Friday, November 16, 2007

Sabse Bada Rupaiya


The appreciation[1] of the rupee versus the dollar has been a matter of concern for everyone and anyone remotely related to the Indian economy. As the rupee becomes stronger, the cost of all imported goods and services reduce. This is good news for a net importer such as India. Common sense would add that since majority of India’s oil needs are imported, a stronger rupee would translate into cheaper oil imports which in turn would mean a fall in goods and commodity prices.

Quotation:

An exchange rate quotation is given by stating the number of units of a price currency that can be bought in terms of 1 unit currency (also called base currency)USD/EUR exchange rate is 1.2 means a euro (unit currency) can be purchased by 1.2 dollars ( price currency)

Direct quotation

Quotes using a country’s home currency as the price currency (e.g., Rs 41 = $1 in the India) are known as direct quotation or price quotation and are used by most countries. In direct quotation as used in India the strength of home currency is inversely proportional to the exchange rate. The higher the strength of the home currency the lower will be the exchange rate. As we all know the excahnge rate has reduced from Rs 44 levels to Rs 40 levels. But the strength of the home currency is said to be increasing in this period.

Direct quotation: 1 foreign currency unit = x home currency units

Indirect Quotation

Quotes using a country’s home currency as the unit currency (e.g., .02439= Rs1 in the India) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and Canada.

Indirect quotation: 1 home currency unit = x foreign currency units

Free or Floating Rate

Demand – Supply in the foreign exchange market decides the quotation price

Pegged/Fixed rate

The exchange rate is fixed by government and remains the same irrespective of market changes. India followed a pegged rate up till liberalization (pre-1991)

Hybrid or Dirty Float

In practice, many countries including India now have a hybrid system called ‘dirty float’. This is basically a floating rate where the government intervenes from time to time, trying to nudge the exchange rate in one direction or the other

Interest rate parity concept

Interest rate parity (IRP) states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential. If Indian interest rates exceed US interest rates then the Indian rupee should depreciate against the USD by an amount that prevents arbitrage.

However IRP showed no proof of working after 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated. This happened because

  1. Foreign exchange chased the higher yielding currency leading to appreciation of the currency.
  2. The gov did not intervene in the forex market as that would have led to increased liquidity leading to increase in inflation.
  3. This led to appreciation of the currency.

This is what we are seeing in the Indian context today.

Balance of payments

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account balance. A nation with a trade deficit will experience reduction in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation’s goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.

Fluctuations in exchange rates

A market based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply. The demand for money is highly correlated to the country’s level of business activity, gross domestic product (GDP), and employment levels. The more people there are out of work, the less the public as a whole will spend on goods and services.

A currency will tend to lose value, relative to other currencies

1. If the country’s level of inflation is relatively higher

2. If the country’s level of output is expected to decline

3. If a country is troubled by political uncertainty. For example, when Russian President Vladimir Putin dismissed his Government on February 24, 2004, the price of the ruble dropped.

The Indian context

As the mad rush to invest into India picks up steam, the demand for rupees in the foreign exchange markets will increase, which will mean the rupee, will rise in value. In the financial year 2006-2007, India received $16 billion dollars in foreign direct investment; this is about three times the previous year’s figure. Another important factor is the interest rate in different countries. If Indian interest rates rise relative to other countries, Indian interest-bearing products become more attractive; this will once again increase demand for the rupee. For instance, if the rate of interest in the US is only 4 per cent on bank deposits and a fixed deposit in India fetches, say, 10 per cent, the 6 per cent difference between the interest rates of these two countries will attract foreign investors to India. In India, the Reserve Bank of India has been raising interest rates in recent months as a way of fighting inflation; this has played a role in the rising value of the rupee.

So what is the impact of a rising rupee on different sectors of the economy?

