currency valuation

8/6/2019 Currency Valuation

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Currency Valuation:

How is a currency valued?

Why is it that to buy one US dollar, we need to shell out 50odd rupees in general?

What can influence the currency market to ensure increase

in the value of one currency vis-à-vis another currency?

Well, there are couple of reasons that seem logical meansof influencing the currency valuations.

What determines as to how much money should be printed?

If for a layman’s example let us assume that we all start printing money artificially to ensure that we all have themoney we need in order to increase our purchasing power

and lead a satisfying life.

Now, when everyone in the economy has a lot of money, people would go out to buy their favorite Goods andServices.



Now, if I go to a Mercedes showroom and readily book a

high end car there, there would consequently be manyothers like me who would be doing the same.

Now, what happens?

The manufacturing capacity of the automobile Industry islimited and it can produce only a said number of cars.

Thus, these auto firms would end up increasing the pricesof their cars as they see unending demand as a result of

continuous money supply.

Hence, even if they increase their prices, people withexcessive cash flows would continue to demand these carsand as a result under any situation, these auto firms end up

experiencing optimum sales.

In the previous scenario, where one used to shell 20 lacs for a Mercedes, now people would end up shelling 30 lacs for

the same variant.

What happens as a result is that the value of money

declines. In other words, excessive money supply is notcorrelating with actual economic output and this result ininflation and a resultant decline in the real value of money.



Thus, it is important that the money in circulation in theeconomy is appropriately supported by corresponding

economic activity in the country.

Any artificial supply money in the economy is likely toinduce inflation and a further induces a decline in the value

of money.

All said and done, how does this determine the money

value of that currency vis-à-vis the money value in someother country? In other words, what logic actually supports

the valuation of one currency in relation with another currency?

Why it is that those 50 odd rupees or 100 odd yens

correspond to one dollar?

One obvious reason could be that the level of economicactivity in those countries is much higher than those in the

other.

But this argument can be challenged again. In the case of Japan itself, her economy is the third largest in the worldand for a long time has held her position as the second

largest economy of the world which was recently overtaken by china.



Clearly the level of economic activity does not support thisargument as even here for exchanging 1 dollar, 100 odd

yens are transacted.



Let us examine some reasons that impact exchange rate

fluctuations of Currencies:

Balance of payment situation:

Countries are not all self dependent by themselves and byvirtue of this fact they are forced to buy goods that they areinsufficient at and for which there is a need in their country.

Correspondingly, they also engage in the practice of selling products which is in excess quantity in their books.

What happens as a result is the practice of trade throughexports and imports.

Now when a country imports goods, it needs to pay money

value of the imported goods to the exporting country andsimilarly when its goods are exported, it ends up receiving

money.

It’s not every time that there is a balance in the receipt and payment of money between countries.

More often than not, there is a case of either a surplus or adeficit occurring out of the receipt or payment from theexports and imports of goods across national boundaries.



This in other words is termed as either Trade Surplus or Trade Deficit.

Trade surplus or deficit is part of the current accountsurplus or deficit. Current Account includes Balance of trade and along with it net factor income and net transfer

payments.

Net factor income encompasses the net of Interests andDividends received and paid and Net transfers are unilateral

transfers such as Foreign aid.

Now, what is the impact of all these terminologies onCurrency Valuation?

Well, when we look at current account as a whole anydeficit in current account would mean that the imports of

the country are much higher than its exports. What thisimplies is that the country is making a lot of payments in

trade in comparison to its receipts.

For example India in its trade with the USA experiences adeficit. What this clearly means is that India is making a lot

of payment via dollar than what the US is making via

Indian Rupees.

Correspondingly, the demand for Dollar spikes. There ishowever a limit to the actual availability of dollar in the

market.



When in spiteOf this condition, the demand for dollar increases as a

result of trade, the economics of demand and supply come

into play.

As in the previous example above, the production capacityof Mercedes cars are limited, but people demand more cars

out of unbounded supply of money. What happens as aresult is that the value of Mercedes increases from 20 lacs

to 30 lacs.

Similarly, when the dollar’s demand increases in spite of limited dollar availability in the market, the value of dollar

correspondingly increases.

Thus, trade is one of the factors causing fluctuations in thevaluations of currencies.



Interest Rate Changes:

Why does the Reserve Bank change interest rates after all?

