China unlike India follows a fixed exchange rate system which means that it does not let its currency rate to be decided by the market forces. By keeping it fixed the central bank of China wants to have complete control on its’ currency much like everything else in their country. I think they just hate the concept of freedom! Starting from blocking their citizens to ‘Google’ certain sites to shooting dead families having more than one child, the Communist Party of People’s Republic of China hate to lose their control on anything. Why is USA bothered about this exchange rate policy of China? The answer to this is very simple. China is an export based economy with most of the goods being exported to United States. Thus, what happens is China keeps getting more and more US dollars. So, it should not come as a surprise to anyone when I tell you that China has the largest treasury or foreign reserve in the world which stands at around 3 trillion with Japan coming distant second with a little more than 1 trillion. As the Chinese Yuen does not appreciate their exports never become expensive thus they keep on accumulating USD without letting go anything. But this year the Chinese have a little bit of respite due to their import, export figures for the December period. The imports have shown stronger figures than the exports which have been lower than that was expected. Their current account though is at HUGE surplus still. One might say that the figures of December are nothing but a minor set back for the Chinese rolling capital account. It is enough for now to keep America off their backs for a while.
The advantage of having huge treasury is simple: You can buy out other countries! Well, if you don’t believe me then you should read the report where China and Japan have decided to buy out bonds from Spain and Portugal worth around 6 billion euros. The official report says that China and Japan actually want to show their support and faith in euro denominated countries and they have full faith in their economy. But here is the real truth: Ireland and Greece are sold out to World Bank and IMF
(which are nothing but US friendly bodies) and Spain and Portugal has been bought by China and Japan. You see where I am getting at? Well of course there is no proof of this fact just like there is no proof that Obama is in Pakistan
But people still believe 9/11 was caused by terrorists and President JFK was shot dead by Henry Oswald. (Please don’t kill me.)
So, if India wants to buy a country, they need to do the following:
i) Go for fixed exchange rate policy again
ii) Export more to States
So the truth is: CHINA WILL NOT APPRECIATE THEIR CURRENCY because if they do so then they might not have enough money to buy Africa. Oh!! I forgot it is an economic article!!
So, here is the ECONOMIC REASON why China will not appreciate their currency. As long as China is expert of producing cheapest goods they are going to dominate US consumer market. Why will someone want to let go of competitive advantage? If US is going to sit on large barrels of oil for themselves by invading Iraq then China has every right to sit on large bundles of USD, because guess what? They will later use that USD to buy oil from USA itself. Now, who do you think is smarter?
Chinese or Americans? Well, I have lived close to them for three years and believe me when I say that Chinese are the smartest ones !
Thursday, February 24, 2011
IS SENSEX A TICKING TIME BOMB Or IS IT JUST GOING THROUGH A RALLY?
Before this question can be answered it would be interesting to look into the fact as to why and how did the Indian BSE hit the 20,000 points mark so fast after stooping as low as 7000 during year end 2008. In that period Indian stock markets which were cruising in January ’08 around higher 20,000 came crashing down by end of December. It will be interesting to see why such a dip took place. Was it due to the fall of Lehman Brothers? Was it the credit crunch? Was it due to falling investor sentiments? Lehman Brothers which outstood the period of Great Depression during 1930’s in States fell in 2008 due to subprime crisis. So does this mean the subprime crisis effect was an even worse scenario than the Great Depression? Well, according to me, subprime crisis was even worse but the similarities between the scenarios are noteworthy1.
The key to understanding as to why the Indian markets are falling now will be realised if the period after the market crash in end 2008 is studied. During the period of 2009 the Indian government in accordance with the rest of the world decided to introduce stimulus package into the economy and reduced the key rates like repo and reverse repo rates. The package for India was more effective than the west due to a simple reason. Indian markets had much lesser exposure to the debt laden high risk mortgage like the west. Therefore, the recovery for the Indian markets was much faster pace than the west. The time lag related to policy implication got narrowed as well as the stimulus directly got transferred into the economy within 2 months of introduction. As it is well known that when there is an introduction of the stimulus package it gets translated into the autonomous component of the IS curve causing it to shift right and leading to an overall output increase. Now, if the IS curve is shifting it leads to higher interest rates which leads to a huge capital inflow. This is exactly what happened for India, huge amounts of FII’s came into the Indian stock markets.
