I am trying to understand some macro economics concepts in addition to my continued focus on fundamental analysis.I was going through min paper yesterday and few doubts cropped up. In a column discussing the alternative to dollar,there was a discussion that pressure is mounting on china to make yuan freely convertible and let it appreciate more.   My questions are:

1. Why is China not allowing its currency to appreciate by market forces like other countries(i understand that the currency is not entirely free,as central banks do interfere many times,but with China its very rigid).
2. The column also says that rupee has not appreciated that much probably because india runs current a/c deficit.What does this mean and how it affects the currency.
3. Finally ,the column says that most central banks are obliged to support their currencies.what does this mean.I mean what will happen if we let rupee appreciate to say 30rs..why cant be do that…

China not allowing its currency to appreciate: (1) The stronger currency will make its goods expensive for foreigners to buy. i.e. the products manufactured in China will not be cheaper with higher valuation. Exports contribute 25 to 30% to China’s economy. Increase in valuation for Yuan will shut down China’s export oriented economy. (2) In addition, China also holds approximately USD 900 billion to USD 1 trillion reserves. Increase in Yuan against dollar will reduce the value of its reserves. In order to make its export competitive, it artificially pegs yuan to a fixed value. It does not allow Yuan to fluctuate. (3) Furthermore, this keeps its economy pumping and growing. This growth allows people to remain employed. Any slow down will cause people to lose jobs. This increases the likelihood of social unrest which is not good for the central communist leadership.

On India rupee not appreciating. That’s because when someone (i.e. Indian government) is running in deficit, its value will diminish. This is a perception issue and more of likelihood scenario. If I am in debt, why would someone increase my value? When I am in debt or running my budget in negative, two things are likely to happen (1) I can print money which reduces value – more supply of rupee will reduce value (2) I can default – which again means reduction in value. In early 90s, Indian government was very close to default. Our government had only 2 months worth money left in its coffers to pay foreign debtors. The gold reserve saved it. Indian government mortgaged our gold to get money. Furthermore, during that time frame, our government took a very bold action to devalue the rupee. In early 90s, dollar was approximately equal to 33 rupees. It devalued to around 39 or 40 rupees (don’t know exact change of value). This helped increase exports because our products become cheaper.

Why we do not let Rupee to appreciate? There are quite a few intricate implications on economy. But for simplicity I will mention only one. Rupee appreciation will make our Indian goods expensive in global market place. This will reduce our competitiveness and hence affect our economy. Indian economy (or its exports) still has a very low contribution to the global economy. Hence we cannot command that influence or value to affect our product sale. Therefore, currency is one way to make it competitive.

Why governments are obliged to support their currency? We cannot let our currency to be too volatile. If it does, it creates business issues and it affects the economy. Typically, businesses work on long term defined vision or roadmap. Large investors who invest in large projects, typically, takes years to implement. If the currency keeps swinging in both directions, it creates problem of transactions, creates problem for valuation, which is a negative factor for doing business. This will affect the business sentiment or environment. This may result in global companies running away from India. e.g. Company A provides a service which costs Rs40. Therefore, it contracts with foreign company for one dollar (at Rs 45) expecting Rs 5 profit. But payments take place over a period of time depending upon when the service is rendered. So if towards the end of the year one dollar = Rs38. This company A is loser….. Expand this example to many businesses and Indian economy and it will be a mess. Therefore, when rupee appreciates, government pumps in rupee (or buys dollar) into the economy through banks. Rupee supply increases and hence it starts reducing in value. When rupee depreciates, government goes pumps dollar into the economy. Thus, governments are obliged to support their currency. A limited range in volatility is acceptable because that’s how market drives it, but wild swings in short time is not good.

You mentioned that Indian govt is running a current a/c deficit(which basically means the imports are greater than imports) .I read somewhere that we run almost 3% of GDP as deficit (that wld be some 30 billion dollars taking our economy at trillion dollars).If we have around 290billion $ of reserves ..

• why don’t we just pay the deficit and then take some policy changes.
• Also does the current situation mean that we never let rupee appreciate substantially so that our exports continue to remain cheap so as to increase the contribution to global economy?Is there any advantage of rising rupee if it is only to not stop the export factor.
• Also in another article ,there was a mention that most of the reserves are due to taxation on capital inflows FIIs..so the quality of reserves is not something to be proud of because its not generated from within rather its at foreigners mercy.

The deficit is not export/import. Deficit is what the government earns and its expenses. All earnings are from various taxation, while expenses are salaries, social programs, etc.  It is projected that deficit will be around 5% which includes economic stimulus.

Your observation about quality of reserves is correct. It is indeed the taxation from capital inflows and other export based taxation. There is no way, our government can generate reserves, solely, from internal resources. Now, government does try to balance deficit by withdrawing from this reserves. But it cannot use it all once or twice and become empty. Over government does understand that it risks level of reserves if capital inflows reduces and/or export reduces. It is necessary for our country to have reserves otherwise we will lose credibility in global economy. Nobody will lend us and nobody will do business with us. Another approach that our government uses for balancing the budget is to sell stakes in PSUs or 3G licenses. That’s where all the money goes – balancing the budget deficit.

Well, I cannot predict what will happen to Rupee. It may appreciate or it may depreciate, who knows. But government will not let this happen in short term, probably slowly over a period of time. Again, I don’t know how much it can appreciate. As long as exports from India are not unique, the currency is likely to remain at low valuations compared to other currencies.

I tried to give you a very simplified view. There are more complex issues associated with this topic, but everything boils down to these fundamental aspects.

My message is…

Knowing this and having little bit of knowledge base is good for you.  However, we individual investors should not get bogged down by macro-economic issues or concerns. Keep looking for fundamentally sound companies that have ability to generate cash and grow it over time, growing profits, and low-to-reducing debt levels. Buying sustainable and consistent performers at a good price is the only concern what should matters to you, and not the macro-economics issues.

If there are any economist or anybody else who can provide a better explanation, then please free to let me know what to edit or leave comments below.