Basel Capital Accords: An Overview*

Banks are one among the major triggers in most of the economic crises. Banks are the veins of circulation of money in an economy. So the soundness of banking system is imperative to prevent the collapse of the system. The premature liberalization of the local financial markets and the failure to keep adequate checks on lending functions of the banks are the major reasons for the Asian economic crisis of 1997. Absence of effective regulation and supervision led to large capital inflows in the domestic short term debt market. Banks lent on long term basis using the foreign inflows. Later when signs of pessimism became visible foreign inflows to economies such as Philippines, Malaysia etc... started to decline. (Buckley n.d.) Similarly, in the year 2008 the reckless lending of US banks like Lehman brothers and securitization of the sub-standard loans into instruments known as CDO-s (Collateral Debt Obligations) and trading of the securities in the stock market led to the sub-prime crisis of 2008 and resultant recession in the follow-up. Thus a perfect regulation and prudential supervision of banks is tellingly important for the smooth sailing of an economy.

Basel I

Capital is the last recourse that would be available for any bank to prevent its failure. In the year 1974, after the failure of Herstatt bank in Germany the need for regulation of banking sector was felt by G-10 countries. They constituted the Basel Committee for Banking Supervisory practices (BCBS) under the aegis of Bank for International Settlements (BIS).   

Basel I was recommended for implementation by the BCBS for mainly addressing the issue of Credit risk in the year 1988. Credit risk implies the risk involved in the recovery of loans that were lent. In order to address the issue BCBS fixed a minimum capital adequacy requirement to be maintained by the banks. It pegged the Capital adequacy ratio (CAR) at 8%. (Tarullo n.d.)

    Capital Adequacy Ratio (CAR) = Tier 1 Capital + Tier 2 Capital/ Risk Weighted Assets

Tier 1 capital represents the capital that is more permanent in nature and is more reliable. Tier 1 capital or core capital of a bank includes the normal paid up share capital of the bank and other disclosed reserves as reduced by the intangible assets of the bank such as Goodwill, fictitious assets such as debit balance to the Profit and loss account, any expenditure that is not written off and the Deferred tax asset. The Tier 1 capital should form atleast 50% of the bank’s total capital base.

 Tier 2 represents the capital that is not as much reliable as the Tier 1 capital because of the lack of corroborated ownership as in the case of Tier 1 capital. Tier 2 or Supplementary capital consists of Undisclosed reserves, Cumulative non redeemable preference share capital, General provisions and loss reserves written back as surplus if the actual loss or diminution is found to be in excess of the provision or loss reserves created earlier, Revaluation reserves, Hybrid capital instruments and Subordinated debt with minimum maturity of 5 years. There are also restrictions such as subordinated debts could not exceed 50% of the core capital, general provisions and loss reserves could not exceed 1.25% of the total risk weighted assets.

‘Risk weighted assets’ is the value of the assets adjusted for the risk of the asset failing to liquidate as valued. 

Risk Weights

Under Basel I, risk weights were classified into 5 Categories namely, 0%, 0% to 50%, 20, 50%, 100%. (Tarullo n.d.)

• The weight of zero percent was assigned to assets such as loans lent to OECD states, Investment with OECD central government’s securities, loans to borrowers, who are backed by the guaranties of the OECD states or  who had given the securities of the OECD countries as collateral. Since OECD states are considered to be developed countries their securities were assigned zero credit risk. Loans to non – OECD countries and central banks too were assigned 0% risk weights, provided loans advanced to them were in their own currency i.e., in the currency of the borrowing country. This is done to eliminate the risk of exchange rate movements on the loans advanced in view of the probable depreciation of the currencies of the non-OECD countries.
• Loans or investment with domestic public sector enterprises that remain outside the ambit of central government were given risk weights ranging from 0% to 50% at the discretion of nation’s regulator , which could be 0%, 10%, 20% and 50%.
• Loans or investment with institutions such as Multilateral development banks, OECD banks, Non-OECD banks with tenor extending upto 1 year, loans guaranteed by OECD incorporated banks, short term loans guaranteed by non-OECD banks were assigned a weight of 20%.
• Loans to non-OECD banks given on a tenor of more than 1 year are assigned a weight of 50%.
• Loans or investment with private sector enterprises, Non – OECD banks with tenor more than one year, capital market instruments issued by other banks were assigned a weight of 100%.
• In order to capture the risk that resides with the off – balance sheet items such as contingent liabilities ‘Credit conversion factor’ (CCF) was deployed. For instance :
•  General guarantees against loans were assigned 0% 
•  Letter of credits against Shipments were assigned 20% 

In 1996, in response to the financial innovations, as instruments like derivatives were started to be widely used, a new factor called market risk was introduced to strengthen the standards.  Market risk is the risk of losses on account of movements in market prices with the on-balance sheet and off-balance sheet positions. (Basel Committee on Banking Supervision 2005) The way CAR would be calculated was modified to factor in Market risk and a new category of capital called as Tier 3 capital. The Tier 3 capital is composed of Short term subordinated bonds that would exclusively cover market risks. Market risk consists of interest rate risk, equity position risk, foreign exchange risk and commodities risk. For measuring market risk, BCBS proposed two approaches namely Standardized approach, where the principles of gauging the market risk were completely prescribed by the BCBS and Internal grading based approach, where a certain degree of independence was granted to banks in assessing market risk.