This was primarily due to high investors’ confidence in Indian economy which was due to multiple reasons. Firstly, Indian growth rate continued to be robust at almost 8% during that period. Secondly, unlike the West, Indian domestic market was very sound with the PSU’s showing exceptional potential. Thirdly, the political condition was sound in the country as well. Huge amounts of money came into the market. The growth actually became so robust that due to inflationary pressures, the RBI had to intervene sooner than expected, as early as Jan 2010. The RBI actually said their focus had shifted from providing further recovery to containing the recovery.
Over the period of 2 years as large as 27 billion USD flowed into Indian markets through FII’s. Actually though everyone might think this is excellent news but this is not entirely true. It is not good for an economy in the long run if no control can be kept on the capital inflows into the economy. If by some reason along with robust capital inflows there is positive current account then the economy tend to get heated up too fast. Another reason is the huge capital inflows generally gets translated into the asset markets which could lead to asset bubble. But the most important problem is the stock exchange might not be showing a true picture i.e. to say as the shares gets bought the prices starts rising and the SENSEX sees green while the reality is all the money is invested by foreign investors.
The problem with this is as the money is drawn out, the market would go BOOM! This is exactly what the case is now!
Due to rising inflation in the country, scams one after the other is giving investors the jitters leaving them with no choice but to withdraw? The thing is as the inflation continues to rise the real interest rates continues to fall. So, investors fear lesser returns. Thus, when only 2.2 billion of the 27 billion FII’s gets drawn out over the period of two months the market falls from 20,000 to 17,000 points. So, only an 8% withdrawal of their money by the foreign investors has led the SENSEX to fall by almost 3000 points. Are you thinking what I am thinking? IMAGINE WITHDRAWL OF UPTO 10 BILLION MORE! BOOOOM!!! There goes SENSEX RED and bleeding.
Well, on the other hand, the scenario might not be so dramatic. Even though food inflation in the country is on a rampage, core inflation level is still stable. The only problem is with the scams that are taking place. But that is not much of a worry for the investors. The growth rate predictions which have been revised to show more than expected growth may draw investors back. The consumer demand in the country remains still very strong and if FII’s goes out there are still possibilities of large numbers of FDI’s to take place via mergers and acquisitions. The fact is as the Western Economy starts to recover the foreign investors want to place their funds in their local markets than abroad as the risks get much lowered with moderate returns. There seems chances are quite low of such huge amount of withdrawals taking place in the economy as the confidence of the investors still remain intact on Indian future. The deal between BP and Reliance shows the kind of potential that still exists in Indian markets. A 9.2 billion dollars deal by the petroleum giants is sure to give a boost and increase investor confidence in India. The deal clearly shows the opportunities that exist in the energy sector of the country. Hence, experts are only saying that the SENSEX is going through a rally and will recover very soon. If you are a rational investor then that is in fact great news for you!
So, you know what to do! Go there and START INVESTING
The key to understanding as to why the Indian markets are falling now will be realised if the period after the market crash in end 2008 is studied. During the period of 2009 the Indian government in accordance with the rest of the world decided to introduce stimulus package into the economy and reduced the key rates like repo and reverse repo rates. The package for India was more effective than the west due to a simple reason. Indian markets had much lesser exposure to the debt laden high risk mortgage like the west. Therefore, the recovery for the Indian markets was much faster pace than the west. The time lag related to policy implication got narrowed as well as the stimulus directly got transferred into the economy within 2 months of introduction. As it is well known that when there is an introduction of the stimulus package it gets translated into the autonomous component of the IS curve causing it to shift right and leading to an overall output increase. Now, if the IS curve is shifting it leads to higher interest rates which leads to a huge capital inflow. This is exactly what happened for India, huge amounts of FII’s came into the Indian stock markets.
