Once there was a little island country. The land of this country was the tiny island itself. The total money in circulation was 2 dollars as there were only two pieces of 1 dollar coins circulating around.
1) There were 3 citizens living on this island country. A owned the land. B and C each owned 1 dollar.
2) B decided to purchase the land from A for 1 dollar. So, now A and C own 1 dollar each while B owned a piece of land that is worth 1 dollar.
The net asset of the country now = 3 dollars.
3) Now C thought that since there is only one piece of land in the country, and land is non producible asset, its value must definitely go up. So, he borrowed 1 dollar from A, and together with his own 1 dollar, he bought the land from B for 2 dollars.
*A has a loan to C of 1 dollar, so his net asset is 1 dollar.
* B sold his land and got 2 dollars, so his net asset is 2 dollars.
* C owned the piece of land worth 2 dollars but with his 1 dollar debt to A, his net residual asset is 1 dollar.
Thus, the net asset of the country = 4 dollars.
4) A saw that the land he once owned has risen in value. He regretted having sold it. Luckily, he has a 1 dollar loan to C. He then borrowed 2 dollars from B and acquired the land back from C for 3 dollars. The payment is by 2 dollars cash (which he borrowed) and cancellation of the 1 dollar loan to C. As a result,
*A now owned a piece of land that is worth 3 dollars. But since he owed B 2 dollars, his net asset is 1 dollar.
* B loaned 2 dollars to A. So his net asset is 2 dollars.
* C now has the 2 coins. His net asset is also 2 dollars.
The net asset of the country = 5 dollars.
A bubble is building up.
(5) B saw that the value of land kept rising. He also wanted to own the land. So he bought the land from A for 4 dollars. The payment is by borrowing 2 dollars from C, and cancellation of his 2 dollars loan to A.
* As a result, A has got his debt cleared and he got the 2 coins. His net asset is 2 dollars.
* B owned a piece of land that is worth 4 dollars, but since he has a debt of 2 dollars with C, his net Asset is 2 dollars.
* C loaned 2 dollars to B, so his net asset is 2 dollars.
The net asset of the country = 6 dollars; even though, the country has
only one piece of land and 2 Dollars in circulation.
(6) Everybody has made money and everybody felt happy and prosperous.
(7) One day an evil wind blew, and an evil thought came to C's mind. "Hey, what if the land price stop going up, how could B repay my loan. There is only 2 dollars in circulation, and, I think after all the land that B owns is worth at most only 1 dollar, and no more."
(8) A also thought the same way.
(9) Nobody wanted to buy land anymore.
* So, in the end, A owns the 2 dollar coins, his net asset is 2 dollars.
* B owed C 2 dollars and the land he owned which he thought worth 4 dollars is now 1 dollar. So his net asset is only 1 dollar.
* C has a loan of 2 dollars to B. But it is a bad debt. Although his net asset is still 2 dollars, his Heart is palpitating.
The net asset of the country = 3 dollars again.
(10) So, who has stolen the 3 dollars from the country? Of course, before the bubble burst B thought his land was worth 4 dollars. Actually, right before the collapse, the net asset of the country was 6 dollars on paper. B's net asset is still 2 dollars, his heart is palpitating.
(11) B had no choice but to declare bankruptcy. C as to relinquish his 2 dollars bad debt to B, but in return he acquired the land which is worth 1 dollar now.
* A owns the 2 coins; his net asset is 2 dollars.
* B is bankrupt; his net asset is 0 dollar. (He lost everything)
* C got no choice but end up with a land worth only 1 dollar
The net asset of the country = 3 dollars.
End of the story; BUT
There is however a redistribution of wealth.
A is the winner, B is the loser, C is lucky that he is spared.
A few points worth noting -
(1) when a bubble is building up, the debt of individuals to one another in a country is also building up.
(2) This story of the island is a closed system whereby there is no other country and hence no foreign debt. The worth of the asset can only be calculated using the island's own currency. Hence, there is no net loss.
(3) An over-damped system is assumed when the bubble burst, meaning the land's value did not go down to below 1 dollar.
(4) When the bubble burst, the fellow with cash is the winner. The fellows having the land or extending loan to others are the losers. The asset could shrink or in worst case, they go bankrupt.
(5) If there is another citizen D either holding a dollar or another piece of land but refrains from taking part in the game, he will neither win nor lose. But he will see the value of his money or land goes up and down like a see saw.
