Author: - Ashish Aggarwal
Before
answering this million dollar question, I would like to give brief introduction
about exchange rates and how they are determined.
Exchange
rate is defined as value of a country’s currency in terms of another country’s
currency. Exchange rates are determined through forces of demand and supply.
For example dollar-rupee exchange rates will depend on how the demand-supply
forces moves. When the demand for dollars in India rises and supply does not
rise correspondingly, each dollar will cost more rupees to buy.
Important
point here to be understood is where this demand/supply does come from?
Sources of Demand: -
Most
important source of demand is Importers which needs Dollars (foreign exchange)
to buy goods and services.
Other
very important source of Demand is Companies / Individuals investing abroad.
Other
important sources of Demand include companies sending profits back to their
home country.
Sources of Supply:-
Again
we can say that most important source is Exporters who sell goods and services
and earn Dollars (Foreign exchange)
Other
very important source of supply is Companies / Individuals investing into
Indian markets.
Other
important sources of supply include Indian MNCs sending profits back.
We
can see that the factors that contribute to the demand for a currency are
mirror images of those that add to their supply.
Rapid increase in value of dollar in recent
times
We
(India) have witnessed a rapid increase in value of Dollars in recent times
which mean there is a change in forces of Demand and supply, obviously demand
has outgrown supply of dollars.
There
are 2 basic factors that have led to the change in this equation. Firstly,
FII’s (Foreign Institutional investors) that have been pumping billions and
billions of dollars until few months back, have been desperately pulling money
out of India and putting it into safer havens like USA and Germany.
Secondly,
Trade deficit gap i.e. gap between values of our Imports and values of our
exports has widened i.e. exporters are not able to bring in as much dollars as
our importers are giving out and hence demand is more than its supply.
What could have efficient government done to
solve the problem?
Solving
first problem i.e. of getting FII’s to put money into India. This problem has
two dimensions to it, they are
First,
FII’s have been pulling money out of India because of financial crisis facing
them in their home market. So they are looking for safe heavens and right now
with Euro zone’s Euro and Japan’s Yen in a mess there is no other safer and
stronger asset than US Dollars.
Second
FII’s are pulling out their money from Indian markets because of slowing rate
of growth of Indian economy.
It
will be totally unfair to say that government can solve or handle the first
dimension of this problem as it is a global phenomenon and Indian economy still
is not big enough to influence world events.
Looking
at second dimension, yes image of India has taken a hit due to following recent
events like
·
Retrospective amendments
·
Going back on FDI reforms in Retail and
aviation sector
·
Various corruption charges against
ministers of central government
·
Increasing Fiscal Deficit
Obviously
an efficient government would have tackled it and have saved image of Indian
economy.
Question
to ask here is that if second dimension of problem is taken care than would it
stop FIIs from pulling their money back from India.
Answer
is NO, because global crisis is a phenomenon much bigger than then few wrong
events occurring in Indian economy. Investors would still have ran towards safe
havens and India is not even close to be known as safe haven by any stretch of imagination. This means money (dollars)
would still have flown out of India.
To
make my argument more convincing I would like to lay stress on fact that India
is expected to grow at 6% to 6.5% this year which is better than almost all the
countries of the world but still investors are not willing to take risk in
current situation and are running toward safe heavens.
Basically
the fact is whenever financial crisis happens investors moves towards safe
heavens as risk appetite reduces during financial crisis.
Solving
second problem i.e. of Trade deficit gap. This problem has come up due to
decreasing growth of values of exports as compared to values of import.
Again
this problem can be broken up into two first lower growth in exports and second
higher growth in value of Imports.
First
part i.e. lower growth in values of export is mainly due to lowering demand in
Europe and US which can again be attributed to financial crisis in Europe and
doubts about growth of US economy.
Second
part i.e. higher growth of imports, basically our Imports depends on price on
Crude Oil in international markets and not on strength of government in India.
Following
two charts will illustrate this fact
Chart 1: Value of Oil Imports of India
Source:
- International Monetary Fund – 2011 World Economic Outlook
Let us look at the trend after 2002 because
that is when India rapidly industrialized.
