Pulling Pants Down….

The Other India (clearly the one which knows NOTHING about Economics) has a whole article on Foreign Exchange Reserves. The level of ignorance, intellectual laziness is astounding. They say never attribute to malice that which you can attribute to stupidity. But I’m sorry – this HAS to be malice.

The article paints foreign reserves as some sort of conspiracy by the West to keep the developing world poor. This concept is so laughable that I my stomach is still hurting.

 For the past 50 years, rich countries have steadily held reserves equivalent to about three months’ worth of their total imports. As money circulates more and more quickly in a globalized economy, however, many countries have felt the need to add to their reserves, mainly to head off investor panic, which can strike even well-managed economies. Since 1990, the world’s nonrich nations have increased their reserves, on average, from around three months’ worth of imports to more than eight months’ worth — or the equivalent of about 30 percent of their G.D.P

China and other countries maintain those reserves mainly in the form of supersecure U.S. Treasury bills; whenever they buy T-bills, they are in effect lending the United States money. This allows the U.S. to keep interest rates low and Washington to run up huge deficits with no apparent penalty.

All the money spent on T-bills — a very substantial sum — could be earning far better returns invested elsewhere, or could be used to pay teachers and build highways at home, activities that bring returns of a different type.

So let’s wee if we can summarize here.

  • Western countries hold only 3 months’ worth of imports, while “nonrich” countries, whatever those are, hold 8 months of imports – to avoid “investor panic”.
  •  And assuming these forex reserves are evil scum sent from those horrendous heretic capitalists with horns on their heads (ok – I am creating a small bhoosa-ka-aadmi here), then having them be 30% of your GDP is bad.
  • Further, all countries are apparently stupid enough to hold their reserves in US t-bills, and not a basket of currencies….

And finally, this means that America is being financed by the universe, and they are living it up like kings (partially true, but not in the tone that has been conveyed above)

So here we go with another Economics for Dummies lesson:

Let’s pretend for a second that America produces cars (and not duds-on-wheels).  Let’s also pretend these cars are sold for US$1

Now let’s add in a desi-boy, Laloo, who lives in India. Laloo wants to buy an American car. He imports it.

Finally, the exchange rate is US$1 = Rs. 41 (which it actually is. Shocking!!)

So what happens in this transaction?

Laloo needs to turn his rupees into dollars to pay the American company. So in effect, he needs to buy dollars and sell rupees. 

So basically, he goes to a bank, sells them 41 rupees, gets $1 for it, and pays the american company.

What does this have to do with Foreign Exchange Reserves? At this point, absolutely NOTHING!

What if a zillion Laloos bought a zillion American cars? Demand & Supply.

The demand for dollars goes up, and the demand for rupees falls. So, the value of the rupee vs the dollar drops

i.e. US$1 = Rs. 50 instead of US$1 = Rs. 41

This is of course a very simplified example. The market for currencies is so ginormous, with so many transactions taking place that even a 0.01 unit change in a currency is BIG deal.

Now let’s say you are upset to see your currency fluctuate so much. What you could do, to raise it up again, is to boost the demand for your currency, and lower it for the dollar. You could do this in a variety of ways, but in the “For Dummies” example, you could do it by encouraging tourism in your country, or you could export something the world really needs, and you are very efficient at producing (Oil, Software, Cars, Goats, or, in the case of India, ignorant leftists).

Now what this means is that every split second or so, your currency is going bounce up and down, depending on who wins – your exports, or your imports (yes this is very simplified, I know).

If you import more than you export, usually, there is downward pressure on your currency – i.e. its value declines, and if you export more than you import, there is upward pressure on your currency

So in effect, your currency bobs up and down like a piece of wood on the sea – i.e. its exchange rate is floating.

Most people in the world, especially left-wing idiots, do not like change. They like stability, equality, and other nonsense. So for those people (and also for growing economies who need a little stability)…we come up with the fixed exchange rate.

What is the fixed exchange rate? Basically, Mulayam Singh Yadav’s daughter wants the exchange rate to be US$1 = Rs. 5. So the royal decree goes out, and it is done. Leftists will have you believe that foreign currencies are also a western conspiracy, and that when the revolution comes, the whole world will have one currency and no borders, much like John Lennon Imagined.

Now the thing is, when an exchange rate is fixed like this, it does not represent a currency’s “true value” and leads to a black market. If you have read Shantaram, you will see what I mean – you could exchange dollars into rupees at a very different rate than the official one, because nobody really wanted to trade at the idiotic offical rate – India’s rate used to be fully fixed.

So we come to the most common type – the managed-floating rate. Now what managed floating says is that your exchange rate will float, it will bob up and down, but only within a certain range. And if it threatens to step out of that range, then the country’s central bank will step in to correct it. But HOW will it do this? You can’t just magically push up exports, or ban imports to correct the fluctuations…..

Hmmm….what if I kept a supply of foreign currencies in pocket. Then, if the demand for the US$ was high, I could sell a big chunk of the dollars that I keep in my pocket to lower the demand, thus stabilising the exchange rate. Ah. A RESERVE OF FOREIGN EXCHANGE.

But where do I get this foreign exchange from? I could just buy them by selling rupees. But that would mean that the value of my currency would drop.  Hmmm, so how about this as a scenario:

If I keep my currency very low compared to the US$, i.e. US$1=Rs43 instead of US$1=Rs. 20, Americans will find the prices of my exports very cheap. So they will buy a lot of them. Now if they buy a lot of them, the demand for my currency will rise. But that will raise the value of my currency, and make the exports more expensive. And I don’t want that to happen. So what I will do to keep the value of the Rupee is low is buy US dollars.

Now this meddling with the currencies will leave me with a bunch of US dollars in hand. Which I will hang on to for a rainy day, in case the Rupee starts to drop too much. Then I will start selling US$ so that Rupee’s value will rise. So therefore, I have a foreign exchange reserve. Now while I hold on to those US$, it is my choice on how I hold them. I might convert them into Yen/Euros and have a mix of currencies to hold on to. I might put them in a bank. I might buy government bonds with them. This choice simply depends on how smart the people working in my country’s central bank are.

  • FOREX RESERVES ARISE WHEN MORE MONEY COMES INTO YOUR COUNTRY THAN GOES OUT (okay, again, this is simplified).
  • THEREFORE, FOREX RESERVES ARE USED TO KEEP CURRENCIES STABLE
  • Could this money be used more productively? It depends on how big your reserves are, what your trade situation is like, and what the monetary situation in your country is like. Countries who export oil, or other resources in high demand usually suffer from lots of problems, because they don’t know what to do with the huge reserves they build up. This is called the Dutch Disease Effect
  • There have been a lot of countries buying US T-Bills, financing America’s debt – and this will go on for a bit due to a variety of factors, and whether it will eventually correct itself or not depends on whom you ask. BUT, this is based on very complicated international finance matters, and if you are bloody clueless about international finance, then keep your ignorant mouth shut about such matters

It is a shame. A right shame that people will stoop to any level to create a picture of a world that does not exist. By spreading such horrible disinformation, they lose the right to call themselves journalists. They are nothing more than glorified tabloid writers. Completely irresponsible and economically illiterate.

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