# Interest Rates & Forex

## It's all relative

We recommend you read our post on inflation, as the discussion there will be very helpful in understanding this article. Interest rate is one of the most common economic terms that we use in daily life. Simply put, interest rate is the return earned on money lent out. So if you lend Rs 100 to your friend and ask her to give back Rs 110 after one year, interest rate charged by you is 10%. Similarly, if you put Rs 100 in your bank account, the bank will pay interest as in this case it’s the bank who is taking money from you. If the bank offers an interest rate of 4%, then after one year you will get Rs 104 from the bank and will earn Rs 4 as interest.

This interest rate that we just discussed and the ones that we generally hear & read about  is called the nominal interest rate. Now let’s see why nominal interest rate is not very relevant. The basic motive behind investing money is to earn returns/interest that allows us to retain purchasing power as well as to grow the savings kitty. This should allow us to improve our standard of living over a period of time. Let us consider an example. Suppose, you have Rs 1,00,000 and want to buy a high-end motor bike costing Rs 1,08,000. You decide to invest your money in a fixed deposit at 9% interest rate. You thought that you will have Rs 1,09,000 at the end of the year and will easily buy your favourite bike.

But after one year, you realize that the price of the bike has gone up to Rs 1,15,000 (increased by approx 6.5%). You are sad, as again you cannot buy the bike. What really happened here? Due to general inflation of around 6.5% in the economy, price of the bike increased proportionately during the course of the year. So in order to achieve your target of buying the bike you should have invested in an instrument that returned 15%  after a year. That would have allowed you to beat inflation of 6.5% and in addition earn real returns of 8.5%.

Real Interest Rate = Nominal Interest Rate – Inflation Rate

In our example nominal interest rate is 9% and inflation is 6.5% and hence real interest rate is 2.5% (9%- 6.5%). When we invest our money, some part of what we are earning is always being eaten away by inflation.

Investors will be able to retain their purchasing power only when they earn returns equal to or more than the inflation rate. Suppose the inflation rate is 9% and interest rate is 8%, in real sense you will actually lose 1% of your money, rather than gain anything. So rather than being able to buy more things after a year, you won’t even be able to buy the same basket of  goods bought earlier, as their market price will be higher than your investment kitty.

Compared to savings bank accounts, fixed deposits, bonds and other instruments, only equities as an asset class have generated positive real rate of return in the last decade. To make money in real sense over the long term, invest in equities.

## Why currencies rise and fall

Foreign exchange market (FX, currency market) can be thought of as a global network of banks and financial institutions, selling and buying currencies from each other; an Indian bank buying Dollars by paying in Rupees, a European bank buying Rupees by paying in Dollars etc. Suppose you are planning a trip to Australia and need Aussie Dollars for being able to buy goods and services in Australia. You can go to your local bank like HDFC/ICICI or a currency dealer and can buy Aussie Dollar by paying in Rupees. Instead of an individual, suppose there is an Indian automobile manufacturer who wants to import auto parts manufactured in Japan. The company will have to pay in Japanese Yen to buy these auto parts. So it will buy Yen from a bank or a dealer by paying in Rupee and then pay Yen to the company from which it is buying these parts. Just like you and this company, there are hundreds of thousands of individuals and companies around the world seeking foreign currency for various reasons. They go to their banks and dealers for their needs and these banks and dealers deal with each other to fulfil the needs of such individuals and companies. Hence currency market can be described as an interconnected network of these institutions.

Every day in the newspapers, we keep reading that currency is falling or that the government is doing nothing about currency deprecation etc. The natural question is why is this so important that it needs so much of our attention and why does currency actually fall or rise? First, let’s discuss the second part of our question. Just like other goods and services, price of a currency is also determined by its demand and supply. Suppose today price of USD 1 is Rs 62. Now assume, lot of Indians suddenly start travelling to USA or many Indian companies start buying products from the USA or many Indians start investing in the US in the hope of better opportunities, all these activities will lead to greater demand for US Dollars from India. We have already learnt that  as demand for a product/service increases, price of the same also increases. So now USD 1 becomes RS 65 ie we need to pay more, in order to buy USD 1. In this example, USD appreciated with respect to Rupee by 4.84% [(65-62)/62]. In an opposite case when demand for USD decreases, its price will decrease and we will have to pay less. Suppose USD 1 becomes equal to RS 60. In this case, USD depreciated with respect to Rupee by 3.23% [(62-60)/62]. It is important to understand that if demand for USD is increasing from India, it doesn’t mean that it’s increasing from rest of the world as well. So USD might not appreciate against other currencies, as its demand is increasing only against Rupee.

