supply of money.

MS = MD H + F = MD F = MD -H

From this relation, it follows that the excess of money

demand over the domestic monetary base is offset by an

inflow of reserves from abroad or international monetary

base in the event of a BOP surplus. On the opposite, if there

is a BOP deficit reflected by the excess of money supply

over money demand, the adjustment can be possible through



an outflow of foreign reserves. The monetary approach also

explains that the BOP disequilibria, under a flexible

exchange system, are corrected immediately through

automatic changes in exchange rate without any

international flow of money or reserves. A deficit in the

BOP resulting from the excess of money supply over money

demand, causes an automatic depreciation in country’s

currency. This leads to a rise in domestic prices and also the

demand for money. As a result, there is an absorption of the

excess supply of money and the BOP deficit gets adjusted.

On the other hand, a surplus in the BOP, caused by the

excess of demand for money over its supply, results

automatically in the appreciation of nation’s currency. It

leads to a fall in domestic prices. As a consequence, the

excess money demand and the BOP surplus get offset. The

monetary approach to the BOP situation has an important

policy implications. It suggests that the policies like

devaluation can have effectiveness in the short period only if

the monetary authority does not increase the supply of

money to match exactly the increase in the demand for

money resulting from devaluation or other adjustment

policies.

The main criticism of monetary approach is as follows:

(i) Stability of Money Demand Functions: This

approach, assumes the demand function of money to

be stable. Such an assumption may be valid in the

long run. But there is a strong opinion among the

economists that money demand function is unstable in

the short period.



(ii) Assumption of Full Employment: In this approach, an

assumption has been taken that there is the existence of

full employment. This assumption does not hold valid

in actual life.

(iii) Invalidity of Single Price: The monetary approach to

BOP adjustment rests upon the assumption of single

price for identical products. Even this assumption is

not true. When the productive factors are diverted to

sectors producing non-traded commodities, the excess

demand for non-traded goods can spill over into the

reduced supply of traded goods. That can cause an

increase in imports. Consequently, the principle of

single price for all traded goods stands violated.

(iv) Neglect of other Influences on Money Demand: In this

approach, the demand function for money is related

only to income and rate of interest. In fact, the money

demand function is related to several other variables

connected with both domestic economy and foreign

trade and exchange.

(v) Possibility of Sterilization of Currency: The critics have

not accepted the validity of the assumption of

impossibility of sterilization of currency under a system

of fixed exchange rates. They have referred to

circumstances in which the sterilization of currency can

become possible. In their opinion, the currency flow can

become sterile, if the private sector is willing to adjust

the composition of its wealth portfolio with regard to the

relative importance of bonds and money balances.

Another situation in which sterilization of currency flow

can be possible occurs if the government is prepared to

have higher budget deficits whenever the country has to



deal with the problem of BOP deficit.

(vi) Market Imperfections: The principle of single price for

identical products is vitiated by the market

imperfections. The price differentials between different

trading countries do exist on account of market

imperfections and various restrictions or regulations

enforced by the governments on the domestic and

international trade.

(vii)Neglect of Monetary Lags: The monetary approach is

conceptually suited to long term balance of payments

adjustment. The prolonged monetary lags between the

recognition of the problem of BOP deficit and ultimate

BOP adjustment have been generally neglected in this

approach.

(viii) Neglect of Other Economic Policies: In this

approach, the emphasis is essentially upon the variation

in credit flows. The BOP equilibrium can be achieved

also through the alternative economic policies of

expenditure switching which can work through domestic

real and money flows as well as the government

budgetary variations.

Despite its weaknesses, the monetary approach is superior to

the traditional price-specie flow theory of D. Hume. That

theory had stressed upon the BOP adjustments through the

gold flows and consequent effects upon prices, international

trade and payments. The modern monetary approach, in

contrast, suggests the correction of BOP deficits or surpluses

through changes in domestic and international monetary

base and their effects upon production, income and

expenditure.



1.6. Automatic, price and income adjustments

Here we integrate the automatic price, income, and

monetary adjustments (i.e., provide a synthesis of automatic

adjustments) for a nation that faces unemployment and a

deficit in its balance of payments at the equilibrium level of

income. The income adjustment mechanism relies on

induced changes in the national income of the deficit and

surplus nations to bring about adjustment in the balance of

payments. To isolate the income adjustment mechanism, we

initially assume that the nation operates under a fixed

exchange rate system and that all prices, wages, and interest

rates are constant. We also begin by assuming that the

nation operates at less than full employment.

Under a freely flexible exchange rate system and a

stable foreign exchange market, the nation’s currency will

depreciate until the deficit is entirely eliminated. Under a

managed float, the nation’s monetary authorities usually do

not allow the full depreciation required to eliminate the

deficit completely. Under a fixed exchange rate system, the

exchange rate can depreciate only within the narrow limits

allowed so that most of the balance-of-payments adjustment

must come from elsewhere. A depreciation (to the extent

that it is allowed) stimulates production and income in the

deficit nation and induces imports to rise, thus reducing part

of the original improvement in the trade balance resulting

from the depreciation.

Under a freely flexible exchange rate system, this

simply means that the depreciation required to eliminate a

balance-of-payments deficit is larger than if these automatic

income changes were not present. Except under a freely

flexible exchange rate system, a balance-of- payments



deficit tends to reduce the nation’s money supply, thus

increasing its interest rates. This, in turn, reduces domestic

investment and income in the deficit nation, which induces

its imports to fall and thereby reduces the deficit. The

increase in interest rates also attracts foreign capital, which

helps the nation finance the deficit. The reduction in income

and in the money supply also causes prices in the deficit

nation to fall relative to prices in the surplus nation, thus

further improving the balance of trade of the deficit nation.

Under a fixed exchange rate system, most of the automatic

adjustment would have to come from the monetary

adjustments unless the nation devalues its currency. On the

other hand, under a freely flexible exchange rate system, the

national economy is to a large extent supposed to be

insulated from balance-of-payments disequilibria, and most

of the adjustment in the balance of payments is supposed to

take place through exchange rate variations. When all of

these automatic price, income, and monetary adjustments

are allowed to operate, the adjustment to balance-of-

payments disequilibria is likely to be more or less complete

even under a fixed exchange rate system. The problem is

that automatic adjustments frequently have serious

disadvantages, which nations often try to avoid by the use of

adjustment policies.

In the real world, income, prices, interest rates,

exchange rates, the current account, and other variables

change as a result of an autonomous disturbance (such as

an increase in expenditures) in one nation, and a

disturbance in one nation affects other nations, with

repercussions back to the first nation. It is very difficult to

trace all of these effects in the real world because of the very

intricate relationships that exist among these variables and

also because, over time, other changes and disturbances



occur, and nations also adopt various policies to achieve

domestic and international objectives. With the advent of

large computers, large-scale models of the economy have

been constructed, and they have been used to estimate

foreign trade multipliers and the net effect on income,

prices, interest rates, exchange rates, current account, and

other variables that would result from an autonomous

change in expenditures in one nation or in the rest of the

world.

1.6.1. Disadvantages of Automatic Adjustments

The disadvantages facing a freely flexible exchange

rate system may be overshooting and erratic fluctuations in

exchange rates. These interfere with the flow of

international trade and impose costly adjustment burdens

that might be entirely unnecessary in the long run. Under a

managed floating exchange rate system, erratic exchange

rate fluctuations can be avoided, but monetary authorities

may manage the exchange rate so as to keep the domestic

currency undervalued to stimulate the domestic economy at

the expense of other nations. Such competitive depreciations

or devaluations (beggar-thy-neighbor policies) proved very

disruptive and damaging to international trade in the period

between the two world wars . On the other hand, the

possibility of a devaluation under a fixed exchange rate

system can lead to destabilizing international capital flows,

which can also prove very disruptive.

A fixed exchange rate system also forces a nation to

rely primarily on monetary adjustments. Automatic income

changes can also have serious disadvantages. For example, a

nation facing an autonomous increase in its imports at the

expense of domestic production would have to allow its



national income to fall in order to reduce its trade deficit.

A nation facing an autonomous increase in its exports

from a position of full employment would have to accept

domestic inflation to eliminate the trade surplus. Similarly,

for the automatic monetary adjustments to operate, the

nation must passively allow its money supply to change as a

result of balance-of-payments disequilibria and thus give up

its use of monetary policy to achieve the more important

objective of domestic full employment without inflation. For

all of these reasons, nations often will use adjustment

policies to correct balance-of-payments disequilibria instead

of relying on automatic mechanisms.

1.7. Mechanism of the Elasticity Approach to the

Balance of Payment Adjustment

1.7.1.Marshall-Lerner condition

The elasticity approach to BOP is associated with

the Marshall-Lerner condition which was worked out

independently by these two economists. It studies the

conditions under which exchange rate changes restore

equilibrium in BOP by devaluing a country’s currency. This

approach is related to the price effect of devaluation.

The Marshall-Lerner condition states that for a

devaluation of domestic currency to improve the balance of

payments, the sum of the price elasticities of demand for

exports and imports must be greater than one.

A fall in the exchange rate will increase the price of

imports in domestic currency which will lead to a decrease

in the quantity demanded. If the demand for imports is price

elastic, which means that the increase in the price will lead



to a larger proportionate decrease in the quantity demanded,

import expenditure will fall which will improve the balance

of trade. If the demand for imports is price inelastic, which

means that the increase in the price will lead to a smaller

proportionate decrease in the quantity demanded, import

expenditure will rise. However, this may not worsen the

balance of trade as export revenue will also rise. A fall in the

exchange rate will decrease the price of exports in foreign

currency which will lead to an increase in the quantity

demanded. As the price of exports in domestic currency will

not be affected by a fall in the exchange rate, an increase in

the quantity demanded will lead to an increase in export

revenue. Therefore, if the sum of the price elasticities of

demand for exports and imports is greater than one, which

means that the Marshall-Lerner condition holds, the increase

in export revenue will be greater than the increase in

import expenditure which will improve the balance of trade

resulting in an improvement in the current account and

hence the balance of payments, assuming export revenue is

equal to import expenditure initially. However, if the sum

of the price elasticities of demand for exports and imports is

less than one, which means that the Marshall-Lerner

condition does not hold, the increase in import expenditure

will be greater than the increase in export revenue which

will worsen the balance of trade resulting in a deterioration

in the current account and hence the balance of payments,

assuming export revenue is equal to import expenditure

initially.

1.7.2. The J-Curve Effect

The effects of devaluation on domestic prices and

demand for exports and imports will take time for

consumers and producers to adjust themselves to the new



situation. The short-run price elasticities of demand for

exports and imports are lower and they do not satisfy the

Marshall- Lerner condition. Therefore, to begin with,

devaluation makes the BOP worse in the short-run and then

improves it in the long-run. This traces a J-shaped curve

through time. This is known as the J-curve effect of

devaluation.

The J-Curve effect refers to a phenomenon wherein the

trade balance of a country worsens following the

depreciation of its currency before it improves. Generally,

any depreciation in the value of a currency is expected to

improve the economy’s overall trade balance by

encouraging exports and discouraging imports. However,

this may not happen immediately due to some other frictions

within the economy. Many importers and exporters in the

country, for instance, may be locked into binding

agreements that could force them to buy or sell a certain

number of goods despite the unfavourable exchange rate of

the currency.

The reason is that when the nation’s net trade balance

is plotted on the vertical axis and time is plotted on the

horizontal axis, the response of the trade balance to a

devaluation or depreciation looks like the curve of a J

(Figure 1.1). The figure assumes that the original trade

balance was zero. Time is taken on the horizontal axis and

deficit-surplus on the vertical axis. Starting from the origin

and a given trade balance, a devaluation or depreciation of

the nation’s currency will first result in a deterioration of the

nation’s trade balance before showing a net improvement

(after time A).



Figure 1.1: J-Curve Effect

1.8. Convertibility of currency

Prior to the First World War the whole world was

having gold standard under which the currency in circulation

was allowed to get converted either in gold or other

currencies based on the gold standard. But after the failure

of Bretton woods system in 1971 this system changed; the

various countries switched over to the floating foreign

exchange rate system. Under the floating or flexible

exchange rate system, exchange rates between different

national currencies are allowed to be determined through

market demand for and supply of the same. Presently

convertibility of money implies a system where a country’s

currency becomes convertible in foreign exchange and vice

versa.



Convertibility is an important factor in international

trade, where instruments valued in different currencies

must been changed. Currency convertibility refers to how

liquid a nation's currency is in terms of exchanging with

other global currencies. A convertible currency one that

can be easily traded on forex markets with little to no

restrictions. A convertible currency (e.g., U.S. dollar,

Euro, Japanese Yen, and the British pound) is seen as a

reliable store of value, meaning an investor will have no

trouble buying and selling the currency. Non-convertible

and blocked currencies (e.g. Cuban Pesos or North

Korean Won) are not easily exchanged for other monies

and are only used for domestic exchange with their

respective borders.

Advantages of Currency Convertibility

• Export promotion: An important advantage of currency

convertibility is that it encourages exports by increasing

their profitability. With convertibility profitability of

exports increases because market foreign exchange rate

is higher than the previous officially fixed exchange

rate. This implies that from given exports, exporters can

get more rupees against foreign exchange (e.g. US

dollars) earned from exports. Currency convertibility

especially encourages those exports which have low

import- intensity.

• Incentive to Import Substitution: Since free or market

determined exchange rate is higher than the previous

officially fixed exchange rate, imports become more

expensive after convertibility of a currency. This

discourages imports and gives boost to import

substitution.



• Incentive to send remittances from abroad: Thirdly,

rupee convertibility provided greater incentives to send

remittances of foreign exchange by Indian workers

living abroad and by NRI. Further, it makes illegal

remittance such ‘hawala money’ and smuggling of gold

less attractive.

• A self – Balancing Ability: Another important merit of

currency convertibility lies in its self-balancing

mechanism. When balance of payments is in deficit due

to overvalued exchange rate, under currency

convertibility, the currency of the country depreciates

which gives boost to exports by lowering their prices on

the one hand and discourages imports by raising their

prices on the other. In this way, deficit in balance of

payments get automatically corrected without

intervention by the Government or its Central bank.

The opposite happens when balance of payments is in

surplus due to the under-valued exchange rate.

• Integration of World Economy: Currency

convertibility gives the chance to any economy to

interact with the rest the world economy. As under

currency convertibility there is easy access to foreign

exchange, it greatly helps the growth of trade and

capital flows between the countries. The expansion in

trade and capital flows between countries will ensure

rapid economic growth in the economies of the world.

In fact, currency convertibility is said to be a

prerequisite for the success of Globalisation.

When looking at currency convertibility, there are three

different categories; fully convertible, partially convertible,

and non-convertible.



1.8.1. Fully Convertible

Currency that is fully or freely convertible can be traded

without any conditions or limits. Generally, fully convertible

currencies come from more stable or wealthy countries. All

major currencies (the US dollar, the euro, the Japanese yen,

pound sterling, and the Swiss franc), are fully convertible

currencies. In addition to the majors, there are a few minor

and exotic currencies that are freely convertible. The

Canadian dollar, Australian dollar, Danish krone, New

Zealand dollar, and Norwegian krone are all minor

currencies that are fully convertible. Examples of fully

convertible exotic currencies are; the Hong Kong dollar,

Indian rupee, and Bahraini dinar.

Merits of full currency convertibility

• The full currency convertibility will give the true

value of any currency against the foreign currencies.

If the market foreign exchange rate is higher than the

previous officially fixed exchange rate, the

profitability of domestic exports would increase.

• Higher market determined exchange rate would also

promote import substitution as imports would become

more expensive which would ultimately encourage

the domestic industries.

• Higher market determined exchange rate would

provide more incentives to the workers living abroad

and NRI to send remittances of foreign exchange. It

would make illegal remittances such as Hawala

money etc unattractive and the remittances would

take place through proper channel.



• Full currency convertibility provides a self balancing

mechanism. If a country is facing balance of payment

(BoP) deficit due to the overvalued exchange rate, full

currency convertibility would depreciate the exchange

rate which would ultimately boost exports and

discourage imports. This will allow the BoP to get

automatically corrected without the intervention of the

central bank. The opposite would happen in the case of

surplus BoP due to the undervalued exchange rate.

• It would lead to greater integration of the domestic

economy with the global economy. It would also allow

Indians to invest globally, and hold an internationally

diversified investment portfolio.

Demerits of full convertibility of rupee

• It leads to the appreciation of domestic currency which

can cause a reduction in the exports overseas.

Appreciation of rupee would also increase imports

which can have negative impacts on the balance of

payment deficit.

• It may also lead to the depreciation of domestic

currency which would ultimately increase the prices of

imports. Imports like oil etc cannot be substituted for

domestic production which could ultimately intensify

the inflationary pressures.

• It would lead to the exchange rate of domestic currency

being based on the market forces of demand and

supply. This can strengthen the speculative tendencies

in the market which could lead to instability in the

financial system.



1.8.2. Partially Convertible

A partially convertible currency is a currency that can be

traded only with restrictions and controls imposed by the

government that issues it. In general, partially convertible

currencies come from countries with less stable economies.

An increase in the price of foreign imports or a capital

flight on currency reserves could easily destabilize an

already fragile economy. Therefore, limits are imposed –

thus making a currency partially convertible. All partially

convertible currencies are exotic currencies. Some

examples include; the Chinese yuan, South African rand,

and Malaysian ringgit.

Rules to exchanging partially convertible currencies vary –

some countries impose restrictions on where you can take

the money (for example, Indonesian rupiahs must stay on-

shore), others can only be converted in-country (like

Philippine pesos). In many cases, documented proof is

required either to show foreign currency buying is for a

legitimate reason or have foreign exchange transactions

registered with the central bank. Other common restrictions

are limits on how much foreign currency you can have and

how much domestic currency you can take out of the

country.

1.8.3. Non-Convertible

Non-convertible currencies or “blocked currencies” are, as

the name suggests, not at all traded on the foreign exchange

market. Currency is blocked by the issuing government,

usually to protect the country’s extremely fragile economy.

The only way to exchange non-convertible currency is on

the black market, making business in countries with non-



convertible currency both risky and difficult. Often, non-

convertible currencies are exotic. An example of a blocked

currency is the Venezuelan bolívar.

1.9.Current Account and Capital Account Convertibility

1.9.1. Current Account Convertibility

Current account convertibility refers to the freedom in

payments and transfers in the current account international

transactions. Article VIII, section 2, section 3 and section 4

of the International Monetary Fund (IMF) puts an

obligation on the member countries for restoring the current

account convertibility of their currencies. It puts obligation

for removing the restrictions on current payments, avoiding

any kind of discriminatory currency practices such as

multiple exchange rates etc. However, capital account

restrictions are allowed.

Current account convertibility is the next phase for

attaining full convertibility of any currency. Current

account convertibility relates to the removal of restrictions

on payments relating to the international exchange of goals,

services and factor incomes, while capital account

convertibility refers to a similar liberalization of a country’s

capital transactions such as loans and investment, both

short term and long term. Current account convertibility

has been defined as the freedom to buy or sell foreign

exchange for the following international transactions:

2. All payments due in connection with foreign trade,

other current business, including services and normal

short term banking and credit facilities;

3. Payments due as interest on loans and as net income



from other investments;

4. Payments of moderate amount of amortization of

loans or for depreciation of direct investment; and

5. Moderate remittances for family living expenses.

1.9.2. Capital Account Convertibility

Capital account convertibility refers to a liberalization of

a country’s capital transactions such as loans and

investment, both short term and long term as well as

speculative capital flows.

In a way, capital account convertibility removes all the

restrains on international flows on countries capital account.

There is a basic difference between current account

convertibility and capital account convertibility. In the case

of current account convertibility, it is important to have a

transaction – importing and exporting of goods, buying and

selling of services, inward or outward remittances, etc.

involving payment or receipt of one currency against

another currency. In the case of capital account

convertibility, a currency can be converted into any other

currency without any transaction.

The Benefits of Capital Account Convertibility

The Tarapore Committee mentioned the following

benefits of capital account convertibility to India:

1. Availability of large funds to supplement domestic

resources and thereby promote economic growth.

2. Improved access to international financial markets and

reduction in cost of capital.



3. Incentive for people to acquire and hold international

securities and assets, and

4. Improvement of the financial system in the context of

global competition.

5. Freedom to convert local financial assets into

foreign ones at market-determined exchange rates

6. Leads to free exchange of currency at lower rates and

an unrestricted mobility of capital

1.9.2. Convertibility of Currency in India

In India, after the economic reforms of 1991, the rupee was

made partially convertible under the liberalised exchange

rate management scheme from March 1992 onwards. Under

this scheme, 60% of all receipts on current account was to

be freely converted into rupees whereas 40% was on the

basis of official exchange rate fixed by the RBI. India

acquired the article VIII status of IMF in 1994.

The 40% of fixed exchange rate convertibility was meant

for fulfilling the government's exclusive requirements for

the import of essential commodities. In March 1993, the

foreign exchange budget was abolished and the exchange

rate was unified, and transactions on the trade account were

made free from the exchange control. The exchange rate of

rupee was now left to be determined by the market forces of

demand and supply.

In August 1994 rupee was made fully convertible on the

current account. In January 1997, the RBI announced some

major relaxation in the currency exchange control. The RBI

removed the monetary ceilings prescribed for remittances of



foreign exchange for various purposes. The authorised

dealers could not allow remittances without having to take

prior clearance from the Reserve Bank of India.

Indian rupee is now fully convertible in any foreign

currency for the current account transactions. However,

some restrictions from the Foreign Exchange Management

Act, 1999 (FEMA) is still applicable. These restrictions

include non-convertibility for activities such as betting,

gambling and on prohibited items. Different limits have

been imposed on convertibility in the current account for

traveling to other countries, sending gifts, educational

purposes, employment, and medical treatment etc.

Capital account convertibility-India

Full capital account convertibility of Indian rupee was not

introduced because the prevailing conditions were not in its

favour as India was facing a large current account deficit.

The government wanted to ensure the availability of foreign

exchange at lower prices for the input of essential goods and

commodities. India adopted a cautious approach in the full

capital account convertibility of rupee in the view of the

Mexican crisis. The subsequent East Asian crisis justified

the approach of partial capital account convertibility. Earlier

also partial capital account convertibility was allowed under

certain conditions.

Complete capital account convertibility can increase the

inflow of capital in the country but if the conditions become

unfavourable there is a great risk of the outflow of capital

from the home country. This can lead to higher volatility in

the exchange rates and can even create a crisis like situation

as happened during the East Asian crisis.



Current Status of Capital Account Convertibility

Capital account convertibility exists for foreign investors

and Non-Resident Indians (NRIs) for undertaking direct

and portfolio investment in India.

Indian investment abroad up to US $ 4 million is eligible

for automatic approval by the RBI subject to certain

conditions.

In September 1995, the RBI appointed a special

committee to process all applications involving Indian

direct foreign investment abroad beyond US $ 4 million

or those not qualifying for fast track clearance.

Tarapore committee on capital account convertibility

In 1997, RBI appointed a committee on the capital account

convertibility under the chairmanship of Mr. S.S. Tarapore,

the former Deputy Governor of The Reserve Bank of India.

As per the committee, capital account convertibility refers to

the freedom to convert the foreign financial assets with the

local financial assets and vice versa at the exchange rate

determined by the market forces of demand and supply. The

ultimate aim of capital account convertibility is to allow

foreign investors to easily move in and move out of the

Indian market and to make it clear to the foreign investors

that India has sufficient Foreign Exchange Reserves for

meeting any outflow of capital from India to any extent.

Full capital account convertibility would ensure availability

of large funds for promoting the economic growth of India.

It would provide the Indian economy easy access to the

international financial markets and can reduce the cost of

capital. It would incentivize the Indian investors for



acquiring the international assets and securities which would

ultimately improve India s position in the global

competition.

Conditions to be fulfilled before full capital account

convertibility

Tarapore committee gave the following conditions to be

fulfilled before adopting full capital account convertibility

in India.

The government should reduce the fiscal deficit to 3.5

percent of the GDP. The committee recommended for

setting up the Consolidated Sinking Fund (CSF) for the

reduction of government debt.

It recommended for mandated inflation targeting between

3% to 5%. The RBI was to be given full freedom for

using monetary policy tools for achieving this inflation

target.

The committee recommended for strengthening the

financial sector by deregulating the interest rates,

reducing the non-performing assets to 5 , and the cash

reserve ratio to 3%. It recommended for either the

liquidation of weak banks or their merger with other

strong banks.

The current account deficit should be brought down to

manageable limits and the debt service ratio to be

reduced to 20 % from the present 25% of the export

earnings.

The Reserve Bank of India should have the exchange rate

band of 5 of the real effective exchange rate. The RBI



should intervene in the exchange rate market only when

the real effective exchange rate is outside this band.

To have adequate foreign exchange reserves in the range

between $22 billion and $32 billion for meeting the

import and debt service payments.

The restrictions on the movement of gold need to be

removed completely by the government.

Features under full capital account convertibility

proposed by the Tarapore committee

The Indian corporate sector to be allowed to issue the

foreign currency denominated bonds to the domestic

investors, to issue the Global depository receipts, to

invest in such securities and deposits, and to go for

external commercial borrowings with certain limitations

without the approval of the Reserve Bank of India.

Allowing Indian residents to have foreign currency

denominated deposits with Indian banks, allowing capital

transfer to other countries with certain limitations etc.

To allow the Indian banks to borrow from the foreign

markets for short term and long term within certain

limits, to accept and extend loans denominated in any

foreign currency, and allowing them to invest in the

foreign money markets etc.

All India Financial Institutions which fulfill the specified

prudential and regulatory requirements would be allowed

to participate in the forex market with the authorized

dealers.



The banks and financial Institutions which would be

allowed to participate in the international markets would

also be allowed to freely purchase and sell gold and offer

the gold denominated deposits and loans.

The committee had given a period of 3 years to achieve

targets like current account convertibility etc which was too

short to meet the preconditions and the macroeconomic

indicators. Further, the political instability and the East Asian

financial crisis did not allow the recommendations of the

Tarapore committee to be implemented completely at that

time.

Second Tarapore committee

In 2006, the RBI constituted the second Tarapore committee

on the fuller capital account convertibility. The committee

submitted its report in September 2006 and had drawn

roadmap for 2011 for full capital convertibility of Indian

rupee. At that time, Indian economy was having certain

strong fundamentals such as forex reserves of $165 billion,

liberalised foreign exchange system, a prudent financial

system for dealing with external capital flows etc.

However, certain economic events such as the global

financial crisis of 2007-09 etc could not allow the RBI to

go for full capital account convertibility. The partial

capital account convertibility had helped India to cope up

with the extreme capital outflows which could have taken

place during 2008-09.

In 2015, former deputy governor of the RBI, HR Khan had

said that India is not yet ready for full capital account

convertibility of rupee. This is because the Indian economy

is expanding and it needs stability on the external front.



According to him, India needs an eclectic combination of

some capital account openness and some flexibility in the

exchange rate.

However, the former RBI governor Raghuram Rajan in

April 2015, had said that India may have full capital account

convertibility in a short number of years. Therefore, it is

expected that India would gradually move towards full

capital account convertibility depending upon the

macroeconomic indicators of the economy.

1.10. Foreign Exchange Management Act (FEMA), 1999

It is a set of regulations that empowers the Reserve Bank of

India to pass regulations and enables the Government of

India to pass rules relating to foreign exchange in tune with

the foreign trade policy of India. FEMA replaced an act

called Foreign Exchange Regulation Act (FERA). FERA

(Foreign Exchange Regulation Act) legislation was passed

in 1973. It came into effect on January 1, 1974. FERA was

passed to regulate the financial transactions concerning

foreign exchange and securities. FERA was introduced

when the Forex reserves of the country were very low.

FERA did not comply with the post-liberalization policies of

the Government. The main change brought in FEMA

compared to FERA is it made all the criminal offences as

civil offences.

The legal framework for the administration of foreign

exchange transactions in India is provided by the Foreign

Exchange Management Act, 1999. Under the FEMA, which

came into force with effect from 1st June 2000, all

transactions involving foreign exchange have been classified

either as capital or current account transactions.



Current Account Transactions: All transactions

undertaken by a resident that do not alter his / her assets

or liabilities, including contingent liabilities, outside India

are current account transactions. Example: payment in

connection with foreign trade, expenses in connection

with foreign travel, education etc.

Capital Account Transactions: It includes those

transactions which are undertaken by a resident of India

such that his/her assets or liabilities outside India are

altered (either increased or decreased). Example:

investment in foreign securities, acquisition of

immovable property outside India etc.

