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Economics 2

Rupee trend in the exchange market

Date of submission 9th April, 2012 Abhinav Singh Negi 1864 National Law School of India University Bangalore

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Table of contents
1. Introduction . 3 2. Rupee since 1991................................. 5 3. Depreciation of Rupee: 2011- 2012.... 9 4. Intervention in the rupee exchange rate..... 13 5. Conclusion. 15 6. Bibliography. 17

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Introduction
As India becomes more open and increasingly integrated into the world economy, the rupees exchange rate is likely to play a very important role in defining the competitiveness of Indian goods and services in the international markets. Since 2003-4 the average monthly activity of the foreign exchange market has increased six folds with the average monthly turnover reaching US$ 1,016 billion in March 2010, which is about 8 times the monthly turnover at the National Stock Exchange and Bombay Stock Exchange for all cash, derivatives and debt instruments combined.1 Like the rest of the world, in India too, the foreign exchange constitutes the largest financial market by far.2 It has been growing at a really fast pace, faster than its worldwide growth rate. In 1998, rupee-related transactions accounted for 0.05% of the worlds currency transactions. 3 By 2010 the figure had risen to 0.45%.4 After 1991, the old and rigid exchange system was replaced with a less regulated, market driven arrangement. Even though the rupee is still not fully floating, the intensity of intervention and range of independence tolerated have undergone significant changes.5 With an abundance of foreign exchange reserves, imports are no longer viewed with fear and scepticism.6 The Reserve Bank of India and its allies have reduced the amount of intervention in the foreign exchange markets and they intervene sometimes not to support the rupee but often to avoid an appreciation in its value.7 Full convertibility of the rupee is in sight and might be a reality sooner than we think. The effects of these developments are palpable in the explosive growth in the foreign exchange market in India.8 Keeping in mind these developments, the study of the trend of rupee in the exchange market has become the area of interest of many economists not only in India but also worldwide and this is precisely what the project aims to do. Studying the changing trend of rupee in the exchange market is also important because changing rupee rates have a direct impact on the

T HE NEW OXFORD COMPANION TO ECONOMICS IN INDIA, Vol.1, 194 (Kaushik Basu, and Annemie Maertens eds., 5th edn., 2012). 2 Rajesh Chakrbarti, T HE FINANCIAL SECTOR IN INDIA: EMERGING ISSUES, 34 (1st edn., 2006). 3 Id. 4 Supra note 1. 5 Rajesh Charbarti, Supra note 2. 6 Rajesh Charbarti, Supra note 2. 7 Supra note 1, at 195. 8 Rajesh Chakrbarti, Supra note 2, at 35.

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people. Even if the fluctuations are small, its effects are felt. Just like a small ripple can create disturbances in a placid lake, a small change in the exchange rate of rupee can impact the economy. Since the exchange rates play an important role in a countrys level of trade, the exchange rates are among the most watched, analysed and governmentally manipulated economic measures.9 The project deals with the technical aspects about the rupee and the exchange market and adopts a descriptive approach in the initial part, later it focuses on the analysing the change in the rupees exchange rate and what factors contribute to this change. Then it focuses on the effects of these changes. In the final chapter, the researcher has discussed about the role that RBI plays by intervening in the exchange market.

Available at [Link] (last visited on April 9, 2012).

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Rupee since 1991

After taking a look at Indias Balance of Payments since 1970-71, one can see that external account mostly balances in 1970s.10 In fact, in the second half of 1970s there is a current account surplus.11 This was a period of import substitution strategy and India adhered to a closed economy model.12 In 1980s, current account deficits started to rise culminating in a BoP (Balance of Payment) crisis in 1991.13 After the Union Budget of 1991 the Indian Rupee was devalued and the India economy was opened up. Several reforms liberalizing the economy followed and the exchange rate regime underwent a transition from fixed to a managed floating one.14 Hence, the need arises to analyse the current account and rupee movement from1991 onwards. Table 1: Balance of Payments (in USD bn)15 Year 1990-00 2000-05 2005-2011 Current account -3.8 3.7 24.3 Capital account 7.9 14.7 49.3 BoP 4.1 18.4 25.0 Forex reserves 23.5 85.4 249.4

In 1990s, Balance of Payments surplus was just about $4.1 bn and increased to $22 bn in 2000s (taking the average of the two periods, i.e. 2000-05 and 2005-11). When the periods are divided into 2000-05 and 2005-11, we can see a sharp rise in both capital account surplus and current account deficit. 2005-11 also shows rise in the forex reserves. This rise in forex reserves was because of the huge inflow of FDIs and FIIs.

