CURRENCY DEPRECIATION

CURRENCY DEPRICIATION

CURRENCY DEPRECIATION

Executive Summary

The recent times have seen the sudden downward spiral of the value of rupee against other reference currencies. This report delves into the factors contributing to currency depreciation. In addition to that, it specifically aims to study the underlying drivers of the fall in the value of the Indian rupee, the subsequent consequences, measures taken by the Indian central Bank and the effect of these measures on the Rupee.

CONTENTS

OBJECTIVES AND KEY DELIVERABLES -------------------------------------------------06STUDY, ACTIVITIES AND KEY LEARNINGS.--------------------------------------------07

REPORT ON CURRENCY DEPRECIATION--------------------------------------------08-19CURRENCY DEPRECIATION------------------------------------------------------------08DEPRECIATION VS DEVALUATION--------------------------------------------------08CAUSES OF CURRENCY DEPRECIATION-------------------------------------------09 WHAT HAPPENED IN INDIA------------------------------------------------------------13 WHY DID THE RUPREE DEPRECIATE-----------------------------------------------13 REASONS FOR CONCERN ABOUT RUPEE DEPRECIATION-----------------16 STEPS TAKEN BY THE RBI-------------------------------------------------------------18 EFFECT OF MEASURES ON THE RUPEE--------------------------------------------19

Objectives And Key Deliverables I took up this internship with Karvy to explore the various aspects of the equity stock broking industry. The internship was structured to make me understand the varied stock market terminology, stock price movements, methods to evaluate stocks and understand the customer mindset in portfolio management.As part of the internship I was advised to study and report the causes, concerns and consequences of currency depreciation specific to the Indian currency. Furthermore, I also took note of the measures taken by RBI in this regard and their effect on the Indian Rupee.

Study Activities And Key Learnings My day in the office started from with a fresh market analysis by the Karvy morning equity reports and by Mr. Sudarshan Sukhani on CNN-IBN. This routine, over a period of time, helped me immensely in getting better insights into the equity market.Once the market opened at 9:15 am my work consisted of watching the stock price movement and making calls to customers to report the changes in their respective portfolios. Depending on this information the customer would make hold, sell or buy decisions. Attending these calls helped me get a basic understanding into the customers risk taking behaviour. I observed that customers can be classified, as taught in class, into conservative, moderate and aggressive investor classes.In addition to these activities, my mentor would take time out every day to clear our queries and talk about various issues relating to the equity markets. I awaited these sessions everyday as they exposed me to new dimensions of the equity markets.Apart from these avenues of learning, my interaction with other interns during our coffee breaks were a great time to brainstorm about our own analysis predictions and understanding of the equity markets.

Currency DepreciationThe value of a countrys currency is often judged by weighing it against other countries currencies. The loss of a countrys currency value with respect to other currencies, usually in a floating exchange rate system is called currency depreciation. To explain further, if the Indian rupee depreciates relative to the American dollar then it is said that the exchange rate has risen; it takes more rupees now to purchase 1 dollar.Depreciation vs Devaluation Contrary to popular belief, there is a difference between devaluation and depreciation. A currency loses its value both when it depreciates and when it is devalued. The difference, however, is that devaluation is an official decision. This means that the lowering of the currency with respect to other reference currencies is intentional. This may not be the case with respect to currency depreciation.Devaluation is the official lowering of the value of a country's currencywith regard to goods, services or other monetary units with which the currency can be exchanged. On the contrary,depreciationis used to describe a decrease in a currency's value due tomarket forces.

Causes Of Currency Depreciation Factors that can cause a nation's currency to depreciate include

Relative Product Prices If a country's goods are relatively expensive, foreign consumers would not want to buy the goods. Consequently, the demand for that nations currency will drop, thereby causing its currencys value to depreciate.

Monetary PolicyCountries with expansionary monetary policies will be increasing the supply of their currencies, causing their currency to depreciate. However, if a nation's central bank pursues an expansionary monetary policy while its trading partners pursue monetary policies that are even more expansionary, the currency of that nation is expected to appreciate relative to the currencies of its trading partners.

InflationInflation occurs when the general prices of goods and services in a country increase. Inflation causes the value of the rupee to depreciate, reducing purchasing power. If there is unbridled inflation, then a currency will depreciate in value. The causes of inflation can be:Printing Money-Though printing money does not always cause inflation, inflation occurs when the money supply is increased faster than the growth of real output.Huge National Debt- To finance huge national debts, governments often print money, fuelling inflation.

