Balance of Trade (BoT),Current Account Deficit (CAD),

 

                     

Balance on Current Account has two components:

1. Balance of Trade or Trade Balance
2. Balance on Invisibles

Balance of Trade (BoT) =

• Value of Goods Exported out - Value of Goods Imported into the country.

Balance of Trade is in Deficit or Trade Deficit:

• Imports of Goods in Country >>>> Exports of Goods out of Country 

Trade deficit is unfavorable for a country.

Balance of Trade is in Surplus:

Exports of Goods out of Country >>>> Imports of Goods in Country

•  Surplus BoT is said to be favorable.
•  BOT is typically the biggest bulk of a country's Balance of Payments (BoP). 

Balance of Trade is balanced:

• Imports of Goods in Country = Exports of Goods out of Country

RBI uses the term Balance of Trade in Merchandise and Balance of Trade in services separately.

Factors that affect the Balance of Trade include:

• Cost of factors of production in the exporting economy vis-à-vis those in the importing economy.
•  Exchange rate movements; 
• Multilateral, Bilateral and Unilateral Taxes or restrictions on Trade; 
• Non-tariff barriers such as environmental, health or safety standards; 
• The availability of adequate foreign exchange with which to pay for imports.

IS World Balance of Trade (BoT) always Balanced:

• It is not easy to measure the ‘Balance of Trade’ accurately because of problems in recording and collection of data.  
• When official data for all the world's countries are added up, exports exceed imports by almost 1% giving an impression of positive Balance of Trade (BoT) .
• This is despite of the fact that all transactions involve an equal credit or debit in the account of each nation. 
• The discrepancy can only be explained by transactions intended to launder money or evade taxes, smuggling and other visibility problems. 

Net Invisibles: 

• Invisibles include services, transfers and flows of income that take place between different countries. 
• Services trade includes both Factor and Non-Factor income.
• Net Invisibles is the difference between the value of exports and value of imports of invisibles of a country in a given period of time. 

Current Account can be either:

1. Current Account Surplus if  Current Account Receipts > Payments
2. Balanced Current Account if Current Account Receipts = Payments
3. Current Account Deficit if Current Account Receipts < Payments

Current Account Deficit (CAD):

Current Account Deficit (CAD) comprises deficit in:

• Trade Account, 
• Services Account ,
• Net Income and Transfer from abroad. 

Out of these three components, Trade Account/Balance of Trade is the largest.

Implications of Current Account Deficit (CAD) :

• Current Account Deficit (CAD) means that India is importing more goods and services than it is exporting. 
• India typically runs a current account deficit as it is a developing economy which relies on imports of several commodities like crude oil. 
• India saw a rare current account surplus in FY2020-21.
• Current Account Deficit (CAD) is not necessarily a bad thing. 
• For India, a current account deficit of around 2.5-to-3 percent of the gross domestic product is said to be sustainable. 
• Deficits beyond this threshold are a cause for concern. 
• Sustained period of CAD  led to currency depreciation, high rates of inflation which further effects the incoming foreign investment. 
• Current Account Surplus implies the country is a net lender to the rest of the world, while Current Account Deficit (CAD) indicates it is a net borrower. 

Balance of Payments (BoP), The Current Account, Invisible Account, Income and Current Transfers

Balance of Payments (BoP):

It is the statistics that systematically summarize:

• the economic transactions of an economy with the rest of the world
• for a specific period-usually a year.

• Typically, the transactions included in BoP are country's exports and imports of goods, services, financial capital, and financial transfers. 
• The compilation and dissemination of BoP data is the prime responsibility of RBI.
• The concept of “residence” and not citizen is central to BoP compilation. 

  The Balance of Payments (BoP) can be broadly divided into two accounts namely:

 

Balance of Payments (BoP) cab be Surplus, Balanced or in Deficit depending upon the

situation as mentioned below:

BoP Surplus	Balanced BoP	BoP Deficit
Credit Side > Debit Side	Credit Side = Debit Side	Credit Side < Debit Side

The Current Account:

It measures the transfer of real resources (goods, services, income and transfers) between an economy and the rest of the world. 

The current account is subdivided into:

The Merchandise Account:

It consists of transactions relating to Exports and Imports of goods and is said to be trade in goods.