10

Deepak Nayyar, Indias Balance of Payments, Vol. 17 (14), ECONOMIC AND P OLITICAL WEEKLY, 641(April 1982). 11 Id. 12 Ashima Goyal, Rupee: Changing Trends, Vol. 39 (23), ECONOMIC AND P OLITICAL W EEKLY, 2335 (June 5, 2004). 13 Id. 14 Ashima Goyal, Supra note 12. 15 Anmol Agarwal, Rupee Depreciation: Probable Causes and Outlook, STCI REPORT (December 21, 2011).

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As India opened up its economy post 1991, Rupee depreciated as it had current account deficits. Earlier current account deficits were mainly on account of merchandise trade deficits. However, as services exports picked up it helped lower the pressure on current account deficit. Without services exports, current account deficit would have been much higher. Then there was a downfall during South East Asian crisis when current account deficit increased from $4.6bn to $5.5 bn in 1997-98. Capital inflows declined from $11.4 bn to $10.1 bn leading to a decline in BoP surplus and depreciation of the rupee. 16 However, given the scale of the crisis the depreciation pressure on Rupee was much lesser. This was due to active monetary management by RBI during the period (can be seen in table 3). Till around 2005, India received capital inflows just enough to balance the current account deficit. The situation changed after 2005 as India started receiving capital inflows much higher than current account deficit.17 This was because India entered a favourable growth phase registering growth rates of 9% and above since 2003 and it surprised investors as few had imagined India could grow at that rate consistently.18 The high growth led to increase investments by foreign investors and surge in capital inflows. The capital inflow composition also changed where external financing dominated in early 1990s and now most of the capital inflows came via foreign investment.19 As capital inflows were higher than the current account deficit, Rupee appreciated against major currencies. Indias inflation started rising around 2007 leading to RBI tightening policy rates. This led to higher interest rate differential between India and other countries leading to additional capital inflows as highlighted above.20 It is important to understand that at that time investors did not feel that inflation will remain persistent and thought it to be a transitory issue which could be tackled by monetary policy changes.21

16

Ross Garnaut, Exchange Rates in the East Asian Crisis, Vol. 15 (3), ASEAN E CONOMIC B ULLETIN, 328 (December 1998). 17 Nagesh Kumar, Liberalisation, FDI Flows and Development: An Indian Experience, Vol. 40 (14), ECONOMIC AND P OLITICAL W EEKLY (April 2, 2005). 18 A.V. Rajwade, The Fall of the Rupee: Background, Remedy and Policy, Vol. 67 (2), ECONOMIC AND P OLITICAL W EEKLY, 10 (January 14, 2012). 19 Id. 20 Rudrani Bhattacharya et al, Early Warnings of Inflation in India, ECONOMIC AND P OLITICAL W EEKLY, 62 (December 6, 2008). 21 Id.

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Table 3: RBI Sales/Purchases in the Forex Market ($mn)22 FY 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-1223 Purchase 24,077 28,203 22,822 30,635 55,414 31,398 15,239 26,824 79,696 26,563 4,010 2,450 0 Sales 20,828 25,847 15,759 14,926 24,941 10,551 7,096 0 1,493 61,485 6,645 760 1,788 Net 3,249 2,356 7,063 15,709 30,473 20,847 8,143 26,824 78,203 -34,922 -2,635 1,690 -1,788

But then, during Lehman crisis, capital flows shrunk sharply from a high of $107 bn in 200708 to just $7.8 bn in 2008-09 and led to sharp depreciation of the currency. 24 Rupee plunged from around Rs 39 per $ to Rs. 50 per $. Before this, there was a huge capital inflow and there was hardly any capital intervention by the RBI in 2007-08, which had led to a sharp rupee appreciation from Rs 43.20 per $ to Rs 39.65 per $.25

22 23

A.V. Rajwade, Supra note 18. Up to October. 24 Anmol Agarwal, Supra note 15. 25 As evident from table 3.