Resident Indians: A 'person resident in India' is defined in

Section 2(v) of FEMA, 1999 as : Barring few exceptions, a

person residing in India for more than 182 days during the

course of the preceding financial year. Any person or body

corporate registered or incorporated in India.

An office, branch or agency in India owned or controlled

by a person resident outside India. An office, branch or

agency outside India owned or controlled by a person

resident in India.

Main Features of Foreign Exchange Management Act, 1999

It gives powers to the Central Government to regulate

the flow of payments to and from a person situated

outside the country.

All financial transactions concerning foreign securities

or exchange cannot be carried out without the approval

of FEMA. All transactions must be carried out through

“Authorised Persons.”



In the general interest of the public, the Government of

India can restrict an authorized individual from carrying

out foreign exchange deals within the current account.

Empowers RBI to place restrictions on transactions from

capital Account even if it is carried out via an authorized

individual.

As per this act, Indians residing in India, have the

permission to conduct a foreign exchange, foreign

security transactions or the right to hold or own

immovable property in a foreign country in case

security, property, or currency was acquired, or owned

when the individual was based outside of the country, or

when they inherit the property from individual staying

outside the country.

Foreign Exchange

Regulation Act

(FERA)

Foreign Exchange

Management Act (FEMA)

Parliament of India

passed the Foreign

Exchange Regulation

Act in 1973

Parliament of India enacted

the Foreign Exchange

Management Act (FEMA) on

29 December 1999 replacing

FERA.

FERA came into force

from January

1, 1974.

FEMA came into force from

June 2000.

FERA was repealed

in 1998 by

Vajpayee Government

FEMA succeeded FERA

FERA has 81 sections FEMA has 49 sections

https://byjus.com/free-ias-prep/foreign-exchange-management-act-fema/





FERA was conceived

with the notion that

Foreign Exchange is a

scarce resource.

FEMA was conceived with

the notion that Foreign

Exchange is an asset.

FERA rules regulated

foreign payments.

FEMA focused on increasing

the foreign exchange reserves

of India, focused on

promoting foreign payments

and foreign trade.

The objective of

FERA was

conservation of Foreign

Exchange

The objective of FEMA is

Management of Foreign

Exchange

The definition of

“Authorized Person”

was narrow.

The definition of “Authorized

Person” was widened

Banking units did not

come under the

definition of Authorized

Person.

Banking units came under

the definition of Authorized

Person.

If there was a

violation of FERA

rules, then it was

considered as Criminal

offence.

If there was a violation of

FEMA rules, then it is

considered as civil offence

A person accused of

FERA violation was not

provided legal help.

A person accused of FEMA

violation will be provided

legal help.

There was no provision

for Tribunal, the appeals

were sent to High Courts

There is provision for Special

Director (Appeals) and Special

Tribunal



For those guilty of

violating FERA rules,

there was provision for

direct punishment.

For those guilty of violating

FEMA rules, they have to pay

a fine, starting from the date of

conviction, if the penalty is

not paid within 90 days, then

the guilty will be imprisoned.

If there was a need for

transferring of funds for

external operations, then

prior approval of the

Reserve Bank of India

(RBI) is required.

For External trade and

remittances, there is no need

for prior approval from the

Reserve Bank of India (RBI).

There was no provision

for IT

There is provision for IT

https://byjus.com/free-ias-prep/rbi/





Module II

Exchange Rate and Theories of

Exchange Rate

2.1. Foreign Exchange Reserves

Foreign exchange reserves are the foreign currencies held

by a country’s central bank. They are also called foreign

currency reserves or foreign reserves. One of the most

important reasons for holding reserves is to manage the

currency’s value.

Foreign Exchange reserves consist of:

Foreign Currency Assets

Gold

Special Drawing Rights (SDR) holdings of the government

Reserve Tranche

Foreign Currency Assets (FCAs)

The currencies of various countries held in foreign

exchange reserve are called foreign currency assets. For

example, reserves held in US Dollars, Euro, Japanese Yen,

etc. Apart from currencies, it includes foreign bank

deposits, foreign treasury bills and short term and long term

foreign government securities. The deposit agreements with

IMF trust is also a part of FCAs and are readily available to

meet a BOP financing need.



Gold

The RBI uses its gold stock as a back up to issue currency

and meet the unexpected Balance of Payment problems.

Special Drawing Rights (SDRs)

The SDR is an international reserve asset, created by the

IMF in 1969 to supplement its member countries’ official

reserves, and help countries meet Balance of Payment

problem. The member countries contribute to this account to

avail this benefit. The contribution is in proportion of their

IMF quota (membership fee). SDRs can be exchanged for

freely usable currencies. The value of the SDR is based on a

basket of five major currencies – the US dollar, the euro, the

Chinese renminbi (RMB), the Japanese yen, and the British

pound sterling. The SDR is neither a currency, nor a claim

on the IMF. Rather, it is a potential claim on the freely

usable currencies of IMF members. Holders of SDRs can

obtain these currencies in exchange for their SDRs in two

ways:

1. Through the arrangement of voluntary exchanges between

members

2. By the IMF, designating members with strong external

positions, to purchase SDRs from members with weak

external positions.

Reserve Tranche

It is the proportion of the required quota of currency that

each IMF member country must provide to the IMF, but can

designate for its own use. The reserve tranche portion of the

quota can be accessed by the member nation at any time,



whereas the rest of the member’s quota is typically

inaccessible. If any money was lent over and above the

quota to the IMF’s General Resource Account, it becomes

part of Reserve Tranche.

2.2. Exchange Rate

The price of one currency in terms of the other is known as

the exchange rate. A currency’s exchange rate vis-a-vis

another currency reflects the relative demand among the

holders of the two currencies. For e.g. If the US dollar is

stronger than the rupee (implying value of dollar is higher

with respect to rupee), then it shows that the demand for

dollars (by those holding rupee) is more than the demand for

rupees (by those holding dollars). This demand in turn

depends on the relative demand for the goods and services

of the two countries. Foreign Exchange Rate is the amount

of domestic currency that must be paid in order to get a unit

of foreign currency. According to Purchasing Power Parity

theory, the foreign exchange rate is determined by the

relative purchasing powers of the two currencies. Example:

If a Mac Donald Burger costs $20 in the USA and Re 100 in

India, then the exchange rate between India and the USA

will be (100/20=5), 1 $ = 5 Re.

2.2.1. Forces Behind Exchange Rate Determination

Foreign Exchange is a price of one country’s currency in

relation to other country’s currency, which like the price of

any other commodity is determined by the demand and

supply factors. The demand and supply of the foreign

exchange rate come from the residents of the respective

countries.



Demand for Foreign

Exchange (Foreign Money

goes out)

Supply of Foreign

Exchange (Foreign Money

Comes in)

Foreign Currency is needed

to carry out transactions in

foreign countries or for the

purchase of foreign goods

and services (IMPORTS).

The source of foreign

currency available to the

domestic country are

foreigners purchasing our

goods and services

(Exports).

Foreign currency is needed

to invest in foreign country

assets/shares/bonds etc.

Foreigners investing in

Indian Stock markets,

Assets, Bonds etc. (FPIs

and FDIs)

Foreign currency is needed

to make transfer payments.

Example: Indian Parents

sending Money to his/her

son/daughter studying in the

USA.

Transfer payments.

Example: Indian working

in the USA, sending

money to his/her old aged

parents.

Indians holding money in

overseas Banks

Foreigners holding assets in Indian

Banks.

Indians Travelling abroad for

Tourism Purpose.

Foreigners travelling to

India.



The DD curve represents the demand for foreign exchange

by India. The SS curve represents the supply of foreign

exchange to India. The point where both DD and SS curves

intersect is the point of equilibrium. At this point demand

for foreign exchange is exactly equal to the supply of

foreign exchange. At equilibrium point E0, the exchange

rate is 1 $ equal to 5 Re.

In normal day to day functioning of markets, the exchange

rate may fluctuate. If at any point in time, the exchange rate

is at E1(1$=15Re), then the demand for foreign exchange

falls short of supply of foreign exchange, as a result at this

point Indians are demanding less foreign currency due to

which Re will appreciate vis-a-vis foreign currency. The

appreciation mainly occurs due to a favourable balance of

payment situation (Surplus). Both the points, E1 and E2

(upward and downward movements) shown depreciation as

per the diagram.



By the same token at point E2, demand for foreign exchange

is greater than the supply of foreign exchange, at this point

Indians are demanding excess foreign exchange than what

the foreigners are willing to supply, as a result, at E2 Re will

depreciate vis-à-vis foreign currency. The depreciation

mainly occurs due to the unfavourable balance of payments

situation (Deficits).

2.2.2. Nominal Exchange Rate

Nominal exchange rate means a rate by which you can

exchange your domestic currency with the foreign

currency at any financial institutions like banks, NBFCs

etc.

It is the value of money which is received in an exchange

with another currency.

So in short, the nominal exchange rate is the rate

which is presented by the financial institutions.

If the Nominal exchange rate is high it will benefit

an economy a lot in the trading activities.

If it is high, the goods and services get more foreign units

If there is a change in the Exchange rate, Nominal

Exchange rate is less affected as compared to the Real

exchange rate.

2.2.3. Real Exchange Rate

The real exchange rate is a rate which measures

how many times an item of goods purchased locally

can be purchased abroad.



So, it indicates the ratio of items purchased in the

domestic market to the items purchased in the foreign

market.

Real exchange rate actually determines the ratio of

price in the local market to the price in the foreign

market.

So, it indicates the goods and services consumed as

compared to another country.

It is complex and also a difficult method to calculate the

real exchange rate, thus it measures the purchasing

power of domestic currency to the foreign currency at a

prevailing time.

Real exchange rate is highly affected by the change in

the exchange rate in the global market.

2.2.4. Effective Exchange Rate

Effective exchange rates compare a country’s currency

to a basket of other countries’ currencies.

The most common way to identify the basket of

currencies is to consider a country’s major trade

partners. In this case, the effective exchange rate is

called the trade-weighted index because the weights

attached to other countries’ currencies reflect the

relevance of the home country’s trade with these

countries.

It measures the value of the domestic currency against

the weighted value of a basket of foreign currencies,

where the weights reflect the foreign countries’ share in



the domestic country’s trade. Therefore, you use the

effective exchange rate if you’re interested in the

domestic currency’s performance compared to the

country’s most important trade partners.

It is usually expressed as an index number out of 100.

An increase in the effective exchange rate indicates a

strengthening of the home currency with respect to

other currencies considered in its calculation.

Conversely, a decline in the effective exchange rate

means a weakening of the home currency.

2.2.5. NEER (Nominal Effective Exchange Rate)

The nominal effective exchange rate (NEER) is an

unadjusted weighted average rate at which one country’s

currency exchanges for a basket of multiple foreign

currencies. The nominal exchange rate is the amount of

domestic currency needed to purchase foreign currency.

In economics, the NEER is an indicator of a country’s

international competitiveness in terms of the foreign

exchange (forex) market. Forex traders sometimes refer to

the NEER as the trade- weighted currency index.

The NEER may be adjusted to compensate for the inflation

rate of the home country relative to the inflation rate of its

trading partners. The resulting figure is the real effective

exchange rate (REER). Unlike the relationships in a

nominal exchange rate, NEER is not determined for each

currency separately. Instead, one individual number,

typically an index, expresses how a domestic currency’s

value compares against multiple foreign currencies at once.

NEER = Domestic currency exchange rate in terms of

SDR/Foreign currency exchange rate in terms of SDR.



How to calculate NEER?

The Nominal Effective Exchange Rate can be calculated

from the following formula:

2.2.6. Real Effective Exchange Rate (REER)

The real effective exchange rate (REER) is the weighted

average of a country’s currency in relation to an index

or basket of other major currencies, adjusted for the

effects of inflation. The weights are determined by

comparing the relative trade balance of a country’s

currency against each country within the index.

This exchange rate is used to determine an individual

country’s currency value relative to the other major

currencies in the index.

REER is determined from NEER after correcting it for

price change. „ REER = NEER × (Domestic Price

Index/Foreign Price Index).



The formula used for calculating REER is mentioned

below:

How to calculate REER?

A country’s REER can be derived by taking the average of

the bilateral exchange rates between itself and its trading

partners and then weighing it using the trade allocation of

each partner. The average of the exchange rates is

calculated after assigning the weightings for each rate. For

example, if a currency had a 60% weighting, the exchange

rate would be raised to the power by

0.60 and do the same for each exchange rate and its

respective weighting. Multiply each exchange rate in step 2

by each other and multiply the final result by 100 to create

the scale or index. Some calculations use bilateral exchange

rates while other models use real exchange rates, which

adjusts the exchange rate for inflation. Regardless of the

way in which REER is calculated, it is an average and



considered in equilibrium when it is overvalued in relation

to one trading partner and undervalued in relation to a

second partner.

2.3. Exchange Rate Regime

Exchange rate regime refers to the ‘way’ the value of the

domestic currency in terms of foreign currencies is

determined. It is closely related to monetary policy and the

two are generally dependent on many of the same factor.

Exchange rate regimes can broadly be categorized into two

extremes, namely fixed and floating. Foreign Exchange: It

refers to money denominated in a currency other than the

domestic currency. Exchange Rate: Like any other

commodity, foreign exchange has a price. The exchange

rate is the price of one currency in terms of another. For

example, if the exchange rate between the rupee and the US

dollar (USD) is Rs. 65, this means that Rs. 65 is required to

purchase 1 Dollar.

2.3.1. Fixed/Pegged Exchange Rate Regime

In a fixed exchange rate regime, the domestic currency

is tied to another foreign currency such as the U.S.

dollar, Euro, the Pound Sterling or a basket of

currencies.

In a fixed exchange rate system, the government

(or the central bank acting on the government’s behalf)

intervenes in the foreign exchange market to ensure that

the exchange rate stays close to a predetermined target.

Under this system, exchange rate stability is achieved,

but if the exchange rate is fixed at the wrong rate it may

be at the expense of domestic economic stability.



In a fixed exchange rate system, a rise in the exchange

rate of the domestic currency vis- à-vis another foreign

currency is called a devaluation. This means that in

order to buy 1 unit of a given foreign currency more of

the domestic currency is needed. On the other hand,

when the exchange rate falls it is termed as a

revaluation.

Fixed rates provide greater certainty for exporters and

importers as there are no or limited exchange rate risks.

However, a significant gap between the official rate and

that determined by the market can promote black

markets. In a black market, the bulk of foreign exchange

transactions are carried out outside the banking system.

This may force the government to draw down on

reserves to meet its obligations and cause scarcity of

foreign exchange.

The fixed or pegged rate of exchange can be shown

through Fig. (a) and (b), the amount of foreign

currency is measured along the horizontal scale and

the rate of exchange is measured along the vertical

scale. In Fig.(a), the equilibrium fixed official

rate of exchange is R0 determined by the intersection

between the demand and supply function D and S

respectively. If the demand for foreign currency

increases such that the demand function shifts from D

to D1, given the exchange rate, there is excess demand

gap which is likely to appreciate the exchange value of

foreign currency in terms of domestic currency to R1

or cause corresponding depreciation in the exchange

value of domestic currency.

It is possible for the government or monetary authority



of the home country to fill up the foreign exchange gap

AB in any of three possible ways:

Reduction in the foreign exchange reserves built

through BOP surplus in past years (which implies sale

of foreign exchange),

Borrowing of short-term funds externally as

accommodating transactions, and

Export of monetary gold.

The resort to any one of the measures will help

maintain the exchange rate at the official level rate of

exchange R0.



In Fig. (b), the fixed official rate of exchange is again R0. If

there is an increase in the supply of foreign currency due to

BOP surplus, the supply curve shifts to the right from S to

S1. This creates an excess supply gap A1B1. Consequently,

the exchange value of foreign currency in terms of domestic

currency depreciates to R2 or there is a corresponding

appreciation in the exchange value of domestic currency.

In order to maintain the exchange rate at the official level

R0, the government or monetary authority will be obliged to

buy the foreign currency in the exchange market. Thus in a

system of fixed exchange rates, the pegging operations (sale

or purchase of foreign currency) can help maintain the

equilibrium rate of exchange at the official level.

Merits of Fixed Exchange Rate System

Fixed exchange rate prevents the member countries

from the economic fluctuation which can weaken the

economic policies.

It promotes capital movements. Fixed exchange rate

system attracts foreign capital because a stable

currency does not involve any uncertainties about

exchange rate that may cause capital loss.

Reduce the Uncertainty and Risk

Discourage Speculation

Prevention in Depreciation of Currency

Adoption of Responsible Macroeconomic Policies

Attraction of Foreign Investment

Anti-inflationary



Demerits of Fixed Exchange Rate System

It creates a barrier on achieving the objective of free

markets.

Under this system, countries with deficits in balance

of payment uses their stock of gold and foreign

currencies to solve the problem. This can further

create serious problem for them. They may be forced

to devalue their currency. On the other hand, countries

with surplus in balance of payments will face the

problem of inflation.

Speculation Encouraged

inadequacy of Foreign Exchange Reserves

Internal Objectives of Growth and Full Employment

Sacrificed

International Competitive Environment bypassed

2.3.2. Floating Exchange Rate System

It is an exchange rate system in which market’s

supply and demand of currencies determines the

exchange rate.

The exchange rate is allowed to vary to international

foreign exchange market influences. Thus, government

does not intervene.

Automatic variations in exchange rates consequent

upon a change in market forces are the essence of

freely fluctuating exchange rates.



A deficit in the BOP account means an excess supply

of the domestic currency in the world markets. As

price declines, imbalances are removed. In other

words, excess supply of domestic currency will

automatically cause a fall in the exchange rate and

BOP balance will be restored.

There is no pre-determined exchange rate target of the

government or the Central Bank.

The Central Bank (RBI) or government can indirectly

influence the exchange rate by managing the level and

volume of foreign and domestic currencies in the

banking system.

Under a floating exchange rate system, a rise in the

exchange rate of the domestic currency vis-a-vis

another foreign currency is called depreciation. This

means that more rupees are required to buy one unit

of foreign currency.

On the other hand, appreciation is the fall in the

exchange rate of the domestic currency vis-a-vis

another foreign currency. This means that fewer

rupees are required to buy one unit of foreign

currency.



In Figs. (a) and (b), the amount of foreign currency is

measured along the horizontal scale and rate of exchange is

measured along the vertical scale. In Fig. (a), given the

demand and supply functions of foreign currency D and S,

the initial equilibrium rate of exchange is R0. If demand

increases and demand function shifts to the right to D1,

there is excess demand for foreign currency at R0 rate of

exchange. The excess demand pressure causes an

appreciation of foreign currency to R1 (depreciation of

home currency).



In Fig. (b), the original equilibrium rate of exchange is R0.

If there is an increase in supply of foreign currency, the

supply function shifts to the right to S1 causing depreciation

in foreign currency R1 (appreciation of home currency). On

the opposite, a decrease in supply causes a shift in the

supply function to the left to S2. There is shortage of the

foreign currency at the original rate. It leads to an

appreciation of foreign exchange upto R2 (depreciation of

home currency). With the change in economic conditions

underlying demand and supply, the exchange rate will

automatically change without any intervention by the

Government. That is why, it is called floating or variable

exchange rate system.

Merits of Flexible Exchange Rate System

It eliminates the problem of overvaluation or

undervaluation of currencies, Deficit or surplus in

balance of payments is automatically corrected under

this system.

It frees the government from problem of balance of

payments.

Promotes Growth of Multilateral Trade

Floating Exchange Rates does not necessarily show

large fluctuations:

Demerits of Flexible Exchange Rate System

It creates situations of instability and uncertainty. Wide

fluctuations in exchange rate are possible. This hampers

foreign trade and capital movements between countries.



The uncertainty caused by currency fluctuations can

discourage international trade and investments.

Widespread speculation with a de-stabilizing effect

Provides an inflationary bias to an economy

Relationship of Exchange Rate and Exports/Imports:

If a country has a high dependence on imports, e.g.,

India, more foreign currency leaves the country than

what enters. This puts downward pressure on the

exchange rate and can cause depreciation of the local

currency. When depreciation occurs, imported goods

will become more costly in the local currency. But

depreciation will benefit the exporters as they will get

more revenue in rupees when they exchange the dollars

they got by exporting their products. The reverse case

happens in the case of appreciation.

2.3.3.The Pegged Float Exchange Rate

Pegged floating currencies are pegged to some band or

value, which is either fixed or periodically adjusted.

These are a hybrid of fixed and floating regimes. There

are three types of pegged float regimes:

Crawling bands: The market value of a national

currency is permitted to fluctuate within a range

specified by a band of fluctuation. This band is

determined by international agreements or by unilateral

decision by a central bank. The bands are adjusted

periodically by the country’s central bank. Generally the

bands are adjusted in response to economic

circumstances and indicators.



Crawling pegs: A crawling peg is an exchange rate

regime, usually seen as a part of fixed exchange rate

regimes, that allows gradual depreciation or

appreciation in an exchange rate. The system is a

method to fully utilize the peg under the fixed exchange

regimes, as well as the flexibility under the floating

exchange rate regime. The system is designed to peg at

a certain value but, at the same time, to “glide” in

response to external market uncertainties. In dealing

with external pressure to appreciate or depreciate the

exchange rate (such as interest rate differentials or

changes in foreign exchange reserves), the system can

meet frequent but moderate exchange rate changes to

ensure that the economic dislocation is minimized.

Pegged with horizontal bands: This system is similar

to crawling bands, but the currency is allowed to

fluctuate within a larger band of greater than one

percent of the currency’s value.

2.3.4. Managed Floating Exchange Rate System

In between the two extreme exchange rate regimes,

there is the managed floating (semi- fixed exchange

rate) exchange rate system.

It is the mixture of fixed and floating exchange rate

system.

In this system, the exchange rate is given a specific

target and a central bank keeps the rate from deviating

too far from a target band or value.

Under this regime, the exchange rate is the main target

of economic policy making (interest rates are set to



meet the target).

Governments attempt to affect the exchange rate

directly by buying or selling foreign currencies, or

indirectly through monetary policy (e.g. by changing

interest rates on foreign currency bank accounts).

Most of the countries have shifted to this system of

exchange rate determination.

Managed floating exchange rate are :

Crawling peg system: Under this, the central bank

keeps on adjusting exchange rate based on the new

demand and supply conditions of the exchange rate

market. It follows a system of regular checks and

balances and the central bank undertakes small

devaluations based on the market conditions.

Clean floating: Under this, the exchange rate of

domestic currency is based on the market forces of

demand and supply without the government

intervention. This system is identical to the floating

exchange rate.

Adjusted peg system: Under this, the central bank tries

to hold the exchange rate of domestic currency until the

foreign exchange reserves of that country gets

exhausted. After this, the central bank goes for the

devaluation of the domestic currency to move to another

equilibrium of the exchange rate.

Dirty floating: Under this, the exchange rate is mainly

determined by the market forces of demand and supply

but the central banks occasionally intervened to remove



excessive fluctuations from the foreign exchange

markets.

2.4. Exchange Rate Regimes

Gold Standard (1870-1914)

Bretton Woods System (1946-1971)

Pegged regime(1971-1992):

Towards Managed Floating Exchange Rate: 1995

onwards

2.4.1. Fixed exchange rate system - Gold Standard

(1870-1914)

USA would issue $1 note, if only it has 14 grams of

gold in reserve, whereas England

would issue one pound note if only it has 73 grams of

gold in its reserve. Accordingly, their exchange rate will

be 1 Pound =73/14 = about 5 USD.

And, each Central Bank Governor has promised to

convert their currency into gold at a fixed amount. So,

a person could walk with paper currency and demand

the gold coins or gold bars in return.

When the gold mining production declined, nations

gradually shifted to ‘bimetallism’. $1 promised with 14

gm gold or 210 gm of silver whichever available with

their Central Bank.

This system collapsed during the First World War

(WW1) because the nation’s currency printing capacity



was limited by their gold reserve, but their governments

where more eager to print more money to finance the

war (soldiers’ salaries, rifles, ammunition etc.)

2.4.2. Fixed exchange rate system -Bretton Woods

System (1946-1971)

Here, USA agreed to fix price of its $1 = (1/35) ounces

of gold. [1 ounce = 28 grams]. USA allowed free

convertibility of Dollar to Gold. So if a person walked

into the US Federal Reserve with $35, their chairman

(Governor) will give him one ounce of gold.

Then IMF fixed the exchange rate of every country’s

currency against USA. e.g.₹ 1=

$0.30 = about 0.24 grams of Gold. So, that implied

India can’t issue more currency if RBI does not have

proportionately sufficient gold reserve of its own. Still

if RBI issues more ₹ currency, International Monetary

Fund (IMF) will order India to devalue its rupee

exchange rate against dollar.

Robert Triffin (American Economist) claimed this

system will collapse eventually because gold is a finite

commodity and its price will continue to rise (from 1

ounce of gold = $35 to $40). So there is always danger

of people converting the local currency into dollars and

then converting dollars into gold at $35, then selling it

in open market at profit, then US Feds Chairman can’t

continue honouring his promise. It was called “Triffin

Dilemma”. He therefore suggested an alternative SDR

(Paper gold) system for IMF.

USA President Robert Nixon, in 1971 pulled out of



Bretton Woods gold convertibility system, mainly

because he wanted freedom to print more dollars to

finance the Cold War and arms race against the USSR.

Thus, USA shifted to “Floating Exchange System”.

Eventually most of the nations also shifted in that either

floating / managed-floating system.

Ecuador adopted Dollarization in 2000.e. it abandoned

the domestic currency and adopted the US dollar as

their official currency.

2.5.Devaluation of a currency

Under the fixed rate regime, the central bank or the

government decides the value of the currency with

respect to other foreign currencies. The central bank

or the government purchases or sells its currencies to

maintain the exchange rate. When the government or

the central bank reduces the value of its currency, then it

is known as the devaluation of the currency.

For instance, in 1966 when the India was following the

fixed exchange rate regime, the Indian Rupee was

devalued by 36 %.

Advantages of Currency Devaluation

To increase Exports: countries go for currency

devaluation to boost their exports in the international

market. Devaluation of currency makes its goods

cheaper compared to its International competitors.

Competitive devaluation (race to the bottom):if one

country devalues its currency other countries are also



incentivized to devalue their own currency to maintain

their competitiveness and the international export

market.

To reduce trade deficits: currency devaluation makes a

countries exports cheaper, while imports become more

expensive. This leads to an increase in exports and

decrease in imports. This situation favors the improved

balance of payment and reduces trade deficits.

To reduce the sovereign debt burden: If the debt

payments are fixed, devaluation of currency will make

the domestic currency weaker and will ultimately make

the payments less expensive over time.

Disadvantages of currency devaluation

Inflation: it can lead to increase in the inflation rate as

essential imports such as oil etc will become more

expensive. It can also lead to demand-pull inflation.

It reduces the purchasing power of the country’s citizens

and foreign goods and foreign tours become expensive

for them.

Large and quick devaluation of currency may reduce the

faith of international investors in the domestic

economy. Foreign investors would be less interested in

holding the government debt as devaluation reduces the

value of their holdings.

Devaluation of currency negatively impacts the

corporates and individuals who hold debt in the foreign

currency.



2.6.Depreciation of a currency

In the floating exchange rate regimes, the value of a

country’s currency is determined by the market forces

of demand and supply. The exchange rate of the

currency changes on daily basis as per the demand and

supply of that currency with respect to foreign

currencies. A currency depreciates with respect to

foreign currency when the supply of currency in the

market increases while its demand falls.

Reasons for Depreciation of Currency

Decline in exports: The decline in a country’s overall

exports leads to a decline in export revenues. This

reduces the demand for the country’s currency and

leads to its depreciation.

Large increase in imports: A large increase in the

demand for imported goods and services can lead to a

trade deficit. Increase in the current account deficit can

lead to a net outflow of the currency which can weaken

the exchange rate leading to currency depreciation.

Monetary policy of Central Bank: If the central bank

reduces its policy interest rates it can lead to the

outflow of hot money such as foreign portfolio

investment etc. This can lead to the depreciation of

domestic currency.

Open market operations of the central bank: If the

Central bank (in Indian case, RBI) undertakes open

market operations to buy foreign currency and gold etc.

it can lead to the depreciation of domestic currency.



Devaluation vs depreciation

Both devaluation and depreciation lead to the decline

in the value of domestic currency. However, there are

certain differences between them.

Devaluation Depreciation

Devaluation is the official

reduction in the

value of a currency.

