In Nepal, the latter two demands combined make up about half of total money demand, the other half comprises transaction demand. In more developed economies— Singapore and the US—transactions demand usually absorbs just about 10 percent of total money supply, the rest of the money supply going to meet precautionary and speculative demands.
SUKHDEV SHAH
There is a growing alarm over the fall of the rupee to a historic low, going over Rs.100 per US dollar. This rate is one third the level that prevailed just two years ago.
Because Nepalese rupee (NRs) is pegged to Indian rupee (IRs), its lower exchange rate with the dollar reflects a similar decline in Indian rupee-US dollar (USD) exchange rate. At its low-point last week, IRs slided to 65 per USD, equivalent to NRs104. The short-term forecast is that IRs would soon reach 70 level, which would push the NRs exchange rate above 110.
In order to make an assessment of the decline of the rupee, we must make sense of why the Indian rupee has declined and is expected to continue declining.It is important to note that most of the decline in IRs/USD exchange rate reflects underlying economic factors and very little of it is driven by speculation—a very normal feature of currency markets. Effects of currency speculation lasts for a very short period of time but decline in currency value because of basic economic conditions—the so-called underlying factors—is long-lasting and usually not reversible without fundamental course correction that helps improve the economy’s long-term outlook.
Writing of India’s economic weaknesses causing the rupee to depreciate against US dollar, The Washington Post commentator Rama Lakshmi offered the following analysis: “India is grappling with huge budget deficit, and the country has foreign exchange reserves to pay for only seven months of imports. Economic growth slowed down to a dismal 5 percent last year, the lowest in a decade. Prices are spiraling. Foreign investors are no longer lining up; some are even packing up.”
Looking at actual numbers, India has been incurring year-after-year budget deficits of above 8 percent of GDP. National money supply broadly defined increased by 20 percent this year. Predictably, high rate of growth in liquidity has led to high inflation and loss of competitiveness. Exports value declined by about 3 percent in fiscal 2013, compared with growing at 24 percent rate in 2012 and 37 percent in 2011. More than anything else, falling off of exports has been the largest contributor to India’s exchange rate debacle.
Because of our pegged rate with Indian rupee, NRs has also suffered deep depreciation, as noted above. Rupee value going down from 68 per US dollar to now nearly105 is, indeed, a national calamity, and ameliorative measures are needed to correct this situation—to stabilize or boost the rupee value against IRs.
Reaction to the rupee decline by our policy-makers and experts has been that all this happened due to pegging of the rate with Indian rupee. The implied reference is that we either float the rupee for a market-determined exchange rate or peg it with a stronger currency, like US dollar.
Such arguments, however, are economic nonsense, if not plainly absurd. Let us look at economic fundamentals that shape the overall health of the economy as well as have an influence on the exchange rate.
Over the past two years, we achieved a growth rate of under 4 percent, lower than even India’s declining rates of growth. Like India, we have had inflation of above 10 percent that has been supported by loose fiscal and monetary policies. Broadly defined money supply increased by a whopping 23 percent in 2012 and is increasing by 15 percent this year. And our economy’s external performance has actually been a disaster, with trade deficit expanding to US $5.5 billion last year, equivalent to 27 percent of GDP, a very high level by any comparison. This reflects stagnant exports in the face of ballooning imports.
The conclusion then is that rupee rate in terms of US dollar would be the same as now—regardless of the IRs peg. Pegging of the rupee to IRs hasn’t made any difference to the level of exchange rate or the speed at which it has depreciated. Movement in the rates of two currencies vis-à-vis US dollar almost entirely reflects economic fundamentals. If we would have had a system of free float, the exchange rate outcome for NRs would, actually, be much worse. This is so because our financial markets remain too thin to be defended against speculative attacks on the currency, real or imagined.
Many people would still like to go for some kind of peg other than with Indian currency, or opting for a free float. Both choices would be unwise and carry an unmanageable degree of risk. The need for such caution ensues mainly from our shaky economy and the country’s unpredictable politics. This would hurt confidence in the rupee if, for example, we end the NRs/IRs peg.
What non-economists making or influencing exchange rate decisions forget is that, in large part, stability of (what economists call) the demand for money is or should be the main consideration for making a decision on the exchange rate: why people hold money and how much they hold at any given income and savings they have accumulated?
