8/10/2019 Fall of the Indian Rupee

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By : Aneesh Sharma

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Factors that affect exchange rate

1) Differentials in Inflation 

 As a general rule, a country with a consistently lower inflation rate exhibits arising currency value, as its purchasing power increases relative to other

currencies. Those countries with higher inflation typically see depreciation intheir currency in relation to the currencies of their trading partners

2) Differentials in Interest Rates

Interest rates, inflation and exchange rates are all highly correlated. Bymanipulating interest rates, central banks exert influence over both inflationand 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 foreigncapital and cause the exchange rate to rise and vice versa

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3) Current Account Deficits

The country requires more foreign currency than it receives through sales ofexports, and it supplies more of its own currency than foreigners demand for itsproducts. The excess demand for foreign currency lowers the country's exchange

rate until domestic goods and services are cheap enough for foreigners, andforeign assets are too expensive to generate sales for domestic interests

4)Political Stability and Economic Performance 

Foreign investors inevitably seek out stable countries with strong economicperformance in which to invest their capital. A country with such positiveattributes will draw investment funds away from other countries perceived tohave more political and economic risk. Political turmoil, for example, can cause aloss of confidence in a currency and a movement of capital to the currencies ofmore stable countries.

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 Why is the INR depreciation bad?

The persistent decline in rupee is a cause of concern.

• Depreciation leads to imports becoming costlier which is a worry for India as it meetsmost 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 ifprices of global oil and commodities decline, the Indian consumers might not benefit asdepreciation will negate the impact.

•  The depreciating rupee will add further pressure on the overall domestic inflation andsince 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 onaccount of rupee depreciation.

• Studying aboard: For Indian students abroad, the pain just aggravates. Earlier, if youcould get $2 for Rs 100, now you will have to pay Rs 30 more to get the same amount ofdollars. The only way out will be to take a loan from family and friends or dig into own

savings to meet the funding gap between your education loan amount, and actual totalcost.

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• Exchange rate risk also drives away foreign investors which inturn depreciates the local currency. Indian Rupee is currentlycaught 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.

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FACTORS THAT LED TO

DEPRECIATION OF INDIAN

RUPEE

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1. Strong US Dollar

• The main reason causing the rupee to fall is the immense strength of the DollarIndex, which has touched its three-year high level of 84.30. The record settingperformance of US equities and the improvement in the labor market has made

 Americans more optimistic about the outlook for the US economy, thereby

spurring greater hopes of QE tapering.

• QE or Quantitative Easing refers to a complex stimulus process in which theFederal Reserve pumps in about 80 Billion USD per month into the USeconomy by purchasing assets such as bonds,stocks,etc.They have also kept

short term lending rates to near 0.This resulted in excess money in the USeconomy which was then invested into emerging economies for better returns.Since Mr. Bernanke made a statement about possible QE tapering, markets allover the world reacted in shock as the excess money bought into emergingmarkets would be taken back to the US economy as investors believe the US

economy is showing strong signs of recovery and targets are being met andhence they would find it hard to fund CAD’s 

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• The fact that the Euro zone is in a recession is just another reason whyinvestors are snapping up dollars. The monetary policies of the ECB and theBoJ pose a threat to the value of the EUR and JPY whereas the next move bythe Fed should support the dollar. This divergence is bringing the dollar moreinto the limelight as a 'safe haven'. Capital preservation is just as important ascapital appreciation in the present times and for this reason the direction ofthe monetary policy and the consequent implications for the currency hasbecome very important.

• The US dollar is looking like gold these days because the Federal Reserve is ina very different position versus the ECB, BoJ and the RBA. The FederalReserve is talking about tapering asset purchases at a time when Europeanofficials are considering more aggressive monetary easing measures such asnegative deposit rates.

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2. Eurozone Crisis

• The rupee is also feeling the pinch of the recession in the Euro zone. The euro,

 which was seen holding the key level of 1.30, has dropped lower to 1.28 levels onthe back of deterioration in the local economic data. For the past month,investors have been selling Euros and buying dollars on the premise that theEuro zone is in a recession; and the ECB is considering more stimulus at a time

 when the Fed is considering less. It is believed that Greece,Portugal and Spain

shall require more bailout packages .If the data shows a deeper contraction inEurope and Mr. Draghi ( head of ECB) reminds investors that the Central bankis watching the economic data carefully to see if additional action is necessary,the EUR/USD could extend its losses.

