8/28/13 Depreciating Rupee - Causes, Impacts and Actions

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Depreciating Rupee - Causes, Impacts and Actions

Written by Siddharth P, Vinod V, IIM Rohtak

Tuesday, 31 July 2012 12:14

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Indian currency (INR) has depreciated close to 22% in the last 1 year. In the article we will try to study the

concerns of a country facing depreciating currency, the factors that led to this depreciation and the measures

government can take to stabilize the situation. Most importantly we will see if global economic uncertainty rides

over all the other domestic factors to determine strength of a currency especially in developing economies.

Why don’t we need a depreciating INR?

The persistent decline in rupee is a cause of concern. Depreciation leads to imports becoming costlier which is a worry for

India as it meets most of its oil demand via imports. Apart from oil, prices of other imported commodities like metals, gold etc

will also rise pushing overall inflation higher. Even if prices of global oil and commodities decline, the Indian consumers might

not benefit as depreciation will negate the impact. The depreciating rupee will add further pressure on the overall domestic

inflation and since India is structurally an import intensive country, as reflected in the high and persistent current account

deficits month after month, the domestic costs will rise on account of rupee depreciation. Exchange rate risk also drives away

foreign investors which in turn depreciates the local currency. Indian Rupee is currently caught in this vicious cycle; it will have to

find a stable level to regain investors’ confidence. The depreciating rupee has serious effects on the external debt figures of the

nation. The total external debt has increased by Rs. 2186.8 billion to Rs 16384.9 billion by the end of November 2011.

Factors that pushed INR into the well

Continued Global uncertainty: Owing to uncertainty prevailing in Europe and slump in international market, investors prefer to

stay away from risky investments (flight to security). This has significantly affected the portfolio investment in India. Credit rating

agency’s downgrade of India to BBB- with a negative outlook, the last of the investment grade has not helped the cause. Any

outward flow of currency or decrease in investment will put a downward pressure on exchange rate. This Global uncertainty has

adversely impacted the domestic factors (current and capital account etc.) and caused the depreciation of rupee.

Current Account Deficit: While a country like China will be more than happy with a depreciating currency, the same doesn’t

apply for India. China exports more than it imports, thus a depreciating currency makes its exports cheaper in the International

market, in turn making China more competitive. India on the other hand does not enjoy this luxury, mainly because of

increasing demand of oil, which constitutes a major portion of its import basket. The fall of oil price to $90/barrel has helped

India to fight the depreciating rupee up to some extent but at the same time Euro zone, one of the major trading partners of India

is under severe economic crisis. This has significantly impacted Indian exports because of reduced demand. Thus India

continues to see current account deficit of around 4.3%, depleting the forex reserve and thus depreciating INR.

Capital Account flows: Deficit countries need capital flows and surplus countries generate capital outflows. India needs

dollars to finance its current account deficit. Institutional investors investing in India are directly impacted by the global market

uncertainty. In 2008 India had a net outflow of $14billion of FIIs and INR depreciated from 39 level to 52 against dollar. A volatile

currency is never good for a foreign investor as it increases the transaction risk. Thus the relation becomes a vicious cycle,

thereby further magnifying the volatility. Though RBI has intervened through open market operations to arrest the downfall of

INR (managed float) but the reserves of $290billion don’t provide enough room to make a significant impact.

Persistent inflation: India has experienced high inflation, above 8%, for almost two years. If inflation becomes a prolonged one,

it leads to overall worsening of economic prospects and capital outflows and eventual depreciation of the currency. The Real

Effective Exchange Rate (REER) index (6 currencies- Euro, Yen, Pound Sterling, US Dollar, Hongkong Dollar and Renminbi)

has fallen by 13.84% during the last one year while the nominal rate has depreciated by 24%. REER index measure includes

the level of inflation differences across nations; it reflects a country's competitiveness in international trade. Thus the trend

suggests that the country's competitiveness (measured by REER) has not improved as much as the decline in nominal

exchange rate points out mainly because of increase in domestic costs. Under normal circumstances inflation is tamed by

increasing interest rates, but since India already has high interest rates, it does not leave that option open, as it may lead to

further slowdown in growth.

Interest Rate Difference: Higher real interest rates generally attract foreign investment but due to slowdown in growth there is

increasing pressure on RBI to decrease the policy rates. Under such conditions foreign investors tend to stay away from

investing. This further affects the capital account flows of India and puts a depreciating pressure on the currency.

