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Chapter 1

Understanding Currencies

A currency is the token that is used as money in a country. Normally every country has a unique currency of its own and that is in line with the sovereign nature of governments. For example, India has the INR, Japan has the Yen, UK has the GBP, the US has the USD and China has the Yuan (or RenMinBi in local parlance). These are all sovereign currencies of every country. Europe is the only region in the world that has a common currency called the Euro (€), which subsumes erstwhile currencies like the German Mark, French Franc, Spanish Peseta, Italian Lira, Greek Drachma, Irish Punt etc.

How are currencies issued and by whom?

In every country, the issuer of currency is the central bank of the country. In India it is the Reserve Bank of India, in the US it is the Federal Reserve, in Japan it is the Bank of Japan, in China it is the People’s Bank of China and in the Euro Region it is the European Central Bank. The central banks have the sole authority to issue and regulate the quantum of currency in the respective country. But on what basis are the currencies issued? Broadly, there are four types of currency issue.

  • Fiat currencies are issued based on the forces of demand and supply. The government and the central bank determine how much currency needs to be issued to maintain equilibrium in the financial markets and the economy. Most of the large modern currencies are fiat currencies; meaning they are issued by fiat of the governments.
  • Asset backed currencies are currencies that are backed by hard assets like gold and silver; either to the full extent or proportionately. The US was on the gold standard under the Bretton Woods system before it broke up in the early 1970.
  • Commodity backed currencies are hardly used these days but in the old days currencies used to be backed by commodities like agri commodities, metals or live stock. However, this made the currencies extremely volatile and was not preferred in the larger interests of stability.
  • Digital currencies are a very recent phenomenon and have only come about in the last 10 years since the financial crisis of 2008. Classic example of digital currency is the crypto currencies like Bitcoin. However, they are based on the principle of scarcity and regulation remains a challenge.

What is meant by hard currencies?

Most of us use the term Hard currency quite generally. In reality, hard currency is a currency that has been adopted as an acceptable payment method in multiple countries. For example, it is difficult to use the INR in the US or European countries but currencies like the USD, GBP and Euro can be used in multiple countries. Normally, hard currencies are issued by developed countries that have a strong industrial economy accompanied by a stable government. In fact, one of the pre-conditions of being a hard currency is that the currency should be fully convertible on the capital account; meaning it should be freely tradable. Currencies like the INR still have too many restrictions on convertibility.

Hard currencies are frequently used to denominate commodities and serve as a benchmark for foreign exchange markets. For example, if you take any commodity like oil, gold or even metals they are all denominated in USD. Hard currencies are also preferred currencies for maintaining forex reserves by the central banks.

What are exchange rates and how are exchange rates fixed?

The exchange rate gives the relative value of one currency against another currency. Exchange rates are always expressed in terms of two currencies. For example, the US Dollar will have a unique exchange rate with Euro, Pound, Yen, and INR etc. When we say that the USD/INR exchange rate is 70.50 it means that one needs to pay Rs.70.50 per dollar. The US dollar is the most commonly used reference currency, which means other currencies are usually quoted against the US dollar.

How does the currency rate get determined? For example, how is it decided that the USD-INR should be Rs.70.50 and not something else? While broadly, these exchange rates are determined by the factors of demand and supply, there is also an underlying fundamental factor that determines the exchange rates.

The most common theory to explain the relationship between two currencies that can change in value is the purchasing power parity (PPP) theory. Globally, this PPP is best illustrated with the “Big Mac index” created by The Economist magazine. In a perfect world, a Big Mac should have the same value everywhere in the world, regardless of the local currency. In a simplified example, assuming the exchange rate for USD/British pound is 2 and the price of a Big Mac is £2.50 in the UK, a Big Mac should cost $5 in the US. If the purchasing power of the British pound increases relative to that of the US dollar, the exchange rate has to adjust so that the pound buys more dollars than previously. Otherwise, consumers will start to buy goods in the cheaper country.

What about countries like India where Big Mac is not really the reference point? We use something called the inflation differential. For example, if US inflation is 2% and Indian inflation is 5%, then each year the INR must depreciate by 3% (5%–2%). That is the simplest explanation of how exchange rates are fundamentally driven. In countries like India, the INR is also driven by factors like foreign investment flows especially from the FPIs and the FDI flows.

Key players in the forex market

The influence of the players in the FX market has shifted over the years. Traditionally, the most important players in the FX markets were importers and exporters of goods, trading currencies through banks. International trade was thus the primary driver of supply and demand for currencies. Trade still influences FX markets directly through commerce and indirectly through market movements that follow official international trade and investment flow data. However, with the risk in forex market trading and speculation, the importance of trade has waned as financial investors have become increasingly active in FX markets.

In recent years, investors discovered currencies as a distinct asset class and potentially an additional source of income. Lower returns on traditional asset classes, such as equities and bonds, and a mismatch between the assets and future liabilities of pension funds led investors to seek new, uncorrelated sources of return. Currencies can offer not only diversification but also the potential for additional returns due to inefficiencies in the FX market.

Large and established financial institutions have become the biggest players in the FX market. Interbank business accounts for about half of FX turnover, according to the Bank for International Settlements, but the greatest growth in participation comes from other financial institutions; including insurance companies, pension funds, hedge funds, asset managers, endowments and, most of all, central banks and sovereign funds.

Understanding drivers of rupee movement

Like every country India also maintains forex reserves which gives stability to the economy and also can be used to defend the rupee value. Let us now focus on what drives the INR. Broadly there are 6 factors that impact the movements of the INR. Let us look at each of them.

  • Inflation shifts are a key factor because a country with a lower relative inflation rate will see an appreciation in the value of its currency.
  • Interest rates are related to the rate of inflation and actually act as a shield against a fall in the currency.
  • Trade deficit and current account deficit also make a difference in the Indian context. A deficit in current account due to spending more of its currency on importing products than it is earning through sale of exports causes depreciation.
  • High levels of government debt mean that India is less likely to acquire foreign capital, leading to inflation.
  • Political Stability and the reforms progress also make a difference to the currency. When the government gives a reformist tone, there is FDI willing to flow in and that makes the INR stronger. The rupee is vulnerable to political instability as we have seen in the forex crisis in 1991 when India had to pledge gold with the Bank of England.
  • Speculation is something we cannot miss out. The INR may not be freely traded but there is a robust spot market, a robust futures & options market and also a strong offshore market in Dubai and Singapore. These factors make the rupee vulnerable to wild swings. They may be speculative in nature but they impact the USD-INR nevertheless.
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