The Indian currency has gradually depreciated since the global 2008

economic crisis. Liberalizing the currency regime led to a sharp jump in

foreign investment inflows and boosted the economic growth. The Indian
rupee extended falls to a new low of 65.50 to the dollar as heavy demand
from importers along with weak domestic equities continued to weigh on
sentiment. Weakness was also seen after Federal Reserve minutes hinted
that the United States was on course to begin tapering stimulus. Moreover,
continuing its slide, the rupee also made all time low against British
pound and breached the 102 mark on local bourses. With this, British pound
has become the first major foreign currency to cross 100 levels against
rupee. 10 DEPRECIATION OF RUPEE Exchange Rate Mechanism All economies that
interact with international economy can be broadly classified into three
categories on the basis of exchange rate policy of the country:- 1. Fixed
Exchange Rate:- These economies peg the value of their currency with some
other prominent currency like US dollar. This system is simple and
provides stability to the economy (of course, if the economy of the country
to whose currency its currency is pegged is stable). This type of exchange
rate regime is maintained by generally smaller economies like Nepal and
Bhutan (pegged to Indian Rupee) or several African nations. Rational
behind such regime is that in case of small economy if the exchange
rate is market determined the sudden influx or out flux of even
relatively small amount of foreign capital will have large impact on
exchange rate and cause instability to its economy. Notable exception is
China which despite being large economy has its currency pegged to US
dollar. But then when it comes to China, its irrational to talk about
rationality. 2. Floating (or free) Exchange Rate:- Bigger and developed
economies like US, UK, Japan, etc. generally let market determine their
exchange rate. In such economy exchange rate is determined by demand and
supply of the currency. For example consider exchange rate of US dollar
versus Japanese Yen. If US wants to import certain item from Japan, it
will have to pay the Japanese company in Japanese Yen. This is because
in common market of Japan, dollar will not fetch you anything. But the
American company will not have Yen, so it will purchase Yen from the
international currency market. This will increase the demand of Yen and
supply of Dollar. Thus the value of Yen vis--vis dollar will increase.
Similarly if Japanese company is importing something from US, it will
increase value of Dollar as compared to Yen. 11 Export-import, though the
major, is not the only source for currency exchange. Capital flow
Americans investing in Japan and Japanese investing in USA is also a
significant source of currency exchange. Another source of currency
exchange is remittance that is the money sent home by Americans working
in Japan and vice versa. Cumulative of all these exchanges determine the
exchange rate. If net requirement of Dollar by Japanese is more than net
Yen required by USA, Dollar will appreciate against Yen. You should also
understand that this is oversimplified for the purpose of illustration.
In real world, there will be multilateral interactions and final exchange
rate will be equilibrium reached by all those interactions. 3. Hybrid
System:- Most mid-sized economy like India practices a mix of both these
regimes. It allows for the exchange rate to float in a range which it deems
comfortable. Once the market determined rate tries to breach this range,
central bank (government) intervenes in the currency market and controls
the exchange rate. Factors That Influence Exchange Rates The exchange rate
is one of the most important determinants of a country's relative level
of economic health. Exchange rates play a vital role in a country's level
of trade, which is critical to most every free market economy in the world.
For this reason, exchange rates are among the most watched analyzed and
governmentally manipulated economic measures. Here we look at some of the
major forces behind exchange rate movements. Before we look at these
forces, we should sketch out how exchange rate movements affect a nation's
trading relationships with other nations. A higher currency makes a
country's exports more expensive and imports cheaper in foreign markets;
a lower currency makes a country's exports cheaper and its imports more
expensive in foreign markets. A higher exchange rate can be expected to
lower the country's balance of trade, while a lower exchange rate would
increase it. Exchange rates are relative, and are 12 expressed as a
comparison of the currencies of two countries. The following are some of
the principal determinants of the exchange rate between two countries.
Differentials in Inflation:- As a general rule, a country with a
consistently lower inflation rate exhibits a rising currency value, as
its purchasing power increases relative to other currencies. During the
last half of the twentieth century, the countries with low inflation
included Japan, Germany and Switzerland, while the U.S. and Canada
achieved low inflation only later. Those countries with higher inflation
typically see depreciation in their currency in relation to the currencies
of their trading partners. This is also usually accompanied by higher
interest rates. Differentials in Interest Rates:- Interest rates,
inflation and exchange rates are all highly correlated. By manipulating
interest rates, central banks exert influence over both inflation and
exchange rates, and changing interest rates impact inflation and currency
values. Higher interest rates offer lenders in an economy a higher return
relative to other countries. Therefore, higher interest rates attract
foreign capital and cause the exchange rate to rise. The impact of higher
interest rates is mitigated, however, if inflation in the country is much
higher than in others, or if additional factors serve to drive the currency
down. The opposite relationship exists for decreasing interest rates -
that is, lower interest rates tend to decrease exchange rates. Current
- Account Deficits:- The current account is the balance of trade between
a country and its trading partners, reflecting all payments between
countries for goods, services, interest and dividends. A deficit in the
current account shows the country is spending more on foreign trade than
it is earning, and that it is borrowing capital from foreign sources to
makeup the deficit. In other words, the country requires more foreign
currency than it receives through sales of exports, and it supplies more
of its own currency than foreigners demand for its products. The excess
