India, China and Forex Game

Chetan Subramaniam is a god level professor at IIM B. With his phenomenal passion towards macroeconomics, he takes you by surprise. He gives simple examples and  makes you think about the complexity of several nation level economic problems. And I just love macro economics and Chetan's class and had to bid high to secure his course in term 5.

I plan to share as many thing taught by him in and out of the class on economics. As I've already mentioned, this is much for my reflection and will be glad if it helps some one else too. 

Currency Devaluation - India - 1991

Well, I was surprised to know that Greece in present shape (2011-12) is in many ways similar to what India was in 1990-91. Back then, India was facing huge debts. Actually, huge foreign debts. Just like for any human being who he is in debt, any nation has only two options left. One, generate steady immediate source of income and two, cut back personal spending on unnecessary stuff (national expenses on unproductive activities). 

Now, there is a glitch here. As i said, the debts that India had are not internal. They are huge FOREIGN debts which have to be paid back in FOREIGN currency. HOW DO WE DO THAT? For this we shall use some simple numbers and ratios:

E(Re/$) . Let us call this thing as exchange rate(of how many rupees is a dollar worth of). Currently it is around 57 INR . Back then on 1990s it was around 30-35 INR. I shall state a simple ratio now: 

Relative Prices = Price of US Good *  E(Re/$)/ Price of Indian good

Now, if I have to increase income and thereby increase my foreign currency levels, I need to EXPORT more good. How do I do that? I can increase my exports by reducing my price drastically in comparison with similar goods abroad. This is done by devaluing our indian currency(By rising exchange rate E(Re/$)). Now when I  increase E(Re/$),  RELATIVE PRICE of indian good over US is decreasing as per the ratio above. 

So, whenever, our  exchange rates rise(which means our price of good become cheaper relatively), it is evident that the value of indian rupee falls in comparison with relative country.

And our govt along with RBI, managed to (How? we shall come to that next) increase exchange rate (it rose to above 40 INR) level, thereby making indian goods cheaper and globally competitive. This rapidly increased indian exports and indian treasury started getting filled with foreign currency with which foreign debts could be repaid. Thus devaluing currency helped generate income and save our day. 

However, now Greece is part of Eurozone and it doesnot have monetary independence to devalue its currency (which is Euro and is managed by ECB) . So, only option left for its govt is to cut back on spendings on unproductive activities. These are typically, penison benefits, welfare programs etc. This is definitely against popular sentiment and will not go well with public. Hence so many protests and changes of govt heads. In short, all hands of Greece are tied up to come out of foreign debts. One solution would be to come out of Eurozone and have independent monetary policy. Time has to tell how things would evolve. 

China and US

China is known for keeping its currency artificially undervalued. This makes chinese goods very cheap and US imports very costly in China. Hence there is huge flow of dollars from US to China (by selling chinese goods in large numbers to US). China is now sitting on a huge pile of US dollars. US asks China to appreciate its currency(why? :) Simple: When Yuan appreciates, US expects its exports to look cheaper and hence increase its exports to China. This expectation has caveats seemingly ) (by lowering the exchange rate: E(yuan/$)), which china doesn't heed to. 

Now, let us see how this appreciation and depreciation of currency is made possible. This is done by and Open market operations Committe sitting with RBI(central bank of a country in other countries). They buy/sell (suck/push) a currency in exchange of another currency. We shall see the financial dynamics sometime later in other post. 

If I am to appreciate my currency (ie to lower my exchange rate), I will have to make my currency scarce or/and make dollars abundant. So, if I have to make my currency scarce, I will have to suck out liquidity from my economy. However when you suck out liquidity, your prices go down . (MV=PY is the basis for this statement). This lowers inflation too. Bottom line is prices would go down, even in this case. But domestic growth rate would be impacted. When prices would anyway fall , either you depreciate or appreciate currency and will impact growth in the latter case, why would China heed to US requests to appreciate currency.