Tag Archives | Varun Ramachandra

More thoughts on accrual accounting

This is a part of a series on Defence Economics. Previous blogs on the same topic can be found here, here, and here.

In continuation with the last piece that dealt with democratic accountability and defence economics, this post provides some more sources that have analytically written about the importance of an accrual-based accounting system.

Gur Saroop Sood  in this excellent article refers to the cash-based accounting thus:

 “Under the cash-based system, the currency transactions, pertaining to a Financial Year, are available till the closing of accounts. Once the accounts are closed, past transactions do not become readily available. In this system, committed liabilities incurred do not get recorded in the accounts at the time of their occurrence. Therefore, for commitment control, such information has necessarily to be generated through additional reports. If the committed liabilities are not available, the possibility of over or under committing resources vis-à-vis available funds in a Financial Year cannot be ruled out. The accounting system also does not generate information for the decision-makers to know whether the money is being spent on core or peripheral activities. Due to the principle of lapse, the Executive tends to spend the earmarked funds during the month of March, sometimes also referred to as ‘March rush’, in order to avoid surrender of unspent funds spend the earmarked funds during the month of March, sometimes also referred to as ‘March rush’, in order to avoid surrender of unspent funds.”

Amaresh Bagchi in his Business Standard piece says

Such a system does not provide a full picture of the government’s liabilities, because accrued liabilities such as those from unfunded pensions and commitments are not taken into account; two, it keeps no track of the assets of the government, nor do they provide information on the costs of holding and operating them or of their consumption or use”

The 12th Finance Commission’s recommendations are as follows

“Compared to the cash based system, the system of accrual accounting recognizes financial flows at the time economic value is created, transformed, exchanged, transferred or extinguished, whether or not cash is exchanged at that time. It is different from cash based system in that it records flow of resources. Expenses are recorded when the resources (labour, goods and services and capital) are consumed, and income when it is earned, i.e. when the goods are sold or the services rendered. The associated cash flows generally follow the event after some time and may or may not take place during the same accounting period. Thus, in addition to cash flow, unpaid consumptions (payables) and unrealized income (receivables) are also recorded. Resources acquired but not fully consumed during an accounting period are treated as assets (inventory and fixed assets). Payments made for acquisition of inventory are included in the operating cost for the period in which it is consumed. Payments made for acquisition of physical assets, that have future service potential, are amortized over the entire useful life of the asset by charging depreciation

The system of accrual accounting thus, inter alia, allows better cost – price calculations, records capital use properly, distinguishes between current and capital expenditures, presents a complete picture of debt and other liabilities and focuses policy attention on financial position, as shown in the whole balance sheet not just cash flows or debts thereby providing a complete measure of cost of various services and provides net worth and their changes over time

The Controller General of Defence Accounts while talking about implementation of accrual accounting in Government says the following

Accrual accounting system enables system enables a more effective assessment of the performance and provides the necessary information for linking the input costs to outputs and outcomes that is required by services.

The challenge of moving to an accrual based accounting is the time that is required for the transition. Also, the switch will place considerable demands on the accounting personnel particularly at the lower and middle levels of the accounting hierarchy.

Amaresh Bagchi’s Business Standard piece has a solution to this problem as well where he suggests

 transitioning in a phased manner and in the interim both cash and accrual accounting can run in parallel to ensure a smooth transition.

There is overwhelming evidence, and scholarly  agreement about moving towards an accrual based accounting system. It is a matter of wonder that the move has not yet happened. Perhaps, an analysis on why cash based accounting  system is still in vogue is an exercise worth undertaking.

Varun Ramachandra is a policy analyst at Takshashila Institution, he tweets @_quale

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Democratic accountability and defence economics

The previous post on defence economics described the need to study the subject. it was concluded that: development of defence economics is necessary from the perspectives of

  • democratic accountability
  • efficiency of resource allocation to ensure preparedness
  • military effectiveness to ensure the right mix of services are deployed to ensure peace
  • improvement of service conditions — that ensures state of the art quality of life for servicemen, ex-servicemen and their families

This post focusses on democratic accountability and the need to maintain it even while dealing with complex choices in defence.

