Currency Valuation: How is a currency valued? Why is it that to buy one US dollar, we need to shell out 50 odd rupees in general? What can influence the currency market to ensure increase in the value of one currency vis-à-vis another currency? Well, there are couple of reasons that seem logical means of influencing the currency valuations. What determines as to how much money should be printed? If for a layman’s example let us assume that we all start printing money artificially to ensure that we all have the money we need in order to increase our purchasing powerand lead a satisfying life. Now, when everyone in the economy has a lot of money, people would go out to buy their favorite Goods and Services.
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Why is it that to buy one US dollar, we need to shell out 50odd rupees in general?
What can influence the currency market to ensure increase
in the value of one currency vis-à-vis another currency?
Well, there are couple of reasons that seem logical meansof influencing the currency valuations.
What determines as to how much money should be printed?
If for a layman’s example let us assume that we all start printing money artificially to ensure that we all have themoney we need in order to increase our purchasing power
and lead a satisfying life.
Now, when everyone in the economy has a lot of money, people would go out to buy their favorite Goods andServices.
Now, if I go to a Mercedes showroom and readily book a
high end car there, there would consequently be manyothers like me who would be doing the same.
Now, what happens?
The manufacturing capacity of the automobile Industry islimited and it can produce only a said number of cars.
Thus, these auto firms would end up increasing the pricesof their cars as they see unending demand as a result of
continuous money supply.
Hence, even if they increase their prices, people withexcessive cash flows would continue to demand these carsand as a result under any situation, these auto firms end up
experiencing optimum sales.
In the previous scenario, where one used to shell 20 lacs for a Mercedes, now people would end up shelling 30 lacs for
the same variant.
What happens as a result is that the value of money
declines. In other words, excessive money supply is notcorrelating with actual economic output and this result ininflation and a resultant decline in the real value of money.
Thus, it is important that the money in circulation in theeconomy is appropriately supported by corresponding
economic activity in the country.
Any artificial supply money in the economy is likely toinduce inflation and a further induces a decline in the value
of money.
All said and done, how does this determine the money
value of that currency vis-à-vis the money value in someother country? In other words, what logic actually supports
the valuation of one currency in relation with another currency?
Why it is that those 50 odd rupees or 100 odd yens
correspond to one dollar?
One obvious reason could be that the level of economicactivity in those countries is much higher than those in the
other.
But this argument can be challenged again. In the case of Japan itself, her economy is the third largest in the worldand for a long time has held her position as the second
largest economy of the world which was recently overtaken by china.
Let us examine some reasons that impact exchange rate
fluctuations of Currencies:
Balance of payment situation:
Countries are not all self dependent by themselves and byvirtue of this fact they are forced to buy goods that they areinsufficient at and for which there is a need in their country.
Correspondingly, they also engage in the practice of selling products which is in excess quantity in their books.
What happens as a result is the practice of trade throughexports and imports.
Now when a country imports goods, it needs to pay money
value of the imported goods to the exporting country andsimilarly when its goods are exported, it ends up receiving
money.
It’s not every time that there is a balance in the receipt and payment of money between countries.
More often than not, there is a case of either a surplus or adeficit occurring out of the receipt or payment from theexports and imports of goods across national boundaries.
This in other words is termed as either Trade Surplus or Trade Deficit.
Trade surplus or deficit is part of the current accountsurplus or deficit. Current Account includes Balance of trade and along with it net factor income and net transfer
payments.
Net factor income encompasses the net of Interests andDividends received and paid and Net transfers are unilateral
transfers such as Foreign aid.
Now, what is the impact of all these terminologies onCurrency Valuation?
Well, when we look at current account as a whole anydeficit in current account would mean that the imports of
the country are much higher than its exports. What thisimplies is that the country is making a lot of payments in
trade in comparison to its receipts.
For example India in its trade with the USA experiences adeficit. What this clearly means is that India is making a lot
of payment via dollar than what the US is making via
Indian Rupees.
Correspondingly, the demand for Dollar spikes. There ishowever a limit to the actual availability of dollar in the
Why does the Reserve Bank change interest rates after all?
What necessitates the RBI to initiate changes in its Interestrate policies and what implications do such changes haveon the currency market and on the Economy as a whole?
Interest Rate is used as a tool to effectively control the
money supply in the Economy. When there is excessivemoney it leads to inflation and inflation has a negative
bearing on the real growth rate of GDP.
Let us try and understand this little better
Suppose you deposit money in a bank that gives you say
10% rate of interest annually. What this means is thatwhen you deposit 100000 Rs, you end up earning 10000 Rs
as interest income at the end of the year.
Let us assume that in the same year the rate of inflation is5%.
