Modern Exchange Rate Theory and a Sandwich Made of Dollar Bills

Rs.66.49/$, Rs.66.82/$, Rs.66.03/$, Rs.67.01/$.. Have you ever looked at the financial page of a newspaper and wondered how the value of the Rupee moves everyday? There’s a famous theory in International Finance that states that currency values are random. That is to say, their movements do not have a logic and hence, cannot be predicted.

But the general understanding otherwise is that currency rates go up and down due to two basic factors in Economics that you might have already heard of: Supply and Demand.

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(Source: Investopedia)

Before knowing how currencies move, there has to be a basic understanding of how Supply, Demand and by extension, Price are related. Supply is inversely related to Demand and Demand is directly related to Price (This also means that Supply is inversely related to Price). This is Economics. But this is the boring kind of explanation.

We can understand this phenomenon with a more interesting example. Assume that you need to have sandwich for breakfast everyday. There’s no other option. Now, would you give Rs.1000 to get that sandwich? That sound crazy, right? But what if there were only 10 sandwiches in your entire locality? Would you pay the Rs.1000, considering there are handful of other people who also want them? What if there was only 10 sandwiches in the entire country? Would you then pay Rs.5000, Rs.10000? You have to. Because you need the sandwich and the supply is low. So you are willing to pay a higher price to get it.

Now flip it around. Imagine that every other shop in your locality and millions of shops in the country sell sandwiches. Would you still pay Rs.1000? Rs.100? If a shop is selling it at Rs.50 or below, you’d probably get it from there. Why do you do this? Because the supply is humongous. If you feel that one shop has priced the sandwich higher, you can go to the next one. You have several options. You are only willing to pay the least possible price or at least a price that is comparatively very low for a good sandwich.

The same is the case with currencies, because a currency is nothing but another commodity, albeit with very different properties. In this case, the foreign currency is the sandwich.

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Let us say that the current price of the Dollar-Sandwich is Rs.67.14. Whenever more people in India demand for more Dollar-Sandwiches, the price will move to Rs.67.14, Rs.67.85, Rs.68.21 and so on, upwards. When this happens, we say that the Indian Rupee is depreciating against the Dollar (Or that the Dollar is appreciating against the Indian Rupee). When the demand for Dollar-Sandwiches fall, the the price of one Dollar-Sandwich moves from Rs.67.14 to Rs.66.98, Rs.66.02 and so on below. When this happens, we say that the Indian Rupee is appreciating against the Dollar (or that the Dollar is depreciating against the Indian Rupee).

That’s all there is to it.

This article is written by Dinesh Sairam (PGDM, XIME-B, Batch 21)

Islamic Banking: The Implications of an Interest-less Banking System

Quite a few heads were turned when the Reserve Bank of India (RBI) recently set up a three-member panel to review the feasibility of the Islamic Banking System in India, including Rajesh Verma, a deputy general manager, department of banking operations, Archana Mangalagiri, general manager, non-banking supervision and Bindu Vasu, joint legal adviser. This move was a surprise, considering how an earlier committee appointed in 2007 rejected the idea of implementing such a system in India.

 

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(Source: ILMABAD)

 

What is Islamic Banking?

 

Islamic Banking is a Banking System being followed in several parts of the world, mostly in Islamic nations like the Middle East. It follows the Islamic rulings or Shari’ah. Among other things, Islamic Banking prohibits ‘Riba’, roughly translated to ‘Money earned by money’, or in the modern parlance, Interest. The justification given is that money is not seen as an asset in Shari’ah, rather only a medium of exchange. This also means that there is no ‘creditor’ or ‘debtor’ in the system.

 

How do Islamic Banks function?

 

First and foremost, since Interest payments are prohibited, Islamic Banks do not accept deposits. They only ‘lend’ money. In return, instead of interest, the banks take a share of equity in the company. Whatever profit the company makes will then directly translates into better share value for the bank. Of course, if the company does not do well, the bank loses out as well. It is a kind of ‘brotherhood’ under which Islamic Banking operates. In addition to the prohibition of interest, Islamic Banking also prohibits all activities deemed evil by Shari’ah, such as investing in businesses that are related to pork, involving in activities that are highly risky and gambling. The functioning of an Islamic Banking system can be explained somewhat through the below diagram:

 

islamic-banking-cycle

 

Why Islamic Banking in India?

