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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 dont 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 agencys
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 doesnt 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
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 dont 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.
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.

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

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.

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
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.
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 ECBs. 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.