To elucidate this a little further, let us take the example of one specific commodity say Dry fruits.
A trader in Dry Fruits buys them from one source and sellsthem in the market for profit.
If the cost of 1 kg of Dry Fruits in 2010-11 is say 500 Rsand suppose he sells the same in the market for 550 Rs. The
rate of Inflation in 2010-11 is 5%.
Now this trader is doing a comparison of his probablereturns from two different sources. One from his regular
trading and the other through his deposits in bank.
In the given scenario, even if the bank offers 10% intereston the deposits, his returns from both his trading activity as
well as his bank deposits will equal.
But assuming the trader has the liberty to raise pricescomfortably in the market without impact on his resultant
profit, his returns from the trading activity would continueto be 10%, but as a result of inflation, his actual returns
from the bank would only be 5% (i.e. 10% interest rate – 5% rate of inflation).
In a real scenario it is difficult to presume nil impact on any potential price raise by the trader on his profits. But even
then, his likely returns are much likely to be higher than the5% of actual returns that he would get from the bank
deposits.
Thus, inflation has the potential to derail the real growthrate of the economy.
So what RBI does is that it exercises its power toeffectively control the money supply in the economy byinitiating changes in its interest rate policies that either
Reduce or expand the overall money supply of theeconomy.
How does currency valuation get impacted as a result?
Let us begin to understand the impact of one particular scenario to begin with:
Assuming there inflation in the economy, logically the RBIcomes under pressure to check the same. Correspondingly,
it raises the interest rates to curtail the money supply.
What happens when interest rates are raised is that, peopleare more induced to deposit their money in he banks as
they start providing higher rate of returns.
When more number of people state depositing their money
in the banks, the overall money supply in the economy isreduced.
As in the case of Mercedes, when more money chases fewgoods (i.e. demand pull inflation), the general price level
tends to rise.
Now when as a result of interest rate hikes, when themoney supply in the economy has been curtailed, there is proportionately less money chasing these goods and hence,
Even Foreign investors eye such markets that providehigher interest rates.
As a result the demand for that particular currencyincreases as even these foreign investors would look to
invest in the local currencies of the said country.
This in turn ensures a rise in the valuation of that particular currency
An increase in interest rate however has an impact ongrowth as well.
When the money supply in the economy is curtailed, notenough funds are available for commercial activities as
these avenues promise better returns.
Thus, the overall economic activity is impacted to a certainextent. Hence, whenever there is inflation, raising the
interest rates alone does not guarantee smooth economicgrowth.
When measures to control inflation through interest rate
hikes are undertaken, even these have a bearing on thegrowth rate as they impact the pace of actual production of goods and services and the pace of commercial activities as
Even Fiscal deficit can have its impact on currencyvaluation. If a country is experiencing Fiscal Deficit i.e. the
budgeted expenditure far outpaces the budgeted revenue,then the government would be forced to finance the deficitthrough loans of by issue of government bonds
Note:
Fiscal deficit: The case where the budgeted expenditure of the state far outpaces its budgeted revenue.
Bonds: Bonds are form of debentures that are issued for some purpose (usually economic purposes like highway
construction, electricity generation etc). But bonds are alsoissued for non economic purposes like Defense bonds.
These instruments carry a fixed rate of interest which the
holder of the bond instrument is entitled to receive.
Certain Bonds also have a maturity period i.e. they arevalid only for a stipulated period of time.
Let us understand this concept a little further.
When Ram purchases a rural electrification bond worth 5lacs, what Ram is essentially doing is that he is providingthe rural electrification authority a sum of 5 lac rupees for the purpose of development of electricity in the rural areas.
Now, money never comes free. When Ram is deciding toinvest 5lac rupees into such a project, as a rational investor,
he would also seek returns on his investment.
If the bank offers him 10% interest, Ram would be better off investing this amount in the bank and earning 50000 Rs
at the end of the year as interest on his deposit.
Now, the government or the rural electrification authority is
in need of funds to carry out its project. Now how does itobtain these funds?
The avenues herein would be like either raising a loan or bygranting tax waiver upon investments in certain sectorslike the rural electrification sector as in this case, or byissuance of these instruments called as Bonds with a
specific rate of interest.
Now, which of the option the rural electrification boardchooses to opt is to be left up to the jurisdiction of the board itself, based on what it perceives as the most
profitable avenue.
Now, when these bonds are issued in the market,Individuals who wish to invest in them based on the promised returns (i.e. the interest they offer) go ahead and
As mentioned earlier, as a result of the fiscal Deficit, thegovernment would be forced to finance the deficit through
loans, bonds or other measures.
When Fiscal Deficit forms a substantial percentage of thecountry’s GDP, what happens as a result is that the
economy would be under that much strain to finance thesame.