• Owing to the uncertainty prevailing in Europe and the slump in theinternational markets, investors prefer to stay away from risky investments. Thecredit rating agency's downgrade of India to BBB- with a negative outlook — the last of the investment grade — has not helped its cause. Any outward flowof currency or a decrease in investments will put a downward pressure on therupee exchange rate. This global uncertainty has adversely impacted the

domestic factors and could lead to a further depreciation of the rupee

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3. Current Account Deficit

•  Current account deficit means that the amount received from abroad is less

than the amount sent abroad. It includes imports , exports as well remittanceetc.

•   A large part of the import bill is driven by other resources as well. The facts

show that fertilizer imports surged by 30% in the last two years and coalimports have doubled. Also, India remained a huge importer of Gold beforethese stringent measures were taken. We also import 70% of our crude oil froabroad and hence need USD to trade. We are a huge importer and hence, witincrease in the deficit the effect on the currency is much higher : the problem

of CAD continues to persist.

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• The Indian economy needs to debug its structural reforms and the gapbetween the imports and exports.

•

 With the reduction in exports and an increase in imports, on one side thecurrent account deficit has increased while on the other, the fiscal deficit isalso expected to be above the comfort levels due to increased subsidy. Aslowdown in the global economy has adversely reduced the demand forIndian goods. The Eurozone, which is a major trading partner for India, isalso suffering from a crisis which impacts our exports .The falling

commodity prices on the other hand have increased imports resulting in animbalance between payments and receipts. India needed about 80 BillionUSD last year to fund it’s CAD, and the dependence on this external moneymakes so vulnerable.

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4.High Inflation

• India has experienced high inflation, above 8%, for almost two years. Ifinflation becomes a prolonged one, it leads to overall worsening of economicprospects and capital outflows and eventual depreciation of the currency.

•

The Real Effective Exchange Rate (REER) index (6 currencies- Euro, Yen,Pound Sterling, US Dollar, Hong Kong Dollar and Renminbi) has fallen by13.84% during the last one year while the nominal rate has depreciated by24%. REER index measure includes the level of inflation differences acrossnations; 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 outmainly 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.

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5.Policy Paralysis

•  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 ( Vodafonecase)

•  Attempts are being made to control the subsidy bills but fiscal deficitcontinues to hover around 5% of GDP. The government announced FDI inretail but had to hold back amidst huge furor from both opposition andallies. This has further made investors sentiment negative over the Indian

economy

•  Due to corruption and red tapeism, infrastructural projects worth severallacks of Crores are still in the pipeline, waiting for approval. The

government also hesitates to take stringent economic actions as they donot want to upset their vote banks in the pre election year.

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6. War in Syria

• The recent fall in the rupee has been largely attributed to the sell off in all

emerging market currencies, due to the concern that the US may resort tomilitary action in Syria, according to Reuters.

• The Indonesian rupiah hit a fresh four-year low on corporate dollar demand.The Malaysian ringgit touched its lowest in more than three years on selling byforeigners, while the Thai baht hit a three-year low on capital outf lows. The

Philippine peso fell to its weakest in more than two and a half years as localstocks plunged.

• If there is war, investors flock to safer havens, and there is no asset safer thanthe US Dollar. Hence, demand for the US Dollar will increase and the buying

pressure will raise the price

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7. Food Security Bill

•

 Another reason for the rupee’s decline is the passage of Food Security Bill in theLok Sabha.

• The cost of the implementation of the bill has been put at around Rs 1.3 lakhcrore annually.

• There are fears that the bill may adversely impact the government’s ability to reinin the fiscal deficit at targeted 4.8 percent of GDP for this year. Finance MinisterChidambaram’s assertion the execution of the scheme will not breach the red lineon the deficit did little to calm the forex market. An increased deficit putspressure on the government

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8. Speculation

 A lot of fluctuations in the INR were because of the increased volatility

in the market which is caused by excessive speculation. Due to asummation of the above stated reasons, hedge funds/traders believedthat the INR will further weaken. Hence they started selling INR in themarkets to capitalize on the downside later on. Due to an excess ofbuying pressure on the USD/Selling pressure on the INR,the INR felldown even further .

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