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A better way to understand the Rupee movement is to track the real effective exchange rate. Real effective exchange rate (REER) is based on basket of currencies against which a country trades and is adjusted for inflation. A rise in index means appreciation of the currency against the basket and a decline indicates depreciation. The importance of studying REERs is that it gives an accurate picture of the rupee rate by taking into consideration the performance of currencies of major trading partners and by accommodating for changes in inflation levels. RBI releases REER for 6 currency and 36 currency trade baskets since 1993-94.26 Table 2: Balance of Payments and REER27 Year 1990-00 2000-05 2005-11 BoP (in bn $) 4.1 18.4 25 6 REER 99.5 99.2 107.0 36 REER 98.5 99.8 101.2

REER moved from 112.76 in 2007-08 to 102.97 in 2008-09 depreciating sharply by 9.3%.28 The current account deficit also declined sharply as well tracking decline in oil prices from $ 12 bn in Jul-Sep 08 to $0.3 bn in Jan-Mar 09. The currency also depreciated tracking the global crisis which led to preference for dollar assets compared to other currency assets.29 Indian economy recovered much quicker and sharper from the global crisis. The capital inflows increased from $7.8 bn to $51.8 bn in 2009-10 and $57 bn in 2010-11.30 The higher capital inflows were on account of both FII and FDI. External Commercial Borrowings also picked up in 2010-11. The current account deficit also increased from $27.9 bn in 2008-09 to $44.2 bn in 2010-11. REER (6 currency) appreciated by 13% in 2010-11 and 36 REER by 7.7%.31

26 27

Ashima Goyal, Supra note 12. Ashima Goyal, Supra note 12. 28 Anmol Agarwal, Supra note 15. 29 Anmol Agarwal, Supra note 15. 30 Anmol Agarwal, Supra note 15. 31 Anmol Agarwal, Supra note 15.

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Depreciation of Rupee: 2011-2012

Average Rates (2011) January 45.3975 INR February 45.423 INR March 44.9699 INR April 44.3954 INR May 44.9377 INR June 44.8426 INR July 44.4151 INR August 45.365 INR September 47.6585 INR October 49.2856 INR November 50.7911 INR December 52.5228 INR Average Rates (2012) January 51.1976 INR February 49.1978 INR March 50.404 INR April 50.9916 INR (5 days average)32

32

Data from [Link] (last visited on April 10, 2012).

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value of 1$ in Rs
54 52 50 49.28 52.55 51.19 50.4

48
value of 1$ in Rs 46 44 42 40 2011 jan 2011 march 2011 june 2011 aug 2011 oct 2011 dec 2012 jan 2012 march 45.39 45.42 44.84 45.36 Linear (value of 1$ in Rs)

Form the above data it can be seen that the rupee has been depreciating with respect to the dollar, though there are some fluctuations which have temporarily caused it to appreciate, the overall trend is of depreciation. (As shown by the black line in the above graph). There is difficulty in capital inflow because the world economy itself is unstable at this time. Investments are on a decline as both foreign and domestic exporters have been doubtful about investments because of the following reasons: 1. Inflation: Inflation has remained at almost 9-10% in the past 2 years.33 It is important to recall that in 2007-2008, despite high inflation and high interest rates, capital inflows were abundant. This was because the investors at that time believed that the inflation was temporary. Capital inflows resumed quickly as India recovered from the global crisis. However, as inflation remained persistent and became more of a structural issue investors became reluctant to invest in the Indian economy.34 2. Current account deficits: Current account deficit occurs when a countrys total import exceeds the total exports. This makes the country a net debtor to the rest of the world. India has a high deficit; this indicates that we are trading more outside the country than what we are actually earning inside the country. This is not good for

33 34

Data available at [Link] (last visited on April 10, 2012). A.V. Rajwade, Supra note 18.

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India because, the country needs to buy more foreign currency and a greater demand for the foreign currency has reduced the value of rupee in India.35 3. Growth Rates: Just at the beginning of the year, forecasts for Indias growth for 2011-12 were around 8-8.5% but that has now been revised downwards to around 6.5%-7%, further acting as a deterrent to investment.36 4. Corruption: In the last 2 years, we have seen lot of corruption cases. Anna Hazares campaign against corruption has grabbed the attention of the global media, which has affected investor sentiments globally.

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. The primary consequences of a weaker rupee due to depreciation have been felt in the following ways: 1. Increase in Import Bill: due to depreciation, Indian importers have to pay more money to import the same amount of goods and hence they incur losses. In the last year, the rupee cost of imports has increased by Rs 65999 crore.37 2. Higher Inflation: Increase in import prices of essential commodities like crude oil, chemicals, coal and other industrial raw materials leads to increase in the production cost of goods and hence causes an increase in prices. Thus consumers have to pay more money to buy the same amount of goods. Since prices increase, consumers tend to save more and consume less, it leads to a drop in demand and hence leads to unemployment which further leads to lower income and the cycle continues. 3. Increase in the governments fiscal burden: due to the increase in prices of essential commodities like oil, coal and fertilisers the government will have to grant subsidies to soften the impact of inflation and unemployment, this will lead to an increase in the fiscal burden of the government.