These finances, whether in the form of loans or bonds carry
a certain interest rate as well with them.
Unless the government comes up with measures to narrowthe fiscal deficit, through its budget, given the interest rate
pressures, the deficit is likely to broaden further.
Again if the loans taken to finance the deficits are taken
from within the country, it is relatively a better bet as themoney circulation happens within the country itself.
For example, if the infrastructure financing is taking a tollon the overall government expenditure and the governmentis of the opinion of issuing infrastructure bonds to finance
the same, the circulation of money is likely to be within the
Even when the government pays interest to the bondholders, the interest money is likely to circulate within the
country.
With that little extra interest income, people may choose to buy new clothing, dine in a restaurant etc and all this
ensures in the local circulation of that money.
If however, for some reason the government, out of compulsion or other vice chooses to borrow money from
external sources like the World Bank or the IMF, the
interest money to that extent will go out of the country.
Now again to pay back the loan, the government will haveto finance either the World Bank or IMF or any other country from which it has taken the loan in their local
currencies.
What happens as a result again is that the demand for thoserespective currencies increases proportionately and so does
Foreign Direct Investment is another concept having a potential impact on currency valuation.
As a result of liberalization, firms are free to do businessany where in the world. Thus, they also choose this route of foreign direct investment to run their commercial activities.
Heavy FDI inflow again spikes the demand for the particular country’s currency impacting its currency
valuation.
Well, all of the above mentioned give a sense of the potential factors that have an impact on the currency
valuations.
But the fundamental question is, based on what exact parameters or logic is the value of a currency determined at
the first place?
Let us take a look at the history of certain currencies andtheir Valuation:
Exports, then in exchange of say “x” amount of currency A,
they demand “y” amount of currency B. Now this currencyB becomes the foreign exchange reserve of country A.
Thus as trade progresses, so does the foreign exchangereserves oh both the countries. When a lot more countries
join this process there is accumulation of foreign exchangereserves under a number of currency denominations. Now,as the global trade grows, so does the demand and supply
of various currencies.
Note:
In the example above the central bank initially accepts
currency denomination of another country just keep themas reserves. These reserves can be used for future trade
transactions wherein there is a necessity to make paymentto the concerned country in their respective currency
denomination.
Now based on the above scenario when there is a growingdemand and supply of currencies of various denominations
The value of these currencies starts fluctuating. Also as aresult of other factors like Interest rate hike, Fiscal or
Current account situations or foreign direct investments etc,the extent of fluctuation in the currency value starts
Increasing. Thus, over a period of time the exchange ratesystem comes into place.
Some countries like china artificially keep their currencyvalues low to ensure that their production costs are low and
their exports increase.
If the real aim through currency value alteration is to
suddenly increase the GDP numbers as stated above, therewill be a lot of countries in the rush for it. As said beforecurrency valuation is also a science. If the value of your
currency is high and if it is not supported well by theground fundamentals, from a trade perspective alone, theexport numbers will be constrained. As a result current
account deficit will follow that will strain the economy. If
there is no corresponding adjustment to the currency valuetherein, it may create huge problems as in India’s case in1990. Before liberalization, India hardly had the ability tosupport three weeks imports. For exchange of aid, one of
the conditions put forth on India was that it had to devalueits currency.
The US$ and Indian Rupee exchange rates drastically wentfrom 16 Rs to 1US$ in 1991 to about 48 Rs in 2008. Whenthe value of rupee declined, exports got a boost,
Current account situation was brought under control andforeign exchange reserves began to swell.
Hence, though artificial increase in the value of currencymay bring good to the GDP, but if not supported well by
Ground fundamentals, the real economic condition isunlikely to show any real improvement.
Let us now look at China’s case a little more in detail:A Country with a low currency denomination is notnecessarily a country that is poor. This is very much
evident in the case of China.
But again as said before, china artificially keeps the valueof Yuan (its currency) low. So when the currency valuation
in this case is artificially induced, as per our earlier arguments, it should have an impact on the economy as
well
Let us explore this case further
Many currencies like the US$ or the British Pound arefreely traded in the international market and their relative
prices keep fluctuating on a daily basis.
In the case of Chinese Yuan, China’s central bank simplydeclares an exchange rate and by law ensures that all
Well, 8 Chinese Yuan roughly equal 1 US $. How doesChina ensure that in spite of international market pressures,
it maintains the fixed exchange rate of 8 Yuan for 1 US$.
China’s Central Bank constantly buys US Treasury Bondsto ensure this fixed exchange rate. When china starts
heavily buying US Treasury bonds, what it does is that itinvests in those bonds through the US$, there by increasingits relative value. By doing so, China’s central bank ensures
the fixed exchange rate of Yuan vis-à-vis the US$.
