Devaluation

I. Devaluation vs. Depreciation

  • Devaluation: Rupee’s value is reduced intentionally by the central bank.
  • Depreciation: Rupee’s value decreases due to market forces (supply and demand).

Depreciation of Rupee

Positives:

  1. Exports increase: Indian goods become cheaper for foreign buyers.
  2. FII (Foreign Institutional Investors) and NRI deposits increase: Depreciation makes investments in India more attractive.
  3. FDI increases: Foreign investors take advantage of the cheaper rupee.
  4. Domestic firms: Encourages import substitution or pushes for higher productivity, leading to innovation and invention.

Negatives:

  1. Inflation increases: Importing goods becomes costlier, raising prices domestically.
  2. Import costs rise: Essential goods like oil become more expensive.
  3. Government subsidy burden: To keep goods affordable, the government provides subsidies, increasing the fiscal deficit (FD).

Balance of Payments (BoP)

1. Current Account

  • Includes all one-time and one-way transactions.
  • Formula:
    Current Account = Merchandise + Services + Transfer Payments

Components:

  • Trade Balance: Balance between imports and exports of goods.
  • Trade in Services:
  • Factor Income:
    1. NFIA (Net Factor Income from Abroad).
    2. Net income from compensation of employees.
    3. Net investment income.
  • Non-Factor Income: Shipping, tourism, etc.
  • Transfer Payments: Includes remittances, gifts, and grants.
  • Net Invisibles:
    Net Invisibles = Trade in Services + Transfer Payments.

Note: Foreign investment in the securities market is part of the current account.

2. Capital Account

  • Covers multiple and two-way transactions.

Components:

  1. External Assistance: Loans from bilateral or multilateral sources.
  2. External Commercial Borrowing (ECB).
  3. Short-term debt.
  4. Banking Capital: Foreign assets and liabilities of commercial banks.
  5. Foreign Investment:
  • Foreign Assets of Central Bank:
    1. Foreign currency holdings.
    2. Rupee overdrafts to non-resident banks.
  • Foreign Liabilities:
    • Non-resident deposits:
    1. FCNR(B):
      • Deposits in foreign currencies.
      • Only term deposits (1–3 years).
      • Interest rate linked to LIBOR or SWAP rates.
    2. NRE Account:
      • Deposits in Indian Rupees.
      • Only term deposits (1–3 years).
      • Interest rate linked to LIBOR or SWAP rates.
    3. NRO Account:
      • Accounts for Indians ordinarily living abroad.
      • Held in rupees.
      • Can be fixed deposits, current accounts, recurring deposits, or savings accounts.

Foreign Investment

A. Foreign Direct Investment (FDI)

  • Defined by Arvind Mayaram Committee: FDI is investment in a company above 10%.
  • Shares acquired through:
  • IPO
  • Preferential allotment
  • Private arrangements

FDI Prohibited in:

  1. Chit funds and NIDHI companies.
  2. Real estate business, except for:
  • REIT (Real Estate Investment Trust).
  • Construction of townships, roads, residential premises, and bridges.
  1. Atomic energy, except for:
  • Manufacturing equipment to support nuclear and other power plants.
  1. Cigarette, lottery, and gambling industries.

B. Foreign Portfolio Investment (FPI)

  • Investments made through the Stock Exchange (secondary market).

Three Major Types:

  1. Foreign Institutional Investment (FII):
  • Made by foreign institutions.
  • FIIs may issue P-notes abroad (must report to SEBI but not the names of final beneficiaries).
  1. Depository Receipts (DR):
  • Includes GDR (Global Depository Receipts) and ADR (American Depository Receipts).
  • Allow foreigners to invest in Indian companies (any public, private, listed, or unlisted Indian company can issue these).
  1. Offshore Funds:
  • Money raised from offshore destinations by mutual funds or other investment funds.

Rupee Convertibility

1. Historical Milestones:

  • 1993: Full convertibility on the trade account.
  • 1994: Full convertibility on the current account (aligned with Article VIII of the IMF).

2. Capital Account Convertibility (CAC)

  • India is more liberal with inflow convertibility but restricts outflow convertibility.

Note: Investments in the security market are treated as part of the current account for convertibility purposes.

Prerequisites for Fuller Convertibility:

  1. Fiscal Deficit (FD) under control.
  2. Adequate forex reserves.
  3. Minimal NPAs (Non-Performing Assets).
  4. Moderate inflation and interest rates.

3. Recommendations by Committees:

  • Tarapore Committee on CAC (1997):
  • Recommended a phase-wise implementation of capital account convertibility.
  • Tarapore II on Fuller Rupee Convertibility (2006):
  1. Ban on P-notes.
  2. Equalize FIIs with NRI investors.
  3. Ease overseas borrowing regulations.
  4. Simplify outflows and remittance limits.
  5. Undertake banking system reforms.
  • Arvind Mayaram Committee:
  • Suggested liberalizing FDI limits in 12 sectors.

Forex Reserve

  • Components:
  1. Foreign Currency Assets (FCA)
  2. Gold
  3. Reserve Tranche Position (RTP) in the IMF
  4. Special Drawing Rights (SDRs)

Sovereign Wealth Fund (SWF)

  • A fund made up of foreign currency, intended for investment in global assets.
  • Typically established by countries with:
  1. Substantial forex reserves.
  2. Economies relying heavily on oil revenue resources.
  • Focuses on investing in sectors with potential growth, such as energy assets.

Currency Board

  • A monetary authority responsible for issuing notes and coins, and it performs no other functions.
  • Required to maintain a fixed exchange rate with a specific foreign currency.
  • Represents an extreme form of pegged exchange rate, where both exchange rate management and money supply control are removed from the central bank’s purview.

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