demand for foreign currency lowers the country's exchange rate until
domestic goods and services are cheap enough for foreigners, and foreign
assets are too expensive to generate sales for domestic interests. 13
Public Debt:- Countries will engage in large scale deficit financing to
pay for public sector projects and governmental funding. While such
activity stimulates the domestic economy, nations with large public
deficits and debts are less attractive to foreign investors. The reason
is, a large debt encourages inflation, and if inflation is high, the debt
will be serviced and ultimately paid off with cheaper real dollars in the
future. In the worst case scenario, a government may print money to pay
part of a large debt, but increasing the money supply inevitably causes
inflation. Moreover, if a government is not able to service its deficit
through domestic means (selling domestic bonds, increasing the money
supply), then it must increase the supply of securities for sale to
foreigners, thereby lowering their prices. Finally, a large debt may prove
worrisome to foreigners if they believe the country risks defaulting on
its obligations. Foreigners will be less willing to own securities
denominated in that currency if the risk of default is great. For this
reason, the country's debt rating is a crucial determinant of its exchange
rate. Terms of Trade:- A ratio comparing export prices to import prices,
the terms of trade is related to current accounts and the balance of
payments. If the price of a country's exports rises by a greater rate than
that of its imports, its terms of trade have favorably improved.
Increasing terms of trade, shows greater demand for the country's exports.
This in turn, results in rising revenues from exports, which provides
increased demand for the country's currency (and an increase in the
currency's value). If the price of exports rises by a smaller rate than
that of its imports, the currency's value will decrease in relation to
its trading partners. Political Stability and Economic Performance:-
Foreign investors inevitably seek out stable countries with strong
economic performance in which to invest their capital. A country with such
positive attributes will draw investment funds away from other countries
perceived to have more political and economic risk. Political turmoil,
for example, can cause a loss of confidence in a currency and a movement
of capital to the currencies of more stable countries. 14 How does
Government Control Exchange Rate In fixed or hybrid exchange rate regime
where government controls exchange rate, control is exercised by actively
participating in international currency market through its central bank
(Reserve Bank of India or RBI in our case). Suppose there is huge demand
of rupee in India which is driving the value of rupee. Also, let us assume
that RBI is comfortable only in range of Rs.50 to Rs.60 per US dollar.
This rapid surge in the demand of rupee, which might be because:- a) Indian
export is far more than its import, b) Foreign investors want to invest
in India and c) Large number of Indians earning abroad are remitting their
money back home, is pushing the exchange rate below Rs.50 per dollar. The
RBI will then step in the market and will offer Rs.50 for each dollar.
Those buying rupees against dollar will now purchase from RBI since its
offering better rate. Soon other traders will have to arrive at this rate,
if they want to participate. Since RBI has the ability to print currency
notes, it can keep the lower limit of exchange rate fixed at this value.
When demand for rupee is subsided, RBI will step back and let market
determine the exchange rate. In the process, RBI will have accumulated
a pool of dollars; this is called Forex Reserve or Foreign Exchange Reserve.
Suppose Indian exports have dwindled, imports are on surge, foreign
investors are fleeing Indian market and remittances are at all-time low.
Now, everyone wants dollar but there is little supply. This will drive
the price of dollar up. It is about to breach the upper limit of Rs.60
USD. RBI will step in again and will put its dollar reserves on sale at
the rate of Rs.60 USD. This will stop the further depreciation of rupee.
As you can see, in order to be able to stop the currency from appreciating,
RBI will have to print money and for preventing its depreciation it needs
a reserve of dollar. This constraint has interesting implications on the
current predicament of RBI in the context of depreciating rupee. 15 Effect
of Exchange Rate on Import and Export An Exchange Rate is the rate at which
one nation's currency can be exchanged for that of another. Exchange rates
impact, and are impacted by, international trade, in a freemarket system
that helps to maintain a balance of trade and balance of capital. Suppose
US company wants to buy Indian textile and suppose on T-Shirt costs Rs.120
and exchange rate is Rs.50 per USD. So for American company the cost of
T-Shirt is $2.4. Now, if rupee depreciates to Rs.60 per USD the price of
T-shirt becomes $2 only. This will make Indian T-shirt cheaper to buy and
will increase its demand. Companies who were importing from other nations
(may be China or Bangladesh) might shift to India and Indian exports will
increase. Consider the opposite scenario. Rupee appreciates to Rs.40 per
USD making the cost of one T-shirt $3. This will repel US importers and
might drive them to other rival exporters whose garments are cheaper. Thus,
depreciating currency helps exports while appreciating currency has
opposite effect. Similarly if India imports $1000 i-Pad from US, at
exchange rate of Rs.60, it will cost Rs.60000. If currency appreciates
to Rs.50 per USD the price will reduce by Rs.10000. This might encourage
many new people to by i-Pad which earlier thought it to be too expensive.
Thus, the demand for imported products will increase in appreciating
currency and will drive imports upward. Depreciating currency will have
opposite effect. The differences in currency values can affect our ability
to buy imports or sell exports, affecting our standard of living.
Therefore, the effects of currency crises in other nations are not limited
to those nations - they can affect our economy and our lives in important
ways. 16 Economics of Currency Predicting currency movements is perhaps
one of the hardest exercises in economics as it has many variables
affecting the market movement. However, over a longer term currency
movement is determined by following factors:- 1. Balance of Payment (BoP)
Accounts:- International monetary transactions of a nation is recorded
in two accounts:- a) Current Account:- Current account surplus means
exports are more than imports. In economics we assume prices to be in