What necessitates the RBI to initiate changes in its Interestrate policies and what implications do such changes haveon the currency market and on the Economy as a whole?

Interest Rate is used as a tool to effectively control the

money supply in the Economy. When there is excessivemoney it leads to inflation and inflation has a negative

bearing on the real growth rate of GDP.

Let us try and understand this little better

Suppose you deposit money in a bank that gives you say

10% rate of interest annually. What this means is thatwhen you deposit 100000 Rs, you end up earning 10000 Rs

as interest income at the end of the year.

Let us assume that in the same year the rate of inflation is5%.

To elucidate this a little further, let us take the example of one specific commodity say Dry fruits.

A trader in Dry Fruits buys them from one source and sellsthem in the market for profit.



If the cost of 1 kg of Dry Fruits in 2010-11 is say 500 Rsand suppose he sells the same in the market for 550 Rs. The

rate of Inflation in 2010-11 is 5%.

Now this trader is doing a comparison of his probablereturns from two different sources. One from his regular

trading and the other through his deposits in bank.

In the given scenario, even if the bank offers 10% intereston the deposits, his returns from both his trading activity as

well as his bank deposits will equal.

But assuming the trader has the liberty to raise pricescomfortably in the market without impact on his resultant

profit, his returns from the trading activity would continueto be 10%, but as a result of inflation, his actual returns

from the bank would only be 5% (i.e. 10% interest rate – 5% rate of inflation).

In a real scenario it is difficult to presume nil impact on any potential price raise by the trader on his profits. But even

then, his likely returns are much likely to be higher than the5% of actual returns that he would get from the bank

deposits.

Thus, inflation has the potential to derail the real growthrate of the economy.

So what RBI does is that it exercises its power toeffectively control the money supply in the economy byinitiating changes in its interest rate policies that either



Reduce or expand the overall money supply of theeconomy.

How does currency valuation get impacted as a result?

Let us begin to understand the impact of one particular scenario to begin with:

Assuming there inflation in the economy, logically the RBIcomes under pressure to check the same. Correspondingly,

it raises the interest rates to curtail the money supply.

What happens when interest rates are raised is that, peopleare more induced to deposit their money in he banks as

they start providing higher rate of returns.

When more number of people state depositing their money

in the banks, the overall money supply in the economy isreduced.

As in the case of Mercedes, when more money chases fewgoods (i.e. demand pull inflation), the general price level

tends to rise.

Now when as a result of interest rate hikes, when themoney supply in the economy has been curtailed, there is proportionately less money chasing these goods and hence,

the inflationary scenario tends to cool down.



Note:

Inflation is generally of three major types. The one that isillustrated in the example above is that of Demand PullInflation.

Demand Pull inflation happens when the aggregate demandin the economy outpaces the aggregate supply.

The demand for Mercedes cars was huge as a result of

unbounded money supply at the hands of people, but thesupply of the same resulting from its stated production

capacity was limited.

Thus, there was a demand pull Inflation.

The other two types of inflation are Cost push inflation and

Built in inflation.

Cost push inflation happens as a result of sudden drop inthe supply of a commodity.

For example, if there is a sudden drop in the supply of onions due to some reason, the prices of onions will rise.

The number of people wanting to buy onions will remainmore or less the same, but at the same time its supply is

limited.



Even Foreign investors eye such markets that providehigher interest rates.

As a result the demand for that particular currencyincreases as even these foreign investors would look to

invest in the local currencies of the said country.

This in turn ensures a rise in the valuation of that particular currency

An increase in interest rate however has an impact ongrowth as well.

When the money supply in the economy is curtailed, notenough funds are available for commercial activities as

these avenues promise better returns.

Thus, the overall economic activity is impacted to a certainextent. Hence, whenever there is inflation, raising the

interest rates alone does not guarantee smooth economicgrowth.

When measures to control inflation through interest rate

hikes are undertaken, even these have a bearing on thegrowth rate as they impact the pace of actual production of goods and services and the pace of commercial activities as

a whole.



The key solution to thus tackle inflation lies in spurringeconomic growth through fiscal measures like tax

exemption, subsidies etc ensuring that the money supply

corresponds to actual level of economic activity.

Nevertheless, all the above concepts have been stated withintent to illustrate the impact of interest rate changes on the

valuation of currencies.

Note: Fiscal account represents government expenditure

and revenue.