35

Mohit Kakade, Why Rupee is Depreciating, Unpublished, but available at [Link] (last visited on April 10, 2012). 36 A.V. Rajwade, Supra note 18. 37 Rupee Exchange Depreciation: Impact Analysis, ASSOCHAM India Report, January 2012, available at [Link] (last visited on April 4, 2012).

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4. Increase in cost of borrowings: Interest rate differentials in the global and domestic markets encourages the industry to borrow money from foreign markets 38, however if the rupee depreciates then the amount which will now have to be returned to the lenders will be much more than what had to be returned had there been no depreciation of the rupee.

38

Id.

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Intervention in the rupee exchange rate

Each person has a different perspective as to what the value of rupee should be. For example, the nationalists are of the view that the value of rupee should be strong irrespective of the costs of over evaluation. There always exists a scope of conflict because one mans gain can be at the cost of the other. The exporters gain from rupee depreciation at the cost of importers and the consumers. Large forex transactions, excessive inflows and the tendency of market participants to follow each other make the forex market unstable and volatile.39 The job of deciding what is the most utilitarian position is done by the RBI in India. It intervenes in the exchange market and tries to prevent the volatility in the exchange market and keeps a check on the appreciation as well as depreciation of the rupee. Which means that the Indian exchange rate is not a fully market determined floating rate but adheres to a managed float type exchange policy.40 The RBI uses a variety of techniques in intervening in the foreign exchange market. It can use an indirect method like issuing a press statement or a direct intervention measure in the form of monetary measures to affect the value of rupee.41 The RBI intervenes in the exchange market from time to time to ease the pressure. It simply does this by buying the dollars using rupees and this usually takes the pressure off.42 However this selling of rupees creates another problem. Since it sells rupees in lieu of dollars, the actual amount of flowing money in the economy increases and the pressure of inflation starts building up because now there is too much money chasing too few goods4344; the classic definition of inflation. To counter this, the RBI resorts to a tactic know as sterilisation. The RBI, as the name implies, sterilises the increase in flowing money.45 For example, if the prevailing exchange rate is 1 dollar = 50 rupees, the RBI sells Rs 5000 crore and receives $1 billion. Now to ensure that the Rs 5000 crore does not add to the money supply, it issues government bonds
39 40

Ashima Goyal, Supra note 12. Ashima Goyal, Supra note 12. 41 Supra note 1, at 196. 42 Supra note 1, at 196. 43 Mohit Kakade, Supra note 35. 44 James Duesennberry, The Mechanics of Inflation, Vol. 32 (2), T HE REVIEW OF ECONOMICS AND STATISTICS, 144 (May, 1950). 45 Soumya Kanti Ghosh, Monetary Policy, Sterilisation and Capital Mobility: Dilemmas of RBI, Vol. 39 (51), ECONOMIC AND P OLITICAL W EEKLY, 5365 (December 18, 2004).

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for exactly Rs 5000 crore and sucks the money out of circulation. As a result of this, the money supply remains the same as before.46 Like the nationalists many people have a misconception about the rupee and the exchange market. Many believe that more the value of rupee against the dollar, the better it is for us, because stronger the currency, the stronger the economic power. The appreciating rupee rate is no doubt beneficial for the consumers as well as the importers, but it is equally harmful for the exporters.47 If the rupee appreciates too much then the exporters are not able to offer exports at lower prices and other competitive nations like China will gain from this rupee appreciation. 48 For example, the software industry is a booming and important industry in India and if rupee appreciates too much then the demand for software exports will go down and the industry will suffer and the software companies of other countries will be able to capture a greater market share. Hence we have seen that neither too much appreciation nor too much depreciation of the rupee is good for a developing economy like India, this is why intervention by the RBI in the exchange market is so important.

46 47

Id. Ajit Ranade, and Gaurav Kapur, Appreciating Rupee: Changing Paradigm?, Vol. 38 (8), ECONOMIC AND P OLITICAL W EEKLY, 769 (February 22, 2003). 48 Id.

