Inflation n Increase in Forex Reserve

7/27/2019 Inflation n Increase in Forex Reserve

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India Economy Watch

My working Notes On The Indian Economy

Friday, April 11, 2008

India Wholesale Inflation and Foreign ExchangeReserves 29 March 2008

India's inflation accelerated to the fastest pace in more than threeyears, raising concern the central bank may increase borrowing costsat the next meeting later this month. Benchmark bond yields climbedto a nine-month high. Wholesale prices rose 7.41 percent in the weekended March 29 from a year earlier, faster than the previous week's 7

percent gain, the Ministry of Commerce and Industry said in New Delhitoday.

Reserve Bank of India Governor Yaga Venugopal Reddy has raised thecash reserve ratio, or the proportion of deposits commercial lenders

need to place with the central bank, five times since December 2006.He has lifted the central bank's key policy rates nine times since

October 2004 to check inflation.

India this week is holding the biggest sale of debt since January toreduce the supply of money in the financial system and temper prices.The central bank plans to sell 230 billion rupees ($5.8 billion) of bonds

and bills this week, including 90 billion rupees of securities to drainexcess money from the banking system.

The central bank will make an ``apt'' response in its April 29 policy
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announcement to tackle inflation, Deputy Governor Rakesh Mohan saidon April 9. The authority kept the key repurchase rate unchanged at7.75 percent at the last monetary policy announcement on Jan. 29.

Oil touched an unprecedented $112.21 a barrel on April 9 in New York.

Palm oil, used mostly for cooking, reached a record 4,486 ringgit($1,423) a metric ton on March 4, and wheat in Chicago has more

than doubled in the past year, reaching an all- time high of $13.495 abushel on Feb. 27.

The government today scrapped export incentives for rice, steel andcement to boost local supplies and tame inflation, which is choking

economic growth and driving up costs. Trade Minister Kamal Nath, whoannounced the withdrawal of export inducements in New Delhi, saidthe central bank must also act to contain price gains. Bonds declined

for a second day on speculation the Reserve Bank of India mayincrease borrowing costs as soon as this month.

India's government this month scrapped import duty on crude edibleoil and banned the export of rice and pulses to boost supplies anddrive down prices. The government also elicited assurances from

steelmakers on April 2 to restrict price increases to help cool inflation.

Foreign Exchange Reserves Rise Again

India's foreign exchange reserves rose $2.7 billion to touch $311.9

billion during the week ended April 4, partly on account of RBIintervention to mop up excess dollar inflow. the Reserve Bank of India

(RBI) said in its weekly statistical supplement (WSS), in Mumbai.While the value of gold in reserves rose $481 million, the value of SDR

and reserves with the IMF dipped $1 million and $15 millionrespectively.
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The change in foreign-currency assets is partly because of changes inthe value of the dollar against the euro, yen and other currenciesduring the period, the central bank said. The country's foreign-

exchange reserves rose Rs 3, 81,923 crore over the past year, the

bank said. The RBI bought $3.88 billion of foreign currency inFebruary, its 16th straight month of purchases. The central bank's

currency purchases in February fell 72% from a record $13.6 billion inthe previous month. The RBI bought a total $75.4 billion in the first 11months of the fiscal year ended March 31, boosting foreignexchange

reserves to a record $309.2 billion as of March 28.

Regarding the updated money M3 supply figures, the total stock ofmoney in the system amounted to Rs 39,98,887 crore, up Rs 1,21,615

crore - or 2.07% -over the previous fortnights figures. While thecurrency with the public dipped Rs 2,017 crore, demand deposits andterm deposits rose Rs 77,288 crore and Rs 45,919 crore respectively.

On another front revised loan figures show that the slowdown in creditofftake has been steeper that the earlier indicated. During FY08 credit

rose 21.6% against 28.1% in the previous year.

According to the figures released in the weekly statistical supplement(WSS), total bank credit amounted to Rs 23,48,493 crore as on March28, up Rs 75,891 crore over the previous fortnights. While food credit

rose Rs 894 crore, non-food credit rose Rs 74,997 crore during the

fortnight.

For the year 2007-08, credit rose 21.6% as compared to 28.1% in theprevious year. Aggregate deposits mobilised by commercial banks

amounted to Rs 31,92,141 crore as on March 28, up Rs 1,16,917 croreover the previous fortnights. While demand deposits rose Rs 74,010crore, term deposits rose Rs 42,907 crore. Annual deposit growth forthe year works out to lower at 22.1% as a compared to 23.8% in the

previous year.

