[Economy Q] Story of Forex Part II

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Continuing the Technically-not-so-correct story of Forex and currency conversion

Kashyap asked,

First Question

Why king of Saudi does not accept payment in rupees?

• If he accepts rupees, his hands are 'tied', meaning he can only use that cash to buy stuff from India.
• But even If he wishes to import Indian mangoes or oranges, the Indian exporters would gladly accept American dollars, so why bother with rupees?
• Secondly, What if he wants to buy I-phone or Ferrari from America?
• He'll have to get those rupees converted into Dollars. 
• But everytime he converts one currency to another, there will be taxes and Commission charges applied @ the forex market. So why waste money in it? Just get the dollars- it's universally accepted-Can buy anything from anywhere.
• You buy something from my medical store and pay but instead of returning change (छुट्टे पैसे), I give you plastic coin or coupon with "2-rupees" written on it. It can be used to purchase items from my store only. So, will you accept that plastic coin currency or will you demand an actual Indian currency coin? Which one has more benefits?

Second Question

At the beginning only 1$=Rs.40?why not 1$=Re.1?

First, Why do we want to convert one currency to another? Because we want to buy something from that country, or to invest in that country.

Let's just presume for a moment,there is no share-market or speculation or FDI/FII, just plain buy n sell of goods between nations.

• In the initial years after independence, we didnot have the excellent manufacturing technology,
• There were droughts so food shortage. We were dependent on the west for food supplies. 
• There was heavy inflation because of wars with China and Pakistan.
• We emphasized on 'Swadeshi', we were using "Import substitution strategy". We prevented the entry of foreign companies, hence our Swadeshi automobiles, cameras, etc were not of 'export-quality'. If the third guy (British) wanted to buy a car, he'd convert his pounds to dollars and buy a ford from America and won't come to India to buy the khataraa Ambassador.
• In those years, America was quickly advancing, they had color TV, missiles, tanks, weapons, sports cars for sale and export in their show-room.
• Compared to them, We didnot have much expensive stuff to export. 
• As we saw a paragraph ago: why we exchange currency? so that we can buy something from their local market. So how do you motivate an American to exchange his one dollar to your rupees?
• 1$=1Rupee? ofcourse not. Why should he give you his one dollar for just one rupee?
• What is so precious in your Indian show-room that he feels tempted to exchange his dollars for your rupees?
• 1 gallon is approx 4 litres. He can buy 4 litres of petrol, in about 16$ on American gas-station while you'll need Rs. 280 to buy 4 liters in Indian petrol pump.
• He can buy a computer mouse in 7 dollars in America, while here it costs no less than Rs.150 in India. ( I mean to say, if he exchanges 1 dollar for 1 Rupee and imports things from India, he is at loss.)
• Besides, we are have desperate need of dollars to purchase his weapons, his machinery, or to pay $$ for crude oil.
• So you would need to motivate him by offering more rupees for each dollar so that he can purchase more from India.

That's why 1 Dollar did-not equal to 1 Rupee. You had to offer him more than 1 Rupee.

PS issues of officially Fixed exchange rate, devaluation etc intentionally skipped to keep the explanation plain and simple. You can read more about that by clicking me

Third Question

3. why did Allen exchanged dollars with rupees?

• Because India would have appeared a good investment-destination 3-4 years ago when Allen came, and America was struggling with recession. 
• But then thanks to Jairam Ramesh's Environmental activism, Niyamgiri-POSCO agitations, Cairn-Vedanta deal obstacles, mining scams and energy crisis etc. the scenario right now, may not appear attractive to new investors.