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Conclusion
Rupees exchange rate plays a very important role in defining the competitiveness of Indian goods and services in the international markets. Rupee was devalued and the India economy was opened up after the Union Budget of 1991. This was followed by several reforms aimed at liberalizing the economy and the exchange rate regime underwent a transition from fixed to a managed floating one. Post 1991, rupee depreciated as it had current account deficits, mainly because of merchandise trade deficits. However, as services exports picked up it helped lower the pressure on current account deficit. Following this, current account deficit increased during South East Asian crisis and capital inflows were reduced leading to a decline in BoP surplus and depreciation of the rupee. The situation improved from 2005 onwards when India started getting high capital inflows on account of the consistent growth rate it exhibited. Rupee had begun to gain value and by 2007 traded around Rs 39 to 1 US dollar , due to sustained foreign investment flows into the country. REER moved from 112.76 in 2007-08 to 102.97 in 2008-09. The current account deficit also declined sharply as well. The currency also depreciated tracking the global crisis which led to preference for dollar assets compared to other currency assets. After the global financial meltdown, the capital inflows started increasing from $7.8 bn to $51.8 bn in 2009-10 and $57 bn in 2010-11. The higher capital inflows were due to both FII and FDI.. The current account deficit also increased from $27.9 bn in 2008-09 to $44.2 bn in 2010-11. 6 REER appreciated by 13% in 2010-11 and 36 REER by 7.7%. In the recent times i.e. 2011-12, the rupee has been depreciating because is difficulty in capital inflow as the world economy is itself unstable at this time. Investments are on a decline as both foreign and domestic exporters have been doubtful about investments because of reasons like persistent inflation, high current account deficits and slow growth. This rupee depreciation has led to problems like increase in the governments import bill, higher inflation, increase in governments fiscal burdens and increased cost of borrowings. Though rupee depreciation may be troublesome for many of us, high rupee appreciation also has its own drawbacks. If the rupee appreciates too much then the exporters cant offer exports at lower prices and other competitive nations like China tend to gain from this rupee appreciation. Various IT and BPO firms tend to suffer losses due to appreciation as the bulk of their earnings come from outside the country.

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Therefore the need to intervene in the exchange market and keep the exchange rates in a somewhat fixed range arises. In India, this task is done by the RBI. It intervenes from time to time to ease off the pressure on the exchange market. Thus we see that the exchange rates play an important role in a countrys level of trade, both domestic and international. What the consumers spend and save is also based on the on-going trends in the exchange market as well as their predictions of the volatility or stability of the exchange market in the future. There is no doubt that the exchange rates are and will be among the most watched, analysed and governmentally manipulated economic measures.

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Bibliography
Books:
1. THE NEW OXFORD COMPANION TO ECONOMICS IN INDIA, Vol.1 (Kaushik Basu, and Annemie Maertens eds., 5th edn., 2012). 2. Rajesh Chakrbarti, THE FINANCIAL SECTOR IN INDIA: EMERGING ISSUES (1st edn., 2006).

Articles:
1. Anmol Agarwal, Rupee Depreciation: Probable Causes and Outlook, STCI REPORT (December 21, 2011). 2. Ashima Goyal, Rupee: Changing Trends, Vol. 39 (23), ECONOMIC AND POLITICAL WEEKLY (June 5, 2004). 3. Ashwini Deshpande, Exchange Rate Management: Myth and Reality, Vol. 31 (18), ECONOMIC AND POLITICAL WEEKLY (May 4, 1993). 4. Deepak Nayyar, India's Balance of Payments, Vol. 17 (14), ECONOMIC AND POLITICAL WEEKLY (April 1982). 5. Foreign exchange market, available at [Link] (last visited on April 10, 2012). 6. James Duesennberry, The Mechanics of Inflation, Vol. 32 (2), THE REVIEW OF ECONOMICS AND STATISTICS, (May, 1950). 7. Mohit Kakade, Why Rupee is Depreciating, Unpublished, but available at [Link] 8. M. Ramachandran, Resisting Rupee Appreciation, Vol. 43 (15), ECONOMIC AND POLITICAL WEEKLY (April 14, 2007). 9. Nagesh Kumar, Liberalisation, FDI Flows and Development: An Indian Experience, Vol. 40 (14), ECONOMIC AND POLITICAL WEEKLY (April 2, 2005). 10. Ross Garnaut, Exchange Rates in the East Asian Crisis, Vol. 15 (3), ASEAN ECONOMIC BULLETIN (December 1998). 11. Rudrani Bhattacharya et al, Early Warnings of Inflation in India, ECONOMIC AND POLITICAL WEEKLY (December 6, 2008).

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12. Rupee Exchange Depreciation: Impact Analysis, ASSOCHAM India Report, January 2012, available at [Link] (last visited on April 4, 2012). 13. Soumya Kanti Ghosh, Monetary Policy, Sterilisation and Capital Mobility: Dilemmas of RBI, Vol. 39 (51), ECONOMIC AND POLITICAL WEEKLY (December 18, 2004).

Online sources:
1. [Link] 2. [Link] 3. [Link] 4. [Link] 5. [Link]