During
the period 2003 to 2008 there was increase in prices of crude oil from 26$ per
barrel to 140$ per barrel similar trend is visible in value of Oil import by
India.
Also
we can see that slope of both the curves are in coherence.
After
2008 till 2010 we can see Crude prices falling from 140$ per barrel to around
75$ per barrel similar trend is seen in value of Oil import by India
From
this we can easily see that value of our oil imports depends heavily on price
of crude oil in international market.
Now
since 70% of our import bill is Oil imports that mean our imports are heavily
dependent on price of crude oil.
Hence
above argument proves that Increase in trade deficit in current conditions in
case of India is due to global phenomenon and not because of ineffective
government.
So
far the discussion put forward has been India specific; now let’s talk about
various other reasons why we can’t say that weak currency is an indicator of
weak government.
Following
are some of the reasons:-
· Many
strong countries want weak currency: - Two prominent
examples for such countries are Japan and China. This is because it keeps prices
of their export lower so that its products and services become attractive for
consumers in other countries. This helps them increase production which creates
more jobs and also gets foreign currency which ultimately leads to overall
growth of economy of the country.
· Role
of Speculations: - In any
market, expectations and speculation play an important role. For example, when
there is an expectation that the dollar will rise against the rupee, exporters
tend to hold back their earnings in the hope of getting a higher rate.
Similarly, importers will try and buy as much as they can today,
adding to the current demand and making the dollar rise even more.
All this skews the supply-demand equation even further and thus
setting off a vicious cycle.
Does weak government
means weak currency?
Again
we need to see how can weak government affect demand supply equations?
Following
are some of the adverse effect of weak government: -
Loss of investor’s confidence:
- perhaps the most adverse effect of political instability is on investor
confidence. There may be certain policies that may not be in the interest of
business or government may not be working in larger interest of economy,
government may not be strong enough to take unpopular but necessary decision
like increase in fares of public transport or increase in fuel prices or
reduction in subsidies, All these can lead to lack of investor’s confidence in
future growth of country making him pull out his money from the market of that
country.
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Poor business environment:
- Poor business environment means high taxes, unclear tax regime, poor law and
order, difficulties in setting up new business, lack of infrastructure like
lack of roads and electricity etc all this results in lesser production for
domestic companies which results in lesser revenues also it discourages foreign
companies to invest in the country leading to lesser inflow of foreign exchange
in form of foreign direct investment again adversely affecting demand and
supply situation.
Poor Fiscal Management:
- Generally it is seen that ineffective government are unable to keep their
expenditure under check and there is excess of expenditure over revenues. As
such governments have to borrow more and more money which increases their
borrowing cost and country with fiscal deficit needs to pay more for each
dollar they borrow.
Uncontrolled Inflation:
- High inflation may persist in such countries because of supply side problems.
High inflation is dangerous for overall health of economy as it may lead to
lack of savings and more of spending which further increases inflation, as a
result Interest rates are higher in such countries leading to increased cost of
borrowing and hampering the growth of business.
All
of these may or may not occur simultaneously but all of them are harmful for
growth and development of an economy.
Cause
|
effect on Supply of dollar
(Foreign Exchange)
|
effect on Demand of
Dollar(Foreign exchange)
|
Effect
on currency
(Weakens
or strengthens)
|
Loss
of investor’s confidence
|
Reduced
|
No Direct impact
|
Weakens
|
Poor
business environment
|
Reduced
|
No Direct impact
|
Weakens
|
Poor Fiscal Management
|
No Direct impact
|
Increases
|
Weakens
|
Uncontrolled Inflation
|
Reduced
|
Increased
|
Weakens
|
Above
table summarizes ill effects of weak and inefficient government and we can see
that weak government does leads to weak currency.
Conclusion
From the above argument
it can be concluded that weak currency does not necessarily means weak
government, just by looking at state of currency we cannot say much whether the
government is weak or not, we need to carefully analyze causes for weakness in
the currency to determine whether it is due to some global phenomenon or
whether country has intentionally kept its currency weak or whether it is due
to weak government.
Vice Versa, i.e. if we
have weak government at centre than surely currency of the country is going to
be weak.
