OPEN ECONOMY

Economies of the world are open in three ways:

1. Consumers/firms have the opportunity to choose b/w domestic & foreign goods. Due to international trade.
2. Investors have opportunities to choose b/w domestic & foreign assets. Constitutes financial market linkages.
3. Factor market linkage: Firms choose where to locate production & workers to work. Labour market linkages have been relatively less due to various immigration laws. The movement of goods has traditionally been seen as a substitute for the movement of labour.

Foreign trade influences Indian aggregate demand in two ways:

1. Spending escapes as a leakage from the circular flow of income decreasing aggregate demand.
2. Exports to foreigners enter as an injection into circular flow, increasing aggregate demand for domestically produced goods.

Degree of openness:

The Degrees of openness are measured in terms of total foreign trade (import + export) / GDP ratio.

The countries are often reluctant to open their Economies. This is because Money moves in the opposite direction of goods. There is no single currency in the world. Economic agents accept a national currency only if they are convinced that the currency will maintain a stable purchase power.

Confidence in currency

The government tries to gain confidence by announcing that the national currency will be freely convertible at a fixed price into another asset (over whose value they have no control). Why?

There are two aspects of credibility:

• Ability to convert freely in unlimited amounts and
• The price at which conversion takes place.  Currency should act as a great store of wealth if its value does not decrease.

But free convertibility might lead to a balance of payment crisis as it did in India in 1991.

Balance of Payments (BoP):

The balance of payments (BOP) is a statement of all transactions made between entities in one country and the rest of the world over a defined period of time, such as a quarter or a year.

It is a record of the transactions in goods, services, and assets b/w residents of a country within the world.

The transaction of currency into or out of a country can happen on two accounts:

1. Current account -Mainly deals with currency exchanges due to trade.
2. Capital account – Mainly deals with currency exchanges on account of investment inflow or outflow.

Current Account:

It records exports & imports of goods & services & transfer payments. It consists of the following:

1. Trade balance: Balance of imports & exports.
2. Current Account balance: adding services & net transfers to it.
3. Trade in services is called invisible trade(not seen to cross borders)
4. Transfers Include:-
   • factor payments: Interest, profits, and dividends on our inputs & investment (Minus) foreign input & investment.
   • Non-factor income: shipping, banking, insurance, tourism, software services.
   • Transfer payments: receipts ‘for free’; which create no future liability. Remittances, gifts & grants.

Capital Account:

It includes all international purchases & sales of assets: money, bonds & stocks, etc. [Thus asset reduction & creation of liabilities]

Note: Any transaction resulting in a payment to foreigners is entered as a debit: -ve sign. If results in a receipt from foreigners is entered as credit: +ve sign.

BoP Surplus/deficit:

An individual who spends more than her income must finance the difference by selling assets/borrowing,

• The current account deficit is financed by a capital inflow. Extra inflow is added to the stock of foreign exchange. The country could engage in official reserve transactions, running down its reserves of foreign exchange, in case of deficit by selling foreign currency in the foreign exchange market.
• Monetary authorities are the ultimate financiers of any deficit in the BoP.

BoP equilibrium:

It occurs when the sum of the current account and its non-reserve capital account equals zero; It means that the Current a/c balance is financed entirely by international lending without reserve movements.

Elements of BoP:

• Autonomous transactions: when transactions are made independent of the state of BoP. [Called  ‘above the line items of BoP] If autonomous receipts are greater than autonomous payments: BoP is in surplus.
• Accommodating transactions:[below the line] to accommodate the fluctuations of autonomous transactions. They are determined by the net consequence of autonomous items. These are official reserve transactions.
• Errors & Omissions: [‘balancing item’] It reflects our inability to record all international transactions accurately.

