Currency Convertibility
Hello everyone. Welcome to our course on International Business. I am sure you must bedoing pretty fine when you are listening to me. So, in the last lecture, we had started withthe currency convertibility, right. And before that we had discussed about foreignexchange, the factors affecting the foreign exchange, right. So, how foreign exchange isdetermined and what factors affected, and why it is important for international business,right. So, we had discussed on those.So, today we will be continuing with the same, and first we will discuss about rupeeconvertibility or convertibility first we will discuss today and then we will go into thesome of the theories of foreign exchange. There are basically (Refer Time: 01:09)theories we will talk about, but let us start with the rupee convertibility.(Refer Slide Time: 01:14)So, currency convertibility as you understand essentially we discussed that it means theability of residents and non-residents to exchange domestic currency for foreigncurrency. That means, for example, you want to trade you make some buy some goods oryou know some services, in that case you need some foreign dollars from foreigncurrencies for the transaction, right. So, in such conditions you would require this foreigncurrency, right.So, at that point of time convertibility is very important because you have to give yourrupees and in exchange you have to take that foreign currency. So, in convertibilitybecomes very important, because otherwise if there is no convertibility or very you knowit is very rigid, then the point is business transactions become very difficult, it is not verysmooth, ok.So, currency convertibility refers to the freedom to convert the domestic currency intoother internationally accepted currencies like dollar, euro, peso whatever, right and viceversa at market determined rates of exchange. So, what is the rate of exchange?And for example, today we say India 1 dollar is equal to 71 rupees or it might be 72whatever around 71, 72. So, how does it come to that number magical number come? So,that is basically largely dependent on the demand and supply forces in the market, right.So, how much is the rupee strengthening against the dollar or is the rupee falling againstthe dollar? So, what is the according to demand and supply and it is a very very dynamicfeature, ok.Currency convertibility is vitally important in the foreign exchange market becausehigher convertibility means that a currency is more liquid and therefore, less difficult totrade, right.Suppose, a currency is not easily convertible then that means, the foreign partners wouldnot like to get associated with us and they would not like to make business because thetransactions are not smooth, it is not easy. So, every time they nobody would like to getinto a you know bureaucratic and a very long process, right. Nobody wants to wastetime.For example, rupee can be converted in US dollars and more easily and US dollars canbe converted into in Indian currency for buying and selling of goods and services. This isan example, ok.(Refer Slide Time: 03:49)So, there are two popular categories. When we talk about currency convertibility, twoimportant types are there. One call the current account convertibility, the second is calledthe capital account convertibility.Now, these are very important, very it is not it is easy to understand also. So, what itsays? The convertibility for current international transactions. As you can understandfrom the word current, right something that is on, ok. So, when you have a convert whenyou need some convertibility for a current transaction that is an ongoing transaction, so itis called current account convertibility.So, anything that you want to buy directly you know goods and services for thatwhatever transaction you want to make and in that when you want to exchange theconvert that rupees into dollars or rupees into euros or euros into rupees whatever it iscalled a current account convertibility.On the other hand, when the convertibility is for international capital movements it iscalled capital account convertibility. So, let us see that. So, current accountconvertibility, the money is classified under current account can be easily converted intodollar, yen, pound, rupee or anything for that, right.On the other hand, capital account convertibility says money classified under the capitalaccount cannot be easily, it is a slightly complex, it is slightly complex than the currentaccount. So, this is more complex, right this is less, right into different. RBI has strictguidelines for example, in Indian case the RBI has very strict guidelines to for capitalaccount convertibility. We do not have a full capital account convertibility as of now,right.