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China devalued renminbi by 2% in a single day last August and sent stock markets in a tizzy. Currency was devalued again by 0.5% in January this year. Overall, it has depreciated some 8% against the dollar. Immediately, charges of competitive devaluation were levied and China was accused of stating a global currency war. Japan, European union all are trying to keep their rates down. Meanwhile, the rupee has also depreciated and has now reached 68, 2 years low. Yet exports are falling month after month and exporters are claiming rupee to be overvalued.

So why are major economies trying to devalue their currency? How does devaluation help? And if low exchange rate is really such a great thing, why were we crying when rupee was falling in the wake of taper tantrum in September 2013? What do we actually want??

But first thing first

What’s the exchange rate and how is exchange rate determined?

Exchange rate is the rate at which one currency will be exchanged for another. It is the value of one country’s currency in terms of another currency. So if for 1 $, we get 100 rupees, $/rupee exchange rate is 100. This is nominal bilateral exchange rate.

Nominal because it is just a numeric term and does not tell us anything about purchasing power or competitiveness of a currency.

Bilateral as only 2 countries are compared while we might be trading with n number of counties.

Then, what’s real exchange rate ?

It’s real because it tells us about purchasing power and competitiveness aspects as well. It is nominal exchange rates multiplied by the price indices of the two countries i.e. takes inflation into account.

NOTE- In economics, real means adjusting for inflation. For instance,Real GDP is GDP adjusted for inflation.

How does real exchange rate provide us with more information? Let’s understand by an example-

Suppose India and USA ,both only produce apples and there is free trade with zero tariff. At present exchange rate is 100. 1 kg apples cost 1$ in US and 100 rs in India. Now, because of technological improvements combined with cheaper labour costs,  prices in India declined to 90, everyone will convert their $ to rupee and buy from India. Now there’s more demand for Indian rupee i.e. rupee value will go up.  It will force exchange rate to move up to 90 and trade is balanced again. That’s how markets determine nominal exchange rates. As productivity levels rise, inflation declines, exchange rate moves up.

Note here, Real rates haven’t changed. Real rate remains 100 ( 90 (nominal rate)* 100 ( US price level)/ 90 (Indian Price Level).

But what if RBI tried to con the market and maintained exchange rate at 100 ? While nominal rates remain unchanged, rates have depreciated in real terms because real rate is inflation adjusted i.e. 100* 100/ 90.

Or we can say, US dollar has appreciated in real terms. What’s the effect? Nobody would buy apples from US. US farmers would go bankrupt.

In effect, lower real rates make domestic prices cheaper and promotes export while at the same time making imports costlier. That’s the reason central banks resort to devaluation to make their currencies competitive in world market.

But is is that simple?? More demand for your products # more demand for currency # exchange rate moving up # trade balancing??

If only goods and services were traded, determination of exchange rates would have been so simple. Inflation would put downward pressure on exchange rate while rising competitiveness would put upward pressure. Nominal rates will move up and down but real rates will remain stable and there will be balance of trade.

But currencies also move in financial markets for investment and speculation and that creates complication.

So if US companies invest in Indian stock markets or bring FDI, they would buy rupees, demand for rupee high, exchange rate will go up. Real rate also goes up as there’s no immediate change in inflation-competitiveness dynamics. Bad news for exporters.

How would rates adjust?

More rupee in the economy now ( dollars converted into rupee). If no increase in production, it would result in inflation and nominal exchange rate would come down, real rate would readjust to previous value.

In capital starved countries like India, investment results in building of new infrastructure, new products # production increased to blunt some effect of rising money supply # nominal exchange rates would come down according to inflation differential.

Now you can understand, why rupee was 40 to $ a decade back and is 68 to $ today. High inflation in India reduces purchasing power of rupee and it has to depreciate to maintain competitiveness.

Why were we panicking when rupee was plunging during taper tantrum days?