Rupee Gains

At the same time India's rupee traded near the highest this month onspeculation the central bank will allow gains in the currency to keep

inflation from accelerating.


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The rupee was little changed at 39.955 a dollar at 5 p.m. in Mumbai,from 39.945 yesterday.

Factors which move forex rates

Foreign exchange rates are extremely volatile and it is incumbent on those involved withforeign exchange - either as a purchaser, seller, speculator or institution - to know whatcauses rates to move.

Actually, there are a variety of factors - market sentiment, the state of the economy,government policy, demand and supply and a host of others.

The more important factors that influence exchange rates are discussed below.

Strength of the Economy

The strength of the economy affects the demand and supply of foreign currency. If aneconomy is growing fast and is strong it will attract foreign currency therebystrengthening its own. On the other hand, weaknesses result in an outflow of foreignexchange.

If a country is a net exporter (as were Japan and Germany), the inflow of foreigncurrency far outstrips the outflow of their own currency. The result is usually a
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strengthening in its value.

Political and Psychological Factors

Political or psychological factors are believed to have an influence on exchange rates.Many currencies have a tradition of behaving in a particular way such as Swiss francswhich are known as a refuge or safe haven currency while the dollar moves (either up ordown) whenever there is a political crisis anywhere in the world. Exchange rates can alsofluctuate if there is a change in government. Some time back, Indias foreign exchangerating was downgraded because of political instability and consequently, the externalvalue of the rupee fell. Wars and other external factors also affect the exchange rate. Forexample, when Bill Clinton was impeached, the US dollar weakened. During the Indo-Pak war the rupee weakened. After the 1999 coup in Pakistan (October/November 1999),the Pakistani rupee weakened.

Economic Expectations

Exchange rates move on economic expectations. After the 1999 budget in India there wasan expectation that the rupee would fall by 7% to 9%. Since such expectations affect theexternal value of the rupee, all economic data - the balance of payments, export growth,inflation rates and the likes - are analysed and its likely effect on exchange rates isexamined. If the economic downturn is not as bad as anticipated the rate can evenappreciate. The movement really depends on the market sentiment - the mood of themarket - and how much the market has reacted or discounted the anticipated/expectedinformation.

Inflation Rates

It is widely held that exchange rates move in the direction required to compensate forrelative inflation rates. For instance, if a currency is already overvalued, i.e. stronger thanwhat is warranted by relative inflation rates, depreciation sufficient enough to correct thatposition can be expected and vice versa. It is necessary to note that an exchange rate is arelative price and hence the market weighs all the relative factors in relative terms (inrelation to the counterpart countries). The underlying reasoning behind this conviction isthat a relatively high rate of inflation reduces a countrys competitiveness and weakensits ability to sell in international markets. This situation, in turn, will weaken the domesticcurrency by reducing the demand or expected demand for it and increasing the demand or

expected demand for the foreign currency (increase in the supply of domestic currencyand decrease in the supply of foreign currency).

Capital Movements

Capital movements are one of the most important reasons for changes in exchange rates.Capital movements of foreign currency are usually more than connected withinternational trade. This occurs due to a variety of reasons - both positive and negative.


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When India began its economic liberalisation and invited Foreign Institutional Investors(FIIs) to purchase equity shares in Indian companies, billions of US dollars came into thecountry strengthening the currency. In 1996 and 1997, FIIs took several billion USdollars out of the country weakening the currency. These were capital outflows. One of

the reasons popularly believed for the rupee not depreciating in the manner other South-east Asian currencies did in 1997-98 was because the rupee was not convertible on thecapital account.

Speculation

Speculation in a currency raises or lowers the exchange rate. For instance, the foreignexchange market in Kenya is very shallow. If a speculator enters and buys US $1 million,it will raise the value of the US dollar significantly. If a few others do so too, the price ofthe US dollar will rise even further against the Kenya shilling.

The most famous speculator in foreign currency is Mr George Soros who made over abillion pounds sterling in Europe (by correctly predicting the devaluation of the pound)and then is believed to have triggered the free fall of the currencies of South-east Asia.

Balance of Payments

As mentioned earlier, a net inflow of foreign currency tends to strengthen the homecurrency vis--vis other currencies. This is because the supply of the foreign currencywill be in excess of demand. A good way of ascertaining this would be to check thebalance of payments. If the balance of payments is positive and foreign exchangereserves are increasing, the home currency will become stronger.