 

The reasoning behind considering the implementation of Islamic Banking in India is that a lot of Muslims in the country shy away from conventional Banking because Shari’ah prohibits it as ‘haram’. The Reserve Bank of India in tandem with the Modi government wants to explore this reform solely for the purpose of furthering financial inclusion, an agenda that is dear to both the central bank and the central government.

 

What are the implications of Islamic Banking?

 

Islamic Banking is very similar to traditional banking, except that traditional banking exchanges its funds for a liability (Debt), whereas Islamic Banking exchanges its funds for equity. In both the cases, the banks earn a ‘fee’ for parting with their funds, over several periods. In case of a default, the traditional bank loses out on interest payment and potentially the principal amount. In Islamic Banking, when the businesses in the bank’s portfolio do badly, the equity value held by the Islamic Bank will erode and the bank will eventually run out of liquidity. But at least, in traditional banking, there is a scope for recovery via Strategic Debt Restructuring and the central bank can control the supply of money via interest rates. In these frontiers, the Islamic Banking system offers little to no solution. There is also a major concern that Islamic Banking is convenient for illegal funds to flow through easily.

But Islamic Banking has become an inevitable part of modern banking and will also be implemented in India. It is only a question of whether or not the entire traditional banking system in India should be overthrown and replaced by Islamic Banking or should both the systems co-exist, that needs answering the most (Islamic Banking system is already allowed in very few banks across India). Hopefully, the latest committee set up by the Reserve Bank of India will find an answer. If not for anything else, there is a good chance that Islamic Banking will be introduced as an add-on service to traditional banking in order to encourage the marginalized sections of the Muslim population to take part in Banking activities.

 

This article was written by Dinesh Sairam (PGDM, XIME-B, Batch 21)

The Rajan Effect

Raghuram Rajan Takes Charge As Governor of The Reserve Bank of India
(Source: JapanTimes)

 

It’s time to bid a bittersweet adieu to Rajan. On the 4th of September, Raghuram Rajan, the current RBI Governor, will have completed three years in office. In these years, Rajan has garnered immense popularity as a central banker, especially for his determination and strict policies of fighting inflation. He gained nicknames such as ‘R3’ and ‘Rockstar’ as a part of his massive fan-following. The media made a highlighted his every public move, even comparing him with the likes of James Bond, for his famous words “My name is Rajan. I do what I do.” All in all, Rajan was a new kind of Central Banker to India that his predecessors never were – the famous kind.

A IIT-D and an IIM-A Gold Medalist, Rajan is also a distinguished University of Chicago scholar. Before his stint at the RBI, he served as the Chief Economist of the International Monetary Fund. Rajan is best known for anticipating the 2008 subprime lending crisis in his paper, “Has Financial Development Made The Word Riskier?” He also reiterated his views in the post-crisis short film “Inside Job“.

 

 

His record at the Reserve Bank of India speaks for itself. Raghuram Rajan walked into Mint Street in September 2013 while a currency crisis was unfolding. The rupee was nose diving and had almost hit Rs. 69 to a dollar while currency reserves had hit a three-year low. Inflation was galloping as well and at that time looked far beyond anyone’s control. While Consumer Price Inflation had hit 9.84 per cent in September 2013, inflation in primary food articles had crossed the 18 per cent mark.

On day one as central bank chief, Rajan vowed to preserve the value of the currency. He waged a war against inflation and straightened the rupee in weeks. To calm the vulnerable rupee, Rajan launched the FCNR (B) (Foreign Currency Non Resident (Bank) account is an account that can be opened with an Indian bank by a Non Resident Indian or a Person of Indian Origin in foreign currency) scheme under which it offered discounted currency swaps to banks to spur inflow.

 Banks raised $25 billion through FCNR deposits and another $9 billion through foreign currency borrowings. Surprising many, Rajan hiked Repo Rate not once but twice in October 2013 and January 2014 to break the spiral of rising inflation. The Indian economy has seen significant changes over the three years that Raghuram Rajan has been the Governor of the Reserve Bank of India.

In September 2013, when Rajan took over, the economy was part of the infamous ‘Fragile Five’ grouping. Today, it is celebrated as the fastest growing major economy in the world.While fortuitous factors like a drop in commodity prices have helped steady the fundamentals of the Indian economy, so have sound macroeconomic policies like a focus on bringing down inflation, building foreign exchange reserves and allowing a steady increase in foreign participation in the Indian debt markets.

