Does Weak currency mean Weak Government?

Author: - Ashish Aggarwal

College: - NMIMS, Mumbai (Capital Markets)

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

 Chart 2: Value of Crude Oil in international market

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.

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.

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Behavioral finance - Logic, Psychology, Economics & More ! ! !

Author :Rachit Srivastava , NMIMS 

Economics is probably the science that arguably has had the most impact in today’s times. In fact it can barely be called a science in a strict sense, since human behavior is not governed by laws of nature unlike other non living objects, which makes the prediction and forecasting stock prices, economic conditions  all the more difficult.  In recent decades economists have tried to give a more structured and mathematical explanation to their theories concerning how human beings make their decisions. However these theories have come under immense criticism as they don’t hold true in real time. In reality, human beings rarely behave rationally which is the basic assumption in many of the economic theories; rather we make a lot of our decisions based on our intuition and limited knowledge available to us. When the financial crisis of 2008 came upon us, a lot of questions were raised on the apparent predictive abilities of the various economic theories. Merely 12 economists were able to foresee the massive crisis which now shows signs of deepening into a double dip recession.

Since then economists have looked at alternative theories to explain and predict the real world dynamics. This is where the behavioral economics comes in. Among other things, it seeks to explain why humans behave how they behave, what are the impacts of this in the economy (here we are particularly concerned with financial markets), how we can avoid various biases to make better investment decisions.

What is the role of investor’s confidence in the financial markets? Why a downgrade of the US treasury sends ripples in the stock markets all over the world .How do investors react to such kind of information? Do we take all the information into account before making an investment decision?  Can we really predict the stock prices?

In 1985 Werner Bondt and Richard Thaler published a research paper “Does the stock market overreact?” forming the start of what has become known as behavioral finance. They discovered that people systematically overreact to unexpected and dramatic news events results in substantial weak-form inefficiencies in the Stock market. This was both surprising and profound.

Behavioral finance is a relatively new branch of economics which is gaining acceptance in the academic as well as non academics world. In simple language, is seeks to explain how various social and psychological attributes of human beings  affect their behavior, particularly decision making, while making financial and investment decisions. What drives us to make seemingly rational yet blatantly irrational decisions?  For example; even when people were constantly warned by experts that Speak Asia, an alleged market research company was nothing more than a Ponzi scheme, they still invested money in it. What drives this brave risk taking behavior on one hand and loss aversion on the other?

An interesting TED talk by Dan Ariely points this flaw in humans out, “Are we control of our own decisions” he asks. The crux of his point was that human beings have a very strong tendency to make decisions not in absolute, but in relative terms. Dan Ariely is a behavioral economics professor at MIT, a very interesting experiment he did to prove his point was as follows: He presented the students at MIT with the following economist newspaper subscription advert.

	Subscription Type	Subscription price (Yearly subscription in $)	Percentage of students who took the option.
1.	Print only	75	16%
2.	Online only	125	0%
3.	Print and online both	125	84%

 

He then did the same experiment again, only this time he removed option number 2;

	Subscription Type	Subscription price (Yearly subscription in $)	Percentage of students who took the option.
1.	Print only	75	75
2.	Print and online both	125	35

That point that he makes here is that when there was option 2 present , we not only tend to compare between option 2 and 3 but we also tend to ignore option one ,thus reaffirming the fact that we  think relatively. This can have potential impact on the way investors and brokers choose portfolios etc.

How do human beings look at random events? There have been numerous theories in the field of risk analysis and psychology about randomness, both measurable and non measurable. Yet human behavior assigns value to random events which are not rational. Nicholas Taleb has captured the essence of how human beings respond to random events in his bestseller “Fooled by Randomness”. Among other things he talks about how human beings attribute their success to themselves and hard work and failures to others performances, how we focus  more on one success story and ignore thousands of failures ( survivor ship bias) ,how we tend to respond differently when the same scenario is presented to us in different forms, and so on. In his other book The Black Swan Prof. Taleb talks about how we perceive and ignore to some extent highly improbable events which have a huge impact , e.g.; financial crisis.

Anchoring, one of the most evident biases occurs when our brain gets fixated on the first information that we receive. For example, a professor asks two kids to estimate the pop of country xyz and the first one gives the answer 10 mn. Now it is almost certain  that the second boy would give an answer which would be very close to 10 mn or very far away, because he got hinged on the figure 10 million.  

People also tend to act “foolishly” when it comes to picking portfolios. A research done by The Economist newspaper through an investment research firm about how good people are at picking portfolios showed that people particularly in U.S chase fads. The statistics showed that investors tend to invest in funds that have had strong returns in the past 12 months. But, these popular funds lost steam subsequently and performed lower than the average. The statistics showed that the most popular sectors declined in terms of returns after people invested heavily in them.

We now move to another aspect of human behavior, which is loss aversion. Loss aversion is the human tendency to value losses more than proportionate gains, that is, they assign a value to loss which is higher to the value assigned to a gain of equal amount. Risk has been central to trading not just in the financial markets but in the olden days as well. Multiple theories are present to show how humans judge risk, how they accept some gambles and reject others. There was the expected utility hypothesis, which stated that we ascertain whether to take a bet or not on the basis of utility derived.

Another theory by Daniel Kahneman and Amos Tversky called the Prospect theory, explains how humans attach values to different gains and losses rather than the final outcome, and thus take or avoid risk. They say that since human beings derive different utility from the same event and they tend to value outcomes that are certain more than uncertain outcomes. In general empirical studies have shown that humans are risk averse, and they value loss more than gains from a bet, which means that wealth shows diminishing marginal utility.

There is a lot of research work going on in this particular field, more so since the crisis of 2008. The purpose of this article was to make readers aware of the subject .Behavioral finance is an interesting mix of logics, psychology and economics. Budding investors and management students should look into this in more detail so that they are better equipped to make financial decisions.

 

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