What Governments won't tell you about currency devaluation? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster
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What Governments won't tell you about currency devaluation? 

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In this issue:
» India one of the largest issuers of sovereign debt
» IPO market facing the heat
» ....and more!


00:00

'So, when is Raghuram Rajan doing a China?' a friend based in the US asked, referring to the recent currency devaluations in China. 'India's economy isn't exactly firing on all cylinders either,' he added, hinting that India could do with a little depreciation of its own.

Now, my friend had a personal axe to grind here. Rupee depreciation plays to his advantage in the US. His paycheque looks better after converting to rupees and allows him to ship more money to India.

For someone holding dollars, rupee depreciation is certainly good news. But how about for those who do all their spending in rupees?

They are worse off, isn't it?

Currency depreciation reduces purchasing power. The same rupee after deprecation buys fewer goods and services. The effect is the same as a salary cut.

Yet, most governments across the world think currency depreciation is a good idea. As per their logic, depreciating their currency makes their nation's products more competitive in the global market. That, in turn, boosts GDP, creates employment, and improves capacity utilisation.

Confused? How can currency depreciation cut purchasing power and boost GDP at the same time?

To understand, as is often the case, one must take a long-term view.

The first fruits of depreciation are indeed sweet. At first, depreciation boosts exports and helps lift the GDP growth rate of a country. But it's the bitter long-term consequences of depreciation that concern us.

While currency depreciation makes exports competitive, it also makes imports costlier. Companies importing raw materials and capital equipment have to shell out more after the depreciation.

The problem is, while the boost to exports and GDP is immediately measureable, the impact of higher import costs is not. It takes time for the value chain to adjust to this new reality. But the higher costs to importers will make their way through the economy, giving rise to a trickledown effect that raises overall inflation levels.

The exporters, who enjoyed the sweet first fruits, ultimately get a taste of the bitter consequences of devaluation, as the benefits they received from a cheaper currency evaporate in the form of higher input costs.

What then? Another round of devaluation and imports-induced inflation? Quite possible. But the long-term consequences of this cycle are always detrimental to the economy.

In the end, the country depreciating its currency always loses. The winner is its trading partners who walk away with the gains in the form of cheaper goods. Policy makers should therefore discourage, not encourage, currency devaluation.

Luckily in Raghuram Rajan, we have a central banker who's well aware of the bitter long-term consequences. He has time and again called currency depreciation a dangerous trend and has shown no intention of allowing India to join the currency wars. And rightly so.

Sustainable GDP grown can only come from sound structural or fundamental changes to the economy. Currency depreciation is nothing more than government manipulation and distortion. The first fruits may taste like a sweet rise in GDP, but devaluation always turns bitter in the long run as the growth proves unsustainable.

So, where does this leave investors? Well, it should be obvious that they shouldn't buy into the idea that currency devaluation will lead to a sustainable recovery in China. The Chinese could well be setting themselves up for a bigger problem in the long run. And the current crisis may not even be over yet. In fact, this might just be the beginning.

What do you think? Do you think currency depreciation has negative long term consequences? Let us know your comments or share your views in the Equitymaster Club.

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02:15  Chart of the day
Talking a bit more about currencies... The recent turmoil in the global financial markets has clearly rattled all currencies. Emerging market currencies, in particular, have witnessed severe battering after China's yuan devaluation. As you would know, such volatility in the currency market is detrimental to smooth function of economies and international trade. But the adverse impacts can further be compounded if a country has too much foreign currency debt.

Today's chart of the day shows the largest emerging market sovereign debt issuers. As per Moody's Investors Service, emerging market sovereign debt has grown nearly five-fold between 2000 and 2014. After China, India has emerged as the second largest emerging market sovereign debt issuer. Should the outstanding sovereign debt be a matter of worry for these emerging markets?

An important question to be asked in this context is the composition of sovereign debt - how much is denominated in foreign currency and how much in local currency... The answer is relieving. Most of the new debt issuance by emerging market governments has been in local currencies. Here are the numbers... While emerging market foreign currency sovereign debt grew at a tepid annual average rate of 2.3% between 2000 and 2014, the local currency sovereign debt has grown way faster at 14.4% per annum. As a result, 88% of the total emerging market sovereign debt was in local currency at the end of 2014. It is worth noting that India accounts of 14.7% of the total local currency debt issued by emerging markets.

