Last day I was talking to the owner of an electronic devices store. He
was explaining how for some of the items he sells, his selling price is
less than his actual purchase price. For imported items (like Toshiba
laptops in this case) the amount he has to pay is in dollars but the
Maximum Retail Price advertised by the company and printed on its
catalog are in rupee. According to him, it takes around 4-5 months for
consignment to arrive at his store, and by the time products are
delivered to him, value of rupee gets devalued and he has to pay at
current exchange rate but his customers will pay him only in printed
MRP.
I did not believe him completely for the difference in amount he told
me was far more than the actual devaluation of rupee in last 6 months.
But it is hard to ignore the rapid pace with which rupee is
depreciating. As you can see in the chart, the value of dollar in rupee
has increased from 45 to 61 in last two years. That is around 35%. In
other words, value of rupee has depreciated by 35% (assuming inflation
of dollar to be negligible).
Let us delve into this fascinating (though, painful in this case)
phenomena of macro economics and try to understand its causes, impact
and what our government can do to minimize its ill effects.
Exchange Rate Mechanism
Let us first try to understand how exchange rate is determined? All
economies that interact with international economy can be broadly
classified into three categories on the basis of exchange rate policy of
the country.
1.
Fixed Exchange Rate:
These economies peg the value of their currency with some other
prominent currency like US dollar. This system is simple and provides
stability to the economy (of course, if the economy of the country to
whose currency its currency is pegged is stable). This type of exchange
rate regime is maintained by generally smaller economies like Nepal and
Bhutan (pegged to Indian Rupee) or several African nations. Rational
behind such regime is that in case of small economy – if the exchange
rate is market determined – the sudden influx or outflux of even
relatively small amount of foreign capital will have large impact on
exchange rate and cause instability to its economy. Notable exception is
China which despite being large economy has its currency pegged to US
dollar. But then when it comes to China, its irrational to talk about
rationality
.
2.
Floating (or free) Exchange Rate:
Bigger and developed economies like US, UK, Japan etc generally let
market determine their exchange rate. In such economy exchange rate is
determined by demand and supply of the currency.
For example consider exchange rate of US dollar versus Japanese Yen.
If US wants to import certain item from Japan, it will have to pay the
Japanese company in Japanese yen. This is because in common market of
Japan, dollar will not fetch you anything. But the American company will
not have Yen, so it will purchase Yen from the international currency
market. This will increase the demand of Yen and supply of dollar. Thus
the value of Yen vis a vis dollar will increase. Similarly if Japanese
company is importing something from US, it will increase value of dollar
as compared to Yen.
Export-import, though the major, is not the only source for currency
exchange. Capital flow – Americans investing in Japan and Japanese
investing in USA – is also a significant source of currency exchange.
Another source of currency exchange is remittance – that is the money
sent home by Americans working in Japan and vice versa. Cumulative of
all these exchanges determine the exchange rate. If net requirement of
Dollar by Japanese is more than net Yen required by USA, dollar will
appreciate against Yen. You should also understand that this is
oversimplified for the purpose of illustration. In real world, there
will be multilateral interactions and final exchange rate will be
equilibrium reached by all those interactions.
3.
Hybrid system:
Most mid sized economy like India practices a mix of both these regimes.
It allows for the exchange rate to float in a range which it deems
comfortable. Once the market determined rate tries to breach this range,
central bank (government) intervenes in the currency market and
controls the exchange rate.
How does government control exchange rate?
In fixed or hybrid exchange rate regime where government controls
exchange rate, control is exercised by actively participating in
international currency market through its central bank (Reserve Bank of
India or RBI in our case). Suppose there is huge demand of rupee in
India which is driving the value of rupee. Also, lets assume that RBI is
comfortable only in range of Rs 50 to Rs. 60 per US dollar. This rapid
surge in the demand of rupee (which might be because a. Indian export is
far more than its import, b. foreign investors want to invest in India
and c. large number of Indians earning abroad are remitting their money
back home) is pushing the exchange rate below Rs. 50 per dollar. The RBI
will then step in the market and will offer Rs. 50 for each dollar.
Those buying rupees against dollar will now purchase from RBI since its
offering better rate. Soon other traders will have to arrive at this
rate, if they want to participate. Since RBI has the ability to print
currency notes, it can keep the lower limit of exchange rate fixed at
this value. When demand for rupee is subsided, RBI will step back and
let market determine the exchange rate. In the process, RBI will have
accumulated a pool of dollars; this is called forex reserve or foreign
exchange reserve.