 

Here is a summary of how economic indicators have evolved during Raghuram Rajan’s tenure as the Reserve Bank of India Governor:

 

  • Rupee: To say that the rupee was in bad shape will be an understatement. Two months before Rajan took office, the domestic currency had depreciated by a staggering 10.4 per cent as India faced its worst currency crisis in recent memory. Ever since Rajan took over, the rupee has gained 1.12 per cent with implied volatility hitting an eight-year low last week

 

  • Lending rate: Lending rate, or the rate of interest banks charge from borrowers, stood at 10.3 in September of 2013. As of August 2016, it’s down by 90 bps at 9.3 per cent. High lending rate has been one of the key concerns in the second half of Rajan’s tenure, as repeated cuts in repo rate by the central bank didn’t get transmitted fully.

 

  • Inflation: Rajan is known for his primary focus on curbing inflation. His biggest achievement is that he successfully brought down retail inflation to 3.78% in July 2015 from 9.8% in September 2013 – the lowest since the 1990s. Wholesale inflation was down to a historic low of -4.05% in July 2015 from 6.1% in September 2013. Under Rajan, the RBI adopted consumer price index (CPI) as the key indicator of inflation, which is the global norm, despite the government recommending otherwise.

 

  • Equity: In his first speech as RBI governor, Rajan promised banking reforms and eased curbs on foreign banking, following which Sensex rose by 333 points or 1.83%. After his first day at office, the rupee rose 2.1% against the dollar. The equity market, although not directly under Rajan’s influence, has nonetheless had a blast during Rajan’s tenure. The BSE Sensex rose 51 per cent even since Rajan took office through August 8, 2016. The NSE Nifty50 has gained 60 per cent in the same period.

 

  • Gross NPAs:The biggest achievement of Rajan’s tenure may not look like an achievement at all. Gross non-performing assets at India’s scheduled commercial banks jumped three-fold from Rs 2,52,275 crore in December 2013 to Rs 5,94,929 crore by March, 2016, thanks to a clean-up of the banking system that has brought forth the ugly side of the banking sector. With a former RBI governor accepting the responsibility for not doing much about the issue, the burden fell on Rajan and his team.

 

  • Foreign Exchange : Perhaps, a hands-down winner during Rajan’s tenure, foreign exchange reserves of RBI have swelled to record high. From $275 billion in September of 2013, it now stands at a record $365 billion and will provide the arsenal to the central bank to brace for the FCNR bond redemptions coming up in September, which is likely to create some ripples in the currency market. India’s forex reserve is now stronger by about 30% than it was two years back.

 

  • Banking: Under Rajan, two universal banks have been licensed and eleven payment banks have been given the nod. This is expected to extend banking services to the nearly two-thirds of the population who are still deprived of banking facilities.

 

  • Interest rates:After initially raising nominal interest rates by 50 basis points, or 0.50 per cent, to quell inflation, RBI embarked on a journey of rate cutting which is now in its 18th month. When Rajan took office, repo rate stood at 7.5 per cent, which then rose to 8 per cent in January 2014. Post-January 2015, repo rate has been slashed by 1.5 per cent to 6.5 per cent, which is the lowest level in four-and-a-half years.

 

  • Current account deficit:The current account deficit, though essentially a finance ministry domain, has seen a marked improvement over the past three years, climbing down from a record high level of 4.10 per cent to 0.1 per cent in June 2016.

 

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(Source: ETMarkets)

 

 Rajan’s early focus and battle with inflation earned him nicknames ranging from ‘Inflation warrior’ to ‘Inflation Hawk‘. There are a number of points to consider here when viewing the criticisms against Rajan’s stance on inflation and interest rates. He has more aggressively expanded on his predecessor’s attempt at using interest rates to curb inflation. The arguments in favour of Rajan having erred, when it comes to interest rates and inflation, are three-fold.

First, the central idea that the high inflation in the Indian economy was due to excess domestic demand is flawed. This inflation can be more attributed to global excess demand and thus raising interest rates was flawed. If this is true, Rajan’s restrictive monetary policy has been completely off the mark.

Second, even if Rajan’s initial stance of keeping inflation as the RBI’s number one goal was correct, he may have been too late in recognizing when this goal was achieved and therefore late in eventually cutting interest rates. Rajan at the time was still hesitant to cut interest rates even though retail inflation had fallen to 3.8%.