In a nutshell, exporters are hurt and importers celebrate. The logic is simple: suppose an exporter earns $1 million in foreign exchange. At an exchange rate of 47 rupees to the dollar, this is worth Rs. 4.7 crores while at a rate of 43 rupees it’s only worth Rs. 4.3 crores. This is why stocks of export-intensive technology firms like Infosys have performed relatively poorly in recent weeks. Firms in the textile sector have also been hurt. Both the information technology and the textile sector are export-driven and are hurt whenever the rupee’s value increases. The reason is they get less rupees for the dollars they earn through exports. The opposite is true for companies with large imports. A stronger rupee means their import bill will fall in rupee terms. In India, the single biggest import is crude oil, and the rising rupee has seen stock market gains for oil marketing companies like IOC and HPCL in recent weeks. If a barrel of oil cost $ 40, it would cost Rs. 1720 if the exchange rate were Rs 43 per dollar. This would reduce to Rs 1,680 if the rupee appreciates by just Rs1 to Rs 42. This saving directly goes into the net profit kitty of oil marketing companies.

The rising rupee also has a direct impact on consumers who will face lower prices in rupees for imported goods or travelling abroad. For instance a typical weeklong trip abroad costing, say, $1000 (or Rs 42,000; $1 = Rs 42) will be cheaper because of the rise of the rupee in the last six months. The same trip would have earlier cost Rs 44,000 (assuming $1 = Rs 44).

So what’s likely to happen to the rupee in the future?

No one can say for sure as exchange rates are notoriously unpredictable. If the rupee rises significantly, you could see the RBI intervening in the markets and selling rupees in order to lower its value. As of now, it is not doing this, allowing the rupee to increase in value.

However, if India remains an attractive investment destination, the rupee is unlikely to drop significantly from its current level as foreign investments will come pouring in. But if it does ‘rise in value’ further then you and I will be able to buy that imported watch, the latest laptop and of course, oil at much cheaper rates than we are doing now.



[1] Rupee getting stronger means that one needs to shell out lesser rupees to buy a dollar.

The appreciation[1] of the rupee versus the dollar has been a matter of concern for everyone and anyone remotely related to the Indian economy. As the rupee becomes stronger, the cost of all imported goods and services reduce. This is good news for a net importer such as India. Common sense would add that since majority of India’s oil needs are imported, a stronger rupee would translate into cheaper oil imports which in turn would mean a fall in goods and commodity prices.

Quotation:

An exchange rate quotation is given by stating the number of units of a price currency that can be bought in terms of 1 unit currency (also called base currency)USD/EUR exchange rate is 1.2 means a euro (unit currency) can be purchased by 1.2 dollars ( price currency)

Direct quotation

Quotes using a country’s home currency as the price currency (e.g., Rs 41 = $1 in the India) are known as direct quotation or price quotation and are used by most countries. In direct quotation as used in India the strength of home currency is inversely proportional to the exchange rate. The higher the strength of the home currency the lower will be the exchange rate. As we all know the excahnge rate has reduced from Rs 44 levels to Rs 40 levels. But the strength of the home currency is said to be increasing in this period.

Direct quotation: 1 foreign currency unit = x home currency units

Indirect Quotation

Quotes using a country’s home currency as the unit currency (e.g., .02439= Rs1 in the India) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and Canada.

Indirect quotation: 1 home currency unit = x foreign currency units

Free or Floating Rate

Demand – Supply in the foreign exchange market decides the quotation price

Pegged/Fixed rate

The exchange rate is fixed by government and remains the same irrespective of market changes. India followed a pegged rate up till liberalization (pre-1991)

Hybrid or Dirty Float

In practice, many countries including India now have a hybrid system called ‘dirty float’. This is basically a floating rate where the government intervenes from time to time, trying to nudge the exchange rate in one direction or the other

Interest rate parity concept

Interest rate parity (IRP) states that an appreciation or depreciation of one currency against another currency might be neutralized by a change in the interest rate differential. If Indian interest rates exceed US interest rates then the Indian rupee should depreciate against the USD by an amount that prevents arbitrage.