Taxation, disinvestment are some examples of governmentrevenue.

The expenditure for maintaining social infrastructure, likestate electricity, roads, railways etc and government

subsidies etc form part of government expenditure.

By Fiscal measures, we mean allowing tax exemption tocertain sectors, promoting certain sectors by way of

subsidies etc.



Even Fiscal deficit can have its impact on currencyvaluation. If a country is experiencing Fiscal Deficit i.e. the

budgeted expenditure far outpaces the budgeted revenue,then the government would be forced to finance the deficitthrough loans of by issue of government bonds

Note:

Fiscal deficit: The case where the budgeted expenditure of the state far outpaces its budgeted revenue.

Bonds: Bonds are form of debentures that are issued for some purpose (usually economic purposes like highway

construction, electricity generation etc). But bonds are alsoissued for non economic purposes like Defense bonds.

These instruments carry a fixed rate of interest which the

holder of the bond instrument is entitled to receive.

Certain Bonds also have a maturity period i.e. they arevalid only for a stipulated period of time.

Let us understand this concept a little further.

When Ram purchases a rural electrification bond worth 5lacs, what Ram is essentially doing is that he is providingthe rural electrification authority a sum of 5 lac rupees for the purpose of development of electricity in the rural areas.



Now, money never comes free. When Ram is deciding toinvest 5lac rupees into such a project, as a rational investor,

he would also seek returns on his investment.

If the bank offers him 10% interest, Ram would be better off investing this amount in the bank and earning 50000 Rs

at the end of the year as interest on his deposit.

Now, the government or the rural electrification authority is

in need of funds to carry out its project. Now how does itobtain these funds?

The avenues herein would be like either raising a loan or bygranting tax waiver upon investments in certain sectorslike the rural electrification sector as in this case, or byissuance of these instruments called as Bonds with a

specific rate of interest.

Now, which of the option the rural electrification boardchooses to opt is to be left up to the jurisdiction of the board itself, based on what it perceives as the most

profitable avenue.

Now, when these bonds are issued in the market,Individuals who wish to invest in them based on the promised returns (i.e. the interest they offer) go ahead and

purchase these instruments.



Notes:

GDP:

GDP or the Gross Domestic Product refers to the sum totalvalue of all the goods and services produced within the

national boundaries of a particular country in a particular Financial Year.

Let us take a small example to further understand this:

Suppose, let us assume that in a very small country, thereare only three industries:

TourismMining

Agriculture

Agriculture is a primary industry and the output from thefarm industry are mainly farm outputs like rice, wheat etc

Mining can relate to a number of products like coal, gold,oil etc

Finally, Tourism is a service Industry.

Now, each of these three industries have a certain revenuegenerating capacity every year.



These depend on a number of factors. For example, in caseof agriculture, it is the monsoon for Tourism; it is the

number of tourist arrivals and for mining, the technology,

skilled manpower etc.

Assuming that in one particular year, the monsoonexperienced is excellent. Correspondingly the tourist

arrivals for that year also shots up and even the miningindustry comes under a lot of pressure for raw materials

like coal and oil.

If an average tourist spends about 10000$ and say suppose10000 tourists visit that year, the total value generated from

the tourism industry in that year alone amounts to $100million.

Similarly only rice and wheat are produced and both of these demands say $20 per kilogram. If 1000 tonnes of both

rice and wheat are produced, then the revenue generatedtherein amounts to $20 million.

(1 tonne = 1000 kg, hence 1000 tonnes = 1million kg)

Assuming $80 million worth of raw materials were minedin the same year, and then the sum total value of all goods

and services produced in that particular country in a particular financial year amounts to $200 Million.

Remember that the example above is just taken for illustration purpose. Often the number of industries in a

country and the quantum of goods and services produced



therein is much much higher and the entire process is quitetedious and complicated.

There are three different methods of calculating GDP aswell. Namely:

Income Approach

Expenditure Approach and

Output Approach

For the purpose of understanding currency valuation, thesemay however not require much elucidation at this part.



As mentioned earlier, as a result of the fiscal Deficit, thegovernment would be forced to finance the deficit through

loans, bonds or other measures.

When Fiscal Deficit forms a substantial percentage of thecountry’s GDP, what happens as a result is that the

economy would be under that much strain to finance thesame.