Sound financial management of a country’s security sector is key to maintain an efficient and effective security force that is capable of responding to the population’s legitimate security needs. Avoiding excessive, wasteful, and corrupt military expenditures and procurement thus requires high levels of transparency and accountability in military budgeting and procurement processes.”Such processes should adhere to government-wide financial management and oversight practices, within a rigorously-observed defence policy and planning framework. This includes adherence to public expenditure management (PEM) principles of comprehensiveness, discipline, legitimacy, flexibility, predictability, contestability, honesty, information, transparency and accountability”[1].

In the Indian context, the government and citizens must know the full costs of national security and this can be achieved by making the asset value of services explicit without compromising the strategic secrecy that is the imperative of any defence service.  All the forces together own valuable land, spectrum, human resources, and equipment. Arriving at an explicit asset value creates incentives for increasing the efficiency of all these assets and creates a defence establishment that is effective, efficient, and fiscally prudent.

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The process is easier said than done. For example, a simple step that is tedious to implement is a shift towards accrual based accounting. Currently, the defence budgeting system is based on a cash accounting model which ignores all non-cash transactions. This has masked the exact net present value of all the resources that the services currently possess. Such a system “does not provide a full picture of the (government’s) liabilities, because accrued liabilities such as those from unfunded pensions and commitments are not taken into account; two, it keeps no track of the assets of the (government), nor do they provide information on the costs of holding and operating them or of their consumption or use”[2].  An accrual based accounting system enables more effective performance assessment and provides the necessary information to link the input costs to outputs, and outcomes that is required by services[3].

That said, the complexities of a process should not stifle measures that ensure democratic accountability.

Varun Ramachandra is a policy analyst at Takshashila Institution, he tweets @_quale

References:

[1] “Transparency and accountability in military spending and procurement” http://www.sipri.org/research/armaments/milex/transparency, accessed 15-July-2015

[2] Amaresh Bagchi, Accrual accounting in government, Business Standard, 5-April-2005, http://www.business-standard.com/article/opinion/amaresh-bagchi-accrual-accounting-in-government-105040501073_1.html, accessed on 15-July-2015

[3] Implementation of accrual accounting in Government, Controller General of Defence Accounts, http://cgda.nic.in/accounts/accrual.html, accessed on 15-July-2015

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Where India got it right

EU is trying to do what India did in 1947, but it has been trying to do so since 1958 – Varun Ramachandra(_quale)

It appears that the Eurozone leaders have decided to halt the crisis that they have been in recently. They have agreed to provide a third bailout to Greece, subject to certain conditions that the Greek government has to meet by 15th July 2015.

A lack of political union is being cited as a primary reason for the current crisis in Europe. In this context, some of my colleagues have attempted to compare the Indian Union and the European Union and contend that the EU is aspiring to do what India did in 1947.

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Although initially I did not agree, with time and more reading I partly agree with the hypothesis. EU is indeed trying to do what India did in 1947, but it has been trying to do so since 1958. At the time of independence, India faced a problem of political unity; a common currency across most of (today’s) India already existed. The Euro Zone, on the other hand, comprises of several states with independent governments that have agreed to be a part of a monetary union — ie., an adopted common currency.

In this context the words of the  English Economist Nicholas Kaldor sound prophetic

… Some day the nations of Europe may be ready to merge their national identities and create a new European Union – the United States of Europe. If and when they do, a European Government will take over all the functions which the Federal government now provides in the U.S., or in Canada or Australia. This will involve the creation of a “full economic and monetary union”. But it is a dangerous error to believe that monetary and economic union can precede a political union or that it will act (in the words of the Werner report) “as a leaven for the evolvement of a political union which in the long run it will in any case be unable to do without”. For if the creation of a monetary union and Community control over national budgets generates pressures which lead to a breakdown of the whole system it will prevent the development of a political union, not promote it.

