The problem with currency markets
Yesterday, in two different conversations, I got to speak of my misgivings about current day currency markets. In one of them I was asked, if I were able to change something, what would it be? And I responded by saying that I would abolish currency markets in their current form.
Currency, which is fundamentally supposed to be about trade, has today become a weapon of power. And at the centre of it is the current form of currency markets, which, rather than help facilitate global free trade, is actually exacerbating power dynamics across countries and civilisations.
The current form of inter-currency trade has an interesting history. We will not go into detail into this-- I've explained the history of inter-currency trade, in my 2006 book The Power Law of Information.
Currency today is predominantly tightly tied with nations and their sense of national sovereignty. There have been several exceptions to this, but with limited success.
Some countries use or accept currencies of other countries throughout their economy. Similarly, some countries (most notably, countries of the European Union) have come together, to form a common currency across them. None of these are without their complications. Nepal for instance, which used to accept Indian currency in addition to its own currency throughout the country, recently has started discouraging this practice, with its growing anti-India sentiment. Similarly, the Euro is often at the centre of the hurricane whenever there is an economic crisis in any of its member countries. Recently, it was told that the Euro was propped up solely by Germany, and it is in fact underwriting the economic costs of other countries like Greece, which were in crisis.
While currencies spanning across national borders has its problems, inter-currency trade has its own alternate set of issues.
Inter-currency trade is meant to establish a "fair" exchange rate between currency denominations. How do we know what is a good exchange rate between say the US Dollar and the Indian Rupee? The answer to this is to let the "market forces" decide.
So what are these market forces? These are the few hundreds of traders in the currency marketplace who bid to buy and sell currencies. This marketplace is hardly representative of the economy-- let alone "fair". It is largely run on trader sentiment, rather than any form of serious economic valuation of the currencies.
It is common to see the following pattern-- whenever there is a crisis in India, the Rupee falls against the Dollar; and whenever there is a crisis in the US, it is the Rupee again that falls against the Dollar. When I started learning to count as a kid, the exchange rate between the Rupee and the Dollar was about 4 Rupees to a Dollar. Since then, never once has the Rupee gained against the Dollar in a sustained or significant fashion. The latest is the Covid crisis which has hit the US more than India, and the Rupee has promptly fallen against the Dollar to almost reach 80 Rupees to a Dollar.
There is no mystery behind this. Currency markets run on sentiment. Indian traders are much more insecure and crave for the Dollar, than their US counterparts crave for the Rupee. So, whenever there is a crisis anywhere, the clamour for hoarding Dollars increases among Indian traders, while the other side has no such qualms about hoarding Rupees.
These emotional knee-jerk reactions, that are full of herding, groupthink and other fallacies, now becomes representative of the strength of the economy of 1.3 billion people!
There is an alternate notion of inter-currency valuations. This is called the Purchasing Power Parity (PPP). This model is based on a systematic study of prices for different commodities, and calibrating exchange rates based on this.
For instance, on an average, what we can buy for $1 in the US, we can buy for approximately Rs. 15 in India. So according to PPP, one Dollar should exchange to 15 Rupees. But whenever someone exchanges a Dollar, they get close to 80 Rupees! Hence for every Dollar that is exchanged, they receive about 65 Rupees extra!
This disparity between market and PPP exchange rates leads to an enormously skewed economy that has no bearing on economic fundamentals of demand and supply.
In the last century, this difference in exchange rates didn't matter much. Not many people inside the country cared for or were affected by the exchange rate with another currency. But with information technology, and its new line of businesses like IT, software and allied services, this disparity in exchange rates now touches every corner of the economy.
For a fresh graduate in India today, it is much more attractive to serve some other market and earn in Dollars, rather than understand and solve local problems to only earn in Rupees. The professional who has earned 1 Dollar, would have put in the same amount of expertise and labour as someone who has earned say 15 Rupees. But the former will have a much higher buying power within India than the latter.
This economic skew is not some academic curiosity. Its impact goes deep. It rips apart not just the economy, but also families and individual relationships. The 1987 movie "Wall Street" hits close to home for many of us in India, because we face the same kind of social and family strife that is seen in the movie.
With the current system of inter-currency trade, we now have just one definition of wealth, one definition of poverty, and one goal of life. Earlier, when economies were largely independent of each other, national and cultural sovereignty meant something. Cultures and nations had a lot of leeway in deciding what is important for them. But today, there is a homogeneity in wants and ambitions, that are orchestrated by a small set of multi-national corporations.
If I had my way then, I would abolish currency markets in their current form. Currency valuations would be computed year on year, based on PPP, and currency trade would be restricted to keep exchange rates within a maybe 20% error margin of the PPP exchange rate. Hence, if a Dollar exchanges for 15 Rupees, then currency marketplaces would not be allowed to exchange Dollar and Rupee only within the range of 12-18 Rupees to a Dollar.
