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Wednesday, July 06, 2011

Mythbusting: Balance of payments edition

by Jeetendra.

Imagine a world with two countries. If one country has a current account surplus, the other must have an equal and opposite current account deficit. More generally, the sum of the current account balance, of all countries, is zero.

But what about the world's balance of payments? Many economists assume these must also sum to zero. For example, one often hears the claim that if one country is running a balance of payments surplus then others must be running deficits. Another argument often heard is that the RMB cannot become a reserve currency until China stops running a balance of payments surplus, because otherwise other central banks will not be able to acquire RMB assets.

This is wrong. In fact, if the right conditions come together, every country of the world can simultaneously run a balance of payments surplus.

Once a country starts trading on the currency market, the identity between the current account and the financial account breaks down. As an example, China runs a surplus on both the current and capital accounts. (That's how it is piling up so much reserves). Thus, when even one country in the world is trading on its own currency market, it is no longer the case that the balance of payments of the world have to add up to zero.

Does the accumulation of reserves by one country imply a loss of reserves by another? Consider the following two country example. Let's say the two countries are the US and China, and lets assume that the RMB and dollar are both reserve currencies. Let's say that the currencies are pegged at 1:1, so it doesn't matter if you are talking about RMB or dollars. And let's say that trade is balanced, so we can ignore it.

The US government now sells a 100 bond to the PBOC. And the Chinese government sells a 100 bond to the Fed. This yields a balance of payments surplus of 100 in both countries. Reserves went up by 100 in both countries. In both countries the economy (outside the central bank) has imported 100 in capital by selling bonds. So, the financial account in each country shows an inflow of 100, creating a surplus of 100.

What is going on? In this example, the central banks are inflating reserves by exchanging assets -- I buy your government's bond and you buy mine. But we call this a balance of payments surplus (in both countries) because we draw an arbitrary line, above which we record the government part of the transaction (inflow of fx from the bond sale) and below which we show the offsetting central bank transaction (outward investment). Since the assets are accumulating to the central bank in each case, we say that both nations are running BOP surpluses.

When countries do this, all countries can run a balance of payments surplus at the same time. Admittedly, this will be difficult for countries running current account deficits and facing capital outflows. But it is, technically, possible. That's why, say, China has been able to build up $3 trillion in reserves without any major country losing reserves at all.

Tuesday, July 05, 2011

Interesting readings

The frontiers of Nifty.

Next steps on the SEBI story: An interview with U. K. Sinha, by Puja Mehra and Rajiv Bhuva, in Business Today. Mobis Philipose in the Mint. Uproar over I-T raids on SEBI members, in Business Today. In probing SEBI board members, go by CVC rule: Abraham, by Sunny Verma, in the Financial Express. Sebi may stick to its guns in MCX-SX case by N. Sundaresha Subramanian in the Business Standard. Sebi's Abraham emerges front-runner for FMC top job by Ashish Rukhaiyar & Sanjeeb Mukherjee in the Business Standard. An editorial in the Business Standard. Sunil Jain on the problem of recruiting a UTI Chairman, in the Financial Express. SEBI looks to amend law to protect officials from investigative agencies by Reena Zachariah, in the Economic Times. SEBI seems to have not backed away in the high court on MCX-SX.



Shubhashis Gangopadhyay in the Business Standard on land acquisition.

We should be learning from these Afghans!

A difficult patch in the Indian IPO market.


Demystifying Swiss banking by Priti Patnaik, in the Financial Express.

Imagine there's no central bank.



Sunday, July 03, 2011

New BOP data -- a reminder of the paradigm shift that is required in our heads

Recently, India released BOP data. Many people, writing about this new data, wrote text such as:
The current account deficit (CAD) moderated to 1.1% of GDP in Q1 from 2.2% in Q4 2010, due to an improvement in the trade deficit and a sharp rise in the invisibles surplus.

Net capital inflows moderated sharply to 1.7% of GDP in Q1 from 2.9% in Q4, due to a steep fall in equity inflows and a moderation in debt capital inflows.
This is wrong.

Under a floating rate, the current account deficit is the same as net capital flows. Net capital flows finance the current account deficit. The exchange rate is moving constantly so that the two are equalised. It's no longer the case that each of these have a distinct and unrelated causal story.

Under a fixed exchange rate, such decoupled thinking was okay! You would look at the trade side and talk about why the CAD moved. You would look at capital flows and talk about why the net capital inflow moved. The two stories would take place on their own without a tight connection. That intuition has to be jettisoned once a country grows up into a market determined (i.e. floating) exchange rate, where there is a new macroeconomics which shapes both pieces.

On this theme, see Mythbusting: Current account deficit edition, on this blog, 20 December 2010.

Most of what we knew about Indian macroeconomics in 1993 has become obsolete. The good news is that standard undergraduate textbooks in macroeconomics, which are used internationally, are now much more useful in understanding India when compared with the way things used to be. And, you might like to read this integrated kit of four papers -- one, two, three, four -- which will give you a modern framework for thinking about Indian macroeconomics. If I had to teach a class in macroeconomics in India, I would teach these four papers (along with some other material).

Friday, July 01, 2011

India is losing the market for trading the Indian rupee

The recent order by the Competition Commission of India on NSE and MCX-SX has a bunch of difficulties based on a lack of understanding of new age industries where a pricing of zero is quite feasible and important, a focus on protecting a competitor instead of upholding competition, etc. I wrote about this in the previous blog post.

The most important problem with this order is that it represents a diversion away from the real story. The real story is that trading in the Indian rupee is leaving India.

The rupee is traded on three venues:
  1. The onshore exchange-traded market (NSE, MCX-SX, USE)
  2. The onshore OTC market
  3. The offshore OTC market (which is called the `non-deliverable forward' or NDF market).
In an article in the Business Standard today, Jamal Mecklai says:
in April 2011, NDF volumes, at nearly $43 billion a day, were more than double those of the onshore OTC market (about $21 billion a day), and nearly 40 per cent higher than the combined OTC and futures onshore volume. Clearly, the bulk of price discovery for the Indian rupee has migrated offshore.
While we are bickering about the valuation of one player in the onshore exchange-traded market, we are losing the plot. The real story is that India is losing the market where the rupee is traded. While we are fussing about NSE's charges on the currency futures market, the OTC market offshore charges zero and has steadily gained market share.

This is part of a larger concern which needs to be more carefully considered. As India internationalises, domestic customers of financial services, and the foreign order flow, will increasingly shift their business to providers abroad when there are problems in the local financial system. These problems fall into three kinds:
  1. Non-residents do not like to send orders to India given that India as yet lacks a residence-based taxation framework; they would rather send their orders to Singapore or Dubai or London which do.
  2. Indian capital controls hinder orders from non-residents: E.g. RBI prohibits FIIs from trading on the exchange-traded currency futures market (the only edge that India has in the trading of the rupee).
  3. An array of mistakes in regulations in India hinder the emergence of a capable domestic financial system (e.g. the CCI order, prohibition of options trading on INR/EUR, mistakes in how RBI will compute the INR/USD reference rate which must be used in the functioning of the exchange-traded contracts, etc.)
Our mistakes in policy on these three fronts generate a genuine possibility of a hollowing out of the domestic financial system in coming years.

The overseas market is the real source of competitive pressure. Unless overturned, the CCI order is working to reduce the market share of the onshore market.

Financial policy has two goals in this field. First, we'd like for more business to be on the transparent exchanges instead of the OTC market. This goal is assisted by a price of zero at exchanges. Second, we'd like for more business to be in India rather than the overseas market. This goal is also assisted by a price of zero at exchanges.