The Yuan does fluctuate, but only in a narrow range unlikeother currencies.
But, is this kind of a practice considered good in the longrun? What benefit does china derive by this kind of fixed
exchange rate policy?
Chinese firms gain enormous cost advantage by keepingtheir currency fixed. Their products are much cheaper inthe international market giving them an upper hand in the
in the international trade circles.
China enjoys a current account surplus as a result of its
high exports.
On the other hand, for the USA, though this is beneficial tothe consumer segment, for businesses and for the economy
as a whole in the long run, it may prove disastrous.
China enjoys a current account surplus, but not the US. Ascheap Chinese goods flood the US market, their imports
surge. As a result of high imports compared to their exports, the US experiences current account deficit and hasfor long been experiencing the same.
The USA has a trade deficit with china alone to the tune of $ 200 Billion. If the fixed exchange rate system prevails,the trade deficit will further broaden having an adverse
impact on the US Economy as well as the global Economy
given the size of US Economy in the world.
Continuous dependence on china for selling the TreasuryBonds would ensure slow pace of economic growth in the
US resulting from factors as mentioned above.
In order to break free from this vicious cycle of dependence
on china, policymakers in USA will try to pressure china torevalue its currency. But such a revaluation may not be that
smooth after all.
If there is an abrupt revaluation of Chinese Yuan, it wouldnot continue to buy US Treasury Bonds. The US would be
forced to sell those bonds to other investors at a much
higher rate of interest and as a result other mortgage and
long term debts that are benchmarked against the US $would also correspondingly raise the interest rates.
The US Consumer in such a situation is more likely toinvest their money in the atmosphere of increased interest
rates. Thus the liquidity in the economy dries up. Thiscould be terrible as it could make the US economynosedive even further. The extent of the down turn is
debatable, but such a scenario has the potential to pull theUS into recession again.
What impact does such a scenario have on China?
Well, in the short to medium term China would continue toenjoy current account surplus for a considerable period and
rapid growth of its economy.
But the current account deficit of USA gains an increasing proportion as a percentage of its GDP; the economy
condition will continue to worsen. The mounting debt as a
result would add to the pressures of interest payment too.
If the situation remains persistent, then beyond a certain point in time even the US may begin to default on its
interest obligations. The economic condition would not beconducive for employment opportunities and all this will
begin to have an impact on Chinese exports.
The actual extent of the impact may not be as drastic aseven in that kind of scenario Chinese goods will remain to be competitively priced. For the impact that however gets
created in that scenario, china may be able to bring thesame under control without any major damage to its own
economy. Thus, clearly China would be acting from thedriver’s seat herein.
Thus, in a rational scenario, revaluation would happen, butaccording the China’s intent and needs.
Thus, if the currency is overvalued as in the case of IndianRupee prior to liberalization, the country’s exports will be
constrained and imports would be larger than exportscreating a scenario of current account deficit.
If however, if the currency is undervalued as in the case of Chinese Yuan, the exports are much likely to be higher
than the imports given the cost advantage and the countryenjoys a current account surplus. But the catch point here isthat such a growth is not necessarily a fair one and is likelyat the cost of another country( in this case at the expense of
USA)
Note:
Whenever a currency is undervalued from an overvalued position (as in India’s case), there is likely to be an increase
This may prompt many to question as to how this actuallyaddresses the problem to trade deficit. It does not
necessarily change the situation from that of currentaccount deficit to that of a current account surplus case.
What such a move does is that, it ensures the overallincrease in trade (both exports and imports) of the country.This surge in the overall trade activity is likely to narrowthe gap in relation to current account deficit, increase theforeign exchange reserves of the country, thereby easing
pressure and giving more room to Economic reform andfurther imputes to growth in the country.
China’s growth is mainly export oriented and at theexpense of other major Economies. Apart from USA, its
undervalued currency gives china an unfair advantage even
with respect to a number of other countries like India.
Artificial pegging of currencies either by undervaluation or by overvaluation is unhealthy and in the long run, would
prove to be highly disadvantageous.
Even for USA, given the current state of dollar versusYuan, in the long run, mounting debt would increase the
bond yields, there by further increasing the interest payment pressures. The strain the US Economy would
experience in terms of yield payments would weaken dollar and may also induce investors to look for reallocation of
their dollar investments. When increasing number of investors dump US dollar for other currencies, the dollar may well lose its status as the World’s Reserve Currency
over a period of time.
The ultimate solution for all this seems to lie in the freemarker nature of currencies. Further countries should notencourage other nations to peg their currencies at a fixed
exchange rate.
A free market exchange rate system in the long rum wouldfinally prove beneficial to the Global Economy as a Whole.