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CURRENCY WAR

A COMPLETE INFORMATION ABOUT APPRECIATION AND DEPRECIATION OF CURRENCIES AND THEIR EFFECT ON DOMESTIC AND INTERNATIONAL ECONOMY

A lot of articles have been written on this topic, but in this article, I have tried to explain the basic fundas of currencies in International trade and economies. A lot number of times we come across the debates that rupee has appreciated or depreciated… oil prices will go up or down due to revaluation of rupee; etc., but have we really understood the meaning of appreciation and depreciation? How can simple currencies affect the world economy so much so that major political debates in most of the developed countries center around this commodity? Why is currency so important that in USA there is growing demand to brand China as a ‘currency manipulating country’ and thus impose sanction against it through WTO?

First of all let us understand the meaning of appreciation and depreciation. A currency is said to appreciate against the dollar when its price as compared to dollar decreases. Suppose Indian currency is currently $1 = R50. This means that if the tourists coming to India pay $1 at the Airport currency exchange, he will get R50. If value of Indian currency against dollar appreciates, this means that new value of Indian currency is $1 = R48 or 47 or anything lesser. Rupee is said to get strengthened against dollar. Now if the foreign tourist pays $1 at Airport Currency exchange counter, he will get R48 or lesser. The vice versa is depreciation. If $1 in above example becomes equal to R52 or 53 or anything more, we say that rupee has fallen in comparison to dollar.

Now what affect will this appreciation and depreciation will have on the international economy? Any one by reading the above explanation could very well say that the tourism will be discouraged. But tourism is not the major source of income in most of the countries of the world. Then why so much of hue and cry? Let us take the issue in detail and understand the implications of appreciation and depreciation.

  1. 1.       INDIAN RUPEE DEPRECIATES.

a)      Effect on Imports

Let $1 =   R50

This means that if a business man in India wants to import some product (say raw materials or finished products) from US worth $1 he will have to pay R50.

But suppose the rupee depreciates and now the new rate is

$1 = R100

In this case the importer has to pay R100 for importing the same product worth $1.

So the product is same and its price is same but the importer is paying more due to the depreciation effect. If his cost of production (import) has increased, he will have to raise the selling price in order to compensate the loss, but doing this will make his product expensive and will not be able to compete other locally manufactured low cost products.

Hence, in this case import will be discouraged.

b)      Effect on Exports

Let $1 = R50

Suppose a business man manufactures a product. The cost of manufacture is R50. He launches the product in US market for $2. Here he will make a profit of R50. His product being also cheap, he will be able to compete easily with the home products there.

But suppose the rupee depreciates and now the new rate is

$1 = R100

In this case, suppose the exporter’s cost of production still remains the same (the raw materials being completely local); he will be manufacturing the product in R50 only. But now when he sells the product in US market for $2, he takes away R200 instead of R100 earlier. He can also lower down the selling price to $1.5 and throw away the home products out of competition. He will still be making more profits.

So the product is same, the cost of production is same but profits have increased due to the depreciation effect.

Hence, in this case the export will be encouraged.

  1. 2.       INDIAN RUPEE APPRECIATES.

a)      Effect on Imports

Let $1 = R100

This means that if a business man wants to import a product in the Indian market worth $1, he will have to pay R100.

But suppose the rupee appreciates and the new rates are

$1 = R50

In this case, if the business man wants to import the same product he will pay only R50 instead of R100.

So imports will be encouraged.

b)      Effect on Exports

Let $1 = R100

This means that if a business man manufactures a product for R100 and wants to sell it in US market; he will launch his product for at least $2, so that he can take back at least R200 (a profit of R100)

But suppose the rupee appreciates and the new rates are

$1 = R50

In this case, suppose the exporter’s cost of production still remains the same (the raw materials being completely local); he will be manufacturing the product in R100. But since he was earlier earning R100 on each product sold, he would like to retain the profits. For doing so he will have to launch the product in the US market for at least $4 (R200), i.e. double the earlier selling price. So earlier he was selling the product in the US market for $2 and still making a profit of R100. But now to continue making R100 profit he will have to raise the price of his product because if he continues selling the product for the same $2, he will only take back R100, which is only the cost of production, means zero profit. And if he raises the selling price of the product he will be unable to compete with the locally manufactured products.

Hence, exports will be discouraged.

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So it is necessary to maintain a balance between appreciation and depreciation of currency. This is undertaken by every nation’s central bank (RBI in our case). Central bank maintains the rate by buying and selling the dollars in exchange of their currencies in international money market. When the value of a currency depreciates beyond the preferable limit, Central bank starts buying the dollar through their currencies. By buying the dollar in large quantity, supply of dollar in the market decreases and due to the increase in demand, the value of dollar goes up or that of currency goes down (appreciates).

On the other hand if the value of currency appreciates beyond the limit considered safe by central bank, it starts buying heavily its own currency in the money market, thereby increasing the demand. As demand increases, supply remaining the same, prices tends to go up (depreciates). It also starts selling dollars to increase its supply and thus lower down the value.