Foreign Exchange Market

The exchange rate between currencies refers to different types of exchanges as noted as follows:

• Nominal Exchange Rates: (or bilateral exchange rate) Price of one currency in terms of other. Defined in two ways:
  • Domestic currency in terms of foreign: (give foreign take domestic)
  • Foreign currency in terms of domestic: (give domestic take foreign) more used in economic literature.
• Real exchange rate: Ratio of foreign to domestic prices (of free-flowing goods?), measured in the same currency.
  • Measures purchasing power in two places of the same currency.
  • It is taken as a measure of a country’s international competitiveness.
• Nominal effective Exchange rate(NEER): multilateral rate representing the price of a representative basket of foreign currencies, each weighted by its importance to the domestic country in international trade.
  • It is the index for exchange rates against other currencies.
• Real Effective Exchange rate(REER): weighted average of the real exchange rates of all its trade partners, the weights being the shares of respective countries in the foreign trade.
  • It is interpreted as the quantity of domestic goods required to purchase one unit of a given basket of foreign trade.

Exchange rate systems

There are mainly only two types of exchange rate systems in the world:

1. Flexible exchange rate
2. Fixed exchange rate

We shall study a “Managed floating system” in this chapter.

Flexible exchange rate: (or floating exchange rate)	Fixed Exchange rates: (or pegged exchange rate system) In it the exchange rate is pegged at a particular level.
Without commitments:  greater freedom to convert currencies but price is not guaranteed.	Regime of commitment: such as a gold standard.
No interference: Central banks do nothing to directly affect the level of exchange rates;	Interference: Can be fixed by agreements or maintained by monetary authorities(pegged) – a policy variable.
Currency moves to equate the demand & supply of foreign money. The link b/w BoP & transactions in the foreign exchange market is evident from expenditure on foreign goods & transfer payments.	Adjustments to BoP deficit/surplus can’t be brought through changes in the exchange rate. Adjustment must either ‘automatically’ through the workings of the economic system(Hume) Or by devaluation & revaluation. Or by use of fiscal & Monetary policies.

Flexible exchange rates:

It shows the following properties:

1. Trade is Unit elastic: meaning simply that a 1% increase in the exchange rate, must result in an increase in demand of more than 1%. [Extra rise in demand] The Rupee volume of our exports will rise more than proportionately to the rise in the exchange rate. Thus earnings in dollars would increase.
2. Interest rate differential: the difference between interest rates between countries.

1. 1. Huge funds in the world move around the world in search of the highest interest rates.
   2. A rise in the interest rates at home often leads to an appreciation of the domestic currency.

3. Income and the Exchange rates: Income increases spending. Thus, imports rise too.  Thus a depreciation in the domestic currency.
4. Exchange rates in the long run: indicate an equilibrium according to the PPP theory.

Purchasing power parity (PPP) theory:

The PPP theory is used to make long-run predictions about exchange rates in a flexible exchange rate system.

• As long as there are no barriers to trade, exchange rates should eventually adjust so that the same product costs the same wherever it is measured. Thus currencies reflect the differences in the price levels in the long run.
• If one country has higher inflation than another, its exchange rate should be depreciating.

Fixed exchange rates:

It shows the following properties:

• Devaluation: when the exchange rate is increased (for USD) by social action under a pegged exchange rate system.
  • It makes imports expensive and exports cheaper; Thus can be used to bridge trade deficits.
• Revaluation: Vice versa
• Overvalued: when the official exchange rate is below the equilibrium exchange rate system;
• Undervalued: Vice versa.

This often leads to the following crisis.

The problem of Speculation:

If it is believed that the rate can’t be held long by a country, speculators start buying massive amounts of foreign currency; Thus sharply rising BoP deficit. Without sufficient reserves, the central bank may have to allow the exchange rates to reach their equilibrium level.

This led many countries to abandon the fixed rate system in 1971.

 Managed floating:

• Exchange ratesfluctuate from day to day, but central banks attempt to influence their countries’ exchange rates by buying and selling currencies to maintain a certain range. The peg used is known as a crawling peg.
• A mixture of floating & pegged systems; Also called dirty floating;
• Central banks intervene to buy & sell foreign currencies in an attempt to moderate exchange rate movements whenever they feel that such actions are appropriate.

