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Thursday, September 8, 2011

What is Devaluation ? In a commodity market, will anybody suffer losses voluntarily ??

In modern World, money is the purchasing power – it is manifested in the hard currency of the Country.  Theoretically, money is what is widely accepted and used in transactions involving transfer of goods or services.   Rupee is our currency and all goods and services are valued in Rupees.  Thus the price is determined and displayed by its Rupee value.  Though they may not the regularly accepted mode, the value of any commodity expressed in Rupee can also be represented in any other International currency say in Dollar, Pound Sterling, Yen,  Rial and the like.
Strangely the money which was created to buy goods and services can themselves be bought in International market !!   The value or strength of the currency is what it can buy and in International parlance, the price is how much it can or how much is required to buy that currency !  Thus in International market the value of a currency of a Nation is determined just like the price of any commodity in the market – by the relative demand and supply.  If there are lesser buyers then the value of the currency would weaken – meaning its price will come down.   Such value of a currency in International market, is determined by the value of its exports to other Nations as also by the investments that others would like to do on that currency or assets denominated in that currency.  One can easily understand why US wants petroleum to be traded in Dollars rather than the currency of the Country which possesses it.   If a country has more imports, it would create trade imbalance that it would have to pay more in foreign currency and thus the value of that Nation’s currency would reduce.
Unlike commodities which will be ruled by Demand and Supply curve – the currency market is to a large extent controlled to ensure that the value of the currencies do not fluctuate too much.  A band in which they should remain is determined beyond which the Central banks would intervene to ensure that prices remain within that select band.   Realise that the value of the currency is not merely its statistical average value of any particular period but it is the power – purchasing power weighed  by its capacity to purchase in International currency market. 
Just a few years back during the global economic crisis, China pressed fro consideration of a global currency.  A UN panel of expert economists has proposed replacing the current US dollar-based system by greatly expanding the IMF's SDRs or Special Drawing Rights.  In olden days, the reference currency was Pound Sterling which’s place was taken by US Dollar after WW II.   So to keep things under tab in the times of economic crisis, Governments might resort to reduction in the value of currency.  This official lowering of  currency value is known as “devaluation”.   It is a process by which the Central bank or the Monetary authority fixes a new rate in relation to foreign reference currency.  
Since its Independence in 1947, India has faced  two major financial crises and two consequent devaluations of  the  rupee.  These  crises were  in 1966 and 1991.    Every Nation would try to keep a large stock of foreign currency reserves facilitates trade with other nations and lowers transaction costs associated with international commerce.  If a nation depletes its foreign currency reserves and finds that its own currency  is not accepted abroad,  then the Nation will have to follow the individual way of borrowing.  The paying back of the loan has to be in the currency of the giver  or other acceptable currency.   To avert financial crisis, Nations will try to stable exchange rates and would resort to trade barriers on imports and financial restrictions.   There could be hard times when despite such measures, the Govt. would be forced to devalue its currency.  That is the sagging tale of Under developed countries !!
Here is a different tale – the one of Swiss Nation famous for its chocolates – yes a country famous for the high quality chocolates….. Switzerland a landlocked country is a federal republic consisting of 26 cantons.  It is situated in Western Europe bordered by Germany, France, Italy, Austria and Liechtenstein.  The two global cities are Zurich and Geneva.   Its currency is Franc – the Swiss Franc with code CHF.  The legal tender in notes is issued by Swiss National Bank  the federal Swiss mint issues coins.  The Latin name of the Nation is  ‘Confoederatio Helvetica’ which explains the CHF.
The value of the CHF climbed past US $ 1.10 in Mar 2011 and in June it became 1.20 remarkably due to Greek sovereign debt crisis.  In Aug 11, it marched past 1.30 $ - i.e., one US dollar would fetch 0.769 CHF and one CHF would fetch 1.30 US dollar.   Today, One Dollar would fetch 46 rupees and Euro would get 63 rupees !  Outwardly, a Country should feel happy when the value of its currency goes up.  But Swiss is different  as recently, the Swiss National Bank set a minimum exchange rate of 1.20 francs to the Euro saying "the value of the franc is a threat to the economy", and that It was "prepared to buy foreign currency in unlimited quantities.  Immediately, the currency lost close to 10%  and shocked some who were trading on it regarding it to be a safe haven.   Whilst it is the story of devaluation,  the Swiss central bank is imposing a ceiling on its value, reportedly for the first time in more than three decades.  The National Bank is intentionally weakening its currency !   Parts of Europe is steeling under worsening debt crisis  and good currencies are getting pushed upwards.  The Bank and the Nation are voluntarily incurring losses planning for the long term advantages.  For some it is “a problem of aplenty” and the present move by the Swiss Bank is indeed a calculated bold move.  
With regards – S. Sampathkumar.
PS :  When India devalued Rupee in 1991, PV Narasimha Rao was the Prime Minsiter and Manmohan Singh was the Finance Minister.

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