Basel II

As years passed by, Basel II evolved. Basel II was given approval in the year 2004. The propositions of  Basel II accord were on three fronts which are given by the three pillars viz: 

1.The minimum capital requirement; 

2.The supervisory review; 

3.The market discipline.

The level of minimum capital requirement was continued to be maintained at 8% under the new framework. A new benchmark of risk called Operational risk was introduced. Operational risk is defined as the risk of loss resulting from the failure of internal processes or from the external events. For instance, Operational risk includes employee frauds, sabotage of assets of the bank, external frauds etc… Put simply, the losses that the bank may suffer, other than, in the normal course of business.  

Pillar 1

Basel II provided three different approaches for credit risk determination. They are:

1. Standardized approach
2.  Foundation internal rating based approach (F-IRB) 
3. Advanced internal rating based approach (A-IRB).

The standardized approach provides that risk weights should be assigned based on the ratings given by the External Credit Rating Institutions (ECAI). Under the new approach risk weights may range from 0% to 150%. Unlike Basel I, where loans to OECD central banks and OECD states where assigned a lower risk weights considering their credibility, in Basel II ratings assigned by the external credit rating agencies were considered as benchmarks and loans to foreign banks were assigned risk weights based on the ratings given by them. However when a foreign bank that is operating in a country lends to the central bank of the country, where it is incorporated then a lower risk weight may be applied to such asset provided the loan is funded and denominated in the domestic currency of the foreign bank. Another prominent feature of the Basel II accord is a corporate may get rated by an ECAI and be assigned a lower risk weight based on the ratings. This stands in contrast to the Basel I accord, where all the corporates were assigned a uniform risk weight of 100%. This might cause the banks to infer that lending to SME-s (Small and Medium Scale Enterprise) may prove to be expensive. (Francis n.d.) Internal ratings based approach allows the banks to devise their own models to assess the risk. Under the other two approaches, Banks use their own model to measure the parameters like PD (Probability of default), EAD (Exposure at default), LGD(Loss given default), which are used in calculating the Risk weighted assets (RWA).

To cover operational risk of loss, Basel II prescribes three approaches namely basic indicator approach, standardized approach and advanced measurement approach. 

• Basic indicator approach and standardized approach requires an appropriation of 15%, 12% to 18% respectively of bank’s average annual gross income to the reserves in the preceding three years.
•  Under the standardized approach, bank’s activities are divided into eight business lines each possessing a different "Denoted beta" ranging from the 12% to 18%. The past three years average of the gross annual income of  each business line is multiplied with the respective beta to arrive at the capital charge.
• Under the Advanced measurement approach banks can quantify the capital to cover operational risk using their own internal model taking into account internal risk variables and profiles.

Pillar 2

Pillar 2 specifies the norms for regulatory authorities. The banks should have deployed a system for assessing the stability of the capital and preclude any fall below the standard level. The regulator should mandate the banks to operate above the minimum capital requirement and should prevent the capital of the banks from falling below the minimum level, which is specified.

Pillar 3

Under the Pillar 3, banks are required to follow a formal disclosure policy. Disclosures regarding capital adequacy, credit risk mitigation, the internal ratings systems that it follows under the IRB approach were all specified under Pillar 3.

Indian Scenario

In India, Basel I was implemented in the year 1999. Later the RBI proposed the initial guidelines for implementation of Basel II in the year 2005. It announced that initially banks would have to adopt the Standardized approach for the determining risk weights for credit risk and the Basic indicator for determining operational risk. It was mandated that the CAR has to be maintained at 9% level, a step ahead of the prescribed Basel II CAR of 8%.

In the aftermath of the global financial meltdown in 2008, the vulnerability of the global financial system was exposed. Basel III guidelines were proposed in the year 2010 by the BIS. Modified parameters such as leverage ratio, mandatory capital conservation buffers and discretionary counter cyclical buffers were introduced.

While Basel III norms are yet to be implemented in India, the need for strengthening our banking system is telling. Between March 2011 and September 2012, the ratio of gross NPA-s to gross advances in the banks surged from 2.4% to 3.59%. (R.Kannan 2013)Thus a scientific study and review of the banking laws and practices is warranted, given the lessons that history has been teaching time and again through the financial turmoils across the globe.

Works Cited

Basel Committee on Banking Supervision. "Amendment to the Capital Accord to incorporate market risks." 2005.

Buckley, Ross P. International Finance system - Policy and regulation.

Francis, Smitha. "The Revised Basel Capital Accord: The Logic, Content and Potential."

R.Kannan. "How to swat the NPA bug." Business Line, 4 5, 2013.

Tarullo, Daniel K. Banking on Basel: The Future of International Financial Regulation.

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* The article was originally published in the site Caclubindia.com on 30th June, 2014.

Evolution of Economics

The theory of economics traces back its origin to the times of Adam Smith, who is known as the Father of Economics. His book ‘The Wealth of nations’, which was written in 1776, had laid the groundwork for the theory of Economics. The crux of the book lies around his propositions such as that an economy in order to bolster its position must increase its exports and resist its imports, an economic system is self balancing and independent in nature and the state need not involve in regulating measures such as price regulation, provision of subsidies. This idea of economic thought is known as Classical school of Economics. Prominent classical school economists are Adam Smith, J.B. Say, and David Ricardo. The classical school of economic thought could even be better illustrated through Say’s law that is popularly given as ‘Supply creates its own demand’. This means that whatever an organization produces would be bought in the market. This proposition is based on the ground that the organization in the course of its production would employ its labour. The reward that they give to the labour in the form of wages would be used by them to purchase from the market whatever the organization produces.
 