Once we bring back exchange rates to relative purchasing power, currencies will start becoming meaningful as an economic instrument once again.
Currency, which is fundamentally supposed to be about trade, has today become a weapon of power. And at the centre of it is the current form of currency markets, which, rather than help facilitate global free trade, is actually exacerbating power dynamics across countries and civilisations.
The current form of inter-currency trade has an interesting history. We will not go into detail into this-- I've explained the history of inter-currency trade, in my 2006 book The Power Law of Information.
Currency today is predominantly tightly tied with nations and their sense of national sovereignty. There have been several exceptions to this, but with limited success.
Some countries use or accept currencies of other countries throughout their economy. Similarly, some countries (most notably, countries of the European Union) have come together, to form a common currency across them. None of these are without their complications. Nepal for instance, which used to accept Indian currency in addition to its own currency throughout the country, recently has started discouraging this practice, with its growing anti-India sentiment. Similarly, the Euro is often at the centre of the hurricane whenever there is an economic crisis in any of its member countries. Recently, it was told that the Euro was propped up solely by Germany, and it is in fact underwriting the economic costs of other countries like Greece, which were in crisis.
While currencies spanning across national borders has its problems, inter-currency trade has its own alternate set of issues.
Inter-currency trade is meant to establish a "fair" exchange rate between currency denominations. How do we know what is a good exchange rate between say the US Dollar and the Indian Rupee? The answer to this is to let the "market forces" decide.
So what are these market forces? These are the few hundreds of traders in the currency marketplace who bid to buy and sell currencies. This marketplace is hardly representative of the economy-- let alone "fair". It is largely run on trader sentiment, rather than any form of serious economic valuation of the currencies.
It is common to see the following pattern-- whenever there is a crisis in India, the Rupee falls against the Dollar; and whenever there is a crisis in the US, it is the Rupee again that falls against the Dollar. When I started learning to count as a kid, the exchange rate between the Rupee and the Dollar was about 4 Rupees to a Dollar. Since then, never once has the Rupee gained against the Dollar in a sustained or significant fashion. The latest is the Covid crisis which has hit the US more than India, and the Rupee has promptly fallen against the Dollar to almost reach 80 Rupees to a Dollar.
There is no mystery behind this. Currency markets run on sentiment. Indian traders are much more insecure and crave for the Dollar, than their US counterparts crave for the Rupee. So, whenever there is a crisis anywhere, the clamour for hoarding Dollars increases among Indian traders, while the other side has no such qualms about hoarding Rupees.
These emotional knee-jerk reactions, that are full of herding, groupthink and other fallacies, now becomes representative of the strength of the economy of 1.3 billion people!
There is an alternate notion of inter-currency valuations. This is called the Purchasing Power Parity (PPP). This model is based on a systematic study of prices for different commodities, and calibrating exchange rates based on this.
For instance, on an average, what we can buy for $1 in the US, we can buy for approximately Rs. 15 in India. So according to PPP, one Dollar should exchange to 15 Rupees. But whenever someone exchanges a Dollar, they get close to 80 Rupees! Hence for every Dollar that is exchanged, they receive about 65 Rupees extra!
This disparity between market and PPP exchange rates leads to an enormously skewed economy that has no bearing on economic fundamentals of demand and supply.
In the last century, this difference in exchange rates didn't matter much. Not many people inside the country cared for or were affected by the exchange rate with another currency. But with information technology, and its new line of businesses like IT, software and allied services, this disparity in exchange rates now touches every corner of the economy.
For a fresh graduate in India today, it is much more attractive to serve some other market and earn in Dollars, rather than understand and solve local problems to only earn in Rupees. The professional who has earned 1 Dollar, would have put in the same amount of expertise and labour as someone who has earned say 15 Rupees. But the former will have a much higher buying power within India than the latter.
This economic skew is not some academic curiosity. Its impact goes deep. It rips apart not just the economy, but also families and individual relationships. The 1987 movie "Wall Street" hits close to home for many of us in India, because we face the same kind of social and family strife that is seen in the movie.
With the current system of inter-currency trade, we now have just one definition of wealth, one definition of poverty, and one goal of life. Earlier, when economies were largely independent of each other, national and cultural sovereignty meant something. Cultures and nations had a lot of leeway in deciding what is important for them. But today, there is a homogeneity in wants and ambitions, that are orchestrated by a small set of multi-national corporations.
If I had my way then, I would abolish currency markets in their current form. Currency valuations would be computed year on year, based on PPP, and currency trade would be restricted to keep exchange rates within a maybe 20% error margin of the PPP exchange rate. Hence, if a Dollar exchanges for 15 Rupees, then currency marketplaces would not be allowed to exchange Dollar and Rupee only within the range of 12-18 Rupees to a Dollar.
Once we bring back exchange rates to relative purchasing power, currencies will start becoming meaningful as an economic instrument once again.
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