The Droopy Rupee

by Deepthi Sai

A currency depreciation essentially entails a loss in the value of the currency with respect to other currencies. Thus, the cost of the foreign currency in terms of the depreciating currency increases. On 22nd August, the rupee breached a record low of Rs. 65 against the dollar.

Why does a currency depreciate?

The economics behind a currency depreciation follows the usual market mechanism of demand and supply. The rupee will depreciate against the dollar if the demand for dollars in India is high and supply is relatively low. As the demand for a currency increases relative to supply, it is allocated to only those who are willing to pay more for it.

Every country maintains accounts of monetary transactions with the rest of the world. This is called the balance of payments (BOP). The BOP essentially has two accounts: the current account and the capital account. The current account gives the difference between imports and exports. When imports exceed exports, the current account goes into a deficit. In this case, the deficit may be financed through borrowings where financial assets are sold in exchange for foreign currency. This shows up as a surplus on the capital account. Thus, for a balance, a deficit on the current account must be matched by an equivalent surplus on the capital account and vice versa.

Recently in India, the current account has been constantly going into deficits to the tune of 4.8 percent of GDP. One reason why import bills and dollar-demand is high is massive demand for crude oil, which is quoted in the dollar. Sadly, the massive deficits on the current account is not being matched by an equivalent surplus on the capital account due to wary foreign investors and an unfriendly investment climate in the country. In the global economy, the crisis in Europe killed risk appetite and drove investors to dollars or gold. Thus, while the demand for the dollar is high, supply is low, leading directly to the appreciation of the dollar and depreciation of the rupee.

A major part of the volatility in the value of the rupee can be attributed to changes in the US monetary policy. The United States had been using quantitative easing (QE) post the recession to boost its economy. Under this, the Fed (central bank in the US) buys bonds from commercial banks on a regular basis. Buying bonds begins to inflate bond prices and consequently the interest rates on the bonds start falling. The availability of funds at low interest kickstarts economic activity. Now, the US has tapered off QE. This has caused bond prices to fall and interest rates to increase, making US bonds attractive to investors. In the last 3 months, approximately 12 billion dollars have moved from India to the US. The short supply of dollars on this account has also contributed to the depreciation.

How can depreciation be stopped?

The RBI took measures to counter the impact of the depreciating rupee. Theoretically, a depreciation can be countered either by providing the necessary amount of the foreign currency or by making the rupee more scarce so that its value increases. The RBI put a cap on the amount of money and the rate at which banks could borrow funds. Fundamentally, this should decrease a bank’s ability to make loans to the masses and reduce the amount of rupees in circulation and increase its value. Additionally, the RBI also sold bonds in exchange for the rupee to drain liquidity in the economy. When money supply falls below money demand, the rate of interest on borrowings starts increasing and the higher returns could incentivize investors. These solutions were implemented half-heartedly and thus failed to show desired results.

The government on the other hand has taken some steps to curb the downfall which includes cap on imports of non-essential commodities, liberalisation of foreign direct investment (FDI) norms in several sectors including telecom, reduction in subsidies and fast completion of infrastructural projects. All these reforms are aimed at reducing the current account and improving economic climate for foreign institutional investors (FII). However, these claims sound good only theoretically and have seen little or no empirical success. Only time will tell if the government is functioning in favour of economic or political goals.

There is no doubt that the sliding rupee has had grave consequences by increasing cost of imports, decelerating growth, increasing cost of acquiring education abroad, adversely affecting the SENSEX and increasing inflation in India. But we can take solace in the fact that FIIs may take interest in Indian stocks since their prices have fallen considerably and buying at this time may just prove to be lucrative. Thus, if the current account deficit is taken care of, we can hope for a return of investments as long as the global economic scenario doesn’t worsen.

Depreciation, very often tends to be a ‘self-fulfilling prophecy.’ That is, if we believe and spread messages leading others to believe that the rupee will hit the 70 mark against the dollar, it will only make investors more risk averse and cause the rupee to actually meet such a mark. Thus, as citizens, we can try to be optimistic about the future of our currency and turn to Indian goods rather than foreign goods, as far as possible, so that demand for the rupee increases relative to the dollar.

References

"Measures Taken to Stem Rupee Fall: P. Chidambaram." The Economic Times. Press Trust of India, 20 Aug. 2013. Web. 21 Aug. 2013. <http://economictimes.indiatimes.com/markets/forex/measures-taken-to-stem-rupee-fall-p-chidambaram/articleshow/21935905.cms>.

Bandyopadhyay, Tamal. "Why the Rupee Is Falling." Http://www.livemint.com/. Live Mint, 06 Aug. 2013. Web. 21 Aug. 2013. <http://www.livemint.com/Opinion/DvvFh0hg6nDL3nZ5GtyFAK/Why-the-rupee-is-falling.html>.

Panandiker, D. H. Pal. "When Will the Rupee Recover?" Expert Zone. Reuters, 23 Nov. 2011. Web. 21 Aug. 2013. <http://blogs.reuters.com/india-expertzone/2011/11/23/when-will-the-rupee-recover/>