Economists classify money demand into three types: transaction demand; precautionary demand; and speculative demand. The main consideration when talking of the exchange rate is (or should be) that we shouldn’t take into account only the transaction demand for money which, in fact, is usually a very small part of money holdings, compared to precautionary and speculative demands.
In Nepal, the latter two demands combined make up about half of total money demand, the other half comprises transaction demand. In more developed economies— Singapore and the US—transactions demand usually absorbs just about 10 percent of total money supply, the rest of the money supply going to meet precautionary and speculative demands.
This segregation of money demand is very important for understanding what we may call the exchange rate dynamics and, indeed, this view of the operation of the financial markets was the main contribution of John Maynard Keynes—the inventor of aggregative economics called macroeconomics.
Its relevance to the exchange rate policy is that while the transaction demand for money can be stable— a fixed fraction of income (GDP)—the other two demands can be very volatile, depending on individual’s future needs for liquidity (precautionary) and decision about holding of money as wealth (speculative).Moving to the main theme of this discussion, if two currencies are floating, the weaker or smaller economy’s currency would be at a greater risk of speculative bubbles that may generate huge swings in other two demands for money—precautionary and speculative. The weaker or smaller economy will carry a high risk of being overwhelmed by speculative attacks on its currency which may destabilize the entire economy, not just the exchange rate.
This scenario actually did play out in the 1950s when Nepal maintained a floating rate of the rupee with Indian rupee—then the only foreign currency that mattered for exchange transactions. Exchange rate with Indian rupee changed almost daily and could swing up to 10 percent either way in a day. Of course, such volatility of the exchange rate adversely affected confidence that made the public not hold NRs, except for a minimum amount needed for essential transactions. All these translated into meager rupee holdings by businesses and households and Nepali rupee circulated just in Kathmandu Valley. In most parts, NRs was demonetized, with good currency (IRs) driving out the bad currency (NRs).
Such a scenario may again ensue if we end the IRs-NRs peg. Other arrangements like pegging with US dollar doesn’t seem to be a viable option either, in view of our huge trade with India, open borders, and our inability to maintain economic discipline—like a zero inflation rate—which will be needed for sustaining the peg with a stronger and—in this case—a reserve currency.
source:SHAH,SUKHDEV(2013),"Facts and fiction",republica,27 August 2013
LINK
SUKHDEV SHAH
There is a growing alarm over the fall of the rupee to a historic low, going over Rs.100 per US dollar. This rate is one third the level that prevailed just two years ago.
Because Nepalese rupee (NRs) is pegged to Indian rupee (IRs), its lower exchange rate with the dollar reflects a similar decline in Indian rupee-US dollar (USD) exchange rate. At its low-point last week, IRs slided to 65 per USD, equivalent to NRs104. The short-term forecast is that IRs would soon reach 70 level, which would push the NRs exchange rate above 110.
In order to make an assessment of the decline of the rupee, we must make sense of why the Indian rupee has declined and is expected to continue declining.It is important to note that most of the decline in IRs/USD exchange rate reflects underlying economic factors and very little of it is driven by speculation—a very normal feature of currency markets. Effects of currency speculation lasts for a very short period of time but decline in currency value because of basic economic conditions—the so-called underlying factors—is long-lasting and usually not reversible without fundamental course correction that helps improve the economy’s long-term outlook.
Writing of India’s economic weaknesses causing the rupee to depreciate against US dollar, The Washington Post commentator Rama Lakshmi offered the following analysis: “India is grappling with huge budget deficit, and the country has foreign exchange reserves to pay for only seven months of imports. Economic growth slowed down to a dismal 5 percent last year, the lowest in a decade. Prices are spiraling. Foreign investors are no longer lining up; some are even packing up.”
Looking at actual numbers, India has been incurring year-after-year budget deficits of above 8 percent of GDP. National money supply broadly defined increased by 20 percent this year. Predictably, high rate of growth in liquidity has led to high inflation and loss of competitiveness. Exports value declined by about 3 percent in fiscal 2013, compared with growing at 24 percent rate in 2012 and 37 percent in 2011. More than anything else, falling off of exports has been the largest contributor to India’s exchange rate debacle.
Because of our pegged rate with Indian rupee, NRs has also suffered deep depreciation, as noted above. Rupee value going down from 68 per US dollar to now nearly105 is, indeed, a national calamity, and ameliorative measures are needed to correct this situation—to stabilize or boost the rupee value against IRs.
