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April 7, 2012

Currency Fluctuation

Currency Fluctuation


* In economics, the terms currency appreciation and currency depreciation describe the movements of the exchange rate induced by market fluctuations.

* If a country is fixing the exchange rate, official adjustments to the fixed exchange rate are called currency revaluation and devaluation.

* Currency appreciates when its value increases with respect to the value of another currency or a “basket” of other currencies. Currency depreciates when its value falls with respect to the value of another currency or a basket of other currencies.

Types of Exchange

There are two main systems used to determine a currency's exchange rate: floating currency and pegged currency.

The Floating Exchange Rate

The market determines a floating exchange rate. In other words, a currency is worth whatever buyers are willing to pay for it. This is determined by supply and demand, which is, in turn, driven by foreign investment, import/export ratios, inflation, and a host of other economic factors.

Generally, countries with mature, stable economic markets will use a floating system. Virtually every major nation uses this system, including the U.S., Canada and Great Britain. Floating exchange rates are considered more efficient, because the market will automatically correct the rate to reflect inflation and other economic forces.

The floating system isn't perfect, though. If a country's economy suffers from instability, a floating system will discourage investment. Investors could fall victim to wild swings in the exchange rates, as well as disastrous inflation.

The Pegged Exchange Rate

A pegged, or fixed system, is one in which the exchange rate is set and artificially maintained by the government. The rate will be pegged to some other country's dollar, usually the U.S. dollar. The rate will not fluctuate from day to day.

A government has to work to keep their pegged rate stable. Their national bank must hold large reserves of foreign currency to mitigate changes in supply and demand. If a sudden demand for a currency were to drive up the exchange rate, the national bank would have to release enough of that currency into the market to meet the demand. They can also buy up currency if low demand is lowering exchange rates.

Countries that have immature, potentially unstable economies usually use a pegged system. Developing nations can use this system to prevent out-of control-inflation. The system can backfire, however, if the real world market value of the currency is not reflected by the pegged rate. In that case, a black market may spring up, where the currency will be traded at its market value, disregarding the government's peg.

When people realize that their currency isn't worth as much as the pegged rate indicates, they may rush to exchange their money for other, more stable currencies. This can lead to economic disaster, since the sudden flood of currency in world markets drives the exchange rate very low. So if a country doesn't take good care of their pegged rate, they may find themselves with worthless currency.

The Hybrid Exchange Rate

In reality, few exchange rate systems are 100 percent floating, or 100 percent pegged. Countries using a pegged rate can avoid market panics and inflationary disasters by using a floating peg. They peg their rate to the U.S. dollar, and that rate doesn't fluctuate from day to day. However, the government periodically reviews their peg, and makes minor adjustments to keep it in line with the true market value.

Floating systems aren't really left to the mercy of market forces, either. Governments using floating exchange rates make changes to their national economic policy that can affect exchange rates, directly or indirectly. Tax cuts, changes to the national interest rate, and import tariffs can all change the value of a nation's currency, even though the value technically floats.

Although this system works pretty well most of the time, it's not always the best solution.

What causes currency fluctuation?

Actually, there are a lot of factors affecting the currency fluctuation. Generally speaking, changes in economic position and the macroeconomics policies are the underlying factors for the long term currency trend. The analysts are always very concerned about certain economic indices like GNP (gross national product), consumer index and changes in interest rate, etc. By knowing these economic indices, it helps them to find out the currency fluctuation trend.

International profits significantly affect the currency trend. International profits are the net amount of income and expenses on foreign economic activities. Under normal circumstances, trade deficit indicates that the demand exceeds the supply for the foreign currency/trade/imports. Under the floating rate system, market demand and supply determine the currency fluctuation. A trade deficit can cause the depreciation of local currency while appreciation of foreign currency, vice versa.

National Income or Gross National Income (GNI) also affects the currency trend. In general, when the national income increases, the people spend more locally. This is in fact an indication of local currency demand. If the demand of local currency remains unchanged, the additional demand on local currency cause it to appreciate.

Of course, whether the change in national income induces a currency depreciation or currency appreciation depends on factors causing the change in national income. If the change is caused by increased product supply, the purchasing power of such currency increases in the long run. Foreign currency is likely to depreciate. If the national income increases due to governmental expenses or demand, which may increase the foreign import, then foreign currency may appreciate.

