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Making Sense Of The Fall Of The Rupee

22 August 2013 |08:57 |Ravishankar

What is happening to the Rupee? Where is the Rupee headed?

The last few weeks have seen an extraordinary drop in the value of the Rupee. Given the headlines, everyone is worried. Some of our investors have asked us to explain whats happening. In this article we try to give you a clear picture of why the Rupee has been so weak, the reasons behind the fall, possible direction of the Rupee and the data to watch out for.

What determines the dollar value of the rupee?

The currency markets is primarily driven by demand and supply for the currency. In order to understand the movement of the currency market, one needs to understand the factors affecting demand & supply.

The demand for the Rupee is driven by two sources:

A. Current Account or Trade (broadly speaking) B. Capital account or investments

Current Account: India as a country is a trade deficit country. This means that we buy more physical goods from foreign countries than we sell to them. On the other hand, we export a lot of services (IT/BPO) as well as receive money from NRIs. This is called invisibles.

The two together make up what is called Current Account Deficit.

Current Account Deficit (CAD) = Trade deficit Invisibles = Imports Exports Invisibles

Current account deficit leads to demand for more dollars and therefore a weakening of the Rupee.

Capital Account: There are broadly three ways in which foreigners invest in India

1. FII Equity: The money invested in Indian stocks through the markets 2. FDI (Foreign Direct Investment): The money invested directly into companies 3. FII / Foreign Debt, including ECB, etc.: Money borrowed by Indian entities

Investments into India or what is called Capital Account surplus leads to demand for more rupees and therefore a strengthening of the Rupee.

The value of the Rupee remains stable when the demand for rupees and demand for dollars remains balanced. For this to happen, the current account deficit must be matched by capital account surplus. If the demand for dollars is more, Rupee will fall. If demand for Rupee is more, dollar will fall.

This is what has happened over the last few years. The Rupee has depreciated gradually on account of the small ($1 billion or so, see next section) shortfall not made up for by capital flows. There were years where despite the current account deficit, the Rupee strengthened driven by capital inflows.

Lets talk numbers If you do not have an appetite for a large dose of numbers, you can skip the tables you should still understand the logic.

Our CAD is currently at about $78 billion, which the government expects to decrease to about $ 70 billion this year. This translates to about $6 billion of CAD per month. Or in other words $6 billion is flowing out of India every month. Note that this has increased from about $3.3 billion per month ($38 billion for the year) in 2010. Current Account Balance ($ billion) 1. Exports 2. Imports 3. Trade Balance (1-2) 4. Net Invisibles 5. Current Account (3-4) 2012 309.8 499.5 (189.8) 111.6 (78.2) 2011 256.2 383.5 (127.3) 79.3 (48.1) 2010 182.4 300.6 (118.2) 80.0 (38.2) 2009 189.0 308.5 (119.5) 91.6 (27.9)

In the past, of the required $ 6 billion per month to match this, about $ 3.8-4 billion per month of steady capital inflows have come from FII Equity and FDI. The balance came from debt. The following table shows the inflows since January 2012.

Capital Inflows ($ billion) January 2012 February 2012 March 2012 April 2012 May 2012 June 2012 July 2012 August 2012 September 2012 FII-Equity 2.0 5.1 1.7 (0.2) (0.1) (0.1) 1.9 1.9 3.6 FDI 3.0 2.2 1.6 1.9 1.3 1.2 1.5 2.3 4.7 Debt 3.0 2.0 (1.3) (0.7) 0.7 0.3 0.6 0.1 0.1

October 2012 November 2012 December 2012 January 2013 February 2013 March 2013 April 2013 May 2013 June 2013 July 2013 Average *=FDI data is published 2 months late

2.2 1.7 4.6 4.1 4.6 1.7 1.0 4.0 (1.9) (1.0) 1.9

1.9 1.1 1.1 2.2 1.8 1.5 2.3 1.6 * * 1.9

1.5 0.1 0.3 0.6 0.7 1.1 1.0 1.1 (5.7) (2.0) 0.2

So what happened now to cause this fall?

What triggered the steep fall in the Rupee since the middle of May 2013 is a sudden departure of FII Debt money. Look at the debt column in the table Capital Inflows for June and July 2013. Almost $10 billion of debt was suddenly pulled out of India accompanied by $2.9 billion of FIIEquity. This led to a sudden demand for dollars and the rupee collapsed. Since May 22, when the INR-USD was 55.6, the Rupee has depreciated to 64.5 today a sudden depreciation of 16%.

Why was the FII Debt suddenly pulled out?

For that we need to understand the background of how this debt money came into India. As of April 2013, the total FII Debt market investment was about $ 32 billion, a good part of which, we understand from anecdotal sources, was hot money. What is hot money? This is essentially an investor who borrows money in USD at very low rates, invests money in India at high rates and hedges the currency risk. This is an arbitrage trade, which holds good as long as his borrowing rate holds. When the US started to make announcements on reversing its regime of low interest rates, the US 10 year bond yields went up from 1.5% to 2.6%. In other words, this investor could no longer borrow money cheap and the hot money trade became unprofitable. The result was a sudden rush of money out of India (and other markets around the world).

Whats next for the rupee?

It is our hypothesis that the sharp fall in the Rupee was more due to the sudden rush of $10 billion of FII Debt outflow, rather than Indias inability to bridge the CAD. Once this outflow stops, we should see the Rupee stabilize.

The good news is, of the total of $ 32 billion of FII Debt money (as of April 2013), about $ 10 billion has already gone out. We are not sure how much of the remaining $22 billion is hot money, a guestimate is that about 50-60% of the $32 billion was hot money so a possibility of another $6-8 billion leaving exists. With luck it would be less. The outflow of FII Debt money should, therefore, slow down in the coming days, though we need to watch this closely. FII Equity flow has turned positive in August, or at least the negative flows have ebbed.

What can be done to stabilise the situation?

As we demonstrated above, the gap in demand for dollars (assuming FII/FDI flows remain constant) is only about $2 billion per month. This can be met in two ways:

1. Export pickup: The best way to reduce the CAD is for exports to pick up. With the Rupee weakening, exports become competitive (if we were selling something for 1$ or Rs 55, its now only 87 cents so hopefully foreigners will buy more of it). We should therefore see exports pick up over time and result in reduced CAD. We have started to see early signs of a pick-up in exports, but this process will take some time. Although some industries like garments are already projecting a 15-16% increase this year.

2. Equity Inflows (FII & FDI): Note that FIIs own close to $ 200 billion of equities, nearly 18% of Indian equities. This source of funds is committed to India for the long run. FDI money is also money invested by MNCs in India to build manufacturing plants and is a stable source of money. With a little bit more of liberalisation of investment norms and policy stability, a lot more FDI money is willing to invest in India.

3. Debt : Long term stable debt (not the kind that can disappear overnight) also remains a source of capital to bridge the deficit.

Can things go out of control?

One concern for the market has been the policy response to this problem, some of which seems to go against the principles of reforms. This could adversely impact investor sentiment and affect the equity flow. In an increasingly globalised world, where India has made its mark on the basis of it competence, liberalisation will have to be the way forward. We do believe policy response will be pro-liberalisation with time.


In simple terms, once FII Debt outflow reduces, the Rupee should find stability. Much of the hot money has already gone out and this trend cannot sustain for too long. The fundamental problem is not as big as the current sentiment makes it out to be. The gap between the CAD and Foreign inflows of less than $1 billion per month is small for a $ 1.7 trillion economy and can be fixed with the right policy action. Looking beyond the headlines helps.