Urrency Value - Essay Example

International Finance Prepared by on International finance Submitted to Length 1. Introduction The international fisher effect estimates the currency value on the basis of interest rates prevailing in the country. This states that the expected change in the exchange rate of currencies of any two countries depends on the difference of the interest rates in those two countries. In general the country having lowest interest rates have more value for its currency compared with the country having higher interest rates. The exchange rate of currency of a particular country A with a country B can be estimated by following formula. E = i1 – i2/1+i2 = i­1-i2 In the above case i1 and i2 are the interest rates in countries A and B. If i1 is greater than i2 then the exchange rate of i2 against i1 will be greater. Lower the interest rates in any country, greater are the chances of high currency value. This, in turn, indicates the greater domestic production. This is because any country having highest interest rates will have higher inflation rates and thus lesser currency value. This explanation is according to theory of international fisher effect. 1 In the present case the two currencies taken into consideration are USD (US dollar) and INR (Indian Rupee). The Indian rupee has much lesser value against USD at present (September 2006) at 40.45 rupees per USD. This is due to the higher interest rates in India than in the US. In India the interest rates range from 11 to 14 percent at present, on the other hand US is having the interest rates at 4 percent only. As a result the USD is having higher value than Indian rupee. In fact the value of Indian rupee has been appreciated with some fluctuations from 1996 to 2006. This is due to gradual decrease of interest rates in the considered 10 years period. In 1996 the exchange rate of USD and INR used to be 1 USD = 35.73 INR. This value of INR is more than the value in 2006. In fact the interest rates in 1996 were much higher in India than in 2006. This despite the fact that the rupee enjoyed much higher value in 1996. This is due to the fact that the US was also having much more interest rate (more than or equal to 5 percent) than in India around the same time. As the interest rates in both countries were higher in 1996 than in 2006, the currency exchange rate was observed to be according to this difference in interest rates. The industrial production decreased in 1996-97 and there were some discrepancies in the exchange rate due to the same. After the industrial production started increasing the value of rupee continued to decrease till 2000 and then started increasing slowly. In the following graph the trend of INR and USD in the period between 1996-2006 can be observed along with the period beyond the limits mentioned. The above graph is adopted from http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/77577.pdf It can be observed that the INR and USD exchange rate is divided into three parts; par value, basket peg and market determined. It can be observed that in the period of 1996-2001 the value of INR against USD did not not have remarkable growth. After that, between 2001 and 2006 the remarkable growth can be observed. International fisher effect predicts the magnitude and direction of the exchange rate regarding any two or more currencies. This is done according to the nominal interest rate rather than inflation along with the interbank rates. The profit earned by commercial banks involving the foreign exchange trade also shows effect on the exchange rate as the profits of the banks gradually increase due to the trade. This increase of the profits by commercial banks due to trading in foreign exchange also effects the exchange rate. The profits are substantial according to the following figure. The above figure is adopted from http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/77577.pdf So the effect of the inflation is not taken into consideration while calculating the exchange rate according to IFE. This is because the IFE argues that the currency’s value is adjusted to reflect the difference in interest rates between the countries. It is advised that the after estimating the future exchange rates according to interest rates, the expected rates of interest are also taken into consideration. The anticipated high inflation due to high interest rate is taken into consideration while estimating the exchange rate. In 1996 the inflation in India was higher than that of 2006, and so were interest rates. After a reasonable growth in industry sector, the inflation rate started to decrease and the currency exchange of INR increased against USD compared to the time around year 2000. 2 In fact the currency exchange rates can be estimated using international fisher effect, the business environment, stock market, economic data, government influence. And productivity of an economy can be taken into consideration while estimating the currency exchange rates. It can be observed from oanda.com that 1USD was equal to 46.1450 in September 2006. This is far lesser value when compared to the value of INR against USD in 1996 as 1USD was equal to 35.73 INR. This is due to the lack of industrial growth and international trade when compared to the situation in 2006. The following graph shows the demand of INR and USD at different periods between 2004 to 2006. The above figure is adopted from http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/77577.pdf It can be observed that when the value of INR against USD is taken from October 2004 to September 2006 then there is not any considerable change in the value. The trends shown in the above figure show that the value of INR increased rapidly between these periods and had fallen in the period between June 2006 to September 2006 due to the internal adjustments of the market. Though it is out of the consideration of this paper it can be said that the value of INR increased against USD after September 2006 due to increase of industrial production, investments in India and due to decrease of inflation. The same trends, which acted in an opposite direction along with the interest rate affect, caused the decrease of INR in the period starting from the November 2005 to September 2006. The absence of connection of Indian industry to international market in 1996 at the level of 2006 resulted in appreciation of INR as the basket peg method was involved in the control of government on exchange rate decisions. In the following years the decreased control of government on exchange rate resulted in decrease of INR against USD. After 2001 the increase of industrial production and gradual (though not remarkable) decrease of interest rates resulted in gradual increase of INR against USD. In 1996 as the industry in India was not as much connected to other countries like in 2006, the exchange rate did not reflect the real value. The positive indication from policy and competitive advantages and market sizes increased the demand of the currency as more companies wanted to invest in the country. While considering fisher effect the indications from business environment also should be taken into consideration to estimate the real exchange rate of currency. The next factor that is to be considered while using fisher effect is the stock market. In the period prior to globalization or at the starting of economic reforms in India (for example in 1996) there was less demand for the shares in stock market when compared to 2006 or in the period between 1996 and 2006. This can be another reason to be considered for the higher value of the currency of India against USD as not many Indian companies are not registering their shares in the international stock markets. It is this thing that resulted in giving a higher value than the actual one for INR in 1996. Even economic data like labor report, unemployment rate and average hourly earnings effect the exchange rate. After 1996 the real values regarding the economic data of industry in India started coming to fore due to increased transparency. As a result the value of INR started decreasing till 2001 and reached a maximum value of even a rate of 49.17 INR for each USD. After that when there was reasonable growth in industry. This resulted in a sharp increase of rupee and resulted in a value of 46.14 INR for each USD by September 2006. The higher value of the rupee against dollar in 1996 was due to avoiding devaluation of currency at any cost according to the theories like international fisher effect and purchasing power parity. 