Solving The Riddle

Pritam P Hans Edition: February 2012

STORY TOOLS

 How rupee volatility affects your budget

 Why falling rupee is good for investors

With the exception of someone living in a cave on an undiscovered island, everyone uses money.
Shops accept currency notes and coins, but they also accept credit cards. Is credit card money?

Money is the value assigned to a commodity, a piece of paper, a coin or electronic data (think
online banking and credit cards). It can be of different types-commodity money, representative
money, fiat money and commercial bank money. Gold coins, cocoa beans, cattle or anything that
has a value of its own and is used as a medium of exchange is commodity money. The use of
commodity money is similar to barter, except that the commodity used is widely accepted and
can be easily handled.

Representative money is token coins and notes that can be exchanged for a fixed amount of
precious metals or other commodities. In contrast, fiat money's value is imposed by the
government, which makes refusal of payments made in the notified legal tender, in the form of
currency notes and coins, illegal.

Instruments such as cheques, demand drafts and banker's drafts are commercial bank money.
They exist as entries in ledgers of financial intermediaries and can be used to make payments for
goods and services.

THE CHANGING FACE

Money is not an organic creature but its value keeps changing with the society and its economic
conditions. One rupee in 1947 is not the same as one rupee today, both in terms of appearance
and purchasing power.

The value of a country's currency is linked with its economic conditions and policies.

The value of a currency depends on factors that affect the

economy such as trade, inflation, employment, interest rates,
growth rate and geopolitical conditions.
Pramit Brahmbhatt
 Money Supply
Amount of currency in circulation

CEO, Alpari India

"The value of a currency depends on factors that affect

the economy such as imports and exports, inflation,
employment, interest rates, growth rate, trade deficit,
performance of equity markets, foreign exchange
reserves, macroeconomic policies, foreign investment Comprises all the currency in the
inflows, banking capital, commodity prices and economy as well as the money in
geopolitical conditions," says Pramit Brahmbhatt, chief savings and current accounts held
executive officer, Alpari Financial Services (India), a with banks (demand deposits).
foreign exchange brokerage.

Income levels influence currencies through consumer

spending. When incomes increase, people spend more.
Higher demand for imported goods increases demand for
foreign currencies and, thus, weakens the local currency.

Balance of payments, which comprises trade balance (net

inflow/outflow of money) and flow of capital, also affects
the value of a country's currency.

"A country that sells more goods and services in overseas Includes money held in post office
markets than it buys from them has a trade surplus. This savings accounts along with M1.
means more foreign currency comes into the country than It excludes money in post office
what is paid for imports. This strengthens the local fixed deposits and National
currency," says Kishore Narne, head, commodity and Savings Certificates.
currency research, Anand Rathi Commodities, a
brokerage house.

Another factor is the difference in interest rates between

countries. Let us consider the recent RBI move to
deregulate interest rates on savings deposits and fixed
deposits held by non-resident Indians (NRIs). The move
was part of a series of steps to stem the fall in the rupee.
By allowing banks to increase rates on NRI rupee
accounts and bring them on a par with domestic term
deposit rates, the RBI expects fund inflows from NRIs, Comprises M2 money supply plus
triggering a rise in demand for rupees and an increase in fixed deposits (or time deposits)
the value of the local currency. held with banks. It is used as a
common measure of money
The RBI manages the value of the rupee with several supply.
tools, which involve controlling its supply in the market
and, thus, making it cheap or expensive.

"Some ways through which the RBI controls the

movement of the rupee are changes in interest rates,
relaxation or tightening of rules for fund flows, tweaking
the cash reserve ratio (the proportion of money banks have to keep with the central bank) and
selling or buying dollars in the open market," says Brahmbhatt of Alpari.

The RBI also fixes the statutory liquidity ratio, that is, the proportion of money banks have to
invest in government bonds, and the repo rate, at which it lends to banks.

While an increase in interest rates makes a currency expensive, changes in cash reserve and
statutory liquidity ratios increase or decrease the quantity of money available, impacting its
value.

INFLATIONARY PRESSURE

Every generation complains about price rise. Prices shoot up when goods and services are scarce
or money is in excess supply. If prices increase, it means the value of the currency has eroded
and its purchasing power has fallen.

Let us say the central bank of a country increases money flow in the economy by 4 per cent
while economic growth is 3 per cent. The difference causes inflation. If the growth in money
supply is 10 per cent, inflation will surge because of the mismatch between economic growth and
money supply. In such a scenario, loan repayments will be a lesser burden if interest rates are
fixed, as you will pay the same amount but with a lower valuation.

A fall in purchasing power due to inflation reduces consumption, hurting industries. Imports also
become costlier. Exporters, of course, earn more in terms of local currency.