Inflation rate is another fundamental factor that affects currency fluctuation. If a nation has over issued its currency which exceeds the demand in product purchasing, there will be inflation. Inflation decreases the purchasing power of the people and therefore leads to currency depreciation. In general sense, the local currency depreciates means the foreign currencies appreciate.

The change in inflation rate changes the demand and supply in currencies, bonds, and currency value expectation. Inflation leads to higher product price internally. Under the same currency rate, the nation loses on exports and gain in imports. In the currency market, the demand of foreign currencies increases, therefore causing the appreciation of foreign currencies.

There are other factors like foreign investments, productivity, unemployment etc. that can also result into fluctuation of the currency.

Introduction to Indian Rupee Fluctuation

The Indian Economy is the eleventh largest economy in the world with a nominal GDP of US$1,235,975 million (IMF list). The Indian market has been booming in leaps & bounds. By 2008, India had established itself as the world's second-fastest growing major economy after China, with a growth rate of 9.4%. However, the year 2009 saw a significant slowdown in India's GDP growth rate to 6.8%. The Rupee hit a record low during early 2009 on account of the global recession. However, due to a strong domestic market, India managed to bounce back sooner than the western countries. Since September 2009 there has been a constant appreciation in Rupee versus most Tier 1 currencies. The exchange rate as on 30th October, 2010 is Indian rupee44.345 to the USD. A rising rupee prompted Government of India to buy 200 tonnes of Gold for $6.7 billion from IMF in 2009 as a total role reversal from 1991. Indian forex reserves stands at $294.01 billion (Oct, 2010).

Advantages of Rupee Appreciation

Dampening of inflation: Normally, currencies appreciate when the economies are doing well and the rise in their value is a cause for celebration especially for consumers. A higher value of rupee will result in cheaper imports which, in turn has a dampening effect on inflation Thus, rupee appreciation helps control inflation.

Foreign debt servicing: Appreciation of the rupee helps in easing the pressure, related to foreign debt servicing (interest payments on debt raised in foreign currency), on India and Indian companies. With Indian companies taking advantage of the United States soft interest rate regime and raising foreign currency loans, known as external commercial borrowings (ECBs), this is a welcome phenomenon from the point of view of their interest commitments on the loans raised. This will help them avoid taking a bigger hit on their bottom-line, which is beneficial for its shareholders. Indian companies which have Foreign Currency Convertible Bonds (FCCBs) like Reliance Communications, Bharat Forge, Sun Pharma and Ranbaxy benefit from the appreciation of rupee.

Outbound tourists/student bonanza: The appreciating rupee is a big positive for tourists traveling or wanting to travel abroad. Considering that the rupee has appreciated by over 10% against the US dollar since mid-2002, traveling to the US is now cheaper by a similar quantum in rupee terms. The same applies to students who are still in the process of finalizing their study plans abroad. For example, a student's enrollment for a $1,000 course abroad would now cost only Indian rupee44,000 instead of the earlier Indian rupee49,000!

Government reserves: Considering that the government has been selling its stake aggressively in major public sector units in the recent past, and with a substantial chunk of this being subscribed by FIIs, the latter will have to invest more dollars to pick up a stake in the company being divested, thus aiding the governments build up of reserves.

Disadvantages of Rupee Appreciation

Exporters' disadvantage: The exporters are at a disadvantage owing to the currency appreciation as this renders their produce expensive in the international markets as compared to other competing nations whose currencies haven't appreciated on a similar scale. Small exporters are hit badly by rupee appreciation as they have limited access to hedging products. This tends to take away a part of the advantage from Indian companies, which they enjoy due to their cost competitiveness. However, it must be noted that despite the sharp currency appreciation in recent times, Indian exports have continued to grow.

Dollar denominated earnings hurt: The strengthening rupee has an adverse impact on various companies/sectors, which derive a substantial portion of their revenues from the US markets (or in dollar denominations). Software and BPO are typical examples of the sectors adversely impacted by the appreciation of rupee.