The validity of the ideas of the classical school of economics was questioned in 1930-s when the capitalist economies experienced economic crisis popularly termed as Great depression. The classical school of economics was unable to provide an explanation to the widespread prevalence of unemployment during the 1930-s. Classical thought was questioned on the footing that ‘If Supply could create its own demand, why is the question of over production arises..?’ At that point emerged another theory that was propounded by the British economist John Maynard Keynes as an answer to the puzzle. Contrary to the theory of Classical economists that the system is self regulating, Keynes made his proposition that it is not the inherent characteristic of a capitalist economy to maintain the economy at full employment. Over production of output does occur and as a result unemployment problem could arise.

The understanding of the grounds of rebuttal of theory of Classical economists by Keynes demands a finer understanding of the operational dynamics of the classical thought.  Classical economists justified their stance that full employment equilibrium tends to be natural state of existence of a capitalist economy through positing that the system is self adjusting so that the labour market and the capital market would act within itself to maintain full employment. The explanation to the self adjustment is two pronged.

The income of any individual could either be spent on goods that he consumes or saved. If the income is spent entirely on consumption, as long as the demand, which is backed by the individual’s earning, is strong enough to absorb the production of an organization, there won’t be any problem about the stability of the employment level. But if the demand falls short of the supply then the equilibrium in the employment level would be lost. The classical economists formulated a theory that the prices and the real wage rate would react among themselves to restore full employment, if the potency of demand falls short failing to absorb the entire production .  

On the other hand if an individual would have saved a part of his income, an element called savings needs to be factored in to articulate the mesh. They proposed that all the money that is saved would be invested with banks or other financial intermediaries, from where, the entrepreneurs would borrow and spend their borrowings on capital investments such as machinery, land etc... This capital investment will employ its own chunk of labour force. Thus the level of employment could be increased. The question how system could ensure all the money saved will be invested was addressed by a factor called as Rate of interest. When the rate of interest is high, people will be more willing to deposit their money as deposits in banks and will be more hesitant to borrow money from the bank. On the other hand, if the rate of interest stands low, lesser amount of money would be deposited since banks offer them lesser returns on their savings whereas more money would be borrowed since the cost of such borrowings is less now. The Central bank of a country would fix the interest rate in such a way that the deposits and borrowings strike a balance i.e., No surplus or deficit of deposits or borrowings. Thus all the money saved would be made to be invested. Therefore the question of unemployment is eliminated. Thus the classical economic thought was sailing comfortably, on the hypothesis that no matter what one earns and what one saves, the inherent nature of the system will ensure that economy remains balanced with no massive turbulence in terms of unemployment until the Great depression of 1930-s. But the inability of the classical thought to provide an explanation to the depression warranted an alternative economics to develop. 

Keynesian economics offered a solution to the conundrum. His attack on classical economics was on two fronts – The so called adjusting factors namely Real wage rate, Prices and Interest rate would not always provide for the system to strike a balance. Contrary to classical economist’s proposition that all the money saved would be made to be invested by the system, Keynes said that the system may fail to plough back the savings into investments. 

In his book ‘General Theory on Employment, Interest and Money’ he states that when a sense of pessimism takes over in the minds of the people about the business expectations, no matter however much the interest rate is brought down, the investment would not surge. Apart from rate of interest, he said, people’s attitude about business expectation plays a major role in bringing savings and investment to equilibrium. On the other hand, classical thought conceived that interest rate cuts could promote business expansion in every scenario. But the Second World War (1929-35), which was on at that time, prevented the business expectations to pick up. As a way out, Keynes proposed that the government through its fiscal policy mechanism (Tax regime) should ensure that public expenditure should be increased to create increase the employment level. This mode of increased financing by the state to create employment in excess of its earning capacity is known as deficit financing. Thus Keynesian economics entrenched.

It prevailed to be the popular theory providing the basis of economic policy formulation until    1970-s. But in the early 1970-s following events such as Vietnam war, collapse of Bretton woods system  the economic scenario in USA so turned out that it started developing both high inflation and high employment. The situation paved way for other theories to emerge such as Monetarism, which is again a theory that stood aligned to classical thought in essence. Milton Friedman, the one who propounded Monetarism, argued that an effective monetary policy (Rate of Interest wielding) by a central bank could only be a cure for economic 

crisis.

Thus over the period of time economic theory has evolved taking different forms in response to the spurs of different point of times. Of late economies have started deploying unconventional tools such as Quantitative Easing (QE), modified methods of deploying monetary policy etc... to fight against economic crisis. With the emergence of new complexities the need for a wary conception and implementation of economic theories into the policies stands very imperative.

Exchange rate determination and its dynamics

                                             

Many a time, when we hear in news that Indian rupee depreciates or appreciates against US dollar, a common question that arises in the our mind is ‘How are  exchange rates determined?’.  Though the fluctuations appear to be a conundrum they are actually not. In fact they are as much simple, interesting and natural as any other economics concept. Before a CA student goes for learning ‘How to account for exchange differences?’ as per AS11 it is essential for him to understand the underlying groundwork.

What are exchange rates?

