Most conversations on the rise of the US Dollar against the Rupee blame almost any calamity as its cause - be it power cuts or bird flu. But why does a currency fluctuate? How does it hit the taxpayer and what should the government do? These might be some basic questions worth dwelling upon instead of placing blames blindly. 

 

Like any commodity, the exchange rate or price of a currency is determined by the forces of demand and supply. Strong demand for the US Dollar pushes its price upward, and vice versa. Exchange rates indicate the price at which currencies are bought and sold. Banks, corporations, brokers and governments buy and sell US Dollars every day and daily variation in demand alters its price each day. 

 

When an economy grows, it goes to a virtuous cycle where global investors bring in funds withdrawing from other stalling economies, in anticipation of better returns. When an emerging market shows better growth than a developed economy, investment starts to flow in to such market. Alternatively, when the US economy starts showing signs of recovery, global investors withdraw money from emerging economies due to probability of higher risk and volatility which overshadows the return. It created a demand-supply gap and is the reason why the US Dollar is more costly now.  

 

In all likelihood, the US will bring in various steps like withdrawing an easy monetary policy. This would drain more funds from struggling emerging economies like India. Besides that, high demand for gold and high crude oil imports will increase demand for US Dollars too.  

 

When the dollar becomes costly, certain cyclic reactions happen within the economy. Interest rates would be the first casualty. A country’s dependence on foreign investors to bridge the current account deficit is one of the key factors that changes interest rates, and so, interest rates would inevitably go up. This would hit the GDP hard as loans - be it consumer or investment loans - would be costlier. Foreign education and travel would be costly and oil prices would go up. This would start a vicious cycle as rise in transport costs would create a domino effect. Cost of transportable items like food and commodity materials would go up and a weak currency would increase the cost of import. Imported consumer products and raw materials would be dearer resulting in a run on the consumer’s wallet with rising inflation rates. Every item would cost more than what it did yesterday.

 

Weakened local currencies may boost export competitiveness against other emerging markets, but that alone will never boost exports. To achieve sustainable export competitiveness, one needs to enhance productivity and reduce cost of production which inflation may prevent from happening.

 

What can a country do? Not much on a short-term basis. It could raise the combined foreign investment limit on government and corporate debts. But there are issues like the country’s security, protecting the middle class and securing senior citizens which have to be considered. 

 

The Central Bank can ask exporters to immediately convert a part of their overseas foreign currency earnings in the market. But this provides only short term relief. Banks and financial institutions can be persuaded to raise funds abroad and lend locally which may work only if there is an attractive overseas rate. 

 

There are some strong measures the government can take like delaying or staggering import payments. But this will have larger implications on the balance of payments and credit ratings of a country. Nobody will like their credit rating to be reduced to junk status. The Central Bank can even open a dollar window for oil companies for direct purchase, albeit at the cost of draining out FOREX reserves. They can hold auctions to buy bonds from oil companies by paying in dollars or other international currencies. But the outstanding amount of oil bonds will be small if the government is giving direct cash subsidy to oil companies. 

 

Some distressed measures like review limits of foreign investment in certain key and strategic sectors like Defense, Insurance, Pension scheme, etc. can be looked at.  

 

In the long term, a country needs major reforms to ensure it stays globally competitive. Corruption and syndication are major barriers for such reforms. As the world is shrinking every day, if a country does not smoothen out its legal wrinkles and provide efficient infrastructure for businesses to enjoy better returns, it will never attract investment and always suffer from the fluctuation of a stronger global currency. As Thomas Friedman mentioned in his book The World is Flat, a country has to carry out long term macro reforms at the policy level and micro reforms at the operational efficiency level to stay afloat. He aptly termed it as ‘Reform Wholesale’ and ‘Reform Retail’. 

 

We have to demand that our leaders take steps to curb corruption and bring in reforms that are sustainable. We must not feel satiated or indifferent when others suffer because it could happen to us as well. As Harry S Truman said “It’s a recession when your neighbour loses his job; it’s a depression when you lose your own.” Tomorrow, it could be us.