Another important difference between the EU and India is that the individual Indian state derive its legitimacy from the Union. This is sorely lacking in Europe, where the Union draws its legitimacy from the individual members.

It is therefore safe to contend that the Indian experiment is actually a success, at least when compared to the ongoing European experiment, whose results are not yet out.

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Opportunity cost of delays

Recent news reports suggest that the final operational clearance for  India’s homegrown Light Combat Vehicle might be delayed. If this is indeed true, this is not good news.  There is also news about handing over the entire project to the private sector. Irrespective of whether the LCA will be delayed or not, most newspapers and reports suggest that the Indian government has spent enormous amounts of money on this project.

Although the losses are significant,merely looking at a huge rupee number does not complete the story. The concept of opportunity costs has to be factored in while analysing such delays in projects. Opportunity cost in simple terms can be defined as the loss of the next best opportunity. In case of the LCA or any other delayed projects the question that must be raised is “What is the next best thing we could have done with the money”?

In an area like defence, the opportunity costs are exacerbated because delays inevitably reduce combat preparedness. A logical question to raise therefore is to track how many such delays have affected India in the numerous conflicts that it has had to face in the past.

As this ET report suggests

Sources said discussions have taken place in the top echelons of the government on the best ways to inject urgency into the Tejas programme, possibly even with the involvement of a private sector player that would be clearly incentivised to deliver a new aircraft on time and within budget

One wonders why the government has decided to bring in private players so late in the game(Depending on how the timelines are viewed, there has been a delay of more than 10 years in the LCA project).  The idea about only state-run firms handling  strategic programmes has not been a success. It is time the defence ministry and the defence establishment views efficiency, as opposed to ownership, as the metric while choosing vendors/partners.

Better late than never. Hopefully.

Varun Ramachandra is a policy analyst at Takshashila Institution and tweets @_quale

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Need for a systematic study of defence economics

Ensuring security from external aggression is a basic public good that the governments have to provide and given that it is not possible to reveal individual preferences, this has to be financed from taxes.   The important issue confronted by the policymakers, however, is the basic economic dilemma of scarcity and choice.  The funds allocated for defence are not available for spending on physical infrastructure or human development which are necessary to improve the living conditions of people.

As stated by David Greenwood[1], “What the budgeting system should ideally do is to ensure that the ‘right’ amount is spent on defence in the light of pattern of national priorities, and the ‘right’ military capabilities developed in the light of the structure of security priorities” The answers to what the “right” amount is depends on the economic choices the government has to exercise in providing various public goods, merit goods and services, given the overall resource envelope.

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As the world’s largest democracy, with an annual gross domestic product (GDP) of almost $2 trillion it is imperative to understand what the ‘right’ amount is and to evaluate whether what we are currently spending is high, low, or indeed the ‘right’ amount. While understanding the numbers are important, it is also important to explore the following

  1. various priorities in which defence spending can happen
  2. assessing existing resources
  3. investigating the possibility of developing  normative frameworks to understand security priorities & threat perception
  4. how the defence forces can be effective and yet be fiscally prudent

The national security of a country depends on defence installations and facilities being in the right place, at the right time, with the right qualities and capacities. Spending on defence, therefore, is a resource allocation problem and the budgeting for defence has two broad functions[2]

  1. Management Function — to enable concerned personnel to spend money for various activities in an efficient and economical manner.
  2. Planning Function — Budgetary resources are to be allocated such that it enables achievements regarding operational preparedness and defence capability-building.