     Every economy is distinct by itself in terms of every economic feature – be it inflation or demographics or unemployment or interest rates. Given this diversity, one rupee in India cannot be equal to one dollar is USA. Because inflation may be hovering at 6% in India, whereas, it may be doing at 4% in USA. Thus one currency expressed in terms of another currency is called as exchange rate. Generally exchange rates refer to nominal exchange rates. When it is said that 1 USD is equal to Rs 50, it is nominal exchange rate.

     But there is one more exchange rate called real exchange rate. The rate at which one country‘s goods can be exchanged for another country’s is called as Real exchange rate. If the cost of burger in India is twice the cost of burger is USA, then the real exchange rate of Indian burger to US burger can be said as 2. To make it appear more technical it can be put like this:

RER= Domestic price * Nominal exchange rate / Foreign price

If 1USD is trading at Rs 50 and  a burger is trading at Rs 100 in India and 1USD in USA, then the RER would be  100*(1/50)/1  =2 .

     Theory of Purchasing power parity

     One popular theory of exchange rate determination is the theory of purchasing power parity. It is based on the ‘Law of one price’, which states that a good must sell at the same price everywhere. There remains parity in the price of the commodity everywhere.

     Now how is this parity related to exchange rate determination? The answer lies in reverse engineering - Suppose the 1kg of coffee costs Rs50 in India and 1 USD in USA then the exchange rate is nothing, but 1USD=Rs 50. If the price of coffee goes to Rs 60 due to inflation in India, then the exchange rate is said as 1USD= Rs 60. Thus the parity in purchasing power acts as a balancing force for exchange rate determination.

     How can this parity in purchasing power exist?

     Any theory to hold good must justify and satisfy the senses. The law that says a good must sell at same price everywhere does this job very well. Let us imagine that USA and India are neighbouring towns. Before we get deeper, we should ensure that we understand the Law of demand.

If the demand for good goes high, the availability of the good may stammer to cater everyone’s need. Hence the manufacturer would increase its price to filter the demand.

If demand goes down, to boost sales the manufacturer would bring down the price. This is law of demand. Put in another way, if a good is available in abundance, to get them sold the manufacturer would bring down their price. If they are in short supply their price would be increased.

If coffee seeds are traded at Rs 50 in India and Rs 30 in the neighbouring town of USA, people would purchase coffee from USA and sell it in India to take advantage of the price difference. When this process continues at a point of time, the availability of coffee seeds would get strained in USA due to excess demand for US coffee seeds, which would induce coffee manufacturers in USA to increase the price of coffee seeds to, say, Rs 40.Whereas in India, since its supply has increased, price of coffee seeds may go down, to Rs 40. Thus the price is same everywhere. Thus prices have become equalized. This process of trading taking advantage of price difference is called as arbitrage. This kind of reaction happens across the globe to ensure that price of the good remains the same everywhere thus validating the purchasing power parity.

     Dynamics of Exchange rate

1.   Money supply:

When the money supply increases in the economy, it will cause the price level to increase. According to the theory of purchasing power parity, just because the price level has increased in the economy, a USD will not fetch lesser quantity of goods than what it was fetching earlier. For convenience sake we shall use the previous example. If the coffee price has increased to Rs 60 from Rs 50, 1USD will not fetch lesser coffee seeds. It will fetch the same 1Kg of coffee which it was fetching when the price of the coffee was Rs 50. This implies 1USD will be equal to Rs 60 after the price rise, which means the inflation has caused the currency to depreciate.

2.   Interest rates:

This is a key factor in the hands of central bank of a country to have a control over exchange rates. To understand this, it is necessary to get a deeper understanding over one more concept called Capital outflow. Capital outflow refers to the amount of foreign assets purchased by the economy. Net capital outflow refers to the total amount of capital owned by the citizens of economy, which is invested outside the frontiers of the economy less the amount of capital invested inside the economy by foreign nationals. When the central bank of a country rises the interest rates – both lending and deposit rates- the citizens of the country will

a)   Grow hesitant to borrow money from banks

b)   Deposit cash that is inside their bureaus in the banks as they would fetch more returns.

   

Foreign Institutional Investors, who look for abode to park their money, will

a)   Find the banks of the economy as a prospective parking yard. Thus they will park their foreign currency as domestic currency of the economy in the banks.

Now much of the currency of the economy, whose interest rates have gone up, would be in the banks of the economy. So the amount available for transaction outside would be lesser. So forex traders cannot offer their currency as generously as they were doing. Thus earlier if 1USD had fetched Rs 60, now it would fetch only Rs 50, which means there, happens an appreciation of currency. Thus when the interest rates increase, the currency tend to appreciate.

3.   Political Stability

 

When there prevails a state of political turbulence, the investors both outside and inside the country might lose faith on the economy and may take away their money to park it somewhere else. This sudden scuttle of the capital out of the country is called as capital flight. When such an event happens the net capital outflow would increase meaning excess availability of a country’s currency outside for transaction purpose. This excess supply causes the currency to depreciate.ie. if a dollar had fetched Rs 50 so far, since the quantity of INR available for transaction outside is more now it would cause a USD to fetch more INR, say, Rs 60. Thus a capital flight causes depreciation of the currency.

4.   Trade deficits

If the economy’s import is greater than export it would cause the current account balance of the economy to go negative.ie. It would need more foreign currency to settle the trade dues that it has incurred. So it means that the quantity of the currency, say, INR available in the transaction flow is high because of their dues. Thus the value of the currency would depreciate causing the economy to reflect its real status.