equilibrium and hence to balance the surplus, the currency should
appreciate. Likewise for current account deficit countries, the currency
should depreciate. This records all the trades (export-import),
remittances, interests and earnings on investments made into outside
countries and other flows which is current in nature (meaning with no
intention of future return). If total inflows in the country (its export,
remittances and earning from its investments abroad) is more than its
outflows (its import, remittances out of the country, payments of
interests, etc.) then the country is said to have current account surplus.
China, owing to its huge exports, is currently the nation with largest
current account surplus. Similarly, if outflows exceeds inflows, the
country is said to be in current account deficit. USA has the largest
current account deficit. India too has huge current account deficit. b)
Capital Account:- As currency adjustments do not happen immediately to
adjust current account surpluses and deficits, capital flows play a role.
Deficit countries need capital flows and surplus countries generate
capital outflows. On a global level we assume that deficits will be
cancelled by surpluses generated in other countries. In theory we assume
current account deficits will be equal to capital inflows but in real world
we could easily have a situation of excessive flows. So, some countries
can have current account deficits and also a balance of payments surplus
as capital inflows are higher than current account deficits. In this case,
the currency does not depreciate but actually appreciates as in the case
of India. Only 17 when capital inflows are not enough, there will be
depreciating pressure on the currency. This records all the flow (into
or out of the country) made for future return investment in stocks,
bond or companies, in real estate or FDI (investment made for setting up
of business or industry). It also includes loans taken from abroad (which
actually is investment by foreign lender into the nation). Foreign
Currency Reserves are also part of Capital Account but are generally not
reported. A country is said to be in Capital Account surplus if total
inflows into the country (FII, FDI and borrowing from foreign
companies/banks) exceeds total outflows (investments into foreign
countries and lending to foreign countries or companies). In case
situation is reversed, country has capital account deficit. Payments
Always Get Balanced You can spend only as much money as you have. Or in
other words, total amount you spend and invest must always be equal to
the money you have earned and loans you have taken. What this means in
the context of BoP is that current account surplus must always be balanced
by Capital Account deficit and if a country is having current account
deficit, it must always get equivalent money form of capital account
surplus. BoP and Forex Reserves Countries having floating exchange rate
and free capital flows do not have to build foreign currency reserves.
But as we have seen earlier, those who exercise some or full control over
exchange rate, do so by manipulating their Forex Reserves. The difference
in current account surplus and capital account (excluding Forex Reserves)
deficit is balanced by equal increase in Forex Reserves (China) and if
country is not able to meet current account deficit by capital flows, then
it will have to liquidate its Forex Reserve (current situation of India).
For example, China which has huge exports (current account surplus) as
well has huge inflows in FDI and FII, balances this by building up huge
Forex Reserves as well as by investing in foreign countries. Chinese
government parks large percentage of its surplus into US government bonds
18 and encourages its government backed and other companies to buy assets
in foreign countries (mostly US). So it deliberately runs huge capital
account deficit so that it can export. Otherwise, it will have to let its
artificially depreciated currency appreciate. 2. Interest Rate
Differentials:- This is based on interest rate parity theory. This says
that countries which have higher interest rates their currencies should
depreciate. If this does not happen, there will be cases for arbitrage
for foreign investors till the arbitrage opportunity disappears from the
market. The reality is far more complex as higher interest rates could
actually bring in higher capital inflows putting further appreciating
pressure on the currency. In such a scenario, foreign investors earn both
higher interest rates and also gain on the appreciating currency. This
could lead to a herd mentality by foreign investors posing macroeconomic
problems for the monetary authority. 3. Inflation:- Higher inflation
leads to central banks increasing policy rates which invites foreign
capital on account of interest rate arbitrages. This could lead to further
appreciation of the currency. However, it is important to differentiate
between high inflation over a short term versus a prolonged one. Over
short-term foreign investors see inflation as a temporary problem and
still invest in the domestic economy. If inflation becomes a prolonged
one, it leads to overall worsening of economic prospects and capital
outflows and eventual depreciation of the currency. Apart from this,
inflation also helps understand the real changes in a value of currency.
Real exchange rate = Nominal Exchange Rate* (Inflation of foreign
country/Inflation of domestic economy). This implies if domestic
inflation is higher, the real change in the value of the currency will
be lower compared to the nominal change in currency. 4. Fiscal Deficit:-
Fiscal deficits play a role especially during currency crisis. If a
country follows a fixed exchange rates and also runs a large fiscal deficit
it could lead to speculative attacks on the currency. Higher deficits
imply government might resort to using Forex Reserves to finance its
deficit. This leads to lowering of the reserves and in case there is a
speculation on the currency, the government may not have adequate reserves
to protect the fixed value of the currency. This 19 pushes the government
to devalue the currency. So, though fiscal deficits do not have a direct
bearing on foreign exchange markets, they play a role in case there is
a crisis. 5. Global Economic Conditions:- Barring domestic conditions,
global conditions impact the currency movement as well. In times of high
uncertainty as seen lately, most currencies usually depreciate against
US Dollar as it is seen as a safe haven currency. Hence even over a longer
term, multiple factors determine an exchange rate with each one playing
an important role over time.

