Depreciation of Rupee

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The value of rupee has been depreciated to unprecedented levels in last few months. Media reports, economists and scholars are all involved in tracing the causative factors behind it and to suggest remedies. This article is an attempt to throw the light on the concept of depreciation of a currency and to simplify the issues related to it.

Understanding depreciation

For clearly understanding the issue, let’s replace rupee with eggs. Today, one US dollar can buy 55 eggs. Next week 1 US dollar can buy 65 eggs. It means that eggs have depreciated in value. The same is true for the rupee. When one US dollar can buy 55 rupees today and 65 rupees next week, it means that the value of the rupee has depreciated.

Exchange Rate Mechanism

To understand the fundamentals behind the currency appreciation or depreciation, it is important to understand the exchange rate mechanism.  An exchange rate is simply the cost of one currency in another currency.

All economies that interact in international markets can be broadly classified into three categories on the basis of exchange rate policy of the country.

1. Fixed Exchange Rate: These economies peg (benchmark) the value of their currency with some other prominent currency like US dollar. This system is simple and provides stability to the economy (of course, if the economy of the country to whose currency its currency is pegged is stable). This type of exchange rate regime is maintained by generally smaller economies like Nepal and Bhutan (pegged to Indian Rupee) or several African nations. Rational behind such regime is that in case of small economy – if the exchange rate is market determined – the sudden influx or out flux of even relatively small amount of foreign capital will have large impact on exchange rate and cause instability to its economy.

2. Floating (or free) Exchange Rate: Bigger and developed economies like US, UK, Japan etc generally let market determine their exchange rate. In such economy exchange rate is determined by demand and supply of the currency.

3. Hybrid system: Most midsized economy like India practices a mix of both these regimes. It allows for the exchange rate to float in a range which it deems comfortable. Once the market determined rate tries to breach this range, central bank (government) intervenes in the currency market and controls the exchange rate.

Currency and elementary law of demand and supply

Like any commodity or service the value of a currency depends majorly upon its demand and supply in the international markets. If the demand for a particular foreign currency is more than its supply in a country the foreign currency appreciates vis-à-vis the domestic currency. The same logic holds well in the case of its depreciation, wherein the supply exceeds the demand.

In the present context related to Indian economy rupee depre­ci­a­tion means that rupee has become less valu­able with respect to dol­lar. This in very simple terms means that in India, the demand of US Dollar is more than its supply.

For example if an Indian company (say XYZ) wanted to buy the laptops from a store located in America. The XYZ Company has to essentially pay the amount in US Dollars. However being an Indian company they have Rupees with them. To facilitate this transaction the Indian Company has to first buy US Dollars from the international market or from a financial institution. As a result of buying US Dollars and paying it to the store in US, the supply of equivalent amount of US Dollars in international market will be reduced. Also at the same time due to this transaction the supply of Indian Rupee will be increased by the equivalent amount in the international market.

 In nut shell any economic activity in the international market which leads to inflow of the US Dollar in the country like earnings from exports, remittances of NRIs, inflow of foreign direct investment (FDI) and foreign institutional investments (FIIs) etc result in the enhancement of supply of US Dollar in the country. On the other hand payments for imports, domestic investors investing abroad, outflow of FIIs etc leads to enhancement of demand of US Dollar.

The investment in a country (FDI and FII’s) substantially influence the demand and supply of US Dollar, the factors which result in the inflow or outflow of the foreign investments also play critical role in appreciation or depreciation domestic currency. As a matter of fact the investors would like to invest in only those ventures and countries where the risk to the capital is minimum and the chances of lucrative returns on their investment is maximum. Therefore in this context macroeconomic indicators like GDP growth rate of the economy, Fiscal Deficit and Current Account Deficit play a critical role as they reflect the overall growth of the economy. These macroeconomic indicators help the investors to predict the tentative returns on their investment. Likewise the investors also keep their eye on the credit rating of the countries in which they are keen to invest as credit rating is perceived to be linked with the risk.

Reasons for Rupee depreciation in the recent past

The causative factors for the depreciation of the Rupee vis-à-vis US Dollar are complexly interwoven in the domestic policies and global economic scenario.  The following are the important reasons for the depreciation

Widening Current Account Deficit

A country's current account consists of its visible (exports and imports of goods) and invisible trade — income and expenditure from export and import of services such as banking and insurance, and profits earned on investments and remittances by workers.

India runs a large trade deficit; that is, its imports exceed exports. Some of this trade deficit is covered by the surplus on the invisibles side -- largely IT exports and remittances by Indian workers overseas --leaving India with a net deficit on the current account. This Current Account Deficit in layman’s parlance means that every year we spend more US Dollar then we earn.

Meltdown in Europe

The grim global economic outlook, essentially due to the European debt crisis has resulted in the appreciation of US Dollar.  Due to turbulence in European markets, investors across the globe are considering US Dollars as stable and safe haven for their investments in the longer run. This led to an increased demand for dollars vis-à-vis the supply for rupee and thus the depreciation.

An important question that arises here is that if investors are disinvesting from Europe and looking for other destinations, why do they not prefer India? The answer to this question in simple words is perceived unfavorable investment atmosphere in India because of critical macroeconomic indicators like sluggish growth rate in the recent past, high inflation rate, ballooning Current Account Deficit etc.

Signs of end of fiscal stimulus by the US

In order to mitigate the economic meltdown that reached its climax in US in 2007-08, the Federal Reserve of US (Fed) adhered to the fiscal stimulus. The Fed has pumped trillions of dollars of liquidity into the banking system over the past four and a half years. It has accomplished this by buying unprecedented amount and variety of securities. In the process, its balance sheet has ballooned from $900 billion to $3.1 trillion, and it is expected to expand further, to about $4 trillion, later this year.

As a result of this supply of US Dollars in international markets and banking systems increased tremendously. However off late the US economy has shown the signs of recovery. As a result the Fed is keen to stop the fiscal stimulus. The Fed has shown the signs to begin tightening monetary policy in order to prevent the exceptional level of liquidity in the banking system from feeding into inflation. This would reduce the supply of the US Dollar from the international market and banking system making US Dollar dearer and thus resulting in its further appreciation.

Volatile equity market

Our equity market has been volatile for some time now. So, the FII’s are in a dilemma whether to invest in India or not. Even though they have brought in record inflows to the country in this year, if they pull out, it will result in a decrease of inflow of dollars into the country. Therefore, the decrease in supply and increase in demand of dollars results in the weakening of the rupee against the dollar.

Overseas investors pulled out a record Rs 44,162 crore (over $7.5 billion) from the Indian capital market in June 2013. The widening current account deficit and the depreciating rupee are definitely cause for concern. A weaker rupee further erodes the returns earned by the foreign investors in the Indian market.

Role of speculation

The fall in rupee can be largely attributed to the speculations prevailing in the markets. Due to a sharp increase in the dollar rates, importers suddenly started gasping for dollars in order to hedge their position, which led to an increased demand for dollars. On the other hand exporters kept on holding their dollar reserves, speculating that the rupee will fall further in future. This interplay between the two forces further fuelled the demand for dollars while sequestering its supply from the market. This further led to the fall in rupee.