5.   Large debts

If the economy is going to finance its expenditure through debts and borrowings, the situation would be called as deficit financing. As the expenditures made are of capital nature such spending would cause surge in employment level leading to rise in demand thereby causing increase in price level. Thus deficit financing would cause inflation in the economy. Due to inflation the value of money goes down. According to the purchasing power parity, this plunge in the value would cause the currency to face depreciation.

Types of exchange rate systems

a)   Fixed exchange rate system

Under this system, the value of the currency is fixed. It would not be allowed to fluctuate in the ways of supply and demand in the forex market. If the demand for a currency is going to increase, the currency would not be let to appreciate. The central bank would counter the surge in demand by allowing more of the currency of the economy to float in the market. This can be done by buying foreign currency denominated assets for which they have pay through converting their currency into foreign currency. Thus forcible selling takes place to counter the demand for their currency. Vice versa happens in case of depreciation.

b)  Floating exchange rate system

Exchange rates fluctuate daily according the supply and demand conditions in the forex market. Central bank won’t do much to control and bridle the exchange rates.

c)   Managed float

In practice, this is popular method of exchange rate management. Here the exchange rates are allowed to fluctuate but within a specified band limit i.e. INR may fluctuate any way as the market determines but between limits of Rs 45 and Rs 55. When market pushes the value of the currency across this limit the central bank would act upon to control.

In India manged float is the system of exchange rate management regime.

History of exchange rate determination

Until 1914 Gold standard was the exchange rate management regime across the globe, where currencies can be converted into ounces of gold at the exchange rates prevailing then. Here the exchange rates are determined as the measure of quantity of gold that a unit of the nation’s currency could buy. If 100 INR could buy 50grams of gold and 100 USD could buy 5000 grams of gold, then the exchange rate would be 100USD per INR.

  

In 1944, after World War II, Bretton woods accord was signed by the world countries. It was agreed that US would maintain the value of 1USD equal to 35 Ounces of gold. Other currencies were pegged at rates against USD. However they can allow their value of the currency to fluctuate upward or downward by 1% from the forepegged value. This means that only the dollar enjoys the benefit of getting fixed quantity of gold in return for a fixed quantity of their currency. Other countries have to produce an amount of their currency equal to a dollar to get the said 35 ounce of gold.

Later during the early 1970-s, following the Vietnam War the US economy faced an economic congestion. Inflation soared in the US. Net capital outflow from the economy surged. As a result the country’s currency started losing its value in the world arena. The countries of the world started losing their faith on dollar. Countries started redeeming their dollar reserves as gold. France converted their dollar reserves worth $191 Million into gold followed by many other countries. All these jamming finally led the US to end its gold standard preservation. The then president of US Nixon made announcement that the dollar can no longer be converted into fixed quantities of gold. This end of the Bretton woods practice is termed popularly as Nixon shock.

Since then most of the countries follow floating exchange rate system, which was formally recognized in the Jamaican accord of 1978. As at 2002, 76 countries adopted floating exchange rate regimes and 111 countries adopted fixed exchange rate regimes.

 Thus dollar lost its identity as the world reserve currency. But still dollar stands as major component of foreign reserves of the countries across the globe (65.7% as of 2007). However the dollar’s supremacy is questioned with increasing prominence of other currencies like canadian dollar, renminbi etc…

Hope this scribbling would have given some idea about Exchange rate determination.

Sustenance of Renminbi and its leverage over the world economy*

                                                                      Abstract 

                  This paper studies the macro economic trajectory of China with a special emphasis on its foreign exchange management regime. This study comes at a time when china is facing international pressures from across the globe to allow its currency renminbi appreciate. Recently Robert Zoellick, President of the World Bank came out with his view hinting of replacing dollar as the world’s reserve currency. The U.S.’s debt burden will climb to 97.5 percent of gross domestic product next year from 87.4 percent, the Organization for Economic Cooperation and Development forecast in June this year. Given that the US Dollar is losing its stability and credibility, a need for shift to a more reliable value holder is felt across the world. This paper studies whether renminbi can serve for that purpose or not, given the skepticism around the world towards it's sustainability, albeit the fact that it is the second largest economy and is the fastest growing economy in the world. The rising prominence of renminbi got reiterated recently when Malaysia bought renminbi denominated bonds for its reserves. It deals with the renminbi’s current position in the global scenario, it's increasing prominence, the benefits that  it  is enjoying by means of pegging it's exchange rate this lowly at the domestic context  and at the international context, export and import structure, their leverage over it's economy as a whole, capital market, fund flow benefits, trade balance it maintains with nations across the globe and how the other countries 's  around the domestic economy  is affected by china's export structure. To sum up, this paper is centered on china's foreign exchange management regime .It deals with it’s correlation with the other macroeconomic parameters.

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* D.Gowtham, 2^nd  year B.com, Loyola college, Chennai.  Originally presented in the 'International conference on recent trends in growth patterns – A Global perspective' held at  

Loyola college, Chennai on 7th February 2011.

Sustenance of Renminbi and its leverage over the world economy

Exchange rate management regime:

Exchange rate refers to the price of one country's currency expressed in another country's currency. In other words, the rate at which one currency can be exchanged for another. Countries often peg the value of their currency either above or below the value of another currency to correct the trade imbalances that occur in their economy relative to other economies. The exchange rate regime is the way a country manages its currency in respect to foreign currencies and the foreign exchange market.

