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Know How Forex Works

25 Dec, 2019 Divesh Mishra

No country is an island in itself. It sells something (goods or services) and buys something (goods or services, again). To buy it requires a common currency which is acceptable across. In the modern history, this currency has been and is US Dollars.

The position of a country’s foreign currency is known as its Reserves. More the reserves, better that country’s bargaining power, economic stability, international reputation and strength of its local currency. Opposite of it is equally true.

The reserves of foreign currency are built out of the below commercial activities:

  1. Selling of goods or services to other countries (known as exports). These are of permanent nature.
  2. Investment by foreign individuals or companies or countries in our industry (FDI). These are of semi permanent nature, though very stable.
  3. Our countrymen working abroad and sending to us a part of their income (inward remittances). Permanent and stable.
  4. Investment in equity or bonds through our stock markets or private placements (portfolio investments). Volatile and temporary.
  5. Arrival of foreign tourists (inbound tourism). Permanent.

Our foreign currency outflow are for more or less same reasons. However, our dependence upon overseas purchase (imports) of fuel oil, edible oil, gold, diamonds and defense purchases makes our foreign currency reserves very vulnerable.

The rate of the local currency v/s USD is determined by the freely trading markets. Any intervention by the local governments is known as ‘intervention’ which is actually a manipulation. As we all know, manipulations inflict greater damage in the long run. In the decades of 50s, USD was artificially fixed at 4.76 (1 dollar equal to Rs. 4 and paise seventy six). This intervention made the Rupee overvalued and our exports were rendered uneconomical. This macro mismanagement resulted in virtually there being no reserves by 1958. This also resulted in the country being unable to import the crucial machinery for augmenting our manufacturing. China and S E Asia took an unassailable lead on us during that period only.

The mistake could be rectified as late as 1991. This resulted in the value of Rupee versus USD going from 17.50 in 1990 to 74 today. But it has not resulted in any chaotic and disastrous situation for the country. Many financially stronger countries with huge oil exports such as Turkey, Argentina, Brazil, Iran, UAE and Venezuela have faced far bigger foreign exchange economic crisis than our country.

People would ask as to why the Rupee has slid down so heavily if we are prudent in forex policies. One of the reasons is our ever burgeoning dependence on imported oil without seeking serious replacement of this energy source. Secondly, Rupee is virtually a free floating currency (convertible on current account). Any person can educate its children abroad, visit abroad, buy imported goods, buy a residential or commercial property abroad, send money to relatives etc., etc. There are hardly any curbs. Yes, large scale repatriation of money is still not allowed but unscrupulous people are hoodwinking the system.

US had generated a global financial crisis in 2008. US wanted to rebuild itself and opened its chests for the builders and manufacturers. That had resulted in low interest rate regime there. The money flew to those nations where there was an arbitrage opportunity to earn more owing to higher prevailing interest rates. India was one such destination. A lot of ‘volatile money’ flew into our bourses and companies. Now interest rate in US is hardening and the money is slowly, albeit surely moving back to from where it had come. This conversion of Rupee into the Foreign Currency (mainly USD) has put pressure on the local currency and has increased the value of USD. Hence, the higher Fx rate.

We must learn our lessons. We must know the sources of our foreign currency inflows. The cheaper the source, the more short term it would be, the more shady it would be. The investment in our companies, in our infrastructure and in our manufacturing would be long term, slightly costlier but stable. Sources from Germany, USA, Japan, Singapore, Canada, S Korea and Australia would be more stable. Monies from investment companies in Saudi, UAE, Mauritius, Cayman Islands and Seychelles etc would be shady and volatile.

This is also the time to invest in:

  1. Consolidating our exports in the thrust areas of software, handicrafts, gems, pharma
  2. Go for green (recyclable) energy
  3. Manufacturing electronic goods locally as much as possible
  4. Developing medical, eco and educational tourism

There is no need to panic, though.