The problem of different perspectives here – whether India was undergoing disinflation or deflation – stemmed from the RBI’s decision to look at retail inflation (CPI) while deciding its monetary policy. So while the wholesale price index sat at negative 4% at that point of time, CPI was still at 3.8%.

The last argument for Rajan having tripped up was that even after he started his rate cut cycle, he didn’t do enough to help the money markets that were gasping for liquidity; a crucial side-effect of this was that a free transmission of rate cuts did not happen. It was only in his last year, and more specifically in the last five months, that the RBI governor set out to make more cash available in the banking system.

Out of these three arguments, there is greater evidence and support for the last two. In some ways it’s a pity that criticism levied against Rajan comes from parties that had a vested interest in his policies: politicians, India Inc. lobby groups, debt-laden promoters and wilful defaulters.

In his farewell letter, Rajan expresses a tinge of disappointment that he will not be able to see through two important developments: The formation of a monetary policy committee that may eventually reduce the role of the RBI governor, The asset quality review of public-sector banks.

Apart from these two issues, however, what has received less media attention was Rajan’s aim of overhauling the RBI’s administrative structure, including hiring talented external employees as well as improving the quality of institutional research.

One big mistake Rajan did was he failed to fathom the tolerance level of ruling political dispensation to criticism, especially on political matters. In a country, where all government bureaucrats are supposed to toe the line of their employer, no government servant, even if he is the RBI Governor, is supposed to speak his mind on sensitive political issues. That’s a taboo. The moment Rajan stepped out of his mandate and started commenting on political issues, the discord between him and the government started.

Rajan’s work is nothing short of exceptional. However, newer Central Bankers will most likely match his performance and maybe even exceed it. But whether India will have such an honest, outspoken and fearless Central Banker is a huge question mark. Rajan himself has assured that he remains loyal to India and will be happy to serve the people whenever he is called upon again. At this moment, we can only be thankful for his contributions and restate the message of the RBI Staff in their tribute rangoli to their outgoing boss: “Alvida na kehna” (“Never Say Goodbye“).

 

This article was written by Varnita Deep (PGDM, Batch 22,  XIME-B)

 

The Power of Compounding

There’s a wonderful real-life story (Some say a myth) that puts the power of compounding into perspective.

In 1626, a tribe of Native Indians called the Lenape, who were the inhabitants of a city in the east coast of the U. S. sold their entire land to Dutch immigrants. They took their payment in trinkets and beads amounting to $24 (This is, of course, just a rough representation and often contested by many researchers. The U. S. did not have rules and regulations for Real Estate valuation so far back and the Dutch ones could not be applied to lands in the U. S.). The seemingly low price is justified, seeing as how the Lenape were also looking to form military alliances with the Dutch to combat rival Native Indians.

 

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Sale of Manhattan Island (Source: Wikipedia)

 

But what happened to that piece of land now? That piece of land is now called by the name New York. The sale supposedly took place in the area now known as Inwood Hill Park. Consider the Real Estate prices and approximately evaluate the entire worth of New York city. Did the Lenape get the short end of stick? Well, no.

Let’s look at the historical interest rates in the United States. There is a chart that dates as far back as 1790 and until 2013 (222 Years), but that’s good enough for an approximation of interest rates beyond 1790. The website of the US Department of the Treasury will tell you the highest interest rates achieved between the 2013–2016 period: an average of around 3%.

 

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200+ Years of U.S. Interest Rates (Source: CNBC)

 

Given this information, let us assume that the average interest rate for the 390-year period from 1626 to 2016 is 8%. Remember that the highest interest rate in the US was 20%. So 8% is a reasonable assumption.

Coming back to the Lenape, imagine that their tribe had lived on through the generations and they were somehow able to deposit the $24 for a period of 390 years at 8% average interest rate.

While the amount compounds, let us look at the value of the modern New York City as a whole. The New York City Department of Finance releases the city’s property valuations every year. As per this report, the value of all the properties in the New York City amount to $988 Billion in 2015.

So do you think by 2016, the Lenape would have been able to buy back their land? Behold the power of compounding interest.

$24*(1.08)^390 = $260301027018004 (Approximately). That’s a whooping $26.03 Trillion.

That would have bought the Lenape 26 New Yorks. Or you know, they could have bought the entire United States and more to boot, given that the United States was valued only at $23 Trillion.

No wonder Albert Einstein said, “The strongest force in the universe is Compound Interest.”

 

This article was written by Dinesh Sairam (PGDM, Batch 21, XIME-B)