Governments Monetary and Fiscal Policies

Governments, through their monetary and fiscal policies affect international trade, thetrade balance and the supply and demand for a currency. Increasing the supply of moneyraises prices and makes imports attractive. Fiscal surpluses will slow economic growthand this will reduce demand for imports and encourage exports. The effectiveness of thepolicy depends on the price and income elasticities of demand for the particular goods.High price elasticity of demand means the volume of a good is sensitive to a change inprice.

Monetary and fiscal policy support the currency through a reduction in inflation. Thesealso affect exchange rate through the capital account. Net capital inflows supply directsupport for the exchange rate.

Central governments control monetary supply and they are expected to ensure that thegovernments monetary policy is followed. To this extent they could increase or decreasemoney supply. For example, the Reserve Bank of India, to curb inflation, restricted andcut money supply. In Kenya, the central bank in order to attract foreign money into the


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country is offering very high rates on its treasury bills.

In order to maintain exchange rates at a certain price the central bank will also interveneeither by buying foreign currency (when there is an excess in the supply of foreign

exchange) and selling foreign currency (when demand for foreign exchange exceedssupply). This is known as central bank intervention.

It must be noted that the objective of monetary policy is to maintain stability andeconomic growth and central banks are expected to - by increasing/decreasing moneysupply, raising/lowering interest rates or by open market operations - maintain stability.

Exchange Rate Policy and Intervention

Exchange rates are also influenced, in no small measure, by expectation of change inregulations relating to exchange markets and official intervention. Official intervention

can smoothen an otherwise disorderly market. As explained before, intervention is thebuying or selling of foreign currency to increase or decrease its supply. Central banksoften intervene to maintain stability. It has also been experienced that if the authoritiesattempt to half-heartedly counter the market sentiments through intervention in themarket, ultimately more steep and sudden exchange rate swings can occur.

Interest Rates

An important factor for movement in exchange rates in recent years is interest rates, i.e.interest differential between major currencies. In this respect the growing integration offinancial markets of major countries, the revolution in telecommunication facilities, the

growth of specialised asset managing agencies, the deregulation of financial markets bymajor countries, the emergence of foreign trading as profit centres per se and thetremendous scope for bandwagon and squaring effects on the rates, etc. have acceleratedthe potential for exchange rate volatility.

Kenya intrinsically has a very weak economy but the rates offered within the countryhave always been very high. To illustrate this point the treasury bill rate in September1998 was as high as 23%. High interest rates attract speculative capital moves so theannouncements made by the Federal Reserve on interest rates are usually eagerly awaited- an increase in the same will cause an inflow of foreign currency and the strengtheningof the US dollar.

Tariffs and Quotas

Tariffs and quotas exist to protect a countrys foreign exchange by reducing demand. Tillbefore liberalisation, India followed a policy of tariffs and restrictions on imports. Veryfew items were permitted to be freely imported. Additionally, high customs duties wereimposed to discourage imports and to protect the domestic industry. Tariffs and quotasare not popular internationally as they tend to close markets. When India lifted its


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barriers, several industries such as the mini steel and the scrap metal industries collapsed(imported scrap became cheaper than the domestic one). Quotas are not restricted todeveloping countries. The United States imposes quotas on readymade garments andJapan has severe quotas on non-Japanese goods.

Exchange Control

The purpose of exchange control is to manage the supply and demand balance of thehome currency by the government using direct controls basically to protect it. Currencycontrol is the restriction of using or availing of foreign currency at home/abroad.

In India, up to liberalisation in the nineties there was very severe exchange control.Access to foreign currency was tightly controlled and the same was released only forpermitted purposes. This was because Indian exports had not taken off and there werestill large imports. There are several countries that maintain their rates at artificial levels

such as Bangladesh.

India is now fully, convertible on the current account but not as yet on the capitalaccount. This, to an extent, possibly saved India when the run on currencies took place inAsia in 1997. If the Indian rupee was fully convertible and there were no exchangecontrol restrictions, the rupee would have been open for speculation. There would havebeen large outflows at a time of concern resulting in a snowballing plunge in its value.

As long as the par value system prevailed, the rates could not go beyond the upper andlower intervention points. The only real question under the fixed rate system was whetherthe balance of payments and foreign exchange reserves had deteriorated to such an extent

that a devaluation was imminent or possible. Countries with strong balance of paymentsand reserve positions were hardly called upon to revalue their currencies. Hence, a watchhad to be kept only on deficit countries. However, under generalised floating regime,exchange rates are influenced by a multitude of economic, financial, political andpsychological factors. But the relative significance of any of these factors can vary fromtime to time making it difficult to predict precisely how any single factor will influencethe rates and by how much.