Negative Feedback Mechanism

Negative feedback is defined as following Negative feedback
occurs when the result of a process influences the operation
of the process itself in such a way as to reduce
changes. In order to understand this concept look at the
above diagram. As you can see in the diagram, when water
level in the reservoir decreases, the piston stopping water
flow is lifted and water starts to pour in. When water is
filled, the piston will again come down to stop more water
from pouring and this will maintain the water at desired
level. The equilibrium level of water will be determined by
the arrangement of the system rather than the flow of
water.

Similar negative feedback system exists in economics. For

example, consider exchange rate and export-import. Actual
situation will be very complicated because of a large number
of variable interacting together. To keep things simple, we
will consider only two variables at a time export-import
and exchange rate. As we have discussed above, appreciation
currency causes increase in import while discourages export.
This will lead to increase in demand for foreign currency
and simultaneously increase in supply of local currency. This
putting a downward pressure on exchange rate. If government
does not interfere and there is no net capital flow, then
exchange rate will quickly adjust such that values of
imports and exports are perfectly matched.

21

Relation between Interest Rate and Exchange Rate (Interest

Rate Parity)

Another beautiful example of such feedback system is interest

rate parity. In order to explain it lets assume interest
rate for borrowing in USA is 4% and interest one gets on
government bond in India is 8%. It will make perfect
business sense if you borrowed $1000 from USA, purchased
Indian government bond and after a year you got interest of
$80. Paid $40 as interest to the bank you borrowed from,
and made a profit of $40. That without investing a single
penny of your own. Such situation where you can make money
without investing any capital at all is called arbitrage
(which in itself is fascinating financial concept and
deserves a complete article on itself).