This was primarily due to high investors’ confidence in Indian economy which was due to multiple reasons. Firstly, Indian growth rate continued to be robust at almost 8% during that period. Secondly, unlike the West, Indian domestic market was very sound with the PSU’s showing exceptional potential. Thirdly, the political condition was sound in the country as well. Huge amounts of money came into the market. The growth actually became so robust that due to inflationary pressures, the RBI had to intervene sooner than expected, as early as Jan 2010. The RBI actually said their focus had shifted from providing further recovery to containing the recovery.
Over the period of 2 years as large as 27 billion USD flowed into Indian markets through FII’s. Actually though everyone might think this is excellent news but this is not entirely true. It is not good for an economy in the long run if no control can be kept on the capital inflows into the economy. If by some reason along with robust capital inflows there is positive current account then the economy tend to get heated up too fast. Another reason is the huge capital inflows generally gets translated into the asset markets which could lead to asset bubble. But the most important problem is the stock exchange might not be showing a true picture i.e. to say as the shares gets bought the prices starts rising and the SENSEX sees green while the reality is all the money is invested by foreign investors.
The problem with this is as the money is drawn out, the market would go BOOM! This is exactly what the case is now!
Due to rising inflation in the country, scams one after the other is giving investors the jitters leaving them with no choice but to withdraw? The thing is as the inflation continues to rise the real interest rates continues to fall. So, investors fear lesser returns. Thus, when only 2.2 billion of the 27 billion FII’s gets drawn out over the period of two months the market falls from 20,000 to 17,000 points. So, only an 8% withdrawal of their money by the foreign investors has led the SENSEX to fall by almost 3000 points. Are you thinking what I am thinking? IMAGINE WITHDRAWL OF UPTO 10 BILLION MORE! BOOOOM!!! There goes SENSEX RED and bleeding.
Well, on the other hand, the scenario might not be so dramatic. Even though food inflation in the country is on a rampage, core inflation level is still stable. The only problem is with the scams that are taking place. But that is not much of a worry for the investors. The growth rate predictions which have been revised to show more than expected growth may draw investors back. The consumer demand in the country remains still very strong and if FII’s goes out there are still possibilities of large numbers of FDI’s to take place via mergers and acquisitions. The fact is as the Western Economy starts to recover the foreign investors want to place their funds in their local markets than abroad as the risks get much lowered with moderate returns. There seems chances are quite low of such huge amount of withdrawals taking place in the economy as the confidence of the investors still remain intact on Indian future. The deal between BP and Reliance shows the kind of potential that still exists in Indian markets. A 9.2 billion dollars deal by the petroleum giants is sure to give a boost and increase investor confidence in India. The deal clearly shows the opportunities that exist in the energy sector of the country. Hence, experts are only saying that the SENSEX is going through a rally and will recover very soon. If you are a rational investor then that is in fact great news for you!
So, you know what to do! Go there and START INVESTING
Thursday, February 10, 2011
Depreciation of currency : A Boon in disguise or An Evil ?
Before talking about depreciation of currency it is important to point out that there are two kinds of exchange rates that exist: A fixed exchange rate and a flexible Exchange Rate. For example: China follows a fixed exchange rate system while India
The main difference in the two systems is that in case of fixed exchange rate system (as the name suggests) the exchange rate of the currency is fixed and can be changed only by the government and not by the market forces. A government if it wishes then can either revalue or devalue its currency. But in the case of flexible exchange rate system the value of the currency is determined externally via the market forces i.e. by the demand and the supply of the currency in the market. Now it is here the concept of depreciation comes in.
A currency is said to depreciate when its value declines or falls against another currency i.e. when more of domestic currency is required to buy one unit of another foreign currency then the domestic currency is said to have depreciated against that foreign currency. For example: If the exchange rate of INR against USD yesterday hypothetically was 46.40/ 47.20 and today is 48.50/ 49.30 then the INR is said to have depreciated against the US dollars. Exact opposite to depreciation is the concept of appreciation where lesser units of domestic currencies are required to buy one unit of foreign currency. It is to be remembered always that it is not in the hand of a government to control the currency as such. Though there are ways to do so but for now let’s assume that it is only the market forces that decides when a currency should appreciate or depreciate. It is important to talk about depreciation or appreciation of a currency due to its implications.