Now let us move to other extreme. Suppose Indian exports have
dwindled, imports are on surge, foreign investors are fleeing Indian
market and remittances are at all time low. Now, every one wants dollar
but there is little supply. This will drive the price of dollar up. Its
about to breach the upper limit of Rs. 60/ USD. RBI will step in again
and will put its dollar reserves on sale at the rate of Rs. 60/ USD.
This will stop the further depreciation of rupee.
As you can see, in order to be able to stop the currency from
appreciating, RBI will have to print money and for preventing its
depreciation it needs a reserve of dollar. This constraint has
interesting implications on the current predicament of RBI in the
context of depreciating rupee.
Effect of exchange rate on Import and Export:
Suppose US company wants to buy Indian textile and suppose on T-Shirt
costs Rs. 120 and exchange rate is Rs. 50/$. So for american company the
cost of T-Shirt is $2.4. Now, if rupee depreciates to Rs. 60/$ the
price of T-shirt becomes $2 only. This will make Indian T-shirt cheaper
to buy and will increase its demand. Companies who were importing from
other nations (may be China or Bangladesh) might shift to India and
Indian exports will increase.
Consider the opposite scenario. Rupee appreciates to Rs. 40/$ making
the cost of one T-shirt $3. This will repel US importers and might drive
them to other rival exporters whose garments are cheaper. Thus,
depreciating currency helps exports while appreciating currency has
opposite effect.
Similarly if India imports $ 1000 iPad from US, at exchange rate of
Rs. 60, it will cost Rs. 60000. If currency appreciates to Rs. 50/$ the
price will reduce by Rs. 10000. This might encourage many new people to
by iPad which earlier thought it to be too expensive. Thus, the demand
for imported products will increase in appreciating currency and will
drive imports upward. Depreciating currency will have opposite effect.
Balance of Payment (BoP) Accounts
International monetary transactions of a nation is recorded in two accounts.
1.
Current Account: This
records all the trades (export-import), remittances, interests and
earnings on investments made into out side countries and other flows
which is current in nature (meaning with no intention of future return).
If total inflows in the country (its export, remittances and earning
from its investments abroad) is more than its outflows (its import,
remittances out of the country, payments of interests etc.) then the
country is said to have current account surplus. China, owing to its
huge exports, is currently the nation with largest current account
surplus. Similarly, if outflows exceeds inflows, the country is said to
be in current account deficit. USA has the largest current account
deficit. India too has huge current account deficit (about 120 billion
USD in FY 2012)
2.
Capital Account:
This records all the flow (into or out of the country) made for future
return – investment in stocks, bond or companies, in real estate or FDI
(investment made for setting up of business or industry). It also
includes loans taken from abroad (which actually is investment by
foreign lender into the nation). Foreign Currency Reserves are also part
of Capital account but are generally not reported. A country is said to
be in Capital account surplus if total inflows into the country (FII,
FDI and borrowing from foreign companies/banks) exceeds total outflows
(investments into foreign countries and lending to foreign countries or
companies). In case situation is reversed, country has capital account
deficit.
Payments always get balanced:
You can spend only as much money as you have. Or in other words, total
amount you spend and invest must always be equal to the money you have
earned and loans you have taken. What this means in the context of BoP
is that current account surplus must always be balanced by Capital
account deficit and if a country is having current account deficit, it
must always get equivalent money form of capital account surplus.
BoP and Forex Reserves:
Countries having floating exchange rate and free capital flows do not
have to build foreign currency reserves. But as we have seen earlier,
those who exercise some or full control over exchange rate, do so by
manipulating their Forex Reserves. The difference in current account
surplus and capital account (excluding forex reserves) deficit is
balanced by equal increase in forex reserves (China) and if country is
not able to meet current account deficit by capital flows, then it will
have to liquidate its forex reserve (current situation of India).
For example, China which has huge exports (current account surplus)
as well has huge inflows in FDI and FII, balances this by building up
huge forex reserves as well as by investing in foreign countries.
Chinese government parks large percentage of its surplus into US
government bonds and encourages its government backed and other
companies to buy assets in foreign countries (mostly US). So it
deliberately runs huge capital account deficit so that it can export.
Otherwise, it will have to let its artificially depreciated currency
appreciate. This is interesting and perhaps topic for another future
article.
Negative Feedback Mechanism
Example of negative feedback system
Wikipedia defines negative feedback as following “
Negative
feedback occurs when the result of a process influences the operation of
the process itself in such a way as to reduce changes.” In order
to understand this concept look at the adjacent diagram (Again taken
from Wikipedia). As you can see in the diagram, when water level in the
reservoir decreases, the piston stopping water flow is lifted and water
starts to pour in. When water is filled, the piston will again come down
to stop more water from pouring and this will maintain the water at
desired level. The equilibrium level of water will be determined by the
arrangement of the system rather than the flow of water.