The only problem with this is it will not be only you who
can think of this. Other people too would want to make
profit out of this opportunity and soon there will be many
dollars flowing from USA to India causing Indian Rupee to
appreciate in comparison to USD and whatever gains you could
make from excess interest rate will be offset by the
increase in exchange rate.

Self Fulfilling Prophecies or Positive Feedback

Directly opposite to the concept of negative feedback is

Self Fulfilling Prophecies or Positive Feedback. For example
suppose there is a rumor, completely unfounded, that the
price of gold is going to increase to very high in a week.
People will want to profit from this information and will
buy some gold to sold later at higher price. Initially,
some people will be fooled by the rumor and buy gold. This
temporary surge in short term demand will lead to momentary
increase in price. This increase in price will give credence
to the rumor, and more people will flock in to buy gold.
This will further increase the price, pulling even more
people. The rumor, which originated without any analysis or
fundamental cause, was the reason itself for the rumor
becoming true.

Such positive feedback are very common in our life,

engineering and economics. In context of exchange rate,
sometimes positive feedback plays a prominent role. Suppose,
all the traders in foreign exchange market believe that
rupee has depreciated far below

22
its intrinsic value and it will appreciate in near future.
In order to profit from this anticipated gain, they will
try to hoard the rupee, thus increasing its demand and
causing it to appreciate.

Opposite of this is also true. If traders believe that

rupee (or for that matter any currency) is about to
depreciate, they might actually trigger it by shorting the
currency.

The Paradox of Negative and Positive Feedback

What seems to be positive feedback in short term might

actually be negative feedback if looked broadly. For example,
let us look at the currency example again. The general
belief that currency has fallen far below its true value
caused it to appreciate through positive feedback mechanism.
But, at the same time it also prevented currency to
depreciate further and hence acted as negative feedback.

Existence of negative and positive feedback loops give rise

to several interesting phenomena in economics and in other
areas. It is what economists say Impossible Trinity.

Impossible Trinity

The concept of Impossible Trinity states that a country (or

an economy) cannot simultaneously have Fixed Exchange Rate,
Free Capital Flow and Independent Monetary Policy (which
roughly means control over interest rate).

For example, suppose India pegs its currency to say Rs.60

per USD and intends to maintain free capital flow. Now, if
it sets interest rate that is higher than that of USA, then
money will start flowing in from US to bank on this
arbitrage opportunity (as we discussed earlier). So, in order
to maintain its exchange rate, it will have to buy Dollars.
But it will have a limit to how much it can buy.
Similarly, if it sets interest rates lower than US, money
will start flowing out. To prevent rupee from falling, it
will have to
23

sell off its dollar reserve. But that can last only till
its reserves gets fully depleted. Thus government will have
to set interest rate equal to that of US.

If you look closely, India, in recent times, has tried to

achieve this impossible trinity to some extent. It kept
currency undervalued, wanted foreign investors to come in,
and had to increase interest rate to contain inflation. What
makes this more ludicrous is that it was attempted when our
premier is a trained economist.

Causes of Depreciation

What is good for economy is bad for politics. Indias trade

balance is highly unfavorable. What this means is India
imports far more than it exports. Infact, Indian export is
only about 80% of its imports, a deficit of about $120
billion (2011). This deficit is largely balanced by
remittances (which stood at $69 billion in 2012), FDIs and
FIIs.

Economically it makes sense for India to let its currency

appreciate because it will make imports cheaper and help
reduce its trade imbalance. But, appreciating currency will
have negative impact on its exports. Now, India mainly
exports labor intensive goods and services Software
services, polished diamond, textiles, processed cashew nuts,
leather goods. These sectors generate huge employment.
Appreciation of currency causes fall in the profitability in
these sectors, leading to many people lose their jobs.
Looked from perspective of politicians, this is hugely
unpopular.

Even though the overall gain from appreciated rupee is far

more than the losses, gains per individual are small in
magnitude and distributed over a large population; whereas
losses per individual is large and concentrated in minority
of the population. Such policies are impossible to pursue in
a democracy like India because those at loss will be far
more vocal while people at gain will not bother at all.