Exchange rate management: International experience

The world worked on a Gold standard between the 1870s to 1914; an epitome of a fixed exchange system. In this system, each country committed to guaranteeing the free convertibility of its currency into gold at a fixed price. This made it easier for the currencies to convert into each other(as all were convertible into gold). The exchange rate was defined in terms of gold.

The rates would fluctuate between an upper and a lower limit, these limits being set by the costs of melting, shipping, and reconciling between the two currencies.

The problem of BoP deficit in the gold standard

If a country imported too much to lose its stock of gold;

• Mercantilist explanation: unless the state intervened, through tariffs or quotas or subsidies, on export, a country would lose its gold;
• David Hume(1752): refuted the view: He said if the balance of stock of gold goes down, all prices & costs would fall commensurately & no one would be worse off. The equilibrium is stable & self-correcting, requiring no tariff and state action.

Several crises caused the gold standard to break periodically.

• Gold price levels were at the mercy of gold discoveries; If GNP increased at 4%, gold should have increased by 4%  to keep prices stable; This was not possible for long. The Discovery of gold in Klondike and SA kept deflation at bay till 1929.
• Bimetallism: silver sometimes supplemented gold.
• Fractional reserve banking helped to economize gold.

Gold exchange standard:

It is adopted by many countries which kept their money exchangeable at fixed prices with gold, but held no or little gold. But held currencies of some large economies. Paper currency was not entirely backed by gold; typically countries held 1/4^th of gold against its paper currency.

After the 1930s free float system worked and till 1944, the world reference currency was Pound Sterling (British). In the aftermath of the world wars, a new stable system was required. Thus, a new system was born out of the Bretton Woods Conference of 1944.

Bretton Woods system

It did two things:

1. It set up IMF & WB;
2. It re-established a system of fixed exchange rates.

An elaborate system of convertibility was necessary; It was a two-tier convertibility system;

• 1st tier: guarantee of US authorities: Dollar was fixed at $35/Ounce of gold.
• 2nd tier: Commitment of IMF members participating in the system to convert into dollars at a fixed price. The latter was called the official exchange rate.

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

The Fundamental Problem of the dollar peg

The US had 70% of official world gold reserves and a credible gold convertibility of other currencies would have required a massive redistribution of gold stock; it was believed that existing gold stock would be insufficient to sustain the growing demand of international liquidity.

Later, imports by the US went up, financed by drawing their own reserves. The US dollar was also the main component of the currency reserves of the rest of the world. Those reserves expanded and thus US was under a continuous BoP deficit.

The credibility of US commitment eroded. The US eventually gave up its commitment.

Triffin’s Dilemma

Robert Triffin, an economist, was the main critic of the Bretton Woods system. He highlighted a major shortcoming of the doller-gold peg system, popularly known as the Triffin’s Dilemma. The Triffin Dilemma: When a country’s currency (e.g., the US Dollar) serves as the world’s reserve currency, it faces the following dilemma: To meet global demand for its currency, the issuing country must run persistent trade deficits, leading to increasing external debt and financial instability. This creates a conflict between short-term global liquidity needs and long-term domestic economic stability. If the country stops running deficits, the global economy faces a liquidity shortage, but if it continues, it risks currency devaluation and economic crises. This dilemma remains central to discussions on monetary policy and global financial stability.

Special drawing rights (SDR):

Triffin suggested that the IMF should be turned into a ‘deposit bank’ for central banks and a new ‘reserve asset’ be created under the control of the IMF.

• In 1967, gold was displaced by creating SDRs, known as ‘paper gold’, in the IMF with the intention of increasing the stock of international reserves.
• SDR 35 = ounce of gold
• Redefined several times since 1974.
• Presently calculated daily as the weighted sum of the values in dollars of five currencies: U.S. dollar 41.73%, Euro 30.93%, Chinese Yuan 10.92%, Japanese yen 8.33%, British pound 8.09%. Of six countries (China, France, Germany, Japan, the UK and the US)
  • China’s latest entrant: 3 criteria: ‘freely usable’ & ‘widely used’ & ‘widely traded’.