Defence budgeting literature indicates that budget is a three-tiered exercise in choice. First, it involves choosing how much to spend on defence, given the resource constrtaint, keeping in view other competing demands. Second, it involves choosing the basis for allocating resources among the services (army, navy and airforce). Third, it involves allocation among various programmes for capability-building, which entails what capabilities to acquire & maintain and the degree of military preparedness to aspire for[3]. Therefore, development of defence economics is necessary from the perspectives of

  • democratic accountability
  • efficiency of resource allocation to ensure preparedness
  • military effectiveness to ensure the right mix of services are deployed to ensure peace
  • improvement of service conditions — that ensures state of the art quality of life of servicemen, ex-servicemen and their families.

Varun Ramachandra is a policy analyst at Takshashila Institution and tweets @_quale

[1] David Greenwood, “Budgeting for Defence”, RUSI, 1972, p8.

[2] AK Ghosh, “ Defence budgeting and planning in India”, p.25

[3] Ibid 27

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PS- My thanks to Nitin Pai and Dr. M. Govinda Rao for their inputs and help.

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Linguistic States in India

In an otherwise uneventful journey, recently, I had the pleasure of talking to a bus driver who was plying between Indian states A and  B. He was ruing about how commercial and other state transport vehicles(from the ‘other’ states) do not let you overtake based on the letter code on your number plate.

Anecdotes are the lowest forms of data, that is if it can be considered data at all. That said, the story about overtaking(or the lack of it) is an excellent example of how linguistic sub-nationalism surfaces in India.

The movement for linguistic states in India existed much before Independence, but became a reality due to the unfortunate death of Potti Sriramulu who fast unto death for the creation of a separate Andhra Pradesh. Linguistic states are a now reality and have, depending upon the situation, been a matter of great elation and/or chaos.

Language cloud

Creation of linguistic states has had many advantages but it has also had several negative effects. First, boundary tensions exist between several states. Second, water-sharing agreements between higher and lower riparian regions are still not sorted. Third, multilingual scholarship has been a serious casualty  —  it has become the job of another state to promote their own language.

It is undeniable that strong sentiments are attached to languages. The sub-continent itself has witnessed civil wars and creation of an independent nation on the basis of a language. Therefore, it is important to be cognisant about this sentiment, but it is also important to ensure that sentiments do not get the better of us.

In his excellent essay titled State Name and Linguism in  Public Affairs in 1972, the Kannada poet and intellectual D.V Gundappa, says the following

 Emphasising the linguistic element in the nomenclature of the Provincial states in India is a way of promoting separatism and disharmony. (…) The names of the Provincial States should not be such that they could be used as a handle by a fanatic of any kind. Language is emphatically such, as much as Religion. The name could no harm if it is based upon locality or town or upon a  historic dynasty now extinct and incapable of separatist or offensive sentiment — like Kadamba or Chola. If unprovocative is not found , the best course would be to assign a number to the State. The names of States given in Schedule I to the constitution may be rearranged in alphabetical order and numbered consecutively so that they will be known as State the Eighth, State the Fifteenth, State the Twentieth and so on. This may not be the most convenient nomenclature. It may put great strain on memory. But at whatever cost, our provincialism must be subordinated to our nationalism.

Although DVG’s suggestion about numbering the states is not too practical, it raised extremely valid points, especially at a time when the fervour for linguistic states was at its peak.  It is therefore important for us to now ask similarly important questions: Are linguistic states a ticking countdown for something bad? Will linguistic states continue to strengthen the Indian state with a sub-nationalist layer? Is the linguistic organisation of states truly successful both economically and culturally?

This topic deserves holistic analysis and should not be pushed into the realm of taboo.

Varun Ramachandra is a policy analyst at Takshashila Institution and tweets@_quale

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What’s up in China?

Here is attempt to collate a bunch of links to know everything about what is happening in the Chinese Stock Market right now

This is a bubble of epic proportions. In 12 months, Chinese stock markets rose enough to create $6.5 trillion of value. It’s hard to picture, but that’s a stunning amount of money. It’s the equivalent of about 70 percent of China’s GDP in 2013, and about 40 percent of the total value of the New York Stock Exchange. It’s enough to pay off Greece’s debt 20 times over, circle the Earth250 times with $100 bills, or build 43 International Space Stations.

