Global Economic Analysis - Currency Appreciation and Depreciation

Current and Financial Account Surpluses and Deficits Current account deficits (or surpluses) and financial deficits (or surpluses) do not directly affect an economy. In fact, these deficits (surpluses) are actually the result of what is occurring in an economy, instead of being the cause. Trade deficits often occur when a nation's economy is growing faster than the economies of its trading partners. Rapid domestic growth increases the demand for imports, while slow or no growth with foreign economies can cause a decline in demand for the country's exports. Trade balances are also affected by capital flows. If a nation's economy offers investment opportunities that are relatively better than other nations, then capital will flow into the country. With flexible exchange rates, this capital inflow will tend to increase the value of the nation's currency. Economic statistics support the hypothesis that trade deficits are associated with investment opportunities and economic growth. Between 1973 and 1982, which was a time of stagnant economic growth for the U.S., trade deficits and net foreign investment were fairly small. As the U.S. economy grew rapidly after the 1982 recession, net foreign investment greatly increased. During the recession of the early 1990s, capital inflow greatly decreased and the current account was actually slightly positive during one of those years. The time between 1993 and 2000 was one of substantial economic growth; net capital inflows greatly increased, which caused the U.S. dollar to appreciate and the current account ran large deficits. Budget deficits and trade deficits tend to be linked An increase in the U.S. government budget deficit will cause an increase in the real interest rate, which causes additional foreign capital to flow into the country. The inflow of foreign currencies will cause the value of the U.S. dollar to increase in relation to other currencies. The increase in value of the U.S. dollar will make U.S. exports relatively less attractive to foreigners and imports into the U.S. will be relatively less expensive; therefore, net exports will go down. The increase in the budget deficit leads to an increase in the trade deficit. Causes of a Nation's Currency Appreciation or Depreciation Factors that can cause a nation's currency to appreciate or depreciate include: Relative Product Prices - If a country's goods are relatively cheap, foreigners will want to buy those goods. In order to buy those goods, they will need to buy the nation's currency. Countries with the lowest price levels will tend to have the strongest currencies (those currencies will be appreciating). Monetary Policy - Countries with expansionary (easy) monetary policies will be increasing the supply of their currencies, which will cause the currency to depreciate. Those countries with restrictive (hard) monetary policies will be decreasing the supply of their currency and the currency should appreciate. Note that exchange rates involve the currencies of two countries. If a

nation's central bank is pursuing an expansionary monetary policy while its trading partners are pursuing monetary policies that are even more expansionary, the currency of that nation is expected to appreciate relative to the currencies of its trading partners. Inflation Rate Differences - Inflation (deflation) is associated with currency depreciation (appreciation). Suppose the price level increases by 40% in the U.S., while the price levels of its trading partners remain relatively stable. U.S. goods will seem very expensive to foreigners, while U.S. citizens will increase their purchase of relatively cheap foreign goods. The U.S. dollar will depreciate as a result. If the U.S. inflation rate is lower than that of its trading partners, the U.S. dollar is expected to appreciate. Note that exchange rate adjustments permit nations with relatively high inflation rates to maintain trade relations with countries that have low inflation rates. Income Changes - Suppose that the income of a major trading partner with the U.S., such as Great Britain, greatly increases. Greater domestic income is associated with an increased consumption of imported goods. As British consumers purchase more U.S. goods, the quantity of U.S. dollars demanded will exceed the quantity supplied and the U.S. dollar will appreciate Impact on financial The rupee has depreciated by more than 18 percent since May 2011, moreover with the rupee breaching the 53 dollar mark, profit margins of companies that import commodities or components would come under severe pressure, which could result in price increases for the consumer. The rupee depreciation will particularly hit the industrial sector and put higher pressure on their costs as items like oil, imported coal, metals and minerals, imported industrial intermediate products all are getting affected. Although the prices of most of the imported commodities have fallen, the depreciating rupee has meant that the importer gets no respite as they need to pay more to purchase the same quantity of raw materials. The depreciating rupee would keep the price of imported commodities elevated. Thus the industrial sector is bound to get adversely hit. Impact of Rupee Depreciation Primarily the consequences of weak rupee are to be felt through: A. Increase in the Import Bill A depreciation of the local currency results in higher import costs for the country. Failure of a similar rise being experienced in the prices of exportable commodities is going to result in a widening of current account deficit of the country. B. Higher Inflation Increase in import prices of essential commodities such as crude oil, fertilizer, pulses, edible oils, coal and other industrial raw materials are bound to increase the prices of the final goods. Thereby making it costlier for the consumers and hence inflation might be pushed up further. C. Fiscal Slippage The central government fiscal burden might increase as the hike in the prices of imported crude oil and fertilizer might warrant for a higher subsidy provision to be made for these commodities.