Most developing countries have economies based largely on exports that are competitive in global markets because of low prices. When those countries' currency gains value, they are no longer able to offer exports to the global market at the same low prices that they planned to. This may cause importers to look elsewhere to country's with lower valued currency and thus prices or to order less than they would have otherwise. Thus, the share of exports in economy will be affected, if the currency appreciates. The main effect on the exporters is that an appreciated currency makes the exporter’s products more expensive in overseas markets and it thus erodes their international competitiveness.

In the Indian scenario today, the IT industry is growing by 31% YOY and major operations (around 80-85%) are outsourced from the US-based companies. Hotels like ITC, Taj etc. have about 50% of their revenues in terms of dollars. Thus, these industries will stand to lose when rupee appreciates. Similiarly, silk industry had to bear the brunt as it was 71% sensitive to the hardening of the currency. Cotton and jute were less sensitive to the rising rupee at 23% and 18% respectively. The IT sector companies were upto 90% sensitive to rupee appreciation.


The reverse phenomenon happens when you look at rupee appreciation from the importer’s point of view. Oil companies are highly benefitted, more than 80% crude oil is imported from the gulf and other counties. Acc to an Indian Oil Corporation manager, for every Rs1 appreciation, crude oil price dips by 2%. Another major beneficiary of rupee appreciation are the Indian companies who have gone for recent acquisitions using foreign debt-leverage. Indian companies who have International borrowings in their account are also benefitted. An appreciating rupee is beneficial for the country’s external debts as well. Consumer electronic goods, imported apparels etc become available at cheaper prices as a result of a higher valued rupee. Industries which import raw materials get these at a cheaper price.

In 1990, the value of rupee was Indian rupee17.5. Then liberalization happened in 1991 and by 1995, the value of rupee depreciated to Indian rupee32.43. In 2006, the value of rupee was as low as Indian rupee48.34. In 2007, when the Indian economy was booming it appreciated to Indian rupee38.48. The 2009 recession saw the rupee depreciate to Indian rupee45.62. As on October 2010, the exchange rate stands at Indian rupee44.345.

Government Initiatives to the exporters

* It could reduce import duty, excise and service taxes (domestic taxes) to compensate for the reduced export realisation of exporters in rupee terms. In simple words, it could facilitate the reduction of transaction costs of businesses and exporters.

* It could speed up the implementation of the policy measures announced by the Ministry of Commerce and Industry in June 2007 such as the reduction of pre-shipment credit, mandated export credit disbursement by commercial banks and so forth. Thus, government helps exporters through tax incentives, interest reductions, reduction in service taxes.

* Encouraging forward contracts with customers will help to protect exporter’s interest. Forward contracts helps the exporters to hedge the exchange rate risk and be protected from the currency fluctuations.

RBI’s Weakening of Rupee

The purchase of dollars from the markets by RBI is a way to stem the rise of rupee appreciation by curbing the liquidity; however this is a short term remedy. However, it is seen that in the recent period of roughly a year, RBI intervention has subsided.


One School of Thoughts: Policy makers want a weaker rupee so that India’s competitiveness will rise. They do not think that it is normal for the rupee to appreciate as a result of greater foreign exchange inflows into the economy. This absurdity will continue until policy-makers turn their attention to raising productivity of governance and the competitiveness of the aggregate supply chain. It is a pity that many of India’s exporters have chosen to rely on a weak rupee to sustain their competitiveness. They are now deeply disturbed. Their future ‘rupee profitability’ is in jeopardy. They are horrified that the Reserve Bank of India (RBI) has allowed the rupee to strengthen. They are nervous that the RBI may have given up its policy of ‘weakening through intervention’ in the foreign exchange markets. What they want is a weaker rupee so that India’s export competitiveness will rise. They want more exports to lead to greater foreign exchange inflows. They want these inflows to rise so that India can fund its imports. But the rupee will inevitably strengthen if inflows of foreign exchange exceed outflows. They will then argue that the strong rupee is a threat to India’s competitiveness.

Other School of thoughts (Modern Approach) or Productivity & Competitiveness: The reason for the above schools of thoughts is simple and straight forward- the sops turns unprofitable exports profitable. These schools of thought argue that the real exchange rate appreciation is productivity driven and reflects a natural evolution of the economy towards long run equilibrium. This emphasizes supply-side factors such as technological change and labour mobility. At the same time, other demand-side factors such as transitory demand shocks like fiscal expansion and structural factor like rising real income growth, leading to higher services (non-tradable) demand, could cause appreciation. In the Indian case, the driving factor is capital inflows. This appreciation is more likely to negatively impact small and medium firms who are more likely to be credit constrained. They will have less back up, in terms of reserves and access to working capital, to sail through the difficult times as in the current case. Some of them may go out of business if they are not able to manage the declining rupee profit margins and competitiveness.