Depreciation refers to an

unofficial decline in

the currency’s value.

Devaluation is the

phenomena associated

with fixed exchange rate

regime.

Depreciation of a currency

is associated with the

floating or managed

floating exchange rate

regime

Devaluation of the

currency is done purposely

by the central bank or the

government

The market forces of

demand and supply are

responsible for the

depreciation of a currency.

The impact of currency

devaluation is for short

term,

The depreciation of

currency can affect the

economy for a longer time.

Devaluation of currency is

done occasionally by the

central bank.

Depreciation and

appreciation of currency

occur on a daily basis.

2.7.Revaluation

Revaluation refers to an upward adjustment to the

country’s official exchange rate the relative to either

price of gold or any other foreign currency.

Revaluation increases the value of the domestic

currency with respect to the foreign currency.



Revaluation is a feature of the fixed exchange rate

regime, where the exchange rate is determined by the

central bank or the government.

Revaluation is opposite to devaluation, which is a

downward adjustment.

Reasons for currency Revaluation

Current account surplus: the government can go for

currency revaluation for reducing the current account

surplus. This happens for economies where exports are

higher than imports.

To manage inflation: the government may go for

currency revaluation in order to manage that inflation

rate. Revaluation can lead to either higher inflation or

even lower inflation. Currency revaluation can make the

imports cheaper which can reduce the inflation rate in

the domestic economy.

Changes in the interest rates of other countries and

changes in the global economic environment can also

lead to currency revaluation in order to manage its

impact on the domestic economy.

2.8.Currency Appreciation

Currency appreciation refers to the increase in the value

of one currency with respect to other foreign currencies.

Currency appreciation is the unofficial increase in the

value of any currency.

It is a feature associated with floating or managed

floating exchange rate regimes.



Appreciation of a currency takes place when the supply

of the currency is lesser than its demand in the foreign

exchange market.

Causes of currency appreciation

Increase in the policy interest rate by the central bank: it

would make the investors attractive to invest in the

government bonds and domestic securities which can

lead to inflow of foreign investment in the form of hot

money.

Current account surplus: current account surplus can

cause an inflow of foreign exchange in the economy

leading to appreciation in the exchange rate of the

domestic currency.

Increase in exports: it increase the demand for the

domestic currency leading to its appreciation with

respect to foreign currencies.

Intervention by the central bank through open market

operations: buying of domestic currency from the

foreign exchange market by the central bank can lead to

an appreciation of the domestic currency.

Higher economic growth can increase foreign

investment in the economy which can cause appreciation

in the exchange rate.

2.9.Purchasing Power Parity Theory

Currencies are used for purchasing goods and services.

Value of a currency (money) depends upon the quantity

of goods and services that can be purchased by the

currency. Thus, value of money is its purchasing power.



Exchange rate can also be mentioned on the basis of this

purchasing power. Exchange rate is the expression of

one currency in terms of another currency

E.g. INR 60 = $ 1. Suppose by using Rs 60, we can

purchase one kilogram of orange, then the purchasing

power of Rupees can be expressed as Rs 60 = 1 kg

orange. Similarly for purchasing one kg orange, we have

to pay one dollar, then the purchasing power of dollar

can be expressed as $1 = 1 kg orange. Now it is possible

to state the exchange rates in terms of the value of

orange Rs 60 = 1kg orange = $ 1. Now it is possible to

express the exchange rate in terms of their purchasing

power as INR 60 = $1. This expression is on the basis of

the parity of purchasing power of the two currencies.

Purchasing power of currency changes due to inflation

or deflation. When there is inflation, price level

increases, quantity of goods that can be purchased by

one unit of currency declines, thus, the purchasing

power also decline and vice versa. Thus, inflation /

deflation affect the exchange rates. Purchasing power

parity theory explains the relationship between exchange

rate and inflation. This theory is based on “Law of one

price”. Law of one price states that any commodity

cannot command two different prices in two different

markets. If so profits can be taken by trading between

these two markets. Ultimately the difference will set off

the price differential and prices of the two markets

become equal.

PPP theory was proposed by David Ricardo, 19th

century, popularized by Gustav Cassel –in 1920s.

According to this theory, exchange rate of a commodity



is determined on the basis of the purchasing power of the

currency.

This theory considers foreign exchange as a commodity.

Under gold standard, the exchange rate can be stated in

terms of the price of “Mint parity of gold” . But in

flexible or floating exchange rate system in the era of

paper currencies, currencies are not backed up by gold

or gold exchange standard, currencies are not based on

their intrinsic worth in terms of gold. Thus, to determine

the exchange rate, purchasing power of the two

currencies can be considered. In other words, the

exchange rate of two currencies can be determined on

the basis of products of commodities that can be

purchased by the currencies. According to this theory

exchange rates are determined by what each unit of a

currency can buy in terms of real goods and services in

its own country.

The rate of exchange is the amount of currency which

would buy the equivalent basket of goods and services in

both the countries. As mentioned, to purchase one Kg of

orange, in India, we have to pay Rs. 50 and at the same

time to purchase the same quantity of orange in US, one

has to pay $1. in that case Exchange rate (E) = Price of

orange in India / Price of orange in US = 50/1 or 50:1.

Assumptions of law of one price and PPP theory

1. There exist perfect market conditions

2. Absence of transportation costs from one market to

another (country to another)

3. Free trade across the international market



4. No barriers or controls over international trade like

tariffs, taxes, incentives, promotions etc

5. No country is strong enough to influence the exchange

rate.

There are two versions to the PPP theory:

1. The absolute PPP (Positive version) and

2. The relative PPP (Comparative version)

2.9.1. The Absolute PPP Theory

In the olden days (1700 -1970) gold formed the basis for

determination of the exchange rate because it commanded

good demand all over the world. Today, gold is like any

other commodity. Thus, in the olden days PPP was based on

gold prices. According to the Jamaica Agreement in 1976

gold was demonetized. The PPP and the exchange rates are

not determined or governed by a single commodity like

gold. Now, it comprises of a basket of commodities in

which gold is only a commodity. Thus, for the purpose of

determining the exchange rate a basket of commodities

which have common utility among the natives will be

considered. The value of commodities in different places

may differ according to customs, traditions, culture, believes

etc. For determining the inflation rates, every country forms

a common basket of goods in proportion to their utility to the

people. Based on variations in prices inflationary

tendencies are determined.

Inflation influences exchange rates. Consider, Two countries

India and China. Inflation rate in India is 20% and that of

China is 0%; then the INR will depreciate when compared



to Chinese Yuan. Chinese Yuan will appreciate when

compared to INR .

Formerly the currencies were in equilibrium position and

were traded INR 5 = 2 Yuan on account of inflation the

position can be INR 6 = 2 Yuan. Now Chinese get more

INR for their Yuan and they can purchase more goods from

India by giving their Yuan. This will increase Chinese

import from India and or Indian export to China. Thereby

increasing demand for Indian Rupees from Chinese who pay

in term of their Yuan. Demand for INR leads to increase

exchange rate of INR and increased supply of Yuan tends to

reduce the price of Yuan. Thus, ultimately through the

interaction of market forces, the exchange rate reaches again

in equilibrium position.

Demerits 1. Assumes composition of common basket of

goods. Due to factors like culture, tradition, values believes

etc. common goods may not be the same 2. Assumes

identical utility – but utility is different 3. Quality of goods

may be different in different countries 4. Styling and

packing difference 5. Trade barriers 6. Transportation,

insurance cost etc 7. Non-tradable goods (service, human

resource) 8. Time lag : consequence of inflation may occur

in different time 9.Other factors affecting demand and

supply of currencies - interest, investment portfolio returns

etc

2.9.2. Relative Purchasing Power Parity Theory

This theory considers the impact of market imperfections

like transportation cost, tariffs, quotas, incentives etc.

Imperfections result in different prices for the same

commodities in different countries, even if measured in a



common currency. However, this theory argues that “the

rate of exchange in the prices of products will be somewhat

similar when measured in common currency, as long as the

transportation costs and trade barriers are unchanged. In

other words, “the change in the exchange rate over a period

of time should be proportional to the relative change in the

price levels in two countries over the same period”.

Example, Suppose:- t = 0 (base period or year), Pₒd = Price

of the commodity in domestic country during the base

period, Pₒf = Price of the commodity in foreign country

during the base period. Thus, exchange (spot) rate = Sₒ =

Pₒd/ Pₒf. Suppose if the prices changes due to inflation, after

one year the situation will be t = 1 (after one year) P₁d =

Price of the commodity in domestic country after one year,

P₁f = Price of the commodity in foreign country after one

year Thus, exchange (spot) rate = S₁ = P₁d/ P₁f. P₁d = Pₒd +

inflation in domestic country, P₁f = Pₒf + inflation in foreign

country.

If, Inflation in domestic country = Id, inflation in foreign

country = If. Thus, S₁ = Pₒd ( 1 + Id) / Pₒf (1 +If) .

Suppose the price of 1 kg orange in India is INR 50 and that

in USA is $1. The inflation rate in India is 20% and that of

USA is 10%. Determine the new exchange rate When t=o,

Sₒ = Sₒ = Pₒd

/ Pₒf = 50/1 = INR50: $1 t=1, inflation in India (Id), 20 % 0r

0.2 and inflation in USA (If) is 10% or 0.1 Present exchange

rate will be 50 x (1+0.2/1+0.1) = INR 54.45 : $ 1.



2.10. Monetary Approach to the Balance of Payments

and Exchange Rates

The monetary approach to the balance of payments was

started toward the end of the 1960s by Robert Mundell and

Harry Johnson and became fully developed during the

1970s. The monetary approach represents an extension of

domestic monetarism (stemming from the Chicago school)

to the international economy in that it views the balance of

payments as an essentially monetary phenomenon. That is,

money plays the crucial role in the long run both as a

disturbance and as an adjustment in the nation’s balance of

payments.

2.10.1. Monetary Approach under Fixed Exchange Rates

The monetary approach begins by postulating that the

demand for nominal money balances is positively related to

the level of nominal national income and is stable in the

long run. Thus, the equation for the demand for money can

be written as:

Md = kPY (2.1)

where Md = quantity demanded of nominal money balances

k = desired ratio of nominal money balances to nominal

national income P = domestic price level Y = real output.

In Equation (2.1), PY is the nominal national income. This

is assumed to be at or to tend toward full employment in the

long run. The symbol k is the desired ratio of nominal

money balances to nominal national income; k is also equal

to 1/V , where V is the velocity of circulation of money or

the number of times a dollar turns over in the economy

during a year.With V (and thus k) depending on institutional



factors and assumed to be constant, Md is a stable and

positive function of the domestic price level and real

national income. The demand for money is inversely related

to the interest rate (i) or opportunity cost of holding inactive

money balances rather than interest-bearing securities. Thus,

Md is directly related to PY and inversely related to i. The

nation’s supply of money is given by

Ms = m(D + F) (2.2).

where Ms = the nation’s total money supply m = money

multiplier, it is constant over time, D = domestic component

of the nation’s monetary base is the domestic credit created

by the nation’s monetary authorities or the domestic assets

backing the nation’s money supply. F = international or

foreign component of the nation’s monetary base refers to

the international reserves of the nation, which can be

increased or decreased through balance-of-payments

surpluses or deficits respectively. D + F is called the

monetary base of the nation, or high-powered money.

Starting from a condition of equilibrium where Md = Ms, an

increase in the demand for money can be satisfied either by

an increase in the nation’s domestic monetary base (D) or by

an inflow of international reserves, or balance-of-payments

surplus (F). If the nation’s monetary authorities do not

increase D, the excess demand for money will be satisfied

by an increase in F. On the other hand, an increase in the

domestic component of the nation’s monetary base (D) and

money supply (Ms), in the face of unchanged money

demand (Md ), flows out of the nation and leads to a fall in

F (a deficit in the nation’s balance of payments). Thus, a

surplus in the nation’s balance of payments results from an

excess in the stock of money demanded that is not satisfied



by an increase in the domestic component of the nation’s

monetary base. A deficit in the nation’s balance of payments

results from an excess in the stock of the money supply of

the nation that is not eliminated by the nation’s monetary

authorities but is corrected by an outflow of reserves. The

nation’s balance-of-payments surplus or deficit is temporary

and self-correcting in the long run; that is, after the excess

demand for or supply of money is eliminated through an

inflow or outflow of funds, the balance-of-payments surplus

or deficit is corrected and the international flow of money

dries up and comes to an end.

The nation has no control over its money supply under a

fixed exchange rate system in the long run. That is, the size

of the nation’s money supply will be the one that is

consistent with equilibrium in its balance of payments in the

long run. Only a reserve-currency country, such as the

United States, retains control over its money supply in the

long run under a fixed exchange rate system because

foreigners willingly hold dollars.

2.10.2. Monetary Approach under Flexible Exchange

Rates

Under a flexible exchange rate system, balance-of-payments

disequilibria are immediately corrected by automatic

changes in exchange rates without any international flow of

money or reserves. Thus, under a flexible exchange rate

system, the nation retains dominant control over its money

supply and monetary policy. Adjustment takes place as a

result of the change in domestic prices that accompanies the

change in the exchange rate. A deficit in the balance of

payments (resulting from an excess money supply) leads to

an automatic depreciation of the nation’s currency, which



causes prices and therefore the demand for money to rise

sufficiently to absorb the excess supply of money and

automatically eliminate the balance-of-payments deficit. On

the other hand, a surplus in the balance of payments

(resulting from an excess demand for money) automatically

leads to an appreciation of the nation’s currency, which

tends to reduce domestic prices, thus eliminating the excess

demand for money and the balance of payments surplus.

Under a flexible exchange rate system, a balance of

payments disequilibrium is immediately corrected by an

automatic change in exchange rates and without any

international flow of money or reserves (so that the nation

retains dominant control over its money supply and

domestic monetary policy). The actual exchange value of a

nation’s currency in terms of the currencies of other nations

is determined by the rate of growth of the money supply and

real income in the nation relative to the growth of the money

supply and real income in the other nations. Thus, according

to the monetary approach, a currency depreciation results

from excessive money growth in the nation over time, while

a currency appreciation results from inadequate money

growth in the nation. A nation facing greater inflationary

pressure than other nations (resulting from more rapid

growth of its money supply in relation to the growth in its

real income and demand for money) will find its exchange

rate rising (its currency depreciating). On the other hand, a

nation facing lower inflationary pressure than the rest of the

world will find its exchange rate falling (its currency

appreciating).

With flexible exchange rates, the rest of the world is to some

extent shielded from the monetary excesses of some nations.

The nations with excessive money growth and depreciating



currencies will now transmit inflationary pressures to the

rest of the world primarily through their increased imports

rather than directly through the export of money or reserves.

This will take some time to occur and will depend on how

much slack exists in the world economy and on structural

conditions abroad. Under a managed floating exchange rate

system of the type in operation today, the nation’s monetary

authorities intervene in foreign exchange markets and either

lose or accumulate international reserves to prevent an

“excessive” depreciation or appreciation of the nation’s

currency, respectively. Under such a system, part of a

balance-of-payments deficit is automatically corrected by a

depreciation of the nation’s currency, and part is corrected

by a loss of international reserves. As a result, the nation’s

money supply is affected by the balance-of- payments

deficit, and domestic monetary policy loses some of its

effectiveness. Under a managed float, the nation’s money

supply is similarly affected by excessive or inadequate

growth of the money supply in other nations, although to a

smaller extent than under a fixed exchange rate system.

2.10.3. Monetary Approach to Exchange Rate

Determination

With the dollar ($) as the domestic currency and the euro (€)

as the foreign currency, the exchange rate (R) was defined

as the number of dollars per euro, or R = $/€. For example,

if R = $1/€1, this means that one dollar is required to

purchase one euro, or if R = $1.20/€1, it would take $1.20 to

get one euro. If markets are competitive and if there are no

tariffs, transportation costs, or other obstructions to

international trade, then according to the law of one price

postulated by the purchasing-power parity (PPP) theory, the

price of a commodity must be the same in the United States



as in the European Monetary Union (EMU). That is, PX ($)

= RPX (€).

The same is true for every other traded commodity and for

all commodities together (price indices). That is,

P = RP∗ and R = P /P∗ (2.3)

where R is the exchange rate of the dollar, P is the index of

dollar prices in the United States, and P∗ is the index of euro

prices in the EMU.

We can show how the exchange rate between the dollar and

the euro is determined according to the monetary approach

by starting with the nominal demand-for-money function of

the United States (Md) and for the EMU (M∗ d ):

Md = kPY and M∗ d = k∗P∗Y∗ (2.4)

where k is the desired ratio of nominal money balances to

nominal national income in the United States, P is the price

level in the United States, and Y is real output in the United

States, while the asterisked symbols have the same meaning

for the EMU.

In equilibrium, the quantity of money demanded is equal to

the quantity of money supplied. That is, Md = Ms and M∗d =

M∗s. Substituting Ms for Md and M∗s for M∗d in Equation

(2.4), and dividing the resulting EMU function by the U.S.

function, we get

M∗s/ Ms = k∗P∗Y∗ /kPY (2.5)

By then dividing both sides of Equation (2.5) by P∗/P and



M∗s/Ms we get

P/ P∗ = Msk∗Y∗/ M∗skY (2.6) But since R = P/P∗, we have

R = Msk∗Y∗/ M∗s kY (2.7)

Since k∗ and Y∗ in the EMU and k and Y in the United

States are assumed to be constant, R is constant as long as

Ms and M∗ s remain unchanged. Several important things

need to be noted with respect to Equation (2.7). First, it

depends on the purchasing-power parity (PPP) theory and

the law of one price. Second, Equation (2.7) was derived

from the demand for nominal money balances in the form of

Equation, which does not include the interest rate. Third, the

exchange rate adjusts to clear money markets in each

country without any flow or change in reserves. Thus, for a

small country (one that does not affect world prices by its

trading), the PPP theory determines the price level under

fixed exchange rates and the exchange rate under flexible

rates.

2.11. Portfolio Balance Model

The portfolio balance approach (also called the asset market

approach) differs from the monetary approach in that

domestic and foreign bonds are assumed to be imperfect

substitutes, and by postulating that the exchange rate is

determined in the process of equilibrating or balancing the

stock or total demand and supply of financial assets (of

which money is only one) in each country. Thus, the

portfolio balance approach can be regarded as a more

realistic and satisfactory version of the monetary approach.

The portfolio balance approach was developed since the

mid- 1970s, and many variants of the basic model have been

introduced.



In the simplest asset market model, individuals and firms

hold their financial wealth in some combination of domestic

money, a domestic bond, and a foreign bond denominated

in the foreign currency. The incentive to hold bonds

(domestic and foreign) results from the yield or interest that

they provide. However, they also carry the risk of default

and the risk arising from the variability of their market value

over time. Domestic and foreign bonds are not perfect

substitutes, and foreign bonds pose some additional risk

with respect to domestic bonds. Holding domestic money, on

the other hand, is riskless but provides no yield or interest.

Thus, the opportunity cost of holding domestic money is the

yield forgone on holding bonds. The higher the yield or

interest on bonds, the smaller is the quantity of money that

individuals and firms will want to hold.

At any particular point in time, an individual will want to

hold part of his or her financial wealth in money and part in

bonds, depending on his or her particular set of preferences

and degree of risk aversion. Individuals and firms do want to

hold a portion of their wealth in the form of money (rather

than bonds) in order to make business payments (the

transaction demand for money). But the higher the interest

on bonds, the smaller is the amount of money that they will

want to hold (i.e., they will economize on the use of money).

The choice, however, is not only between holding domestic

money, on the one hand, and bonds in general, on the other,

but among holding domestic money, the domestic bond, and

the foreign bond. The foreign bond denominated in the

foreign currency carries the additional risk that the foreign

currency may depreciate, thereby imposing a capital loss in

terms of the holder’s domestic currency. But holding foreign

bonds also allows the individual to spread his or her risks

because disturbances that lower returns in one country are



not likely to occur at the same time in other countries. Thus,

a financial portfolio is likely to hold domestic money (to

carry out business transactions), the domestic bond (for the

return it yields), and the foreign bond (for the return and for

the spreading of risks it provides).

Given the holder’s tastes and preferences, his or her wealth,

the level of domestic and foreign interest rates, his or her

expectations as to the future value of the foreign currency,

rates of inflation at home and abroad, and so on, he or she

will choose the portfolio that maximizes his or her

satisfaction (i.e., that best fits his or her tastes). A change in

any of the underlying factors (i.e., the holder’s preferences,

his or her wealth, domestic and foreign interest rates,

expectations, and so on) will prompt the holder to reshuffle

his or her portfolio until he or she achieves the new desired

(equilibrium) portfolio.

According to the portfolio balance approach, equilibrium in

each financial market occurs when the quantity demanded of

each financial asset equals its supply. It is because investors

hold diversified and balanced (from their individual point of

view) portfolios of financial assets that this model is called

the portfolio balance approach. If investors demand more of

the foreign bond either because the foreign interest rate rose

relative to the domestic interest rate or because their wealth

increased, the demand for the foreign currency increases and

this causes an increase in the exchange rate (i.e., depreciation

of the domestic currency). On the other hand, if investors

sell foreign bonds either because of a reduction in the

interest rate abroad relative to the domestic interest rate or

because of a reduction in their wealth, the supply of the

foreign currency increases and this causes a decrease in the

exchange rate (i.e., appreciation of the domestic currency).



Thus, we see that the exchange rate is determined in the

process of reaching equilibrium in each financial market.

2.12. Exchange Rate Overshooting

Overshooting was introduced to the world by Rüdiger

Dornbusch, a renowned German economist focusing on

international economics, including monetary policy,

macroeconomic development, growth, and international

trade. Dornbusch first introduced the model, now widely

known as the Dornbusch Overshooting Model, in the

famous paper "Expectations and Exchange Rate Dynamics,"

which was published in 1976 in the Journal of Political

Economy. Before Dornbusch, economists generally believed

that markets should, ideally, arrive at equilibrium and stay

there. Some economists had argued that volatility was

purely the result of speculators and inefficiencies in the

foreign exchange market, such as asymmetric information or

adjustment obstacles. Dornbusch rejected this view. Instead,

he argued that volatility was more fundamental to the market

than this, much closer to inherent in the market than to being

simply and exclusively the result of inefficiencies. More

basically, Dornbusch was arguing that in the short run,

equilibrium is reached in the financial markets, and in the

long run, the price of goods responds to these changes in the

financial markets.

The Overshooting Model

The overshooting model argues that the foreign exchange

rate will temporarily overreact to changes in monetary

policy to compensate for sticky prices of goods in the

economy. This means that, in the short run, the equilibrium

level will be reached through shifts in financial market



prices, rather than through shifts in the prices of goods

themselves. Gradually, as the prices of goods unstick and

adjust to the reality of these financial market prices, the

financial market, including the foreign exchange market,

also adjusts to this financial reality. So, initially, foreign

exchange markets overreact to changes in monetary policy,

which creates equilibrium in the short term. Then, as the

prices of goods gradually respond to these financial market

prices, the foreign exchange markets temper their reaction

and create long-term equilibrium. Thus, there will be more

volatility in the exchange rate due to overshooting and

subsequent corrections than would otherwise be expected.

Panel (a) shows that the U.S. money supply unexpectedly

increases by 10 percent from $100 to

$110 billion at time t 0. In panel (b) the increase in the U.S.

money supply immediately leads to a decline in the U.S.

interest rate from 10 percent to 9 percent. Panel (c) shows

that the U.S. price index rises by 10 percent from 100 to 110

only gradually over the long run. Panel (d) shows that the

exchange rate of the dollar (R) immediately rises (the dollar

depreciates) by 16 percent, from

$1/€1 to $1.16/€1, thus overshooting its long-run

equilibrium level of $1.10/€1, toward which it will then

gradually move by appreciating (R falling) in the long run.

As U.S. prices rise, the U.S. interest rate also gradually rises

back to its original level of 10 percent in the long run.



F

The immediate depreciation of the dollar will lead to a

gradual increase in the nation’s exports and reduction in the

nation’s imports, which will result (everything else being

equal) in an appreciation of the dollar over time. Since we

know from the PPP theory that the dollar must depreciate

by 10 percent in the long run, the only way to also expect

that the dollar will appreciate in the future is for the dollar

to immediately depreciate by more than 10 percent as a

result of the unexpected 10 percent increase in the U.S.

money supply. Of course, if other disturbances occur before

the exchange rate reaches its long-run equilibrium level, the

exchange rate will be continually fluctuating, always

moving toward its long-run equilibrium level but never

quite reaching it. This seems to conform well with the

recent real-world experience with exchange rates.

Specifically, since 1971, and especially since 1973,

exchange rates have been characterized by a great deal of



volatility, overshooting, and subsequent correction, but

always fluctuating in value.

2.13. Exchange Rate System in India

The exchange rate system in India has undergone a

systematic change since Independence. From the system of

the pegged exchange rate to the present form of market

determined exchange rate after liberalisation in 1993.

Objectives of Exchange Rate Management In India

To ensure that the economic fundamentals of the

Indian economy are correctly reflected in the external

value of Indian rupee.

To reduce the volatility in exchange rates for ensuring

that changes in the exchange rates take place in a

smooth and orderly manner.

To maintain a sufficient level of foreign exchange

reserves to deal with any external currency shocks.

To help in the elimination of market constraints for

ensuring the growth of a healthy foreign exchange

market.

To help in the prevention of the emergence of any

destabilizing and speculative activities in the foreign

exchange market.

Factors affecting the Exchange Rate of India

Intervention of The Reserve Bank of India:

During high volatility in the exchange rate, RBI

intervenes to prevent the exchange rate going out of



control.

For example, the RBI sells dollars when Indian rupee

depreciates too much, while it purchases dollars when the

Indian rupee appreciates beyond a certain level.

Inflation rate:

The increase in inflation rate can increase the demand for

foreign currency which can negatively impact the exchange

rate of the national currency.

For example, an increase in the inflation level of

petroleum oil can increase the demand for foreign currency

leading to the depreciation of Indian rupee.

Interest rate:

Interest rates on government securities and bonds,

corporate securities etc affect the outflow and inflow of

foreign currency.

If the interest rates on government bonds are higher

compared to other country forex markets, it can increase

the inflow of foreign currency, while lower interest rates

can lead to the outflow of foreign currency. This affects the

exchange rate of Indian rupee,.

Exports and imports:

Exports and imports affect exchange rate as exports earn of

foreign currency while imports require payments in foreign

currency.

Thus, if the overall exports increases, the national currency

appreciates, while increases in imports leads to the

depreciation of the national currency.

Apart from above, the Indian foreign exchange market is



also affected by factors such as the receipts in the accounts

of exports in invisibles in the current account, inflow in the

capital account such as FDI, external commercial

borrowings, foreign institutional investments, NRI

deposits, tourism activities etc.

2.14. Exchange Rate Regime in India

Towards Fixed Exchange Rate

1860

onwards

Fixed Fiduciary System à i.e. British

Indian Govt can issue Rs.10 crore notes

on fiduciary (“trust”) backed by G-

Sec. Beyond that every note must be

backed by gold / silver.

1935

onwards

Proportional Reserve à RBI must keep

about 40% gold to the value of currency

issued. British govt fixed exchange rate.

1946

onwards

Bretton Woods / IMF system of fixed

exchange rate à Wherein ₹ price was

fixed (pegged) against dollar, and dollar

price was fixed (pegged) against gold.

1956

onwards

While RBI could issue any amount of

Indian currency but that has to be

balanced by the Assets of the issue

department (Remember M0). If RBI

printed too much currency backed by

only Indian G-sec but (without adequate

Gold / Forex Reserve, then IMF may

force devaluation of ₹ against Dollar).

So, we adopted “Minimum Reserve

System” i.e. RBI must keep ₹ 400 crore of

foreign currency/security + ₹ ‘specified’

crore worth gold.



Towards Managed Floating Exchange Rate: 1995

onwards

Post 1995 onwards, “Minimum Reserve System; is

continued but RBI is required to only keep ₹ ‘specified’

crores of gold. No compulsion for RBI to keep additional

400 crore worth foreign currency or foreign securities. RBI

can print as much currency it wants as long as its balanced

by the Assets of Issue Dept. (such as Indian G-sec, Foreign

Securities, Gold etc.)

Attracting Dollars: VRR and FAR

To prevent weakening of ₹, we have to attract more $ (and

other foreign currencies) in India. So, RBI taken following

notable measures:

Voluntary Retention

Route (VRR)

Launched in 2019: If an FPI

buys Indian Union/State

Governments’ G-Sec and Indian

Corporates’ Bonds through this

route → FPI will be given more

freedom in certain technical

regulations of RBI & SEBI.