These finances, whether in the form of loans or bonds carry

a certain interest rate as well with them.

Unless the government comes up with measures to narrowthe fiscal deficit, through its budget, given the interest rate

pressures, the deficit is likely to broaden further.

Again if the loans taken to finance the deficits are taken

from within the country, it is relatively a better bet as themoney circulation happens within the country itself.

For example, if the infrastructure financing is taking a tollon the overall government expenditure and the governmentis of the opinion of issuing infrastructure bonds to finance

the same, the circulation of money is likely to be within the

boundaries of the country.



Even when the government pays interest to the bondholders, the interest money is likely to circulate within the

country.

With that little extra interest income, people may choose to buy new clothing, dine in a restaurant etc and all this

ensures in the local circulation of that money.

If however, for some reason the government, out of compulsion or other vice chooses to borrow money from

external sources like the World Bank or the IMF, the

interest money to that extent will go out of the country.

Now again to pay back the loan, the government will haveto finance either the World Bank or IMF or any other country from which it has taken the loan in their local

currencies.

What happens as a result again is that the demand for thoserespective currencies increases proportionately and so does

their valuation gets impacted.



Foreign Direct Investment is another concept having a potential impact on currency valuation.

As a result of liberalization, firms are free to do businessany where in the world. Thus, they also choose this route of foreign direct investment to run their commercial activities.

Heavy FDI inflow again spikes the demand for the particular country’s currency impacting its currency

valuation.

Well, all of the above mentioned give a sense of the potential factors that have an impact on the currency

valuations.

But the fundamental question is, based on what exact parameters or logic is the value of a currency determined at

the first place?

Let us take a look at the history of certain currencies andtheir Valuation:



Case of Indian Rupee versus a basket of global currencies:

Indian rupees per currency unit, averaged over the year.[24]

currenc

ycode 1996 2000 2004 2006 2009 2010

U.S.dollar

USD

35.444

44.952 45.340 43.95448.7611

245.3354

Canadian dollar

CAD

26.002

30.283 34.914 41.09842.9202

644.5915

Euro*EUR

44.401

41.525 56.385 64.12768.0331

260.5973

Poundsterling

GBP55.38

968.119 83.084 80.633

76.38023

71.3313

Swissfranc

CHF28.71

426.654 36.537 40.451

45.05846

45.9957

Australian dollar

AUD

27.761

26.157 33.409 36.972 38.58082

43.9854

http://en.wikipedia.org/wiki/Indian_rupee#cite_note-23

http://en.wikipedia.org/wiki/ISO_4217

http://en.wikipedia.org/wiki/United_States_dollar


http://en.wikipedia.org/wiki/Canadian_dollar


http://en.wikipedia.org/wiki/Euro

http://en.wikipedia.org/wiki/Pound_sterling


http://en.wikipedia.org/wiki/Swiss_franc


http://en.wikipedia.org/wiki/Australian_dollar


http://en.wikipedia.org/wiki/Indian_rupee#cite_note-23















Japaneseyen

JPY0.555

50.4171

10.4194

50.4262

70.52239

0.545447

Singapor e dollar

SGD

25.160

26.079 26.830 30.93233.6038

834.5127

*before Jan 1, 1999, European Currency Unit, code XEU

Link: http://en.wikipedia.org/wiki/Indian_rupee

http://en.wikipedia.org/wiki/Japanese_yen


http://en.wikipedia.org/wiki/Singapore_dollar


http://en.wikipedia.org/wiki/European_Currency_Unit


http://en.wikipedia.org/wiki/Indian_rupee






http://en.wikipedia.org/wiki/Indian_rupee



Most traded currencies

Currency distribution of global foreign exchange marketturnover [24]

Rank CurrencyISO 4217 code

(Symbol)

% daily

share

(April 2010)

