Rupee Movement since 1991

If we look at India’s Balance of Payments since 1970-71, we see that external account mostly balances in 1970s. Infact in second half of 1970s there is a current account surplus. This was a period of import substitution strategy and India followed a closed economy model. In 1980s, current account deficits start to rise culminating into a BoP crisis in 1991. It was in the 1991 Union Budget where Indian Rupee was devalued and the government also opened up the economy. This was followed by several reforms liberalizing the economy and exchange rate regime shifted from fixed to managed floating one. Hence, we need to analyse the current account and rupee movement from 1991 onwards. India has always had current account deficit barring initial years in 2000s (Figure 1). The deficit has been financed by capital flows and mostly capital flows have been higher than current account deficit resulting in balance of payments surplus. The surplus has in turn led to rise in forex reserves from USD 5.8 bn in 1990-91 to USD 304.8 bn by 2010-11 (Figure 2). In 1990-91, gold contributed around 60% of forex reserves and forex currency assets were around 38%. This percentage has changed to 1.5% and 90% respectively by 2010-11.

What is even more stunning to note is the changes in BoP post 2005 (Table 1). In 1990s, Balance of Payments surplus is just about $4.1 bn and increases to $22 bn in 2000s. However if we divided the 2000s period into 2000-05 and 2005-11, we see a sharp rise in both current account deficit and capital account surplus. The rise in Forex reserves is also mainly seen in 2005-11.

Based on this, if we look at Rupee movement, we broadly see it has depreciated since 1991. Figure 3 looks at the Rupee movement against the major currencies. 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. RBI releases REER for 6 currency and 36 currency trade baskets since 1993-94 and we see that the currency did depreciate in the 1990s but has appreciated post 2005. It depreciated following Lehman crisis but has again appreciated in 2010-11.

Table 2 summarizes the findings of Balance of Payments and Rupee movement. In the 1990s, Rupee depreciates against its major trading currencies as the average REER is less than 100. However, in 2000s we see Rupee appreciating against major trading currencies. If we divide the 2000s period further to 2000-05 and 2005-11, we see there is depreciation in the first phase and large appreciation in the second half of the decade.

Hence, overall we see the Rupee following the path economic theories highlighted above have suggested. 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 majorly. Without services exports, current account deficit would have been much higher. There was a blip during South East Asian crisis when current account deficit increased from $4.6 bn 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. However, given the scale of the crisis the depreciation pressure on Rupee was much lesser. There was active monetary management by RBI during the period. Similar measures have been taken by RBI in current phase of Rupee depreciation as well. 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. The capital inflow composition also changed where external financing dominated in early 1990s and now most of the capital inflows came via foreign investment. Within foreign investment, share of portfolio flows was much higher. As capital inflows were higher than the current account deficit Rupee appreciated against major currencies.

Other factors also led to appreciation of the rupee. First, India entered a favorable growth phase registering growth rates of 9% and above since 2003. This surprised investors as few had imagined India could grow at that rate consistently. The high growth led to surge in capital inflows mainly in portfolio inflows. Second, India’s 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. It is important to understand that at that time investors did not feel inflation will remain persistent and thought it to be a transitory issue and could be tackled by monetary policy. During Lehman crisis capital flows shrunk sharply from a high of $107 bn in 2007-08 to just $7.8 bn in 2008-09 and led to sharp depreciation of the currency. Rupee plunged from around Rs 39 per $ to Rs. 50 per $. REER moved from 112.76 in 2007-08 to 102.97 in 200809 depreciating sharply by 9.3%. 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. 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. The higher capital inflows were on account of both FDI and FII. 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%.

The Indian Rupee has depreciated significantly against the US Dollar marking a new risk for Indian economy. Till the beginning of the financial year (Apr 11-Mar 12) very few had expected Rupee to depreciate with most hinting towards either appreciation or status quo in the rupee levels. Those few who had even anticipated may not have imagined the scale of depreciation with rupee touching a new low of around Rs 57 to the US Dollar. What is even more interesting to note is that when other countries are trying to play currency wars and trying to keep their currencies devalued, India is trying to prevent depreciation of the currency I. 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: Balance of Payments: It is the sum of current account and capital account of a country and is an external account of a country with other countries. Both current account and capital account play a role in determining the movement of the currency:  Current Account Surplus/Deficit: 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.  Capital Account flows: 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 when capital inflows are not enough, there will be depreciating pressure on the currency.

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.

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. 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 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. 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.

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 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. (To learn more, see Cost-Push Inflation Versus Demand-Pull Inflation.) 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 make up 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. 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. Sponsored - 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 (as determined by Moody's or Standard & Poor's, for example) 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.