Under such political considerations, our government, a

coalition of several parties cannot afford to be bold. So,
in last 5-6 years, driven by impressive economic growth of
India, when foreign investors flocked, there was upward
pressure on the rupee. Government was unwilling to let rupee
appreciate and kept it artificially devalued. In the process
it amassed huge foreign exchange reserves (about $300bn).

Printing of more money causes inflation, another politically

unpopular thing. So, in order to curb the money supply,
government issued bonds under Market Stabilization Scheme (MSS
bonds). It did curb the inflation to some extent, but when
bond matures, government has to pay the money along with
the interest. So, this scheme does not really curb inflation,
it postpones it. When those bonds matured, government made
payments, again by printing more money, as government is
running budget deficit and

25

does not have income to pay. This caused inflation which

you might have noticed during recent times. Now to curb the
interest rate Government will increase interest rate to
reduce the supply of money.

Increase in interest rate caused a slowdown in growth. Also,

global economic slowdown reduced demand for India exports and
exports fell too (about 30% in last year). Import however,
did not fall by that amount because Oil, the major
component of our imports, is essential commodity. So the
trade balance turned more unfavorable. Also, looking at the
slowing pace of growth new investor abstained from investing
in India and older investor too started to get uneasy. As
they tried to pull back their money, it put downward
pressure on rupee.

If foreign investor expects the currency of a country to

fall, it will withdraw its investments because its investment
value will fall with the currency. For example suppose you
invested $1000 at Rs.40 per USD. So your investment in
India is Rs.40000. Tomorrow if rupee falls to Rs.60 per USD
then value of your investment has fallen to $667. Foreign
investors fearing further fall in rupee started to flee
Indian market and this put further downward pressure on
rupee (Positive feedback). Government could interfere, but
owing to its huge budget deficit, had limited resources and
rupee had a free fall.

Withdrawal by FIIs:- The main driver of rupee depreciation

in the last three months has been the withdrawal of funds
by Foreign Institutional Investors (FIIs) from domestic
economy. The rather pessimistic view of FIIs is being
governed by global developments. FIIs have registered a net
sales position of US $ 1,581 million, between August and
November so far. The ongoing Euro-zone debt crisis seems to
be intensifying and rescue packages have been of limited
assistance in truly resolving the crisis. While the risk of
sovereign default by individual Euro states is a concern,
the risk of an impending contagion is also significant. It
is estimated that the IMF has about $400 billion available
to provide funding to the Euro-Zone, but Italy alone has to
refinance $350 billion worth of debt in the next six months.
The support by the IMF thus is a just fraction of the
cumulative financing requirement to resolve this debt crisis.
Changes in political leaders and

26

finance ministers of these states, debates on the role and

mandate of the European Central Bank (ECB) and European
Financial Stability Facility (EFSF) and quantum of financial
support to be provided by member states remain some points
of in decision. The scenario in the US does not provide an
upbeat picture either. Delays in policy formulation on the
setting of debt ceiling for the state have reflected some
lacunae in management of government finances. While housing
starts, industrial production and consumer spending are
gradually showing signs of improvement, the rate of
unemployment remains uncomfortably high. Growth estimates for
the US have been revised downwards to 2.0% in Q3 from the
earlier estimate of 2.5%. The real estate problem, weakening
local government finances, lack of transparency in operations
and systems of the government and deterioration the assets
of the banking system observed in the Chinese economy are
further drags to the global macro-economic outlook for the
coming months. Domestic macro-economic prospects as well are
weighed by high inflation and sagging industrial production,
which have led to downward revision of growth estimates to
just 7.6%. Consequently, FIIs have withdrawn funds from
emerging markets and invested back in the dollar which has
been strengthening.

Strengthening of Dollar:- As these downbeat forces have

played strong over the last few months, investor risk
appetite has contracted, thereby increasing the demand for
safe haven such as US treasury, gold and the greenback. The
Euro has depreciated 6.55% against the dollar in the last
three months which has in turn made the dollar stronger
vis--vis other currencies, including the rupee. With winter,
the demand for oil and consequently dollar is only expected
to move further upwards. Domestic oil importers have also
contributed to this strengthening to meet higher oil import
bills. Widening Current Account Deficit:- The current account
balance is composed of trade balance and net earnings from
invisibles. While earnings from invisibles have been quite
robust this year (growth of 17%), the trade account has
deteriorated on unfavorable terms of trade. Current account
deficit(CAD), in Q1 FY12 had widened by Rs.40,000 crore,
over Q4 FY11. Furthermore on a
27

