Weak Currency, Strong Economy: Not fiction but a Reality!
Why US Dollar is strengthening when the US economy is failing?
What is the relationship between Crude & Currency?
What does a strong US dollar indicate?
“You have power over your mind―not outside events. Realize this, and you will find strength.”
These words are from a famous Stoic Philosopher and one of the greatest rulers (also called Five Good Emperors) of the Roman Empire — Marcus Aurelius.
Similar thoughts were articulated by Yogeshwar Shree Krishna in Shrimad Bhagwat Gita 5000 + years ago to Arjuna.
Chapter 6, Verse 5:
उद्धरेदात्मनात्मानं नात्मानमवसादयेत्
आत्मैव ह्यात्मनो बन्धुरात्मैव रिपुरात्मन:
Uddhared ātmanātmānaṁ nātmānam avasādayet,
ātmaiva hyātmano bandhur ātmaiva ripur ātmanaḥ
Meaning: Elevate yourself through the power of your mind, and not degrade yourself, for the mind can be the friend and also the enemy of the self.
What holds well for the mortal body, holds good for Organizations and even countries. Strength, courage, and fortitude originate from within & not from outside. This should be the simple matrix to evaluate oneself, not what others hold the opinion about oneself.
When one looks at the present world, one witness, a disturbing trend of the Organization’s interests superseding national interests, year-end bonuses & compensation along with valuations driving the decision-making, collective good being replaced by individualism & narcissism, and myopic short-quick fix overtaking vision, mission & longer-term perspective.
It happens with Companies, Countries & markets as well. Not only in equity, debt, or commodities but the currency market as well.
Recent furor on the Indian rupee cracking to an all-time low of 77.4150 to a US dollar on 12th May 2022 has brought naysayers back into the game rumor-mongering collapse of the Indian economy, reflecting its weakness, its vulnerability, and its dependence.
The fall of the Indian rupee & RBI’s intervention is known to all, but what’s not visible to the human eye and what’s beyond the realm of human understanding is — what does the strength of the Dollar indicate, why this strength still exists? (The US GDP declined by annualized 1.4% in Q1CY22 & Indian GDP is expected to grow 4.5%+ in Q4 FY22, GDP data to come on 31st May 2022).
Before we move forward, let’s reconnect with the basics in brief.
What is currency? Currency is a medium of exchange for goods & services, a standardized system used by a nation or a country. Currency is just a mechanism to ease the complexities of the Barter system and facilitate the free movement of money.
What is an exchange rate? The price of a country’s money or currency in relation to another country’s money.
Price of the Currency: The currency is more valuable if the demand for the currency is higher than its supply. Based on basic economic principles, the valuation of currency is nothing but the demand and supply of it. Since the collapse of the Bretton Woods system (discussed further in the note), Currency is fiat money where a government issues a currency that has no backing of any commodity and thus has no intrinsic value attached to it, apart from the ability of the Government issuing it to honor its commitment. (Currency in turn is a promise made by the Central Bank on behalf of the government to pay the equivalent amount of Gold to the bearer)
But for the US dollar, it’s different and it’s tricky. To understand this, let’s dive into the past.
In July 1944, immediately after the Second World War, the US along with 44 allied nations decided to peg their currencies against the US dollar. The US and the allied states also decided that the US Dollar will keep sufficient Gold reserves (physical) before issuing incremental US dollars and every US dollar will be issued at a fixed Gold rate of 35 USD to an Ounce.
This meant that, if the US needed to issue more US dollars, it needed to have more Physical Gold in its safe custody. This was also known as the Bretton Woods Agreement. (Everyone agreed, as after the Second World War there are no opposition, the only other power Great Britain which commanded GBP as the reserve currency in the last century before the Second World was under severe debt on account of War and was giving countries Independence it had plundered and subjugated for years as the cost of maintaining as compared to the cost of incremental plunder was not worth it)
But, in less than 27 years of the agreement, the US government had already printed more currency than the gold reserve they had or they were supposed to keep as a peg. The result of which was the complete collapse of the Bretton Woods Agreement as well as the system by 1973.