1 United States dollar USD ($) 84.9%

2 Euro EUR (€) 39.1%

3 Japanese yen JPY (¥) 19.0%

4 Pound sterling GBP (£) 12.9%

5 Australian dollar AUD ($) 7.6%

6 Swiss franc CHF (Fr) 6.4%

7 Canadian dollar CAD ($) 5.3%

8 Hong Kong dollar HKD ($) 2.4%

9 Swedish krona SEK (kr) 2.2%

10 New Zealand dollar NZD ($) 1.6%

Other 18.6%

Total[25] 200%

Link: http://en.wikipedia.org/wiki/Yen

Valuation History of Indian Rupee against US Dollar:

http://en.wikipedia.org/wiki/Yen#cite_note-BIS-23








http://en.wikipedia.org/wiki/Hong_Kong_dollar

http://en.wikipedia.org/wiki/Swedish_krona

http://en.wikipedia.org/wiki/New_Zealand_dollar

http://en.wikipedia.org/wiki/Yen#cite_note-24

http://en.wikipedia.org/wiki/Yen

http://en.wikipedia.org/wiki/New_Zealand

http://en.wikipedia.org/wiki/Sweden

http://en.wikipedia.org/wiki/Hong_Kong

http://en.wikipedia.org/wiki/Canada

http://en.wikipedia.org/wiki/Switzerland

http://en.wikipedia.org/wiki/Australia

http://en.wikipedia.org/wiki/United_Kingdom

http://en.wikipedia.org/wiki/Japan

http://en.wikipedia.org/wiki/European_Union

http://en.wikipedia.org/wiki/United_States

http://en.wikipedia.org/wiki/Yen#cite_note-BIS-23








http://en.wikipedia.org/wiki/Hong_Kong_dollar

http://en.wikipedia.org/wiki/Swedish_krona

http://en.wikipedia.org/wiki/New_Zealand_dollar

http://en.wikipedia.org/wiki/Yen#cite_note-24

http://en.wikipedia.org/wiki/Yen



Valuation history

INR Value against USD

Year Exchange rate (rupees per US$)

1970 7.576

1975 8.409

1980 7.887

1985 12.369

1990 17.5041995 32.427

2000 45.000

2006 48.336

2007 (Oct) 38.48

2008 (June) 42.51

2008 (October) 48.88

2009 (October) 46.372010 (January 22) 46.21

2011 (April) 44.17

Link: http://en.wikipedia.org/wiki/History_of_the_rupee

http://en.wikipedia.org/wiki/History_of_the_rupee

http://en.wikipedia.org/wiki/File:INR-USD_v2.svg

http://en.wikipedia.org/wiki/File:INR-USD_v2.svg

http://en.wikipedia.org/wiki/History_of_the_rupee



Let us analyze this table a little in depth.

In one year that is between 2006 and 2007, the value of Indian rupee against the US Dollar had reduced by nearly

10 Rs. What caused this kind of a massive strengthening of the Indian Rupee versus the US Dollar?

According to one article dated may 2, 2007 InstitutionalInvestors had pumped in $2.5 Billion into the India capital

markets since January then and the RBI in its attempt todampen the inflation had raised interest rates 5 times in the

past 12 months.

Link: http://trak.in/tags/business/2007/05/02/what-is-the-future-of-rupee-is-dollar-going-to-appreciate/

Both the parameters stated pretty much fall in line with thelogic that we have discussed before. Investments by the

FII’s into the capital market means that they are pumpingmoney into the shares of listed companies thereby aiding in

their liquidity positions. Again these investments are donein Indian Rupees increasing their values. On top of it

increased liquidity position enables these companies tocarry out their operations even more aggressively spurring

growth in the economy.

http://trak.in/tags/business/2007/05/02/what-is-the-future-of-rupee-is-dollar-going-to-appreciate/






And as discussed earlier, interest rate hike is more likely toincrease the value of currencies.

What utility does a rise in the value of currency put forth?

In the statement above, between 2006 and 2007 clearly thevalue of Indian Rupee had appreciated from 48Rs to $1 US

to almost 38 Rs to $ 1 US. What this means is that if anIndian was earning say 24000 Rs in 2006, his dollar income

was $500 US. By 2007, without any appreciation in his

actual salary, his income in terms of US$ is now $632.

India’s GDP by then would increase in a similar proportionwithout actual increase in the corresponding economic

activity. India’s ranking on the list of largest economies of the world would also suddenly shoot up out of no where.

So, isn’t some kind of currency alteration more suitable tosolve all this problems of economic growth instead of us

aiming for an 8% economic growth annually?

This kind of logic does not take place in reality. Currencyvaluation in itself is a science. The amount of money

prevalent in a country is a result of the economic activitythat has happened in that country.

Let us elucidate this a little further



Imagine a scenario wherein two different countries do notknow about the existence of each other and both of them

are meeting for the first time.