3 2. Purchasing Power Parity The theory of purchasing power parity states that the exchange rates between any two currencies will be in equilibrium when their purchasing power is the same in each of the two countries. If 1USD = 35.73 INR, then the purchasing power of 1 USD in US is equal to 35.73 INR in India. The goods that can be purchased by 1USD in US must be equal to the goods purchased by 35.73 INR in India. This links the exchange rate with the purchasing power of currency in the respective countries. This links the exchange rate with the inflation in those countries as the inflation results in decrease of purchasing power. This decrease the value of currency in the international market as the production cost gets increased and the demand for the currency gets decreased due to less demand from the investors to invest in that particular country. In 1996 according to records of oanda.com1USD was equal to 35.73 INR. This is due to the effect of inflation on the currency value. Though the inflation in India was higher around this time than that of 2006 the value of INR was higher than that of in 2006 when compared to USD. This is because the inflations of two periods of the same country cannot be considered as the purchasing power parity, considering the inflations and the purchasing power of the currencies of two countries at same time. The reason for the higher value of INR in 1996 against USD may be due to the comparison of the purchasing power of the two currencies. The difference between the purchasing power of the USD and INR is less than the difference of purchasing power of these two currencies in 2006. This can be termed as the higher value of INR against USD in 1996. In the phase of market determination the forward premia of USD against INR can be observed from following figure. It can be seen that it remained high. This indicates that the INR was at discount to the USD. In the period between 2004 and 2006 the forward premia come down indicating the decrease of inflation and increase of purchasing power of INR. In the period 2003-04 it can be observed that the forward premia even turned negative for a short period. The above figure was adopted from http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/77577.pdf The trends in forward premia can be explained on the basis for purchasing power parity as the law of one price. The competitive markets equalize the price in the absence of transportation and other transaction costs. This equalization has played a major role in higher value of rupee in 1996 against 1 USD. The law of one price is applied for tradable goods. The immobile goods like houses and many services has not been taken into consideration in 1996 to apply purchasing power parity theory in estimating the exchange rate between USD and INR. This can be termed as another reason for higher value of rupee in 1996 and subsequent decrease of the same in the following period. 4 In 1996 the inflation slowed down due to slow down in industrial production, as there was no demand for bank funds. This resulted in lowering of inflation though there was no real increase in purchasing power of the rupee. In 2006 the industrial production increased manifold than in 1996 and so did the demand for loans. This increased inflation along with the purchasing power of the currency. The inflation played major role in decreasing the value of INR from 1996 to 2006. This indicates that the inflation decides the value of a currency when there is decrease in industrial production temporarily. When the industrial production decreased in India in the following years the demand for the goods increased and the value of INR even decreased for to a level of 49 INR for 1 USD. 5 The GDP growth rate was more in 2006 than in 1996. Similarly, the value of INR is lesser in 2006 than in 1996. This is due to the changes in industry and the investments in the country. Stringent government controls in India in 1996 resulted in higher value than the original value. As the economic reforms started, the controls were lowered and this resulted in leaving the value of INR for the market up to some extent. As a result the value decreased up to 49 INR per 1 USD around 2000. After that the industrial production increased and purchasing capacity of the people increased, thereby decreasing the purchasing power of the currency. This resulted in increase of value of INR but not to the extent as in 1996. 6 The purchasing power parity theory is having a problem of undervaluing the currencies. This needs the updation of the values twice every year. The Purchasing power parity may differ in values due to the differences in evaluations also. In general the exchange movements in short time are news driven. After that they are adjusted according to the facts in the news in the long term. The announcements about interest rate policies also may drive the exchange rates. So the exchange rate at a particular period cannot determine the authenticity of any theory like purchasing power parity or international fisher effect. Particularly the purchasing power parity decides the exchange rate movements in long period. The fall of the INR against USD from 1996 to 2000 and then the rise of it can be explained using purchasing power parity as it is due to the decrease and increase in industrial production and inflations. The fall of INR against USD is due to the fall of industrial production and increase of inflation till 2000 and the increase is due to increase of industrial production and decrease of inflation after 2000. These factors are taken into consideration while evaluating the exchange rate using purchasing power parity. References: 1. investopedia, 2007, international fisher effect, investopedia.com, \ ,electronic, 16-9-07, http://www.investopedia.com/terms/i/ife.asp 2. bsu, 2007, international fisher effect, 2007, bsu.edu, ,electronic, 16-9-07, http://www.bsu.edu/classes/rrathina/course/unit3_7.htm 3. University of British Columbia, 2007, Purchasing power parity, University of British Columbia, ,electronic, 16-9-07, http://fx.sauder.ubc.ca/PPP.html 4. Media wiki, 2007, India, Wikipedia, ,electronic, 16-9-07, http://en.wikipedia.org/wiki/India 5. community, 2007, exchange rates, community/finclub, ,electronic, 16-9-07, http://203.197.126.103/community/FinClub/dhan/dhan1/art11-exch.pdf 6. dbs group, 2006, inflation slows, so does the productin, dbs, ,electronic, 16-9-07, http://www.dbs.com/researchasset/mktalert/2006/mf2006may15inmppfs.pdf 7. the figures are obtained from URL http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/77577.pdf from page no’s 223, 235, Read More