Summary

Exchange rates are dynamic and constantly changing. These changes occur due to several

factors - market sentiment, political happenings, economic situations, interest rates,inflation, government policy and speculation. Several of these are normally short-termbut can extend to the medium and long-term.

Exchange rate management is a delicate skill and has to be undertaken carefully as itaffects the long-term health of the economy and the countrys competitiveness in trade.


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Indian Inflation Continues to Accelerateby: Edward Hugh posted on: June 29, 2008 | about stocks: EPI / IFN /INP / PIN

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India's inflation accelerated again in the week ended June 14, hitting its fastest pace in 13

years and suggesting there may well be more interest rate increases to come from thecentral bank. Wholesale prices rose 11.42 percent in the week leading up to June 14,following an 11.05 percent rate in the previous week, according to a governmentstatement in New Delhi Friday.click to enlarge

This past week the Reserve Bank of India [RBI] increased its key rate to a six-year highof 8.5 percent, joining other central banks across Asia in raising borrowing costs assoaring fuel and commodity prices stoke inflation. Some analysts are speculating thatGovernor Yaga Venugopal Reddy may lift the Indian benchmark by as much as 100additional base points before the end of the year.

The RBI raised the repurchase rate by 0.5 percentage point on 24 June and lifted the cashreserve ratio to 8.75 percent from 8.25 percent, to prevent money in the banking systemfrom fanning inflation. The move followed a quarter-point increase in the benchmarkinterest rate to 8 percent on June 11.
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Money supply in India's banking system grew 21.4 percent from a year earlier to 41trillion rupees ($953.5 billion) in the week ended June 6, more than the Reserve Bank'starget of 16.5 to 17 percent for the fiscal year ending March.

Soaring food prices are also stoking inflation in India, where more than half thepopulation of 1.1 billion survive on less than $2 a day. Food product costs, includingbread, salt, cooking oil and tea, jumped 14 percent in the week leading up to June 14from a year earlier, according to Friday's report. Fuel price inflation rose 16.4 percent inthe week ended June 14 from a year earlier.

India on June 4 raised retail prices of fuel for the second time this year. Higher fuel pricesled to higher transportation costs, making manufactured products and food items moreexpensive.

The index of manufactured products, which has a 64 percent weight in the inflationbasket, rose 9.7 percent.

Foreign Exchange Reserves

Indias foreign exchange reserves rose $1.8 billion during the week ended June 20 despitesustained selling by foreign portfolio investors, indicating that the Reserve Bank of Indiawas a net buyer of forex assets in the market. The rise in reserves comes after a sharpdecline of nearly $5 billion in the previous week.

According to the latest data released by RBI, forex reserves, including gold and SDR(special drawing rights), rose $1,794 million during the week ended June 20 to touch$312.5 billion. While foreign currency assets rose $1,789 million, reserves with IMF rose$5 million. The value of gold and SDR currency with the IMF remained unchangedduring the week.
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Thus, $1,794-million worth of forex assets were absorbed by the central bank during theweek although these assets, even if expressed in dollar terms, include the impact ofmovements in the value of non-US currencies (such as euro, sterling and yen) held in thereserves. The central bank obviously intervenes to buy and sell assets denominated in avariety of currencies, and even though the currency break-down of India's reserves is notmade public, the central bank does reveal the break-down of the SDR-dollar, sterling,euro, yen and non-SDR currencies.

This data suggests that over the years, the share of non-SDR currencies in the reserves -such as the Canadian dollar, yuan and the Australian dollar - has been going up.

The Rupee

India's rupee fell by the most in three weeks last week, after crude oil rose to a record anddemand consequently rose from importers. India's oil imports have averaged $7.7 billiona month this year, compared with $5.4 billion in 2007.

The rupee seems to be heading for its worst quarter in a decade as accelerating inflationhas prompted global funds to sell more Indian equities than they have bought so far thisyear. The rupee is in fact now the second-worst performer among the 10 most-tradedAsian currencies excluding the yen this quarter. The rally in oil led the rupee to retreatfrom the three-week high it touched on Thursday, following the decision by the centralbank to raise its benchmark interest rate by the most since 2000.

The rupee was down 0.5 percent to 42.88 against the dollar by the 5 p.m. close inMumbai Friday. That is the biggest fall since June 9.
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Inflation n Increase in Forex Reserve