On going practice:

Till 1971 all world currencies except the dollar were pegged against dollar, which in turn has agreed to maintain the value of 1 US dollar equal to the value of 35 Ounce of gold. In 1971, following the inability of the dollar to maintain its value as agreed in the Bretton woods system, world countries following West Germany one by one started casting off the dollar as the world reserve currency, which is popularly termed as Nixon shock. However, as United States remained the world's preeminent economic power and as most of the international transactions continued to be conducted with the United States dollar, it remained as the de facto world currency.[1]Still somewhere between 40 and 60 percent of international financial transactions are denominated in dollars.[2]

Waning exclusive hegemony of dollar:

Year	2001	2002	2003	2004	2005	2006	2007	2008	2009
Dollar's Share in  official foreign exchange reserves	70.7%	66.5%	65.8%	65.9%	66.4%	65.7%	64.1%	64.1%	62.2%

Sources: 1995-1999, 2006-2009 IMF: Currency Composition of Official Foreign Exchange Reserves Sources: 1999-2005 ECB: The Accumulation of Foreign Reserve

Between 2000 and 2008 the US dollar’s share in the world countries’ official foreign exchange reserves has significantly reduced from 70% to 62%. With the US unemployment rate hovering around 10%, the exclusive economic supremacy of US that has been enjoyed by it after the Second World War, would be uncertain in the forthcoming times. Calls for replacing dollar as the primary world reserve currency has increased in the recent times – particularly in the wake of 2008 global financial meltdown. Zhou Xiao chuan, Governor of PBC called for a global currency replacing dollar as the primary reserve currency pointing to Triffin dilemma in 2009. In his speech he particularly mentioned about the need for considering SDR for that purpose. Recently Mr. Zoellick, President World bank, calls for a reserve system that “is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi that moves towards internationalization and then an open capital account”. He also says that the system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.[3]

US dollar’s real effective exchange rate is as low as it was at the end of the Bretton woods system in 1971. (Business Line, Tear down this Chinese wall) Former Federal Reserve chairman Alan Greenspan in 2007 mooted the idea of having Euro as the primary reserve currency in the place of US dollar. Thus one could not any longer expect to have US dollar as the de facto world reserve currency.

Surging Chinese economic prominence:

China, with its growth rate as the fastest in world, has raised skepticism around the world of getting into the shoes of the US dollar. Recently it overtook Japan in the GDP terms marking it as the second largest economy in the world after USA. Its healthy state is very much evident from the fact its economic progress remained intact in spite of the sovereign debt crisis that shook the world highly after the sub-prime crisis of 2008. Being the holder of world’s largest labour force, largest exporter of  goods and services, second largest importer, Fifth largest receiver of FDI, largest current account surplus holder, holder of largest foreign exchange reserves adds up to its credentials.

Renminbi in the current global scenario:

In August 2010, china opened its domestic interbank bond market to foreign central banks that have access to renminbi through a series of bilateral currency swaps to the worth of $120 billion. Commercial banks like HSBC, Citigroup were also opened doors to invest in china’s inter bank bond market .Malaysia recently has purchased renminbi denominated bonds for its currency reserves. Shanghai stock exchange in November came up with its plan to issue Hong-Kong based ETF, the first of a cross border investment kind in china. Such things add impulse to the alleged China’s attempt to internationalize renminbi.[4]

China is also, particularly after the wake up of the sovereign debt crisis, is facing mounting pressures from across the globe particularly from the US to allow renminbi to appreciate against artificially keeping its value low. This iterates the inevitability of leverage of the renminbi in the world economic recovery. Thus there is every possibility and right for renminbi to dominate the global currency market in the future.

Forex management in China:

In the year 1994 first major renminbi devaluation occurred to eliminate the current account insufficiency that china has been facing thitherto. From then on current account of china started showing steady rise of surplus - particularly after the China’s accession to WTO in 2001. The unification of Swap rate and official exchange rate into a single official exchange rate marked the first step in China’s entering into the Managed floating exchange rate regime.[5]

          YEAR  CURRENT ACCOUNT BALANCE

1994 6.9 1995 1.6 1996 7.2 1997 29.7 1998 29.3 1999 21.1 2000 20.5 2001 17.4 2002 35.4 2003 45.9 2004 68.7 2004 68.7 2005 160.8 2006 249.9 2007 371.8 2008 426.1  2009 297.1

 SOURCE: http://www.chinability.com/CurrentAccount.htm

In 2005 it gave up it’s thitherto practice of pegging solely against dollar. Instead it started adopting the practice of pegging its currency against a basket of currencies – the major currencies in the basket being US dollar, European Euro, Japanese Yen and the Korean Won. China revalued its renminbi against dollar to tune of 8.11 per USD moving away from its thitherto pegged value of 8.27 renminbi/USD. This is where it is widely regarded that china has started adopting managed floating exchange rate regime abandoning the fixed exchange rate regime. But in the wake up of the 2008 financial crisis it halted the appreciation of renminbi against the dollar. Between 2005 and mid 2008 renminbi appreciated against US dollar by 21%. Since then it remained roughly at 6.83 renminbi / US dollar. [6]

The exchange rate has been allowed to move within a wider band, i.e., from a daily band of 0.3 percent against the US dollar at the start of the reform in 2005 to 0.5 percent in 2007. Before 1994, the RMB exchange rate was determined both by the authorities and the swap market. Now it is determined in the interbank foreign exchange market through OTC transactions, supported by market makers. In June 2010, the People’s bank of china announced that it would allow renminbi to be more flexible, a move which was welcomed by the major economies of the world. In December 2010, the exchange rate of renminbi was roughly at 6.6 renminbi / US dollar.

