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.

The extent to which reform of the capital account is or should be irreversible

This blog post is joint work with Jeetendra.

One important part of capital account decontrol is commitment. If there is risk that capital controls will be brought back in the future, this can have a variety of unpleasant effects. If there is a fear of fresh restrictions coming in on inflows, a surge of money will rush into the country. If there is a fear of fresh restrictions coming in on outflows, a surge of money will rush out of the country. A long-term commitment to openness is required, in order to rule out such behaviour.

As a consequence, when a country moves to full convertibility, this requires not just the removal of restrictions. It also requires the removal of bureacratic process including reporting requirements. As long as forms have to be filled up for `automatic approval', this can easily swing back and become a capital control through breakdowns of rule of law (as has happened in India). See the MoF Working Group on Foreign Investment on issues of rule of law in India's capital controls. It is important to pour concrete on the decontrol so as to give confidence that the controls are gone.

We don't have the exact facts, but in the UK, when they moved to convertibility (back in the late 1970s) this was accompanied by dismantling of reporting requirements.

Korea is very open; there are no restrictions on capital flows. But Korea has kept the reporting requirements and through this, they have retained controls in a certain sense. The reason is that people fear that if they report transactions, then the government may come and investigate, and ask why they are doing it. They might also ask where the money is coming from. So, even though the rules may allow capital transactions, people -- especially individuals, but also small businesses -- remain very wary of these, and refrain from wiring large amounts in and out of the country, apart from some outward investments via mutual funds, where the government can't actually see who is sending the money out. Through this, reporting requirements perpetuate home bias and inhibit international economic integration.

Today we became aware of one mechanism through which some countries have committed themselves to an open economic system: When the US signs free trade agreements and bilateral investment treaties, there are provisions which limit the extent to which capital controls can then be brought back.

A curious letter has brought this to our notice. It says: Under these agreements, private foreign investors have the power to effectively sue governments in international tribunals over alleged violations of these provisions.. How interesting. So that locks down the possibility of a reversal of reforms in countries where the US has free trade agreements, and quite a few more where the US has bilateral investment treaties.

It makes sense for investment and trade treaties to mention capital controls. Trade and finance cannot really be separated: finance follows trade, and enhanced de facto integration in each feeds the other.

Trade requires currency risk management. When an Indian firm signs a long-term contract to buy/sell with invoicing in Yen, the Indian firm needs to be sure that Japan will stay open so as to enable INR/JPY hedging in the future.

If an MNC makes a direct investment in a country, it needs some assurance that it can bring in funds (equity and loans) to finance the investment, take them out when it wants to run down its operations, and repatriate profits in the meantime. It also needs to be able to hedge its currency exposure.

Hence, entering into trade/investment contracts today is assisted by confidence that liberalisation put in place today will still be there tomorrow.

More generally, there is a big difference between (a) a move today and (b) a move today + a commitment about behaviour tomorrow. Permanent tax cuts yield a much greater consumption response. Permanent capital account liberalisation leads to more FDI and trade. A variety of mechanisms need to be found through which reforms can be given stronger commitment so as to rule out risk of reversal in the future.

Author: Jeetendra

• What is the role of WPI in monetary policy?, 22 July 2015.

• Mythbusting: Balance of payments edition, 6 July 2011.
• The extent to which reform of the capital account is or should be irreversible, 7 February 2011.

• Free your mind, 16 May 2009.

• The oil subsidy is causing an indigestion, 8 September 2008.
  

Free your mind

by Jeetendra.
An iconic picture of the global downturn:

The oil subsidy is causing an indigestion

by Jeetendra.

The problems caused by the oil pricing policy are becoming daily more apparent. For the past few weeks, there have been reports of long lines at diesel pumps, particularly in Chennai and Pune, and electricity shortages. Writing in Business Standard, Urjit Patel points out that the problems of oil pricing are not confined to the energy sector -- they extend all the way to the financial and currency markets. And the attempts to solve these problems are only creating new problems.

The problem: oil companies are short of money

The fundamental problem is that the price controls are causing upstream oil companies to bleed cash, since they have to pay world prices for their petroleum imports but can only collect a fraction of these prices at domestic pumps. For some time, they have temporised by borrowing from banks. But now they have hit their credit limits. So, they need a cash infusion, quickly.