quarterly basis, even invisibles earnings have registered some

decline. With contribution of exporters remaining on the
sidelines and earnings from invisibles continuing to decline,
a further widening of the CAD would result in outflow of
dollars from the Indian economy accentuating the depreciation
in rupee. In particular software receipts would be under
pressure given the global slowdown. Decline in other Capital
Flows:- Foreign Direct Investments (FDI), External Commercial
Borrowings (ECBs) and Foreign Currency Convertible Bonds
(FCCBs) have maintained robust trends this year, when
compared with net inflows in FY11. However, on a month on
month basis, ECBs and FCCBs have registered slowdown. A
prospective decline in these other inflows on the capital
account of the balance of payments could cause further
depreciation in rupee. While FDI has been increasing it has
not been able to make up for lower other capital inflows.
28

Impact of Rupee Depreciation

Economists do not agree about impact of nominal exchange

rate on real economy. Many argue that nominal values do not
have any impact on real economy while others claim that the
effect nominal variables have on human psychology and
expectations of future does hamper real economy.

Two very visible impacts are:-

increasing oil prices and India gaining competitive

advantage in certain export.

Why oil price is increasing is quite obvious. The later

impact needs some elaboration. What has made the devaluation
of rupee more problematic is global slowdown. Alternatively,
it might well be that this downfall was brought about by
the global slowdown. But in either cases, the demand for
goods and services in developed economy is dwindling. But
demand in certain goods like textile will not be impacted
that much (people are not going to shun wearing cloths
because of slowdown). Main competitor of India in such
sector is China. During the same period when Indian rupee
has been falling, salaries of labors in China has been on
the rise. This had made Indian export more favorable.

Another impact, which may seem like silver lining in the

dark cloud is that it has forced government to bring
certain economic reforms (FDI in retail and other sectors)
and has brought a near crisis like situation which can
force unwilling government to bring reforms (as it did in
90s). Three areas of concern that may be identified are:-

1. Higher Import Bills:- A depreciation of the local currency

naturally manifests in higher import costs for the domestic
economy. Assuming that both imports and exports maintain
their current growth rates through the year, higher import
costs would widen the trade and current account deficit of
the country. We expect current account deficit to settle at
3.0-3.1% of GDP by March 2012 end. Additionally, the domestic
economy could be faced with a problem of higher inflation
through imports. Commodities prices that are internationally
denominated

29

in US dollars would naturally be priced higher on the back

of a stronger Dollar. Also, while global base metals prices
such as nickel, lead, aluminum, iron and steel would have
eased, the depreciating rupee would keep the price of
imported commodities elevated. 2. Fiscal Slippage:- The fiscal
deficit for FY12 was budgeted at 4.6% of GDP in February,
with the price of oil pegged at US $100 per barrel.
Throughout FY12 so far, however, the price of oil has been
well above this reference rate, hovering at an average of
US $110 over the last three months. Oil subsidy for the
year is about Rs.24,000 crore for FY12. This will rise on
account of the higher cost of oil being borne by the
government. While there have been moves to link some prices
of oil products to the market, there would still tend to
be an increase in subsidy on LPG, diesel, kerosene. The
government has already enhanced its borrowing programed in H2
FY12 by Rs.52,000 crore, to bridge the fiscal gap. 3.
Increased burden on Borrowers:- Higher rates will come in
the way of potential borrowers in the ECB market. Today
given the interest rate differentials in domestic and global
markets, there is an advantage in using the ECB route. With
the depreciating rupee, this will make it less attractive.
Further, those who have to service their loans will have to
bear the higher cost of debt service. 4. Impact on Exports:-
Usually exports get a boost in case the domestic currency
depreciates because exports become cheaper in international
markets. However, given sluggish global conditions, only some
sectors would tend to gain where our competitiveness will
increase such as textiles, leather goods, processed food
products and gems and jewelry. In case, imported raw
material is used in these industries they would be adversely
affected. Therefore, exports may not be able to leverage
fully.
30

