Depreciation of the Indian Rupee

by Deepthi Sai

The rupee has been depreciating consistently against the dollar over the last twelve months and it reached a historical low in June 2012. Depreciation implies a fall in the value of a currency. When the value of a currency falls, we need more of it to buy any good, which is the case with the rupee. One may recall the times when a dollar could be bought for an average of Rs. 46 as opposed to Rs. 56 today. This steep fall in the value of the rupee has made it the worst performing currency in Asia.

Why has the rupee depreciated?

Every country imports and exports certain goods. All transactions of a country with other countries are recorded in the balance of payments. If at any point, a country imports more than it exports, the country faces a deficit and must find a way to finance this deficit. When faced with such a situation, foreign investors and banks, invest in this country to cover the deficit. India has always been incurring a deficit of 2.5-3 percent of GDP which is usually financed by foreign investments or capital inflows. Currently however, the amount of investments coming to India has been curtailed due to turmoil in the world economy. Due to contagion in the Euro zone and recession in America, companies and banks that had been investing in India, pulled out their investments in order to correct their balance sheets back at home and recover losses. Thus the availability or supply of the dollar dropped while the demand for imports still remained the same, leading to a rise in the value of the dollar.

When a company looks at undertaking business abroad, it must do so in foreign currencies. Thus, every company faces risks associated with fluctuations in exchange rates. For instance, if a US based company earns Rs.1000 in India and if the prevailing exchange rate is Rs.50 for a dollar then the company has made $20. Now, suppose there is a change in the exchange rate such that $1 is exchanged for Rs.55. In that case, the country is only earning $18 approximately. To prevent losses resulting from exchange rate fluctuations, companies resort to various techniques. This is called hedging. In order to minimize risks, companies can decide an exchange rate at which currency can be bought or sold. Sometimes they invest in different countries with the rationale that not every economy can do poorly at the same time. In context of the rupee depreciation, banks and companies did not expect such a sudden, steep fall in the value. Many of them thus made no arrangement to minimize risk. This, in turn, lead to losses. Some companies that attempted to minimize risks also fell in distress due to the magnitude of the slide in value. This once again resulted in disinvestment in India further reducing dollar supply.

India had been importing oil from Iran and owed more than $10 billion to National Iranian Oil Co. (NIOC). This liability had to clear off by September 2012. The demand for dollars by oil companies to make these payments has contributed to the slide in rupee value against the dollar. Demand for dollars on the government account for interest payments, defense related payments etc. is also responsible. To make matters worse, until much later there was no intervention by the Reserve Bank of India to correct the situation.

Another reason causing a fall in the value of the rupee is the fall in world demand for Indian goods. While India is continuing to import goods from abroad, contagion abroad has caused a fall in the demand for Indian goods. In such a situation, the world demand for the rupee is falling while Indian demand for foreign currency increases. Thus the less desired currency which is the rupee starts to lose its value.

What is the impact of the depreciation?

A fall in the value of any currency immediately means that one must pay more in terms of the domestic currency for imports. The increased prices of imports of essential commodities like food and oil immediately translate into inflation in the domestic economy. In fact, import costs of oil have increased significantly despite an actual fall in the dollar price of oil. Increasing prices of oil and fertilizer could warrant an increase in government spending on subsidy provision which could put pressure on the government. For corporations, cost of borrowing increases leading to lower profits in the absence of adequate risk management associated with exchange rate fluctuations. A higher import price directly has a bearing on corporations in India that rely on raw material imports. This increases the cost of producing commodities and in turn reduces profits earned by these corporations.

While depreciation increases the value of imports, it also makes domestic goods relatively cheaper and more appealing, giving consumers impetus to turn to them. The increased competitiveness of domestic goods in the market could potentially increase export earnings and foster higher economic activity. As a result of the depreciation, visiting India will be cheaper. Thus we can anticipate an increase in tourism earnings. NRIs that earn in foreign currency and send money back to relatives will benefit since they will now be sending more money back in terms of the rupee. Thus, depreciation does not essentially imply a negative connotation. However, it is important that exchange rate fluctuations are kept in check because they could be a potential hazard to any country’s economic health.

References

Yatheendradas, C.K. "Impact of Depreciation of Indian Rupee." Impact of Depreciation of Indian Rupee. N.p., 04 June 2012. Web. 10 Sept. 2012. <http://www.mudraa.com/trading/135856/0/impact-of-depreciation-of-indian-rupee.html>.

Rupee Exchange Depreciation: Impact Analysis. Rep. The Associated Chambers of Commerce and Industry of India, n.d. Web. 10 Sept. 2012. <http://www.assocham.org/arb/general/Rupee_Exchange_Depreciation_Impact_Analysis-2012.pdf>.

"Currency Appreciation and Depreciation." Wikipedia. Wikimedia Foundation, 19 Sept. 2012. Web. 21 Sept. 2012. <http://en.wikipedia.org/wiki/Currency_appreciation_and_depreciation>.