Depreciation of Rupee: 2011-12
Before we analyse the factors for the recent depreciation of the rupee, let us look at the survey of professional forecasters released by RBI. Current account deficit is more or less same buy consensus expects capital inflows in 2010-11 to be lower in each succeeding quarter. This leads to lower BoP estimate. However, the forecasters maintain their forecast for Rupee/Dollar unchanged. This is surprising as with lower capital inflows, markets should have expected some depreciating pressure on Rupee as well. BoP surplus of $10.3 bn would have been lowest (barring 2008-09) figure since 2000-01. The lowest figure for INR/USD is 47.1 in Q3 10-11, 46 in Q4 10-11 and 45.6 in Q1 10-11. It is safe to say most of the participants missed the estimate by a wide mark. It was a complete surprise for most analysts. Table 3: Forecasts for 2011-12 (median values)

Even the Q1 11-12 numbers did not really sound an alarm (Table 4). The current account deficit was at $14.2 bn and capital account was at $19.6 bn leading to a BoP surplus of $5.4 bn. BoP surplus in Q4 2010-11 was $ 2bn. More importantly, capital inflows had risen from $7.4 bn in Q4 2010-11 to $ 19.6 bn in Q1 2011-12 on account of foreign investment (both FDI and FII). The problems start to surface from Q2 11-12 onwards. In Table 4, we have put some of the data released by RBI and Commerce Ministry for the period post Q1 11-12. As we can see, current account deficits is likely to be higher but capital inflows especially FII inflows are going to be much lower. Compared to EAC projections, current account deficit is likely to be higher and capital account lower leading to either a negligible BoP surplus or BoP deficit.

Apart from difficulty in capital inflows, Indian economy prospects have declined sharply. Just at the beginning of the year, forecasts for India’s growth for 2011-12 were around 8-8.5% and have been revised downwards to around 6.5%-7%. It has been a shocking turnaround of events for Indian economy. Both foreign and domestic investors have become jittery in the last few months because of following reasons: Persistent inflation: Inflation has remained around 9-10% for almost two years now. Even inflation after Dec-11 is expected to ease mainly because of base-effect. Qualitatively speaking, inflation still remains high with core inflation itself around 8% levels. It is important to recall that the episode of 2007-08 when despite high inflation and high interest rates, capital inflows were abundant. This was because markets believed this inflation is temporary. Even this time, investors felt the same as capital inflows resumed quickly as India recovered from the global crisis. However, as inflation remained persistent and became a more structural issue investors reversed their expectations on Indian economy. Persistent fiscal deficits: The fiscal deficits continue to remain high. The government projected a fiscal deficit target of 4.6% for 2011-12 but is likely to be much higher on account of higher subsidies. The markets questioned the fiscal deficit numbers just after the budget and projected the numbers could be much higher. This indeed has become the case. As highlighted above, persistent fiscal deficits play a role in shaping expectations over the currency rate as well.

Lack of reforms: There have been very few meaningful reforms in the last few years in Indian economy. Moreover, the policies seem to be getting increasingly populist. The government wanted to reverse this perception and announced FDI in retail but had to hold back amidst huge furor from both opposition and allies. This has further made investors negative over the Indian economy. As FII inflows are going to be difficult given the uncertain global conditions, the focus has to be on FDI. Continued Global uncertainty: This is an obvious point with global economy continuing to remain in a highly uncertain zone. This has led to pressure on most currencies against the US Dollar. All these reasons together have led to sharp depreciation of the rupee. The rupee has depreciated by nearly 20% against USD from Apr-11 to 20-Dec-11. In terms of 6 REER (AprNov) and 36 REER (Apr-Oct) Rupee has depreciated by 10.44% and 7.7% respectively. The later numbers of REER are likely to show higher depreciation as well. During Lehman crisis, the two indices had depreciated by 9.3% and 9.9% respectively.

Volatility in the exchange rate is increasingly being recognized as a concern for the Indian economy. After maintaining a range bound movement in Q1 FY12, the rupee has registered depreciation against the dollar since August 2011. The question being raised is whether this trend will be reversed or has volatility come to stay in this market? Between August 1, 2011 and November 23, 2011, the rupee has depreciated 18.28% (pointto-point basis).

Rupee Movement in FY12 so far In the first four months of FY12, the rupee had been stable, trading in the range of Rs 44-45 to a dollar. A depreciating trend in the rupee has been observed since the month of August. On October 21, 2011, the rupee crossed the Rs 50/$ mark for the first time this year, settling at Rs 52.10/$, as on November 23, 2011. During the same period, the rupee has depreciated 10.41% against the Euro, settling at Rs 70.07/Euro.