But, with condition FPI

must remain invested in India

for minimum 3 years. (Hot

Money)

RBI decides quantitative

limits to how much money can

FPI invest through this route.



Fully Accessible

Route (FAR)

Budget-2020 had announced

allowing non-resident investors

to invest in G-Sec, without any

restrictions.

2020-March: RBI

announced this window, non-

resident individual investors

(who’re not FPI) can buy G-Sec.

No limits on amount of

investment.

Benefit – Investors will convert $ & other foreign currency

into ₹ currency to buy G-Sec. so more $ coming towards

India which will help keeping BoP and currency exchange

rate stable during crisis.

Currency Exchange Rate in COVID-19 Crisis

2020-Feb

Corona Virus Force Majeure àSENSEX dips

so FPIs Selling shares from Indian

companies= they got ₹₹ → converting them

into $ → running back to USA to invest in

(AAA rated) US treasury bonds which is

safest investment. So there is a great shortage

of dollars in the Indian market. If RBI does

not supply dollars → further weakening of

rupee ($1=₹75 → ₹80).

2020-March

RBI starts Dollars Swap with Indian banks.

i.e. A bank shall buy US Dollars from the

Reserve Bank and simultaneously agree to

sell the same amount of US Dollars at the

end of the swap period (6 months). It is done

through auctioning, so, RBI to earn some %

of profit.



COVID-19 Dollar up-down movements, RBI signing

more swap agreements, Indian Government

borrowing more $$ from ADB, BRICS Bank

etc.

After the collapse of Bretton Woods Exchange Rate

System, IMF was converted into a type of ‘deposit bank’,

where the members would deposit currencies in the

proportion of quotas allotted to them (depending on size of

their economy, openness etc).

IMF will pay them a small interest rate for their

deposits. And IMF would lend this money to a member

facing balance of payment crisis. To operationalize this

mechanism, IMF would allot an artificial currency /

accounting unit called SDR to the members based on their

deposits.

Initially the price of SDR was fixed against the

amount of gold but present mechanism:

Currency Basket Weightage

U.S. Dollar 41.73

Euro 30.93

Chinese Yuan (Renminbi *added in 2015) 10.92

Japanese Yen 8.33

Pound Sterling 8.09

By applying a formula involving (weight *

exchange rate), IMF will obtain value of 1 SDR = how

many dollars?

Presently, 1 SDR = $1.40 = ₹ 98 (assuming $1 is

trading at ₹ 70).



SDR is called ‘Paper Gold’ because it’s merely an

accounting entry or artificial currency, without any gold

involved.

SDR can be traded among the members, it can be

converted into members’ currencies as per above method &

be used to settle their Balance of Payment Transactions /

Crisis.

If the BoP crisis is so big, that a country’s entire

SDR quota exhausts, then member country may borrow

more SDR from IMF (and then convert it into dollar etc. to

pay off the import bill), but eventually member will have to

repay this loan to IMF with interest.

2016-Reforms: The total quantity of SDR was increased,

and India’s quota was increased from 2.44% to about

2.75%, accordingly, we are allotted around 13 billion SDR

[25% of it is kept as reserve tranche position (RTP)]

India is 8th largest quota holder after USA (~18%), Japan

(~7%), China (~6%)…

In IMF, a member’s voting power depends on his

SDR quota contribution.

For India, this voting power is exercised by

India’s Finance Minister as the ex-officio Governor in

IMF’s Board of Governors.

If Finance Minister absent, then RBI Governor can

vote as the Alternate Governor during the IMF’s meetings.

Presently, India has managed floating exchange rate system

wherein, currency exchange rate is determined by the



market forces of supply and demand, however, during high

level of volatility RBI will intervene to buy / sell ₹ or $ to

stabilize the exchange rate. But if people are allowed to

convert the local and foreign currency in an unrestricted

manner, this will led to so much volatility that RBI will not

be able to manage.

So, RBI puts certain restrictions on the convertibility of

Indian rupee to foreign currency using the powers conferred

under: Foreign Exchange Regulation Act, 1973 (FERA),

FERA was later replaced by Foreign Exchange Management

Act, 1999 (FEMA)

RBI Restriction On Convertibility Of Rupee:

1. CONVERTIBILITY OF RUPEE

o Convertibility on Capital Account Transactions

o Convertibility on Current account transactions

Convertibility on Capital Account Transactions:

External Commercial Borrowing

RBI’s External Commercial Borrowing

(BoP → Capital Account → Borrowing

→ ECB) ceiling is up to $750 million (or

equivalent other currency) per year for

Indian Companies. That means even if

Bank of America was willing to lend

$1500 million to Reliance, it can’t bring

all those dollars (or its converted rupee

equivalent) in India. If he tries through

illegal



(ECB) methods like Hawala, then

Enforcement Directorate (ED)

will take action for FEMA violation.

Foreign Portfolio

Investors (FPI)

An Foreign Portfolio Investors

(BoP → Capital Account →

Investment → FPI) can’t invest in

more than 5% of available

government securities in the Indian

market and more than 20% of the

available corporate bonds in the

Indian market.

So, even if Morgan Stanley or

Franklin Templeton investment

fund has billions of dollars they

can’t bring them all to India

because of above restrictions.

Foreign Direct

Investment (FDI)

Similar restrictions on Foreign

Direct Investment (FDI) as well.

Govt decides FDI policy and RBI

mandates the forex dealers

accordingly to convert or not

convert foreign currency into

Indian currency. E.g. Las Vegas’s

Flamingo Casino company can’t

convert $ into ₹ to invest in Goa’s

Casino (Because FDI prohibited in

Casino). If they manage to

‘smuggle’ rupees through Hawala /

Mafia boats then again ED will

take action for FEMA violation.



Conclusion

Thus, Indian rupee is not fully

convertible on capital account

transactions.

Convertibility on Current account transactions

During 2013 to 2014, RBI’s 80:20 norms mandated

min. 20% of the imported gold must be exported back.

Until then Jeweller/bullion dealers will not get

permission to (convert their rupees into dollars/foreign

currency) to import next consignment of gold.

However, if we disregard such few rare

examples/restriction, Indian rupee is considered fully

convertible on current account transactions (i.e. Import and

export, remittance, income transfer gift and donations)

since 1994.

FCRA 2010 violations:

If NGO / Universities were allowed to accept

foreign donations in an unrestricted manner, they may

become puppets of ISI / Pakistan / China / CIA.

So, Ministry of Home Affairs (MHA) requires

them to ‘register’ and furnish annual reports under Foreign

Contribution Regulation Act 2010 (FCRA). Those who

fail to comply with it, are prohibited from accepting

foreign donations.

But this angle takes us towards the ‘National

security and sovereignty of India’. We need not confuse or

mix it up with ‘Economics concept’ of Rupee

convertibility under FEMA ACT.

Full convertibility of Rupee



Meaning – India should permit unrestricted conversion of

Indian ₹ to foreign currency for both current account and

capital account transactions. This will infuse more FDI

investment in India which will help in resolution of NPA

problem, new factories, jobs, GDP growth, rivers of honey

and milk will flow.

Anti-Arguments:

Before 1997, East Asian “Tiger” economies –

(South Korea, Indonesia, Malaysia, Thailand, Vietnam

Philippines etc.) allowed full capital account convertibility

to attract FDI.

But 1997: Their automobile & steel companies

filed bankruptcy. The foreign investors panicked, sold

their shares and bonds and got local currency to convert

into $ and ran away. The flight of this ‘Hot Money’

resulted into extreme depreciation of local currency $1 =

2000 Indonesian Rupiah → $1= 18,000 Indonesian

Rupiah. All developments resulted into heavy inflation of

petrol and diesel, social unrest, riots and political

instability. None of their central banks had enough forex

reserve to combat this crisis.

So, in 1998, their GDP growth rates fell in

negative territory e.g. Indonesia (- 13.7%) Because of

their mistake of allowing full currency convertibility.

Whereas India and China grew at 6-8% because

we had not allowed it.

S.S. Tarapore Committee (1997) on Convertibility of

Rupee

Committee suggested India to allow full Capital



Account Convertibility (CAC) only when the

fundamentals of our economy become strong enough, such

as:

1. RBI must have enough forex to sustain 6 months’

import

2. Fiscal deficit must not be more than 3.5% of GDP

3. Inflation must not be more than 3-5%

4. Banks’ NPA must not be more than 5% of their total

assets, and among others.

So, time is not yet ripe for allowing full CAC.

Rupee Convertibility and RBI reforms (2004-2019)

While RBI has not permitted full convertibility

of Indian rupee (on Capital Account), but over the years it

has liberalised the norms, such as:

2004

Liberalised Remittance Scheme (LRS) for

each financial year, An Indian resident (incl.

minor) is allowed to take out upto $2,50,000

(or its equivalents in other currencies) from

India. He may use it for either current

account or capital account transaction as per

his wish. (e.g. paying for college fees

abroad, buying shares, bonds, properties,

bank accounts abroad.)

Controversy à Panama papers allege certain

Bollywood celebrities used LRS window to

shift money from India in their shell

companies in tax havens. Later used those

shell companies for tax avoidance.



2016

onwards

RBI began relaxing the norms for External

Commercial Borrowing (ECB), mainly to

soften the NPA problem e.g. Software firms

can bring up to $200 million in ECB,

Micro-finance $500 mill, Infrastructure

companies $750 million etc.

2018-19 When ₹ started to depreciate heavily against

dollars ($1 → ₹ 63 → ₹ 74), RBI had to

encourage the flow of dollars into

Indian economy. So, aforementioned

sector- specific limits streamlined → all

eligible companies automatically allowed to

borrow upto $750 million via ECB route.

(Although prohibited in certain categories

e.g. purchase of farm house, tobacco,

betting, gambling, lottery etc.)

2019 RBI allowed ECB even for working capital

& repayment of rupee loans.

Twin Deficit – It’s the term used when both Current

Account Deficit and Fiscal Deficit are high.

CURRENCY WAR 2018

2015: Chinese authorities announced they don’t

manipulate/control Yuan exchange rate. They only

intervene if Yuan’s exchange rate varies more than +/- 4%

from previous day.

During 2018, People’s Bank of China pursued

‘Cheap (Dovish) Money Policy’ to injected more Yuan

(renminbi) in the system to makes loans cheaper in

domestic market and boost the consumption, demand,

growth.



But, on the other side, US Feds pursued Dear

(Hawkish) Money Policy, so dollar supply is shrinking, so

dollar is becoming more expensive against other

currencies.

Results à Increased supply of Yuan vs. reduced

supply of $: resulted in $1=6.20 Yuan weakening to

almost $1= 7 Yuan.

Trump alleges Yuan was deliberately weakened

(due to PCB increasing Yuan supply) to make Chinese

product more cheaper in global trade. He even accused

Russia and Japan of playing similar ‘Currency War’

against him.

Currency War and Fall of Indian ₹ in 2018

2018: Turkey was suffering from high Inflation, current

account deficit and political turmoil.

US Feds was pursuing Hawkish (Dear) monetary policy,

so dollar supply shrinking and resultantly dollar is

becoming more expensive against other currencies. In this

atmosphere, foreign investors feared Turkish companies

(who had previously borrowed lot of money from

American financial market) will not be able to repay their

loans in dollar currency.

So foreign investors began selling their shares and

bonds from Turkey’s market. They got Lira currency and

exchanged it to dollars and ran away from Turkey.

Because of this rush, demand of dollars

strengthened even further and resultantly, other currencies

became even weaker. (Including India: $1=₹ 63 in January



→ $1= ₹ 74 in Oct’18).

In 2019-20 also, India rupee continued to weaken

towards $1=75₹ because Corona Force Majure which

leads to dip in SENSEX. Foreign investors pulling out

money from India.

While such depreciation is good for our exporters

but bad for our importers. To combat this fall, Govt and

RBI initiated following steps:

1. FPI’s investment limits in Bond market was

relaxed. (So they feel encouraged to convert their Dollars

into Rupees and invest in Indian bond market)

2. External commercial borrowing (ECB) norms

were also relaxed.

3. RBI sold about 25 billion dollars from its forex

reserve to calm down the demand of dollars.

4. Further, to attract NRI’s dollar savings into India:

2013. RBI could announce more interest rates on

Foreign Currency (Non- Resident) Account (Banks)

[FCNR (B) Account] & then pay interest subsidy to Indian

Banks, like they had done in 2013.

2014. Govt could also tell RBI to issue NRI bonds to

attract their $ savings to India.

5. But, Urjit Patel avoided doing 4A and 4B

solutions because eventually such borrowed dollars have

to be returned back to NRI with interest, which could

result in exchange rate crisis in future.



6. RBI could also pursue Hawkish Monetary Policy

to reduce rupee supply in market (so that ₹ can also

become expensive just like dollars). But, because RBI act

mandates inflation control within 2-6% CPI, and by

December 2018 the CPI has been falling towards 2% so

RBI’s MPC had to actually reduce the policy rate (2019

Feb to August) to combat deflation.

2018-Oct The central banks of India and Japan

signed Currency Swap Agreement of $75

billions i.e. either party can use that much

dollar currency from other party’s forex

reserve during the crisis. Even in 2008 and

2013 too they had signed similar

agreement but lower amount was involved.

2019- March RBI’s $5 bn Currency Swap with Indian

banks → RBI gains dollar reserve to fight

future volatility in currency exchange rate,

whereas Indian banks got extra rupee

liquidity → (Hopefully) cheaper interest

rates to combat deflation.

2018-Dec India signed pact with Iran to pay crude oil

bill in rupee currency. National Iranian Oil

Co (NIOC) will open a bank account in

India’s UCO Bank (a PSB). Indian oil

companies will make payments there in ₹

currency. This will help curbing the

demand of dollars in India.

Budget –

2019

Nirmala S. announced various measures to

attract more FPI and FDI investment in

India



2020-Feb Corona Virus Force Major dip in SENSEX

so FPIs Selling shares from Indian

companies they got ₹₹ → converting them

into $ → running back to USA to invest in

(AAA rated) US treasury bonds which is

safest investment. So there is a great

shortage of dollars in the Indian market. If

RBI does not supply dollars → further

weakening of rupee ($1=₹75 → ₹80).

2020-March RBI starts Dollars Swap with Indian banks.

i.e. A bank shall buy US Dollars from the

Reserve Bank and simultaneously agree to

sell the same amount of US Dollars at the

end of the swap period (6 months). It is

done through auctioning, so, RBI to earn

some % of profit.

Quantitative Easing and Federal Tapering

Quantitative

Easing

Subprime crisis in USA (2007-08 →

Borrowers unable to repay the home

loans → American Banks and NBFCs’

bad loans / NPA / toxic assets increased

→ to help them, US Federal Reserve

printed new dollars & used it to buy those

toxic assets → increased dollar supply in

the system. Known as “Quantitative

Easing”.

Fed Tapering 2013: US Federal Reserve gradually cut

down its toxic asset purchasing program

→ less new dollars issued → called “Fed

Tapering”



Result

shortage (perceived) of dollars in USA → Loans %

become more expensive in USA so American investors

began selling shares/bonds in other countries, and took

their dollars back to USA (to lend to local

businessmen).

This phenomenon was called “Taper Tantrum”. It

resulted into weakening of other currencies against

USD.

Helicopter Money & Zero interest rate regimes

Economist Milton Friedman (1969) introduced concept

of ‘Helicopter Money’ to combat recession, a central

bank should supply large amounts of money to the

public at near zero interest rate, as if the money was

being showered on them from a helicopter. It will

encourage consumption, demand which will result into

more factories, jobs and economic growth.

In the aftermath of sub-prime crisis and global financial

crisis, there was fall in consumption, demand and so the

deflation & recession scenario.

So, the Central Banks of Sweden, EU and Japan cut

their deposit interest rates into negative figures (-0.1%)

so if a commercial bank parked/deposited its surplus

money into the central bank (through a reverse repo like

mechanism), its money will be deducted in penalty

instead of earning deposit interest.

Results, Commercial banks will proactively try to give

away more loans to customers to boost demand in

economy.



Module: III

Foreign Exchange Market

3.1.Foreign Exchange Market:

The foreign exchange market is a decentralized worldwide

market. Foreign exchange market is the market in which

foreign currencies are bought and sold. The buyers and

sellers include individuals, firms, foreign exchange brokers,

commercial banks and the central bank. The transactions in

this market are not confined to only one or few foreign

currencies. In fact, there are a large number of foreign

currencies which are traded, converted and exchanged in

the foreign exchange market. Foreign exchange market is

also described as an OTC (Over the counter) market as

there is no physical place where the participants meet to

execute their deals. It is more an informal arrangement

among the banks and brokers operating in a financing

centre purchasing and selling currencies, connected to each

other by tele-communications like telex, telephone and a

satellite communication network.

The term foreign exchange market is used to refer to the

wholesale segment of the market, where the dealings take

place among the banks. The retail segment refers to the

dealings take place between banks and their customers. The

retail segment is situated at a large number of places. They

can be considered not as foreign exchange markets, but as

the counters of such markets. The central banks monitor

market movements and sentiments and intervene according



to government policy. The function of buying and selling

of foreign currencies in India is performed by authorized

dealers / moneychangers appointed by the RBI. The foreign

exchange department of the major banks are linked across

the world on a 24 hour basis. Major commercial centers are

London, Amsterdam, Frankfurt, Milan, Paris, New York,

Toronto, Bahrain, Tokyo, Hong Kong and Singapore.

3.1.1. Functions of a foreign exchange market:

Purchasing power is transferred across different

countries which will enhance the feasibility of

international trade and overseas investments

The foreign exchange market acts as a central

focal point wherein prices of various currencies are

discovered.

Enables the investors to hedge or minimize their risks

Enables the traders to arbitrage any inequalities

Provides an investment / trading avenue to entities

who are willing to expose themselves to this risk

3.1.2. Foreign currency and foreign exchange :

In the context of India, any currency other than Indian

rupees is foreign currency. Foreign exchange includes

currency, drafts, bills, letters of credits and traveler cheques

which are denominated and ultimately payable in foreign

currency.



3.1.3. Determinants of Exchange rate

Purchasing power parity (Inflation) theorem:

Difference in inflation rates between two countries is

considered as the most important factor for variations

in exchange rates. If domestic inflation is high, it

means domestic goods are costlier than foreign

goods. This results in higher imports creating more

demand for foreign currency, making it costlier. (In

other words the value of domestic currency will

decline). If a basket of goods cost Rs470 in India and

$10 in US then it is quite natural that the exchange

rate should be Rs47/$1. PPP theory can be expressed

by the formula: PPPr = Spot rate (1+rh) (1+rf) where

rh is inflation rate at home; rf is the inflation rate of

foreign country.

Weakness of PPP theory : It is not only inflation,

which affects foreign currency movements. PPP

ignores substitution effects – i.e. instead of importing

goods might be substituted.

Interest Rate Parity Theorem: The second most

important factor in determining exchange rates

after PPP theory. Money tends to move towards

country offering a higher interest rate thereby

resulting in more demand for the foreign country’s

currency. If interest rates in Japan are lower than

interest rates in US then Japanese investors would

prefer to invest in US which would result in more

demand for US $ in Japan (this will cause US$ to

appreciate in Japan). Interest rates provide the

basis for computing forward rates as under:

Forward rate = Spot rate x (1+If) (1+Ih)



Balance of payments position : The BOP position has a

big impact on the value of a nation’s currency. A big or

consistent deficit would mount a pressure on the

currency of a nation as deficits require payments in

foreign currency. In the case of a fixed currency rate

scenario – the local currency would be devalued thereby

making imports costlier and exports cheaper. However

in the free rate scenario a big or consistent deficit would

be a forewarning for depreciation of a nations currency

Government intervention : At times the government

would intervene by purchasing or selling foreign

exchange to control pressures on the nation’s currency.

Market expectation : Market expectation as regards

interest rates, inflation, taxes, BOP positions etc would

affect the foreign exchange rates. Overseas investment :

E.g. if US investments in India increases there would be

dollar inflows putting downward pressure on dollar in

India.

Speculation : Speculators including treasury managers of

banks, by virtue of their buying and selling, tend to

influence the rates.

3.1.4. Participants in Foreign Exchange Market

Foreign exchange market (Forex market) witnesses a lot

of market participants. However, all of these participants

have different motives. An understanding of these

motives is required to predict their behavior in the

markets. Also, some of these participants have deeper

pockets, better information and are more active than the

others. Therefore, here we discuss the different kinds of



participants that they are likely to come across when

they trade in this market. The participants have been

listed in descending order. This means that dealers are

the most active traders in the Forex markets, followed by

brokers and so on. It would also be fair to say that

dealers have the maximum information about the

market, followed by brokers and so on.

Forex Dealers

Forex dealers are one amongst the biggest

participants in the Forex market. They are also known

as broker dealers. Most Forex dealers in the world are

banks. It is for this reason that the market in which dealers

interact with one another is also known as the interbank

market. However, there are some notable non-bank

financial institutions also that deal in foreign exchange.

These dealers participate in the Forex markets by providing

bid-ask quotes for currency pairs at all times. All brokers do

not participate in all currency pairs. Rather, they may

specialize in a specific currency pair. Alternatively, a lot of

dealers also use their own capital to conduct proprietary

trading operations. When both these operations are

combined, Forex dealers have a significant participation in

the Forex market.

Brokers

The Forex market is largely devoid of brokers. This is

because a person need not deal with brokers necessarily. If

they have sufficient knowledge, they can directly call the

dealer and obtain a favorable rate. However, there are

brokers in the Forex market. These brokers exist because

they add value to their clients by helping them obtain the



best quote. For instance, they may help their clients obtain

the lowest buying price or the highest selling price by

making available quotes from several dealers. Another

major reason for using brokers is creating anonymity while

trading. Many big investors and even Forex dealers use the

services of brokers who act as henchmen for the trading

operations of these big players.

Hedgers

There are many businesses which end up creating an

asset or a liability priced in foreign currency in the

regular course of their business. For instance, importers

and exporters engaged in foreign trade may have open

positions in several foreign currencies. They may

therefore be impacted if there is a fluctuation in the

value of foreign currency. As a result, to protect

themselves against these losses, hedgers take opposite

positions in the market. Therefore if there is an

unfavorable movement in their original position, it is

offset by an opposite movement in their hedged

positions. Their profits and losses and therefore

nullified and they get stability in the operations of their

business.

Speculators

Speculators are a class of traders that have no genuine

requirement for foreign currency. They only buy and

sell these currencies with the hope of making a profit

from it. The number of speculators increases a lot when

the market sentiment is high and everyone seems to be

making money in the Forex markets. Speculators

usually do not maintain open positions in any currency



for a very long time. Their positions are transient and

are only meant to make a short term profit.

Arbitrageurs

Arbitrageurs are traders that take advantage of the

price discrepancy in different markets to make a profit.

Arbitrageurs serve an important function in the foreign

exchange market. It is their operations that ensure that

a market as large, as decentralized and as diffused as

the Forex market functions efficiently and provides

uniform price quotations all over the world. Whenever

arbitrageurs find a price discrepancy in the market,

they start buying in one place and selling in another till

the discrepancy disappears.

Central Banks

Central Banks of all countries participate in the Forex

market to some extent. Most of the times, this

participation is official. Although many times Central

Banks do participate in the market by covert means.

This is because every Central Bank has a target range

within which they would like to see their currency

fluctuate. If the currency falls out of the given range,

Central Banks conduct open market operations to bring

it back in range. Also, whenever the currency of a

given nation is under speculative attack, Central Banks

participate extensively in the market to defend their

currency.

Retail Market Participants

Retail market participants include tourists, students and even

patients who are travelling abroad. Then there are also a



variety of small businesses that indulge in foreign trade.

Most of the retail participants participate in the spot market

whereas people with long term interests operate in the

futures market. This is because these participants only

buy/sell currency when they have a personal/professional

requirement and dealing with foreign currencies is not a part

of their regular business.

3.2. Stability of Foreign Exchange Markets

In this section, we examine the meanings of and the

conditions for stability of the foreign exchange market. We

have a stable foreign exchange market when a disturbance

from the equilibrium exchange rate gives rise to automatic

forces that push the exchange rate back toward the

equilibrium level. We have an unstable foreign exchange

market when a disturbance from equilibrium pushes the

exchange rate further away from equilibrium.

3.2.1. A Stable and Unstable Foreign Exchange

Markets

A foreign exchange market is stable when the supply

curve of foreign exchange is positively sloped or, if

negatively sloped, is less elastic (steeper) than the demand

curve of foreign exchange. A foreign exchange market is

unstable if the supply curve is negatively sloped and more

elastic (flatter) than the demand curve of foreign

exchange.

These conditions are illustrated in Figure 3.1. With D€

and S€, the equilibrium exchange rate is R = $1.20/€1, at

which the quantity of euros demanded and the quantity

supplied are equal at €10 billion per year (point E in the

left panel of Figure 3.1). If, for whatever reason, the



exchange rate fell to R = $1/€1, there would be an excess

demand for euros (a deficit in the U.S. balance of

payments) of €4 billion (AB), which would automatically

push the exchange rate back up toward the equilibrium

rate of R = $1.20/€1. On the other hand, if the

exchange rate rose to R =

$1.40/€1, there would be an excess quantity supplied of

euros (a surplus in the U.S. balance of payments) of €3

billion (NR), which would automatically drive the

exchange rate back down toward the equilibrium rate of R

= $1.20/€1. Thus, the foreign exchange market shown in

the left panel of Figure 3.1 is stable.

The center panel of Figure 3.1 shows the same D€ as in

the left panel, but S€ is now negatively sloped but steeper

(less elastic) than D€. Once again, the equilibrium

exchange rate is R =

$1.20/€1 (point E). At the lower than equilibrium

exchange rate R = $1/€1, there is an excess demand for

euros (a deficit in the U.S. balance of payments) equal to

€1.5 billion, which automatically pushes the exchange rate

back up toward the equilibrium rate of R = $1.20/€1. At

the higher than equilibrium exchange rate of R = $1.40/€1,

there is an excess supply of euros (a surplus in the U.S.

balance of payments) of €1 billion, which automatically

pushes the exchange rate back down toward the

equilibrium rate of R = $1.20/€1. In this case also, the

foreign exchange market is stable.

The right panel of Figure 3.1 looks the same as the center

panel, but the labels of the demand and supply curves are

reversed, so that now S€ is negatively sloped and flatter



(more elastic) than D€. The equilibrium exchange rate is

still R = $1.20/€1 (point E). Now, however, at any

exchange rate lower than equilibrium, there is an excess

quantity supplied of euros, which automatically drives the

exchange rate even lower and farther away from the

equilibrium rate. For example, at R = $1/€1, there is an

excess quantity supplied of euros of €1.5 billion, which

pushes the exchange rate even lower and farther away

from R = $1.20/€1. On the other hand, at R = $1.40/€1,

there is an excess quantity demanded for euros of €1

billion, which automatically pushes the exchange rate even

higher and farther away from the equilibrium rate. Thus,

the foreign exchange market in the right panel is unstable.

Figure 3.1: Stable and Unstable Foreign Exchange

Markets

When the foreign exchange market is unstable, a flexible

exchange rate system increases rather than reduces a

balance-of-payments disequilibrium. Then a revaluation or

an appreciation rather than a devaluation of the deficit

nation’s currency is required to eliminate or reduce a



deficit, while a devaluation would be necessary to correct a

surplus. These policies are just the opposite of those

required under a stable foreign exchange market.

Determining whether the foreign exchange market is stable

or unstable is, therefore, crucial. Only after the foreign

exchange market has been determined to be stable will the

elasticity of D€ and S€ (and thus the feasibility of

correcting a balance-of-payments disequilibrium with a

depreciation or devaluation of the deficit nation’s currency)

become important.

3.2.2. The Marshall–Lerner Condition

The Marshall-Lerner condition, which states that a currency

devaluation will only lead to an improvement in the

balance of payments if the sum of demand elasticity for

imports and exports is greater than one, is named after

English economist Alfred Marshall (1842-1924) and the

Romanian born economist Abba Lerner (1905 – 1985).

This refers to the proposition that the devaluation of a

country’s currency will lead to an improvement in its

balance of trade with the rest of the world only if the sum

of the price elasticities of its exports and imports is greater

than one. For instance, if total export revenue falls due to

inelastic demand for a country’s exports and total import

expense rises due to inelastic demand for its imports, this

will lead to a further worsening of the country’s trade

deficit. So devaluing its currency may not always be the

best way forward for a country looking to reduce its trade

deficit.