Reason for being managed this tightly:

China cast off the fixed exchange rate management regime in 2005. But that does not mean that it has become considerably liberal in its exchange rate management regime. Chinese economic growth is largely export driven. So its exchange rate should be favoring its export sector.

The reason for being so rigid in its exchange rate management regime is to gain competitive advantage over the global countries. Its rigidity is very much evident from the fact that china adhered to its exchange rate value of its currency during a period when the world was suffering a global financial melt down from 2008 to June 2010. China’s exports plunged by 21.3% during 2009 whereas the exports of India, that is the second fastest growing economy and widely regarded as the fitting competitor of china has declined by 29.2% during the global recession period.[7]

 The loosening of its hold in June 2010 is more of an act of dousing international pressures. Its announcement came up during the run up of the Toronto G 20 summit at which it was widely anticipated that it is going to face condemnations against maintaining a strong hold over its exchange rate. Thus china’s keenness in its management of its exchange rate management regime can be attributed to the reason that it, by doing so, is very much keen in spurring its export led growth. China’s cost advantage in the products they export exceeds the 20 % to 30 % difference that a stronger Yuan could achieve. [8]

Thus by not allowing the, appreciation as asked by afflicted major economies it further ensures its export driven growth.

Benefits that China enjoys by managing their currency tightly at the domestic and international context:

   By means of maintaining its exchange rate this tightly it ensures price stability for international dealers of the Chinese goods. This in turn attracts investors to invest in Chinese economy, which ensures them a stable economic climate. Thereby it is able to attract a large FDI into its economy. It has grown as the third largest FDI receiver in the world in 2006.

   In 2010 it has grown as the second largest FDI attractor of FDI followed by USA.[9]  This creates a good number of employment opportunities in the country. Because of that it is able to maintain its unemployment ratio at 4.2% albeit the colossal population it has. Given its totalitarian regime, exchange rate regime that it follows renders it with a good hold over the domestic demand. Since it does not go for frequent adjustments of its exchange rate in relation to the international supply and demand conditions it should go for adjustment in the domestic market to maintain its exchange rate. So its domestic demand has to naturally get calibrated to sustain its exchange rate. Thus its exchange rate management regime facilitates government’s pursuits in its policies.

China has grown as a country with the highest current account surplus by maintaining its exchange rate to its favour. China has grown as the largest exporter of goods and services. This has given it a competitive advantage over other countries. So it is able to produce goods at low cost

.

Allowing minimal appreciation of the renminbi has developed china as the largest holder of the foreign exchange reserves. As of June 2010 its foreign exchange reserves has grown to $2,454.3 Billion. Thus it endows China with enormous economic potential. [10]

Export structure:

China’s share in the total world exports jumped to 10% in 2009, replacing Germany as the world’s largest exporter. Over the years China’s export structure has undergone drastic change - from being a manufacturer of low value added products to high value added products. Products such as electronic goods, telecommunication instruments have found increasing presence in its manufacturing list while the share of textiles, apparels has reduced. [11] The export identity of china has been transformed from an exporter of low value added products to high value added products.

   

  

   China has been able to sustain its export growth in real terms, which is hardly achieved by any other country in the world. Its export is able to grow over time regardless of the price fluctuations in the world trade. This senses the inevitability of the China’s exports in the world trade.[12].China’s export sector composition contains a major share of processing industry with it. In other words, it is more a producer of intermediate or Semi-finished goods.11 This states the fact that if the exports of the China is affected it not only will affect its economy. Also the economies of those countries from which it imports to manufacture those intermediate goods will also get affected. This adds prominence to its export sector in the world scenario and explains the reason for its export growth in real terms. Over the ten years before 2008, China’s exports grew by an annual average of 23% in dollar terms, more than twice as fast as world trade. Projections in the IMF’s World Economic Outlook imply that China’s exports will account for 12% of world trade by 2014. The China’s export share of 10 % in the world trade is almost equal to that of Japan’s during 80-s. But Japan was not able to sustain with that export growth rate – the reason being succumbing to pressures across the globe to appreciate Yen – particularly from US. The Plaza accord of 1985 allowed US dollar to devalue strengthening Yen. Yen strengthened against US dollar by more than 100% between 85 and 88. Consequently its export share dropped to less than 5%. China is facing such international pressures at this moment. An IMF working paper published in 2009 calculated that if China remained as dependent on exports as in recent years, then to sustain an annual GDP growth of 8%, its share of world exports would have to rise to about 17% by 2020[13]

Can renminbi appreciation be a solution for global economic imbalances:

Currently, China is running with a largest current account surplus. It is maintaining trade surplus with major economies of the world. In 2009 it was maintaining a current account surplus of $ 297 Billion. In 2005, the U.S. trade deficit with China was at $201 billion. It was followed by the EU-15 which accounted for a deficit of $121.8 billion .It was followed by Japan at $28.5 billion.