Inflation Rate DifferencesInflation is associated with currency depreciation. Suppose the price level increases by 40% in theIndia, while the price levels of its trading partners remain relatively stable, Indiangoods will seem very expensive to foreigners, whileIndian will increase their purchase of relatively cheap foreign goods. The Indian rupee will depreciate as a result.

Income ChangesSuppose that the income of a major trading partner withIndia, such as the United Arab Emirates, greatly decreases, the Indian rupee will depreciate. To elucidate, the Arab consumers purchase less of the Indiangoods as a lower domestic income is associated with a decreased consumption of imported goods. Consequently, the quantity of Indian rupees demanded will be less than the quantity supplied and the Indian rupee will depreciate.

External FactorsDepreciation is basically the symptoms of an underlying problem, particularly disproportion in the Balance of Payment (BOP), springing from excess demand for dollars. Occasionally, external factors like currency speculations on the foreign exchange market can also contribute to depreciation of the local currency

Supply And DemandThe principles of supply and demand apply to the appreciation and depreciation of currency values too. If a country injects new currency into its economy, the money supply in the economy increases. According to the principles of supply and demand, when there is more money circulating in an economy, there is less demand for it. This depreciates the value of the currency.

Economic OutlookIf a country's economy is in a slow growth phase, the value of its currency depreciates. The value of a country's currency also depreciates if its major economic indicators like retail sales and Gross Domestic Product are declining. A high or rising unemployment rate can also depreciate currency value because it indicates an economic hold up. If a country's economy is in a robust growth period, the value of its currency appreciates.

Trade DeficitsA trade deficit occurs when the value of goods a country imports is more than the value of goods it exports. When the trade deficit of a country increases, the value of the domestic currency depreciates against the value of the currency of its trading partners.

The demand for imports should fall as imports become more expensive. However, some imports are essential for production or cannot be made in the country and hence have an inelastic demand; we end up spending more on these essential goods when the exchange rate falls in value. This can cause the balance of payments to worsen in the short run (a process known as the J curve effect)J curve

Collapse Of ConfidenceIf the confidence in the economy or financial sector crumbles, it will lead to an outflow of currency as people do not want to risk losing their money. Therefore, loss of confidence in an economy causes an outflow of capital and consequently depreciation in the exchange rate. Political or economic factors play a vital role in both building and destroying investor confidence in a countrys economy.

Price Of CommoditiesIf an economy depends on export of raw materials, a fall in the price of these raw materials may cause a fall in export revenue leading to a depreciation in the exchange rate.

Interest Rate Differential.Under the assumption that a country with a higher interest rate will also tend to have a higher inflation rate, the increased amount of inflation is expected to cause the currency in the country with the high interest rate to depreciate against a country with lowerinterest rates.

Market SpeculationsMarket speculations can contribute to a process of spiralling depreciation after smaller market players decide to follow the example of the leading dealers and after they lost confidence in a particular currency start to sell it in large volumes.

WHAT HAPPENED IN INDIA

An emerging economy showing signs of sturdy growth attracts the attention of foreign investors. Inward investment comes in together with nig money flows that circumvent capital controls. Capital inflows shoot up the exchange rate, making imports cheaper and exports dearer. The trade deficit bloats up, growth retards, structural flaws become more noticeable and the inflow of funding slowly disappears. This is what happened in India.Why did the rupee depreciate?Apart from the speculations in the market which are aiding the rupee depreciation, the factors which have caused the rupee to reach these lows are the external factors such as the quantitative easing in the US and the internal structural challenges. External factors:The trigger for the run on the rupee has been the news that the Federal Reserve is considering scaling back its bond-buying stimulus programme. This has consequences for all emerging market economies: firstly, fear that a reduced stimulus will indicate weaker growth in the US, spelling negative impact on exports from the developing world.

Secondly, speculation that policy tightening in the US will make the dollar more attractive and subsequently the rupee less so.

Although other developing countries are also facing the heat of the situation with declining currencies, it is India with its large trade and budget deficits that is more prone to the consequences.