Here we discuss the simplified version of Marshall- Learner

condition that is generally used. This is valid when the

supply curves of imports and exports (i.e., SM and SX ) are



both infinitely elastic, or horizontal. Then the Marshall–

Lerner condition indicates a stable foreign exchange market

if the sum of the price elasticities of the demand for imports

(DM) and the demand for exports (DX), in absolute terms, is

greater than 1. If the sum of the price elasticities of DM and

DX is less than 1, the foreign exchange market is unstable,

and if the sum of these two demand elasticities is equal to 1,

a change in the exchange rate will leave the balance of

payments unchanged.

3.3. Spot Market and Forward Market

Foreign exchange markets are sometimes classified into spot

market and forward market on the basis of the period of

transaction carried out. It is explained below:

(a) Spot Market:

If the operation is of daily nature, it is called spot market

or current market. It handles only spot transactions or

current transactions in foreign exchange. Transactions are

affected at prevailing rate of exchange at that point of time

and delivery of foreign exchange is affected instantly. The

most common type of foreign exchange transaction

involves the payment and receipt of the foreign exchange

within two bussiness days after the day the transaction is

agreed upon. The two-day period gives adequate time for

the parties to send instructions to debit and credit the

appropriate bank accounts at home and abroad. This type of

transaction is called a spot transaction, and the exchange

rate at which the transaction takes place is called the spot

rate. The exchange rate R = $/₹ = 1 is a spot rate.

For instance, if one US dollar can be purchased for Rs 40

at the point of time in the foreign exchange market, it will



be called spot rate of foreign exchange. No doubt, spot rate

of foreign exchange is very useful for current transactions

but it is also necessary to find what the spot rate is. In

addition, it is also significant to find the strength of the

domestic currency with respect to all of home country’s

trading partners. Note that the measure of average relative

strength of a given currency is called Effective Exchange

Rate (EER).

(b) Forward Market:

A market in which foreign exchange is bought and sold for

future delivery is known as Forward Market. It deals with

transactions (sale and purchase of foreign exchange) which

are contracted today but implemented sometimes in future.

A forward transaction involves an agreement today to buy

or sell a specified amount of a foreign currency at a

specified future date at a rate agreed upon today (the

forward rate). For example, I could enter into an

agreement today to purchase ₹100 three months from

today at $1.01 = ₹1. Note that no currencies are paid out at

the time the contract is signed (except for the usual 10

percent security margin). After three months, I get the

₹100 for $101, regardless of what the spot rate is at that

time. The typical forward contract is for one month, three

months, or six months, with three months the most

common. Forward contracts for longer periods are not as

common because of the great uncertainties involved.

However, forward contracts can be renegotiated for one or

more periods when they become due. The equilibrium

forward rate is determined at the intersection of the market

demand and supply curves of foreign exchange for future

delivery. The demand for and supply of forward foreign

exchange arise in the course of hedging, from foreign



exchange speculation, and from covered interest arbitrage.

A forward contract is entered into for two reasons: To

minimise risk of loss due to adverse change in exchange rate

(i.e., hedging) and to make a profit (i.e., speculation).

At any point in time, the forward rate can be equal to,

above, or below the corresponding spot rate. If the forward

rate is below the present spot rate, the foreign currency

is said to be at a forward discount with respect to the

domestic currency. However, if the forward rate is above

the present spot rate, the foreign currency is said to be at a

forward premium. For example, if the spot rate is $1 = ₹1

and the three-month forward rate is $0.99 = ₹1, we say that

the rupee is at a three-month forward discount of 1 percent

(or at a 4 percent forward discount per year) with respect to

the dollar. On the other hand, if the spot rate is still $1 = ₹1

but the three-month forward rate is instead $1.01 = ₹1, the

rupee is said to be at a forward premium of 1 percent for

three months, or 4 percent per year. Forward discounts

(FD) or premiums (FP) are usually expressed as

percentages per year.

3.4. Foreign Exchange Futures and Options

Currency futures and options are derivative contracts.

Depending on the selection of buying or selling the

numerator or denominator of a currency pair, the

derivative contracts are known as futures and options.

There are various ways to earn a profit from futures and

options, but the contract-holder is always obliged to certain

rules when they go into a contract. Currencies are always

traded in pairs. For example, the Euro and U.S. Dollar pair

is expressed as EUR/USD. When someone buys this pair,

they are said to be going long (buying) with the numerator,



or the base, currency, which is the Euro; and thereby selling

the denominator (quote) currency, which is the Dollar.

When someone sells the pair, it is selling the Euro and

buying the Dollar. When the long currency appreciates

against the short currency, people make money.

Foreign Exchange Options:

A foreign exchange option is a contract giving the purchaser

the right, but not the obligation, to buy (a call option) or to

sell (a put option) a standard amount of a traded currency on

a stated date or at any time before a stated date and at a

stated price (the strike or exercise price). If an investor

purchases the right to buy an asset at a specific price within

a given time frame, he has purchased a call option. On the

contrary, if he purchases the right to sell an asset at a given

price, he has purchased a put option. The seller has the

corresponding obligation to fulfill the transaction that is to

sell or buy if the buyer (owner) exercises the option. The

buyer pays a premium to the seller for this right. An option

that conveys to the owner the right to buy something at a

certain price is a "call option"; an option that conveys the

right of the owner to sell something at a certain price is a

"put option".

Options contracts were used for many centuries, however

both trading activity and academic interest increased when,

as from 1973, options were issued with standardized terms

and traded through a guaranteed clearing house at the

Chicago Board Options Exchange. Today many options are

created in a standardized form and traded through clearing

houses on regulated options exchanges, while other over-

the-counter options are written as bilateral, customized

contracts between a single buyer and seller, one or both of



which may be a dealer or market- maker. Options are part of

major category of financial instruments termed as derivative

products or simply derivatives.

Features of options:

A fixed maturity date on which they expire (Expiry

date).

The price at which the option is exercised is called the

exercise price or strike price.

The person who writes the option and is the seller is

denoted as the "option writer", and who holds the option

and is the buyer, is called "option holder".

The premium is the price paid for the option by the

buyer to the seller.

A clearing house is interposed between the seller and

the buyer which guarantees performance of the contract.

Foreign Exchange Futures:

An individual, firm, or bank can also purchase or sell

foreign exchange futures and options. Trading in foreign

exchange futures was initiated in 1972 by the International

Monetary Market (IMM) of the Chicago Mercantile

Exchange (CME). A foreign exchange futures is a forward

contract for standardized currency amounts and selected

calendar dates traded on an organized market (exchange).

The currencies traded on the IMM are the Japanese yen, the

Canadian dollar, the British pound, the Swiss franc, the

Australian dollar, the Mexican peso, and the euro. The IMM

imposes a daily limit on exchange rate fluctuations. Buyers



and sellers pay a brokerage commission and are required to

post a security deposit or margin (about 4 percent of the

value of the contract). the futures market only a few

currencies are traded; trades occur in standardized contracts

only, for a few specific delivery dates, and are subject to

daily limits on exchange rate fluctuations; and trading takes

place only in a few geographical locations, such as Chicago,

New York, London, Frankfurt, and Singapore. Futures

contracts are usually for smaller amounts and thus are more

useful to small firms than to large ones but are somewhat

more expensive. Futures contracts can also be sold at any

time up until maturity on an organized futures market. The

market for currency futures is small and it has grown very

rapidly, especially in recent years.

Foreign Exchange Swaps

Swap means to exchange one for another. A foreign

exchange swap refers to a spot sale of a currency combined

with a forward repurchase of the same currency—as part of

a single transaction. It means, where one leg's cash flows are

paid in one currency, while the other leg's cash flows are

paid in another currency. It can be either fixed for floating,

floating for floating, or fixed for fixed. In order to price

foreign exchange swap, first each leg is present valued in its

currency. For example, suppose that Citibank receives a $1

million payment today that it will need in three months, but

in the meantime it wants to invest this sum in euros.

Citibank would incur lower brokerage fees by swapping the

$1 million into euros with Frankfurt’s Deutsche Bank as

part of a single transaction or deal, instead of selling dollars

for euros in the spot market today and at the same time

repurchasing dollars for euros in the forward market for

delivery in three months—in two separate transactions. The



swap rate (usually expressed on a yearly basis) is the

difference between the spot and forward rates in the

currency swap. Most interbank trading involving the

purchase or sale of currencies for future delivery is done not

by forward exchange contracts alone but combined with

spot transactions in the form of foreign exchange swaps.

The foreign exchange market is dominated by the foreign

exchange swap and spot markets. Swaps were first

introduced to the public in 1981 when IBM and the World

Bank entered into a swap contract. Presently, swaps are

among the most heavily traded financial contracts around

the globe.

3.5. Foreign Exchange Risks, Hedging, and

Speculation

Foreign Exchange Risks

Through time, a nation’s demand and supply curves for

foreign exchange shift, causing the spot (and the forward)

rate to vary frequently. A nation’s demand and supply

curves for foreign exchange shift over time as a result of

changes in tastes for domestic and foreign products in the

nation and abroad, different growth and inflation rates in

different nations, changes in relative rates of interest,

changing expectations, and so on. For example, if U.S.

tastes for EMU products increase, the U.S. demand for euros

increases (the demand curve shifts up), leading to a rise in

the exchange rate (i.e., a depreciation of the dollar). On the

other hand, a lower rate of inflation in the United States

than in the European Monetary Union leads to U.S. products

becoming cheaper for EMU residents. This tends to increase

the U.S. supply of euros (the supply curve shifts to the

right) and causes a decline in the exchange rate (i.e., an



appreciation of the dollar). Or simply the expectation of a

stronger dollar may lead to an appreciation of the dollar. In

short, in a dynamic and changing world, exchange rates

frequently vary, reflecting the constant change in the

numerous economic forces simultaneously at work. The

frequent and relatively large fluctuations in exchange rates

impose foreign exchange risks on all individuals, firms, and

banks that have to make or receive future payments

denominated in a foreign currency.

Whenever a future payment must be made or received in a

foreign currency, a foreign exchange risk, or a so-called

open position, is involved because spot exchange rates vary

over time. In general, businesspeople are risk averse and

they will want to avoid or insure themselves against their

foreign exchange risk. A foreign exchange risk arises not

only from transactions involving future payments and

receipts in a foreign currency (the transaction exposure) but

also from the need to value inventories and assets held

abroad in terms of the domestic currency for inclusion in the

firm’s consolidated balance sheet (the translation or

accounting exposure), and in estimating the domestic

currency value of the future profitability of the firm (the

economic exposure).

Hedging

Hedging refers to the avoidance of a foreign exchange risk,

or the covering of an open position. It is a financial

technique that helps to reduce or mitigate the effects of

measurable type of risk from the future changes in the fair

value of commodities, cash flows, securities, currencies,

assets and liabilities. It is a kind of an insurance that do

not eliminate the risk completely but mitigate its effect. In



other words, it is a risk-reducing tool wherein the firm uses

the derivatives and other instruments to offset the future

changes in the value of securities, currencies, assets, etc.

The firm uses several derivatives or other instruments to

hedge against the exchange risk.

The following are the main advantages of risk management

through hedging:

The financial risk management enables the managers to

hedge against the probable movement in the exchange rates

and interest rates. These are the factors that are beyond

management control and cannot be predicted with certainty.

Thus, it encourages the managers to direct their efforts

towards the improvement of the operations rather than

worrying about the factors that are not under their control.

It helps to differentiate the effects of fluctuation in the

external factors viz. exchange rates and interest rates and

management performance. Even if the company hedges its

risk and suffers a huge loss, then it can be said that

management is bad.

Thus the primary objective of the risk management tool is to

reduce the risk, not to save cost or earn profits.

The cost of avoiding the foreign exchange risk equal to the

positive difference between the borrowing and deposit rates

of interest. Hedging usually takes place in the forward

market, where no borrowing or tying up of funds is required.

A foreign exchange risk can also be hedged and an open

position avoided in the futures or options markets. In a

world of foreign exchange uncertainty, the ability of traders

and investors to hedge greatly facilitates the international



flow of trade and investments. Without hedging there would

be smaller international capital flows, less trade and

specialization in production, and smaller benefits from trade.

Note that a large firm, such as a multinational corporation,

that has to make and receive a large number of payments in

the same foreign currency at the same time in the future

need only hedge its net open position. Similarly, a bank has

an open position only in the amount of its net balance on

contracted future payments and receipts in each foreign

currency at each future date. The bank closes as much of its

open positions as possible by dealing with other banks

(through foreign exchange brokers), and it may cover the

remainder in the spot, futures, or options markets.

Speculation

Speculation is the opposite of hedging. Whereas a hedger

seeks to cover a foreign exchange risk, a speculator accepts

and even seeks out a foreign exchange risk, or an open

position, in the hope of making a profit. If the speculator

correctly anticipates future changes in spot rates, he or she

makes a profit; otherwise, he or she incurs a loss. As in the

case of hedging, speculation can take place in the spot,

forward, futures, or options markets—usually in the forward

market. Speculation in foreign exchange is very risky and

can lead to huge losses.

We begin by examining speculation in the spot market. If a

speculator believes that the spot rate of a particular foreign

currency will rise, he or she can purchase the currency now

and hold it on deposit in a bank for resale later. If the

speculator is correct and the spot rate does indeed rise, he or

she earns a profit on each unit of the foreign currency equal

to the spread between the previous lower spot rate at which



he or she purchased the foreign currency and the higher

subsequent spot rate at which he or she resells it. If the

speculator is wrong and the spot rate falls instead, he or she

incurs a loss because the foreign currency must be resold at

a price lower than the purchase price. If, on the other hand,

the speculator believes that the spot rate will fall, he or she

borrows the foreign currency for three months, immediately

exchanges it for the domestic currency at the prevailing spot

rate, and deposits the domestic currency in a bank to earn

interest. After three months, if the spot rate on the foreign

currency is lower, as anticipated, the speculator earns a profit

by purchasing the currency (to repay the foreign exchange

loan) at the lower spot rate. If the spot rate in three months is

higher rather than lower, the speculator incurs a loss.

In both of the preceding examples, the speculator operated

in the spot market and either had to tie up his or her own

funds or had to borrow to speculate. It is to avoid this

serious shortcoming that speculation, like hedging, usually

takes place in the forward market. When a speculator buys a

foreign currency on the spot, forward, or futures market, or

buys an option to purchase a foreign currency in the

expectation of reselling it at a higher future spot rate, he or

she is said to take a long position in the currency. On the

other hand, when the speculator borrows or sells forward a

foreign currency in the expectation of buying it at a future

lower price to repay the foreign exchange loan or honor the

forward sale contract or option, the speculator is said to

take a short position (i.e., the speculator is now selling what

he or she does not have).

Speculation can be stabilizing or destabilizing. Stabilizing

speculation refers to the purchase of a foreign currency

when the domestic price of the foreign currency (i.e., the



exchange rate) falls or is low, in the expectation that it will

soon rise, thus leading to a profit. Or it refers to the sale of

the foreign currency when the exchange rate rises or is high,

in the expectation that it will soon fall. Stabilizing

speculation moderates fluctuations in exchange rates over

time and performs a useful function. On the other hand,

destabilizing speculation refers to the sale of a foreign

currency when the exchange rate falls or is low, in the

expectation that it will fall even lower in the future, or the

purchase of a foreign currency when the exchange rate is

rising or is high, in the expectation that it will rise even

higher in the future. Destabilizing speculation thus

magnifies exchange rate fluctuations over time and can

prove very disruptive to the international flow of trade and

investments. In general, it is believed that under “normal”

conditions speculation is stabilizing, and we assume so here.

Speculators are usually wealthy individuals or firms rather

than banks. However, anyone who has to make a payment

in a foreign currency in the future can speculate by speeding

up payment if he or she expects the exchange rate to rise and

delaying it if he or she expects the exchange rate to fall,

while anyone who has to receive a future payment in a

foreign currency can speculate by using the reverse tactics.

For example, if an importer expects the exchange rate to

rise soon, he or she can anticipate the placing of an order

and pay for imports right away. On the other hand, an

exporter who expects the exchange rate to rise will want to

delay deliveries and extend longer credit terms to delay

payment. These are known as leads and lags and are a form

of speculation.



3.6. Currency Arbitrage

The exchange rate between any two currencies is kept the

same in different monetary centers by arbitrage. This refers

to the purchase of a currency in the monetary center where it

is cheaper, for immediate resale in the monetary center

where it is more expensive, in order to make a profit.

Arbitrage refers to purchase of an asset in a low price

market and its sale in a higher price market. This process

leads to equalisation of price of an asset in all the segments

of the market. Arbitrageurs take advantage of the different

exchange rates prevailing in various foreign exchange

markets due to different interest rates. They purchase

foreign currency from the foreign exchange market with

lower exchange rate and sell the same in market with a

higher exchange rate. Arbitrage is also possible within the

country where two banks offer two different bids and asking

rate. When arbitrage involves only two currencies or two

countries, it is called two-point arbitrage. It increases the

supply of dearer currency.

For example, if the dollar price of the euro was $0.99 in

New York and $1.01 in Frankfurt, an arbitrageur (usually a

foreign exchange dealer of a commercial bank) would

purchase euros at $0.99 in New York and immediately

resell them in Frankfurt for $1.01, thus realizing a profit of

$0.02 per euro. While the profit per euro transferred seems

small, on €1 million the profit would be $20,000 for only a

few minutes work. From this profit must be deducted the

cost of the electronic transfer and the other costs associated

with arbitrage. Since these costs are very small.

As arbitrage takes place, however, the exchange rate

between the two currencies tends to be equalized in the two



monetary centers. Continuing our example, we see that

arbitrage increases the demand for euros in New York,

thereby exerting an upward pressure on the dollar price of

euros in New York. At the same time, the sale of euros in

Frankfurt increases the supply of euros there, thus exerting a

downward pressure on the dollar price of euros in Frankfurt.

This continues until the dollar price of the euro quickly

becomes equal in New York and Frankfurt (say at $1 = €1),

thus eliminating the profitability of further arbitrage.

When only two currencies and two monetary centers are

involved in arbitrage, as in the preceding example, we have

two-point arbitrage. When three currencies and three

monetary centers are involved, we have triangular, or three-

point, arbitrage. While triangular arbitrage is not very

common, it operates in the same manner to ensure consistent

indirect, or cross, exchange rates between the three

currencies in the three monetary centers.

As in the case of two-point arbitrage, triangular arbitrage

increases the demand for the currency in the monetary

center where the currency is cheaper, increases the supply of

the currency in the monetary center where the currency is

more expensive, and quickly eliminates inconsistent cross

rates and the profitability of further arbitrage. As a result,

arbitrage quickly equalizes exchange rates for each pair of

currencies and results in consistent cross rates among all

pairs of currencies, thus unifying all international monetary

centers into a single market.

3.7. Internal and External Balance with Expenditure-

Changing and Expenditure- Switching Policies

The adjustment policies are the policies that are used to



achieve full employment with price stability and equilibrium

in the balance of payments. The need for adjustment

policies arises because of the absence of automatic

adjustment mechanisms. The economist most responsible

for shifting the emphasis from automatic adjustment

mechanisms to adjustment policies was James Meade. The

most important economic goals or objectives of nations are

(1) internal balance, (2) external balance, a reasonable rate

of growth, (4) an equitable distribution of income, and (5)

adequate protection of the environment.

Internal balance refers to full employment or a rate of

unemployment of no more than, say, 4 to 5 percent per year

(the so-called frictional unemployment arising in the process

of changing jobs) and a rate of inflation of no more than 2 or

3 percent per year. External balance refers to equilibrium in

the balance of payments (or a desired temporary

disequilibrium such as a surplus that a nation may want in

order to replenish its depleted international reserves). In

general, nations place priority on internal over external

balance, but they are sometimes forced to switch their

priority when faced with large and persistent external

imbalances.

To achieve these objectives, nations have the following

policy instruments at their disposal: (1) expenditure-

changing, or demand, policies, (2) expenditure switching

policies, and (3) direct controls.

Expenditure-changing policies include both fiscal and

monetary policies. Fiscal policy refers to changes in

government expenditures, taxes, or both. Fiscal policy is

expansionary if government expenditures are increased

and/or taxes reduced. These actions lead to an expansion of



domestic production and income through a multiplier

process (just as in the case of an increase in domestic

investment or exports) and induce a rise in imports

(depending on the marginal propensity to import of the

nation). Contractionary fiscal policy refers to a reduction in

government expenditures and/or an increase in taxes, both of

which reduce domestic production and income and induce a

fall in imports.

The introduction of the government sector means that the

equilibrium condition of Equation 3.1 must be extended to

become Equation 3.2, where G refers to government

expenditures and T to taxes:

I + X = S + M (3.1)

I + X + G = S + M + T (3.2)

Government expenditures (G), just like investments (I)

and exports (X), are injections into the system, while taxes

(T), just like savings (S) and imports (M), are a leakage from

the system. Equation (3.2) can also be rearranged as

(G − T) = (S − I ) + (M − X) (3.3)

Which postulates that a government budget deficit (G>T)

must be financed by an excess of S over I and/ or an excess

of M over X. Expansionary fiscal policy refers to an

increase in (G −T), and this can be accomplished with an

increase in G, a reduction in T, or both. Contractionary fiscal

policy refers to the opposite.

Monetary policy involves a change in the nation’s money

supply that affects domestic interest rates. Monetary policy

is easy if the money supply is increased and interest rates



fall. This induces an increase in the level of investment and

income in the nation (through the multiplier process) and

induces imports to rise. At the same time, the reduction in

the interest rate induces a short-term capital outflow or

reduced inflow. On the other hand, tight monetary policy

refers to a reduction in the nation’s money supply and a rise

in the interest rate. This discourages investment, income,

and imports, and also leads to a short-term capital inflow or

reduced outflow.

Expenditure-switching policies refer to changes in the

exchange rate (i.e., a devaluation or revaluation). A

devaluation switches expenditures from foreign to domestic

commodities and can be used to correct a deficit in the

nation’s balance of payments. But it also increases domestic

production, and this induces a rise in imports, which

neutralizes a part of the original improvement in the trade

balance. A revaluation switches expenditures from

domestic to foreign products and can be used to correct a

surplus in the nation’s balance of payments. This also

reduces domestic production and, consequently, induces a

decline in imports, which neutralizes part of the effect of the

revaluation.

Direct controls consist of tariffs, quotas, and other

restrictions on the flow of international trade and capital.

These are also expenditure-switching policies, but they can

be aimed at specific balance-of-payments items (as opposed

to a devaluation or revaluation, which is a general policy and

applies to all items at the same time). Direct controls in the

form of price and wage controls can also be used to stem

domestic inflation when other policies fail. Faced with

multiple objectives and with several policy instruments at its

disposal, the nation must decide which policy to utilize to



achieve each of its objectives.

According to Tinbergen (Nobel prize winner in economics

in 1969), the nation usually needs as many effective policy

instruments as the number of independent objectives it has.

If the nation has two objectives, it usually needs two policy

instruments to achieve the two objectives completely; if it

has three objectives, it requires three instruments, and so on.

Sometimes a policy instrument directed at a particular

objective also helps the nation move closer to another

objective. At other times, it pushes the nation even farther

away from the second objective. For example, expansionary

fiscal policy to eliminate domestic unemployment will also

reduce a balance-of-payments surplus, but it will increase a

deficit. Since each policy affects both the internal and

external balance of the nation, it is crucial that each policy

be paired with and used for the objective toward which it is

most effective, according to the principle of effective market

classification developed by Mundell.

Use of expenditure-changing and expenditure-switching

policies to achieve both internal and external balance

Here we examine how a nation can simultaneously attain

internal and external balance with expenditure-changing and

expenditure-switching policies. For simplicity we assume a

zero international capital flow (so that the balance of

payments is equal to the nation’s trade balance). We also

assume that prices remain constant until aggregate demand

begins to exceed the full- employment level of output.

In figure 3.2, the vertical axis measures the exchange rate

(R). An increase in R refers to a devaluation and a decrease

in R to a revaluation. The horizontal axis measures real



domestic expenditures, or absorption (D). Besides domestic

consumption and investments, D also includes government

expenditures (which can be manipulated in the pursuit of

fiscal policy). The EE curve shows the various combinations

of exchange rates and real domestic expenditures, or

absorption, that result in external balance. The EE curve is

positively inclined because a higher R (due to a devaluation)

improves the nation’s trade balance (if the Marshall–Lerner

condition is satisfied) and must be matched by an increase in

real domestic absorption (D) to induce imports to rise

sufficiently to keep the trade balance in equilibrium and

maintain external balance.

For example, starting from point F on EE, an increase in R

from R2 to R3 must be accompanied by an increase in D

from D2 to D3 for the nation to maintain external balance

(point J _ on EE). A smaller increase in D will lead to a

balance-of-trade surplus, while a larger increase in D will

lead to a balance-of-trade deficit. On the other hand, the YY

curve shows the various combinations of exchange rates (R)

and domestic absorption (D) that result in internal balance

(i.e., full employment with price stability). The YY curve is

negatively inclined because a lower R (due to a revaluation)

worsens the trade balance and must be matched with larger

domestic absorption (D) for the nation to remain in internal

balance. For example, starting from point F on YY , a

reduction in R from R2 to R1 must be accompanied by an

increase in D from D2 to D3 to maintain internal balance

(point J on YY ). A smaller increase in D will lead to

unemployment, while a larger increase in D will lead to

excess aggregate demand and (demand-pull) inflation.



In Figure 3.2, we see that only at point F (i.e., at R2 and

D2), defined as where the EE and YY curves intersect, will

the nation be simultaneously in external and internal

balance. With points above the EE curve referring to

external surpluses and points below referring to deficits,

and with points below the YY curve referring to

unemployment and points above referring to inflation, we

can define the following four zones of external and internal

imbalance:

Zone I External surplus and internal unemployment

Zone II External surplus and internal inflation

Zone III External deficit and internal inflation

Zone IV External deficit and internal unemployment

From the figure 3.2 we can now determine the combination

of expenditure-changing and expenditure-switching policies

required to reach point F. For example, starting from point

C (deficit and unemployment), both the exchange rate (R)

and domestic absorption (D) must be increased to reach



point F. By increasing R only, the nation can reach either

external balance (point C_ on the EE curve) or, with a larger

increase in R, internal balance (point C on the YY curve), but

it cannot reach both simultaneously. Similarly, by increasing

domestic absorption only, the nation can reach internal

balance (point J on the YY curve), but this leaves an external

deficit because the nation will be below the EE curve. Note

that although both point C and point H are in zone IV, point

C requires an increase in domestic absorption while point H

requires a decrease in domestic absorption to reach point F.

Even if the nation were already in internal balance, say, at

point J on YY , a devaluation alone could get the nation to

point J _ on EE, but then the nation would face inflation.

Thus, two policies are usually required to achieve two goals

simultaneously. Only if the nation happens to be directly

across from or directly above or below point F will the

nation be able to reach point F with a single policy

instrument. For example, from point N the nation will be

able to reach point F simply by increasing domestic

absorption from D1 to D2. The reason is that this increase in

domestic absorption induces imports to rise by the precise

amount required to eliminate the original surplus without

any change in the exchange rate. But this is unusual.

Figure 3.2. is called a Swan diagram in honor of Trevor

Swan, the Australian economist who introduced it. Under

the fixed exchange rate system that prevailed from the end

of World War II until 1971, industrial nations were

generally unwilling to devalue or revalue their currency

even when they were in fundamental disequilibrium.

Surplus nations enjoyed the prestige of the surplus and

the accumulation of reserves. Deficit nations regarded

devaluation as a sign of weakness and feared it might lead to



destabilizing international capital movements. As a result,

nations were left with only expenditure-changing policies to

achieve internal and external balance.

3.8. Mundell-Fleming Model

The Mundell–Fleming model is used to show how a nation

can use fiscal and monetary policies to achieve both

internal and external balance without any change in the

exchange rate. This model is relating to appropriate use of

monetary and fiscal policy in an open economy under fixed

exchange rates with capital mobility. Under floating

exchange rate there is limited scope for government

intervention to achieve internal and external balance. The

model differentiates the effect of monetary and fiscal policy

on the open economy.

