A report on CNN news today said India is raising its central bank interest rates to combat a devaluing rupee. The government stated that it has to do this to draw money from abroad which in turn will raise the value of the rupee. Funny, this is exactly the opposite of the case for devaluing your currency to increase earnings from abroad by making your exports more price competitive.

So what is the best way to gain foreign income, devalue to make your exports more attractive to foreign buyers or raise interest rates to draw investment funds from abroad and in the process revalue your currency? Complex, no?

The truth is that neither course of action is certain to increase foreign earnings. The actual case of devaluing to make your exports more attractive is not certain to raise exports since most exports are relatively price inelastic, i.e. changes in prices do not readily affect consumption. However, devaluing your currency will certainly increase the cost of your imports. In most cases countries usually see their trade inbalance rise when they devalue since the prices for imports go up faster than their exports may rise due to cheaper prices.

The truth for drawing investors by raising interest rates is also suspect. Interest rates reflect risk, thus higher interest rates suggest a riskier investment, not a more attractive investment. We do know that the dollar to euro ratio is most affected by interest rates on either side of the Atlantic. When interest rates are higher in Europe, as is the case now, the dollar loses value as funds flow to Europe. The reverse will be true if and when US interest rates rise. But this is almost a unique situation since the risk factor on both sides of this equation is relatively equal. Other countries such as India may not have the same results.

In sum, manipulating interest rates and currency values to improve your foreign earnings is a tricky business with probably more to lose than to gain.