The elementary principle of economics is that the price of a
thing that has any economic value is determined by the forces of demand and
supply. Often in the short term a state of inequilibrium may exist leading to
higher volatility in prices. However, the equilibrium is usually restored by
operation of a variety of factors.
There is no denial that economics is youngest amongst the
scientific discipline and pure scientists hesitate in admitting it as a
discipline of science. Nonetheless it is evolving fast and becoming popular.
Not getting into this academic debate, what I have understood is that in
popular economics theory is that:
(a) Price of currency is
usually a function of demand and supply of that currency at any given point in
time. Higher supply should normally lead to lower exchange value and vice
versa. The demand of the currency is determined by the relative real rate
of return (interest) and structure of economic activity (e.g., current account
balance and inflation) in the parent jurisdiction.
(b) Price for a particular
commodity is determined by the demand and supply conditions of that commodity
at any given point in time. The demand of commodities fluctuates as per the
level of economic activity in the consuming jurisdiction, export demand and
outlook for the foreseeable future. The supply of commodities may fluctuate due
to a variety of reason - local to the producing jurisdiction as well global.
Cost of production, weather conditions, civil and geopolitical disruptions,
inventory levels & cost of carrying inventory, etc are some of the key
factors that may influence the supply of commodities in the short term.
(c) Interest rates are
usually function of demand and supply of the money in the monetary system.
Demand for money is again impacted by the level of economic activity and
outlook in foreseeable future; whereas supply of money is mostly a function of
risk perception and relative returns.
The traits of human behavior like "greed", "fear",
"complacence", "renunciation", and "aspirations"
are usually accounted for as the balancing factors for demand and supply and
not considered as determinates of price as such. This in my view is the cause
of most problems facing global economy in the present times. Consequently, the
business of forecasting and trading in currencies, money and commodities has
become extremely difficult and fraught with risk. The huge volatility and
irrationality in crude oil market in past 6 months is just an example of this.
In past three months I have seen hundreds of reports forecasting
prices of commodities, currencies, and interest rates. Most of these forecasts
appear mere extrapolation of the current price trend and hence do not inspire
any confidence.
In Indian context, exchange value of INR, 10yr benchmark yield
and crude oil prices evoke much interest. Interestingly most economic growth
forecasts appear predicated on these, whereas logically it should be the other
way round.
INR depreciation is beyond economics
In the summer of 2007, I had just moved to the financial capital
Mumbai from the political capital Delhi. The mood was as buoyant as it could
be. Everyday plane loads of foreign investors and NRIs would alight at Mumbai
airport with bagful of Dollars. They would spend two hours in sweltering heat
to reach the then CBD Nariman point (Worli Sea link was not there and BKC was
still underdeveloped), and virtually stand in queue to get a deal where they
can burn those greenbacks.
Mumbai properties were selling like hot cakes. Every day one
used to hear some mega property deal. NRIs from middle east, Europe and US were
buying properties without even bothering to have a look at them.
Bank were hiring jokers for USD 100 to 500k salary for doing
nothing. I was of course one of these jokers!
That was the time, when sub-prime crisis has just started to
grab headlines. Indian economic cycle started turning down in spring of 2007,
with inflation raising its head. RBI had already started tightening. Bubble was
already blown and waiting for the pin that would burst it.
INR appreciated more than 10% vs. USD in first six months of
2007.
Then INR depreciated over 75% during period from January 2008 to
August 2013. This was the time when Fed was printing USD at an unprecedented rate.
There was no shortage of EUR, GBP and JPY either.
The point I am making is that in the present times when most
globally relevant central bankers are using unconventional policy measures with
impunity to stabilize their respective economies, the value of currency is
seldom a function of demand and supply alone.
Regardless of the economic theory, it is the faith of people in
a particular currency that is primary determinate of its relative exchange
value.
2005-2007 was the time when the Indians had developed good faith
in their currency. Local people were happy retaining their wealth in INR
assets, despite liberal remittance regulations and NRIs were eager to convert a
part of their USD holding in INR assets. The situation changed 2010 onwards. There is no sign of
reversal yet. Despite huge popularity of Narendra Modi amongst overseas
Indians, we have not seen any material change in remittance pattern in past six
years. Despite tighter regulations, local people appear keen to diversify their
INR assets. Most of the USD inflows have come from "professional
investors" who invest others' money to earn their salaries and bonuses.
These flows are bound to chase the flavor of the day, not necessarily the best
investment. Whereas the outflows are mostly personal, or by corporates with
material promoters' stakes.
In my view, no amount of FII/FDI money can strengthen INR if
Indians do not have faith in their own currency. Yield and inflation have
become secondary considerations.
...so are interest rates
Yesterday, RBI auctioned 91 days and 182 days treasuries bills
at far below the policy repo rate and lower than the recently reduced reverse
repo rate. Even at ~3.6%, it accepted only one fifth of the bids received. SBI
has reduced the rates on whole sale fixed deposits to 2.5%.
Obviously, the supply of money at this point in time is
overwhelming higher than the demand. Like crude, banks have no place to park
their deposits.
However, interpreting these lower rates as supportive for growth
would be a huge mistake; just as it was with lower crude prices (see
here). In fact in the present circumstances, low interest rates are likely
to do more harm to the economy than help it. In next 12months, there is going
to be hardly nay growth in investment demand irrespective of the interest
rates. However, lower interest rates may damage the consumption demand as it
may lead to lower interest and rental income for consumers, negative real
return for savers, worsening income inequality.
Remember, lower interest rates because demand for money is less
is as bad a thing as in case of anything else.
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