Now after getting to know each other, they also find that both of them have some products that each others need and

which is in excess on their side.

So they get into the practice of trade. When it comes to the payment part, both the countries seem confused. Both of

them have sizable economies. And at the moment it’s tough

for both of them to assess each others currency valuation.

Rationally what happens from hereon is that they take intoaccount the different goods and services that have been

imported and exported by both the parties. For the rest of the goods or services that are in excess, the actual payment

part comes in.

Now obviously, even herein, even if the currency of theother country is accepted, it is no value as it is not used in

that country. Thus, there is a need felt to convert onecurrency into another.

Here again, the question as to what value one currency

carries with respect to another currency arises and there isno clear means of determining their values or determiningtheir convertibility.

The Central Bank of both the Countries comes into playhere. If country A needs say “x” amount of money for its



Exports, then in exchange of say “x” amount of currency A,

they demand “y” amount of currency B. Now this currencyB becomes the foreign exchange reserve of country A.

Thus as trade progresses, so does the foreign exchangereserves oh both the countries. When a lot more countries

join this process there is accumulation of foreign exchangereserves under a number of currency denominations. Now,as the global trade grows, so does the demand and supply

of various currencies.

Note:

In the example above the central bank initially accepts

currency denomination of another country just keep themas reserves. These reserves can be used for future trade

transactions wherein there is a necessity to make paymentto the concerned country in their respective currency

denomination.

Now based on the above scenario when there is a growingdemand and supply of currencies of various denominations

The value of these currencies starts fluctuating. Also as aresult of other factors like Interest rate hike, Fiscal or



Current account situations or foreign direct investments etc,the extent of fluctuation in the currency value starts

Increasing. Thus, over a period of time the exchange ratesystem comes into place.

Some countries like china artificially keep their currencyvalues low to ensure that their production costs are low and

their exports increase.

If the real aim through currency value alteration is to

suddenly increase the GDP numbers as stated above, therewill be a lot of countries in the rush for it. As said beforecurrency valuation is also a science. If the value of your

currency is high and if it is not supported well by theground fundamentals, from a trade perspective alone, theexport numbers will be constrained. As a result current

account deficit will follow that will strain the economy. If

there is no corresponding adjustment to the currency valuetherein, it may create huge problems as in India’s case in1990. Before liberalization, India hardly had the ability tosupport three weeks imports. For exchange of aid, one of

the conditions put forth on India was that it had to devalueits currency.

The US$ and Indian Rupee exchange rates drastically wentfrom 16 Rs to 1US$ in 1991 to about 48 Rs in 2008. Whenthe value of rupee declined, exports got a boost,

Current account situation was brought under control andforeign exchange reserves began to swell.



Hence, though artificial increase in the value of currencymay bring good to the GDP, but if not supported well by

Ground fundamentals, the real economic condition isunlikely to show any real improvement.

Let us now look at China’s case a little more in detail:A Country with a low currency denomination is notnecessarily a country that is poor. This is very much

evident in the case of China.

But again as said before, china artificially keeps the valueof Yuan (its currency) low. So when the currency valuation

in this case is artificially induced, as per our earlier arguments, it should have an impact on the economy as

well

Let us explore this case further

Many currencies like the US$ or the British Pound arefreely traded in the international market and their relative

prices keep fluctuating on a daily basis.

In the case of Chinese Yuan, China’s central bank simplydeclares an exchange rate and by law ensures that all

market players observe that rate.

How does China do this?



Well, 8 Chinese Yuan roughly equal 1 US $. How doesChina ensure that in spite of international market pressures,

it maintains the fixed exchange rate of 8 Yuan for 1 US$.

China’s Central Bank constantly buys US Treasury Bondsto ensure this fixed exchange rate. When china starts

heavily buying US Treasury bonds, what it does is that itinvests in those bonds through the US$, there by increasingits relative value. By doing so, China’s central bank ensures

the fixed exchange rate of Yuan vis-à-vis the US$.

The Yuan does fluctuate, but only in a narrow range unlikeother currencies.

But, is this kind of a practice considered good in the longrun? What benefit does china derive by this kind of fixed

exchange rate policy?

Chinese firms gain enormous cost advantage by keepingtheir currency fixed. Their products are much cheaper inthe international market giving them an upper hand in the

in the international trade circles.

China enjoys a current account surplus as a result of its

high exports.