Invisible Account:

Current account except merchandise account is called as Invisible Account. Invisible Account comprises of:

• Services Account 
• Income and Current Transfers

Services Account: 

Services Account refers mostly to the transportation and insurance of merchandise shipments, transport fares paid by travelers, tourist services (hotels, restaurants), royalties and license fees, communications, software services,ITES, construction, house rentals, government purchases (in connection with embassies) and other items.

Income and Current Transfers:

• Income may be derived from labor, and from financial assets or liabilities.
• Financial income is interest income on investment on financial assets and dividends on corporate stocks.

Primary vs Secondary Income:

RBI used the term primary income for factor and Non-factor income while the term secondary income for Current Transfers.

Current transfers: 

• Transfer payments are the receipts which the residents of a country get for ‘free’, without having to provide any quid pro quo. 
• They could be given by the government or by private citizens living abroad in the form of gifts, remittances and grants. 
• Government transfers are donations by countries in the form of grants and gifts while the main component of private current transfers is usually workers’ remittances and gifts.

Purchasing Power Parity (PPP), Market Exchange Rate vs Exchange Rate (PPP), Implications of Higher GDP (PPP)

 

PURCHASING POWER PARITY (PPP):-

• Purchasing power parity (PPP) is a form of Exchange Rate that takes into account the cost of a common basket of goods and services in the two countries compared.
• It is the measure of the actual purchasing power of those currencies at a given point in time for buying a given basket of goods and services.
• Purchasing power parity (PPP) is often expressed in U.S. dollars.
• Purchasing Power Parity (PPP) exchange rate is not directly observable – there is no market where you can buy or sell currencies at PPP exchange rates. 

To Understand:

NER 1 $=80 Rs.

Let 1 chocolate cost =Rs 20 in India

Cost of same chocolate = 1 $ in US.

As 1 $ and the 20 Rs are in a position to purchase the same amount of items in US and India respectively so there purchasing power is same in their respective countries.

So as per definition, this Exchange Rate ie 1 $ =20 Rs is nothing but Purchasing Power Parity.

• Value of dollar in this reference is Rs 20 ie Exchange rate is 1$ =Rs 20 but this exchange rate is different than market Exchange Rate ie NER and it is referred to as ER (PPP).
• Both currencies  ie either one dollar in US has the same purchasing power as that of 20 Rs in India.

 Why difference between Exchange Rate and Exchange Rate (PPP):

What affects Market Exchange Rate:

• Foreign currency is required for multiple reasons in the international market ie for trade, speculation, investment and other reasons and this creates a market of demand and supply or that currency in the market so Exchange Rate -Market is always higher than ER-PPP.
• The market exchange rate tells you how many rupees you can buy for $1,000, the PPP exchange rate tells you how many rupees you would need in India to maintain the same standard of living you could achieve in the United States for, say, $1,000 per month.

The relative version of PPP is calculated as: 

REER = NEER *Domestic Price/Foreign price

            =NEER* ER(PPP)

STATUS OF INDIAN ECONOMY:

India is 5^th largest economy in nominal terms while 3^rd on PPP terms.

HIGHER GDP IN PPP TERMS FOR INDIA-What does that mean :

• The implications of a high GDP in PPP terms can be understood in terms of increasing strength of the Indian consumer in recent years. 
• A high PPP implies that a basic set of essential goods and services is cheaper inside India, in comparison to the consumers in Japan, USA or the UK. 
• India has made significant improvements in public life and economy allowing for a low cost of living, across the population. 
• This has also resulted in India being generally safe against inflation shocks and shocks of the global economy.

Effective Exchange Rate, Nominal Effective Exchange Rate (NEER) vs Real Effective Exchange Rate (REER), Overvaluation vs Undervaluation of Rupee

 

EFFECTIVE EXCHANGE RATE (EER):

• Effective Exchange Rate (EER) is an index that describes the relative strength of a currency relative to a basket of other currencies. 
• EER is an indicator of international Trade competitiveness.  
• EER can be either Real Effective Exchange Rate (REER) or Nominal Effective Exchange Rate (NEER).
•  Base year for calculating NEER and REER is shifted from 2004-05 to 2015-16.
• Both NEER and REER are calculated by Reserve Bank of India.

