[Economy 4 Newbies] Currency Devaluation, Dollar-Rupee Exchange RATES

[Economy 4 Newbies] Currency Devaluation, Dollar-Rupee Exchange RATES

[Economy 4 Newbies]

Currency Devaluation, $ to Rupee Exchange Rate

By

VENKATESH

P.S. Examples given in this articles are neither politically nor technically 100% correct.

First read the Balance of Payment (BoP) article, to understand this concept better. (Click Me) 

Consider this example.

1$ = 50 Rs.

Price of one diamond = 50 Rs.= you can buy only 1 diamond in 1$

Now Suppose, RBI and Govt. of India declares that from now on 1$ will be equal to 100 Rs.

Then ??

1$= 100 Rs= 50+50 = you can buy 2 diamonds in 1$!

So as an American you’ll import lot more, if the Rupee is ‘devalued.’

Devaluation means

-         The reduction of something's value or worth

-         An official lowering of a nation's currency; a decrease in the value of a country's currency relative to that of foreign countries

Timeline of Rupee Devaluation

-         Before 1966: 1$ = 4.76 Rs.

-         In 1966: 1$= 7.50 Rs. (Rupee was devalued for the first time)

This is ‘fixed rate system’ means Govt. says 1$= 7.50 Rs. = it’s permanent; It doesn’t keep changing every now and then. This fixed rate system is also known as ‘Bretton Woods system’ or ‘pegged currency’

This system was abandoned by most countries in 1973.

India also abandoned this ‘Fixed Rate system’ in 1975, and moved to the floating rate system. In the Floting rate system , the market forces of supply and demand decide the value of Dollar and rupee.

Why Devaluation ?

Like I showed ago, if Rupee is devalued, Americans can buy more diamond in 1 dollar = Export increases.

China uses this strategy. They intentionally keep their Yuan weak compared to Dollar. So in 1 Dollar, the Americans can import more ‘quantity’ of products from China, compared to India.

This way, China is major exporter of most electronic and consumer items, because its cheap!

Thus, China made a huge Foreign Exchange reserve by exporting.

Currently China has more than 1400 Billion Dollars in their reserve! While India has only about 270 Billion Dollars in its reserve.

Then lets do Rupee Devaluation?

Now if you think we should also keep our Rupee very weak (like 1$= 5000 Rs.)  to boost our exports and get lot of Forex like Chinese… you are forgetting something.

When you declare that 1$= 5000 Rs. Then obviously, Americans will import a LOT from India. But

When you’re buying Crude Oil Barrels from Middle East, you’ve to Pay in Dollars!!

Suppose if 1 Oil Barrel ‘s price was 1 Dollar, then now you’ll have to pay 5000 Rs. To buy just one Barrel! (earlier you were paying only 50 Rs. To buy one barrel.)

Thus diesel & petrol becomes very costly, = road transport cost increased = milk, veggies and everything transported by trucks become very costly.=inflation. So whatever money you gained in export, you lose here.

That’s why  you’ve to maintain a fine balance between your Rupee’s Value against Dollar vs. How much import items you need to run your Country + the well being of your citizens.

In short

1.    Devaluation increase exports and decreases imports

2.    Devaluation gives a price advantage to the exporting contry.

How does Currency Devaluation help in Solving BoP Deficit

-         In BoP Deficit, you’re importing more than what you’re exporting.

-         When your currency is devalued, your export increases (1$ buys 2 diamonds)

-         And you decrease your import (people will stop using cars, when 1 Liter petrol is sold for 5000 Rs.)

-         Thus Export is increased and import is decrease = Deficit solved!

Why India had to go Devaluation?

1966 Economic crisis

·       Since 1950, India ran continued trade deficits because of the Quota-Licence-inspector raj. (Already explained in LPG article, click me to read.)

·       Government of India had a budget deficit problem and could not borrow money from abroad or from the private corporate sector.

·       As a result, the government issued bonds to the RBI, which increased the money supply, leading to inflation.

