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A PROJECT ON

DEPRECIATION OF RUPEE

IN THE SUBJECT

Economics of Global Trade & Finance

SUBMITTED BY

Soumeet D. Sarkar

A041

M.Com. Part-I

UNDER THE GUIDANCE OF

Prof. Jose Augustine

TO

UNIVERSITY OF MUMBAI

FOR

MASTER OF COMMERCE PROGRAMME (SEMESTER - II)

In

ADVANCE ACCOUNTANCY

YEAR: 2013-14

SVKM’S

NARSEE MONJEE COLLEGE OF COMMERCE &ECONOMICS

VILE PARLE (W), MUMBAI – 400056.

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EVALUATION CERTIFICATE

This is to certify that the undersigned have assessed and evaluated the

project on “ DEPRECIATION OF RUPEE ” submitted by Soumeet D.

Sarkar student of M.Com. – Part - I (Semester – II) in Advance Accountancy

for the academic year 2013-14. This project is original to the best of our

knowledge and has been accepted for Internal Assessment.

Name & Signature of Internal Examiner

Name & Signature of External Examiner

PRINCIPAL

Shri. Sunil B. Mantri

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DECLARATION BY THE STUDENT

I, Soumeet D. Sarkar student of M.Com.(Part – I) in Advance Accountancy, Roll

No.: A041, hereby declare that the project titled “DEPRECIATION OF

RUPEE” for the subject ECONOMICS OF GLOBAL TRADE & FINANCE

submitted by me for Semester – II of the academic year 2013-14, is based on

actual work carried out by me under the guidance and supervision of Prof.

Jose Augustine. I further state that this work is original and not submitted

anywhere else for any examination.

Place: Mumbai

Date:

Name & Signature of Student

Name : Soumeet D. Sarkar

Signature : _________________

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ACKNOWLEDGEMENT

This project was a great learning experience and I take this opportunity to

acknowledge all those who gave me their invaluable guidance and inspiration

provided to me during the course of this project by my guide.

I would like to thank Mr. Jose Augustine - Professor of Economics of Global

Trade & Finance (MCOM – Narsee Monjee College).

I would also thank the M.Com Department of Narsee Monjee College of

Commerce & Economics who gave me this opportunity to work on this project

which provided me with a lot of insight and knowledge of my current curriculum

and industry as well as practical knowledge.

I would also like to thank the library staff of Narsee Monjee College of

Commerce & Economics for equipping me with the books, journals and

magazines for this project.

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CONTENT

Sr. No. PARTICULARS Page No.

CHAPTER I – INTRODUCTION

1.1 INTRODUCTION to RUPEE 6

1.2 JOURNEY SINCE INDEPENDENCE 8

CHAPTER II – DEPRECIATION of RUPEE

2.1 EXCHANGE RATE MECHANISM 10

2.2 FACTORS INFLUENCING EXCHANGE

RATES

11

2.3 HOW DOES GOVERNMENT CONTROL

EXCHANGE RATE

14

2.4 EFFECTS ON IMPORTS & EXPORTS 15

2.5 ECONOMICS of CURRENCY 16

2.6 NEGATIVE FEEDBACK MECHANISM 20

2.7 RELATION BETWEEN INTEREST RATE

AND EXCHANGE RATE

21

2.8 POSITIVE FEEDBACK 21

2.9 PARADOX of POSITIVE & NEGATIVE

FEEDBACK

22

2.10 CAUSES of DEPRECIATION 24

2.11 IMPACT of RUPEE DEPRECIATION 28

2.12 RUPEE EXCHANGE DEPRECIATION:

IMPACT ANALYSIS

30

2.13 POLICY OPTIONS AVAILABLE WITH RBI 31

CHAPTER III – CONCLUSION

3.1 CONCLUSION 33

CHAPTER IV – APPENDIX

4.1 Bibliography 35

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INTRODUCTION

The monetary value of an asset decreases over time due to use, wear and tear or

obsolescence. This decrease is measured as depreciation. Depreciation, i.e., a decrease in

an asset's value, may be caused by a number of other factors as well such as

unfavorable market conditions, etc. Machinery, equipment, currency are some examples of

assets that are likely to depreciate over a specific period of time. Here, we will discuss

the depreciation of currency, especially Rupee.