D. Increase in Cost of Borrowings Interest rate differentials in domestic and global markets encourage the industry to raise money through foreign markets however a fall in the rupee value would negate the benefits of doing so. Usual discussions on the fall in the rupee bring up macro-economic matters such as slowing economic growth, corporate earnings and market volatility. However, the woes arent restricted to corporate corridors or the Dalal Street. For the common man, the falling rupee is going to hit where it hurts the most-the pocket. From essentials such as food and education to foreign vacation and the swanky gadget you plan to buy, the falling rupee will hurt you in more ways than one. GROCERY BILL High inflation has been pinching you for more than a year now. Now, the weakening rupee has made crude oil, fertilizers, medicines and iron ore, which India imports in large quantities, costlier. Though these items are not for your daily consumption, they impact your finances indirectly. For instance, since India depends on imports for a large part of crude oil it consumes, a weak rupee will influence petrol and diesel prices. Fuel being directly connected with the cost of transportation, prices of goods that are transported from one part of the country to another, such as food, are bound to rise. This will have a direct impact on the household budget. Fast moving consumer goods (FMCG), such as soaps, detergents, deodorants and shampoos, of which crude oil is an input, are likely to become more expensive. The impact of rupee depreciation on the FMCG sector will be due to higher cost of imported raw materials. The companies were already facing cost pressures. The rupee depreciation has added to their woes. They will have to revise prices. Hindustan Uniliver and Procter & Gamble have already taken steps in this direction. Pulses and oil, which account for a large part of Indias imports, will also be affected. Crude palm oil prices set the pace for prices of other edible oils. It is imported in large quantities and any rise in its price will add to the inflationary pressure. JOBS AND REMUNERATION Not only is the rupee falling, for some, the pay cheque may shrink as well. Every industry which is dependent on imports will have to face an increase in cost of production and operations. In order to nullify the increase, these companies will have to rationalize costs within their control. One of this will be human resources. So, either lesser number of people will be hired or the salary bill will be kept constant or reduced. However, it is a good time for industries which earn in dollars. The information technology sector stands to gain, but global recessionary conditions may set off the impact. BUYING A CAR Depreciation of rupee has impacted the automobile sector in three ways. First, input costs have raised as these companies use imported components. Second, some companies will have to pay higher royalty to foreign parent firms. Third, many have foreign currency loans in the form of external commercial borrowings and foreign currency convertible bonds. Therefore, more or less all auto companies will have to increase prices. Maruti has already revised prices twice in last two months. Others like Hyundai, Honda and Ford that have large import content in their cars will have to soon increase prices to protect margins.

 ENTERTAINMENT The imported paperback, your favourite pizza and the latest laptop will also become more expensive. There is an increase in the cost of imported books as well as the cost of sourcing them. In most cases we are trying to absorb the increased cost, but there may be scenarios where the end-user will get impacted. Electronic consumer goods such as computers, televisions, mobile phones, etc, with imported components will also become costlier. International food chains which run outlets in India are not denying the impact on profitability. The depreciating rupee has had a significant impact on our capital expenditure as we import a lot of special kitchen equipment. There has been an indirect impact too as a small part of inputs are imported by our suppliers. If the trend continues, we will be forced to pass on some burden to customers, says Vikram Bakshi, managing director and JV Partner, McDonalds India (North & East).
NEW DELHI, India Across global markets, gold has lost its glimmer. Investors are fleeing the yellow metal, whose price has slumped more than 10 percent over the past three months. But Indians are so gold crazy they're sacrificing their currency and their countrys economy in the bargain. By buying up billions of dollars worth of foreign gold, they are sending Indian cash overseas, disrupting the balance money entering and leaving the country, and thus driving down the value of the rupee. That in turn makes key imports *more costly*, and makes it harder for business to pay international loans. "If for one year there are no gold imports, it will change the current account deficit story of the country," said Finance Minister P. Chidambaram on Thursday. Indians think they are buying gold in rupees. Actually they are buying gold in dollars. India is the world's biggest gold importer, soaking up a third of the world's supply every year. Gold is the country's biggest foreign purchase after oil. The impact? The current account deficit (the net outflow of money) is 5.4 percent of GDP, about double what economists recommend. "I once again appeal to everyone to resist the temptation to buy gold, Chidambaram said. This will show positive impact on every aspect of the Indian economy. While India's current account deficit is too high, the real concern is whether enough money is flowing into the country to make up the difference, Bibek Debroy, an economist affiliated with the New Delhi-based Center for Policy Research, told GlobalPost. And there things get extra tricky. The worry for the government really is that whatever capital inflows we have are in the nature of portfolio investments such as stock purchases which tend to come and go, Debroy said. In contrast, direct investment in factories and in other ventures tend to carry long-term benefits, and the capital remains regardless of short term market fluctuations.