(6) When the bubble was in the growing phase, everybody made money.
(7) If you are smart and know that you are living in a growing bubble, it is worthwhile to borrow money (like A) and take part in the game. But you must know when you should change everything back to cash.
(8) As in the case of land, the above phenomenon applies to stocks as well.
(9) The actual worth of land or stocks depends largely on psychology (or speculation).
*P.S: Got this story as a forward.
**P.P.S: I'm not that creative ;)
Showing posts with label Global Market. Show all posts
Showing posts with label Global Market. Show all posts
Tuesday, October 14, 2008
Monday, October 6, 2008
Fall of Indian Rupee in the Global Market
I was discussing this current trend with one of my friends, and found that I had a naive understanding of the dynamics of the global market. So I did some basic research, and will list down my findings, so that others in my state can benefit out of it.
The discussion started when we saw the newspaper clipping which read that rupee had fallen to a 2 year low against US Dollar. What surprised me the most was "Why the hell is the rupee value falling, when it should have been the other way around? The US market is at its worst, India is not hit as badly as the US, Indian companies are still making a 2 digit growth, then what was the reason for the falling rupee." And to my surprise there was a perfectly valid reason for this.
As I write this, the rupee is trading at 47.2 to a dollar. To put this into some perspective, it was 39.3 to a dollar in January 2008. That is a 20% increase in the value of the dollar in 10 months. Just to illustrate this point, it was not too long ago, the Indian Software giants were sacking people, just because they could not cope with the increase in the value of the rupee to a dollar, which resulted in them getting lesser income for the same client billing.
Let me just give a small description of my understanding on how this index is created. It is calculated as the amount of foreign investment in another country, i.e Amount of Dollars invested in India to the amount of Rupee invested in US. There are many participants in any foreign exchange market. These entities -- like banks, corporations, brokers, even individuals -- buy and sell currencies everyday. Here too the universal economic law of demand and supply is applicable: when there are more buyers for a currency than sellers, its exchange rate rises. Similarly, when there are more sellers of a particular currency than buyers, its exchange rate in the global markets will fall. This does not mean people no longer want money; it only means that people prefer to keep their wealth in some other form or another currency
With this knowledge let me list out the main reasons for the fall in Rupee:
1. The main reasons behind the fall of the rupee are an increased demand for dollars due to a spurt in crude oil prices and the flight of foreign funds from the Indian market (the market situation in India is growing grim by the day, with the main index BSE going below the 12,000 mark as I write this). Demand for rupees, simultaneously, has dipped because capital inflows are down. The American sub-prime crisis that shook the global financial markets has seen unprecedented bailouts and infusion of dollars into the US economy. This infusion has been at a cost of many an emerging market, from where funds have been pulled out to plough back into America. India has been one of the worst hit countries on this count, as foreign funds took flight, thereby making dollars scarce. The sudden and colossal demand for the US dollar has seen it strengthen, while the rupee's exchange rate has depreciated dramatically during the same period. India's stock market regulator, the SEBI, has said that foreign investors sold more Indian shares than they bought.
2. The higher price of imported goods, especially oil that is now ruling at over $90 per barrel, has also led to an increase in domestic inflation and a fall in the value of the Indian currency. High inflation and a strong growth in the Indian economy have already forced the RBI to raise interest rates. The inflation is hovering around 12% mark for the past 2 months.
3. One more reason for the fall of the rupee, as propounded by some economists, is the overseas non-deliverable forward (NDF) market that is not sanctioned by the Reserve Bank of India. An NDF is a non-deliverable forward contract where financial institutions buy forward dollars (that is, they book dollars now for delivery at a predetermined future date) in the Indian market and at the same time sell a similar amount of dollars in an overseas market -- or vice-versa -- so that on the delivery date they make a profit or loss, which is the difference between both the rates.
So what is the conclusion of this? Who gets affected, and more interestingly who is under loss and who is gaining out of the current situation?
As the rupee falls, foreign investors will want bigger returns for their money to compensate for the higher risk. This means that the Indian government, companies and individuals will have to pay more for the money they borrow: in other words, higher interest rates. This will also mean that Indian Govt will have to pay that much more for the foreign loans, like from the World Bank. This could further deter foreign investment, which results in a cumulative effect (people stop investing because the rupee is devalued which is a result of foreign players divesting).
So how do we reverse this trend?