Nominal Exchange Rate (NER):

• Nominal Exchange Rate (NER) is the rate at which one currency will be exchanged for another foreign currency. 

• It is nothing but Exchange Rate.

Nominal Effective Exchange Rate (NEER):

• Nominal Effective Exchange Rate (NEER) is the unadjusted weighted average value of a country's currency relative to basket of currencies. 
• The weights of currencies are determined by weightage of trade done by the country in that currency, as measured by the Balance of Trade. 
• Nominal Effective Exchange Rate (NEER) focuses on the exchange of basket of currency.

Real Exchange Rate (RER) –

Real Exchange Rate (RER) is the value of currency wrt any foreign currency adjusted for the effects of inflation.

Real Effective Exchange Rate (RER) –

• Real Effective Exchange Rate (REER) is the weighted average of a country's currency relative to an index or basket of currencies adjusted for the effects of inflation. 
• Inflation component is measured in terms of CPI 
• The weights of currencies are determined by weightage of trade done by the country in that currency ,as measured by the Balance of Trade. 
• In India, Reserve Bank of India (RBI) compiles REER indices. 
• REER publishes two indices ie first one is based on six country’s trade-based weights and the second on 40-currencies’ export and trade-based weights. 
• The base year for calculating REER is taken as 100 and currently the base year is 2015-2016.

NEER vs REER: 

• Nominal Effective Exchange Rate (NEER) focuses on the exchange of currency while Real Effective Exchange Rate (REER) focuses on the exchange of goods and services.
• Increase in Real Effective Exchange Rate (REER) signifies appreciation of the Rupee and REER of more than 100 indicates that the rupee is overvalued.

 Overvaluation of the Rupee:

• Overvaluation of the rupee means that its price in terms of foreign currencies is too high ie appreciated.  
• Overvaluation of the Rupee makes our exports costly and our imports cheaper.

Undervaluation of the Rupee:

• Undervaluation of the rupee means its price in terms of foreign currencies is too low ie depreciated.
• Undervaluation of the Rupee is in favor of exports and against imports.

Analysis of REER and its correlation to NEER and Trade

As per RBI methodology, Exchange rate of Indian INR wrt $ is :

If 1 $=80 Rs ,then RBI calculates it as 1 INR =1/80 $ ie .0125 $/INR.

                      REER = NEER *Domestic Price/Foreign price

REER of INR vs U.S. $ = (Indian prices / US Prices in $)*Exchange rate of the INR vs. US $ * 100

*****Exchange Rate is as per RBI methodology ie 1 INR =1/80 $ ie .0125 $/INR and not 1 $=80 INR.

SIGNIFICANCE OF REER:

• REER focuses on the exchange of goods and services. 
• Increase in REER exchange rate means inflation is increasing.
• If a countries real exchange rate is rising it means its goods are becoming more expensive  relative to its competitors.

IMPACT OF CHANGES IN NEER UPON REER:

If prices in India and US remain constant and there is only change in NEER:

Assuming 1 INR =1/80 $ ie .0125 $/INR as basis for all calculations:

1.If INR appreciates then 1$=50 Rs ie .02 $/INR,

•                                                   then NEER will appreciate 
•                                                   and hence REER will also appreciate and 
•                                                    it will be non Trade-competitive .

2. If INR depreciates then 1$=100 Rs ie .001 $/INR,

•                                                then NEER will depreciate 
•                                                and REER will also depreciate 
•                                                and it will be Trade - competitive.

Analysis:

Assuming Exchange rate to remain constant,

1.If prices in the two countries are the same, then the REER is 100.

2. If Indian domestic prices are higher than US  prices, then REER > 100.

3.If U.S. prices are higher than Indian prices, the REER < 100.

If the REER > 100:

• Domestic prices are relatively high and hence domestic products are non-Trade competitive. 
• Domestic currency is overvalued. 
• In this case there is more imports in comparison to Exports, leading to widening of the Current Account Deficit (CAD).

If the REER < 100: 

• Domestic prices are relatively low and hence domestic products are trade competitive. 
• Domestic currency is Under-valued.
• In this case there is more exports in comparison to imports, leading to lowering of the Current Account Deficit (CAD).

Conclusively REER is:

•                                             Directly proportional to Domestic Prices 
•                                             Inversely proportional to Foreign prices 
•                                             Inversely proportional to Trade competitiveness.

