Determinants that Impacts our Economy

By: Albert Dovei

Have you ever wonder what was the exchange rate of INR (vs USD) when Indian got Independent?

To your taste, the equation is,

1 INR= 1 USD as of 15th August 1947.

(Although the dynamics of Exchange rate between the currencies is not the same as today and make 1USD=59.4 INR)

Not many people from among the Nagas, are aware of this change. And still fewer are aware of the impact of this change.

No one would precisely know which factors had moved the currency value of a country and by what quantum. It is because the factors are numerous and its impact could be varied. The impact is still further made complicated because some of these factors are interrelated. So, many different economists may cite various different factors, but they could mean the same thing at different time- giving them the benefit of doubts. If there is one clear cut rule, then the currency traders wouldn’t be having so much of fun and bonuses and vice versa.

Economists had played very safe and have club all these factors together to fit into the term “DEMAND and SUPPLY”. Consider, if there are only few soya growers and still fewer who make AKHUNI/Fermented Soya – SUPPLY, judging by the way we (the nagas) consume AKHUNI – DEMAND, we would be at the mercy of the soya growers and the manufacturer of AKHUNI. In a world without UG, we would be amazed at the way they priced Soya and AKHUNI like the way many are amazed by the TAX.

Of the so many factors, the following are significant and common;

  1. Inflation
  2. Interest Rates
  3. Other country’s Economic Indicators ( Growth, Country’s current Account, Govt debt)
  4. Terms of Trade
  5. Political Stability

1. Countries with a lower inflation rate, generally will have a rising currency value as compared to the one with higher inflation rate. Purchasing Power Parity or popularly knows as PPP is an economic theory which reflects that a currency value of a country moves towards an equilibrium. Its basis is the law of “one price”.

Consider the following example;

Say there are three countries and exist independently (no communal feelings):

COUNTRY 1; NAGA (AKHUNI Consumer and Producer)

COUNTRY 2: MEITEI (AKHUNI Consumer)

COUNTRY 3: KUKI (AKHUNI Consumer and Producer)

Cost of 100 gms of AKHUNI = 10 NAGA $(=10 KUKI $ = 10 MEITEI $)

Let us also suppose that the values of these countries’ currency are same as at 31-12-2010. Imagine the total cost of transporting (including Trade terms such as Tax) AKHUNI to imphal from KUKI CITY and NAGA CITY and between KUKI CITY and NAGA CITY is same and equal =ZERO (an assumption so that this factor does not influnced the outcome though it reality, this never exist). Imagine everything else remain the same, MEITEI will likely import 50% from NAGA CITY and 50% from KUKI CITY. Lets consider for now, there is nothing like Supra State and Kuki state equally in DEMAND.

Consider a scenario, the price of AKHUNI in NAGA CITY has increased (now 11 NAGA $ per 100gms of AKHUNI) because of increase of labour cost for production of AKHUNI in NAGA city – A case of INFLATION. BUT the price of AKHUNI in KUKI remain the same. This is called ARBITRAGE.

You can expect the following situation;

  1. MEITEI and NAGA consumer of AKHUNI will certainly desire to buy AKHUNI from KUKI CITY.
  2. The DEMAND for NAGA AKHUNI declines–> They need to lower their price to be competetive.
  3. The DEMAND for KUKI AKHUNI increases–> they took advantage

Eventually, the three factors will meet somewhere where the business will continue as usual but with one thing change – the value of the currency.

Lets say in the process, the price of the KUKI AKHUNI is increased 10.53 per 100 gms and the NAGA AKHUNI price has thus declined to 10.8, this would push the bring the Exchange rate to.

1 NAGA $ = 0.975 KUKI $

Or is it the other way round? Because of the three activities above,

1 NAGA $ = 0.975 KUKI $

And has push the price of KUKI AKHUNI to 10.3 KUKI $ per 100gms and NAGA AKHUNI to 10.8 NAGA $ per 100 gms.