It is not so long ago (until early 2007) that RBI was actively trading in the currency market, championing the cause of India's exporters, and it has got them in enough trouble. In some ways, our inflation crisis today is the legacy of the unprecedented credit boom of the Y V Reddy years. Today's India is only more open than the India where Y V Reddy's regime tripped up on currency trading. In other words, RBI intervention has subsided substantially.

Rising Yen

 60 Day Chart

US$ vs. YEN in the past one year.

Yen is gaining strength despite stimulation measures taken through quantitative easing by BOJ to help its struggling economy. Japan has a massive Total Public & Private Debt of 375 pct of its GDP. Its Central Bank Rate is 0.1 pct since Dec 2008. Yen is now close to 15-year High of 82.02. Investors will be looking for the Japanese Central Bank intervention. It was probably reported in 2004 that 115 Yen to a USD was the desired level to support Japan’s export. Currently Yen is hovering around 85.50, but today its economy is in better shape and its export is still growing.

since 1970, the Yen has risen by a whopping 350% against the Dollar. It has doubled in value since 1990 and risen 14% since the start of the year, en route to a 15-year high. Over the same period (actually since 1980; I couldn’t find data from the 1970), Japan’s economy has expanded by an average annualized growth rate of 2.2%. Over the last 10 years, the average is a paltry .9%. The contradiction between fundamentals and reality could not be more stark!

Investor risk appetite has been reinvigorated with the decline of the Yen carry trade. During most of the last decade, carry trading caused the Yen to decline to 120 USD/JPY as investors borrowed Yen in bulk in order to purchase high-yielding assets. The credit crisis spurred a short squeeze (i.e. rapid unwinding of carry trade positions) in early 2007, and caused the Yen to rocket upward.

The recent run-up in emerging market currencies, global equities, commodities, and other risky assets would certainly seem to support a carry trade strategy. For its part, the Bank of Japan is also doing its best to create a healthy environment for carry trading by printing currency, easing monetary policy, and fighting to keep the Yen from rising. And yet, if indeed there are still carry traders (and there certainly are!), the current trend in forex markets suggests that they are very much outnumbered by those betting on the Yen’s rise. In addition to this, those that hold Yen earn a nominal return of near 0%. Long-term interest rates (proxied by 10-year government bonds) are only slightly higher – at 1% – and certainly too low to attract any foreign institutional interest. Besides, it’s well-known that 90% of Japanese government debt is held by domestic savers. Meanwhile, the Japanese stock market has stagnated for more than 2 decades, and the Nikkei average is lower than at any point since 1985 (except for a brief period following the dot-com bust. Japanese real estate is equally unattractive.

As a result, there are only two conceivable reasons for the Yen’s continued upward push. The first is fundamental/structural and is connected to Japan’s trade surplus. In spite of an appreciating currency, the Japanese export sector continues to be the lone bright spot in an economy with otherwise limited sources of growth. Compared to 2009, the trade surplus is up 83%, helped by a rise of 50% in September. It is on pace to top $100 Billion for the year. In this regard, foreigners that buy Japanese Yen do so because they must- for purposes of trade.

Japan inflation rate chart 1970 - 2010

The second source of demand for Japanese Yen is so-called safe haven flows. While the Japanese Yen is not a high-yielding currency, it is actually an excellent store of value. [This is one of the three primary functions that a currency should fulfill. The other two are medium of exchange and unit of account]. That’s because inflation in Japan is the lowest in the world, often to the point of being nil. Since 1970, the inflation rate has averaged only 3%, compared to 4.5% in the US. Over the last 15 years, inflation has been 0%. In other words, even if they are invested in low-yielding savings accounts, Japanese savers can ensure that 1 Yen today will probably still be worth 1 Yen 5 years from now. Foreign investors can take advantage of the same phenomenon, when they bet that the exchange value of the Yen will be equally stable.