However, if the increase in money supply lags economic growth, the economy will face
deflation, or negative inflation. The purchasing power of money will increase when the economy
enters the deflationary state. If you think deflation will help you consume more and enjoy life
more, you are wrong.

Unless the fall in prices of goods is because of improved production efficiencies, you will have
less money to spend. If you have a fixed-interest loan to repay, your debt will have a higher
valuation. Yields from fixed-income investments made before deflation set in will, of course,
increase in value.

MINTING MONEY

A fantasy world where trees have banknotes and bear coins instead of fruits might sound like a
dream come true. Economists will be the devil's messenger in that world when they break the
news that your money is as good as dry leaves.

If you are looking for a machine that can print money, just meet someone who actually owns
one-the government. Money is printed by governments, but they cannot print all the money they
need. When a government prints money to meet its needs without the economy growing at the
same pace, the result can be catastrophic. Zimbabwe is a recent example.
 True Value
Relation among value of currency,
its supply and economic growth

After the 1990s land reforms in free Zimbabwe, farm

production as well as manufacturing declined drastically.
However, the government continued to print money for
its expenses. Zimbabweans started losing faith in the
local currency. As inflation surged drastically, the
Zimbabwean dollars were printed in denominations as
high as 100 trillion. After the currency lost its value,
people started using US dollars. In April 2009, the
country put its currency on hold and switched to US
dollars. Let us assume that a farmer has a
tank in which he stores water for
In the past, governments used to back their currencies irrigation. He decides to add
with gold reserves or a foreign currency such as the US another field and builds another
dollar that could be converted into gold on demand. The tank that he connects to the
existing one. However, there is no
gold standard currency system was abandoned as there
increase in the amount of water
was not enough gold to issue money and currency harvested. At the end of the rainy
valuations fluctuated with the supply and demand of gold. season, he has two fields but
water for just one field.
In the modern economy, governments print money based
on their assessment of future economic growth and
demand. The purchasing power of the currency remains
constant if the increase in money supply is equal to the
rise in gross domestic product and other factors
influencing the currency remain unchanged.

FOREX DEMAND

Though international trade and movement of people is

increasing rapidly, there is no currency that is acceptable Now, consider a situation where
across the globe. Whether you go for higher studies to the he knows that the rainfall will
double from the next season. He
US or fly to Rio for a vacation, you have to pay for
decides to add another tank. At
services and goods in the currency that is accepted in the end of the rains, both the tanks
country. Even while shopping online on stores run by have water. If the water tank is the
foreign companies, you have to pay in foreign exchange. currency, the stored water is the
purchasing power.
The foreign exchange rate for conversion of currencies
depends on the market scenario and the exchange rate
being followed by the countries. Floating exchange rates,
or flexible exchange rates, are determined by market
forces without active intervention of central governments.
For instance, due to heavy imports, the supply of the

The increase in rainfall is like

rupee may go up and its value fall. In contrast, when exports increase and dollar inflows are high,
the rupee strengthens.

Earlier, most countries had fixed exchange rates. This system has been abandoned by most
countries due to risk of devaluation of currencies owing to active government intervention. Most
countries now adopt a mixed system of exchange rates where central banks intervene in the
market to buy or sell the different currencies to control the movement of their own currencies.

Not everyone loses in a weak currency scenario. Exporters across the 17-country euro zone, for
instance, are benefiting from a weak local currency. Sometimes countries use various ways to
keep their currencies undervalued to promote exports. Chinese Renminbi is one such currency
that several economists say is undervalued.

BEHIND THE FALL

Now that we know the factors that determine the value of a currency, how does the rupee in your
bank account and purse stand at present? Over the past few months, since August, the rupee has
been weakening against the dollar.

"The recent fall in the rupee was mainly due to conditions in the euro zone, plunging stock
markets, falling foreign investment inflows and strengthening of the dollar," says Brahmbhatt of
Alpari.

"Rising fiscal deficit and untameable inflation were behind the fall in the rupee. As India runs a
large current account deficit, it needs a constant inflow of dollars, which was not there. High oil
prices inflated the import bill and resulted in further widening of the current account deficit,
which accelerated the rupee fall," says Narne of Anand Rathi.

"The decision by the government to allow foreign investors to directly invest in Indian equity
could bring some capital flows and have a positive impact on the economy and the rupee," adds
Narne.

The rupee has recovered somewhat in January, but the danger still looms. If you need some
foreign currency in the future such as for the tuition fee of your daughter studying in the US or a
summer vacation in Ireland, plan right now and hedge your risk with the help of currency
futures. Consider the basics of currency movements and their likely impact before taking your
next investment decision.

Hot air balloon figures (below) are highest daily inflation rates in recent history. At 100%
daily inflation, prices double in 24 hours.
Source: Cato Institute