The Indian rupee, which was on a par with the American currency at the time of

Independence in 1947, has depreciated by a little more than 65 times against the

greenback in the past 66 years. The rupee touched its historic record low of below 65

against the dollar. The currency has witnessed huge volatility in the past two years. This

volatility became severe in the past six months affecting major macro-economic data,

including growth, inflation, trade and investment.

Managing volatility in the currency markets has become a big challenge for

policymakers. Despite of a series of measures taken by the central bank as well as the

government to curb the volatility in the markets, the rupee continues to depreciate. The

trend is unlikely to reverse any time soon. This rupee depreciation is badly hurting the

Indian economy. It is fuelling inflation and has hurt economic growth.

Foreign exchange reserves are an extremely critical aspect of any country‟s ability to

engage in commerce with other countries. A large stock of foreign currency reserves

facilitates trade with other nations and lowers transaction costs associated with

international commerce. If a nation depletes its foreign currency reserves and finds that

its own currency is not accepted abroad, the only option left to the country is to borrow

from abroad. However, borrowing in foreign currency is built upon the obligation of the

borrowing nation to pay back the loan in the lender‟s own currency or in some other

“hard” currency. If the debtor nation is not credit-worthy enough to borrow from a

private bank or from an institution such as the IMF, then the nation has no way of

paying for imports and a financial crisis accompanied by devaluation and capital flight

results.

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The de-establishing effects of a financial crisis are such that any country feels strong

pressure from internal political forces to avoid the risk of such a crisis, even if the

policies adopted come at large economic cost. To avert a financial crisis, a nation will

typically adopt policies to maintain a stable exchange rate to lessen exchange rate risk

and increase international confidence and to safeguard its foreign currency (or gold)

reserves. The restrictions that a country will put in place come in two forms:- trade

barriers and financial restrictions. Protectionist policies, particularly restrictions on imports

of goods and services, belong to the former category and restrictions on the flow of

financial assets or money across international borders are in the latter category.

Furthermore, these restrictions on international economic activity are often accompanied

by a policy of fixed or managed exchange rates. When the flow of goods, services, and

financial capital is regulated tightly enough, the government or central bank becomes

strong enough, at least in theory, to dictate the exchange rate.

However, despite these policies, if the market for a nation‟s currency is too weak to

justify the given exchange rate, that nation will be forced to devalue its currency. That

is, the price the market is willing to pay for the currency is less than the price dictated

by the government.

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JOURNEY SINCE INDEPENDENCE

The Indian currency has witnessed a slippery journey since Independence. Many

geopolitical and economic developments have affected its movement in the last 66

years.

When India got freedom on August 15, 1947, the value of the rupee was on a

par with the American dollar. There were no foreign borrowings on India's

balance sheet.

To finance welfare and development activities, especially with the introduction of

the Five Year Plan in 1951, the government started external borrowings. This

required the devaluation of the rupee.

After independence, India had chosen to adopt a fixed rate currency regime. The

rupee was pegged at 4.79 against a dollar between 1948 and 1966.

Two consecutive wars, one with China in 1962 and another one with Pakistan in

1965; resulted in a huge deficit on India's budget, forcing the government to

devalue the currency to 7.57 against the dollar.

The rupee's link with the British currency was broken in 1971 and it was linked

directly to the US dollar.

In 1975, value of the Indian rupee was pegged at 8.39 against a dollar.

In 1985, it was further devalued to 12 against a dollar.

