The World this Week October 22 - October 26 2012

The World this Week October 22 - October 26 2012 from Karvy Private Wealth

Global economic imbalances

One of the most important and immediate causes of the real estate bubble is the US and a lot of other economies, was low interest rates for remarkably long period of time. While there have been several reasons cited for this phenomenon, the most plausible answer seems to be the global economic imbalances starting in the 90’s. Both the theory and the practice of these imbalances is fairly intricate & a very recent economic development.  

Theory of Economic Imbalances

In a closed economy with zero mobile capital, the income levels are fine tuned to domestic demand. Any sudden decrease or increase in this demand or supply alters the incomes of all participants in the economy and establishes a new equilibrium.

Without capital flows, it’s impossible to have a current account deficit or surplus. In this case, the exports and the imports are merely terminologies to describe overseas flow of goods. For all other purposes, the exporters and importers in the faraway country are another element of the domestic economy itself.

Even with capital flows, there is an upper limit on the time for which a country can have trade deficit- since with each year, the capital flows from deficit country to surplus country. There has to be a way of getting the capital back for the next round of deficit.  Thos is the famous imbalance described above in which the capital does flow back from Asia to the US as a credit. Till here, fluid currencies are not required.

Even with gold standard currencies, a country can have sustained deficits if the surplus country is willing to lend money to the deficit country (the mechanism of this can be detailed) – the question is why would it do that?

The Asian attempt to hold the dollar already versus their currencies was a strategy in effect to enforce the gold standard on the dollar. In purchasing dollars to prop it, the Asians did two things – one was to lend money to US to fund its deficit & two, was to  signal the US that it would print more dollars if it wished and that dollar would still be held in a  certain value range by them.

The Asians were propping up the dollar to ensure that the Americans have something to pay with for their imports of Asian goods .Why did Asians need American consumers? Were they an easy target than domestic?

Source : Anatomy of froth

What is Carry Trade In Currency?

It is a strategy whereby an investor sells a certain currency with a relatively low interest rate and uses the receipts to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

 For example, in a rupee-carry trade, a trader borrows $10 million from an American bank, converts the funds into Indian rupees and buys a bond for the equivalent amount. Let’s assume that the bond pays 8% and the American interest rate is set at 2%. The trader stands to make a profit of 6% as long as the exchange rate between the countries do not change. Many professional traders use this trade because the gains can become very large, if leveraged.

The big risk in a carry trade is the uncertainty of exchange rates. These transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless the position is hedged appropriately.

Source : ET

What is currency war?

Explanation:
The term ‘currency war’ was used in recent times by Brazil’s finance minister Guido Mantega in the first week of October this year reacting to China’s attempt to protect the yuan from rising too quickly against the dollar.

It comprises competitive measures by governments to improve their trade by maneuvering exchange rates. A cheap currency,vis`-a-vis´ the dollar, adds to the competitive advantage to the exporter.
An attempt by the government to prevent its currency from appreciating too steeply and too fast against competing nation is what is seen as currency war between different countries.

What is its impact on Indian economy?
When competitors devalue their respective currencies, domestic exporters tend to lose out on the price advantage on their exportable as buyers prefer to buy from a cheaper currency.

The central bank at such times tries to intervene — buy dollars and create an artificial demand for the dollar, devaluing the value of the rupee in the process and retain some price advantage for the exporter.
But buying dollars involves a fiscal cost as the central bank has to pump in equivalent amount of rupees and again mop it up by selling bonds. These bonds need to be serviced by the government. This would in turn worsen the fiscal position.

Source: Economic Times