Solution: give the oil companies "government oil bonds"

A simple solution to the problem could have been this: government could have compensated the oil companies for their "underrecoveries" with regular government bonds. Then, the oil companies could have sold the bonds in the market, converted the rupees into dollars, and used the dollars to buy crude oil. But the government didn't do this. Instead, it created special "government oil bonds", which the oil companies have been unable to sell, at least not for anywhere near their face value.

Why are banks demanding such large discounts on these bonds? On the face of it, this seems very strange. After all, the oil bonds are IOUs from the government, and will surely be honored in full. The answer: these bonds, unlike regular government bonds, are not "SLR eligible". Which means banks cannot use them to fulfill their Statutory Liquidity Ratio (SLR) requirement. Nor can the banks discount these bonds at the RBI, in case they themselves need cash. So, the banks don't want them. Which means the oil companies are stuck.

Problem: the bond market is segmented

Why did the RBI choose to create a special oil bond, forcing a segmentation of the bond market? The answer, most likely, is that this was done to contain the fiscal deficit.

The huge oil subsidies are putting tremendous pressure on the government budget, imperiling the fiscal targets. Paying the subsidies by issuing bonds has the signal advantage that such spending is kept off budget. But it has the disadvantage of increasing the government's interest expenses. Expenses increase because the amount of government debt increases. Then, they could go up some more because the increase in government debt might lead to a rise in interest rates. It's a simple matter of supply and demand: the higher the supply of bonds, the lower the bond price -- which means the higher the interest rate.

By making oil bonds a separate category, not eligible for the SLR, the RBI could preserve demand and supply in the regular bond market. Banks would ignore the oil bonds and bid aggressively for regular government bonds to meet their SLR requirements, thereby keeping interest rates low and keeping the government interest burden down.

But this "solution" created two new problems. First, it segmented the government bond market. There are now two completely different prices for government bonds, depending on whether they are SLR-eligible or not. This is a major impediment to market efficiency and development. For how can private firms price their bonds accurately, when even government bonds for similar maturities have two different prices?

The second problem is that the special oil bonds failed to solve the original problem. The oil companies still need cash.

Solution: RBI's Special Market Operations scheme

The RBI then responded by creating the Special Market Operations (SMO) scheme. Under the SMO, the central bank purchases the bonds from the oil companies, in exchange for foreign currency from its reserves. That way, the oil companies can unload the paper they don't want, and get the foreign exchange they need to pay for their imports.

Problem: Undermining monetary policy

Urjit argues that the SMO doesn't really solve the problem. It just shifts it to the central bank. After years of effort to clean up the RBI's balance sheet, the central bank is now getting stuck with illiquid government bonds. That's a problem because the essence of modern central banking is exchanging one liquid asset for another. When the economy is short of money, central banks buy bonds and inject cash. When the economy has too much money, it does the reverse. In both cases, central banks need paper that can be readily bought and sold.

It is true that central banks do occasionally buy illiquid paper. In fact, the US Fed and the ECB are doing this right now. That's because they're facing a financial crisis, forcing them to help out financial institutions in order to safeguard the overall system. That's one of their core responsibilities.

But India has no financial crisis.

Also, when central banks do purchase illiquid paper, they normally demand large discounts. This has not been done with SMO. Indeed, the whole point of the exercise was to ensure the opposite -- that the oil companies did not have to suffer a "haircut" when selling the bonds into the market.

Problem: Undermining exchange rate policy

Besides affecting the RBI's balance sheet, a further problem with the SMO is that it distorts exchange rate policy. The scheme has forced RBI to channel foreign exchange not to the market in general, but to specific companies. Again, this is a retreat from the efforts to create a modern, market-friendly, and firm-neutral approach. This is not a minor retreat. So far, the central bank has swapped no less than $4.4 billion under the SMO, and there are reports that further swaps are in the offing.

There is no free lunch

Problems of a few percentage points of GDP cannot be wished away! Oil subsidies, sounded, at first, like a `mere' distortion of the oil sector. But such magnitudes are very hard to digest, and inexorably impinge on monetary and fiscal policy. The price controls are distorting market prices for bonds and foreign exchange, undermining financial and currency market development, and reversing progress toward a modern central bank.

We started with the core problem: price controls. Then, there had to be special bonds, with a forced fragmentation of the bond market. Then, the SMO had to be created, undermining monetary and exchange rate policy. We keep scrambling from one problem to the next. One can only imagine the amount of staff time at MOF and RBI that has been wasted on this. It would have been better utilised doing genuine economic reforms.