In 1991, India faced a serious balance of payment crisis and was forced to

sharply devalue its currency. The country was in the grip of high inflation, low

growth and the foreign reserves were not even worth to meet three weeks of

imports. Under these situations, the currency was devalued to 17.90 against a

dollar.

1993 was very important. This year currency was let free to flow with the market

sentiments. The exchange rate was freed to be determined by the market, with

provisions of intervention by the central bank under the situation of extreme

volatility. This year, the currency was devalued to 31.37 against a dollar. The

rupee traded in the range of 40-50 between 2000 and 2010.

It was mostly at around 45 against a dollar. It touched a high of 39 in 2007.

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The Indian currency has gradually depreciated since the global 2008 economic

crisis. Liberalizing the currency regime led to a sharp jump in foreign investment

inflows and boosted the economic growth.

The Indian rupee extended falls to a new low of 65.50 to the dollar as heavy

demand from importers along with weak domestic equities continued to weigh on

sentiment.

Weakness was also seen after Federal Reserve minutes hinted that the United States was

on course to begin tapering stimulus. Moreover, continuing its slide, the rupee also made

all time low against British pound and breached the 102 mark on local bourses. With

this, British pound has become the first major foreign currency to cross 100 levels

against rupee.

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DEPRECIATION OF RUPEE

Exchange Rate Mechanism

All economies that interact with international economy can be broadly classified into

three categories on the basis of exchange rate policy of the country:-

1. Fixed Exchange Rate:- These economies peg 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. Notable

exception is China which despite being large economy has its currency pegged to

US dollar. But then when it comes to China, its irrational to talk about

rationality.

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. For

example consider exchange rate of US dollar versus Japanese Yen. If US wants

to import certain item from Japan, it will have to pay the Japanese company in

Japanese Yen. This is because in common market of Japan, dollar will not fetch

you anything. But the American company will not have Yen, so it will purchase

Yen from the international currency market. This will increase the demand of Yen

and supply of Dollar. Thus the value of Yen vis-à-vis dollar will increase.

Similarly if Japanese company is importing something from US, it will increase

value of Dollar as compared to Yen.

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Export-import, though the major, is not the only source for currency exchange.

Capital flow – Americans investing in Japan and Japanese investing in USA – is

also a significant source of currency exchange. Another source of currency

exchange is remittance – that is the money sent home by Americans working in

Japan and vice versa. Cumulative of all these exchanges determine the exchange

rate. If net requirement of Dollar by Japanese is more than net Yen required by

USA, Dollar will appreciate against Yen. You should also understand that this is

oversimplified for the purpose of illustration. In real world, there will be

multilateral interactions and final exchange rate will be equilibrium reached by all

those interactions.

3. Hybrid System:- Most mid-sized 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.

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

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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.

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 makeup 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.

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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. 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 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.

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How does Government Control Exchange Rate

In fixed or hybrid exchange rate regime where government controls exchange rate,

control is exercised by actively participating in international currency market through its

central bank (Reserve Bank of India or RBI in our case). Suppose there is huge demand

of rupee in India which is driving the value of rupee. Also, let us assume that RBI is

comfortable only in range of Rs.50 to Rs.60 per US dollar. This rapid surge in the

demand of rupee, which might be because:-

a) Indian export is far more than its import,

b) Foreign investors want to invest in India and

c) Large number of Indians earning abroad are remitting their money back home,

is pushing the exchange rate below Rs.50 per dollar. The RBI will then step in the

market and will offer Rs.50 for each dollar. Those buying rupees against dollar will now

purchase from RBI since its offering better rate. Soon other traders will have to arrive

at this rate, if they want to participate. Since RBI has the ability to print currency notes,

it can keep the lower limit of exchange rate fixed at this value. When demand for rupee

is subsided, RBI will step back and let market determine the exchange rate. In the

process, RBI will have accumulated a pool of dollars; this is called Forex Reserve or

Foreign Exchange Reserve.