Thus all the major economies are running in deficit with China in trade. [14]

Given this kind of a trade dominance of china with the rest of the world it is a matter of uncertainty that whether an appreciated renminbi alone can make up for financial congestion that the world is facing. Since joining the WTO, China provides one-fifth of American imports, but buys only 7.4 per cent of US exports. It has built up a bilateral trade surplus of $226 billion and, in the process, emerged as America’s banker. During late 2008 or at early 2009 China became the largest foreign holder of US securities.[15]  However US imports from China are mostly of intermediate kind of goods, which are made up into finished products in the US. Thus US imports from China are providing employment in US. A Centre for Economic Policy research study states that reduction in US imports from China will impinge negatively on its employment opportunities. The CEPR study estimates that a 10 per cent rise in the value of the renminbi could see China cut imports of components by as much as 6 per cent. The fact that China by being an intermediate exporter, is not only at the receiver’s end but also is at the giver’s end is reiterated from the fact that a 10% increase in China’s income leads to 4 to 5 percent increase in the exports of countries like Japan and Singapore. India too experiences a 2.3% increase in exports. India is a latecomer, when compared to other countries, as a supplier of raw materials to Chinese exports. [16]In 2009 US exports to China, which is the third largest importer of Chinese products rose by 13%. Whereas in the case of Mexico and Canada, which are even the other two largest importers of US goods than China, the import share has fallen by 14%. Thus it would not be just to deem China being very much mercantile in its trade policy.[17]

Conclusion

China’s current account surplus is driven not only by its large exports. The other factors that account for its huge current account surplus are its prudent savings. Its savings rate stands at 54 percent of GDP versus an average of 33 percent among developing countries and 17 percent among Organization for Economic Cooperation and Development Economies8. This high savings also largely explains the reason for its current account surplus. In China state control is large over the affairs. The government is totalitarian in its character. Given such a kind of strict regime, it can be said that this kind of high savings is largely driven by the state control. This can be better explained by the fact that its savings comes from corporate sector rather than households. Given their graying demographics, this high level of savings rate means that Chinese are riding with a vision to ensure safety for their future. China is now at the peak of experiencing its demographic dividend. China’s average age of population would be 39 by 2020. By 2040, the world’s second largest population after India will be Chinese pensioners, who would be more than 400 million in number.[18] Given the uncertainty over the productivity of china because of its enfeebling demographics, China should act prudently now to sustain in the future. China does this by means of saving much and maneuvering its exports prudently. Succumbing to the capitalistic pressures from the west would prove to be mutually detrimental phenomena .Because western countries know less about capitalizing on the opportunities that a devalued renminbi would create.  This can be substantiated by the Sub-Prime crisis of 2008 that arose due to the speculative practices in US which eventually ensued Asset bubbles in US. Already savings rate of US economy is hovering at some point less than 1%.If China goes for currency appreciation it may help the economy of US to pick up in the short run. But in the long run it may not be possible because speculation may again start driving the economy of US. This may result in asset bubbles. If china goes for a big appreciation of renminbi, it also will have to face the ill effects of such appreciation. This is what happened in the case of Japan in 1985. Japan lost its export market and suffered an economic loss because of the currency appreciation, which is being termed as the lost decade. So China should be prudent in managing its exchange rate regime. Global economic recovery is essential. But that should not occur at the cost of failure of healthy economies. So the ideal thing would be allowing the renminbi to appreciate gradually, without allowing Chinese economy to slack in the long run at the same time empowering the sickened economies by making them to realize the seriousness by means of offering sustained resistance.

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REFERENCES

[1]As of December 26,2010 Wikipedia listed on its website  http://en.wikipedia.org/wiki/World_currency

[2] Robert Gilpin, Global political economy: Understanding the international economic order, 2001

[3]As of December 26, 2011 “Financial times” listed on its website http://www.ft.com/cms/s/0/eda8f512-eaae-11df-b28d-00144feab49a.html#ixzz18viOCZzi

[4] As of December 26,2011 “Financial times” listed on its website

http://www.ft.com/cms/s/0/fecc16fc-c417-11df-b827-00144feab49a.html#showclipthis

http://www.ft.com/cms/s/0/f52217ea-f40b-11df-886b-00144feab49a.html#axzz190xGUeZE

[5]“A Managed Floating Exchange Rate Regime is an Established Policy”, People’s bank of China, accessed December 26, 2011,

http://www.pbc.gov.cn/publish/english/956/2010/20100727144152118668062/20100727144152118668062_.html

[6]“Chinability,” Renminbi exchange rates,  http://www.chinability.com/Rmb.htm

[7]“Chinability,” http://www.chinability.com/Trade.htm

“Wikipedia Foundation,” Economy of India,

http://en.wikipedia.org/wiki/Economy_of_India#External_trade_and_investment

[8]Alberto Alesini, Luigi zingales, “China Needs a U.S. Lesson”

 Bloomberg, 2010

[9] World investment report, UNCTAD, 2006, 2010

[10] Chinability, “Foreign exchange reserves of China”, http://www.chinability.com/Reserves.htm

[11] Mary, Caroline, “China's Export Boom’’, Finance and development 44, 2007

[12] Prof. Bhattacharya, Weekly current affairs bulletin, A.I.R, 10^th December 2010

[13] “Fear of Dragon”, Economist, 7^th Jan 2010

[14]“Federation of American scientists”,  http://www.fas.org/sgp/crs/row/RL31403.pdf

[15] Congressional Research Service , China’s Holdings of U.S. Securities: Implications for the U.S. Economy, July 30, 2009

[16] Nayan chanda ,Freeing the renminbi, Business world, 24^th April 2010

[17] Fear of Dragon, Economist, 7^th Jan 2010

[18] Helen qiao, Goldman sachs, BRIC report, 2006