·       In 1966, America stopped foreign aid to India (because Americans were friendly to Pakis) and we were fighting Indo-Pak war of 1965. During this war, Govt.’s 25% expenditure was spent in fighting pakis.

·       All this lead to problems, you’ve high inflation, you don’t have enough money to buy crude oil. And you can’t  print more money to buy crude oil (click me to know why) ,

·       so what will you do? You’ve to boost your exports to earn from $$. And for that you’ve to reduce the value of your Rs.

·       Same thing had to be done in 1991, due to BOP crisis.

Who exactly determines the Exchange Rate?

·       1$= 50 Rs. =this is exchange rate, but who exactly determines this?

·       In 1991, India still had a fixed exchange rate system, where the rupee was pegged to the value of a basket of currencies of major trading partners. (= Central  Govt. + RBI deciding 1$ = will be equal to how many rupees?)

·       But then they had to liberalize and Nowadays, it’s the market forces of Supply and demand who will decide the Exchange rate. = it’s the players @ Foreign Exchange market.

What is foreign exchange market (forex, FX, or currency market)

·       Its a worldwide financial market for the trading of currencies.

·       (just like you’ve sharemarket to sell and buy shares)

·       The foreign exchange market allows businesses to convert one currency to another.

For example, you’ve a factory in Noida to make bikes, you sell these bikes in India = you earn in Rupees. But the engines of those bikes are imported from America, so you’ve to pay in Dollars to that American supplier. So how will you get dollars? Simple, go to the Forex Market, give you rupees and buy the dollars. Here the ‘supply and demand’ rules will decide the value of 1$= How many rupees.

Its almost same like vegetable market, today it can be 10 Rs. Per kg potato, tomorrow it might go 20 Rs. /kg, depending on demand and supply.

Consider this talk @ Forex Market

Rupeeguy: hey man! take this 50 Rs. And give me 1 dollar.

$ guy: dude, we’ve only few dollars, and I know you’ve plenty of Liquidity In India, your economy is booming and you people are earning lot of money. so give me 100 Rs. Otherwise I’ll not sell. (=$ supply is low)

Rs.Guy: damn it, anyways I need to pay $$ do my American supplier so here take this 100 Rs. And give me 1$. (=$ demand is high)

=Rs. Is devalued

Let see another deal.

Suppose American banks pay 18% interest rate on your deposit. And Indian Banks are giving only 7% interest per year on your deposit. Then? If you’re a big player, you want to put your money in American banks. but they’ll accept only dollars. So what will you do? You go to the Forex Market to get your Rupees converted into Dollars. But After a few days, there will be huge rush to buy Dollars. So value of Rs. Will decrease.

Rs.guy = hey man take this 50 Rs. Give me 1 $

$ Guy= I know you want to put that dollar in American bank to earn high interest! I’ve plenty of people offering me more than 100 Rs. To get 1 Dollar, so you better give me 100 Rs. Or get lost from here.

Rs. Guy= Ok I agree.

(= rupee is devalued)

3^{rd deal}

^{There is economic boom in India. If you start a mobile phone factory in Noida, then you can make a mobile only for 500 Rs and sell it for 1000 Rs. = 100% profit.}

^{Now you’re a Rich American, and American banks are giving you only 18% interest rate for your deposits. = you’re earning only 18% profit, so You want to invest your money in setting up Mobile phone factory in India. (= Foreign direct investment/FDI)  but for that you’ve to buy land, cement, labors and they’ll accept payments in only Rupees. So you’ll go to Forex market, to get your Dollars converted into Rupees.}

^{$ Guy= take this 1$ and gimme 100 Rs.}

^{Rs.Guy= I know you’re going to invest it in India and get 100% profit, plenty of Americans like you are offering me Dollars. So give me 2$ and I’ll give you 100 Rs. Otherwise get lost from here.}

^{$ Guy= well that still better than parking my $$ in American banks and earn only 18% interest. so ok, I accept, here are 2$, give me 100 Rs. [1$=50 Rs.]}