Suppose Indian exports have dwindled, imports are on surge, foreign investors are fleeing

Indian market and remittances are at all-time low. Now, everyone wants dollar but there

is little supply. This will drive the price of dollar up. It is about to breach the upper

limit of Rs.60 USD. RBI will step in again and will put its dollar reserves on sale at

the rate of Rs.60 USD. This will stop the further depreciation of rupee.

As you can see, in order to be able to stop the currency from appreciating, RBI will

have to print money and for preventing its depreciation it needs a reserve of dollar. This

constraint has interesting implications on the current predicament of RBI in the context

of depreciating rupee.

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Effect of Exchange Rate on Import and Export

An Exchange Rate is the rate at which one nation's currency can be exchanged for that

of another. Exchange rates impact, and are impacted by, international trade, in a free-

market system that helps to maintain a balance of trade and balance of capital.

Suppose US company wants to buy Indian textile and suppose on T-Shirt costs Rs.120

and exchange rate is Rs.50 per USD. So for American company the cost of T-Shirt is

$2.4. Now, if rupee depreciates to Rs.60 per USD the price of T-shirt becomes $2 only.

This will make Indian T-shirt cheaper to buy and will increase its demand. Companies

who were importing from other nations (may be China or Bangladesh) might shift to

India and Indian exports will increase.

Consider the opposite scenario. Rupee appreciates to Rs.40 per USD making the cost of

one T-shirt $3. This will repel US importers and might drive them to other rival

exporters whose garments are cheaper. Thus, depreciating currency helps exports while

appreciating currency has opposite effect.

Similarly if India imports $1000 i-Pad from US, at exchange rate of Rs.60, it will cost

Rs.60000. If currency appreciates to Rs.50 per USD the price will reduce by Rs.10000.

This might encourage many new people to by i-Pad which earlier thought it to be too

expensive. Thus, the demand for imported products will increase in appreciating currency

and will drive imports upward. Depreciating currency will have opposite effect.

The differences in currency values can affect our ability to buy imports or sell exports,

affecting our standard of living. Therefore, the effects of currency crises in other nations

are not limited to those nations - they can affect our economy and our lives in important

ways.

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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:-

1. Balance of Payment (BoP) Accounts:- International monetary transactions of a

nation is recorded in two accounts:-

a) Current Account:- 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. This records all

the trades (export-import), remittances, interests and earnings on investments

made into outside countries and other flows which is current in nature

(meaning with no intention of future return). If total inflows in the country

(its export, remittances and earning from its investments abroad) is more

than its outflows (its import, remittances out of the country, payments of

interests, etc.) then the country is said to have current account surplus.

China, owing to its huge exports, is currently the nation with largest

current account surplus. Similarly, if outflows exceeds inflows, the country

is said to be in current account deficit. USA has the largest current

account deficit. India too has huge current account deficit.

b) Capital Account:- 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

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when capital inflows are not enough, there will be depreciating pressure on

the currency. This records all the flow (into or out of the country) made

for future return – investment in stocks, bond or companies, in real estate

or FDI (investment made for setting up of business or industry). It also

includes loans taken from abroad (which actually is investment by foreign

lender into the nation). Foreign Currency Reserves are also part of Capital

Account but are generally not reported. A country is said to be in Capital

Account surplus if total inflows into the country (FII, FDI and borrowing

from foreign companies/banks) exceeds total outflows (investments into

foreign countries and lending to foreign countries or companies). In case

situation is reversed, country has capital account deficit.

Payments Always Get Balanced

You can spend only as much money as you have. Or in other words, total

amount you spend and invest must always be equal to the money you

have earned and loans you have taken. What this means in the context of

BoP is that current account surplus must always be balanced by Capital

Account deficit and if a country is having current account deficit, it must

always get equivalent money form of capital account surplus.