The stock market weakness, should it spread to the Chinese economy over the long term, could prompt Beijing to reassess its overseas loans and investments. Many countries, industries and companies have come to depend on Chinese money to fund their own growth. But Chinese outbound investment could still increase if companies and individuals seek safety overseas.

There are a few other interesting, potential casualties of the latest market drop. Some analysts say that the Chinese government’s repeated pledges to boost the market and subsequent failures to do so could damage its credibility and lead to a crisis of confidence. Even if that doesn’t happen, the government’s latest measures are definitely calling into question its 2013 pledge to let the market play a “decisive” role in governance — the central promise of its economic reform agenda.”

 it is (easy) to frame market data in a way that sounds either scary or benign, depending on your inclination. “The Chinese stock market has dropped 32 percent in a month” is scary. “The Chinese stock market is up 70 percent over the last year” sounds great. Both are true

Those market dynamics can create a chain reaction of selling. China’s major exchanges prevent a stock from falling more than 10 percent on any given day. When that happens, analysts say, many investors opt for selling other shares, broadening the sell-off. Then when the market opens the next day, they continue selling down the stock that was previously halted, effectively prolonging the turmoil.

But the boy was not of the timid kind. “Oh yeah,” he yelled back at Kennedy, “well, I got a tip for you too: buy Hindenburg!” Intrigued, Kennedy turned around and walked back. “What did you say?” – “Buy Hindenburg, they are a fine company,” said the boy. “How do you know that?” –- “A guy before you said he was gonna buy a bunch of their stocks, that’s how.” – “I see,” said Kennedy. “That’s a fine tip. I suppose, I was a little harsh on you earlier,” he said, pulling off a glove and reaching in his side pocket for some change. “Here, you’ve earned it.”

Little did the boy know that Kennedy, a cunning investor, thought to himself: “You know it’s time to sell when shoeshine boys give you stock tips. This bull market is over.

Update:

But that calculus would change if China’s economy crashes along with its markets. Now it’s important to remember that “crash” is a relative term for China. Its economy is supposed to grow around 7 percent this year, so anything less than 5 percent would push unemployment up enough to feel like a recession. This kind of “hard landing” would hit the commodity countries like Russia or Australia that have been feeding China’s insatiable appetite for raw materials, well, the hardest—although the ripple effects would also reach rich countries like the U.S. that actually sell $100 billion of goods to China each year. That really isn’t all that much in the context of our $16 trillion economy, but if you added up how much other countries being hurt would hurt us as well, it wouldn’t be nothing.

Update 2:

There are several reasons for this unusual behaviour: firstly, when I teach stock market investment to my Chinese students, I always remind them that the Shanghai stock exchange should be thought of more as a casino, rather than as a proper stock market. In normal stock markets, share prices are – or, at least, should be – linked to the economic performance of the underlying companies. Not so in China, where the popularity of the stock market directly correlated with the fall in casino popularity.

Varun Ramachandra is a policy analyst at Takshashila Institution and tweets@_quale

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Why is the Dollar the World’s Reserve Currency?

By Anupam Manur and Varun Ramachandra

Strength, stability, universal acceptability, and a lack of a viable alternative to the dollar makes it the global reserve currency. 

Global trade and businesses function best when there is a currency that is widely accepted. This doesn’t imply a common currency, instead, it refers to the usage of a widely acceptable currency for international transactions. Such a currency reduces the transaction costs of converting one currency to another and enables easy invoicing of traded goods and services. This common currency is referred to as the reserve currency.

The brief history of reserve currencies:

Historically, a reserve currency implied a currency that was in wide circulation even outside the issuing state’s borders. Currently, the US dollar is the world’s reserve currency but this hasn’t been the case forever. The silver Drachma issued by the ancient Athens was probably the first reserve currency. The Roman Aureus and Denarious coins, the Byzantine Solidius coins, the Arabian Dinar, the Florence Fiorino, and the Dutch Gulden have at various points had the status of being the world’s reserve currency.

