The end of the year post. I know this is supposed to be either a fun post or a summary of lessons post or a post oozing out wisdom. I hope this doesn’t drive you away, but unfortunately for you, it is neither.
Okay, thank you for still daring to brave the deluge of words that would be unleashed on you. This has been an year that showed me how important an understanding of economics was to the society – and of course, the spotlight, in my view, was my total inability to grasp anything being said about the functioning of the economy. As the year closes, I find that I have put quite some effort to understand what an economist would consider simple concepts – inflation, interest rates, forex rate etc. While I find that I have already imposed on your patience when it comes to inflation and my views on it, I have not said even a word on forex rates. I know its that time of the year when lengthy articles are abhorred and didactic writers like me are avoided like plague; however, I feel the residue of this year must not be taken on to the new one – so here is a brief on how I guess exchange rates work. Be warned, I may be completely wrong, but then I am no stranger to the “foot-in-mouth” syndrome. So let me go through the (highly ficticious) economic history as I imagine it would have happened and hopefully my understanding on exchange rates is clear. This is how I believe it all started.
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A small story
The good old days were all about barter – I have a box of apples and you have 3 chicken; we both make and exchange and are both happy. It was a clean and clear system; your bargaining power determined what you got. But there was a big problem –perishability of your goods. And that is where currency came in. You were able to convert your perishable apple to some form of imperishable equivalent.
But what was this currency and how did it get its value? As I imagine, it would have been that the local big man (say the king or the don) gives you 3 “coins” that he designed for your 3 chicken. Whatever you want can be then exchanged for the 3 coins either with him or with anyone else in that region. Ofcourse, this big man was the biggest consumer and his word is worth its weight, each item got its value as per supply-demand and so you have no problems with this arrangement. Over time, the “big man” would have taken up the role of issuing coins for general trade and not just trade with him (albeit taking a small commission for issuing coins – the so called seigniorage). And as there were many such big men in other regions, each issuing their own “currencies”, you had to trade in currencies for taking your goods to other regions.
Since the same goods (say, apples) would have to have the same effective value across regions (arbitrage theory), therefore we can say that
Price of the goods in Region1 × Value of Currency1 = Price of the goods in Region2 × Value of Currency2
Otherwise put,
Price of the goods in Region1 × Exchange Rate between Currency1 and Currency2= Price of the goods in Region2
Going by incremental increase and not in absolute terms,
Change of price of the goods in Region1 × Exchange Rate between Currency1 and Currency2 = Change of price of the goods in Region2
In case of financial products (bonds etc), the change of price is depicted through interest rates. So we have
Interest Rates in Region1 × Exchange Rate between Currency1 and Currency2 = Interest Rates in Region2
Determinants of Interest Rates
Based on the story above, let us see if we can determine what affects the interest rates.
- The first factor affecting exchange rates would be how much of goods a particular currency can purchase. This is the so called purchasing power parity. The more goods the currency can purchase, the better is the currency exchange rate in context of other currencies.
- Inflation has a bearing on the interest rate and a high inflatory scenario compounds the exchange rate problems of a currency
- High debt burden by the issuer of the currency leads to high interest rates as the lenders view the issuer as risky. So the extent of borrowing impacts the exchange rates.
- Supply demand factors also affect the exchange rate. In case the currency issued by one issuer is deemed of a higher quality, then inspite of the above factors, the exchange rate would be favourable to the issuer of higher quality currency.
How does India fare
In light of the above, let us see how the India rupee fares.
- The PPP of Indian economy is one of the highest. However, one of our biggest problems is the huge oil and gold bill we run up as a nation. With the prices of both these goods touching the stratosphere, it is no wonder then that the exchange rate is under pressure.
- Inflation, although high, isn’t the worst in the world
- Debt burden, although high is nowhere near that being serviced by majority of western powers.
Conclusions
So where does this discussion leave us. Nowhere, I would say. After a lot of effort, I seem to be able to grasp some (hopefully correct) concepts of determinants of exchange rate. As I said, understanding economics is so important that it’s better to remain ignorant of the concepts rather than have a half baked knowledge of them. Therefore, I look forward to clarification of any concept misconstrued, misunderstood or mistaken.
Have a happy year ahead and god bless .
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PS: I intended to write sections on what we can do about the exchange rate and whether the topic impacts us to such an extent that it merits so many reams of paper. I didn't put on paper my thoughts because I wanted to retain some appearance of being knowledgeable. But as some one said, once your foot is in your mouth, it doesn't matter if you are merely sucking your toes or biting your heel off. So here is what I intended to say but didn't.
Is the exchange rate really that important to us, the "aam admi"
Exchange rate impacts our daily life in two ways -
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PS: I intended to write sections on what we can do about the exchange rate and whether the topic impacts us to such an extent that it merits so many reams of paper. I didn't put on paper my thoughts because I wanted to retain some appearance of being knowledgeable. But as some one said, once your foot is in your mouth, it doesn't matter if you are merely sucking your toes or biting your heel off. So here is what I intended to say but didn't.
Is the exchange rate really that important to us, the "aam admi"
Exchange rate impacts our daily life in two ways -
- One, as you guessed rightly, the oil prices are always quoted in dollars and so a bad exchange rate offsets falling price of crude oil (as happened recently when in spite of rent crude falling to 95$ per barrel, we had a price increase due to pressures of an adverse exchange rate movement) and compounds the effect at the time of rising crude price.
- Most of the commodity prices (eg. steel, cement etc) are quoted in dollars even when the trade is between two local traders in India. A rising dollar thus impacts internal trade prices also despite the source and target for the goods is within the country.
What can "we" do about it
As individuals and even the GoI can't do much. Maybe if, as a nation, we take a collective decision to reduce our fuel and gold consumption, then some impact might be felt. But I guess we might as well be talking about colonising and mining the moon; that might be easier than reining in our love for gold.
Of course, the Govt can decide that a part of all our payments towards international commitments would be made in Rupees and that internal trade should always be quoted in Rs.; but with the govt having so much on its plate due to its mismanagement, I guess this idea's turn would come in the 250th five year plan, if ever.
So all we can do is grunt and bear.... Not a very reassuring thought to close the year and begin a new year, but no concave mirror ever did benefit a fat lady.