So we should really be asking, Why aren't investments coming in? rather than picking on people who are buying gold. According to Chidambaram, India's gold imports fell from an average of $135 million in the first half of May to $36 million in the second half of the month, but he neglected to mention the reason: This year the Akshaya Tritiya festival, the second-biggest holiday for buying gold, fell on May 13. The post-holiday lull gave some relief to the central bank, which on Tuesday was forced to intervene in currency markets to bring the rupee back from its lowest level against the dollar in history (58.98 rupees to the greenback). But the rupee resumed its fall after the finance minister's speech Thursday. And the dip in gold demand is likely only to be temporary because for Indians gold is more than an investment. Gold is synonymous with savings and security for many of Indias 1.24 billion people, for a variety of reasons. Only about 36,000 of India's 650,000 villages have a bank branch. And minimum balances and other requirements mean that house maids, security guards and construction workers hold much of their assets in gold coins and jewelry as a hedge against bad times, when they can be sold or used as a collateral with the local moneylender. Moreover, the metal's cultural importance makes it essential for weddings and various other ceremonies. Even bankers and lawyers still think of buying gold jewelry as a foolproof financial strategy. And with both the capital markets and real estate losing luster lately, India's wealthy have emerged as a new class of gold buyers. Traditionally, there's always been a demand for gold. But what has added to that in the last four years or so is a different kind of demand. That is a demand for gold that I would call investment, said Debroy. There is quite a bit of investment in gold now that is actually in bullion. Consider this: Even though gold prices have plunged from more than $1800 in November to around $1400 an ounce last month, the World Gold Council has forecast that India's gold imports for April-June would amount to almost half the total imported in 2012. Bad investment? Probably. Experts say a rise in gold prices is unlikely without a big slump in the US stock market or in the value of the dollar, neither of which seems likely. And even long term, gold prices tend to skyrocket and plunge because there's paltry real business demand for the yellow metal, with investors who buy gold and sit on it as an investment accounting for more than half of the volume purchased every year. For the Indian economy, however, the gold obsession is worse than a poor investment. Unlike buying stocks or bonds, parking money in gold slows, rather than stimulates, economic growth by sucking cash out of the system. (In contrast, even oil imports, while bad for the trade deficit, literally fuel industry). Meanwhile, a growing trade deficit forces the country to devalue its currency for India, about 10 percent a year for the past two decades. Those plunging values scare people out

of rupees, and foreign funds out of India. That, in turn, means less investment and slower growth, and thus a further weakening rupee.

As an icing on the cake, the Reserve Bank of India has deregulated interest rates on NRI deposits. In response, banks have increased rates on such deposits by up to six percentage points. NRI deposits, which used to earn less than 4 per cent a couple of months ago, are now fetching up to 10 per cent a year. NRI investors wary of equity markets can now invest their dollar earnings in Indian bank deposits and get close to 7 per cent post-tax returns.

Experts say the decline in the rupee is expected to continue due to foreign institutional investor outflows, rising trade deficit and strengthening dollar. Alex Mathew, head of research, Geojit BNP Paribas, says the rupee will fall to 55 against the dollar in the immediate future. Rounaq D Neroy, senior research analyst, PersonalFN, a financial advisory firm, says, "Unless the macro-economic environment improves, the rupee may remain under pressure." So, if you are an NRI, you can expect to benefit from a weakening rupee for some more time, provided you keep your money invested in India. THE REVERSE IMPACT The trend is not entirely in favour of people based abroad. If you repatriate your rupee investments to the country where you stay, you stand to lose. For instance, your mutual fund investments worth Rs 1,00,000 converted into US dollars would have got $1,896 on January 9, 2012, as against $2,270 in August 1, 2011. "Rupee depreciation has eroded the value of NRI investments in India by nearly 20 per cent in dollar terms. The drop in asset prices (equities, real estate) is over and above the losses due to rupee depreciation," says Sachin Shah, fund manager, Emkay Investment Managers. Also, for resident Indians whose children are studying abroad, the weak rupee adds to the burden as they have to shell out more in rupee terms. The same is true about travellers to foreign destinations.

REASONS FOR INVESTING IN INDIA To increase dollar inflows and check the decline in the rupee, the RBI recently deregulated the interest rates offered by banks on non-resident external (NRE) and non-resident ordinary rupee (NRO) accounts. An NRE account is a rupee account from which money can be fully repatriated, that is, sent back to the country of your residence. An NRO account is also a rupee account, but one can repatriate only up to $1 million every year from this account. Foreign currency nonrupee account is the same as the NRE account except that the deposits are in foreign currencies.