You may also refer to REER (Real Effective Exchange rate Index) for readings an improve your knowledge on Exchange Rates.

2. Interest Rates plays a very important in the cash Inflows/Outflows of foreign currency into a country. You will see many central banks across the world change their policy rate based the changes in other countries. Many Asian countries’ central Banks waits for the Fed’ Rate policy revision. Investors today are very clever, and a slight arbitarage could shift their investment destination. If you look closely, FORWARD Exchange rate is related to the Interest Rates.

F= S(1+id)/(1+if)

where

F is the forward exchange rate

S is the current spot exchange rate

id is the interest rate in domestic currency

if is the interest rate in foreign currency

Note: Time factored in

The Forward exchange rate is used for Forward Exchange Rate trading and impacts the currency exchange rate. From the above formula, we know the interest rate of a country impacts the exchange rates.

Govt. 10 Year bond for some countries are as follows (All annualised as at the day of 31-12-2012);

India =7.5% (Interbank rate 7.31%)

Pakistan=12.07% (9.33%)

China = 3.71% (Interbank Rate 6%)

Japan = 0.86% ( Interbank Rate 0.16%)

Have you been thinking to borrow money from Japan and invest in India?

Sometimes, the interest rates in certain countries goes negative (have you ever thought how it could possibly happen?)

3. Economic indicators of a country are the beckoning light for the investors. Based on the soundness of the state of the economy, investors will regulate their inflow of money into the country. As at the current Quarter, the FOREX EXCHANGE RESERVE of India stood at USD mio 287,846 rose from 4,646 in 2003. China on the other hand, during the same period the Forex Exchange Reserve stood at USD mio 3,442,649 as against 403,251 in 2003.

We can see what has been happening. Growth in India and China has been phenomenon during the last decades. And that was how, the FOREX increases and during some part of the period, the value of Indian currency picked up to as high as INR 38 against a dollar.

Investors examine their risk appetite before investing into any country. Often investors perform their risk return profile analysis for investments. China and India top the list in the GDP growth rate and this provided a platform to the foreign investors for capital gain and high interest income.

Besides the GDP, there are many other economic indicators that tells the health of a country economy. PUBLIC DEBT and Current Account are also important economic indicators. Public debt of China is 23% as compared to 50.40% for Pakistan and 67.57% for India (as per 2012). Partly because of this high public debt, the rating agent has downgrade India to the last investment grade (BBB-) with a negative outlook, last year (this is as per S&P rating, Baa3 as per Moody’s with a stable outlook). As a comparison, Pakistan was rated B- by S&P with stable outlook and China with AA- and stable outlook by S&P.

Here are public debt figures of some countries;

US= 101.60%

Japan= 211.70%

Greece= 156.90%

Greece is currently facing economic turbulence because of the high public debt.

Current Account figure is a reflection of the movement of currency across the boundary of the country. Current Acccount (as a fraction of GDP) of India, China and Pakistan for the FY2012 are -4.8%, 2.3% and -2% respectively. Negative values also indicate, total import outweighs total exports.

4. Terms of Trade: Governments sets the terms of Trade and it has direct impacts on import and export. Taxation is a very important factor which could promote/discourage any business. For example, Bangladesh textile exporters have more privilege than the Indian counterparts among the textile consumer countries (e,g Europe). What does this mean? There will be more business for Bangladesh textile industry meaning more exports to other countries. Foreigners need to buy Bangladeshi Taka for import of Bangladesh’s goods. Bangladesh gains on Textile Industry.

Similarly, there are many industries, where trade with one country is more convenient/cost efficient than the other leading to preference of one country over the other leave aside the political issues. Recently, the European countries have asked India to reduce the import tax on luxury cars to India and it is learnt that India has asked European union to lift the tax on Indian textile imported to European countries. Likewise the import tax between countries could be very complex and sometimes not healthy.

Are we trying to understand such complexities?

Do you know why Cars are so cheap in America and Middle East? If not because of import tax, average middle Indian could be driving HONDA CITY.