History of money

 

In 1717, Britain adopted the gold standard – a system where central banks had to back each paper currency note they printed with an equal or proportional amount of gold — and simultaneously built a vast empire. At the height of its power, more than 60% of world trade was invoiced in pounds and this led to the pound sterling becoming the world’s reserve currency. At around the end of the 19th century, America’s economic significance rose and this resulted in the US dollar toppling the pound as the most sought-after currency. Today, more than two-thirds of foreign exchange reserves held by central banks around the world are in US dollars (see figure).

COFER

 

Why do central banks maintain reserves?

Two important reasons for holding reserves are as follows:

First, safety. Reserves act as savings, and central banks can benefit from this in hours of need. When a country faces a balance of payments crisis or some other form of financial crisis, the central bank can use its reserves to alleviate the situation. Typically, central banks manage enough reserves to cover for three months’ worth of imports to maintain continuity of trade in times of crises. Reserves also act as positive assurance to debtors.

Second, reserves are maintained to manage a country’s exchange rate policy (the previous post explored this aspect). Whenever a country’s currency appreciates or depreciates, and moves away from the target exchange rate set, the central bank steps in and uses its reserves to maintain exchange rate stability. The Reserve Bank of India has done this on numerous occasions when the rupee has appreciated or depreciated.

Why is the US dollar the reserve currency?

Since the United States boasts of the world’s largest economy (around $18 trillion) and has a stable political environment, most international trade is invoiced in dollars and about 50-60% of US dollars circulate outside US borders. Since there has been no default or major devaluation of the dollar in the past few decades, the USD and the US government’s treasury bonds are thought of as the safest assets in the world; this inherent stability and risk-free nature of the dollar is attractive to investors and has therefore ensured that the US dollar is the world’s reserve currency.

According to economist Ewe-Ghee Lim, there are five factors that facilitate international currency’s status: a large economic size, the existence of a well-developed financial system, confidence in the currency’s value, political stability, and network externalities. Additional features for currencies that assume reserve status are large-scale current account and financial account convertibility, an independent central bank, a high degree of capital mobility, surveillance of economic policies, and cooperation of monetary policymaking at regional and multilateral levels. The dollar checks almost all of these boxes.

The rise of China since the 80s has made the Chinese Yuan an important world currency, but since the Yuan has been deliberately undervalued to aid exports, the real exchange rate of Yuan is unknown. Japan and Britain are waning economic powers, the emerging markets are too volatile, the Euro has many internal problems, and gold is too static a commodity to be held as the reserve currency. This leaves the dollar as the only viable option for the time being, and probably for some more time to come.

Anupam Manur is a Policy Analyst at Takshashila Institution  and tweets @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and tweets   @_quale

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Does a strong currency mean a strong economy?

by Anupam Manur & Varun Ramachandra

Exchange rates have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.

In their book The Dollar Crisis, Paul Simon and Ross Perot famously said that “A weak currency is the sign of a weak economy, and a weak economy leads to a weak nation”. The quote was mentioned in the larger context of American military and economic might, but the feelings espoused in the quote are shared by many. For instance, this article in the Economist describes the feeling of despair amongst the citizens of Hong Kong when the value of their currency (Hong Kong dollar) slipped below that of Mainland China (Yuan). Politicians, central bankers, economists, and policy makers often share the ‘blame’ for a weak currency. But is a ‘weak’ currency truly an indicator of a ‘weak’ economy? Consequently does a ‘strong’ currency necessarily imply a ‘strong’ economy? This post aims to answer these questions.