Dollarisation vs De-Dollarisation, Hard currency /Safe-Haven Currency / Strong Currency, SOFT CURRENCIES

 

DOLLARIZATION: 

• An Economic situation in when citizens of a country use foreign currency in parallel to or instead of the domestic currency. 
• Foreign currency in Dollarization does not mean usage of  U.S dollar only but the use of any foreign   currency.
• Zimbabwe adopted dollarization after the collapse of the Zimbabwean dollar.

Benefits of Dollarization:

• Stable (foreign) Currency will attract investment and growth.
•  As the foreign currency can be earned only through exports and foreign capital inflows, exports would be promoted and conditions for capital inflows would be eased. 
• There is no possibility of monetization of deficit and so there is control on wasteful expenditure.

Negatives of Dollarization:

•          Central banks will loose control on monetary policy and can't influence the money supply 
•      Central banks can't devalue currency to promote exports

DE-DOLLARIZATION:

•      Reduction in the dependency upon Dollar as a reserve currency by nations, medium of exchange,  or basis for international trade
•      De-dollarization is in Favour of other currencies or alternative systems, like regional and national currencies, or even digital currencies like cryptocurrencies.
•    Russia-Ukraine war and call of BRICS for an alternative currency have given a voice for de-dolallarisation.
•      US Pres in his opening remarks has also warned BRICS for this.  

      Hard currency /Safe-Haven Currency / Strong Currency: 

• Globally traded currency issued by developed countries.
• These Currencies remain stable 
• These currencies draw power from the political & Economic stability of the country.
• Theses currencies are held by nations for trade purposes.

     SOFT CURRENCIES:

• Currencies whose value fluctuates in the Exchange rate markets.
• Fluctuation is on account of Country's political and economic instability.
• Countries avoid holding these currencies for trade purposes.
• Developing countries usually hold these currencies.

EXCHANGE RATE REGIME, FIXED EXCHANGE RATE /PEGGED FLOAT, FLOATING / FLEXIBLE EXCHANGE RATE, MANAGED EXCHANGE RATE, EXCHANGE RATE SYSTEM IN INDIA

EXCHANGE RATE REGIME: 

• An Exchange-Rate Regime is the manner in which an authority manages the Exchange Rate of its domestic currency in relation to other currencies in the foreign exchange market.
• Exchange-Rate Regime is closely related to Monetary Policy and both affects each other.

There are three main types of Exchange rate regimes:

●        Floating / Flexible Exchange Rate

●        Fixed Exchange Rate

●        Managed Exchange Rate 

FIXED EXCHANGE RATE /PEGGED FLOAT:

In Fixed Exchange Rate regime:

• Currency's value remains fix 
• Currency does not respond to Foreign-Exchange market fluctuations.
• The regime helps control inflation, and a stable environment for facilitating international trade. 
• Qatar is following Fixed Exchange Rate regime where 1 USD=3.64 Qatari Rial.

FLOATING / FLEXIBLE EXCHANGE RATE:

In Floating Exchange Rate regime:

• Currency's value fluctuates in response to Foreign-Exchange market mechanisms
• Market Mechanisms include speculation and supply and demand forces in the market.
• Currency is known as floating currency. 

Most of the countries have adopted Floating exchange rates after the failure of the Gold Standard and the Bretton Woods agreement.

MANAGED EXCHANGE RATE:

• Halfway between Floating Exchange Rate regime and Fixed Exchange Rate regime system.

In normal times, Currency's value fluctuates in response to Foreign-Exchange market mechanisms

                                                                 but 

The government or the country’s central bank may occasionally intervene to direct the country’s currency value into a certain direction. 

DIRTY FLOAT EXCHANGE RATE:

• When a country / the central bank manipulates the exchange rate without following rules and regulations.

EXCHANGE RATE SYSTEM IN INDIA:

Since independence------------Fixed Exchange Rate in the form of sterling parity & world currencies.

                                ⇓

Post independence “Fixed and Adjustable” regime. Exchange Rate $1=Rs 1 (1947)

                     ⇓

Economic crises associated with Balance of Payment crisis since independence led to devaluation of INR to 1 $ =31 Rs by 1993.

                     ⇓

                              Post 1993, Floating Exchange Rate Regime