(Refer Slide Time: 05:36)So, what it is saying let us see. Current account convertibility means freedom to convertdomestic currency into foreign currency and vice versa, to execute trade and in servicesinvisibles means services, ok.On the other hand, capital account convertibility implies freedom of currency conversionrelated to capital inflows and outflows. Let us see what does it mean. So, as I had saidcapital account convertibility is more complex in nature than the current accountconvertibility, right. Capital account convertibility is not just the currency convertibilityfreedom, so that is this is very important, but more than that. What is more than that? Itinvolves the freedom to invest in financial assets of other countries. So, this is what itmakes more complex, right.Capital account convertibility is thus the freedom of foreign investors to purchase Indianfinancial assets for example, shares, bonds, etcetera in the Indian market and that of thedomestic citizens that means, like you people like us to purchase foreign financial assets,ok.Now, article 6 or 3 of agreement of the International Monetary Fund IMF allowsmembers to exercise such controls as necessary to regulate international capitalmovement. So, the IMF’s desires that there has to be a free movement, right, but not soas to restrict payments for current transactions, right. So, it allows the members toexercise controls, right.(Refer Slide Time: 07:11)What is this current account transaction? Now, let us see some examples. All importsand exports of merchandise this is for current account, right. Invisible, this is serviceoriented, right exports and imports. Inward private remittances, so somebody is working,he is sending salary or whatever. Pension payments. Government grants. So, these are allthe come under the example of current account transactions, ok.(Refer Slide Time: 07:45)What is there in let us see the other one. Transactions relating to inflows and outflows ofcapital. Borrowing from or lending abroad. Sales and purchase of securities abroad,right. So, all this is abroad actually, right.So, capital account transactions are like capital direct foreign investments, investment insecurities, government loans, short term investments. Now, you can see thisclassification how capital account transactions are classified. So, under portfolioinvestment, direct investment and other investment.So, under portfolio investment you have stocks, bonds, bank loans, derivatives, and adirect investment you have real estate, production facilities, equity, right. So, somebodyis making FDI or something, right that case. Other investments are holdings in loans,bank accounts, and currencies. So, this is the basic difference between the capital and thecurrent account convertibility.(Refer Slide Time: 08:38)Now, what is the case in India? Till 1991, one had to get permission from thegovernment or the RBI, the RBI the central bank as the case may be to procure foreigncurrency say the US dollars for any purpose, right. 1991 was a time when we hadliberalization. Now, be it import of raw material, travel abroad, right procuring books orpaying fees for a ward who is studying abroad anything, you want some any transaction,so you need permission.Similarly, any exporter who exports goods or services and brings foreign currency intothe country has to surrender the foreign exchange to RBI and get it converted at a ratepredetermined by the RBI. So, this exercise was highly controlled, till 1991 it wasextremely you know there was lot of rigidity and it was not liquid at all right. It was veryless liquid.Up to 1991, so this there was rigid control on both capital and the current account, ok.But in 1991 we saw some change, right, India opened up its boundaries and we went forliberalization, privatization and globalization. So, India accepted the IMF rules forcurrency reforms.After the announcement of the economic liberalization in 1991, the Government of Indiaannounced partial convertibility of rupee from March 1, 1992. Now, this is veryimportant date because this was the time when India was seeing a major change in itseconomic condition. So, under this partial convertibility 40 percent of the currentaccount transactions were convertible in rupee at officially determined exchange rate.So, the RBI was determining the exchange rate, right. And remaining 60 percent atmarket determined exchange rate. So, what had happened? So, 40 percent and 60percent. So, 40 percent is what the RBI would determine, 60 percent is the market forceswould determine, right.India is still a country of partial convertibility in the capital account, right. In March1994, even indivisibles and remittances from abroad were allowed to be freelyconvertible into rupees at market determined exchange rate on the basis of this strictguidelines. There was a committee, so I will talk about this.(Refer Slide Time: 11:06)Capital account convertibly was introduced in India in august 1994, ok. So, capitalaccount convertibility introduced in 1994. In 97, the government set up a very importantthis is called a Tarapore committee, to spell out a roadmap for the full convertibility ofthe rupee, ok. RBI appointed the second Tarapore committee to set out the frameworkfor full capital account convertibility because capital account has its own difficulties, sothey set up a committee to discuss on that.The committee was established to revisit the subject of full capital account convertibilityin the context of the progress in economic reform. So, as reforms were going happening,so they have started thinking whether it should be we should move ahead towards a fullcapital account convertibility. The stability of the external and financial sectorsaccelerated growth and global integration. For looking at these conditions they thoughtover