16 Dec 2007

A dollar at 35 Rupees !!!

"The rupee is testing 38, we are playing in the 38-40 band. It has so far been a two-rupee band and the rupee could come to 35 vis a vis the dollar in some years," says K V Kamath, CEO of ICICI Bank as rediff reports. Indeed, if it would be, a proud moment for India. A sure and potent sign of a strong economy. Its not that this would be the first time though, it was pretty much the same before the Rupee was devalued during the last emergency of 1975, but now the appreciation is on account of the strength of the economic value that Rupee carries, therefore exhilaration is due indeed.

Of late there was much hype and euphoria when the Chinese Yuan was appreciated. However the situation was different there. No doubt the Yuan was becoming strong but the appreciation was on account of change in peg to basket of currencies rather than on account of the intrinsic worth of Yuan itself. I am pretty sure by now most of the readers without a background in monetary economics would be at bay with what I have written here. So its time for simplification.

Currencies the world over were initially valued in terms of their convertibility with gold, i.e. the 'Gold Standard'. This meant that the value of the currency was how much gold it could purchase with one unit of its currency. This also meant that the holder of the currency was entitled to get gold equivalent to the currency which he held, i.e. the 'Gold Convertibility' and the national governments or their central banks (like Federal Reserve for US, Bank of England for UK, Reserve Bank for India, etc.) were obliged to give equivalent amounts of gold to the currency that was presented to them for conversion. This however meant that the Banks could issue currency only equivalent to the amount of gold they carried.

This restriction on ability to issue currency severely impacted the roles national governments and their central banks could play in the regulation and management of their economies. Further, with the Great Depression proving a disaster for macro-economic management, countries the world over shifted to 'partial convertibility' i.e. gold would be given in exchange of the currency but not to the full extent of the value depicted on the currency but only partly. So for example when earlier for presenting $500 you would get gold worth $500, now for presenting $500 you could get gold worth only $50 and so on and so forth.

Then came the World Wars and the countries were in need of money more than ever. Simultaneously the IMF was also established. This led to the rejection of the gold standard altogether. Countries across the world agreed to covert their currencies now in only different variants and not in gold. So earlier when you could get gold worth $50 for submitting $500, now you could only get other dollar bills. So for 5 $100 notes you could get 100 $5 notes and so on. But the IMF held in more than this. It determined at that point the value of each currency on the basis of gold it could purchase and then calculated the value of each currency vis-a-vis each other, i.e. 'exchange rate'. The countries which came later on were given option to determine the value of their currency on the basis of an existing currency value or a mixture of them.

So India adopted a 'basket of currencies', currently 12 but unknown, where upon a formula developed by it the value of Indian rupee would be determined. China, prior to the appreciation I talked about above, was pegged to US dollar. So whatever the value of US dollar, the value of Chinese Yuan would be xUS$ where x was what China would decide.

Naturally Chinese products were always cheaper in US than US goods. And consequently the trade advantage China got allowed itself to occupy a huge market share (we all know how huge) not only in US but all over the globe. And so economically US was always constrained and this led it to raise a political agenda to get Yuan change from pegged to a basket, which China in fact did.

Now there is a concept of fixed, floating and dirty exchange rate as well. But I think this would get this post will get too heavy. Will write somewhere else. In any case, coming back to our originally discussion, since it has not been the influence of RBI or any external agency that Rupee has been appreciating, it is surely the outcome of economic growth and relative stability that India has been facing on the monetary front, which is good news indeed for the county as a whole but with the exception of exporters which have been having a good time with a weak rupee. Let us hope they can continue to make the best of their business by entrepreneurial initiative instead of looking for a fiscal relief from the Finance Minister.

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