So when a currency appreciates, it means we need to pay more in order to buy 1 unit of the currency. Similarly if currency depreciates, we need to pay less in order to buy 1 unit. As you might have already noticed, price of one currency is given in another currency. In our example, price of USD was given in Rupee. So when one currency in the pair appreciates, another is depreciating simultaneously and vice versa. Let’s say initially USD 1 = INR 60 or 1 INR = 1/60 USD. Now USD depreciates. This means we will have to pay less to buy 1 USD. Suppose it becomes 1USD = 58 INR. So INR 1 becomes USD 1/58. Initially we had to pay USD 1/60 to buy INR 1, but now we will have to pay USD 1/58, which is more. Thus, Rupee appreciated when USD depreciated. Hence, we say that for a currency pair, if one currency is appreciating, the other depreciates and vice versa.

To understand the first part of our question, that why this appreciation and depreciation is so important, read on.

## Not too much, not too little.. just right

Let’s continue our discussion on currency market and movements that we started in our previous article. We just understood what a currency market is and why currency appreciates and/or depreciates. In this article let’s try to understand why this upward/downward movement of currency is so important.

Suppose you want to import a costly laser machine from USA. The cost of machine is USD 1000. Currently the conversion rate given to you by your dealer is USD 1 = INR 65. So as of today, you will have to spend INR 65,000 to buy this machine. Due to some issues, you postpone your purchase and decide to buy it next month. Meanwhile due to reasons beyond your control, USD appreciates. We know that USD appreciation means INR depreciation. Thus, we will have to pay more in order to buy each unit of Dollar. Now after one month, you again ask for a quote from your dealer and he quotes USD 1 = INR 70. Thus, you will now have to pay more to import the same machine because of USD appreciation (INR depreciation).

Let’s take another example. Suppose you manufacture cycles. You want to export one cycle to US for INR 6000. The person importing this cycle in US will have to pay in INR and thus asks for a quote from his dealer to buy INR. His dealer quotes 1USD = 60 INR. So to buy INR 6000, he will have to spend USD 100 (6000/60). Just as in previous example, he also faces some issues and postpones his purchase by one month. After one month, you are again willing to sell the cycle at INR 6000, but suppose USD appreciated. Now it becomes USD 1 = INR 65. Thus, the US buyer will only have to pay USD 92.5, in order to buy the same product.

Above examples make it very clear that when foreign currency appreciates (domestic currency depreciates), local goods become cheaper in other countries, as foreigners will have to pay less to buy the same amount of INR. At the same time, it makes foreign goods costly as you will have to pay more to buy each unit of foreign currency. So when local currency depreciates, imports become costly and price of exported goods becomes cheap for foreign nationals. As price of imported goods increases, demand for imported article decreases and as price of goods exported becomes cheaper for foreigners, foreign demand for local goods increases. Hence we can now conclude that domestic currency depreciation leads to higher exports and lower imports. Opposite will happen when domestic currency appreciates.

India is a major oil importer as it doesn’t produce sufficient crude oil to meet its energy demands. Thus when rupee depreciates, it becomes more expensive for the Government to import oil. Higher oil prices increases the overall price level, as explained in our article on stagflation. Thus, it becomes important for many countries to ensure that their currency doesn’t excessively depreciate. But if a country doesn’t import many things, then it would want local currency to depreciate, so that local goods become cheaper in other countries and exports increases. Countries with excessive focus on exports use currency depreciation technique to boost their exports.