it.The report was made public on 1st September 2006, and had a roadmap for 2011 as thetarget date for fuller capital account convertibility of rupee. The government is adoptinga cautious approach taking into consideration all aspects and the risks involved inopening up the economy by allowing convertibility.Now, what are the major risks that can happen? Right. For example, why is thegovernment thinking about it? See, it is not that simple that we open up the market as wewish because by opening up the market we are that means, allowing others also to buyassets into in India.So, that how intelligent is it and how safe is it we do not know. So, till we are not sureabout our own productivity, our people’s productivity, our nation’s policies and ourstrength, we cannot make it fully open, right. So, the government has been going with alot of caution they have been going slowly, right for that.So, you have understood now capital account convertibility and current accountconvertibility, what convertibility means, right. So, it is very important we haveunderstood.(Refer Slide Time: 13:20)Now, so when we are talking about the after this we will talk about a few exchange ratetheories, right. So, what is this let us see.(Refer Slide Time: 13:25)As we have started, we have understood at the most basic level, exchange rates aredetermined by the demand and supply of one currency related to the demand and supplyof another. So, we have said we have understood that exchange how do you determinethe exchange rate.The exchange rate is determined by the demand and supply of one currency incomparison to the other. For example, let us say how much of demand of rupees there incomparison to the dollar or how much of euro is in demand, what is the supply level. So,this demand and supply level in the market dictates the transaction the exchange rates,ok.So, economic theories of exchange will give us a deeper understanding of how exchangerates are determined, right. So, there are 3 theories we will talk about. One, thepurchasing power parity theory, right in which it is there are two types, again absolutepurchasing power parity and relative Purchasing Power Parity.Then, we will talk about the Interest Rate Parity theory and the Fisher Effect, right. So,let us see if we can complete all of them today, right.(Refer Slide Time: 16:40)So, what did he saying? Purchasing power parity theory, this is given by, this is one ofthe oldest theories of exchange rate determination, right. It was developed by GustavCassel in 1918, he must have been a very wise man.What did he say? Purchasing power parity is an economic theory that allows thecomparison of the purchasing power of various world currencies to one another. So, letus see again what did he saying. It allows the comparison of the purchasing power howmuch your currency can buy, right in comparison to another currency. It is a theoreticalexchange rate that allows you to buy the same amount of goods and services in everycountry.That means, to buy let us say you want to buy a Coca-Cola let us say, you want to buy aCoca-Cola, so how much are you going to pay in US dollars, how much you are going topay in Australian dollars, right say, how much are you going to pay in Indian rupees,right. So, how much you are going to pay in some other country.So, what did he saying is basically, it allows you to buy the same amount of good that isone bottle of Coca-Cola and services in every country, how much you are going tospend, right. So, government agencies use PPP, this purchasing power parity to comparethe output of countries that use different exchange rates, right. So, the government usesthis to compare the output, right.Now, as I said its one of the oldest theories, right and this theory is states that in ideallyefficient markets. So, you know the efficient market theory and identical goods shouldhave only one price. If there is an efficient market and the identical goods are there andyou are using the same currency the price should be same, right. It is based on the law ofone price loop, right.(Refer Slide Time: 18:46)So, let us see this. So, what is this law of one price? The law of one price states that inthe absence efficient market, right, in the absence of trade frictions that means, there isno trade friction, and conditions of free competition and price flexibility all identicalgoods whatever be the market, whatever market it is must have only one price if they areusing a common currency.So, if you are using a common currency that means, suppose let us say in market abc if Iuse buy through dollar the same value of good this what would be the bottle of Coca-Cola in terms of dollars in India, in terms of dollars in America, in terms of dollars inEngland in different markets. Suppose we use a common currency what would be theprice, right.The two goods are not in the same market, then if the two goods are not in the samemarket then arbitrage would operate to equalize the prices. Now, you have understoodwhat is arbitrage. Arbitrage means when there is a differential in price in two markets, soa person would a person who is intelligent and opportunistic in nature would like to buyit at the from the market where it is less at price and sell it at the in the market where it isof a higher fetches