Friday, June 17, 2011

The concept of fx reserves

The presence of more than insignificant foreign exchange reserves with a central bank itself implies that the domestic currency is undervalued. Typically, the foreign exchange would have flowed into the domestic economy which would have caused the local currency to appreciate thereby reducing chances of prolonged monetary inflationary pressures.
However, a state-run company exporting goods and earning foreign exchange changes the equation; this is because the earnings belong to the state and need not 'flow' into the local economy. The middle-eastern oil exporting nations are a good example of this - these countries can use this 'ammo' to import things they need/ want.

However, when an India starts accumulating foreign exchange, in effect depriving the local economy of the foreign exchange, it retains its export competitiveness - however, this would lead to inflation in the local economy which would counter-balance the prior benefits. Over a longer horizon export competitiveness would be neutral; to this, the government might interfere and offer subsidies which would become a drag on the entire economy (in terms of household consumption strength) but would be very fruitful for certain sectors.
In order to battle inflation, the government/ central bank would make borrowing more difficult through rate hikes. Artificially low interest rates would definitely cause borrowing to soar, finally altering the consumption power of the local economy, thereby spurring inflation.

Now, if I were to rename India as China in the above paragraph, something goes wrong. China's reserves are at extremely high and unprecedented levels (currently above USD 3 Tn) which would imply that the currency is significantly undervalued; however, at current levels of 6.47 Yuan = 1 USD people do say that 'OK, I believe we are alright."
Why do they say so? Because Chinese export competitiveness has deteriorated due to wage-inflation and domestic inflation. Exporters in China complain that their margins are wafer thin and without government benefits are even lesser. Many Chinese companies (I have heard and read) have borrowed at sub-market interest rates. The weird thing, though, is that inflation has been very low. It has been near the 3% levels, and the world is panicking because it is now 'high' at 5.5% odd levels.
My response to this, for a while now, has been... how has inflation remained so low?
The problem here is management. the computation of inflation numbers (unknown to me) are plausibly manipulated through 'errors' and/ or allocation towards nonsensical baskets.
There is something incorrect about China's current status, especially the last 5 years or so. China's resilience has defied logic and the country is now on the brink of faltering. It is an investment propelled economy with many examples of ghost towns, ghost buildings, ghost trains, etc. As long as a country keeps building more 'stuff', GDP shall grow, but a country cannot endlessly pursue this path.

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