The strength of a currency, in economic terms, implies the price (or the exchange rate) of one currency in terms of another foreign currency; this is usually measured with respect to the US Dollar, which is considered as the world’s reserve currency. (We will discuss why the US dollar is the world’s reserve currency in our next post). An exchange rate higher than one implies that the currency is stronger than the dollar and an exchange rate lesser than one implies that it is weaker.

The strength of an economy is measured by various means and the most used measure is the value of its Gross Domestic Product (or GDP).  The GDP measures the level of economic activity within a country and is the final monetary value of all the finished goods and services produced. It is a comprehensive measure of economic strength of a country[1]. The table below illustrates the metrics discussed thus far.

ExchangeRateGDP

Source: GDP, GDP per capita and the ranks from IMF database. Exchange rate is obtained from IMF and XE.com

Note on exchange rate rank:  It is obtained by sorting, in ascending order, the dollar value of domestic currencies. This is a metric derived purely for understanding the ideas discussed in this post and is not a robust measure.

Note on US$, per unit: This number indicates the number of US dollars that can be bought using the domestic currency. Example, exchange rate of 0.0160 for India means that one Indian rupee can buy 0.016 US dollars.

It is clear from the table that China, India and Japan are the second, third and fourth largest economies in the world, but their currencies are relatively weak. In fact, the per-capita GDP and exchange rates are also not comparable variables.

EXCHANGE RATE DETERMINATION

According to economics textbooks, the exchange rate is determined by the demand and supply for a currency relative to another foreign currency. This exchange rate arises out of three major factors:

First, the demand for a currency comes from people acquiring more of a particular currency to pay for foreign goods that they wish to buy (imports). Therefore, the exchange rate is determined by the volume of exports and imports of a country. If a country exports more than it imports, the demand for the exporter country’s currency and its exchange rate rises. Generally, an exporting country would want all or some of its payments made to it in its local currency, which would increase the demand for its currency.

Second, the demand for currencies arises from the financial markets and interest rate regimes. London is the one of the biggest financial centres — measured in terms of the volume of foreign exchange turnover– in the world and hence there is high demand for the Pound Sterling, as is the case with Swiss Francs. Further, countries with higher interest rates normally tend to have stronger currencies, as investors hope to get higher returns on their investments. A high interest regime encourages conversion into these local currencies and helps attain larger returns.

Third, it is in the interest of certain countries to have a weaker currency. A weaker currency will make exports cheaper and imports expensive giving these countries a competitive edge in the world market. Thus, the central banks and governments of different countries deliberately try to have a weaker currency.

The three factors discussed are not comprehensive and do not possess equal weightage; the eventual exchange rate dynamics depends on several other parameters.

Market determination of exchange rate does completely explain the exchange rate determination. There are more exceptions to this than adherents. For example, the Bahamian Dollar is exactly on par with the US dollar, despite playing a negligible role in world trade. This is due to the fact that the central bank of Bahamas has artificially pegged its currency 1:1 with the US dollar. That is even an infinitesimal change in the US dollar is directly reflected in the Bahamian dollar. Currency pegging (either 1:1 or some other predetermined ratio) is done by many countries to maintain stability. For example, Nepal and Bhutan have pegged their currency to the Indian rupee.

In conclusion, it is flippant to estimate the strength of an economy solely through the value of a currency. The strength of an economy is dependent on several variables that exhibit multi-causal relationship amongst themselves. Exchange rate have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.

 

[1] For simplicity, this post considers the GDP as the measure of strength of economy; to eliminate large country/ population bias we must consider the per-capita GDP (total GDP divided by the population) to arrive at a precise figure. Countries like India rank high in terms of GDP but, thanks to its population, rank much lower in per-capita GDP. Kuwait, on the other hand, ranks high in terms of per-capita GDP.

Anupam Manur is a Policy Analyst at Takshashila Institution  and can be found on twitter @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and can be found on twitter  @_quale

 

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Repo Rates

by Anupam Manur & Varun Ramachandra

The Repo rate is the interest rate at which the Reserve Bank of India lends to commercial banks.

