Depreciation of Rupee
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.
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