Similar negative feedback system exists in economics. For example,
consider exchange rate and export-import. Actual situation will be very
complicated because of a large number of variable interacting together.
To keep things simple, we will consider only two variables at a time –
export-import and exchange rate. As we have discussed above,
appreciation currency causes increase in import while discourages
export. This will lead to increase in demand for foreign currency and
simultaneously increase in supply of local currency. This putting a
downward pressure on exchange rate. If government does not interfere and
there is no net capital flow, then exchange rate will quickly adjust
such that values of imports and exports are perfectly matched.
Relation between interest rate and exchange rate (Interest Rate Parity)
Another beautiful example of such feedback system is interest rate
parity. In order to explain it lets assume Interest rate for borrowing
in USA is 4% and interest one gets on government bond in India is 8%. It
will make perfect business sense if you borrowed $1000 from USA,
purchased Indian government bond and after a year you got interest of
$80. Paid $40 as interest to the bank you borrowed from, and made a
profit of $40. That without investing a single penny of your own. Such
situation where you can make money without investing any capital at all
is called arbitrage (which in itself is fascinating financial concept
and deserves a complete article on itself).
The only problem with this is it will not be only you who can think
of this. Other people too would want to make profit out of this
opportunity and soon there will be many dollars flowing from USA to
India causing Indian Rupee to appreciate in comparison to USD and
whatever gains you could make from excess interest rate will be offset
by the increase in exchange rate.
Self fulfilling prophecies or Positive Feedback
Directly opposite to the concept of Negative feedback is Self
Fulfilling Prophecies or Positive feedback. For example suppose there is
a rumor, completely unfounded, that the price of gold is going to
increase to very high in a week. People will want to profit from this
information and will buy some gold to sold later at higher price.
Initially, some people will be fooled by the rumor and buy gold. This
temporary surge in short term demand will lead to momentary increase in
price. This increase in price will give credence to the rumor, and more
people will flock in to buy gold. This will further increase the price,
pulling even more people. The rumor, which originated without any
analysis or “fundamental” cause, was the reason itself for the rumor
becoming true.
Such positive feedback are very common in our life, engineering and
economics. In context of exchange rate, sometimes positive feedback
plays a prominent role. Suppose, all the traders in foreign exchange
market believe that rupee has depreciated far below its ‘intrinsic’
value and it will appreciate in near future. In order to profit from
this anticipated gain, they will try to hoard the rupee, thus increasing
its demand and causing it to appreciate.
Opposite of this is also true. If traders believe that rupee (or for
that matter any currency) is about to depreciate, they might actually
trigger it by shorting the currency.
The paradox of negative and positive feedback
What seems to be positive feedback in short term might actually be
negative feedback if looked broadly. For example, lets look at the
currency example again. The general belief that currency has fallen far
below its true value caused it to appreciate through positive feedback
mechanism. But, at the same time it also prevented currency to
depreciate further and hence acted as negative feedback.
Existence of negative and positive feedback loops give rise to
several interesting phenomena in economics and in other areas. But the
article has already surpassed 2600 words, so I can not give many
examples. However, one example very crucial to our ongoing discussion
can not be omitted. It is what economists say
Impossible Trinity.
Impossible Trinity
The concept of impossible trinity states that a country (or an
economy) can not simultaneously have Fixed exchange rate, Free capital
flow and independent monetary policy (which roughly means control over
interest rate).
For example, suppose India pegs its currency to say Rs. 60/$ and
intends to maintain free capital flow. Now, if it sets interest rate
that is higher than that of USA, then money will start flowing in from
US to bank on this arbitrage opportunity (as we discussed earlier). So,
in order to maintain its exchange rate, it will have to buy Dollars. But
it will have a limit to how much it can buy. Similarly, if it sets
interest rates lower than US, money will start flowing out. To prevent
rupee from falling, it will have to sell off its dollar reserve. But
that can last only till its reserves gets fully depleted. Thus
government will have to set interest rate equal to that of US.
If you look closely, India, in recent times, has tried to achieve
this impossible trinity to some extent. It kept currency undervalued,
wanted foreign investors to come in, and had to increase interest rate
to contain inflation. What makes this more ludicrous is that it was
attempted when our premier is a trained economist!
Now let us look at the unprecedented devaluation of rupee more closely.
Causes
What is good for Economy is bad for Politics: India’s trade balance
is highly unfavorable. What this means is India imports far more than it
exports. In fact, Indian export is only about 80% of its imports, a
deficit of about $ 120 bn (2011). This deficit is largely balanced by
remittances (which stood at $69 bn in 2012), FDIs and FIIs.
