If you’ve been following the financial news, you’ve probably seen a fair number of articles on the sudden and drastic slide of the Indian Rupee versus the US dollar in the past few days. I must admit I wasn’t paying much interest until I received a forward (one of those that requests you to forward to every friend “if you care”) that said the solution to this crisis was to stop buying non-Indian goods. I laughed.. but my curiosity was peaked about the real causes and decided to do some research.
I was expecting to find a link online that clearly explained the factors leading to the slide but was disappointed so I thought I’d take a crack at understanding the factors involved here and thus, form a thesis on how a currency’s value is determined. I was helped greatly by this excellent resource from Tutor2U.net and I’m borrowing heavily from it.
First, the situation – this graph documents the rather alarming slide of the Indian rupee versus the US dollar in the past months. As you can see, there’s been an increase from 54 rupees per US dollar to 67. That’s a 25% increase in less than 3 months and the slide may not be over yet.
So, why is this happening? Let’s first understand how the value of a currency is determined.
In theory, the right value of a currency (in this case Sterling or British pounds) is an intersection between the supply of the currency and the demand for it. We’ll follow the explanation from Tutor2U for the simple version.
So, how do you determine demand and supply for sterling? (formatted into a table for easier reading)
Thus, the fundamental factors that drive an exchange rate
1. Interest Rates: Interest rates in a country are largely derived by the value of government bonds. If the value of government bonds go down (i.e. if investors are less optimistic about British prospects), interest rates go up. This is a fascinating process and you can expect a detailed post on how this happens in the next few weeks when we kickstart a book learning series on “The Ascent of Money.”
On the one hand, this could mean more investors put money in as they expect a higher return but on the other, it means borrowers within a country suffer since the interest rates on all home and car loans go up. This in turn means people consume less leading to a chain of potential negative effects for the economy.
2. Economic growth. Countries experiencing a deep recession often find that their exchange rate is weakening because government bond values go down, investors pull out, and speculators bet against the currency.
3. Inflation. When inflation is high, a country becomes less competitive in international markets causing a fall in exports (and thus, demand for a currency) and a rise in imports (a supply of currency overseas). A fall in the exchange rate may be needed to restore a country’s competitiveness in overseas markets.
4. Balance of Payments. Essentially, if a country exports more than imports, it runs a trade surplus and thus is a better place than one in trade deficits (or more imports vs exports).
5. Market Speculators. The consequence of global bond markets and global investors is that they can make it hard for a country performing poorly to recover since many factors are linked to each other. One key mover is market speculators who make money by betting on rises and falls. A feeling of pessimism about a market’s prospects can be very costly.
I won’t go on to explain the complex version in great detail because I can’t claim to understand it fully myself. But, here’s a synthesis – the currency value is indeed determined by 2 factors – aggregate demand and aggregate supply.
Aggregate supply is the total supply of goods and services that firms in a national economy plan on selling during a specific time period.
Aggregate demand, however, is a bit more complicated. It is proportional to the following –
1. Consumption or consumer spending
3. Government spending
4. Net export (or Export – Import)
Investment requires a deeper look, however, because it is directly proportional to investment by firms in the country but is inversely proportional to interest rate. This is because increase in interest rates increase the cost of borrowing resulting in a cut down of investment and consumer spending. (equation below)
How does this explain the decline of the Indian rupee and what are the learnings on currencies in general?
My thesis is as follows –
First, the fall of the Indian rupee – the sudden fall of the Indian rupee is an aggregation of a few factors –
1. Poor financial reform => low confidence in the market. The financial reform announced of late has been received with pessimism. This means government bond values are likely to fall and speculators are like to flee. The economic growth hasn’t given the market reasons to change it’s perspective either.
2. Foreign investors are unwelcome. India hasn’t exactly welcomed foreign investment over the past decade by still subsidising prices in key industries and protecting local industry. That hasn’t helped.
3. Ongoing trade deficit. Linked to above points and unhelpful.
4. Spending and investment affected by above factors. As these factors are all interlinked, consumer and business spending and investment is affected.
5. Strengthening of the US dollar. For the long term investor in government bonds (which is almost all pension funds in the world), the US dollar’s strengthening means a massive shift in allocation of investment. The INR’s weakening means this process can be hastened.
So, how can this be solved? It will require a lot of structural reform to win the confidence of the market. It is possible that the spiral was over exaggerated and the rupee may be worth more than it is now. Time will tell.
My learning from attempting to understand this is that I’m able to appreciate the sheer complexity involved. Financial policy makers don’t have it easy. That said, the underlying principles are sound – if your core financials aren’t sound (e.g. good structural policies and higher money in versus out), no amount of massaging financials can save you from the realities of the market.
It’s the same in life – if you don’t have the skills and character, no amount of personality training can save you. The markets, like life, are tough. Only the fittest thrive.
A final note – I am not a financial expert or Forex guru. So, while I’m sure the theory is directionally right, the details may not be perfect. I’m sorry if I’ve made any glaring errors.. and I trust you’ll let me know in the comments. Putting this together has been a great learning experience in itself. Hope it helps!