One measure that can be taken by the RBI, is to change the interest rates, so that value of the rupee is appreciated in the global market. Another thing is for RBI to sell US greenbacks in the open market, thereby getting this situation under control momentarily and stopping the spiraling downward trend.
But the best thing to happen is to hope for a bull run in the market, similar to the one we had in 2007. This will ensure that there is more foreign investment, and as a result the demand for dollar falls, and strengthens the rupee considerably.
The discussion started when we saw the newspaper clipping which read that rupee had fallen to a 2 year low against US Dollar. What surprised me the most was "Why the hell is the rupee value falling, when it should have been the other way around? The US market is at its worst, India is not hit as badly as the US, Indian companies are still making a 2 digit growth, then what was the reason for the falling rupee." And to my surprise there was a perfectly valid reason for this.
As I write this, the rupee is trading at 47.2 to a dollar. To put this into some perspective, it was 39.3 to a dollar in January 2008. That is a 20% increase in the value of the dollar in 10 months. Just to illustrate this point, it was not too long ago, the Indian Software giants were sacking people, just because they could not cope with the increase in the value of the rupee to a dollar, which resulted in them getting lesser income for the same client billing.
Let me just give a small description of my understanding on how this index is created. It is calculated as the amount of foreign investment in another country, i.e Amount of Dollars invested in India to the amount of Rupee invested in US. There are many participants in any foreign exchange market. These entities -- like banks, corporations, brokers, even individuals -- buy and sell currencies everyday. Here too the universal economic law of demand and supply is applicable: when there are more buyers for a currency than sellers, its exchange rate rises. Similarly, when there are more sellers of a particular currency than buyers, its exchange rate in the global markets will fall. This does not mean people no longer want money; it only means that people prefer to keep their wealth in some other form or another currency
With this knowledge let me list out the main reasons for the fall in Rupee:
1. The main reasons behind the fall of the rupee are an increased demand for dollars due to a spurt in crude oil prices and the flight of foreign funds from the Indian market (the market situation in India is growing grim by the day, with the main index BSE going below the 12,000 mark as I write this). Demand for rupees, simultaneously, has dipped because capital inflows are down. The American sub-prime crisis that shook the global financial markets has seen unprecedented bailouts and infusion of dollars into the US economy. This infusion has been at a cost of many an emerging market, from where funds have been pulled out to plough back into America. India has been one of the worst hit countries on this count, as foreign funds took flight, thereby making dollars scarce. The sudden and colossal demand for the US dollar has seen it strengthen, while the rupee's exchange rate has depreciated dramatically during the same period. India's stock market regulator, the SEBI, has said that foreign investors sold more Indian shares than they bought.
2. The higher price of imported goods, especially oil that is now ruling at over $90 per barrel, has also led to an increase in domestic inflation and a fall in the value of the Indian currency. High inflation and a strong growth in the Indian economy have already forced the RBI to raise interest rates. The inflation is hovering around 12% mark for the past 2 months.
3. One more reason for the fall of the rupee, as propounded by some economists, is the overseas non-deliverable forward (NDF) market that is not sanctioned by the Reserve Bank of India. An NDF is a non-deliverable forward contract where financial institutions buy forward dollars (that is, they book dollars now for delivery at a predetermined future date) in the Indian market and at the same time sell a similar amount of dollars in an overseas market -- or vice-versa -- so that on the delivery date they make a profit or loss, which is the difference between both the rates.
So what is the conclusion of this? Who gets affected, and more interestingly who is under loss and who is gaining out of the current situation?
As the rupee falls, foreign investors will want bigger returns for their money to compensate for the higher risk. This means that the Indian government, companies and individuals will have to pay more for the money they borrow: in other words, higher interest rates. This will also mean that Indian Govt will have to pay that much more for the foreign loans, like from the World Bank. This could further deter foreign investment, which results in a cumulative effect (people stop investing because the rupee is devalued which is a result of foreign players divesting).
So how do we reverse this trend?
One measure that can be taken by the RBI, is to change the interest rates, so that value of the rupee is appreciated in the global market. Another thing is for RBI to sell US greenbacks in the open market, thereby getting this situation under control momentarily and stopping the spiraling downward trend.
But the best thing to happen is to hope for a bull run in the market, similar to the one we had in 2007. This will ensure that there is more foreign investment, and as a result the demand for dollar falls, and strengthens the rupee considerably.
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