^{(=Rs. Is revalued)}

^{However things are not this straightforward in real life deals.}

^{Many factors including rumors, Govt. policies, Tax rates, speculative purchase etc. will shift the trends in currency trading, just like your sharemarket.}

^{RBI and Central  Govt. will not intervene in minor fluctuations. They’ll let the market forces of supply and demand decide the exchange rates and play their games. But if there is major problem, then RBI & Central  Govt. will intervene to stop the heavy fluctuations.}

^{Weapons of RBI to control Exchange Rate}

^{Monetary policy}

^{For example,}

^{IF there is plenty of liquidity in Indian market. (= lot of Rs. In circulation)  thus, within India you’ll not get good interest rates from bank and not high profit from your investment so you want to park your Rs. Abroad. = supply is more= Value of Rs. Will go down. Hence 1$ =100 Rs.}

^{So RBI will step in and change the CRR,Repo,Reverse Repo, Bank rates etc. to suck up the extra liquidity  in market. And value of Rs. Will go up. Thus 1$ becomes 50 Rs.}

^{FERA & FEMA}

^{If there is too much dollars in Indian Market or if there is too less Rupees in Indian market, then Exchange Rates will change. (based on supply-Demand principles).}

^{If there are fluctuations like today 1$= 49 Rs. And after 15 days, 1$=47 Rs. This is normal healthy fluctuation but if there is sudden drastic change like in 15 days, 1$=100 Rs. that means bad guys are not playing by the rules. So to prevent such things, we’ve certain Laws.}

^{Foreign Exchange Regulation Act  of 1973 (FERA) (repealed in 2000.)}

^{Foreign Exchange Management Act (FEMA),1999}

^{By these acts, RBI is empowered to oversee and control the forex markets within india.}

^{And the Enforcement Directorate (ED) get the power to investigate and prevent leakage of foreign exchange which generally occurs through the following malpractices :}

^{·        Remittances of Indians abroad otherwise than through normal banking channels, i.e. through compensatory payments. (eg Many Indian living abroad send money to their wives and relatievs via Hawala)}

^{·        Acquisition of foreign currency illegally by person in India. (for example, Ashwarya Rai faced inquiry from the Customs department, which has stumbled upon a mysterious postal parcel addressed to her containing 65,000 euros (Rs.3.7 million) in cash. In another case The ED found evidence of alleged 50 Lakh hawala payments by a Dubai event manager to Ash, and others. (refer CNN-IBN)}

^{·        Non-repatriation of the proceeds of the exported goods.}

^{·        Unauthorised maintenance of accounts in foreign countries.}

^{·        Under-invoicing of exports and over-invoicing of imports and any other type of invoice manipulation.}

^{·        Siphoning off of foreign exchange against fictitious and bogus imports.}

^{·        Illegal acquisition of foreign exchange through Hawala.}

^{·        Secreting of commission abroad.}

^{Third trick is current and capital account convertibility (will write about it in another article.)} 

^{RBI’s own Forex Reserve}

^{Another trick- when 1$= 100 Rs. This means, the dollar supply is low in the market compared to Rupee supply. So RBI will release the dollars from its Forex reserve, or sell its gold in foreign market and buy some dollars and release them in Indian Market.}

^Revaluation

^{·       In the period 2000–2007, the Rupee stopped declining and stabilized ranging between 1 $ = 44–48 Rs..}

^{·       In  2007, it was 1$ = 39 Rs. , on sustained foreign investment flows into the country .}

^{·       This posed problems for major exporters and BPO firms located in the country.}

^{·       The trend has reversed lately with the 2008 financial crisis.}

^{Table: Value of 1 Dollar to Rs.}

^{(just to reference, you don’t have to remember every value in it.)}

^{·       1970= 7.576}

^{·       1975= 8.409}

^{·       1980= 7.887}

^{·       1985= 12.369}

^{·       1990= 17.504}

^{·       1995= 32.427}

^{·       2000= 45.000}

^{·       2006= 48.336}

^{·       2007 (Oct)= 38.48}

^{·       2008 (June)= 42.51}

^{·       2008 (October)= 48.88}

^{·       2009 (October)= 46.37}

^{Now a sidenote- currency devaluation and building Forex Reserve.}

^{Advantages of Huge Forex reserves.}

^{Now you might wonder what exactly is the use of building a huge Forex Reserve by keeping the currency devalued / weak, like China has done? And why do they keep the value of Yuan very low compared to Dollars?}