Then came the system of Petro Dollars in July 1974. OPEC (Organization of the Petroleum Exporting Countries) Arab nations had embargoed the US for supplying oil, quadrupling the oil prices, especially when the entire US economy was dependent, and emerging as the largest consumer of Crude Oil in the world.
Inflation was soaring as it’s happening now, the Stock market crashed as it’s happening now and the US economy was in a tailspin as is happening now. (This time around only the US is more leveraged than ever before in history with a debt of 30 trillion USD -: 130% of US GDP, ~70% of Americans have less than 1000 US dollars in Savings or Investments, and food prices have surged 10 -15% YOY on an average due to limited supply of fertilizers, & arms and ammunition lobby is prospering due to the Ongoing war and the fear of war)
A quick agreement was called out between Saudi Arabia and the US that The United States would buy oil from Saudi Arabia and provide the kingdom with military aid and protection. In return, the Saudis would plow billions of their petrodollar revenue back into Treasuries, whereby Saudi Arabia could buy US treasury bills even before they were auctioned in the open market and thus financing America’s spending. Also, the condition was attached that Oil will only be settled in US dollars and not in any other currency. (It wasn’t easy to break into the Arab World, but several secret polite meetings enabled what at a point in time seemed implausible.)
The cycle that the US followed was simple and easy. The US bought crude oil and paid Saudi in US dollars. Petrodollars came back to the US when the Saudis bought the US treasuries. (And it continues till today)
The US (with a 332 million population) despite being the largest producer of Crude Oil remains the 4th largest importer as well, thus being the largest consumer of Crude.
What has Currency to do with Crude?
For 80+ years, Crude has been the most important medium of energy and transportation. As demand for Crude is settled in US Dollars, thus the US Dollar remains always in demand.
Whosoever produces Crude, the US, instead of oil producers holding US Dollars, swaps US treasury (debt, US Dollar earns nothing, US treasury or US GSEC pays interest) with them, thus bringing back US dollar within the country, creating an artificial shortage in the world.
As the World progressed and Japan became one of the biggest technology & manufacturing hubs post-second world war, it started exporting to the US and emerged as the 4th largest exporter to the US. The process carried on and Japan today remains the largest holder of the US debt.
Next came, China with its mass and cheap manufacturing, and the US being the biggest market, found its favor. The cycle continued and today, China is the largest exporter of goods to the US and remains the second-largest owner of US treasuries.
Russia from nowhere (till the turn of the century) emerged as the world’s largest exporter of oil to global markets. Oil here does not mean only crude, it includes crude oil and its other variants including refined oil fuel oil, naphtha, vacuum gas oil (VGO), Gasoline, LPG, jet fuel, petroleum coke, etc
But Russia was not happy settling energy products in US dollars. Slowly Russian domination of energy sources outside the US dollar has and could have threatened the Petrodollar system. Result of which is Ukraine — Russian War.
(In October 2021, Russia began moving troops and military equipment near its border with Ukraine, with nearly one lac military personnel. In Dec 2021, Russia then sets out a list of demands preventing NATO from moving further. Instead of de-escalating the prospects of war and sending an envoy for peace talks with Russia, the US sends additional military assistance to Ukraine, including ammunition, small arms, and other defensive weaponry, inviting the conflict)
In midst of this politics, where do India and INR stand?
When the US was engaged in pushing US debt to its exporters and supplier of goods, INDIA smartly engaged in bilateral ties to ensure its energy needs are met constantly with the least pressure of US dollar outflow.
Largest amongst them being Iraq, Saudi Arabia, and UAE with over 50% of India’s Oil supplies. With the Middle East, India has pushed serious exports of Rice, Meat, Electrical Equipment, and more importantly refined petroleum. The idea is to get the Oil importing country to have essential commodities dependence on India to curb any future uncertainty concerning the ever-changing currency & political landscape. As a first, India included government procurement in a Free Trade Agreement (FTA), whereby national treatment & status is given to UAE companies, on a par with Indian companies, while bidding for central government tenders.
But today’s case in point is the weakness of the Indian rupee against the USD.
