USC Graduate Series Week 2 speaker: Naikaj P. Bhobe ! !Topic: Everything about Currency!Date: 25 January 2014

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Everything about currency Factors affecting a country’s currency: Long Term factors:

1. Inflation: Inflation is inversely proportional to currency strength.

2. Productivity Growth: We mentioned Inflation above, the equation of which is M*v=P*y. At the RHS, if the productivity i.e. y decreases, the General Price level i.e. P has to go up. When people get more productive it puts down inflation and pushes up GDP, simultaneously. This results in strengthening of the currency.

3. Fiscal Health of the government: More debts and more trade deficit means a weak currency.

4. GDP growth: When everything else is the same, the currency of a growing economy is stronger than that of a weak economy.

Medium Term factors: 1. Trade Imbalance: When a country has imports>exports, the currency will weaken. 2. Capital Outflow: China and Japan invest a lot in the US (through treasuries) and this

capital outflow weakens their currencies. 3. Interest rates. Higher interest rates attract more capital. 4. Restrictions on capital flow. If more restrictions are imposed, currency weakens in the

medium term, though in the long term things can even out if everything else is the same. 5. Investment opportunities. If the economy is open to investments and there are a number of

attractive, investable assets, currency moves up due to inflows. 6. Political stability. 7. Health of the financial system & banks.

Short Term factors: 1. Portfolio investments from Foreign Institutional Investors (FII) and domestic institutions.

Investment flows push up the currency and vice versa. 2. Stability and fiscal condition of neighbours or peers in the same economic category. 3. Market psychology of traders in the global Forex market. 4. Major purchases or sales of the currency by businesses 5. Trading actions of the central bank 6. Stock market and real estate market movement 7. Change in consumer habits: Touring overseas more or having a fad on imported goods can

definitely push down the currency of a country. Why is the value of the rupee falling since its devaluation in 1991? Devaluation  is usually a conscious process of controlling currency in a fixed rate  regime. To do this, the government  (that controls the Forex market  tightly) just has to announce that they are moving to a new level against the dollar. Below I have explained the real long term reason for the fall of rupee.

1. Over the last two years, US inflation has average at about 2% per year. In contrast, Indian inflation has averaged at about 10% per year. What this means is that each year, the dollar loses around 2% of its value due to rising prices, and the rupee loses around 10% of its value due to rising prices. 

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2. Thus, over a 2-year period, the dollar is worth 4% less, and the rupee is worth 20% less. Another way to say this is that the dollar has gained 16% against the rupee over the last two years, simply due to inflation. Now, if the rupee has fallen by 18% against the dollar over the last years, we can see why this is the case. 

3. The fact is that almost all of the rupee's fall against the dollar can be explained by the difference in inflation rates. If we look the performance of the rupee against the dollar in real terms (i.e. adjusting for inflation), it has actually fallen by only 2%, not 18%. 

4. Now, if we analyze the movements of the dollar and the rupee over short and medium term timeframes, we do see a lot of volatility. Various economic events move the currency in different directions over short-term periods. But once we take a long-term view, the only factor that is relevant to explaining the rupee's fall is inflation. 

5. As long as  India's inflation rate  is significantly higher than the US inflation rate, we can expect that the rupee will fall against the dollar over time. And this is not necessarily a problem. High inflation is problem that has many negative consequences, and this is what we should be most concerned with.  !

Why does a Nation devalue its currency? Let us consider a planet with only 3 countries (for the sake of simplicity). Let’s assume these countries are India (Rupees), China (Yuan) and USA (Dollars).  Initially they were all self-sufficient, with each of the countries producing all the rice, vegetables, brick and clothes required for all their inhabitants. Things are working so great since eternity. Now, some villagers in USA found a new, faster way to make bricks.  Thus, they started producing faster than the villagers there could buy.  So, they thought they could sell some of them to the villagers in  China that is going through a rainy season. In return for the bricks,  China guys thankfully gave some rice. USA guys didn't need much rice, so they were willing to offer only one brick for every 10 bags of rice. Meanwhile, India is going through a drought season and goes begging to the USA. So the US gives them 10 bags of rice, in return for the 10 bags of clothes.  The exchange process was however complex. The barter system had so many issues. So the US thought of using some specially made coins. He called those coins Dollars. He sets 1 brick equals 1 Dollar. Thus, China and India need to get these Dollars to buy stuff from USA. Not to be left behind, India and China give colourful names Rupees and Yuan respectively to their own coins. 1 Rupees is set as 10 pair of clothes and 1 Yuan is set as 10 bags of rice. These coins are then used among the villagers to buy and sell stuff among  them. Thus we have pegged the currencies as: 1$= 1 brick 1 Rupee= 10 bags of clothes 1 Yuan= 10 bags of rice Also, at the current rate: 1 Rupees = 1 Yuan = 1 Dollars.   -- Equation 1. Life is good for USA people as they are getting a lot of clothes and rice without working much. As the brick guys keep working hard, others start relaxing more. The situation is very rosy in the US. The drought in India ends and they start producing a lot of rice. Now, they do not need the rice

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from USA and thus need less dollars. As rice is required less, India realizes the demand and is now willing to sell only 5 clothes for every 10 bags of rice. By previous equations, now: 1 Rupees = 10 clothes = 20 bags of rice = 2 Dollars. In the meanwhile,  China adopts a part of brick building process and has started  producing enough bricks. They are now less willing to buy bricks from USA. They now set as: 1 Yuan = 10 bags of rice = 3 bricks = 3 Dollars. This leaves the USA tribes with no options but to devalue their currency to accept the reality that 1 $ = 0.5 Rupees = 0.33 Yuan. This spurs the local farmers and weavers who can no longer buy rice and clothes from outside and start getting back to work again. !How does a weaker currency help in stronger exports? Mr. Singh makes t shirts in his factory at Gurgaon in India. His business works as follows: Number of t-shirts made= Rs. 100 Amount for cotton purchase= Rs. 100 Labour costs= Rs. 150 Printing costs= Rs. 70 Rent & utilities cost= Rs. 100 Administration overheads= Rs. 100 So to make 100 t-shirts, Mr. Singh needs Rs. 520. He manages to find a generous buyer called Stacy in California, USA who agrees to pay him $10 for 100 t-shirts. Converting this amount into local currency he gets Rs. 620 (since $1= Rs. 62 @ Jan 2014). Mr. Singh goes home happy. 3 months later, the Rupee starts appreciating against the dollar. Now $1=Rs. 50. This means that your dollar could only buy 50 Rupees now instead of 62. Stacy however pays the same $10 as she wouldn’t really care about the movement in Chinese currency. Why would she? After all, a shopper doesn’t walk into the store thinking about the Forex markets. The shopper wouldn’t be willing to pay more just because the rupee went u. Mr. Singh now gets only Rs. 500 from Stacy ($10 for 100 t-shirts @ Rs. 50/$= Rs. 500). But the Cost of making those t-shirts doesn’t change. It continues to be Rs. 520. He is actually making a loss of Rs. 20 now for every batch of 100 t-shirts. He will most likely go out of business leading to lower exports for India. In the same manner, an inverse trend in currency would make a healthy profit for Mr. Singh. Having a weaker currency prevents Mr. Singh from going out of business and keeps him exporting stuff from India. !

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