The separation of monetary and fiscal policy was first

accomplished by Swan’s model to include capital flows as

well. ‘External balance’ or ‘balance of payments

equilibrium’ was thus redefined by Mundell to mean a zero

balance in the official financing accounts. In the Mundell

world, the attainment of the external balance target is

influenced by both monetary policy and fiscal policy. For

example, an expansionary monetary policy (in the term of

an decrease in the money supply) which reduces interest

rates will lead to a reduction in the short- term capital

inflows or an increase in short-term capital outflows and to

a BOP deficit.

An expansionary fiscal policy—in the term of an increase

in income and an increase in imports and also a BOP

deficit. Since either expansionary monetary policy or

expansionary fiscal policy is assumed to have an adverse

effect on the BOP, maintaining BOP equilibrium for a



given ex•change rate requires an opposite use of monetary

and fiscal policy in this model, i.e., expan•sionary fiscal

policy must be supported by centractionary monetary

policy, and vice versa.

There is an exactly similar type of policy relationship with

respect to the internal balance target. An increase in the

money supply leads to lower interest rates and tends to

stimulate real investment. This is likely to be expansionary

and/or inflationary. So an increase in investment has to be

offset by a decrease in government spending or by an

increase in taxes that will reduce consumption. Similarly,

maintenance of a given domestic internal balance target

indicates that any increase in government spending (or any

increase in consumption spending via a decrease in taxes)

must be offset by some monetary policy actions such as

raising interest rates by reducing the money supply so as to

prevent the generation of inflationary pressures within the

economy.

Figure 3.3:

Equilibrium in the Goods and Money Markets and in

the Balance of Payments



The IS, LM, and BP curves are shown in Figure 3.3. The IS

curve shows the various combinations of interest rates (i)

and national income (Y) that result in equilibrium in the

goods market. The goods market is in equilibrium

whenever the quantity of goods and services demanded

equals the quantity supplied, or when injections into the

system equal Leakages. The level of investment (I) is now

taken to be inversely related to the rate of interest (i). That

is, the lower the rate of interest (to borrow funds for

investment purposes), the higher is the level of investment

(and national income, through the multiplier process).

The IS curve is negatively inclined because at lower interest

rates, the level of investment is higher so that the level of

national income will also have to be higher to induce a

higher level of saving and imports to once again be equal to

the higher level of investment. At that point, the nation’s

goods market is once again in equilibrium. Exports,

government expenditures, and taxes are not affected by the

increase in the level of national income because they are

exogenous. Thus, equilibrium in the nation’s goods market

is reestablished when I = S + M.

The LM curve shows the various combinations of interest

rates (i) and national income (Y) at which the demand for

money is equal to the given and fixed supply of money, so

that the money market is in equilibrium. Money is

demanded for transactions and speculative purposes. The

transaction demand for money consists of the active

working balances held for the purpose of making business

payments as they become due. The transaction demand for

money is positively related to the level of national income.

That is, as the level of national income rises, the quantity

demanded of active money balances increases (usually in



the same proportion) because the volume of transactions is

greater. The speculative demand for money arises from the

desire to hold money balances instead of interest-bearing

securities. The reason for the preference for money

balances is to avoid the risk of falling security prices.

Furthermore, money balances will allow the holder to take

advantage of possible future (financial) investment

opportunities. However, the higher the rate of interest, the

smaller is the quantity of money demanded for speculative

or liquidity purposes because the cost (interest foregone) of

holding inactive money balances is greater.

The LM curve is positively inclined because the higher the

rate of interest (i ), the smaller the quantity of money

demanded for speculative purposes. The remaining larger

supply of money available for transaction purposes will be

held only at higher levels of national income. To be noted is

that the LM curve is derived on the assumption that the

monetary authorities keep the nation’s money supply fixed.

The BP curve shows the various combinations of interest

rates (i) and national income (Y) at which the nation’s

balance of payments is in equilibrium at a given exchange

rate. The balance of payments is in equilibrium when a

trade deficit is matched by an equal net capital inflow, a

trade surplus is matched by an equal net capital outflow, or

a zero trade balance is associated with a zero net

international capital flow. The BP curve is positively

inclined because higher rates of interest lead to greater

capital inflows (or smaller outflows) and must be balanced

with higher levels of national income and imports for the

balance of payments to remain in equilibrium.

To the left of the FE curve, the nation has a balance-of-



payments surplus and to the right a balance-of-payments

deficit. The more responsive international short-term capital

flows are to changes in interest rates, the flatter is the BP

curve. The BP curve is drawn on the assumption of a

constant exchange rate. A devaluation or depreciation of the

nation’s currency shifts the BP curve down since the

nation’s trade balance improves, and so a lower interest rate

and smaller capital inflows (or greater capital outflows) are

required to keep the balance of payments in equilibrium. On

the other hand, a revaluation or appreciation of the nation’s

currency shifts the BP curve upward. Since we are here

assuming that the exchange rate is fixed, the BP curve does

not shift.

In Figure 3.3, the only point at which the nation is

simultaneously in equilibrium in the goods market, in the

money market, and in the balance of payments is at point

E, where the IS , LM, and BP curves cross. Note that this

equilibrium point is associated with an income level of YE

= 1000, which is below the full-employment level of

national income of YF = 1500. Also to be noted is that the

BP curve need not cross at the IS−LM intersection. In that

case, the goods and money markets, but not the balance of

payments, would be in equilibrium. However, a point such

as E, where the nation is simultaneously in equilibrium in

all three markets, is a convenient starting point to examine

how the nation, by the appropriate combination of fiscal

and monetary policies, can reach the full-employment level

of national income (and remain in external balance) while

keeping the exchange rate fixed. Thus the Mundell-Fleming

model suggests that effective classification of policy

instruments and targets is, no doubt, a strategic issue. It is

an important element in the successful administration of



economic policy in an open economy under fixed exchange

rates.

3.9. The Assignment Problem:

Here we presents and evaluates the so-called assignment

problem, or how fiscal and monetary policies must be used

to achieve both internal and external balance. In Figure 3.4,

movements along the horizontal axis away from the origin

refer to expansionary fiscal policy (i.e., higher government

expenditures and/or lower taxes), while movements along

the vertical axis away from the origin refer to tight

monetary policy (i.e., reductions in the nation’s money

supply and increases in its interest rate).

Figure.3.4: Effective market classification and the policy

mix

The IB line in the figure shows the various combinations of



fiscal and monetary policies that result in internal balance

(i.e., full employment with price stability) in the nation. The

IB line is positively inclined because an expansionary fiscal

policy must be balanced by a tight monetary policy of a

sufficient intensity to maintain internal balance.

Starting at point F in Figure 18.10, an increase in

government expenditures that moves the nation to point A

leads to excess aggregate demand, or demand-pull inflation.

This can be corrected or avoided by the tight monetary

policy and higher interest rate that moves the nation to point

A’ on the IB line. A tight monetary policy that leaves the

nation’s interest rate below that indicated by point A’ does

not eliminate the excess aggregate demand entirely and

leaves some inflationary pressure in the nation. On the other

hand, a tighter monetary policy and higher interest rate that

moves the nation above point A’ not only eliminates the

inflation created by the increase in government

expenditures but leads to unemployment. Thus, to the right

of and below the IB line there is inflation, and to the left of

and above there is unemployment.

On the other hand, the EB line shows the various

combinations of fiscal and monetary policies that result in

external balance (i.e., equilibrium in the nation’s balance

of payments). Starting from a point of external balance on

the EB line, an expansionary fiscal policy stimulates

national income and causes the nation’s trade balance to

worsen. This must be balanced with a tight monetary policy

that increases the nation’s interest rate sufficiently to

increase capital inflows (or reduce capital outflows) for the

nation to remain in external balance.



For example, starting from point F on the EB line, an

expansionary fiscal policy that moves the nation to point A

leads to an external deficit, which can be corrected or

avoided by the tight monetary policy and higher interest

rate that moves the nation to point A” on the EB line. As a

result, the EB line is also positively inclined. A monetary

policy that moves the nation to a point below point A”

leaves an external deficit, while a tighter monetary policy

that moves the nation above point A” leads to an external

surplus.

Thus, to the right of and below the EB line there is an

external deficit, and to the left of and above there is an

external surplus. Only at point F, where the IB and EB lines

cross, will the nation be at the same time in internal and

external balance. The crossing of the IB and EB curves in

Figure 3.4 defines the four zones of internal and external

imbalance. Note that the EB line is flatter than the IB line.

This is always the case whenever short-term international

capital flows are responsive to international interest

differentials.

Expansionary fiscal policy raises national income and

increases the transaction demand for money in the nation.

If monetary authorities increase the money supply

sufficiently to satisfy this increased demand, the interest

rate will remain unchanged. Under these circumstances,

fiscal policy affects the level of national income but not the

nation’s interest rate. On the other hand, monetary policy

operates by changing the money supply and the nation’s

interest rate. The change in the nation’s interest rate affects

not only the level of investment and national income

(through the multiplier process) but also international

capital flows. As a result, monetary policy is more



effective than fiscal policy in achieving external balance,

and so the EB line is flatter than the IB line.

Following the principle of effective market classification,

monetary policy should be assigned to achieve external

balance and fiscal policy to achieve internal balance. If the

nation did the opposite, it would move farther and farther

away from internal and external balance. For example, if

from point C in Figure 3.4, indicating unemployment and a

deficit (zone IV), the nation used a contractionary fiscal

policy to eliminate the external deficit and moved to point

C’1 on the EB line, and then used an easy monetary policy

to eliminate unemployment and moved to point C’2 on the

IB line, the nation would move farther and farther away

from point F. On the other hand, if the nation appropriately

used an expansionary fiscal policy to reach point C1 on the

IB line, and then used a tight monetary policy to reach point

C2 on the EB line, the nation would move closer and closer

to point F.

In fact, the nation could move from point C to point F in a

single step by the appropriate mix of expansionary fiscal

and contractionary monetary policies. The nation could

similarly reach point F from any other point of internal and

external imbalance by the appropriate combination of

fiscal and monetary policies. The more responsive

international short-term capital flows are to interest rate

differentials across nations, the flatter is the EB line in

relation to the IB line. On the other hand, if short-term

capital flows did not respond at all to interest differentials,

the EB line would have the same slope as (and coincide

with) the IB line so that no useful purpose could be served

by separating fiscal and monetary policies as was done



above. In that case, the nation could not achieve internal

and external balance at the same time without also

changing its exchange rate.

Evaluation of the Policy Mix with Price Changes

The combination of fiscal policy to achieve internal balance

and monetary policy to achieve external balance with a

fixed exchange rate faces several criticisms. One of these is

that short- term international capital flows may not respond

as expected to international interest rate differentials, and

their response may be inadequate or even erratic and of a

once-and-for-all nature rather than continuous (as assumed

by Mundell). According to some economists, the use of

monetary policy merely allows the nation to finance its

deficit in the short run, unless the deficit nation continues

to tighten its monetary policy over time. Long-run

adjustment may very well require exchange rate changes.

Another criticism is that the government and monetary

authorities do not know precisely what the effects of fiscal

and monetary policies will be and that there are various

lags in recognition, policy selection, and implementation

before these policies begin to show results.

It is difficult to coordinate fiscal and monetary policies

because fiscal policy is conducted by one branch of the

government while monetary policy is determined by the

central Bank. However, the nation may still be able to

move closer and closer to internal and external balance on a

step- by-step basis (as indicated by the arrows from point if

fiscal authorities pursue only the objective of internal

balance and disregard the external imbalance, and if

monetary authorities can be persuaded to pursue only the



goal of external balance without regard to the effect that

monetary policies have on the internal imbalance.

Another difficulty arises when we relax the assumption that

prices remain constant until the full- employment level of

national income is reached. With price increases or

inflation occurring even at less than full employment, the

nation has at least three objectives: full employment, price

stability, and equilibrium in the balance of payments, thus

requiring three policies to achieve all three objectives

completely. The nation might then have to use fiscal policy

to achieve full employment, monetary policy to achieve

price stability, and exchange rate changes to achieve

external balance. In unusual circumstances, the government

may also impose direct controls to achieve one or more of

its objectives when other policies fail.

Modern nations also have as a fourth objective an

“adequate” rate of growth, which usually requires a low

long-term interest rate to achieve. The nation may then

attempt to “twist” the interest rate structure, keeping long-

term interest rates low and allowing higher short-term

interest rates. Monetary authorities may try to accomplish

this by open market sales of treasury bills and purchases of

long-term bonds .



Module IV

International Capital Flows

Capital, labor, and technology do move across national

boundaries. International trade and movements of

productive resources can be regarded as substitutes for one

another. For example, a relatively capital-abundant and

labor-scarce country, such as the United States, could either

export capital-intensive commodities or export capital itself,

and either import labor-intensive products or allow the

immigration of workers from countries with plentiful labor

supplies. As in the case of international trade, the

movement of productive resources from nations with

relative abundance and low remuneration to nations with

relative scarcity and high remuneration has a tendency to

equalize factor returns internationally and generally

increases welfare. International trade and movements of

productive factors, however, have very different economic

effects on the nations involved. Here we focus on the cost

and benefits of international resource movements. Since

multinational corporations are an important vehicle for the

international flows of capital, labor, and technology, we

also devote a great deal of attention to this relatively new

and crucial type of economic enterprise.

There are two main types of foreign investments: portfolio

investments and direct investments. Portfolio investments

are purely financial assets, such as bonds, denominated in a

national currency. With bonds, the investor simply lends

capital to get fixed payouts or a return at regular intervals



and then receives the face value of the bond at a pre-

specified date. Most foreign investments prior to World

War I were of this type and flowed primarily from the

United Kingdom to the “regions of recent settlement” for

railroad construction and the opening up of new lands and

sources of raw materials. Portfolio or financial investments

take place primarily through financial institutions such as

banks and investment funds. International portfolio

investments collapsed after World War I and have only

revived since the 1960s. Direct investments, on the other

hand, are real investments in factories, capital goods, land,

and inventories where both capital and management are

involved and the investor retains control over use of the

invested capital. Direct investment usually takes the form of

a firm starting a subsidiary or taking control of another firm

(for example, by purchasing a majority of the stock). In the

international context, direct investments are usually

undertaken by multinational corporations engaged in

manufacturing, resource extraction, or services. Direct

investments are now as important as portfolio investments

as forms or channels of international private capital flows.

4.1. International Capital Flows- FDI & FPI

FPI and FDI are both important sources of funding for most

economies. A Foreign Direct Investment (FDI) is an

investment made by a firm or individual in one country into

business interests located in another country. FDI lets an

investor purchase a direct business interest in a foreign

country. Example: Investors can make FDI in a number of

ways. Some common ones include establishing a subsidiary

in another country, acquiring or merging with an existing

foreign company, or starting a joint venture partnership

with a foreign company.



Generally, FDI is when a foreign entity acquires ownership

or controlling stake in the shares of a company in one

country, or establishes businesses there. It is different from

foreign portfolio investment where the foreign entity merely

buys equity shares of a company. In FDI, the foreign entity

has a say in the day-to-day operations of the company. FDI

is not just the inflow of money, but also the inflow of

technology, knowledge, skills and expertise/know-how. It

is a major source of non-debt financial resources for the

economic development of a country. FDI generally takes

place in an economy which has the prospect of growth and

also a skilled workforce. FDI has developed radically as a

major form of international capital transfer since the last

many years. The advantages of FDI are not evenly

distributed. It depends on the host country’s systems and

infrastructure. The determinants of FDI in host countries

are: Policy framework, Rules with respect to entry and

operations/functioning (mergers/acquisitions and

competition), Political, economic and social stability,

Treatment standards of foreign affiliates, International

agreements, Trade policy (tariff and non-tariff barriers),

Privatization policy

Foreign portfolio investment (FPI) consists of securities and

other financial assets passively held by foreign investors. It

does not provide the investor with direct ownership of

financial assets and is relatively liquid depending on the

volatility of the market. Examples of FPIs include stocks,

bonds, mutual funds, exchange traded funds, American

Depositary Receipts (ADRs), and Global Depositary

Receipts (GDRs). FPI is part of a country’s capital account

and is shown on its Balance of Payments (BOP). The BOP

measures the amount of money flowing from one country to

other countries over one monetary year. The brought new



FPI Regulations, 2019, replacing the erstwhile FPI

Regulations of 2014. FPI is often referred to as “hot

money” because of its tendency to flee at the first signs of

trouble in an economy. FPI is more liquid and less risky

than FDI.

Difference Between FDI and FPI

Parameters FDI FPI

Definition The investment

made by foreign

investors to obtain a

substantial interest

in the enterprise

located in a

different country

Investing in the

financial assets

of a foreign

country, such as

stocks or bonds

available on an

exchange.

Role of investors Active investors Passive investors

Type Direct investment Indirect investment

Degree of control High control Very low control

Term Long term investment Short term

investment

Management of

Projects

Efficient Comparatively less

efficient

Investment has

done on

Physical assets of

the foreign country

Financial assets of

the foreign

country

Entry and exit Difficult Relatively easy

Leads to Transfer of funds,

technology, and other

resources to the

foreign country

Capital inflows to

the foreign country

Risks involved Stable Volatile



4.2. Motives for International Capital Flows

Motives for International Portfolio Investments

The basic motive for international portfolio investments is

to earn higher returns abroad. Thus, residents of one

country purchase bonds of another country if the returns on

bonds are higher in the other country. This is the simple and

straight forward outcome of yield maximization and tends

to equalize returns internationally. Residents of one country

may also purchase stock in a corporation in another country

if they expect the future profitability of the foreign

corporation to be greater than that of domestic corporations.

The international portfolio investments occur to take

advantage of higher yields abroad is certainly correct as far

as it goes. It cannot account for observed two-way capital

flows. That is, if returns on securities are lower in one

nation than in another nation, this could explain the flow of

capital investments from the former nation to the latter but

is inconsistent with the simultaneous flow of capital in the

opposite direction, which is often observed in the real

world. To explain two-way international capital flows, the

element of risk must be introduced. That is, investors are

interested not only in the rate of return but also in the risk

associated with a particular investment. The risk with bonds

consists of bankruptcy and the variability in their market

value. With stocks, the risk consists of bankruptcy, even

greater variability in market value, and the possibility of

lower than anticipated returns. Thus, investors maximize

returns for a given level of risk and generally accept a higher

risk only if returns are higher.



Portfolio theory tells us that by investing in securities with

yields that are inversely related over time, a given yield can

be obtained at a smaller risk or a higher yield can be

obtained for the same level of risk for the portfolio as a

whole. Since yields on foreign securities (depending

primarily on the different economic conditions abroad) are

more likely to be inversely related to yields on domestic

securities, a portfolio including both domestic and foreign

securities can have a higher average yield and/or lower risk

than a portfolio containing only domestic securities. To

achieve such a balanced portfolio, a two-way capital flow

may be required.

Risk diversification can explain two-way international

portfolio investments. The investors must determine for

themselves (from their market knowledge and intuition)

what the average returns and variabilities are likely to be in

deciding which stocks to purchase. Since different

individuals can have different expectations for the same

stocks, it is possible that some investors in each nation think

that stocks in the other nation are a better buy. This

provides an additional explanation for two-way

international portfolio investments.

Motives for Direct Foreign Investments

The motives for direct investments abroad are generally the

same as for portfolio investments, that is, to earn higher

returns (possibly resulting from higher growth rates abroad,

more favorable tax treatment, or greater availability of

infrastructures) and to diversify risks. Indeed, it has been

found that firms with a strong international orientation,

either through exports or through foreign production and/or

sales facilities, are more profitable and have a much smaller



variability in profits than purely domestic firms. Many large

corporations (usually in monopolistic and oligopolistic

markets) often have some unique production knowledge or

managerial skill that could easily and profitably be utilized

abroad and over which the corporation wants to retain direct

control. In such a situation, the firm will make direct

investments abroad. This involves horizontal integration, or

the production abroad of a differentiated product that is

also produced at home.

Another important reason for direct foreign investments is

to obtain control of a needed raw material and thus ensure

an uninterrupted supply at the lowest possible cost. This is

referred to as vertical integration and is the form of most

direct foreign investments in developing countries and in

some mineral-rich developed countries. Vertical integration

involving multinational corporations can also go forward

into the ownership of sales or distribution networks abroad,

as is the case with most of the world’s major automobile

producers. Still other reasons for direct foreign investments

are to avoid tariffs and other restrictions that nations impose

on imports or to take advantage of various government

subsidies to encourage direct foreign investments. Other

possible reasons for direct foreign investments are to enter a

foreign oligopolistic market so as to share in the profits, to

purchase a promising foreign firm to avoid its future

competition and the possible loss of export markets, or

because only a large foreign multinational corporation can

obtain the necessary financing to enter the market.

Two-way direct foreign investments can then be explained

by some industries being more advanced in one nation

(such as the computer industry in the United States), while

other industries are more efficient in other nations (such as



the automobile industry in Japan). Direct foreign

investments have been greatly facilitated (in a sense made

possible) by the very rapid advances in transportation (i.e.,

jet travel) and communications (i.e., international telephone

lines and international data transmission and processing) that

have occurred since the end of World War II. These

advances permit the headquarters of multinational

corporations to exert immediate and direct control over the

operations of their subsidiaries around the world, thus

facilitating and encouraging direct investments abroad. The

regional distribution of foreign direct investments around

the world also seems to depend on geographical proximity

or established trade relations.

4.3. Welfare Effects of International Capital Flows

Here we examine the welfare effects of international capital

flows on the investing and host countries. In order to isolate

the effect of capital flows, we assume here that there is no

trade in goods.

Effects on the Investing and Host Countries

In Figure 4.1, we examine a world of only two nations

(Nation 1 and Nation 2) with a total combined capital stock

of OO . Of this total capital stock, OA belongs to Nation 1

and O A belongs to Nation 2. The VMPK1 and VMPK2

curves give the value of the marginal product of capital in

Nation 1 and Nation 2, respectively, for various levels of

investments. Under competitive conditions, the value of the

marginal product of capital represents the return, or yield,

on capital. In isolation, Nation 1 invests its entire capital

stock OA domestically at a yield of OC.



Of the total capital stock of OO , Nation 1 holds OA and its

total output is OFGA, while Nation 2 holds O’A and its total

output is O’JMA. The transfer of AB of capital from Nation

1 to Nation 2 equalizes the return on capital in the two

nations at BE. This increases world output by EGM (the

shaded area), of which EGR accrues to Nation 1 and ERM

to Nation 2. Of the increase in total domestic product of

ABEM in Nation 2, ABER goes to foreign investors,

leaving ERM as the net gain in domestic income in Nation

2.

Other Effects on the Investing and Host Countries

Assuming two factors of production, capital and labor, both

fully employed before and after the capital transfer, that the

total and average return on capital increases, whereas the

total and average return to labor decreases in the investing

country. Thus, while the investing country as a whole gains

from investing abroad, there is a redistribution of domestic



income from labor to capital. On the other hand, while the

host country also gains from receiving foreign investments,

these investments lead to a redistribution of domestic

income from capital to labor. If we allow for less than full

employment, foreign investments tend to depress the level

of employment in the investing country and increase it in the

host country and, once again, can be expected to be opposed

by labor in the former and to benefit labor in the latter.

International capital transfers also affect the balance of

payments of the investing and host countries. A nation’s

balance of payments measures its total receipts from and

total expenditures in the rest of the world. In the year in

which the foreign investment takes place, the foreign

expenditures of the investing country increase and cause a

balance-of-payments deficit (an excess of expenditures

abroad over foreign receipts). The counterpart to the

worsening in the investing nation’s balance of payments is

the improvement in the host nation’s balance of payments

in the year in which it receives the foreign investment. The

initial capital transfer and increased expenditures abroad of

the investing country are likely to be mitigated by increased

exports of capital goods, spare parts, and other products of

the investing country, and by the subsequent flow of profits

to the investing country. It has been estimated that the

“payback” period for the initial capital transfer is between

five and ten years on average.

Another effect to consider in the long run is whether foreign

investments will lead to the replacement of the investing

country’s exports and even to imports of commodities

previously exported. Thus, while the immediate effect on

the balance of payments is negative in the investing country

and positive in the host country, the long-run effects are less



certain. Since foreign investments for most developed

countries are two-way; these short-run and long-run

balance-of-payments effects are mostly neutralized.

Another important welfare effect of foreign investments on

both the investing and host countries results from different

rates of taxation and foreign earnings in various countries.

Foreign investments, by affecting output and the volume of

trade of both investing and host countries, are also likely to

affect the terms of trade. However, the way the terms of

trade will change depends on conditions in both nations,

and not much can be said a priori. Foreign investments may

also affect the investing nation’s technological lead and the

host country’s control over its economy and ability to

conduct its own independent economic policy. Since these

and other effects of international capital transfers usually

result from the operations of multinational corporations.

4.4. Multinational Corporations

One of the most significant international economic

developments of the postwar period is the proliferation of

multinational corporations (MNCs). These are firms that

own, control, or manage production facilities in several

countries. A multinational corporation is a company

incorporated in its home country (country of origin) but it

carries out business operations beyond that country in many

other foreign countries, we call the host countries. Its head

office will be in the home country.

Reasons for the Existence of Multinational

Corporations

The basic reason for the existence of MNCs is the



competitive advantage of a global network of production

and distribution. This competitive advantage arises in part

from vertical and horizontal integration with foreign

affiliates. By vertical integration, most MNCs can ensure

their supply of foreign raw materials and intermediate

products and circumvent (with more efficient intra-firm

trade) the imperfections often found in foreign markets.

They can also provide better distribution and service

networks. By horizontal integration through foreign

affiliates, MNCs can better protect and exploit their

monopoly power, adapt their products to local conditions

and tastes, and ensure consistent product quality. The

competitive advantage of MNCs is also based on economies

of scale in production, financing, research and development

(R&D), and the gathering of market information. The large

output of MNCs allows them to carry division of labor and

specialization in production much further than smaller

national firms. Product components requiring only unskilled

labor can be produced in low-wage nations and shipped

elsewhere for assembly. Furthermore, MNCs and their

affiliates usually have greater access, at better terms, to

international capital markets than do purely national firms,

and this puts MNCs in a better position to finance large

projects. They can also concentrate R&D in one or a few

advanced nations best suited for these purposes because of

the greater availability of technical personnel and facilities.

Finally, foreign affiliates funnel information from around

the world to the parent firm, placing it in a better position

than national firms to evaluate, anticipate, and take

advantage of changes in comparative costs, consumers’

tastes, and market conditions generally.

The large corporation invests abroad when expected profits

on additional investments in its industry are higher abroad.



Since the corporation usually has a competitive advantage

in and knows its industry best, it does not usually consider

the possibility of higher returns in every other domestic

industry before it decides to invest abroad. That is,

differences in expected rates of profits domestically and

abroad in the particular industry are of crucial importance in

a large corporation’s decision to invest abroad. This

explains, for example, Toyota automotive investments in

the United States and IBM computer investments in Japan.

Indeed, it also explains investments of several Japanese

electronics MNCs in the United States as an attempt to

invade the latter’s computer market. All of this information

implies that MNCs are oligopolists selling for the most part

differentiated products, often developed as described by the

technological gap and product cycle models, and produced

under strong economies of scale. Examples of the products

sold by MNCs are motor vehicles, petroleum products,

electronics, metals, office equipment, chemicals, and food.

Multinational corporations are also in a much better

position to control or change to their advantage the

environment in which they operate than are purely national

firms. For example, in determining where to set up a

plant to produce a component, an MNC can and usually

does “shop around” for the low-wage nation that offers the

most incentives in the form of tax holidays, subsidies, and

other tax and trade benefits. The sheer size of most MNCs

in relation to most host nations also means the MNCs are

in a better position than purely national firms to influence

the policies of local governments and extract benefits.

Furthermore, MNCs can buy up promising local firms to

avoid future competition and are in a much better position

than purely domestic firms to engage in other practices that

restrict local trade and increase their profits. MNCs, through



greater diversification, also face lower risks and generally

earn higher profits than purely national firms.

Finally, by artificially overpricing components shipped to

an affiliate in a higher-tax nation and under-pricing

products shipped from the affiliate in the high-tax nation,

an MNC can minimize its tax bill. This is called transfer

pricing and can arise in intra-firm trade as opposed to trade

among independent firms or conducted at “arm’s length.” In

the final analysis, it is a combination of all or most of these

factors that gives MNCs their competitive advantage vis-a-

vis purely national firms and explains the proliferation and `

great importance of MNCs today. That is, by vertical and

horizontal integration with foreign affiliates, by taking

advantage of economies of scale, and by being in a better

position than purely national firms to control the

environment in which they operate, MNCs have grown to

become the most prominent form of private international

economic organization in the world.