a higher price and the difference that he gets is what is his profit,right.So, assumes that there will be no transportation cost, tariff, taxes, quota, trade barriersetcetera. So, but this is a limitation of the theory because it says these are some of thethings which it assumes that they it will not be there, but how is it possible, right. But ifyou keep it then it is very difficult to measure. So, that is why these assumptions aregenerally made, ok.It relates to a particular commodity, security, asset etcetera and not applicable toimmobile goods such as houses. We do not talk about immobile goods, right. Let us takethis example. Suppose, that 1 US dollar is currently selling for 50 Indian rupees. For acalculation we have taken 50, it is not actually 50, 70 now. In the United States supposea cricket bat sells for 40 dollars while in India they sell for 750 rupees.So, since 1 US dollar is 50 Indian rupees the bat which costs 40 dollar in the US, rightcost only how much in Indian, if in the terms of Indian rupee how much? Now, 750 / 50= 15 or this 40 * 50 = 2000 rupees in Indian currency, but whereas, we are actuallygetting is 750. So, clearly there is an advantage of buying the bat in India. So, consumerswould be happier to buy the bat in India.So, this is what actually happens in the international market. That this is how thetransactions between countries happen. For example, if the Japanese in suppose in yen ifyou buy and in you can buy let us say the yen is cheaper, then you can buy more of thebats buy through the 40 dollars suppose or 100 dollars whatever amount that fixedamount you can buy more of the products.So, that, and you can sell maybe at a higher price in again US market. So, that is thedifference which business people or exporters get, right that during the internationaltransactions, ok.(Refer Slide Time: 22:20)Continuing with the above example if consumers decide to do this we should expect tosee 3 things, what are these? American consumers demand for Indian rupees wouldincrease, right which will cause the Indian rupee to be more expensive with time, slowly,when the Indian rupees demand will go up, right because with Indian rupees they areable to buy more number of bats because obviously, they cannot buy through dollarsdirectly know.So, they have to exchange the currency. So, the demand for the rupees will go up. Now,with as the demand for the rupees is going up. So, the rupee will tend to become moreexpensive with time.The demand for cricket bats sold in the United States would decrease and hence its pricewould tend to decrease, right because it is becoming costlier in United States. Theincrease in demand for cricket bats in India would make them more expensive. So, theseare all interrelated.So, as the increase in demand for cricket bats goes up because it is cheaper also, right,slowly the price would tend to move up because a demand is growing. Thus, the prices inthe US and India would start moving towards an equilibrium. So, this is very interesting,right.(Refer Slide Time: 23:31)In an ideal scenario what would happen? Prices in both the countries would becomeequal at some price point. So, for example, you started with 2000 as per US and Indiahad 750. So, this will start growing and here the demand will start falling. So, there willbe a point, there will be a point where they both would maybe at let us say 1300 rupeesor something at some point they would you know match.The increased demand for rupee for instance may lead an increase in its value, so that 1US dollar = 40 Indian rupee, instead of 50 it will become 40 Indian rupee, let us say if itthe demand goes up, right. Second, that means, what? The Indian rupee has becomecostlier now, right. Earlier it was for 1 dollar you had 50 rupees. Now, with 1 dollar youcan only buy 40 rupees.Secondly, due to decrease in demand for the bats the price drops to 30 dollars, right. So,the price which was 2000 or 40 dollars, now has come down to 30 dollars. So, 30 dollarsmeans how much? In our condition now, it is almost 1200 rupees because it is now 40,right.So, thirdly the increase in demand for the bat in India takes its price up to 1200, from750 it moves up to 1200. So, you see, so now, there is an equilibrium point that isreaching. So, here and here, so if you look at this. So, we are coming to a point ofequilibrium.At these levels you can see that the price that there is purchase price parity between boththe currencies, ok. This also means that whether you buy the bat in US or in India its oneand the same thing for the consumer, ok.(Refer Slide Time: 25:19)Types of PPP. So, what are the various types of PPP? So, as we said the first one is theabsolute PPP, right. So, what is it saying? The absolute purchase power parity, rightpostulates that the equilibrium exchange rate between currencies of two countries isequal to the ratio of the price levels in the two nations. We will see what does it mean.Therefore, the price of a product in country X and the price of an identical product let ussay the bat again in country Y, in Y’s currency should be such that the ratio of the pricesin the exchange rate the ratio of the prices is the exchange rate between the currencies ofthese two countries. Now, what is it saying let us see.So, the price of a product in country X / price of a product in country Y = currency of thevalue of the currency of the country X / currency of the country Y, the value, here wemean the value, right, or P X divided by P Y is equal to X divided by Y.Since, X divided by Y is the direct rate for country X, right, P X divided by P Y is equalto. So, you can understand, so this is important, right. So, we understand that price thatthis ratio between the price equal to the value of the currencies, right.