^{Well Huge Forex has its own uses… lets see}

^{Indo-China War}

^{Suppose China and India goto war against each other. (and assuming that no one will intervene to stop the war and they will not use nuke missiles.)}

^{Now what items do you need the most during a war?}

^{1.    Missiles, guns, bullets, bombs.}

^{2.    Medical supplies}

^{3.    Diesel, Petrol}

^{4.    Fighter jet planes}

^{Diesel, Petrol is most important in war because}

^{1.    You need to transport your soldiers to the borders using aero plane , trucks, trains,}

^{2.    You need to setup base camps in remote jungles, but you need electricity to maintain communication with your Head Quarters= you need wireless sets, and to run them, you’ll need diesel generators.}

^{3.    If you want to use Jet-Fighters planes like MiG, to attack on enemy’s positions, then again you need very expensive type of petrol to run those Jet Fighter planes.}

^{4.    Battle Tanks like Arjun don’t give an average like Bajaj’s Bike (1 Litre goes 100 km)  so again you need lot diesel to run these tanks.}

^{·       So ultimately, you’ll have to import huge quantity of crude oil to run a war, and your foreign exchange reserve (whatever dollars or gold you’ve in RBI) = will be reduced.}

^{·       And you can’t print more money to buy oil from middle east. (read my BoP article to know why?) + if the United Nations intervenes, then they’ll place trade and arms embargo on us (= quantitative restrictions on your oil imports)}

^{·       As you know we’ve only 270 Billion $, while China got 1400 Billion $ in their forex, so ultimately our pockets will get empty before their pockets go empty,}

^{·       And there will be no diesel in our tanks and fighter planes and they’ll win the war.}

^{·       Same is the reason why we’ll win against Pakis in a traditional war.}

^{China-America War}

^{·       Lets assume China and America go to war against each other. (again assuming nobody intervenes, and nobody uses nuke missles.)}

^{·       Both have got plenty of money so buying Oil is not a problem for them.}

^{·       But China has 1400 Billion Dollars in their Forex reseve.}

^{·       Suppose it sends all those dollars in American market, then?}

^{·       Suppose China buys plenty of cars, food, etc from American market using the same American Dollars?}

^{·       Too much liquidity in America= everyone has more $$ in pocket than the physical products available in the market. = heavy inflation =1 potato will sell in 1000 $}

^{·       So American economy will collapse. And ultimately they’ll have to declare a ceasefire.}

^{Infact China doesn’t even have to go on a ‘traditional war’, all they need to do is just flood American market with Dollars without firing a bullet and let the economy of America collapse. Americans will automatically accept their defeat. Same case, for China vs. France / Russia / Britain/ Canada or any other 1st world nation.}

^{Thus, having a big Foreign Exchange reserve – makes China a nation, feared and respected by the Western World compared to India.}

^{Low Forex Reserves, is one of the many reasons why India is not getting a permanent seat in UN Security council.}

^{Role of Forex Reserve in Foreign Policy}

^{-         When you’ve plenty of Forex, you can give loans or ‘Donations’ to poor nations in Africa, and then they’ll support your every resolution and policy in United Nation’s General Assembly! They’ll even support your permanent seat in security  council (UNSC)}

^{-         China is buying lot agriculture land in poor African nations & in that land, they’re growing Maize and other crops to produce bio-dieasel. = again China doesn’t have to worry about Crude oil like India. (=getting powerful for war)}

^{-         You can buy latest fighter jets, missiles, bombs, machine guns from France and America. (=again getting powerful for war)}

^{And finally, you can use  that Forex reserve to import pulses, sugar, wheat etc. to control food prices with in your domestic market.}