Sunday, April 30, 2006

Strength of Currency

Understanding the interplay of exchange rates and economic implication
is a complex subject. I would try to explain the things in layman's
terms and would refer serious economics enthusiasts to books
referenced at the end of this message.

Lets imagine a world without currencies and trade based on bartering
of goods. Assume that A deal produces only spices and country B
produces only silk. Thus these two items become their currency for
trade. if the spices are highly sought after items then the economy of
country A would be able to import more goods by forgoing a little part
of their own produce, that is silk. The country would afford a large
buying power for their produce.

Implication 1: Strong currency is helpful to the economy.
All the countries during the periods of their economic superiority
have had strong currencies. The rise of Dollar along with US economy
and fall of Rouble along with the fall of Russia are 2 examples

Now let's assume that there is another country C which produces only
spices. To compete agaist each other to sell their spices both A and C
will have to keep the prices of their spices at reasonable level. If
the country C starts under pricing its spices the trade between
country A and B will suffer and the economy of Country A be affected.

Implication 2: A strengthening currency not helpful to the exports. If
exports drive substantial portion of the GDP, a A strengthening
currency is not helpful economy.

The strength of economy is not directly correlated with the fortunes
of the capital markets which represent only organized corporate
sector. In the countries like India where FII investment is a
significant driver in the investment decisions of market participants
the exchange rate movement matters. This acts through the "expectation
of change in the exchange rate" rather than change itself. If the FIIs
think that they can generate 10% rupee returns and expect rupee to
depreciate by 5% their dollar return becomes only 5% and they would
rather invest in US Govt. treasuries.

If the strong currency is associated with expectation of weakening you
would see large FII/FDI investment. If the exchange rate is expected
to be stable it will not be a significant matter rupee trades at 40/$
or at 50/$.

The more complicated impacts from exchange rates come in form of the
changes in interest rates and inflation. For instance, if the dollar
inflows cause a rupee to appreciate the RBI will have to buy Dollars
and release rupee in the economy. This would cause inflation and rise
in interest rates. To counter this the central banks follow
neutralization tactics like selling Govt. bonds to mop up additional
liquidity. I don't think that I can explain(or even i understand) this
aspect in a message.

None the less I can answer any specific queries you have in this
subject and feel free to post your views.

The General Theory of Employment, Interest, and Money, by Keynes

Wealth of Nations , by Adam Smith

Posted: Feb 8, 2005

1 comment:

Pritesh said...

nice explanation