Economically it makes sense for India to let its currency appreciate
because it will make imports cheaper and help reduce its trade
imbalance. But, appreciating currency will have negative impact on its
exports. Now, India mainly exports labor intensive goods and services –
Software services, polished diamond, textiles, processed cashew nuts,
leather goods. These sectors generate huge employment. Appreciation of
currency causes fall in the profitability in these sectors, leading to
many people loose their jobs. Looked from perspective of politicians,
this is hugely unpopular.
Even though the overall gain from appreciated rupee is far more than
the losses, gains per individual are small in magnitude and distributed
over a large population; whereas losses per individual is large and
concentrated in minority of the population. Such policies are impossible
to pursue in a democracy like India because those at loss will be far
more vocal while people at gain will not bother at all.
Under such political considerations, our government, a coalition of
several parties can not afford to be bold. So, in last 5-6 years, driven
by impressive economic growth of India, when foreign investors flocked,
there was upward pressure on the rupee. Government was unwilling to let
rupee appreciate and kept it artificially devalued. In the process it
amassed huge foreign exchange reserves (about $300bn). Where did the
government bring this money from? It simply printed the money!
Printing of more money causes inflation, another politically
unpopular thing. So, in order to curb the money supply, government
issued bonds under Market Stabilization Scheme (MSS bonds). It did curb
the inflation to some extent, but when bond matures, government has to
pay the money along with the interest. So, this scheme does not really
curb inflation, it postpones it. When those bonds matured, government
made payments, again by printing more money, as government is running
budget deficit and does not have income to pay. This caused inflation
which you might have noticed during recent times. How does government
curb inflation now? It increased interest rate to reduce the supply of
money.
Increase in interest rate caused a slowdown in growth. Also, global
economic slowdown reduced demand for India exports and exports fell too
(about 30% in last year). Import however, did not fall by that amount
because Oil, the major component of our imports, is essential commodity.
So the trade balance turned more unfavorable. Also, looking at the
slowing pace of growth new investor abstained from investing in India
and older investor too started to get uneasy. As they tried to pull back
their money, it put downward pressure on rupee.
If foreign investor expects the currency of a country to fall, it
will withdraw its investments because its investment value will fall
with the currency. For example suppose you invested $1000 at Rs.40/$. So
your investment in India is Rs. 40000. Tomorrow if rupee falls to Rs.
60/$ then value of your investment has fallen to $667. Foreign investors
fearing further fall in rupee started to flee Indian market and this
put further downward pressure on rupee (Positive feedback). Government
could interfere, but owing to its huge budget deficit, had limited
resources and rupee had a free fall. There is more to it, but the
article swelling like Dollar
Impact
Economists do not agree about impact of nominal exchange rate on real
economy. Many argue that Nominal values do not have any impact on real
economy while others claim that the effect nominal variables have on
human psychology and expectations of future does hamper real economy
(applying positive feedback, you can see how?).
Two very visible impacts are 1. increasing oil prices and 2. India
gaining competitive advantage in certain export. Why oil price is
increasing is quite obvious. The later impact needs some elaboration.
What has made the devaluation of rupee more problematic is global
slowdown. Alternatively, it might well be that this downfall was brought
about by the global slowdown. But in either cases, the demand for goods
and services in developed economy is dwindling. But demand in certain
goods like textile will not be impacted that much (people are not going
to shun wearing cloths because of slowdown). Main competitor of India in
such sector is China. During the same period when Indian rupee has been
falling, salaries of labors in China has been on the rise. This had
made Indian export more favorable.
Another impact, which may seem like silver lining in the dark cloud
is that it has forced government to bring certain economic reforms (FDI
in retail and other sectors) and has brought a near crisis like
situation which can force unwilling government to bring reforms (as it
did in 90s).
Remedy
Government has tried several things to control downward spiraling
rupee but those steps are too little, too late and many are pointed in
wrong direction; like curbing import of gold. A government should not be
telling people what to buy and what not to buy. Demand of gold in India
is culture induced. Also, demand of gold increases when economic
uncertainty increases. Trying to micromanage people’s behavior will have
undesirable impact in long term.
There are not many options in short term, but in long term government
needs to bring reforms pending for many decades. Those reforms need
strong political will and I seriously doubt it can be effected without
another crisis. Lets see!
I started out this article in response to questions students have
been asking me about falling rupee. When I set out to explain, it soon
reached epic proportions. I have a lot more to say, but 3800 words are
way too much to read in one sitting. It took me more than a week and 5-6
sessions to write. Will say more later or in comments.