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.

Interesting readings

The frontiers of Nifty.

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

Static on the FM channel by Puja Mehra, in Business Today.

That seventies feeling by Pratap Bhanu Mehta, in the Indian Express.

Shubhashis Gangopadhyay in the Business Standard on land acquisition.

We should be learning from these Afghans!

A difficult patch in the Indian IPO market.

Saurabh Kumar in the Mint on the extent to which IPOs from certain investment bankers are more exciting for investors than others.

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

Imagine there's no central bank.

Steven Levy has a great story of how Google built Plus, in Wired magazine. And, PC World magazine on where and why Google Plus is better.

Sebastian Mallaby in Foreign Affairs on how emerging markets should play the appointment problem of the IMF MD.

Cash-settled futures on the 91-day treasury bill

It took a while, but here they are!

37 minutes into the life of the market, here's the order book:

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

Recently, India released BOP data. Many people, writing about this new data, wrote text such as:

The current account deficit (CAD) moderated to 1.1% of GDP in Q1 from 2.2% in Q4 2010, due to an improvement in the trade deficit and a sharp rise in the invisibles surplus.

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

This is wrong.

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

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

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

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

India is losing the market for trading the Indian rupee

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

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

The rupee is traded on three venues:

1. The onshore exchange-traded market (NSE, MCX-SX, USE)
   
2. The onshore OTC market
   
3. The offshore OTC market (which is called the `non-deliverable forward' or NDF market).

In an article in the Business Standard today, Jamal Mecklai says:

in April 2011, NDF volumes, at nearly $43 billion a day, were more than double those of the onshore OTC market (about $21 billion a day), and nearly 40 per cent higher than the combined OTC and futures onshore volume. Clearly, the bulk of price discovery for the Indian rupee has migrated offshore.

While we are bickering about the valuation of one player in the onshore exchange-traded market, we are losing the plot. The real story is that India is losing the market where the rupee is traded. While we are fussing about NSE's charges on the currency futures market, the OTC market offshore charges zero and has steadily gained market share.

This is part of a larger concern which needs to be more carefully considered. As India internationalises, domestic customers of financial services, and the foreign order flow, will increasingly shift their business to providers abroad when there are problems in the local financial system. These problems fall into three kinds:

1. Non-residents do not like to send orders to India given that India as yet lacks a residence-based taxation framework; they would rather send their orders to Singapore or Dubai or London which do.
   
2. Indian capital controls hinder orders from non-residents: E.g. RBI prohibits FIIs from trading on the exchange-traded currency futures market (the only edge that India has in the trading of the rupee).
   
3. An array of mistakes in regulations in India hinder the emergence of a capable domestic financial system (e.g. the CCI order, prohibition of options trading on INR/EUR, mistakes in how RBI will compute the INR/USD reference rate which must be used in the functioning of the exchange-traded contracts, etc.)

Our mistakes in policy on these three fronts generate a genuine possibility of a hollowing out of the domestic financial system in coming years.

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

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

India's governance crisis: Tales from the battlefront

The Competition Commission of India (CCI) has written an order on NSE and MCX-SX in the currency derivatives market. Even if you do not take interest in financial markets, this is an interesting episode in Indian governance. It illuminates the larger problems of building regulatory agencies, and India's middle income trap.

In an impressive show of strength with the media, there was a flurry of editorial and other commentary praising CCI for this order - even before the order had been released. The files are now on the CCI website. Here is the main order and here is the dissent by two members of CCI.

Gautam Chikermane has written an excellent analysis of the order in the Hindustan Times. Unlike much of the other commentary on this order, he has actually read the two PDF files above. Also see this editorial and column by Mobis Philipose, in Mint, on 6 June.

The order has breathtaking ramifications. If this works as a precedent, it would impose huge complexities upon an array of industries where some products and services are given out free. This feature is particularly prevalent in the new economy, where systems such as google search are free and have been free for the longest time, and where a blizzard of new product launches (e.g. google plus) are free.

In India, regulatory organisations are still finding their feet. They have to gradually build up credibility and respect. When a regulatory body signs on a breathtakingly large penalty which will have huge implications for the economy, they have to be absolutely sure they are right. Otherwise, the institution loses credibility. I fear that with this order, CCI is now in a soup. If the appeals process is half decent, the order will be overturned, which will make CCI look bad. If the appeals process is not half decent, CCI will be seen as a source of trouble in the Indian regulatory landscape. In numerous industries, zero pricing will run into trouble. More generally, such muggings will be a new dimension of the political risk faced by firms operating in India.

India's crisis of governance is about the puzzle of building agencies like the Competition Commission of India, of taking these agencies closer to the competence and honesty seen at SEBI in recent years. How do we master the intricate recipe of public administration, so that such events don't happen? Until this is done, the structure of incentives encourages a certain kind of entrepreneur, and will damage the outlook for India.

How to damage market quality

The problem of measuring the price

In a liquid and transparent financial market, there is no doubt about the price. There is high pre-trade transparency, because orders are visible on the limit order book, and the best estimate of the true price is (bid+offer)/2. You glance at the screen and you know what is the price.