The exchange rate between currencies is dependent on multiple factors and the list is huge. However, some of them that have a major impact include:
· Inflation differential between 2 countries
· The interest rate differential between 2 countries
· Current Account deficit which reflects the exports and imports differential
· Fiscal deficit that puts signifies income & expenditure of the government.
· GDP growth differential
· And finally Sanctions and Geopolitical stability.
In the present day, across all parameters, India stands tall against the United States dollar. However, the dollar continues to remain strong and moves from strength to strength despite the crumbling US economy which is expected to move into recession maybe the 4th quarter of CY 22 or 1st quarter of CY 23 (Strength of the US Dollar signifies, deflationary/recessionary symptoms and fall in US dollar signify growth in Inflationary assets like equities, commodities)
The US Dollar has not only strengthened against INR but basket currencies.
If one compares trillion-dollar economies, the Indian currency has been most stable Vis a Vis the US dollar.
Let’s dig deeper into what’s happening with the Dollar and other currencies and why it’s happening and does it has any repercussions on USD INR trade as well?
The simple measure the world uses is DXY which determines the value of the US Dollar versus a basket of global currencies and estimates the mood (Risk-taking ability or Risk Aversion) of the investors.
The index is currently calculated by factoring in the exchange rates of six foreign currencies, which include the euro (EUR), Japanese yen (JPY), Canadian dollar (CAD), British pound (GBP), Swedish krona (SEK), and Swiss franc (CHF).
The euro is the largest component of the index, making up 57.6% of the basket. The weights of the rest of the currencies in the index are JPY (13.6%), GBP (11.9%), CAD (9.1%), SEK (4.2%), and CHF (3.6%).
The dollar index crossed 104 which is the highest in the last 4 years and can further go up to 107 (20-year high) indicating risk aversion, a rise in inflation, and higher interest rates to follow in the US by the Fed (If the rise in interest rates will not cool off the Inflation, the Fed will have to increase interest rates rather quickly at a faster pace pushing US economy in recession, fall in commodity prices are indicating the same as well.)
Now comes the twist in the tale: Why is the Japanese Yen falling the most and why is the US Dollar strengthening beyond what’s mentioned above?
The U.S & EU imposed sanctions on Russia thus creating inflation in their economies (Rise in prices of food, fertilizers, gas fuel, etc).
Japan is heavily dependent on food, mineral fuel & other essentials for running the economy (Japan imports all of its Oil & Gas) from the US and China and thanks to the Ukraine War, the energy imports bill had surged for Japan, thus making Japan’s trade deficit an 8 year high which till a year back was in surplus. (Exports declined due to shortage of semiconductor Chips & covid-related supply chain disruptions).
As Dollar demand surged due to Oil & Gas, the Japanese Yen kept declining. Thus putting pressure in Yen denominated bonds, which are outstanding in the market equivalent in dollar terms amounting to 12.78 trillion dollars (~ 240% of the Japanese economy) sparking fear of Japan’s bankruptcy (one of the most leveraged economies in the world)
To make things worse Russia is adamant to pay for its gas, crude oil & coal in the Ruble, and hence Euro and JPY continue to weaken and thereby pushing the USD northward. (Euro and JPY both currencies have limited use if they can’t settle their energy bill in their currency or USD. To top it all both Japan and EuroZone have mammoth sovereign debt)
If Euro and JPY further their losses, USD will keep strengthening against the basket of currencies (the Euro & Japanese Yen having the highest weights in the basket), and thus all global currencies will continue to sink against the USD (based on a falling basket of currencies).
Thus one can see that the strength of the USD vis-à-vis the rupee has very little to do with the rupee itself, especially during a period when India’s economy is expected to remain the fastest-growing economy for the next 3 years (CAGR of ~ 8%).
Coming back to where we started from the statement of Marcus Aurelius and Shreemad Bhagwad Geeta, true strength and true power comes from within rather than from outside and India is on its path to becoming completely self-reliant not only in the case of services, agriculture, or manufacturing but even in energy and currency and in the mode of exchange.
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