Bullish on Euro

The Trend of Euro in the recent past

It dove during the financial crisis, only to surge during the apparent recovery phase, fell during the sovereign debt crisis, and rose during the paradigm shift, then fell as risk appetite waned, only to rise again in September, en route to a 5-month high.

There are a handful of factors which currently underlie the Euro’s strength, which can all generally be explained by the fact that risk is “on” at the moment, and the markets are moving away from so-called safe haven currencies and back towards growth investments. Of course that could change tomorrow (or even 5 minutes from now!), but at the moment, risk appetite is high and the Euro symbolizes risk. Never mind how ironic it is, that growth in the EU is projected at 1.8% for the year while Rest of World (ROW) GDP will probably top 5%. All that matters is compared to the Dollar (and Yen, Pound, Franc to a lesser extent) the Euro is perceived as the currency of risk.

The Euro’s cause is also helped by the ongoing “currency wars,” which heated up last week with Japan’s entry into the game. Basically, Central Banks around the world are now competing with each other to devalue their currencies. In contrast, the European Central Bank (ECB) has decided to remain on the sidelines (in favor of fiscal austerity), which is forcing the Euro up (or rather all other currencies down). To make matters even worse, “The U.S. Federal Reserve indicated this summer that it may ease monetary policy further… often seen as printing money to pump up the economy.” As a result, “The euro looks set to keep on climbing in a trend that looks increasingly entrenched.”

There are certainly those that argue that the Euro’s recent surge reflects renewed confidence in the Eurozone economy and prospects for resolving the EU debt crisis. After all, most Euro members will reduce their budget deficits in 2010 and auctions of new bonds are once again oversubscribed. On the other hand, interest rates for the PIGS (Portugal, Italy, Greece, and Spain) have risen to multi-year highs, as investors are finally trying to make a serious effort at pricing the possibility of default.

Eurozone sovereign debt interest rates graph 2007-2010

In addition, the credit markets in the EU are barely functioning, and large institutions remain dependent on the ECB’s credit facilities for financing. Finally, it shouldn’t be forgotten that the only reason crisis was due to the massive support (€140 Billion) extended to Greece. When this program expires in less than three years, the fiscal problems of Greece (and the other PIGS) will be exposed once again, and a new (stop-gap) solution will need to be proposed.

As every analyst has pointed out, none of the EU’s fiscal problems have been solved. EU members have certainly proven adept at resolving acute crises and the ECB certainly deserves credit for keeping credit markets functioning, but none has proposed a viable solution for repairing of member countries’ fiscal and economic health. Currency devaluation is impossible. Sovereign default is being prevented. That leaves wage cuts and increased productivity as the only two paths to equilibrium. The former could be accomplished through inflation, but the ECB seems reluctant to allow this to happen.

More importantly, China is responsible for this as well. China has long spoken about its intentions to change the allocation of its forex reserve holdings, and in hindsight, its timing was perfect. In the beginning of June, the Euro stood at a multi-year low, and the price of US Treasury Bonds stood at a multi-year high. Thus, China’s sovereign wealth fund was able to simultaneously lock in some profits from lending to the US and dissipate risk by swapping US assets for those denominated in Euros and Yen. “China has already bought $20 billion worth of yen financial assets this year, almost five times as much as it did in the previous five years combined.” [Analysts have noted that buying Yen also achieves the peripheral end of making Japanese exports less competitive relative to those from China].

Moreover, China can achieve this diversification without influencing the value of the Yuan, since Dollars can be exchanged directly for Yen and Euros. That is important, since the RMB is still effectively pegged to the Dollar. Speaking of which, the Yuan has hardly budged since its 1% revaluation in June. On a trade-weighted basis, it has actually fallen.


By boosting productivity and improving business conditions, the export growth can remain buoyant despite stronger rupee. Rapid productivity growth plays an important role in explaining why a country’s export performance can remain robust even when its currency strengthens. All currencies would ultimately have to move towards a flexible exchange rate regime, and by moving upwards first rather than downwards, economies would be in a better position to deal with crises. Normally foreign currency exposures are covered for a maximum of a year, but now exporters are contracting forward contracts for 3-5 years to curb the impact of an appreciating rupee on their profits. Hedging of commodity exposures has also risen sharply with volatility in global markets. In any case, weaker rupee would provide no guarantee that the exports would grow faster.

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