In a non-transparent market, it is hard to know the true price. Special schemes have to be constructed in order to measure the price. Price measurement does not happen `for free' as a minor side effect of the very trading process.

Why price measurement matters

As a thumb-rule, the best design for a derivatives contract is to use cash settlement, as long as you can be pretty certain about observing the price. If you can't measure the price, then physical settlement is better.

Cash settlement is a great technology. But it requires sound measurement of the price.

Measuring price on an OTC market

In an OTC market, information is not visible at a glance. It is dispersed. Many traders have private information about the price, but you do not. If you could setup an electronic order book, you would see bid and offer at a glance: these are the prices at which a small buy and a small sell transaction could be done. On an OTC market, the dealer has a sense about where the market is, but you don't. So a natural strategy is that of asking the dealer what he is seeing.

Dealers have positions on the market, so we have to worry about what they say. Standard schemes used involve removing extreme observations, and thus coming up with a more robust price measure. These schemes have been used in India with the NSE MIBOR (the dominant price measure on the interest rate swaps market), the CMIE measurement of commodity spot prices for NCDEX, etc.

RBI's measurement of the INR/USD exchange rate

In India, RBI is an information producer in reporting the INR/USD exchange rate at 12 noon. This `official RBI price' is widely used in computing the settlement price for cash-settled derivatives on the rupee. It is used for the official closing price on the NSE currency futures/options market, which in many ways is shaping up as the main market where the INR exchange rate is discovered. As an example, yesterday (an expiration day), the open interest closed at $7.2 billion, and turnover was $6.2 billion.

RBI has not had a formal methodology for how this price is computed and reported.

I have always been a bit uncomfortable with RBI producing this vital information, since RBI has many other goals which can conflict with the goal of producing high quality information. But for a while, this seemed to be working.

New methodology at RBI

On 1 July, their methodology will change to something new:

1. They will choose a random five-minute window from 10:30 to 12:30 (i.e. a two-hour window).
2. The reference rate will be computed using these five minutes.
3. It will be released at 13:00.

I cannot imagine the logic which led up to this, but I have to say that this is not a good idea.

A two hour window is a lot of time in the life of a market. The RBI reference rate is then no longer a reference rate of the market. It is a measure of the price at a randomly chosen time in that window. This makes it much less informative.

As an analogy, imagine if the official NSE closing price for Nifty was plucked out of a randomly chosen time from 2:30 PM to 3:30 PM. This would be a lot less informative as compared with the present methodology (value weighted average of all trades from 3 PM to 3:30 PM). It would be even better if NSE were to do a call auction from 3:15 PM to 3:30 PM and report that price as the official closing price. That would be sharp and interpretable.

All cash derivatives settling on the RBI reference rate will now suffer from a new source of uncertainty: the randomly chosen time at which the price is reported. The cash-and-carry arbitrageur needs to sell his spot position at the exact time at which the derivatives expire. In the case of the Nifty futures, there is a simple trading strategy which roughly approximates the Nifty closing price: In each of the last 30 minutes, do 1/30 of your required trade. This is typically automated, i.e. it requires algorithmic trading, but it's fully feasible.

With a randomly chosen timepoint over a two hour horizon, the arbitrageur does not know when to closeout. This will exert a negative impact on pricing efficiency and thus basis risk on the derivatives market.

If the INR/USD exchange rate is a random walk in trading time, then the 9% annualised volatility maps to a standard deviation of 28 basis points over a two hour horizon. On a base of Rs.45 a dollar, this is a standard deviation of 12.6 paisa. This is quite a bit for traders and arbitrageurs. These small issues have a disproportionate impact in contaminating market efficiency.

But wait. There are some people who know at what time the pricing is done: the banks who are polled! So suppose there is a fixed panel of banks who are asked by RBI. The moment the RBI phone call comes in, they closeout. These banks will find it profitable to do currency arbitrage while others are not. Such shifts in the currency arbitrage constitute a distortion induced by RBI's new method of price measurement.

Lessons

RBI needs to cultivate improved knowledge of finance amidst its staff.

This illustrates the importance of legal process in rule-making. If RBI had gone through a formal notice-and-comment process, then they could have heard from external experts and desisted from doing this. I wasn't able to find a document on the RBI website explaining the rationale for what is being done.

Information production should be done by specialised information organisations. If information is produced by people who have other conflicting interests, then such sub-optimal decisions are more likely to arise.

Alternative information producers, such as Reuters, should leap into this opportunity by producing a better INR/USD reference rate. FEDAI already has an alternative reference rate. We should all switch away from the RBI reference rate towards alternatives.

Unfortunately, many people in the trade are fearful of the RBI and would not evaluate alternatives rationally. This tells us two things. First, RBI needs to be enveloped in the rule of law so that there is no fear of RBI on the part of market participants. Second, RBI should not be a producer of information. As long as two private agencies are producing INR/USD reference rates, the decision in the derivatives trade about what information measure to use will be based on technical merits alone. If someone then tries to come up with a scheme where a randomly chosen time over a two hour window is used for the measurement, his market share will go to zero.