At that time, FII withdrew money in droves as Fed hinted at raising US interest rate # increased demand for dollar # rupee fall precipitously. Precipitous fall creates huge volatility and uncertainty in the minds of investors. Uncertainty is not good for anyone. That’s why RBI steps in to defend the rupee and curtail the volatility. It dips into reserves and sells Dollars but reserves are limited and that creates further doubts in the minds of investors about the ability of central bank. Net result- Investment environment takes a beating and we panic.

What is China trying to do by devaluing it’s currency?

China grew by over 10% for last 3 decades on back of export led growth. But growth has now slowed down and China just posted slowest growth in a quarter century. Devaluing currency helps-

As we saw above Chinese products will become cheaper for foreigners to buy, more exports from Chinese economy. High growth, jobs etc.

1. Things Chinese import will become costlier so high oil, gas mineral costs. resulting in inflation. Inflation tends to drive down currencies. China might just enter that vicious circle. Falling competitiveness # depreciation # inflation # depreciation.
2. Those who invested in Chinese currency would book losses . If u had invested 100 dollars for 100 yuan, now u get, say 98 dollars back.  It will result in Capital fight from China. Will put further downward pressure on yuan. Stock markets will be down.
3. Chinese corporations and banks who had borrowed in dollars would find it difficult to repay the loan. Earlier if they had borrowed 100$ and got 100 Yuans, they will have to shell out 102 Yuans to pay back same 100$. Banks and corporations will go bust.

Most importantly,

Other countries would want to protect their market. In tat for tat move, they will bring down their exchange rates . Chaos in market. Not good for anyone . Beggar thy neighbor policy. Everyone wanting to grow at the expense of other countries.

Fact is total world exports = total world imports

If no country is willing to import, total imports will come down but since total imports = total exports, overall trade will come down, bad for everyone.

How does it affect India?

1. Weak renminbi will lead to widening of trade deficit.
2. Markets in which China and India compete, Chinese will price out Indians.
3. Chinese will dump cheaper products in our market resulting in factory closure, job losses etc.

Rupee has fallen to 68 against the dollar this January. Why are exporters still complaining about rupee being overvalued?

We don’t trade with only US but with other economies as well . Their exchange rate movement w.r.t. dollar affects us, as rupee will inch up or down relative to those currencies. Russian, Brazilian, Turkish, Indonesian all currencies have fallen more than ours and that makes Rupee overvalued in trade based terms.

To take value of other currencies we trade with into account, we calculate trade weighted exchange rates.  We determine value of our currency w.r.t. a basket of currencies with which we trade. There are two ways of doing this.

1. NEER or Nominal effective exchange rate –  To calculate NEER, we weight the nominal exchange rate of the rupee against the currencies of these trading partners by their share in India’s trade. Then, by summing the weighted exchange rates, we get the NEER.

For instance, suppose we trade only with China and Russia. Earlier, value of 1$ was 100 rupee = 100 yuans = 100 roubles. Now rupee depreciates to 110, yuan to 120 and rouble to 130. Note here that though rupee has depreciated w.r.t. dollar, it has relatively appreciated w.r.t. yuan and rouble. Bilateral nominal exchange rate will not tell that story, but NEER will.

2. REER  or Real effective exchange rate is to NEER what Real rate was to nominal exchange rate. It takes into account inflation and competitiveness.

In REER terms rupee has appreciated significantly i.e. rupee is overvalued or less competitive w.r.t.  currencies with which we trade.

A few Final Comments-

We saw how markets determine exchange rates and central banks intervene to reduce volatility. This type of regime is called managed floating exchange rate regime. When a currency moves up and down, it’s called Appreciation and Depreciation of currency, respectively. Eg. India, USA etc.

In some countries, central banks fix exchange rate and intervene to defend the currency at that value. This type of regime is called Fixed exchange rate regime. When currency moves up and down, it’s called revaluation and devaluation respectively. Eg. Pre reform India, China.