A cursory glance at the business section of newspapers shows us the concern or elation every time the Reserve Bank of India (RBI) hikes or reduces the Repo rate. Commonly called policy rates outside of India, a change in the repo rate can result in an upswing or downswing of markets.  The obvious questions in the minds of most readers are how does this impact our daily lives and is this the same interest rate that commercial banks levy on us? This article attempts to answer these questions and will hopefully leave the reader with a basic understanding of the significance of repo rates.

The Repo Rate:

The Repo rate (Repo is an acronym for repurchase) is the interest rate at which the RBI (Reserve Bank of India) lends to commercial banks.

The central bank of a country  is usually an independent institution that is set up with the specific intention of maintaining the stability of price and total outputin the economy ( this article will focus on the former). Price stability would result in consistent, and hopefully low, levels of inflation in an economy. Inflation, as Ludvig Von Mises describes it, is an increase in the quantity of money without a corresponding increase in the demand for cash holdings. High inflation leads to people having to spend more money to obtain the same amount of goods and services. The point to note here is that money, like all other commodities, is governed by the principles of demand and supply.

The RBI utilises several mechanisms to maintain price stability but its primary tool is the repo rate.  This  rate, which is charged by the RBI, is different from the interest rates charged by commercial banks.  In a commercial bank, if the interest levied is 8%, a loan of Rs. 50,000 would result in an interest sum of Rs. 4,000 after one year. So, the loaner, usually an individual or business, has to pay back Rs. 54,000 to the bank at the end of the year. The RBI however, does not lend to individuals or businesses, it instead lends to commercial banks in certain circumstances; central banks are usually referred to as the lenders of the last resort. The repo rate is the interest at which the RBI grants short term loans (15 days) to commercial banks facing shortage of funds.

Commercial banks borrow from the RBI on a regular (daily) basis, which explains the high influence of the repo rate. In the week of Mar 15 – Mar 20, 2015, commercial banks in India borrowed Rs.72,672 crores from the RBI at 7.75% rate of interest.

Repo Rate

Fig: Repo rates from March 2004

 Transmission Mechanism:

Hypothetically, if the RBI lowers the repo rate from 8.0% to 7.5%, commercial banks can borrow from the RBI at a cheaper rate. As the RBI has decreased the cost of borrowing for commercial banks, the demand for money will increase; as commercial banks can now borrow more money they can use these funds to lend more money to its customers. In essence, by cutting the repo rate the RBI increases the supply of money (the liquidity) in the market. Commercial banks will now have the maneuvering capability to decrease the lending and deposit rates charged to customers. A cut in the lending rate will induce more people to borrow while a cut in the deposit rate will induce people to save less and spend more. Both these mechanisms result in an increase of the disposable incomes of individuals, which further leads to increased consumer spending.  This sequence of events may not necessarily happen all the time, but a change in the repo rate generally gives the banks an impetus to act in the direction of the rates.

However, it must be kept in mind that a change in the repo rate by the RBI can also impact the exchange rate of the rupee. With all other factors remaining the same, a cut in the repo rate can lead to the depreciation of the rupee and vice versa. A fall in the repo rate can make most rupee denominated financial assets less attractive to investors than foreign currency denominated assets. The rate of return on most financial assets in a country will be tied to the interest rates (government bonds, equity, etc). Thus, when the repo rate decreases, the rate of return to the foreign investors also decline. This will precipitate a decrease in inflow of foreign currency into the economy, thereby reducing the demand for rupees which will cause the rupee to depreciate. The fallout of this is that imports become more expensive and the prices of exports go down.

A change in the repo rate can cause an increase or decrease in the supply of money in the markets, which has profound implications on the lives of people as this directly impacts the price of goods and services that we consume on a daily basis.

Anupam Manur is a Research Associate at Takshashila Institution  and can be found on twitter @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and can be found on twitter  @_quale

 

 

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