(Refer Slide Time: 26:47)Suppose, take this example particular. Basket of goods cost rupees 7000 in India. Abasket of goods let us say a bat, a wicket keeping gloves, a ball, you know stumpswhatever and 100 dollars in the USA.That means, what does it mean the same basket of goods is 7000 in India, so that means,what 70 rupees = 1 dollar. So, X / Y = P X / P Y let us see. So, what is its saying? So,rupee/ dollar, right is equal to 7000 / 100 which is 70. This is what it tries to find out, ok.(Refer Slide Time: 27:25)Now, this is the first one. You talked about the absolute this is absolute, right. But let ussee the other one. Now, there is another form which is called the relative PPP theory.Now, what does it mean? It says the purchasing power of currency changes due toinflation, inflation or deflation whatever. So, it is inflation basically.So, whenever there is inflation price level will go up, increases. Quantity of goods thatcan be purchased by one unit of the currency will go down because it is costlier now. So,thus the purchasing power also declines and vice versa. Suppose, it would have gone theprice level would have gone down, so quantity of goods would have now improved. So,it would have been vice versa.Thus, inflation or deflation affect the exchange rates. So, it has a major impact. Whatdoes it say? Relative purchasing power parity is an economic theory which predicts arelationship between the inflation rates of two countries, right, right, over a specifiedperiod and the movement in the exchange rate between their two currencies over thesame period.So, it is a dynamic version of the absolute PPP theory. So, the absolute theory was moreless dynamic, this is more dynamic in nature. The difference in the rate of change inprices at home and abroad minus the difference in the inflation rates is equal to thepercentage, depreciation or appreciation of the exchange rate.So, this difference is important to us. Let us say, if Canada has an inflation rate of 1percent, ok, 1 percent Canada. US has an inflation rate of 3 percent. So, the US dollarwill depreciate against the Canadian dollar by 2 percent per year. This is what it means tosay, ok.(Refer Slide Time: 29:28)Let us take this example. Suppose, t is equal to 0 base period, right P o d or the price ofthe commodity in domestic country during the base period. P o f, price of the commodityin foreign country, f stands for foreign domestic during the base period, right.So, the exchange rate the spot rate, the exchange rate means this the spot rate means theat the same point of time, right. What is the exchange rate? Is equal to S o is equal to P 0d, right price of the commodity in the domestic country during the base period by theforeign in the foreign country, right.Suppose, if the price changes due to inflation, after 1 year the situation will be what? Letus see. After 1 year. So, P 1 d and P 1 f price of the commodity in domestic country after1 year, price of the commodity in foreign country after 1 year.(Refer Slide Time: 30:29)So, the exchange rate now S one is equal to P 1 d by P 1 f, right, the new rate. So, P 1 dis what? Now, the P 0 d the base year rate plus inflation in the domestic country. P 1 f isthe P 0 f plus inflation in the foreign country. If inflation in domestic country is equal toId inflation in foreign country is equal to If let us say.So, what is S 1 now? S 1 is equal to S 0 that means, the rate spot rate at the base periodbase year, right * 1 plus id into 1 plus If. So, this is what is the finally the formula lookslike. So, P 0 d which you this one, right applying here, so we get this. So, this is thepercentage change, this is I mean here S 1 - S 0 / S 0, right.(Refer Slide Time: 31:14)So, this is the problem we will wind up here with this example. The price of 1 kg orangein India is let us say Indian rupees 50 and that in USA is 1 dollar, right. Inflation rate inIndia is 20 percent, assume, just it is not there, but assume. USA is 10 percent.Determine the new exchange rate, right. So, when t is 0 what is the S 0 spot rate? Now,this one. So, that is 50 is to 1, 50:1, right.After 1year inflation is 20 percent or 0.2, in USA it is 10 percent or 0.1. So, what is thenew formula? So, 50 this one, 50 by 1, which is 50, right, into 1 plus 0.2 divided by 1plus 0.1, right. So, this formula, just if you look, this one, right, this part. So, thatbecomes 54.45 is to 1.So, that means, 1, now the at the present rate the new spot rate is exchange rate that is the1 dollar is equal to now instead of 54, it is 54 50, it is 54.45 rupees, right. So, this is howthe purchasing power parity theory works, right.So, we will today because there is less time we cannot continue. We will continue thisinto in the next class, right.And till then, thank you very much. Have a great day.