Reaction to the rupee decline by our policy-makers and experts has been that all this happened due to pegging of the rate with Indian rupee. The implied reference is that we either float the rupee for a market-determined exchange rate or peg it with a stronger currency, like US dollar.
Such arguments, however, are economic nonsense, if not plainly absurd. Let us look at economic fundamentals that shape the overall health of the economy as well as have an influence on the exchange rate.
Over the past two years, we achieved a growth rate of under 4 percent, lower than even India’s declining rates of growth. Like India, we have had inflation of above 10 percent that has been supported by loose fiscal and monetary policies. Broadly defined money supply increased by a whopping 23 percent in 2012 and is increasing by 15 percent this year. And our economy’s external performance has actually been a disaster, with trade deficit expanding to US $5.5 billion last year, equivalent to 27 percent of GDP, a very high level by any comparison. This reflects stagnant exports in the face of ballooning imports.
The conclusion then is that rupee rate in terms of US dollar would be the same as now—regardless of the IRs peg. Pegging of the rupee to IRs hasn’t made any difference to the level of exchange rate or the speed at which it has depreciated. Movement in the rates of two currencies vis-à-vis US dollar almost entirely reflects economic fundamentals. If we would have had a system of free float, the exchange rate outcome for NRs would, actually, be much worse. This is so because our financial markets remain too thin to be defended against speculative attacks on the currency, real or imagined.
Many people would still like to go for some kind of peg other than with Indian currency, or opting for a free float. Both choices would be unwise and carry an unmanageable degree of risk. The need for such caution ensues mainly from our shaky economy and the country’s unpredictable politics. This would hurt confidence in the rupee if, for example, we end the NRs/IRs peg.
What non-economists making or influencing exchange rate decisions forget is that, in large part, stability of (what economists call) the demand for money is or should be the main consideration for making a decision on the exchange rate: why people hold money and how much they hold at any given income and savings they have accumulated?
Economists classify money demand into three types: transaction demand; precautionary demand; and speculative demand. The main consideration when talking of the exchange rate is (or should be) that we shouldn’t take into account only the transaction demand for money which, in fact, is usually a very small part of money holdings, compared to precautionary and speculative demands.
In Nepal, the latter two demands combined make up about half of total money demand, the other half comprises transaction demand. In more developed economies— Singapore and the US—transactions demand usually absorbs just about 10 percent of total money supply, the rest of the money supply going to meet precautionary and speculative demands.
This segregation of money demand is very important for understanding what we may call the exchange rate dynamics and, indeed, this view of the operation of the financial markets was the main contribution of John Maynard Keynes—the inventor of aggregative economics called macroeconomics.
Its relevance to the exchange rate policy is that while the transaction demand for money can be stable— a fixed fraction of income (GDP)—the other two demands can be very volatile, depending on individual’s future needs for liquidity (precautionary) and decision about holding of money as wealth (speculative).Moving to the main theme of this discussion, if two currencies are floating, the weaker or smaller economy’s currency would be at a greater risk of speculative bubbles that may generate huge swings in other two demands for money—precautionary and speculative. The weaker or smaller economy will carry a high risk of being overwhelmed by speculative attacks on its currency which may destabilize the entire economy, not just the exchange rate.
This scenario actually did play out in the 1950s when Nepal maintained a floating rate of the rupee with Indian rupee—then the only foreign currency that mattered for exchange transactions. Exchange rate with Indian rupee changed almost daily and could swing up to 10 percent either way in a day. Of course, such volatility of the exchange rate adversely affected confidence that made the public not hold NRs, except for a minimum amount needed for essential transactions. All these translated into meager rupee holdings by businesses and households and Nepali rupee circulated just in Kathmandu Valley. In most parts, NRs was demonetized, with good currency (IRs) driving out the bad currency (NRs).
Such a scenario may again ensue if we end the IRs-NRs peg. Other arrangements like pegging with US dollar doesn’t seem to be a viable option either, in view of our huge trade with India, open borders, and our inability to maintain economic discipline—like a zero inflation rate—which will be needed for sustaining the peg with a stronger and—in this case—a reserve currency.
source:SHAH,SUKHDEV(2013),"Facts and fiction",republica,27 August 2013
LINK
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