Problems Created by Multinational Corporations

in the Home Country

While MNCs, by efficiently organizing production and

distribution on a world-wide basis, can increase world

output and welfare, they can also create serious problems in

both the home and host countries. The most controversial of

the alleged harmful effects of MNCs on the home nation is

the loss of domestic jobs resulting from foreign direct

investments. These are likely to be unskilled and

semiskilled production jobs in which the home nation has a

comparative disadvantage. However, some clerical,

managerial, and technical jobs are also likely to be created

in the headquarters of the MNC in the home nation as a



result of direct foreign investments. Even if the number of

jobs lost exceeds the number created, it may be that the

home nation would have lost these jobs anyway to foreign

competitors and would have had no jobs created at home

without the direct foreign investment.

A related problem is the export of advanced technology to

be combined with other cheaper foreign factors to

maximize corporate profits. It is claimed that this may

undermine the technological superiority and future of the

home nation. However, against this possible harmful effect

is the tendency of MNCs to concentrate their R&D in the

home nation, thus allowing it to maintain its technological

lead.

Another possible harmful effect of MNCs on the home

country can result from transfer pricing and similar

practices, and from shifting their operations to lower-tax

nations, which reduces tax revenues and erodes the tax

base of the home country. This results from common

international taxing practice. Specifically, the host country

taxes the subsidiary’s profits first. To avoid double taxation

of foreign subsidiaries, the home country then usually

taxes only repatriated profits (if its tax rate is higher than in

the host country), and only by the difference in the tax rates.

Finally, because of their access to international capital

markets, MNCs can circumvent domestic monetary policies

and make government control over the economy in the

home nation more difficult. These alleged harmful effects

of MNCs are of crucial importance to the United States,

since it is home for about one-third of the largest MNCs. In

general, home nations do impose some restrictions on the

activities of MNCs, either for balance-of-payments reasons



or, more recently, for employment reasons.

Problems Created by Multinational Corporations

in the Host Country

Host countries have even more serious complaints against

MNCs. First and foremost is the allegation that MNCs

dominate their economies. Foreign domination is felt in

many different ways in host countries, including (1) the

unwillingness of a local affiliate of an MNC to export to a

nation deemed unfriendly to the home nation or the

requirement to comply with a home-nation law prohibiting

such exports; (2) the borrowing of funds abroad to

circumvent tight domestic credit conditions and the lending

of funds abroad when interest rates are low at home; and (3)

the effect on national tastes of large-scale advertising for

such products as Coca-Cola, jeans, and so on. Another

alleged harmful effect of MNCs on the host country is the

siphoning off of R&D funds to the home nation. While this

may be more efficient for the MNC and the world as a

whole, it also keeps the host country technologically

dependent. This is especially true and serious for

developing nations. Also, MNCs may absorb local savings

and entrepreneurial talent, thus preventing them from being

used to establish domestic enterprises that might be more

important for national growth and development.

Multinational corporations may also extract from host

nations most of the benefits resulting from their

investments, either through tax and tariff benefits or

through tax avoidance. In developing nations, foreign direct

investments by MNCs in mineral and raw material

production have often given rise to complaints of foreign

exploitation in the form of low prices paid to host nations,

the use of highly capital-intensive production techniques



inappropriate for labor-abundant developing nations, lack of

training of local labor, overexploitation of natural resources,

and creating highly dualistic “enclave” economies.

Most of these complaints are to some extent true,

particularly in the case of developing host countries, and

they have led many host nations to regulate foreign

investments in order to mitigate the harmful effects and

increase the possible benefits. India specified the sectors in

which direct foreign investments are allowed and set rules

to regulate their operation. Some developing nations allow

only joint ventures (i.e., local equity participation) and set

rules for the transfer of technology and the training of

domestic labor, impose limits on the use of imported inputs

and the remission of profits, set environmental regulations,

and so on. In the extreme, the host nation can nationalize

foreign production facilities. However, this is likely to

seriously reduce the future flow of direct foreign

investments to the nation.

Efforts are currently in progress within the EU, OECD, the

UN, and UNCTAD to devise an international code of

conduct for MNCs. However, since the interests of home

and host countries are generally in conflict, it is virtually

impossible for such an international code to be very

specific. As a result, it is unlikely to succeed in severely

restricting most of the abuses of and problems created by

MNCs in home and host countries. The Uruguay Round

eliminated only some of the domestic restrictions and

regulations on FDI.

4.5. FDI in India

The investment climate in India has improved tremendously



since 1991 when the government opened up the economy

and initiated the LPG strategies. The improvement in this

regard is commonly attributed to the easing of FDI norms.

Many sectors have opened up for foreign investment

partially or wholly since the economic liberalization of the

country. Currently, India ranks in the list of the top 100

countries in ease of doing business. In 2019, India was

among the top ten receivers of FDI, totalling $49 billion

inflows, as per a UN report. This is a 16% increase from

2018. In February 2020, the DPIIT notifies policy to allow

100% FDI in insurance intermediaries. In April 2020, the

DPIIT came out with a new rule, which stated that the

entity of nay company that shares a land border with India or

where the beneficial owner of investment into India is

situated in or is a citizen of such a country can invest only

under the Government route. In other words, such entities

can only invest following the approval of the Government

of India. In early 2020, the government decided to sell a

100% stake in the national airline’s Air India. From April to

August 2020, total Foreign Direct Investment inflow of

USD 35.73 billion was received. It is the highest ever for

the first 5 months of a financial year. FDI inflow has

increased despite Gross Domestic Product (GDP) growth

contracted 23.9% in the first quarter (April-June 2020). FDI

received in the first 5 months of 2020-21 (USD 35.73

billion) is 13% higher as compared to the first five months

of 2019-20 (USD 31.60 billion.

Gross inflows/ gross investment is same as “total FDI

inflow”. The gross inflow consists of (i) direct investment

to India and (ii) repatriation/disinvestment. The

disaggregation shows that direct investment to India has

declined by 2.4%. Hence, an increase of 47% in

repatriation/disinvestment entirely accounts for the rise in

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the gross inflows. In other words, there is a wide gap

between gross FDI inflow and direct investment to India.

Repatriation- significance : FDI inflow increasingly consists

of private equity funds, which are usually disinvested after

3•5 years to book profits (per its business model). In

principle, private equity funds do not make long• term

Greenfield investment. Similarly, measured on a net basis

(that is, “direct investment to India” net of “FDI by India”

or, outward FDI from India), direct investment to India has

barely risen (0.8%) in 2020•21 over the last year. It is

almost entirely on account of “Net Portfolio Investment”,

shooting up from $1.4 billion in 201920 to $36.8 billion in

the next year. That is a whopping 2,526% rise. Further,

within the net portfolio investment, foreign institutional

investment (FIIs) has boomed by an as founding 6,800% to

$38 billion in 2020•21, from a mere half a billion dollars in

the previous year. So, the mystery of the surge in gross FDI

inflows is solved. It is entirely on account of net foreign

portfolio investment.

FDI has three components, viz., equity capital, reinvested

earnings and intra-company loans. Equity capital is the

foreign direct investor’s purchase of shares of an enterprise

in a country other than its own. Reinvested earnings

comprise the direct investors’ share (in proportion to direct

equity participation) of earnings not distributed as dividends

by affiliates, or earnings not remitted to the direct investor.

Such retained profits by affiliates are reinvested. Intra-

company loans or intra-company debt transactions refer to

short- or long-term borrowing and lending of funds between

direct investors (or enterprises) and affiliate enterprises.



FDI Routes in India

There are three routes through which FDI flows into India.

They are described in the following table:

Category 1 Category 2 Category 3

100% FDI

permitted through

Automatic Route

Up to 100%

FDI permitted

through

Government

Route

Up to 100% FDI

permitted through

Automatic +

Government

Route

Automatic Route FDI: In the automatic route, the foreign

entity does not require the prior approval of the government

or the RBI.

Examples:

Medical devices: up to 100%

Thermal power: up to 100%

Services under Civil Aviation Services such as

Maintenance & Repair Organizations

Insurance: up to 49%

Infrastructure company in the securities market: up to

49%

Ports and shipping

Railway infrastructure




Pension: up to 49%

Power exchanges: up to 49%

Petroleum Refining (By PSUs): up to 49%

Government Route FDI

Under the government route, the foreign entity should

compulsorily take the approval of the government. It should

file an application through the Foreign Investment

Facilitation Portal, which facilitates single-window

clearance. This application is then forwarded to the

respective ministry or department, which then approves or

rejects the application after consultation with the DPIIT.

Examples:

Broadcasting Content Services: 49%

Banking & Public sector: 20%

Food Products Retail Trading: 100%

Core Investment Company: 100%

Multi-Brand Retail Trading: 51%

Mining & Minerals separations of titanium bearing

minerals and ores: 100%

Print Media (publications/printing of scientific and

technical magazines/speciality journals/periodicals and a

facsimile edition of foreign newspapers): 100%

Satellite (Establishment and operations): 100%

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Print Media (publishing of newspaper, periodicals

and Indian editions of foreign magazines dealing with news

& current affairs): 26%

Sectors where FDI is prohibited

There are some sectors where any FDI is completely

prohibited. They are:

Agricultural or Plantation Activities (although there

are many exceptions like horticulture, fisheries, tea

plantations, Pisciculture, animal husbandry, etc.)

Atomic Energy Generation

Nidhi Company

Lotteries (online, private, government, etc.)

Investment in Chit Funds

Trading in TDR’s

Any Gambling or Betting businesses

Cigars, Cigarettes, or any related tobacco industry

Housing and Real Estate (except townships,

commercial projects, etc.)

New FDI Policy

According to the new FDI policy, an entity of a country,

which shares a land border with India or where the

beneficial owner of investment into India is situated in or is

a citizen of any such country, can invest only under the

Government route. A transfer of ownership in an FDI deal



that benefits any country that shares a border with India will

also need government approval. Investors from countries

not covered by the new policy only have to inform the RBI

after a transaction rather than asking for prior permission

from the relevant government department.

The earlier FDI policy was limited to allowing only

Bangladesh and Pakistan via the government route in all

sectors. The revised rule has now brought companies from

China under the government route filter.

Benefits of FDI

FDI brings in many advantages to the country. Some of

them are discussed below.

1. Brings in financial resources for economic

development.

2. Brings in new technologies, skills, knowledge, etc.

3. Generates more employment opportunities for the

people.

4. Brings in a more competitive business environment in

the country.

5. Improves the quality of products and services in

sectors.

Disadvantages of FDI

However, there are also some disadvantages associated with

foreign direct investment. Some of them are:

1. It can affect domestic investment, and domestic



companies adversely.

2. Small companies in a country may not be able to

withstand the onslaught of MNCs in their sector. There is

the risk of many domestic firms shutting shop as a result of

increased FDI.

3. FDI may also adversely affect the exchange rates of a

country.

Government Measures to increase FDI in India

1. Government schemes like production-linked incentive

(PLI) scheme in 2020 for electronics manufacturing, have

been notified to attract foreign investments.

2. In 2019, the amendment of FDI Policy 2017 by

the government, to permit 100% FDI under automatic route

in coal mining activities enhanced FDI inflow.

3. FDI in manufacturing was already under the 100%

automatic route, however, in 2019, the government clarified

that investments in Indian entities engaged in contract

manufacturing is also permitted under the 100% automatic

route provided it is undertaken through a legitimate contract.

4. Further, the government permitted 26% FDI in

digital sectors. The sector has particularly high return

capabilities in India as favourable demographics, substantial

mobile and internet penetration, massive consumption along

technology uptake provides great market opportunity for a

foreign investor.

5. Foreign Investment Facilitation Portal (FIFP) is the

online single point interface of the Government of India



with investors to facilitate FDI. It is administered by the Department for Promotion of Industry and Internal Trade, Ministry of Commerce and Industry.

6. FDI inflow is further expected to increase –

as foreign investors have shown interest in the

government’s moves to allow private train operations and

bid out airports.

Valuable sectors such as defence manufacturing

where the government enhanced the FDI limit under the

automatic route from 49% to 74% in May 2020, is also

expected to attract large investments going forward.

Regulatory Framework for FDI in India

In India, there are several laws regulating FDI inflows.

They are:

Companies Act

Securities and Exchange Board of India Act, 1992 and

SEBI Regulations

Foreign Exchange Management Act (FEMA)

Foreign Trade (Development and Regulation) Act,

1992

Civil Procedure Code, 1908

Indian Contract Act, 1872

Arbitration and Conciliation Act, 1996

Competition Act, 2002

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Income Tax Act, 1961

Foreign Direct Investment Policy (FDI Policy)

Important Government Authorities in India concerning

FDI

Foreign Investment Promotion Board (FIPB)

Department for Promotion of Industry and Internal

Trade (DPIIT)

Reserve Bank of India (RBI)

Directorate General of Foreign Trade (DGFT)

Ministry of Corporate Affairs, Government of India

Securities and Exchange Board of India (SEBI)

Income Tax Department

Several Ministries of the GOI such as Power,

Information & Communication, Energy, etc.

Way Forward with FDI

1. FDI is a major driver of economic growth and an

important source of non-debt finance for the economic

development of India. A robust and easily accessible FDI

regime, thus, should be ensured.

2. Economic growth in the post-pandemic period

and India’s large market shall continue to attract market-

seeking investments to the country.

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https://byjus.com/free-ias-prep/directorate-general-foreign-trade/

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Module V

International Monetary System

5.1. International Monetary System: Evolution and

gold standard International Monetary System: An

Overview

International monetary system is defined as a set of

procedures, mechanisms, processes, and

institutions that establish a rate at which exchange rate is

determined in respect to other currency. To understand the

complex procedure of international trading practices, it is

pertinent to have a look at the historical perspective of the

financial and monetary system. The whole story of

monetary and financial system revolves around 'Exchange

Rate' i.e. the rate at which currency is exchanged among

different countries for settlement of payments arising from

trading of goods and services. To have an understanding of

historical perspectives of international monetary system,

firstly one must have a knowledge of exchange rate

regimes. Various exchange rate regimes found from 1880 to

till date at the international level are described briefly as

follows:

5.1.1. Monetary System Before First World War:

(1880-1914 Era of Gold Standard)

The oldest system of exchange rate was known as "Gold

Species Standard" in which actual currency contained a

fixed content of gold. The other version called "Gold

Bullion Standard", where the basis of money remained



fixed gold but the authorities were ready to convert, at a

fixed rate, the paper currency issued by them into paper

currency of another country which is operating in Gold. The

exchange rate between pair of two currencies was

determined by respective exchange rates against 'Gold'

which was called 'Mint Parity'.

Three rules were followed with respect to this conversion:

• The authorities must fix some once-for-all conversion

rate of paper money issued by them into gold.

• There must be free flow of Gold between countries on

Gold Standard.

• The money supply should be tied with the amount of

Gold reserves kept by authorities.

The gold standard was very rigid and during 'great

depression' (1929-32) it vanished completely. In modern

times some economists and policy makers advocate this

standard to continue because of its ability to control

excessive money supply.

5.1.2. The Gold Exchange Standard (1925-1931)

With the failure of gold standard during First World War, a

much refined form of exchange regime was initiated in

1925 in which US and England could hold gold reserve and

other nations could hold both gold and dollars/sterling as

reserves. In 1931, England took its foot back which resulted

in abolition of this regime. Also to maintain trade

competitiveness, the countries started devaluing their

currencies in order to increase exports and de-motivate

imports. This was termed as "beggar-thy-neighbour "



policy. This practice led to great depression which was a

threat to war ravaged world after the second world war.

Allied nations held a conference in New Hampshire, the

outcome of which gave birth to two new institutions namely

the International Monetary Fund (IMF) and the World

Bank, (WB) and the system was known as Bretton Woods

System which prevailed during (1946-1971) (Bretton

Woods, the place in New Hampshire, where more than 40

nations met to hold a conference).

5.1.3. The Bretton Woods Era (1946 to 1971)

To streamline and revamp the war ravaged world economy

& monetary system, allied powers held a conference in

'Bretton Woods', which gave birth to two super institutions

– IMF (International Monetary Fund) and the World Bank

(WB). In Bretton Woods modified form of Gold Exchange

Standard was set up with the following characteristics :

• One US dollar conversion rate was fixed by the USA as

one dollar = 35 ounce of Gold

• Other members agreed to fix the parities of their

currencies vis-a-vis dollar with respect to permissible central

parity with one per cent (± 1%) fluctuation on either side.

In case of crossing the limits, the authorities were free hand

to intervene to bring back the exchange rate within limits.

The mechanism of Bretton Woods can be understood with

the help of the following illustration: Suppose there is a

supply curve SS and demand curve DD for Dollars. On Y-

axis, let us draw price of Dollar with respect to Rupees (See

fig.)



Suppose Indian residents start demanding American goods

& services. Naturally demand of US Dollar will rise; And

suppose US residents develop an interest in buying goods

and services from India, it will increase supply of dollars

from America. Assume a parity rate of exchange is Rs.

10.00 per dollar. The ± 1% limits are therefore Rs. 10.10

(Upper support and Rs. 9.90 lower support). As long as the

demand and supply curve intersect within the permissible

range; Indian authorities will not intervene. Suppose

demand curve shifts towards right due to a shift in

preference of Indians towards buying American goods and

the market determined exchange rate would fall outside the

band, in this situation, Indian authorities will intervene and

buy rupees and supply dollars to bring back the demand

curve within permissible band. The vice-versa can also

happen. There can be two consequences of this intervention.

Firstly, the domestic money supply, price, G.N.P. etc. can

be effected. Secondly, excessive supply of dollars from



reserves may lead to exhaustion or depletion of forex

reserves, thereby preventing all possibilities to borrow

dollars from other countries or IMF.

During Bretton Woods regime American dollar became

international money while other countries needed to hold

dollar reserves. US could buy goods and services from her

own money. The confidence of countries in US dollars

started shaking in 1960s with chronological events which

were political and economic and on August 15, 1971

American abandoned their commitment to convert dollars

into gold at fixed price of $35 per ounce, the currencies

went on float rather than fixed. Though "Smithsonian

Agreement" also failed to resolve the crisis yet by 1973, the

world moved to a system of floating rates. (Note :

Smithsonian Agreement made an attempt to resurrect the

system by increasing the price of gold and widening the

band of permissible variations around the central parity).

The immediate cause of the collapse of the Bretton Woods

system was the huge balance-of-payments deficit of the

United States in 1970 and the expectation of an even larger

deficit in 1971. This led to massive destabilizing

speculation against the dollar, suspension of the

convertibility of the dollar into gold on August 15, 1971,

and a realignment of currencies in December 1971. The

fundamental cause of the collapse of the Bretton Woods

system is to be found in the lack of an adequate adjustment

mechanism. The persistence of U.S. balance-of-payments

deficits provided for the system’s liquidity but also led to

loss of confidence in the dollar. The dollar was devalued

again in February 1973. In March 1973, in the face of

continued speculation against the dollar, the major

currencies were allowed to fluctuate either independently or

jointly.



5.1.4. Post Bretton Woods Period (1971-1991)

Two major events took place in 1973-74 when oil prices

were quadrupled by the Organisational of Petroleum

Exporting Countries (OPEC). The result was seen in

expended oils bills, inflation and economic dislocation;

thereby the monetary policies of the countries were being

overhauled. Since March 1973, the world has operated

under a managed float (formally recognized in the Jamaica

Accords, which took effect in April 1978). From 1977 to

1985, US dollar observed fluctuations in the oil prices

which imposed on the countries to adopt a much flexible

regime i.e. a hybrid between fixed and floating regimes. A

group of European Nations entered into European

Monetary System (EMS) which was an arrangement of

pegging their currencies within themselves. In March 1979,

the European Monetary System was formed, in October

1988, the European Central Bank was created, the euro was

introduced on January 1, 1999, and began circulating on

January 1, 2002, as the single currency of the European

Monetary Union. Borrowing at the IMF has been relaxed,

and significant new credit facilities have been created.

The most significant monetary problems facing the world

today are the excessive fluctuations and large

misalignments in exchange rates. Target zones and greater

international macroeconomic policy coordination have been

advocated to overcome them. During the past decade, there

were a series of financial and economic crises in Mexico,

Southeast Asia, Russia, Brazil, Turkey, and Argentina, and

in 2008–2009 in the United States and most other advanced

economies. Proposed solutions by the G-20 include

strengthening financial supervision and regulation, fostering

international policy coordination, reforming the IMF, and



maintaining open markets.

Other serious international economic problems are

(1) slow growth and high unemployment in advanced

economies after the “great recession,” (2) trade

protectionism in advanced countries in the context of a

rapidly globalizing world, (3) large structural imbalances in

the United States, slow growth in Europe and Japan, and

insufficient restructuring in transition economies of Central

and Eastern Europe,

(4) deep poverty in many developing economies, and

(5) resource scarcity, environmental degradation, and

climate change that endanger growth and sustainable world

development.

5.1.5. Flexible exchange rate regime

The flexible exchange rate regime that replaced the Bretton

Woods system was ratified by the Jamaica Agreement.

Following a spectacular rise and fall of the US dollar in the

1980s, major industrial countries agreed to cooperate to

achieve greater exchange rate stability. The Louvre Accord

of 1987 marked the inception of the managed-float system

under which the G-7 countries would jointly intervene in the

foreign exchange market to correct over- or undervaluation

of currencies. On January 1,1999, eleven European

countries including France and Germany adopted a

common currency called the euro. The advent of a single

European currency, which may eventually rival the US

dollar as a global vehicle currency, will have major

implications for the European as well as world economy.



Flexible exchange rate regimes were rare before the late

twentieth century. Prior to World War II, governments

used to purchase and sell foreign and domestic currency in

order to maintain a desirable exchange rate, especially in

accordance with each country’s trade policy. After a few

experiences with flexible exchange rates during the 1920s,

most countries came back to the gold standard. In 1930,

before a new wave of flexible rate regimes started, prior to

the war, over 50 countries were on the gold standard.

However, most countries would abandon it just before

World War II started. In 1944, with the war almost over,

international policy coordination was starting to make sense

in everybody’s mind. Along with other international

organisations created during those years, the Bretton Woods

agreement was signed, putting in place a new pegging

system: currencies were pegged to the dollar, which in turn

was pegged to gold. It was not until 1973, when Bretton

Woods completely collapsed, that countries started to

implement flexible exchange rate regimes.

Flexible exchange rates can be defined as exchange rates

determined by global supply and demand of currency. In

other words, they are prices of foreign exchange determined

by the market, that can rapidly change due to supply and

demand, and are not pegged nor controlled by central

banks. The opposite scenario, where central banks intervene

in the market with purchases and sales of foreign and

domestic currency in order to keep the exchange rate within

limits, also known as bands, is called fixed exchange rate.

Within this pure definition of flexible exchange rate, we can

find two types of flexible exchange rates: pure floating

regimes and managed floating regimes. On the one hand,

pure floating regimes exist when, in a flexible exchange rate

regime, there are absolutely no official purchases or sales of



currency. On the other hand, managed (also called dirty)

floating regimes, are those flexible exchange rate regimes

where at least some official intervention happens. This

system would reduce Economic volatility and facilitates

free trade. Floating rates offset the differences in inflation

rates so that other elements such as : wages, employment,

output etc., need not be adjusted. Earlier experience

revealed that the fixed rates did not efficiently work for

longer periods

Criticism: Critics state that the system leads to uncertainty

which discourages free trade. Floating system encourages

speculation. As Per IMF Survey On Floating Regime:

Exchange rate volatility since early 1970s does not impede

world trade. Instead world exports increased for 8 years.

The statement of critics that uncertainty in the exchange

rates, drives the investors in to speculation, is also not valid.

Actually, fixed exchange system is having more chances of

promoting speculation. Both fixed and floating regime has

the same fault of speculation. But fixed regime is having

more fault than floating regime. Keeping in view

inflationary trends, a number of economists have called for

a return to fixed regime. Although history never offers a

convincing model for a system that will lead to long term

exchange rate stability, it points outs 2 (two) basic

requirement: Credible system must have price stability

build into its very core. Without price stability the system

will not be credible.

5.2. The Exchange Rate Arrangements

IMF (International Monetary Fund) categories different

exchange rate mechanism as follows:



Exchange arrangement with no separate legal tender:

The members of a currency union share a common

currency. Economic and Monetary Unit (EMU) who have

adopted common currency and countries which have

adopted currency of other country.

Currency Board Agreement

In this regime, there is a legislative commitment to

exchange domestic currency against a specified currency at a

fixed rate. As of 1999, eight members had adopted this

regime.

Conventional fixed peg arrangement

This regime is equivalent to Bretton Woods in the sense

that a country pegs its currency to another, or to a basket of

currencies with a band variation not exceeding ± 1% around

the central parity.

Pegged Exchange Rates

Within Horizontal Bands In this regime, the variation

around a central parity is permitted within a wider band. It

is a middle way between a fixed peg and floating peg.

Crawling Peg

A currency is pegged to another currency or a basket of

currencies but the peg is adjusted periodically which may be

pre-announced or discretion based or well specified

criterion.

Crawling bands



The currency is maintained within a certain margins around

a central parity which 'crawls' in response to certain

indicators.

Managed float

In this regime, central bank interferes in the foreign

exchange market by buying and selling foreign currencies

against home currencies without any commitment or

pronouncement.

Independently floating

Here exchange rate is determined by market forces and

central bank only act as a catalyst to prevent excessive

supply of foreign exchange and not to drive it to a particular

level.

Now-a-days a wide variety of arrangements exist and

countries adopt the monetary system according to their own

whims and fancies. That's why some analysts are calling is

a monetary "non-system".

5.3. Economic And Monetary Union

Economic and Monetary Union (EMU) represents a major

step in the integration of EU economies. It involves the

coordination of economic and fiscal policies, a common

monetary policy, and a common currency, the euro. The

European Monetary System (EMS) was the pioneer of

Economic and Monetary Union(EMU), which led to the

establishment of the Euro. It was a way of creating an area

of currency stability throughout the European Community

by encouraging countries to co-ordinate their monetary

policies. The decision to form an Economic and Monetary



Union was taken by the European Council in to be the

Dutch city of Maastricht in December 1991. The Treaty of

Maastricht laid down a set of criteria met by member states

if they were to qualify for the EMU. Its main criteria was

Curbing inflation, GDP, Limiting public Cutting interest

rates, Reducing budget deficits to a maximum of 3% of

borrowing, Stabilizing the currency‘s exchange rate. The

Maastricht Treaty laid down the three-stage process: First

stage (1st Jul 1990), Second stage(1st Jan 1994), Third

stage(1st Jan 1999)) in which EMU was established.

Stage One Of EMU

Complete freedom for capital transactions

Increased co-operation between central banks

Free use of the ECU (European Currency Unit)

Improvement of economic convergence

Second Stage Of EMU

(EMI) Establishment of the European Monetary

Institute

Ban on the granting of central bank credit

Increased co-ordination of monetary policies

Strengthening of economic convergence

Process leading to the independence of the

national central banks to be completed at the latest by the

date of establishment of the European System of Central

Banks;



Third Stage Of EMU

Irrevocable fixing of conversion rates

Introduction of the euro

Conduct of the single monetary policy by the

European System of Central Banks

Entry into effect of the intra-EU exchange rate

mechanism (ERM II)

Entry into force of the Stability and Growth Pact

The management of Economic and Monetary Union

involves many actors with different responsibilities. As well

as the governments and central banks of the Member States,

the Council, the European Commission, the European

Parliament and the European Central Bank all have roles to

fulfill. The management of EMU involves three main areas

of macroeconomic policy-making: monetary policy, fiscal

policy and economic policy coordination.

5.4. European Monetary Union

The European Monetary Union is a group of 28 countries

that operate as a cohesive economic and political block. 19

of these countries use EURO as their official currency. 9

EU members (Bulgaria, Croatia, Czech Republic,

Denmark, Hungary, Poland, Romania, Sweden, and the

United Kingdom) do not use the euro. The EU grew out of a

desire to form a single European political entity to end

centuries of warfare among European countries that

culminated with World War II and decimated much of the

continent. The EU has developed an internal single market



through a standardised system of laws that apply in all

member states in matters, where members have agreed to

act as one. Evolution of EU has roots in looking for an

integration of divided Europe because of excessive

nationalism over a long period of time which also witnessed

two world wars. It has played an important role in

improving economic conditions and raising living standard

of people in weaker members of group.

Goals

Promote peace, values and the well-being of all

citizens of EU.