Looking forward, it may be gauged that market participants expect little reversal in this trend of rupee depreciation. Forward premium on the dollar is the cost of carry of the dollar for specified tenure which may also be interpreted as the expected movement in the exchange rate. Using the inter-bank forward premium for different tenure as an indicative measure of the rupee rate, we may infer that rupee depreciation may persist for a while. The one month forward premium on the dollar has especially registered a substantial jump of 454 bps between August and November (Table 1).

Causes of Depreciation Withdrawal by FII’s 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 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 indecision. 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% for FY12. Consequently, FIIs have withdrawn funds from emerging markets and invested back in the dollar which has been strengthening. In November (so far) itself, FIIs have registered a net sales position to the tune of US $ 87 million. Strengthening of Dollar As these downbeat forces have played strong over the last few months, investor riskappetite 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-à-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% y-o-y), the trade account has deteriorated on unfavourable terms of trade. Current account deficit (CAD), in Q1 FY12 had widened by Rs 40,000 crore, over Q4 FY11. Furthermore on a 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.

Generic Impact of Rupee Depreciation
Three areas of concern that may be identified are higher import bills, fiscal slippage and increased burden on borrowers – 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 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, aluminium, iron and steel would have eased, the depreciating rupee would keep the price of imported commodities elevated. 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 programme in H2 FY12 by Rs 52,000 crore, to bridge the fiscal gap. 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. 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 jewellery. In case, imported raw material is used in these industries they would be adversely affected. Therefore, exports may not be able to leverage fully.

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:

A. 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.

B. 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.

C. 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.

D. 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. The next two sections of the study assess the impact of rupee depreciation on the:

1. Import Bill of the Country 2. Import of Key Commodities:  Crude Oil  Thermal Coal

I. Impact on Import Bill
• Table 1 looks at the import figures for India’s top ten import commodities. The import value for the month of December 2011 has been calculated using the rate of growth observed between the months April and August 2011.

• Table 2 tabulates the value of top ten import commodities in Rs. Crore thereby taking into account the exchange rate prevailing for the corresponding months.

• Table 3 has been tabulated based on the scenario that the exchange rates in August and December 2011 were same to the one prevalent in April 2011.

A scenario analysis based on the data from the various tables indicated above suggests that:

From the above table we can see that due to rupee depreciation import bills in the above two situations differ by Rs. 36039.8 crore. Observation: From Table 1 & 2 we can see that in case of Petroleum crude & products • Import bill of petroleum crude & product have declined in international currency in December as compared to April 2011. • However, in terms of domestic currency, the import has increased. Therefore the rupee depreciation has made import of these commodities expensive.

II. Impact of Exchange rate on Different Commodities
Impact of Rupee depreciation on Crude Oil
Crude Oil Fig: Crude Oil (in dollars) and Rupee Depreciation

Source: IMF

• Rupee was depreciating over the period of time. • Dollar price of Crude have declined while exchange rate was depreciating. • Due to depreciation of currency domestic price of crude oil became more costly.

A: Impact on Companies and Consumers
• A depreciating rupee makes import of Crude oil more expensive which directly leads to an increase in the operating expense of the companies. Thereby hitting their profit margins. • For the consumers, a constant rise in import prices of crude oil would mean an increase in petrol prices. Please refer to table below:

B: Impact on importers
• The global prices of Crude Oil in November 2011 were lower than that in April 2011. • However, the depreciation of rupee has meant that the importer has to pay an additional Rs. 489.8 bb to import the same quantity of Crude Oil. Please refer to table below:

From the above table we can see that the impact of rupee depreciation on the import bill of crude oil. • Import bill of crude oil increased by Rs. 5676.7 crore when exchange rate was varying during the respective month. • Import bill of crude oil decreased by Rs. 4405.9 crore when exchange rate was fixed during the respective month. • Import value in terms of international currency has declined in December as compared to April 2011. • However, in terms of domestic currency import costs of Crude oil have increased.

• The impact of rupee depreciation on Crude Oil imports suggests:
    Dollar price of Crude Oil have declined while exchange rate was depreciating. Due to depreciation of currency, domestic price of crude oil has become more costly. Expenditure on power and fuel for industry has increased. The importers have to pay an additional Rs. 489.8 per barrel to import the same quantity of Crude Oil.