Lack of reforms: Key policy reforms like Direct Tax Code (DTC) and Goods and Service Tax (GST) have been in the pipe line for

years. A retrospective tax law (GAAR) has already earned a lot of flak from the business community. Attempts are being made to

control the subsidy bills but fiscal deficit continues to hover around 5% of GDP. The government announced FDI in retail but had

to hold back amidst huge furore from both opposition and allies. This has further made investors sentiment negative over the

Indian economy.

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8/28/13 Depreciating Rupee - Causes, Impacts and Actions

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The rope that can pull INR out-

1. Measures By RBI:

a. Using Forex Reserves: RBI can sell forex reserves and buy Indian Rupees leading to demand for rupee. But using forex

reserves poses risk also, as using them up in large quantities to prevent depreciation may result in a deterioration of

confidence in the economy's ability to meet even its short-term external obligations. And not using reserves to prevent currency

depreciation poses the risk that the exchange rate will spiral out of control. Since both outcomes are undesirable, the

appropriate policy response is to find a balance. Recent data shows that RBI had indeed intervened by selling forex reserves

selectively to support Rupee.

Source:RBI

b. Raising Interest Rates: The rationale is to prevent sudden capital outflows and ultimately lead to higher capital inflows. But

India’s interest rates are already higher than most countries. This was done to tame inflationary expectations. So further raising

interest rates would lead to lower growth levels.

c. Make Investments Attractive- Easing Capital Controls: RBI can take steps to increase the supply of foreign currency by

expanding market participation to support Rupee. RBI can increase the FII limit on investment in government and corporate

debt instruments. It can invite long term FDI debt funds in infrastructure sector. The ceiling for External Commercial Borrowings

can be enhanced to allow more ECB borrowings.

2. Measures by Government: Government should take some measures to bring FDI and create a healthy environment for

economic growth. Key policy reforms that should be initiated includes rolling of Goods and Services Tax (GST), Direct Tax Code

(DTC), FDI in aviation and retail, Companies Bill and diesel decontrol. Efforts should be made to invite FDI but much more

needs to be done especially after the holdback of retail FDI and recent criticisms of policy paralysis. The government took steps

recently to loosen rules for portfolio investment in the Indian market, indicating its desire to sustain external inflows. The

measure to increase External Commercial Borrowings (ECB) to $10bn will help in borrowing in dollar at a less cost. It may take

similar steps to encourage FDI as well, helping sustain external funding.

Is India the only loser?

The ongoing euro zone crisis and declining demand in the developed nations has created risk-aversion in the markets. It

explains why China's growth has decelerated so acutely and also India's. It also tells us that it is the global factor that is

primarily responsible for India's economy running into rough weather not coalition politics, lack of leadership, corruption,

assembly elections or any of the things we have been hearing about.

Source:www.x-rates.com

Above data shows that INR is not the only currency depreciating. Except for China almost every developing country has shown a

deprecating pressure on their currency. Not everyone can be blamed for poor monetary policy or ineffective governance.

Source:SEBI

The FII investment data for 2012 shows that India had huge capital inflows for the first two months and started declining only

after the euro zone crisis reared its head again. This shows that the absence of reforms alone cannot account for the sheer

magnitude of the slowdown. The fact that we have had a comparable slowdown only at the peak of the subprime crisis does

suggest that external conditions must be primarily responsible this time as well.

Through interest rate and inflation data we tried to formulate a model to calculate expected spot rate and compared it with

actual spot rates and it was found that in 2010 and 2011 these rates were very close to each other, but in 2012 there is massive

20% difference(almost same as INR depreciation in last year) in these rates.

Source: www.global-rates.com

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8/28/13 Depreciating Rupee - Causes, Impacts and Actions

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INR appreciated by 2.69%, the biggest ever single day gain on 29th June just after the announcement of Eurozone rescue plan

by the leaders of 27 European Union. All the above mentioned reasons are a testimony to the fact that global economic factors

are playing a bigger role than any domestic economic or political condition.

Conclusion

The Indian Rupee has depreciated significantly against the US Dollar marking a new risk for Indian economy. Grim global

economic outlook along with high inflation, widening current account deficit and FII outflows have contributed to this fall. RBI

has responded with timely interventions by selling dollars intermittently. But in times of global uncertainty, investors prefer USD

as a safe haven. To attract investments, RBI can ease capital controls by increasing the FII limit on investment in government

and corporate debt instruments and introduce higher ceilings in ECB’s. Government can create a stable political and economic

environment. However, a lot depends on the Global economic outlook and the future of Eurozone which will determine the

future of INR.

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