Rupee Exchange Depreciation: Impact Analysis

The rupee has depreciated by more than 18 percent since May

2011, moreover with the rupee breaching the 53 dollar mark,
profit margins of companies that import commodities or
components would come under severe pressure, which could
result in price increases for the consumer. The rupee
depreciation will particularly hit the industrial sector and
put higher pressure on their costs as items like oil,
imported coal, metals and minerals, imported industrial
intermediate products all are getting affected. Although the
prices of most of the imported commodities have fallen, the
depreciating rupee has meant that the importer gets no
respite as they need to pay more to purchase the same
quantity of raw materials. The depreciating rupee would keep
the price of imported commodities elevated. Thus the
industrial sector is bound to get adversely hit. Primarily
the consequences of weak rupee are to be felt through:-

1. Increase in the Import Bill:- A depreciation of the local

currency results in higher import costs for the country.
Failure of a similar rise being experienced in the prices
of exportable commodities is going to result in a widening
of current account deficit of the country. 2. Higher
Inflation:- Increase in import prices of essential commodities
such as crude oil, fertilizer, pulses, edible oils, coal and
other industrial raw materials are bound to increase the
prices of the final goods. Thereby making it costlier for
the consumers and hence inflation might be pushed up further.
3. Fiscal Slippage:- The central government fiscal burden
might increase as the hike in the prices of imported crude
oil and fertilizer might warrant for a higher subsidy
provision to be made for these commodities. 4. Increase in Cost
of Borrowings:- Interest rate differentials in domestic and
global markets encourage the industry to raise money through
foreign markets however a fall in the rupee value would
negate the benefits of doing so.

31

Policy Options Available with RBI

1. Raising Policy Rates:- This measure was used by countries

like Iceland and Denmark in the initial phase of the crisis.
The rationale was to prevent sudden capital outflows and
prevent meltdown of their currencies. In Indias case, this
cannot be done as RBI has already tightened policy rates
significantly since March 2010 to tame inflationary
expectations. Higher interest rates along with domestic and
global factors have pushed growth levels much lower than
expectations. In its December 2011 monetary policy review,
RBI mentioned that future monetary policy actions are likely
to reverse the cycle responding to the risks to growth.
Indias interest rates are already higher than most countries
anyways but this has not led to higher capital inflows. On
the other hand, lower policy rates in future could lead to
further capital outflows.

2. Forex Reserves:- RBI can sell Forex Reserves and buy

Indian Rupees resulting in increased in demand for rupee.
RBI Deputy Governor in a recent speech said using Forex
Reserves poses problems on both sides Not using reserves
to prevent currency depreciation poses the risk that the
exchange rate will spiral out of control, reinforced by
self-fulfilling expectations. On the other hand, 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. Since both
outcomes are undesirable, the appropriate policy response is
to find a balance that avoids either. Based on weekly
Forex Reserves data, RBI seems to be selling Forex Reserves
selectively to support Rupee. Its intervention has been
limited as liquidity in money markets has remained tight in
recent months and further intervention only tightens liquidity
further.

3. Easing Capital Controls:- Dr. Gokarn in a speech said

capital controls could be eased to allow more capital
inflows. He added that resisting currency depreciation is
best done by increasing the supply of foreign currency by
expanding market participation. This in essence, has been
RBIs response to depreciating Rupee. Following measures have
been taken lately:-

Increased the FII limit on investment in government and

corporate debt instruments. First, it raised the ceilings on
interest rates payable on non-resident deposits. This was
later deregulated allowing banks to determine their own
deposit rates. The all in cost ceiling for External
Commercial Borrowings was enhanced to allow more ECB
borrowings. 4. Administrative Measures:- Apart from easing
capital controls, administrative measures have been taken to
curb market speculation. Earlier, entities that borrow abroad
were liberally allowed to retain those funds overseas. They
are now required to bring the proportion of those funds to
be used for domestic expenditure into the country immediately.
Earlier people could rebook forward contracts after
cancellation. This facility has been withdrawn which will
ensure only hedgers book forward contracts and volatility is
curbed. Net Overnight Open Position Limit (NOOPL) of forex
dealers has been reduced across the board and revised limits
in respect of individual banks are being advised to the
forex dealers separately.

After these recent measures, Rupee depreciation has abated

but it still remains under pressure. Both domestic and
global conditions are indicating that the downward pressure
on Rupee to remain in future. RBI is likely to continue
its policy mix of controlled intervention in forex markets
and administrative measures to curb volatility in Rupee.
Apart from RBI, government should take some measures to
bring FDI and create a healthy environment for economic
growth. Some analysts have even suggested that Government
should float overseas bonds to raise capital inflows.