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CURRENCY AS WEAPON

 

The governments of the different countries of the world did not take time in understanding that this foreign exchange rates is a potent weapon to put economic pressure on any country. The most important name that comes in this context is that of China. China did not allow Yuan to be traded on money market for over two decades. By not allowing Yuan to be valued against other currencies of the world, it was able to decide its own rates suiting its economic activities. Still China does not allow the Yuan to be very largely guided by market forces. China keeps its currency undervalued so as to promote exports. This is the reason why Chinese products have captured the world market. Even major companies of the world have set up their manufacturing units in China because of this main reason, and thus bringing employment and revenue for Chinese people and government. Since Yuan is undervalued against US dollar, the exporters can earn huge profits and take back huge quantity of Yuan, even if they sell their products at a very low cost. Experts argue that this has created job loss in USA to a large extent. China being a developing economy, the raw materials and labourers are cheap: and so the cost of manufacturing remains low. Supported by undervalued Yuan, they can easily enter the world market at low price. This is the main reason why the Chinese toys, mobiles, etc are cheap but still earning profits. This activity of China seriously affects the other country’s economy and their home products.

The value of the yuan is controlled by the government – The State Council (and not by China’s Central Bank). China’s economic growth has been helped by the low value of the yuan. With the yuan low, the price of Chinese products and labour remains low, spurring the purchase and export of Chinese-made products and attracting foreign investment to take advantage of cheap labor, stimulating growth. Beijing wants to keep the value of yuan low to keep the economy humming.

Now some of you would like to know how the undervalued Yuan can help China in maintaining low cost of labour and raw materials. Take an example, suppose Indian Central Bank maintains a very undervalued rupee, say $1 = R100. If the Minimum Wages Act of India says that each companies setting up its manufacturing plants in India will have to pay a minimum of R100 per day to each workers. Helped by the undervalued rupee, the companies will have to pay only $1 per day. But suppose, rupee gets over valued and the new rate is $1 = R50. The companies in this case, keeping in view the Minimum Wages Act will have to pay $2 per day to each worker.

Similarly undervalued rupee can also help keep the raw materials cheap. A company can procure more raw materials for $1 if the local currency is highly undervalued. Thus companies will be encouraged to set up manufacturing plants in these countries. This is a win-win situation for both the parties. Companies get low manufacturing costs, government gets revenue and employment.

To keep the yuan undervalued China has to buy dollars to prop up the dollar’s value. Buying dollars means exchanging them for Chinese currency and flooding China with yuan, which normally causes inflation (increase in money with people means increase in purchasing power, which means prices will go up) which the Chinese government avoids by issuing bonds to take yuan out of circulation, a process the Chinese call “sterilization” (banks and individuals purchase these bonds and thus Yuan goes back to the government which the government can again use to buy dollars – the cycle). Interest rates are kept artificially low to keep investors from buying Chinese currency. The artificially low interest rates make it impossible for Chinese to control monetary policy. This means that loans to companies does not reflect their real value, which could create a bubble situation. The United States and other want China to float the yuan.

According to the historian Francis Fukuyama, “China’s de facto export subsidy via its currency policy is theoretically no different from a direct subsidy to its manufacturing, export industries…In a certain sense; China has been in effect de-industrializing much of the rest of the world. I’ve been to the maquillas in Latin America…and seen firsthand how manufacturing capacity is being sucked out of these developing countries.”

However, China argues that if the value of the yuan were to rise 30 percent like some American politician want, it could cause deflation, cut economic growth, cutoff foreign direct investment. If these things happened prices would skyrocket at Wal-Mart and Best Buy, consumers would stop buying the stuff, and the Chinese and Asian economies would grind to a halt, but would have the money and reserves to buy America’s largest corporations.

If the value of the yuan were to rise significantly, the change probably wouldn’t affect the U.S. deficit or the trade deficit or bring jobs back to America. If Chinese imports become too expensive manufacturers will shift location in Asia to, say, Vietnam or Indonesia. With less cash China would not be able to buy U.S. treasury bonds and this could lead to a rise in interest rates in the United States. If the purchasing power of the Chinese grows with a stronger yuan they will buy more commodities such as oil and cause the price of these commodities to rise and snatch American companies and possibly buy up properties as the Japanese did in the 1970s and 80s.

Prodding China to appreciate the undervalued yuan was a hot political issue in the United States in 2010. Some congressmen wanted the Obama administration to raise tariffs on Chinese-made imports and label China “currency manipulator.” In the end Obama decided not to attack China too aggressively on the issue so as not to stir up too much animosity. In one-on-one meetings with the Chinese leader Hu Jintao, Obama prodded him to allow the yuan to appreciate. Beijing responded that it would not bow to foreign pressure and called such pressure “political myopia.”

However, not everyone thinks raising the value of the yuan will help the world’s businesses and economies. William Pesek of Bloomberg described three ways a strong yuan could backfire:

1) it could accelerate inflation by raising prices in the “Wal-Mart economy” that the world has come to depend for a steady stream of cheap good;

2) it could produce a slowdown in the Chinese economy that could deprive the world of a much-needed growth engine; and

3) it could make China so rich and flush with cash that it could snap up major corporations and chunks of choice real estate.

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Posted by on February 5, 2012 in ECONOMICS

 

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