Breakdown of Bretton Woods system:

• In 1967, Britain devalued its currency leading to the creation of a two-tiered gold market (with the official rate at $35 per ounce and the private rate market determined),
• In August 1971, the British demanded that the US guarantee the gold value of its dollar holdings. The US thus gave up the link between the dollar and gold.
• Smithsonian Agreement(1971): It widened the permissible band movement of exchange rates to 2.5% above or below new ‘central rates’ with the hope of reducing pressure on deficit currencies; It lasted for 14 months.
• Developed markets: UK, Switzerland, and Japan began to adopt floating exchange rates in the 1970s.

In revision of IMF articles allowed countries to choose whether to float their currencies or to peg them;

Current Monetary System:

Various countries adopt various systems: Multiple regimes: Most of them change on a day-to-day basis.

• Euro: [EU created in 1999] Common currency of various European nations: Their share is fixed at a fixed rate to the Euro. 19 of 28 members share same currency[needs to be updated]
• Often smaller countries decide to fix their exchange rates relative to an important trading partner. For example, Argentina adopted a Currency board system: They pegged the Peso to the Dollar. However, it let its currency float in Jan 2002 following a crisis.
• China shifted from a pegging system to a free float system following the Chinese market crash in 2015.
• Ecuador gave up its currency in 2000 and is dependent on the Central Bank of the US for Monetary supply.

There has been a virtual elimination of the role of gold. In fact, prices of gold are compared with currencies in a free market.

Convertibility:

It refers to the ease with which a country’s currency can be converted into gold or another currency in global exchanges.

Rupee Convertibility:

Until 1991, anyone willing to transact in a foreign currency would need permission from RBI, regardless of the purpose. All forex exchanges occurred at a pre-determined forex rate finalized by the RBI.

1991 onwards, India allowed Current account convertibility, as a part of its LPG reforms.

Current Account Convertibility (CAC)

It refers to liberalizing the conversion of the rupee into foreign currencies and vice versa for meeting out current account transactions/Trade, such as exports–imports. [Cash, Remittances &Trade]

India allowed full Current account convertibility in the 1990s including for remittances & indivisibles.

Capital Account Convertibility:

It refers to the Liberalisation of the conversion of foreign financial assets.

It allows the local currency to be exchanged for foreign currency without any restriction on the amount for all purposes which may include free movement of investment capital, dividend payments, interest payments, direct investments in domestic projects & businesses, trading overseas equities by locals & domestic equities by foreigners, foreign remittances and Sale & purchase of property globally.

India is a capital account non-convertible.

Advantages of Capital Account convertibility

• It is a sign of a stable and mature market.
• Increased Liquidity
• Increased investment
• The rupee market can further expand with full Capital Account convertibility.

Disadvantages of Capital Account Convertibility

• High Volatility: With a high number of global participants, high volatility, devaluation, or inflation in forex rates might happen.
• Businesses can be prone to foreign debt.
• India may lose competitiveness if the currency rates rise.
• Lack of fundamentals: India’s dependence on exports and socio-economic complexities (subsidies etc) don’t allow such convertibility.
• Tax avoidance: Many might stash away wealth in offshore locations and reinvest in India through P-Notes or FDI with full capital account convertibility.

Way Forward for India

To become a truly global economy and better growth, India must look forward to allowing full capital account convertibility.

• Full Capital account convertibility: as suggested by the Tarapore Committee in 1997. The rupee is substantially convertible for foreigners.
• Say a 2030 deadline for finishing the agenda could be a nice interim milestone. This can allow trading partners to start rupee invoicing, raising corporate rupee borrowing offshore and onshore, and accelerating our CBDC (central bank digital bank currency) plans.

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