The global financial system is built on two pillars of faith. One is fractional reserve banking (FRB), which allows the same money to be deployed many times. For instance, a bank has Rs 100 on deposit. It puts aside Rs 10 to deal with redemptions (this reserve ratio is set by central banks).
The bank lends out Rs 90. The borrowers of that Rs 90 can lend out Rs 81 in their turn. The next set of borrowers may lend Rs 73, and so on. This magically turns that initial Rs 100 into apparently much larger sums. FRB works so long as people have faith in the banking system's soundness. If depositors seek to redeem more than the reserve ratio, FRB systems can collapse.
The second pillar is the currency itself. This is only paper but is backed by faith in governments and central banks. Currency becomes worthless if people lose faith in the issuer. Zimbabwe, for example.
On a daily basis, there is constant adjustment in the relative values of currencies. The strength of a given one is measured against another or against a basket of other currencies. If one currency weakens, another must strengthen.
Short-term supply and demand can skew the value of a given currency. More long-term, traders look at trade balances, inflation rates, interest rates, government debt and deficits. Paradoxically, investors are often happier when the central bank gives up some control, as a free-float currency can always be exchanged if there's a perceived problem.
In theory, foreign exchange rates depend on comparative interest rates. Somebody holding currency A might receive the real interest rate of the risk-free treasury yield on A, minus the going inflation rate for A. He could also convert A into currency B and get the treasury yield on B, minus inflation for B. These two quantities should be equal. If money supply is increased, yields drop and, therefore, increased money supply could lead to currency weakness.
Carry trades occur when traders borrow in currency A at a low interest rate, convert to currency B for higher returns, and convert back to A at a profit. India has often been the beneficiary. Traders have borrowed in yen, euro and dollar, and invested in rupee-denominated assets.
The current global situation is unusual. The euro zone, Japan and China are all attempting to increase their respective liquidities. This makes it hard to judge which currencies should fall against which ones. The European Central Bank and the Bank of Japan have ongoing quantitative expansion (QE) programmes. Several European economies are offering negative bond yields.
So, interest rates are haywire. China made six rate cuts in 2015, along with cuts of reserve ratios. India chopped 1.25 percentage points off policy rates in 2015. The US is sticking with zero interest rates for the moment but is threatening to raise these next month.
Another unusual situation is that, after many years, developed nations will contribute more to global growth than emerging economies. Further, due to low crude oil prices, oil importing nations are seeing lower inflation, while oil exporting nations are struggling with higher inflation.
Ideally, a weaker rupee would be good. Exports have fallen through 2015 and the domestic economy is also threatened by cheaper imports. The rupee should weaken against the dollar, if there's a dollar rate rise. However, it might not weaken much against other currencies, given the QEs and the yuan rate cuts. If foreign institutional investors remain net buyers of rupee assets, the rupee might even harden.
What is guaranteed is currency volatility. In calendar year 2015, the rupee moved between 61.45 and 66.74 to the dollar, an eight per cent swing. It has swung by 15 per cent against the euro, 14 per cent against sterling (British pound) and a little over nine per cent against the yen. It is up by seven per cent against the euro, while being down against the pound, yen and dollar. The amplitude of movement could be larger by March 2016 and directional trends in each of these currency pairs are hard to guess.
The bank lends out Rs 90. The borrowers of that Rs 90 can lend out Rs 81 in their turn. The next set of borrowers may lend Rs 73, and so on. This magically turns that initial Rs 100 into apparently much larger sums. FRB works so long as people have faith in the banking system's soundness. If depositors seek to redeem more than the reserve ratio, FRB systems can collapse.
The second pillar is the currency itself. This is only paper but is backed by faith in governments and central banks. Currency becomes worthless if people lose faith in the issuer. Zimbabwe, for example.
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However, crises aside, the financial system allows for flexible money supply, delinked from constraints like gold being mined or held in reserve. It also allows for quick shifts in interest rates. So, it has helped create wealth. Central banks have many tools to alter liquidity. For example, a central bank might print more money, issue debt to suck out liquidity, cut or raise the reserve ratios, and may cut or raise policy interest rates.
On a daily basis, there is constant adjustment in the relative values of currencies. The strength of a given one is measured against another or against a basket of other currencies. If one currency weakens, another must strengthen.
Short-term supply and demand can skew the value of a given currency. More long-term, traders look at trade balances, inflation rates, interest rates, government debt and deficits. Paradoxically, investors are often happier when the central bank gives up some control, as a free-float currency can always be exchanged if there's a perceived problem.
In theory, foreign exchange rates depend on comparative interest rates. Somebody holding currency A might receive the real interest rate of the risk-free treasury yield on A, minus the going inflation rate for A. He could also convert A into currency B and get the treasury yield on B, minus inflation for B. These two quantities should be equal. If money supply is increased, yields drop and, therefore, increased money supply could lead to currency weakness.
Carry trades occur when traders borrow in currency A at a low interest rate, convert to currency B for higher returns, and convert back to A at a profit. India has often been the beneficiary. Traders have borrowed in yen, euro and dollar, and invested in rupee-denominated assets.
The current global situation is unusual. The euro zone, Japan and China are all attempting to increase their respective liquidities. This makes it hard to judge which currencies should fall against which ones. The European Central Bank and the Bank of Japan have ongoing quantitative expansion (QE) programmes. Several European economies are offering negative bond yields.
So, interest rates are haywire. China made six rate cuts in 2015, along with cuts of reserve ratios. India chopped 1.25 percentage points off policy rates in 2015. The US is sticking with zero interest rates for the moment but is threatening to raise these next month.
Another unusual situation is that, after many years, developed nations will contribute more to global growth than emerging economies. Further, due to low crude oil prices, oil importing nations are seeing lower inflation, while oil exporting nations are struggling with higher inflation.
Ideally, a weaker rupee would be good. Exports have fallen through 2015 and the domestic economy is also threatened by cheaper imports. The rupee should weaken against the dollar, if there's a dollar rate rise. However, it might not weaken much against other currencies, given the QEs and the yuan rate cuts. If foreign institutional investors remain net buyers of rupee assets, the rupee might even harden.
What is guaranteed is currency volatility. In calendar year 2015, the rupee moved between 61.45 and 66.74 to the dollar, an eight per cent swing. It has swung by 15 per cent against the euro, 14 per cent against sterling (British pound) and a little over nine per cent against the yen. It is up by seven per cent against the euro, while being down against the pound, yen and dollar. The amplitude of movement could be larger by March 2016 and directional trends in each of these currency pairs are hard to guess.