Structural challenges:The twin challenges which need to be addressed are the current account deficit and the fiscal deficit.Current Account DeficitCAB = X - M + NY + NCTWhere

X = Exports of goods and servicesM = Imports of goods and servicesNY = Net income abroadNCT = Net current transfersA current account deficit is said to exist when exports are less than the imports and remittances combined or when the current account balance amounts to a negative value. From the year 2004 the government has increased imports of not only gold and oil but also other goods which could be produced in India. Despite the fact that the government uses gold and oil imports as alibi for the current account deficit, the import of capital goods contributed more to the current account deficit than the import of gold and oil. Though import of capital goods is a sign of a vibrant economy and in theory generates higher national production, the industrial production in India saw a drastic fall causing a major trade deficit. This fall in the IIP can only be attributed to the increase in import if capital goods which could otherwise be manufactured in India. Furthermore, contrary to expectations, in the past 9 years the IIP was on a decline despite huge investments into the country.One of the major culprits is the reckless import of capital goods. It has killed the rupee through current account deficit and hit both the domestic production and GDP.

Fiscal DeficitFiscal deficit is the excess outgo of government over its revenues.The deadly combination of huge current account deficits and high fiscal deficits has made the rupee weak.Ill planned stimulus packages and tax cuts/benefits provided to the corporate s over the last 9 years shot up the fiscal deficit of the government.

Reasons For Concern About The Rupee DepreciationCurrent Account Deficit Will WidenWith the increase in the exchange rate the imports become costlier, in turn worsening the current account deficit.CAD as % of GDPFY12-4.2FY13-4.8

Capital Flows May Slow Or ReverseCurrent investors may look for an exit and potential investors might want to wait before plunging in.Apr-$1992mMay-$5176mJune- -$4160m

Companies With Dollar Debt To Come Under Stress Companies with dollar debt find it difficult to pay interest as the real amount of interest to be paid shoots due to the rupee depreciation against the dollar

Costly Imports Will Hasten InflationWholesale and retail inflation is expected to rise. Even if the import of discretionary goods is controlled, large imports of goods such as fuel will contribute to the rising inflation.

Forex Reserves Could Fall, Putting Pressure On RupeeLower capital flows into India would mean that the government has to dig into its already low forex reserves to sustain its foreign expenditure.

Corporate Margins May Fall FurtherTwo factors may contribute to the thinning of corporate profit margins: more expensive material imports and weaker demand for their goods and services. Additionally, a weaker demand may not allow the company to pass on the increase in imported material cost to its customers.

Deficit Target Difficult With Higher SubsidiesThough fuel subsides are partially offset by rising fuel prices, other subsidies such as fertilizer subsidies will be a burden on the already existing deficit.

Foreign Studies And Holidays Will Pinch MoreSpending on any kind of foreign exchange denominated spending will increase.

Demand Will Further Fall Due To Higher PricesSpending on all discretionary and luxury goods will take a beating.

Rate Cut To Stimulate Economy DifficultIf a rate cut is introduced to increase borrowing and therefore the money supply into the economy, inflation, which is already at an unprecedented level, will shoot up. Therefore a rate cut cannot be used to stimulate the economy.

Steps Taken By The RBIThe RBI has undertaken several measures to curb the downward spiral of the rupee. Some of these measures were aimed at halting the excessive speculation which is adding to the volatility in the Indian economic scenario. The main aim has been to squeeze the liquidity from the market which will help in curbing the fall in the value of the rupee.

Measures

Capping the Liquidity Adjustment Facility (LAF) to Rs 7500 crores starting from the 17th July, 2013. The Marginal Standing Facility (MSF) rate , the overnight borrowing rate, has been raised 200 bps to 10.25 per cent.

RBI also raised the minimum daily average holding of the mandated 4% Cash Reserve Requirement to 99% from 70%. Banks have to comply with CRR norms on alternate Fridays and are required to maintain a minimum daily Cash Reserve Ratio (CRR) balance of 99% of the balance. That essentially sucks out an estimated Rs.90000 crore from the financial system.

Restrictions on gold: The RBI set stringent conditions for importers, linking imports to future exports by ensuring that at least 20% of the imported gold is made available for exports.

Effect Of Measures On The RupeeOn one hand, by squeezing money from the financial system, the central bank has made money costlier, raising the demand for the rupee. The scarcity of the rupee has helped to increase the value of the rupee against the dollar. On the other hand, the tight liquidity situation has put strain on the banks. Banks can borrow limited amount from the RBI under the LAF, anything beyond that they would have to borrow at the MSF rate which at 10.25% is quite steep. To meet their cash requirements, banks and financial institutions have been selling government bonds leading to the fall in bond prices across various categories and a rise in the yields. Debt mutual funds will get affected since they invest in the Government bonds and the final prices have led to the significant loss to the debt funds.

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