Offer freedom, security and justice without internal

borders

Sustainable development based on balanced economic

growth and price stability, a highly competitive market

economy with full employment and social progress, and

environmental protection

Combat social exclusion and discrimination

Promote scientific and technological progress

Enhance economic, social and territorial cohesion and

solidarity among EU countries

Respect its rich cultural and linguistic diversity

Establish an economic and monetary union whose

currency is euro.



History

After World War II, European integration was seen

as a cure to the excessive nationalism which had

devastated the continent.

In 1946 at the University of Zurich, Switzerland,

Winston Churchill went further and advocated the

emergence of a United States of Europe.

In 1952, European Coal and Steel Community (ECSC)

was founded under Treaty of Paris (1951) by 6 countries

called Six (Belgium, France, Germany, Italy, Luxembourg

and the Netherlands) to renounce part of their sovereignty

by placing their coal and steel production in a common

market, under it. European Court of Justice (called "Court

of Justice of the European Communities" until 2009) was

also established in 1952 under Paris Treaty.

European Atomic Energy Community (EAEC or

Euratom) is an international organisation established by the

Euratom Treaty (1957) with the original purpose of creating

a specialist market for nuclear power in Europe, by

developing nuclear energy and distributing it to its member

states while selling the surplus to non-member states. It has

same members as the European Union and is governed by

the European Commission (EC) and Council, operating

under the jurisdiction of the European Court of Justice.

European Economic Community (EEC) was created

by the Treaty of Rome (1957). The Community's initial aim

was to bring about economic integration, including a

common market and customs union, among its founding

members (Six). It ceased to exist by Lisbon Treaty-2007 and

its activities were incorporated in EU.



Merger Treaty (1965, Brussels) in which an agreement

was reached to merge the three communities (ECSC,

EAEC, and EEC) under a single set of institutions,

creating the European Communities (ECs). The

Commission and Council of the EEC were to take over the

responsibilities of its counterparts (ECSC, EAEC) in other

organisations.

The ECs initially expanded in 1973 when Denmark,

Ireland, the United Kingdom became members. Greece

joined in 1981, Portugal and Spain following in 1986.

Schengen Agreement (1985) paved the way for the

creation of open borders without passport controls between

most member states. It was effective in 1995.

Single European Act (1986): enacted by the European

Community that committed its member countries to a

timetable for their economic merger and the establishment

of a single European currency and common foreign and

domestic policies.

The Maastricht Treaty-1992 (also called the Treaty on

European Union) was signed on 7 February 1992 by the

members of the European Community in Maastricht,

Netherlands to further European integration. It received a

great push with the end of the Cold War.

o European Communities (ECSC, EAEC, and EEC)

incorporated as European Union.

o European citizenship was created, allowing

citizens to reside in and move freely between Member

States.



o A common foreign and security policy was

established.

o Closer cooperation between police and the

judiciary in criminal matters was agreed.

o It paved the way for the creation of a single

European currency – the euro. It was the culmination of

several decades of debate on increasing economic

cooperation in Europe.

o It established the European Central Bank (ECB).

o It enabled people to run for local office and for

European Parliament elections in the EU country they lived

in.

A monetary union was established in 1999 and came

into full force in 2002 and is composed of 19 EU member

states which use the euro currency. These are Austria,

Belgium, Cyprus, Estonia, Finland, France, Germany,

Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg,

Malta, Netherlands, Portugal, Slovakia, Slovenia, and

Spain.

In 2002, Treaty of Paris (1951) expired & ECSC

ceased to exist and its activities fully absorbed by the

European Community (EEC).

The Treaty of Lisbon 2007:

o European Community (now composed only of

EEC, EAEC, as ECSC already ceased in 2002) was ceased

and its activities incorporated in EU.

o EAEC is only remaining community organization



legally distinct from the European Union (EU), but has the

same membership, and is governed by many of the EU's

institutions.

Euro Crisis: The EU and the European Central Bank

(ECB) have struggled with high sovereign debt and

collapsing growth in Portugal, Ireland, Greece and Spain

since the global financial market collapse of 2008. Greece

and Ireland received financial bailouts from the community

in 2009, which were accompanied by fiscal austerity.

Portugal followed in 2011, along with a second Greek

bailout.

o Multiple rounds of interest rate cuts and economic

stimulus failed to resolve the problem.

o Northern countries such as Germany, the United

Kingdom and the Netherlands increasingly resent the

financial drain from the south.

In 2012, the EU received the Nobel Peace Prize for

having contributed to the advancement of peace and

reconciliation, democracy, and human rights in Europe.

Brexit: In 2016, a referendum (called Brexit) was held

by U.K. government, and the nation voted to leave the EU.

Now the process is under UK Parliament for formal

withdrawal from EU.

Challenges & Reforms

It is no longer self-evident that all old member states

will stay in the Union. The Treaty of Lisbon gave the

members the right to leave the EU. The financial crisis has

hit Greece so hard that many people have predicted for a



long time that the country will exit from the Union.

Layoffs, redundancies and migration of jobs to

countries where labour is cheap affect the daily lives of

European citizens. The EU is expected to find solutions to

economic problems and employment.

There is also demand for standard labour agreements

on terms of employment and working conditions that would

apply across Europe and even worldwide. As a member of

the World Trade Organisation, the European Union is in a

position to influence developments worldwide.

EU is a global leader in the development of Key

Enabling Technologies (KETs). However, EU’s record in

translating this knowledge advantage into marketable

products and services doesn't match this. KETs-related

manufacturing is decreasing in the EU and patents are

increasingly being exploited outside the EU.

Europe is experiencing a renaissance of national

sovereignty supported by a nationalistic turn of public

opinion and represented by parties on both ends of the

political spectrum. Popular disaffection toward EU

membership is fuelled by the contemporaneous occurrence

of two shocks, the economic and the migration crises.

USA, by withdrawing from the Paris climate change

deal, by pulling out of the Joint Comprehensive Plan of

Action (JCPOA) on Iran’s nuclear programme, and by

attacking the integrity of the international trading system

through the unilateral imposition of tariffs, has called into

question Europeans’ formerly unshakeable faith in

diplomacy as a way to resolve disagreements and to protect

Europe.



European leaders now fear that the transatlantic

security guarantee will centre not on alliances and common

interests but purchases of American technology and

materiel.

Like the United States, the EU has been forced to

reconsider its relationship with a more assertive Russia

with implications for European security and stability. The

EU has sought to support Ukraine's political transition,

condemned Russia's annexation of Crimea in March 2014,

and strongly urged Russia to stop backing separatist forces

in eastern Ukraine.

o Democratic regression in Ukraine combined with a

hardening attitude in Moscow imposes constraints on the

Ukrainian government’s freedom of maneuver in pursuing

its European Union membership.

Brexit: EU has imposed too many rules on business

and charged billions of pounds a year in membership fees

for little in return.

o The EU added eight eastern European countries in

2004, triggering a wave of immigration that strained public

services. In England and Wales, the share of foreign- born

residents had swelled to 13.4 percent of the population by

2011, roughly double the level in 1991.

o Brexit supporters wanted Britain to take back full

control of its borders and reduce the number of people

coming here to live and/or work.

o They argued that the EU is morphing into a super-

state that increasingly impinges on national sovereignty.

Britain has global clout without the bloc, they said, and can



negotiate better trade treaties on its own.

o Withdrawal from the EU is governed by Article 50

of the Treaty on European Union.

o A deal between UK & EU that gives it control over

immigration and also preferential access to the EU’s tariff-

free single market of 500 million people (UK), the

economic backbone of the world’s largest trading bloc is

rejected by Germany & other EU leaders.

EU & India

The EU works closely with India to promote peace,

create jobs, boost economic growth and enhance sustainable

development across the country.

As India graduated from low to medium income

country (OECD 2014), the EU-India cooperation also

evolved from a traditional financial assistance type

towards a partnership with a focus on common priorities.

At the 2017 EU-India Summit, leaders reiterated their

intention to strengthen cooperation on the implementation of

the 2030 Agenda for Sustainable Development and agreed

to explore the continuation of the EU-India Development

Dialogue.

The EU is India's largest trading partner, accounting

for €85 billion (95 billion USD) worth of trade in goods in

2017 or 13.1% of total India trade, ahead of China (11.4%)

and the USA (9.5%).

The EU's share in foreign investment inflows to India

has more than doubled from 8% to 18% in the last decade,



making the EU the first foreign investor in India.

EU foreign direct investment stocks in India amounted

to €73 billion in 2016, which is significant but way below

EU foreign investment stocks in China (€178 billion).

INDIA-EU Bilateral Trade and Investment Agreement

(BTIA): It is a Free Trade Agreement between India and EU,

which was initiated in 2007. Even after a decade of

negotiations, India and EU have failed to resolve certain

issues which have led to a deadlock.

o "Data Secure" status not granted by EU affecting

prospects of India’s IT-enabled exports.

o Presence of non-tariff barriers on Indian

agricultural products in the form of sanitary and phyto-

sanitary(SPS) measures which are too stringent and enable

the EU to bar many Indian agricultural products from

entering its markets.

o EU wants India to liberalise accountancy and legal

services. India denies on the ground of already shortage of

jobs.

o EU demands tax reduction on wines and spirits but

in India these are regarded as ‘sin goods’ and the states

which derive huge revenue from liquor sales would be

reluctant to cut taxes.

o Reduction of taxes on automobiles not acceptable

to India as its own automobile industry would not be able to

match the competition from EU automobiles.

o India has rejected an informal attempt by the



European Union (EU) to work towards a global investment

agreement at the World Trade Organisation (WTO)-level

that would incorporate a contentious Investor-State Dispute

Settlement (ISDS) mechanism which will allow

corporations to take sovereign governments to international

arbitration. The ISDS mechanism permits companies to

drag governments to international arbitration without

exhausting the local remedies and claim huge amounts as

compensation citing losses they suffered due to reasons,

including policy changes.

o The non-tariff barriers in pharmaceuticals that EU

has imposed include requirement of WTO—Good

Manufacturing Practice certification, import bans,

antidumping measures and pre-shipment inspection among

others.

o India has cancelled most individual bilateral

investment agreements with EU member states on grounds

that they were outdated. By doing this India is putting

pressure on EU to sign BTIA on favouring terms.

5.5. Optimum Currency Areas

The theory of optimum currency areas was developed by

Robert Mundell and Ronald McKinnon during the 1960s.

An optimum currency area or bloc refers to a group of

nations whose national currencies are linked through

permanently fixed exchange rates and the conditions that

would make such an area optimum. The currencies of

member nations could then float jointly with respect to the

currencies of nonmember nations. Obviously, regions of

the same nation, sharing as they do the same currency, are

optimum currency areas. The formation of an optimum



currency area eliminates the uncertainty that arises when

exchange rates are not permanently fixed, thus stimulating

specialization in production and the flow of trade and

investments among member regions or nations. The

formation of an optimum currency area also encourages

producers to view the entire area as a single market and to

benefit from greater economies of scale in production.

With permanently fixed exchange rates, an optimum

currency area is likely to experience greater price stability

than if exchange rates could change between the various

member nations. The greater price stability arises because

random shocks in different regions or nations within the

area tend to cancel each other out, and whatever disturbance

may remain is relatively smaller when the area is increased.

This greater price stability encourages the use of money as a

store of value and as a medium of exchange, and

discourages inefficient barter deals arising under more

inflationary circumstances. An optimum currency area also

saves the cost of official interventions in foreign exchange

markets involving the currencies of member nations, the

cost of hedging, and the cost of exchanging one currency

for another to pay for imports of goods and services and

when citizens travel between member nations (if the

optimum currency area also adopts a common currency).

Perhaps the greatest disadvantage of an optimum currency

area is that each member nation cannot pursue its own

independent stabilization and growth policies attuned to its

particular preferences and circumstances. For example, a

depressed region or nation within an optimum currency area

might require expansionary fiscal and monetary policies to

reduce an excessive unemployment rate, while the more

prosperous region or nation might require contractionary



policies to curb inflationary pressures. To some extent, this

cost of an optimum currency area is compensated by the

ability of workers to emigrate from the poorer to the richer

members and by greater capital inflows into the poorer

members. Despite the fact that national differences are

likely to persist, few would suggest that poorer nations or

regions would do better by not entering into or seceding

from an optimum currency area or nation. Furthermore,

poorer nations or regions usually receive investment

incentives and other special aid from richer members or

areas.

The formation of an optimum currency area is more likely

to be beneficial on balance under the following conditions:

(1) the greater the mobility of resources among the various

member nations, (2) the greater their structural similarities,

and (3) the more willing they are too closely coordinate

their fiscal, monetary, and other policies. An optimum

currency area should aim at maximizing the benefits from

permanently fixed exchange rates and minimizing the costs.

It is not easy, however, to actually measure the net benefits

accruing to each member nation or region from joining an

optimum currency area.

Some of the benefits provided by the formation of an

optimum currency area can also be obtained under the

looser form of economic relationship provided by fixed

exchange rates. Thus, the case for the formation of an

optimum currency area is to some extent also a case for

fixed as opposed to flexible exchange rates. The theory of

optimum currency areas can be regarded as the special

branch of the theory of customs unions that deals with

monetary factors.



5.6. Currency Board Agreements (CBAs)

A currency board is an exchange rate regime based on the

full convertibility of a local currency into a reserve one, by

a fixed exchange rate and 100 percent coverage of the

monetary supply backed up with foreign currency reserves.

Therefore, in the currency board system there can be no

fiduciary issuing of money. As defined by the IMF, a

currency board agreement is “a monetary regime based on

an explicit legislative commitment to exchange domestic

currency for a specific foreign currency at a fixed exchange

rate, combined with restrictions on the issuing authority”.

For currency boards to work properly, there has to be a

long-term commitment to the system and automatic

currency convertibility. This includes, but is not limited to,

a limitation on printing new money, since this would affect

the exchange rate. The key conditions for the successful

operation of CBAs (besides those generally required for the

successful operation of a fixed exchange rate system) are a

sound banking system (since the central bank cannot be the

“lender of last resort” or extend credit to banks

experiencing difficulties) and a prudent fiscal policy (since

the central bank cannot lend to the government).

Under CBAs, the nation rigidly fixes (often by law) the

exchange rate of its currency to a foreign currency, SDR, or

composite, and its central bank ceases to operate as such.

CBAs are similar to the gold standard in that they require

100 percent international-reserve backing of the nation’s

money supply. Thus, the nation gives up control over its

money supply, and its central bank abdicates its function of

conducting an independent monetary policy. With a CBA,

the nation’s money supply increases or decreases,

respectively, only in response to a balance-of-payments

https://www.policonomics.com/exchange-rate-regime/

https://www.policonomics.com/fixed-exchange-rate/



surplus and inflow of international reserves or to a balance-

of-payments deficit and outflow of international reserves.

As a result, the nation’s inflation and interest rates are

determined, for the most part, by conditions in the country

against whose currency the nation pegged or fixed its

currency.

The first currency boards appeared during the nineteenth

century in Britain and France’s colonies. Since for locals of

those colonies using the metropolitan currency was risky

(loss or destruction of notes and coins, resources being

permanently locked into the currency), the implementation

of currency boards in the colonies made sense. The

principle of the currency board was thus created in 1844 by

the British Bank Charter Act.

The main advantage of CBAs is the credibility of the

economic policy regime (since the nation is committed

politically and often by law to stick with it), which results

in lower interest rates and lower inflation in the nation. The

cost of CBAs is the inability of the nation’s central bank to

(1) conduct its own monetary policy, (2) act as a lender of

last resort, and (3) collect seignorage from independently

issuing its own currency. Examples include the Bulgarian

Lev against the Euro, or the Hong Kong dollar against the

U.S. dollar.

The following figure shows the different regimes according

to four different variables: exchange rate flexibility, loss of

monetary policy independence, anti-inflation effect and

credibility of the exchange rate commitment:



5.7. Dollarization

Dollarization refers to the economic phenomenon wherein

people turn to the U.S. dollar as an alternative to their own

local currency. Dollarization happens mainly because of the

widespread belief that the value of the U.S. dollar is more

stable than other currencies. The dollar thus offers an abode

for people looking to safeguard their savings. Sometimes, a

country’s government may choose to link the supply of its

own currency to the dollar in order to boost confidence

among people in its long-term value. It is usually countries

that have suffered hyperinflation often resort to

dollarization as a means to regain economic confidence.

Dollarization occurs when residents of a country

extensively use foreign currency alongside or instead of the

domestic currency. It can occur unofficially, without formal

legal approval, or it can be official, as when a country

ceases to issue a domestic currency and uses only foreign

currency. Unofficial dollarization occurs when individuals

hold foreign-currency bank deposits or notes (paper money)

to protect against high inflation in the domestic currency.



Official dollarization occurs when a government adopts

foreign currency as the predominant or exclusive legal

tender.

Dollarization has three main varieties: unofficial

dollarization; semiofficial dollarization; and official

dollarization.

Unofficial dollarization:

Unofficial dollarization occurs when people hold much of

their financial wealth in foreign assets even though foreign

currency is not legal tender. (Legal tender means that a

currency is legally acceptable as payment for all debts,

unless perhaps the parties to the payment have specified

payment in another currency. Legal tender differs from

forced tender, which means that people must accept a

currency in payment even if they would prefer to specify

another currency.) The term "unofficial dollarization"

covers both cases where holding foreign assets is legal and

cases where it is illegal. In some countries it is legal to hold

some kinds of foreign assets, such as dollar accounts with a

domestic bank, but illegal to hold other kinds of foreign

assets, such as bank accounts abroad, unless special

permission has been granted. Unofficial dollarization can

include holding any of the following:

foreign bonds and other nonmonetary assets,

generally held abroad

foreign-currency deposits abroad;

foreign-currency deposits in the domestic banking

system;



foreign notes (paper money) in wallets and

mattresses.

Semiofficial dollarization: More than a dozen

countries have what might be called semiofficial

dollarization or officially bi-monetary systems. Under

semiofficial dollarization, foreign currency is legal tender

and may even dominate bank deposits, but plays a

secondary role to domestic currency in paying wages, taxes,

and everyday expenses such as grocery and electric bills.

Unlike officially dollarized countries, semiofficially

dollarized ones retain a domestic central bank or other

monetary authority and have corresponding latitude to

conduct their own monetary policy. Table 1 lists

semiofficially dollarized countries.

Official dollarization: Official dollarization, also

called full dollarization, occurs when foreign currency has

exclusive or predominant status as full legal tender. That

means not only is foreign currency legal for use in contracts

between private parties, but the government uses it in

payments. If domestic currency exists, it is confined to a

secondary role, such as being issued only in the form of

coins having small value.

Officially dollarized countries vary concerning the number

of foreign currencies they allow to be full legal tender and

concerning the relationship between domestic currency--if it

exists--and foreign currency. Official dollarization need not

mean that just one or two foreign currencies are the only

full legal tenders; freedom of choice can provide some

protection from being stuck using a foreign currency that

becomes unstable. Most officially dollarized countries give

only one foreign currency status as full legal tender. In most



dollarized countries, private parties are permitted to make

contracts in any mutually agreeable currency.

Besides the Commonwealth of Puerto Rico and the U.S.

Virgin Islands, Panama has had full or official dollarization

since 1904. Ecuador fully dollarized in 2000 and El

Salvador in 2001. Since 2001, Nicaragua has nearly fully

dollarized and Costa Rica has considered it.

India and Dollarization

India is among the most dollarized countries as far as

invoicing is concerned, and by all these measures of

internationalization, the dollar is largely ahead of other

currencies with euro as a distant second. While international

reserves are held in dollars, dollar is a vehicle currency on

the foreign exchange market. The U.S. gets seigniorage as

people from different countries use dollars, she said, adding

that India was one of the most dollarized countries in the

world, following Brazil, Pakistan and Indonesia, in the share

of imports and exports invoiced in dollars.

Euro is the closest substitute to dollar, as the euro area is

comparable to the U.S. in terms of economic size and in

international trade, but the incomplete architecture of the of

the euro area with 19 finance ministries backing the

currency, and the absence of a euro area wide safe assets

inhibits the internationalization of the euro. The crypto

currency and the private or public digital currency were

alternate options, but would not play an important role in

the international monetary system.

The Benefits of Dollarization

The benefits of dollarization arise from the nation



Avoiding the cost of exchanging the domestic

currency for dollars and the need to hedge foreign exchange

risks;

Facing a rate of inflation similar to that of the

United States as a result of commodity arbitrage, and

interest rates tending to fall to the U.S. level, except for any

remaining country risk (i.e., political factors that affect

security and property rights in the nation);

Avoiding foreign exchange crises and the need for

foreign exchange and trade controls, fostering budgetary

discipline; and

Encouraging more rapid and full international

financial integration.

Costs of Dollarization

Dollarization also imposes some costs on the dollarizing

country:

The cost of replacing the domestic currency with

the dollar (estimated to be about 4 to 5 percent of GDP for

the average Latin American country);

The loss of independence of monetary and

exchange rate policies (the country will face the same

monetary policy of the United States, regardless of its

cyclical situation); and

The loss of its central bank as a lender of last

resort to bail out domestic banks and other financial

institutions facing a crisis.



Good candidates for dollarization are small open economies

for which the United States is the dominant economic

partner and which have a history of poor monetary

performance, and hence very little economic-policy

credibility. Most of the small countries of Latin America,

especially those in Central America, as well as the

Caribbean nations, fit this description very well. Once we

move from small to large countries, however, it becomes

more difficult to come up with clear-cut answers as to

whether dollarization would provide a net benefit to the

nation.

5.8. Brexit

The United Kingdom (U.K.) finally left the European Union

(EU) on 31st January 2020. It was a long-awaited historical

move which will bring an important change in the policies

and politics of the remaining 27 European Union members

states and the U.K. mainly. It becomes important to see how

this will shift the policymaking process and what are the

ways in which nations are going to tackle it.

The UK faced a lot of challenges in materializing this move

finally. It is a notable change for the UK although nothing

will change immediately because of the 11-month transition

period negotiated as part of an EU-UK exit deal, 2019. The

UK will be able to work in and trade freely with EU nations

and vice versa until December 31, 2020. However, it will

no longer be represented in the EU's institutions. From

2021, the UK and EU will enter a new relationship possibly

underpinned by a free trade deal.

European Union: The EU is an economic and political

union involving 28 European countries. It allows free trade,



which means goods can move between member countries

without any checks or extra charges. The EU also allows

free movement of people, to live and work in whichever

country they choose. The UK joined in 1973 (when it was

known as the European Economic Community) and it will

be the first member state to withdraw.

EU-UK Exit Deal

This agreement sets out the exact terms of the UK and EU

relationship immediately after exit but it is not clear, on

what terms the UK and EU’s future relationship will be. A

key part of the withdrawal agreement was, there would be a

transition period, until the end of 2020. The transitional

arrangement is designed to make the separation process

smoother and it covers subjects like trade, law, and

immigration. It will give them more time to iron out all the

details of their future relationship including a possible free

trade deal. During the transition, the UK will be officially

out of the EU and not be represented on EU bodies but

would still have the same obligations as an EU member.

That includes remaining in the EU customs union and the

single market, contributing to the EU’s budget and

following EU law.

Withdrawal Agreement:

Under this, a transition period of 11 months has

finalised until December 2020. However, it might get

delayed until 2022 or 2023.

During this period, the U.K. will continue to

participate in the EU’s Customs Union and in the Single

Market.



The U.K. will apply EU law even if it is no longer

a Member State and will also continue to abide by the

international agreements of the EU.

The transition period makes sure that there is not

a sudden shock but a degree of continuity and allows both

parties to secure an orderly Brexit, minimising disruption

for the citizens, businesses, public administrations, as well

as for the international partners.

Causes of Brexit

So far, there seem to be three theories for what drove so

many people to vote Brexit:

Immigrants: Faced with rising immigration locals

worried about their jobs and the erosion of the English way

of life wanted their government to clamp down on

immigration. This was a revolt against unrestricted

immigration from poorer Eastern European states, Syrian

refugees residing in the EU and millions of Turks about to

join the EU.

Elites: Faced with decades of economic malaise,

stagnant real wages and economic destitution in former

industrial heartlands ever since the rise of “Thaterchism”

and the embrace of Neoliberal policies by Tony Blair’s

New Labour the non-Londoners have decided to revolt

against the elite. This isn’t just about being against the EU

as it stands, and its free market and free movement of

peoples.

Bureaucracy: Faced with Brussel’s asphyxiating

amount of red tape the English people decide to “take back

control” of their country’s bureaucracy.



Impact on the U.K. and the EU

By leaving the EU, the U.K. automatically,

mechanically, legally, leaves hundreds of international

agreements concluded by or on behalf of the EU, to the

benefit of its Member States, on topics as different as trade,

aviation, fisheries or civil nuclear cooperation.

However, with just 11 months to negotiate, there are

only chances of very basic and minimal deals covering

trade, fisheries and security.

In that case, at the end of 2020, differing aspirations

for the trade talks might raise the prospect of a new no-deal

scenario.

In the absence of a deal, the earlier accord on citizens’

rights, money and the Irish border will remain intact.

Both of them will have to be ready for the economic

shift in trading on World Trade Organization (WTO) terms.

The first priority is the trade deal to ensure the tariff

and quota-free flow of goods between the EU and U.K.

However, the EU will only agree to zero tariffs and

zero quotas if the U.K. pledges zero dumping – that is, not

lowering social and environmental standards to outcompete

the EU.

Negotiations will clash over the EU’s refusal to bring

services into the trade deal.



The EU seeks to link goods trade to maintaining

the status quo on access to British waters which is

considered to be a matter of concern for the U.K., so it

might give rise to clashes.

Even the non-trade subjects will be full of

political troubles because the EU Member States will have

to change their policies according to the new deals and the

regulations.

Impact on India

India has had strong historical ties with the U.K.

and currently, it is one of India’s most important trading

partners. In the last four years alone, the number of Indian

companies investing in the U.K. has quadrupled.

Similarly, the U.K. is one of the largest investors

in India, among the G20 countries. Hence, it is important to

see how India and the U.K. can manoeuvre through Brexit

and enter into new trade agreements that are mutually

beneficial to both economies.

Brexit will directly impact not only the Indian

stock market but the global market in totality, including the

emerging markets in the world. This is because of the high

volatility in the pound.

Both the U.K. and EU account for 23.7% of

Rupee’s effective exchange rate. With Brexit, foreign

portfolio investments will outflow and will lead to the

weakening of the rupee.

India’s businesses based in the U.K. will be

hampered as till now they had border-free access to the rest



of Europe.

The investors are concerned as India invests more

in the United Kingdom than the rest of Europe combined.

Impact on the World

Brexit will weaken the EU economically and

politically. The U.K. was the EU’s second- biggest

economy (after Germany) a major net budget contributor,

key military force and one of the bloc’s two nuclear powers

(another one is France) and permanent UN security council

members.

The U.K.’s departure has distracted attention from

a number of other big and urgent problems, including the

climate crisis.

In the longer term of balancing of global powers,

a smaller Europe can be a weaker Europe in the face of an

ambitious China and an increasingly protectionist US.

The Way Forward

The EU and the U.K. are bound by history, geography,

culture, shared values and a strong belief in rules-based

multilateralism which will be reflected in its future

partnership as well. The EU and the U.K. will have to focus

on building a new partnership. The process will start as soon

as the 27 Member States will approve the negotiating

mandate, proposed by the European Commission. The

mandate sets out terms and ambitions for achieving the

closest possible partnership between the EU and the U.K.

Both of them will have to work together, beyond these

historical and trade links, on security and defence areas in



which the U.K. has experiences and assets. These will be

used the best as part of a common effort to tackle the

global challenges and changes such as climate change,

cybercrime, terrorism, inequality etc. These challenges

require collective responses and the more the U.K. is able to

cooperate with the EU and other partners around the world,

the greater are the chances of addressing these challenges

effectively. The EU and the U.K. need to consult each other

and cooperate bilaterally while working with the regional

and global institutions such as the United Nations, the

World Trade Organization, the North Atlantic Treaty

Organization (NATO) and the G20. The EU will need to be

significantly tougher, with a centralised foreign policy and

stronger rules ensuring European companies can compete

with overseas rivals like China and the US. Brexit makes

that imperative even more urgent.

The EU’s core idea is that the member nations are stronger

together and pooling the resources and initiatives is the best

way of achieving common goals. Even if the U.K. has

moved out of it, it will continue to move forward as 27.

Meanwhile, other nations of the world will have to

accommodate themselves according to the shifting balance

of power and politics.

*****

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