However IRP showed no proof of working after 1990s. Contrary to the theory, currencies with high interest rates characteristically appreciated rather than depreciated. This happened because

  1. Foreign exchange chased the higher yielding currency leading to appreciation of the currency.
  2. The gov did not intervene in the forex market as that would have led to increased liquidity leading to increase in inflation.
  3. This led to appreciation of the currency.

This is what we are seeing in the Indian context today.

Balance of payments

This model holds that a foreign exchange rate must be at its equilibrium level - the rate which produces a stable current account balance. A nation with a trade deficit will experience reduction in its foreign exchange reserves which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation’s goods (exports) more affordable in the global market place while making imports more expensive. After an intermediate period, imports are forced down and exports rise, thus stabilizing the trade balance and the currency towards equilibrium.

Fluctuations in exchange rates

A market based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply. The demand for money is highly correlated to the country’s level of business activity, gross domestic product (GDP), and employment levels. The more people there are out of work, the less the public as a whole will spend on goods and services.

A currency will tend to lose value, relative to other currencies

1. If the country’s level of inflation is relatively higher

2. If the country’s level of output is expected to decline

3. If a country is troubled by political uncertainty. For example, when Russian President Vladimir Putin dismissed his Government on February 24, 2004, the price of the ruble dropped.

The Indian context

As the mad rush to invest into India picks up steam, the demand for rupees in the foreign exchange markets will increase, which will mean the rupee, will rise in value. In the financial year 2006-2007, India received $16 billion dollars in foreign direct investment; this is about three times the previous year’s figure. Another important factor is the interest rate in different countries. If Indian interest rates rise relative to other countries, Indian interest-bearing products become more attractive; this will once again increase demand for the rupee. For instance, if the rate of interest in the US is only 4 per cent on bank deposits and a fixed deposit in India fetches, say, 10 per cent, the 6 per cent difference between the interest rates of these two countries will attract foreign investors to India. In India, the Reserve Bank of India has been raising interest rates in recent months as a way of fighting inflation; this has played a role in the rising value of the rupee.

So what is the impact of a rising rupee on different sectors of the economy?

In a nutshell, exporters are hurt and importers celebrate. The logic is simple: suppose an exporter earns $1 million in foreign exchange. At an exchange rate of 47 rupees to the dollar, this is worth Rs. 4.7 crores while at a rate of 43 rupees it’s only worth Rs. 4.3 crores. This is why stocks of export-intensive technology firms like Infosys have performed relatively poorly in recent weeks. Firms in the textile sector have also been hurt. Both the information technology and the textile sector are export-driven and are hurt whenever the rupee’s value increases. The reason is they get less rupees for the dollars they earn through exports. The opposite is true for companies with large imports. A stronger rupee means their import bill will fall in rupee terms. In India, the single biggest import is crude oil, and the rising rupee has seen stock market gains for oil marketing companies like IOC and HPCL in recent weeks. If a barrel of oil cost $ 40, it would cost Rs. 1720 if the exchange rate were Rs 43 per dollar. This would reduce to Rs 1,680 if the rupee appreciates by just Rs1 to Rs 42. This saving directly goes into the net profit kitty of oil marketing companies.

The rising rupee also has a direct impact on consumers who will face lower prices in rupees for imported goods or travelling abroad. For instance a typical weeklong trip abroad costing, say, $1000 (or Rs 42,000; $1 = Rs 42) will be cheaper because of the rise of the rupee in the last six months. The same trip would have earlier cost Rs 44,000 (assuming $1 = Rs 44).

So what’s likely to happen to the rupee in the future?

No one can say for sure as exchange rates are notoriously unpredictable. If the rupee rises significantly, you could see the RBI intervening in the markets and selling rupees in order to lower its value. As of now, it is not doing this, allowing the rupee to increase in value.

However, if India remains an attractive investment destination, the rupee is unlikely to drop significantly from its current level as foreign investments will come pouring in. But if it does ‘rise in value’ further then you and I will be able to buy that imported watch, the latest laptop and of course, oil at much cheaper rates than we are doing now.



[1] Rupee getting stronger means that one needs to shell out lesser rupees to buy a dollar.

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