Impact of Rupee Depreciation on Thermal Coal

• The prices of thermal coal in dollars term has been declining • The Indian Rupee has been depreciating • Import cost in terms of rupee has been rising • The benefit of falling commodity prices is not being transferred to the industry due to rupee depreciation

A. Power Generating Companies
A sharp decline in the value of the rupee is bound to affect the power generation capability of power plants that are heavily dependent upon imported coal for electricity generation. This would mean an increase in the level of energy deficit in the country. Moreover, a fall

witnessed in power generation capacity is likely to have an adverse affect on all the three sectors of the economy namely agriculture, industry and services. Another dimension to the rupee depreciation episode is that not only has the expenditure on imports increased but this coupled with an inflexible tariff structure means that the power companies are going to suffer huge losses.

B. Impact on importers
• The global prices of thermal coal in November 2011 were lower than that in May 2011. • Yet, the depreciation of rupee has meant that the importer has to pay an additional Rs. 684.6 per tonne to import the same quantity of coal. Please refer to table below:

C. Import Bill for Coal, coke & briquettes
• With the respective exchange rates for the months of April and December 2011, the increase in import bill for coal, coke & briquettes comes out to be Rs. 4443.4 crores. • Using April 2011’s exchange rate to calculate the import bill for April 2011 and December 2011, the increase in import bill for coal, coke & briquettes would have been Rs.2928.3 crore. • Due to rupee depreciation the import bills in the above two situation differ by Rs. 1515.1 crore. Please refer to table below:

• The impact of rupee depreciation on Thermal Coal imports suggests:  The benefit of falling commodity prices is not being transferred to the industry due to rupee depreciation.  Rupee depreciation coupled with an inflexible tariff structure means that the power companies will have to suffer huge losses.  The importer has to pay an additional Rs. 684.6 per tonne to import the same quantity of coal.

Outlook and Policy Measures
The above analysis shows that Rupee has depreciated amidst a mix of economic developments in India. Apart from lower capital inflows uncertainty over domestic economy has also made investors nervous over Indian economy which has further fuelled depreciation pressures. India was receiving capital inflows even amidst continued global uncertainty in 2009-11 as its domestic outlook was positive. With domestic outlook also turning negative, Rupee depreciation was a natural outcome. 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. Inflation was expected to decline from Dec-11 onwards but Rupee depreciation has played a spoilsport. Inflation may still decline (as there is huge base effect) but Rupee depreciation is likely to lower the scale of decline. The RBI has maintained strong foreign exchange reserves, to the tune of US $ 320 billion as at October-end (with foreign currency assets accounting for about 89% of these reserves). However, it has refrained from (and has neither indicated in near-future) direct intervention in the forex market to curtail the depreciation of the rupee until now. Assuming that global uncertainty continues to prevail, exports growth is maintained and capital outflows persist, it is expected that this depreciation would continue. A worsening in any of the above variable would aggravate rupee depreciation. Intervention by the RBI could maintain the rupee rate in its current range of Rs 50-52 to a dollar. In the event that the RBI maintains a non-intervention stance under uncertain euro conditions, the rupee moved in a volatile range of Rs 52- Rs 55 to a dollar. What are the policy options with RBI?

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 India’s case, this cannot be done as RBI has already tightened policy rates significantly since Mar-10 to tame inflationary expectations. Higher interest rates along with domestic and global factors have pushed growth levels much lower than expectations. In its Dec-11 monetary policy review, RBI mentioned that future monetary policy actions are likely to reverse the cycle responding to the risks to growth. India’s 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. Forex Reserves: RBI can sell forex reserves and buy Indian Rupees resulting in increase in demand for rupee. RBI Deputy Governor Dr. Subir Gokarn 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 selffulfilling 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 (Figure 8), 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.

Easing Capital Controls: Dr Gokarn in the same 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 RBI’s 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. 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.

Conclusion
Growing Indian economy has led to widening of current account deficit as imports of both oil and non-oil have risen. Despite dramatic rise in software exports, current account deficits have remained elevated. Apart from rising CAD, financing CAD has also been seen as a concern as most of these capital inflows are short-term in nature. PM’s Economic Advisory Council in particular has always mentioned this as a policy concern. Boosting exports and looking for more stable longer term foreign inflows have been suggested as ways to alleviate

concerns on current account deficit. The exports have risen but so have prices of crude oil leading to further widening of current account deficit. Efforts have been made to invite FDI but much more needs to be done especially after the holdback of retail FDI and recent criticisms of policy paralysis. Without a more stable source of capital inflows, Rupee is expected to remain highly volatile shifting gears from an appreciating currency outlook to depreciating reality in quick time.