Fall of the Rupee – Part II

Continuing from the last post, let’s see how the price of rupee is determined vis a vis dollar.

The market determines the price of a currency vis-à-vis another based on its demand and supply.  Some countries that permit exchange rate to be determined by the market do not impose any restriction on the amount of local currency to be exchanged for foreign currency. On the other hand, countries with a nonconvertible currency policy, fix the exchange rate by diktat. The Indian rupee is fully convertible on current account but there are restrictions on convertibility on capital account. This means that though foreign exchange for trade in goods and services is determined on the basis of market demand and supply, but the government has put in some restrictions on flow of different forms of capital in & out of the country.

Some of the probable causes of the rupee’s depreciation against dollar are - 

Deficits in the trade of goods and services - India reported a trade deficit equivalent to $196 billion in October 2011 as compared with $104.4 billion in March 2011. The widening trade deficit poses downside risks to the weak Indian currency. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation's economy and impact the value of currency. The decrease in growth of exports coupled with the increase in imports has contributed to a widening deficit in trade of goods and services.

Fiscal deficits - India has been running large fiscal deficits due to dwindling growth in tax revenues, rising subsidy bill and the government’s failure to raise funds through stake sale in state-run firms. The market usually reacts negatively to widening government budget deficits the impact is reflected in the fall in the value of rupee.

Capital flight - The government has attributed the depreciation in rupee to the withdrawal of funds from India by the Foreign Institutional Investors. A number of scandals, governance deficit, policy delays and slowdown of growth in India, have seen FII’s pull funds from India.

RBI has taken short term steps to stabilize rupee by reducing banks' forex trading limits and curbing speculative activity resulting from exporters cancelling their earlier contracts and rebooking exports to take advantage of sliding rupee, thereby fuelling depreciation. To increase the supply of dollars, RBI may announce a scheme for overseas Indians to bring in their funds, or offer higher returns to NRI’s. RBI may also sell dollars to oil management companies to prevent spikes in demand for $ due to large imports. But there are limitations in selling dollars from capital reserves as India's foreign exchange reserves are mainly created by purchase of dollars bought in by FIIs and may be needed if FIIs choose to exit.

While RBI might not introduce capital controls to prevent outflow of dollars from the country, as it is against India’s policy of moving towards full capital convertibility, but RBI may ease rates in future to bring in liquidity. This will boost the equity market & money will flow into the country as growth picks up. 

Related articles

• CHART OF THE DAY: The Indian Rupee Is Getting Absolutely Brutalized (businessinsider.com)
• Fall Of Rupee
• Currency crisis in the Emerging Markets 

Fall of the Rupee

The Indian rupee continues with its free fall against dollar having fallen up to 18% in Dec 2011 from its year’s high in July 2011. Rupee has been Asia’s worst performing currency this year.

The depreciation of rupee against dollar means that now it takes more rupees to buy a dollar; thus indicative of an increase in the demand of dollar. In absence of sufficient dollars to cater to the increased demand, there is supply-demand mismatch which causes the price of a dollar to rise against the Indian Rupee.

The impact of a depreciating currency varies across businesses. Export oriented industries such as IT services which earn revenues in $ and incur costs majorly in rupee gain from the fall in rupee. In contrast, the import oriented industries such as Oil Management Companies which import crude are negatively impacted due to fall in rupee as they end up paying much higher for the imports. Furthermore the Indian companies that have raised debts in foreign currency will have increased burden to service interest payments.

One way of reducing such losses is to hedge against currency movements. But since it is very difficult to forecast exchange rate, the risk due to sharp changes in currency rates are not completely mitigated . How much a company hedges and at what rates, is therefore based more on the risk appetite of a company rather than on the accuracy of forecasts.  Among the top 3 Indian IT firms, Infosys, is the biggest beneficiary of the current depreciation given that its hedging for $ receivables is lower than that of TCS & Wipro.

None the less, the sudden movement in exchange rates is discomforting for business as well as government. It becomes difficult for the government to meet its targets of fiscal deficit.

Left on the markets and the economy, exchange rate adjusts on its own and again settles to a value such that there is no arbitrage. Till the rate settles, changes in exchange rate will have large implications on the domestic prices, company’s profitability and government finances. But sometimes, these movements can be very steep and a sharp incessant fall can destabilise the economy and put government under pressure to intervene. Which is when, the Reserve Bank of India, central bank to the Government of India takes rescue measures by selling or buying dollars or other open market operations to improve dollar supplies and ease the fall of rupee.

Related articles

• CHART OF THE DAY: The Indian Rupee Is Getting Absolutely Brutalized (businessinsider.com)
• Fall Of Rupee - Part II
• Currency crisis in the Emerging Markets