On the other hand, for the USA, though this is beneficial tothe consumer segment, for businesses and for the economy

as a whole in the long run, it may prove disastrous.



China enjoys a current account surplus, but not the US. Ascheap Chinese goods flood the US market, their imports

surge. As a result of high imports compared to their exports, the US experiences current account deficit and hasfor long been experiencing the same.

The USA has a trade deficit with china alone to the tune of $ 200 Billion. If the fixed exchange rate system prevails,the trade deficit will further broaden having an adverse

impact on the US Economy as well as the global Economy

given the size of US Economy in the world.

Continuous dependence on china for selling the TreasuryBonds would ensure slow pace of economic growth in the

US resulting from factors as mentioned above.

In order to break free from this vicious cycle of dependence

on china, policymakers in USA will try to pressure china torevalue its currency. But such a revaluation may not be that

smooth after all.

If there is an abrupt revaluation of Chinese Yuan, it wouldnot continue to buy US Treasury Bonds. The US would be

forced to sell those bonds to other investors at a much

higher rate of interest and as a result other mortgage and

long term debts that are benchmarked against the US $would also correspondingly raise the interest rates.



The US Consumer in such a situation is more likely toinvest their money in the atmosphere of increased interest

rates. Thus the liquidity in the economy dries up. Thiscould be terrible as it could make the US economynosedive even further. The extent of the down turn is

debatable, but such a scenario has the potential to pull theUS into recession again.

What impact does such a scenario have on China?

Well, in the short to medium term China would continue toenjoy current account surplus for a considerable period and

rapid growth of its economy.

But the current account deficit of USA gains an increasing proportion as a percentage of its GDP; the economy

condition will continue to worsen. The mounting debt as a

result would add to the pressures of interest payment too.

If the situation remains persistent, then beyond a certain point in time even the US may begin to default on its

interest obligations. The economic condition would not beconducive for employment opportunities and all this will

begin to have an impact on Chinese exports.

The actual extent of the impact may not be as drastic aseven in that kind of scenario Chinese goods will remain to be competitively priced. For the impact that however gets

created in that scenario, china may be able to bring thesame under control without any major damage to its own



economy. Thus, clearly China would be acting from thedriver’s seat herein.

Thus, in a rational scenario, revaluation would happen, butaccording the China’s intent and needs.

Thus, if the currency is overvalued as in the case of IndianRupee prior to liberalization, the country’s exports will be

constrained and imports would be larger than exportscreating a scenario of current account deficit.

If however, if the currency is undervalued as in the case of Chinese Yuan, the exports are much likely to be higher

than the imports given the cost advantage and the countryenjoys a current account surplus. But the catch point here isthat such a growth is not necessarily a fair one and is likelyat the cost of another country( in this case at the expense of

USA)

Note:

Whenever a currency is undervalued from an overvalued position (as in India’s case), there is likely to be an increase

in both, the exports as well as the Imports.



This may prompt many to question as to how this actuallyaddresses the problem to trade deficit. It does not

necessarily change the situation from that of currentaccount deficit to that of a current account surplus case.

What such a move does is that, it ensures the overallincrease in trade (both exports and imports) of the country.This surge in the overall trade activity is likely to narrowthe gap in relation to current account deficit, increase theforeign exchange reserves of the country, thereby easing

pressure and giving more room to Economic reform andfurther imputes to growth in the country.

Conclusion:



China’s growth is mainly export oriented and at theexpense of other major Economies. Apart from USA, its

undervalued currency gives china an unfair advantage even

with respect to a number of other countries like India.

Artificial pegging of currencies either by undervaluation or by overvaluation is unhealthy and in the long run, would

prove to be highly disadvantageous.

Even for USA, given the current state of dollar versusYuan, in the long run, mounting debt would increase the

bond yields, there by further increasing the interest payment pressures. The strain the US Economy would

experience in terms of yield payments would weaken dollar and may also induce investors to look for reallocation of

their dollar investments. When increasing number of investors dump US dollar for other currencies, the dollar may well lose its status as the World’s Reserve Currency

over a period of time.

The ultimate solution for all this seems to lie in the freemarker nature of currencies. Further countries should notencourage other nations to peg their currencies at a fixed

exchange rate.

A free market exchange rate system in the long rum wouldfinally prove beneficial to the Global Economy as a Whole.

currency valuation

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