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The Rediff Business Special/Shalabh Kumar

Exchange Rates And All That

The mayhem in Russia and the simultaneous run on the currencies of developing economies set me thinking on the role that currency exchange rates play in the lives of most of us ordinary citizens.

It is something that I have been pondering over due to personal reasons as well -- I have recently moved from the US to the UK after a sojourn in India. Having held jobs in all the three countries in the recent past, I have had the (mis)fortune of discovering that exchange rates prima facie seem to have little to do with living costs.

Economists have, of course, for long been advocating the Purchasing Power Parity method to determine the real value of a currency in terms of living costs. The Economist magazine, light-heartedly, publishes a Big Mac index of currency exchange based on the price of the McDonald's burger in different countries. But these are only measures, real transactions use the exchange rate, and therein lies a tale.

As a middle-level executive in an MNC in Delhi, my salary was in the upper income strata in India -- not rich, but affluent. When I moved to Boston in the US, since the salary was brought in line with executives of similar level there, I moved southwards in terms of classification. The notional change in salary classification means little in practical reality -- in this case it just meant that there are more people richer than me in the US than there were in India, not unexpected in the world's most prosperous nation.

The real impact, however, comes when one starts taking into account the effects of purchasing power differences and what it translates into in lifestyle terms.

This is the basic tenet of the PPP model -- currencies differ in their buying powers domestically and internationally. A rupee will buy far more in the Indian market, especially of goods produced in India, than it would in the international market. The grocery basket is apt for comparison as an example -- we spent around Rs 3,000 on a monthly basis on grocery in India; in the US, without changing consumption patterns significantly, our monthly outlay was approximately $ 300.

Quite clearly, the exchange rate does not even figure in this. The reason stems from the way production of grocery items is structured globally. Except in small countries, grocery items are mostly locally produced and sold, the price getting set by domestic economics. On this example, the PPP exchange rate would be closer to Rs 10 = $1.

The picture turns murkier when we look at costs in the UK. Our grocery bill here is circa £ 350 on a similar basket of goods. This is obviously completely at odds with prevailing exchange rates (£ 1= $ 1.70 = Rs 70). It also indicates that the PPP differences between the £ in UK and the $ in the US are also very significant (often encapsulated in a common US moan -'London is soo.. expensive').

While the difference between India and the US, or India and the UK, could be explained by source of production, this difference between the UK and the US poses a dilemma which is not simply explained by the source of production.

The prices of clothes in the US, which is the primary market for many global suppliers, are extremely competitive. A basic office-wear shirt in the US would cost $ 15 to $ 20 which compares very well with the price of similar shirts in India (Rs 600 to Rs 800). It would seem that since clothing has a global market, the exchange rate holds true. The twist in this tale comes from the 'intangible image value' acquired from marketing efforts, quite often ignored in clinical economic analyses.

An image-brand in the US would cost upwards of $ 50 whereas the shirts in the Rs 600 to Rs 800 category in India are the image brands. The market in India for such shirts remains small, resulting in the absence of discounted brands. The exchange rate between the $ and the £ holds a little truer in this case, with prices in the UK in the range £ 10 to £ 15 for basic (without branding hype) shirts. Designer label shirts in Europe are way out of sync with exchange rates -- a Ralph Lauren shirt in London would cost £ 75 compared to the regular price of $ 60 (and discounted price of $ 30) in the US.

Once again this difference between the UK and the US seems to defy economic and exchange rate logic. In classical economics, this should open the floodgates for arbitrage players, who would buy in the US and sell in the UK, quickly pushing prices down in the UK. In real life, it plays out a little differently.

Housing, being immovable, understandably does not get affected by exchange rates at all. Local economics determine both property values and rentals. Since I have only rented places, here's how the rents of a modest, two bedroom apartment in a modest locality compare: New Delhi Rs 15,000 per month, Boston $ 1,000 per month, London £ 1,200 per month.

For most salaried people, housing would be a significant portion of the expenditure and yet neither the exchange rate nor the PPP formula is of any use in comparing rents. All three cities I have lived in are supposed to be expensive for rentals -- the only difference is that both London and Delhi suffer from overcrowding and housing shortage, pushing up rentals higher than what one would expect.

I have often, in the US and the UK, heard the argument that the pricing in these countries is not strictly comparable to those in India because of quality differences. There is only limited merit in the argument -- in all the examples that I have given so far, I have been careful, not to compare apples and oranges.

(While one could claim that the soap I used in the US and I am using now in the UK are better than the one I used in India, the difference in quality is so marginal that only a bathing connoisseur would be able to detect it!) There is a difference in the quality of life -- no power cuts in London and Boston, but that just means that these countries have managed supply of essentials better. If one were to compare the cost of power, a problem similar to grocery items, etc, holds true with exchange rate.

There are other items where exchange rates are expected to reflect prices: fuel oil for example. This is a commodity which pretty much works on global economics. The prices in the three countries -- $ 1.40 for a gallon (~4 litres), £ 0.66 per litre and Rs 25 per litre. At approximate current exchange rates, the equivalent prices in rupees in the US and the UK are Rs 15 and Rs 46 respectively. The US price best reflects the sourcing price of oil.

The price in India is fixed by the government and the surplus mopped up by the public sector oil companies as profit. Part of the higher price in the UK is explained by heavy government taxes but the other part is consistent with the high domestic prices of goods in the UK seen in the other examples.

In summary, using the dollar as a benchmark of domestic and global purchasing power, the rupee is far stronger domestically than internationally, while the pound is stronger internationally than domestically. This is what gets reflected in the exchange rates and the prices of the goods domestically.

A logical extension of the above observation could be that the exchange rates have a very limited impact on the lives of ordinary people who are primarily concerned with domestic prices. Yet, the events in Russia tell a different tale -- the rapid devaluation of the rouble has had a very tangible and visible effect on the lives of ordinary citizens there.

This is a question that economists need to answer -- the answers will be crucial for economies like India, which, having started late, have the advantage of learning from the mistakes of others.

There are two main areas which I have not looked at in studying the impact of exchange rates. The first is the role of exchange rates in the financial markets -- exchange rates play a direct role in the financial superstructure of every economy, as the Russians have learnt at a terrible price. The strong demand for the pound in the financial markets also explains why the exchange rate of the pound is at odds with its domestic buying power.

The second is the extent of dependence of the economy on international trade. If the economic model is built on trade, like it is in South Korea, Taiwan and other countries, exchange rate changes will have a direct and quick effect on domestic prices. A large domestic economy, with trade below 20 per cent of GDP (like the US, Japan or India) is protected to some extent from these vagaries.

The Russian model of financial superstructure is a house of cards -- just a rumour away from collapse. A balance needs to be found between foreign investment and locally-generated funds. There is a critical 'How?' which needs to answered here. Similarly, a growth-model built on export markets is likely to face similar instability -- production has to be built through both exports and domestic consumption. Interesting questions for policy-planners.

Shalabh Kumar is a frequent contributor to Rediff On The NeT.

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