5. Political Stability is one of the most important factors for investors to invest in a country. The less stable the country, the less number of investors will be for the country. Rating Agency uses political stability as one of the key elements for risk rating.

Three years ago when I tried to book a hotel in Sydney, the price of Zimbabwe dollar runs into million per night. Of course it was during one of those days when the political situation was very volatile and inflations could be in 1200 (%). Have you ever wonder what does this mean? Imagine how much money the middle man (brokers) would have made.

Conclusion:

However, the current volatility in the currency exchange rate is more to do with complex thing which are happening around the world. Although the traditional economic theorems hold true to a certain extend, the dynamics of modern businesses could (and has) created a precarious situation to the financial markets at times. Many structured financial products look very attractive from outside but its real value can be very minimal. The recent financial crisis of 2007 was tagged to US subprime mortgage crisis, but in reality the parties that helped fuel the crisis ranges from Finacial institutions, regulators, credit rating agencies, government housing policies, consumers, insurance companies etc. Using a complex financial instrument known as Credit Default Swaps (CDS), the investors were made to believe that the risks were perfectly hedged in relation to Mortgage backed securities. A synthetic CDO (Collaterilized debt obligations) were created whose payment streams were derived from the premium of CDs. What happen here in the process is, an enormous value was created out from that limited financial instrument’s intrinsic value- can you believe that?

The questions; what happen when such a financial crisis loom large in an economy? What would the investors do when the borrower’s (Government) expenses become too much as compared to the income and the government cannot manage their budget deficit anymore? This is exactly what happens in Greece which along with other European countries almost brought down Europe economy recently. What would you do when you think your borrower is not managing your borrowed money and also his own money properly? Most lenders/investors would try to pull out his investment money. And this adds to the woes of the falling exchange rates when investors pull out their money from your country and never to come back again in the near future.

Specific situations in Financial Institutions can create a temporary volatitlity in the Exchange rate and Interest rate. When SBI launched the Indian Millenium Deposits amounting to Rs 37,000 Crore, it created a considerable volatility in the exchange rate, yields on gilt securities etc.

Another situation is when investors have alternative investment destinations. You will see when the US ecnonomy information (job, GDP etc.) are good, the stock index rises in Dow Jones. Similarly, when the Federal reserve review their policy (e.g Rates) in favour of investors in their home country, you will see a sudden shift in the Market.

In the current scenario, it is reported that overseas investors have pulled out a staggering Rs 29,191 core from the Indian debt and equities in less than a month (during June 2013) due to the weakness in the rupee.

All these reasons add to the volatility in the market rates. But behind all these there is the resources availability, the consumers and the managers of this economy. And how well they managed the economy, is left to the bloggers.

Central Banks also play an important role in controlling the exchange rates by setting policies for the Banks in relation to kinds of financial instruments the Banks are allowed to transact, limits on the open positions for individual currency, external borrowings, capital requirements etc. At times, Central Banks buys or sells foreign currency as a temporary controlling tool for exchange rates movements. Financial news has reported that RBI has intervened to stop further falling down of INR value.

Central banks sometimes squeeze the liquidity with sale of government securities. Currently (since last week) the RBI is trying a sell Rs 12k Crore through open market operations but it looks like the whole process is pushing the interest high indicating the yield which the market demand is definitely higher than what RBI has offered. By squeezing the liquidity from the market- which should decrease the supply of INR- thereby increasing the INR currency value.

But then do you know what would this impact the commoners? By trying to solve an issue, another problem could be just created.

The government of India had on 16th July, in order to boost the economy and put a stop to the sliding of the INR exchange rate has relax the cap on Foreign Direct Investments in the following sector;

     
INDUSTRY WAS (in %) NOW (in %)
TELECOM 74 100
DEFENCE PRODUCTION 26 26 (allows to increase on a case by case basis)
INSURANCE 26 49
ASSET RECONSTRUCTION FIRM 74 100
CREDIT INFO FIRM 49 74
SINGLE BRAND RETAIL   49

 

 

 

 

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