The following implications that I am going to talk about is not immediate i.e. it is not that all this would happen on the same day when the currency depreciates. The implications are due to persistent fall of the currency over a period of time. Now let’s see what happens:
INR depreciates against USD à For people in US it is cheaper to buy INR goods à India’s export becomes competitive à Exports to US risesà Imports from US falls as it is expensive to buy goods from there àTrade Account improves à Net Exports rises àY (output) rises as Y = C + I + G + NX à increase in GDP
When the currency is cheap and interest rates are highà Investors willing to investà more FII’s and FDI’s à capital inflow à money supply increaseà LM curve shifts to the rightà output increases
Before I continue I will like to point out one reason why the currency might depreciate. But the big question is if this is the case that the external market forces are the reason for a currency to depreciate then that will mean that there is no control and the economy should continue to grow infinitely. But this is not the case as there exists automatic stabilizers in the economy. To explain this I would need to take help of the IS-BP-LM model or the Mundell-Fleming model for currency exchange in a floating exchange rate system. Let’s see how: (Of course as always there are lots of assumptions that I am making to simplify the model for understanding)
Let us say that initially we are at E1 with interest rate at iw and output at Y1. Now the government has introduced a new expansionary monetary policy for which the LM curve has shifted to the right from LM to LM1à equilibrium shifts to E*à interest rates fall to i*à there is huge capital outflow as investors see lower returns à this leads to lower demand for INR as the investors sell INR and convert currency to USDà lower demand for INR in the currency market leads INR to depreciate. This withdrawal of money from the economy also to certain extent helps to curb inflation.
MUNDELL – FLEMING MODEL
FALL IN DEMAND FOR INR (leading to depreciation)
This is one way how a currency may depreciate.
Now as seen above, the converse is also true as the currency starts to depreciateà exports become more competitiveà exports rises and imports fall à there is a change in NXà in case of IS curve the NX lies in the autonomous component of the equationà Y = m(A0 – br) where m = multiplier and A0 the autonomous componentà As the A0 increases it causes in Y which is larger due the presence of the multiplierà this is what is causing a larger increase in Y in the figure (Mundell- Fleming Model)àIS curve shifts thus from IS to IS1à equilibrium shifts from E* to E2 à Y increases from Y1 to Y2à increase in output and thus GDP.
The automatic stabilization that I was talking about before has been achieved through the rightward shift of the IS curve. The interest rates have been restored to the original level along with which the output has increased.
Therefore it may seem like that the ultimate benefits achieved from depreciation of a currency are larger for the economy as there is a rise in the output and lowering of inflation as well. So through depreciation two birds can been killed with one stone. But there is a big catch:
As we all remember: Money Supply = money multiplier * High Powered money i.e. Ms = mm * H
But this H has two components: one is domestic (Hd) and one is foreign (Hf) i.e. Ms= mm * (Hf + Hd)
The central bank can control the Hd component of the high powered money as it is domestic but the Hf component is not in their control and is determined primarily by the market forces. So, if the Hf component goes into a spiral then it would really hard for the central bank to control the money supply in the economy. A frequent fluctuation of the money supply in the economy can be disastrous as it may lead to hyperinflation. As the currency continues to depreciate for longer period of time the value of the domestic currency will fall which spells gloom for the economy. On the other hand as the currency persistently depreciates it will be much expensive for the country to import goods like crude oil which is primarily traded in USD. This would lead cost push inflation in the economy. It might happen that as inflation level raises unemployment level also starts rising. Thus the economy would fall into a stagflation scenario. Thus a country has to decide whether it is worth it to let the currency depreciate for a long period of time and enjoy short term benefits at the cost of long term doom. This is exactly why no country wishes to face this problem and does not deliberately depreciate their currency.
Subscribe to:
Posts (Atom)