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Depreciating Rupee - Causes, Impacts and Actions

Written by Siddharth P, Vinod V, IIM Rohtak Tuesday, 31 July 2012 12:14

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.

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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. the same doesn’t apply for India. Persistent inflation: India has experienced high inflation. Hongkong Dollar and Renminbi) has fallen by 13. This further affects the capital account flows of India and puts a depreciating pressure on the currency. The Real Effective Exchange Rate (REER) index (6 currencies. India needs dollars to finance its current account deficit. thus a depreciating currency makes its exports cheaper in the International market. In 2008 India had a net outflow of $14billion of FIIs and INR depreciated from 39 level to 52 against dollar. above 8%. mainly because of increasing demand of oil. A volatile currency is never good for a foreign investor as it increases the transaction risk. it does not leave that option open. Institutional investors investing in India are directly impacted by the global market uncertainty. Thus India continues to see current account deficit of around 4.Causes. This has significantly impacted Indian exports because of reduced demand. IIM Rohtak Tuesday. Thus the relation becomes a vicious cycle. depleting the forex reserve and thus depreciating INR. it reflects a country's competitiveness in international trade. US Dollar. Lack of reforms: Key policy reforms like Direct Tax Code (DTC) and Goods and Service Tax 2/5 . 31 July 2012 12:14 Current Account Deficit: While a country like China will be more than happy with a depreciating currency. India on the other hand does not enjoy this luxury. China exports more than it imports.84% during the last one year while the nominal rate has depreciated by 24%. 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. Capital Account flows: Deficit countries need capital flows and surplus countries generate capital outflows. REER index measure includes the level of inflation differences across nations. Vinod V. 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. which constitutes a major portion of its import basket.3%.Depreciating Rupee .Euro. Yen. 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. If inflation becomes a prolonged one. Under normal circumstances inflation is tamed by increasing interest rates. Impacts and Actions Written by Siddharth P. as it may lead to further slowdown in growth. Pound Sterling. but since India already has high interest rates. one of the major trading partners of India is under severe economic crisis. for almost two years. Under such conditions foreign investors tend to stay away from investing. in turn making China more competitive. thereby further magnifying the volatility. it leads to overall worsening of economic prospects and capital outflows and eventual depreciation of the currency.

A retrospective tax law (GAAR) has already earned a lot of flak from the business community.Causes. It can invite long term FDI debt funds in infrastructure sector.Easing Capital Controls: RBI can take steps to increase the supply of foreign currency by expanding market participation to support Rupee. Make Investments Attractive. But India’s interest rates are already higher than most countries. IIM Rohtak Tuesday. c. the appropriate policy response is to find a balance. Vinod V. Attempts are being made to control the subsidy bills but fiscal deficit continues to hover around 5% of GDP. 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. The ceiling for External Commercial 3/5 . Recent data shows that RBI had indeed intervened by selling forex reserves selectively to support Rupee. This was done to tame inflationary expectations. Source:RBI b. 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. 31 July 2012 12:14 (GST) have been in the pipe line for years.Depreciating Rupee . So further raising interest rates would lead to lower growth levels. The government announced FDI in retail but had to hold back amidst huge furore from both opposition and allies. Raising Interest Rates: The rationale is to prevent sudden capital outflows and ultimately lead to higher capital inflows. And not using reserves to prevent currency depreciation poses the risk that the exchange rate will spiral out of control. Impacts and Actions Written by Siddharth P. This has further made investors sentiment negative over the Indian economy. RBI can increase the FII limit on investment in government and corporate debt instruments. Since both outcomes are undesirable. The rope that can pull INR out- 1.

4/5 . Not everyone can be blamed for poor monetary policy or ineffective governance. IIM Rohtak Tuesday. FDI in aviation and retail. indicating its desire to sustain external inflows. Vinod V. The measure to increase External Commercial Borrowings (ECB) to $10bn will help in borrowing in dollar at a less cost. Source:www. 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 also tells us that it is the global factor that is primarily responsible for India's economy running into rough weather not coalition politics. 2. It explains why China's growth has decelerated so acutely and also India's. It may take similar steps to encourage FDI as well. lack of leadership. Direct Tax Code (DTC). 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.com Above data shows that INR is not the only currency depreciating. Key policy reforms that should be initiated includes rolling of Goods and Services Tax (GST). Measures by Government: Government should take some measures to bring FDI and create a healthy environment for economic growth.x-rates.Depreciating Rupee . corruption. Impacts and Actions Written by Siddharth P. helping sustain external funding. assembly elections or any of the things we have been hearing about. The government took steps recently to loosen rules for portfolio investment in the Indian market. Companies Bill and diesel decontrol. Except for China almost every developing country has shown a deprecating pressure on their currency. 31 July 2012 12:14 Borrowings can be enhanced to allow more ECB borrowings.Causes.

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