What does this shift in the emerging market sovereign debt composition indicate? It means that the local sovereign bond markets have matured and deepened, allowing governments to source funds in local currency instruments. This is indeed a positive sign. It has reduced the susceptibility of these countries to economic shocks compared to previous decades. Also, the growth and development of domestic financial markets increases the effectiveness of monetary and fiscal policy.

India Second Largest Emerging Market Sovereign Debt Issuer

03:40
August 2015. This was indeed a month that spooked many investors. And why not! The BSE-Sensex witnessed the steepest monthly decline in four years. And foreign institutional investors (FIIs) sold the most in seven years. But investors are not the only ones affected by the market mayhem.

Another casualty is likely to be the IPO market. You would have noticed that this year has seen more IPOs than the last two years. But the August market carnage and the ongoing uncertainty in the global markets may put an abrupt brake to the IPO party. The very first victim has been the IPO of Prabhat Dairy. The recent market crash has prompted a cut in the offer price of the IPO. Even the closing date has been extended. Given such a scenario, promoters may be forced to defer their listing plans.

The IPO market tends be a barometer of stock market sentiment. Market buoyancy and investor optimism are the key to successful IPO listing. When investor enthusiasm is high, it is easy for promoters to price their IPOs at premium valuations. For investors, this means lower margin of safety. This is the reason why we look at IPOs with a slightly sceptical eye. Looking at IPOs as a means to make quick gains is a bad investment strategy we believe.

04:40
At the time of writing, Indian markets were trading strong. The BSE-Sensex was trading higher by about 310 points. Metals and capital goods stocks were largely in favour today. Mid and smallcap stocks were also trading firm with their respective indices up by about 1.3% each.

04:55  Today's investing mantra
"The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs." - Warren Buffett
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This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst) and Ankit Shah (Research Analyst).

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6 Responses to "What Governments won't tell you about currency devaluation?"

Rajkumar S D

Sep 6, 2015

China is basically low cost producing country with vast market share product wise and country wise in exports. Hence devaluation at this juncture when other countries are mainly facing problem of recession will certainly improve its balance of trade position. At the same time by imposing tariff or non tariff curbs on imports, it will have double advantage by curtailing imports and enhancing exports. When growth rate has slowed down, it can certainly control its imports with the bare minimum. Further it has sizable amount of US currency in its reserves, which will also appreciate in terms of domestic currency. Hence near term it is beneficial for China.

Thanks with regards

Like 

kicha Ramaiya

Sep 6, 2015

I absolutely agree that depreciation of currency will pull the nation to deeper trouble. De-valuing Rupee is like a mirage.It may appear sweet, especially for our exporters,but it will certainly spell a disaster sooner or later taking our country in totality.
I only pray the almighty, no such devaluation of Re takes place in future.

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subhash

Sep 4, 2015

currency devaluation is good for exports. govt should lower the import duty on capital goods and basic raw material to arrest the rise in cost of input. no need to worry about higher cost of consumer goods.

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T.M.RAMANI

Sep 4, 2015

I have witnessed as an International Banker of 50 years many times the devaluation of various currencies around the world. Let me confine to INR. Your article is forthright correct. We think that devaluation increases exports. But we forget that the foreign importers too observe this and invariably force the exporters to reduce the price. As foreigners do not depend upon our products they arm twist the exporters to reduce the price. I have observed this very closely. The expectation of increase in income by the exporters is nullified. On the contrary we are unable to get import prices reduced as we are heavily dependant upon import articles and so it is not price sensitive.

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P Ramadas

Sep 3, 2015

In that case of possible devaluation of currency, a rupee in hand may not be equivalent to a rupee tomorrow, and this answer be correct in your quiz on valuation methods

Like 

Aakash Rajvanshi

Sep 3, 2015

Currency devaluation as a long term strategy is definitely a wrong idea with significant long term effects as discussed in the write up. However, as a tactical measure, it can prove to be beneficial for country like China which is a export based country.

China's exports growth will come if developed countries import more from them but since developed world is undergoing slow growth, the total imports aren't going to grow. So, China needs a bigger pie of the total imports to sustain growth. Thus, currency devaluation will improve their chance of improving exports in a short term as it will make the Chinese goods cheaper for other countries.

For import based economy, like India, currency devaluation is a total No-No as it will cause significant inflation even in a shorter term. That's why RBI intervene only to control the drop of rupee and never to curtail the appreciation. That's a tactical measure by import based economy like India.

Infact, currency appreciation or depreciation can't be done by central bank of any country on long term basis as market forces will act against such measures. Central banks can only do short-term tactical things to control volatility, improve exports, control inflation etc.

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