BoP and Forex Reserves

Countries having floating exchange rate and free capital flows do not have

to build foreign currency reserves. But as we have seen earlier, those who

exercise some or full control over exchange rate, do so by manipulating

their Forex Reserves. The difference in current account surplus and capital

account (excluding Forex Reserves) deficit is balanced by equal increase in

Forex Reserves (China) and if country is not able to meet current account

deficit by capital flows, then it will have to liquidate its Forex Reserve

(current situation of India).

For example, China which has huge exports (current account surplus) as

well has huge inflows in FDI and FII, balances this by building up huge

Forex Reserves as well as by investing in foreign countries. Chinese

government parks large percentage of its surplus into US government bonds

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and encourages its government backed and other companies to buy assets

in foreign countries (mostly US). So it deliberately runs huge capital

account deficit so that it can export. Otherwise, it will have to let its

artificially depreciated currency appreciate.

2. 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.

3. 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.

4. 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

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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.

5. 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.

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Negative Feedback Mechanism

Negative feedback is defined as following “Negative feedback occurs when the result of

a process influences the operation of the process itself in such a way as to reduce

changes.” In order to understand this concept look at the above diagram. As you can see

in the diagram, when water level in the reservoir decreases, the piston stopping water

flow is lifted and water starts to pour in. When water is filled, the piston will again

come down to stop more water from pouring and this will maintain the water at desired

level. The equilibrium level of water will be determined by the arrangement of the

system rather than the flow of water.

Similar negative feedback system exists in economics. For example, consider exchange

rate and export-import. Actual situation will be very complicated because of a large

number of variable interacting together. To keep things simple, we will consider only

two variables at a time – export-import and exchange rate. As we have discussed above,

appreciation currency causes increase in import while discourages export. This will lead

to increase in demand for foreign currency and simultaneously increase in supply of

local currency. This putting a downward pressure on exchange rate. If government does

not interfere and there is no net capital flow, then exchange rate will quickly adjust

such that values of imports and exports are perfectly matched.

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Relation between Interest Rate and Exchange Rate (Interest Rate Parity)

Another beautiful example of such feedback system is interest rate parity. In order to

explain it lets assume interest rate for borrowing in USA is 4% and interest one gets on

government bond in India is 8%. It will make perfect business sense if you borrowed

$1000 from USA, purchased Indian government bond and after a year you got interest

of $80. Paid $40 as interest to the bank you borrowed from, and made a profit of $40.

That without investing a single penny of your own. Such situation where you can make

money without investing any capital at all is called arbitrage (which in itself is

fascinating financial concept and deserves a complete article on itself).

The only problem with this is it will not be only you who can think of this. Other

people too would want to make profit out of this opportunity and soon there will be

many dollars flowing from USA to India causing Indian Rupee to appreciate in

comparison to USD and whatever gains you could make from excess interest rate will

be offset by the increase in exchange rate.

Self Fulfilling Prophecies or Positive Feedback

Directly opposite to the concept of negative feedback is Self Fulfilling Prophecies or

Positive Feedback. For example suppose there is a rumor, completely unfounded, that the

price of gold is going to increase to very high in a week. People will want to profit

from this information and will buy some gold to sold later at higher price. Initially,

some people will be fooled by the rumor and buy gold. This temporary surge in short

term demand will lead to momentary increase in price. This increase in price will give

credence to the rumor, and more people will flock in to buy gold. This will further

increase the price, pulling even more people. The rumor, which originated without any

analysis or “fundamental” cause, was the reason itself for the rumor becoming true.

Such positive feedback are very common in our life, engineering and economics. In

context of exchange rate, sometimes positive feedback plays a prominent role. Suppose,

all the traders in foreign exchange market believe that rupee has depreciated far below

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its „intrinsic‟ value and it will appreciate in near future. In order to profit from this

anticipated gain, they will try to hoard the rupee, thus increasing its demand and causing

it to appreciate.

Opposite of this is also true. If traders believe that rupee (or for that matter any

currency) is about to depreciate, they might actually trigger it by shorting the currency.

The Paradox of Negative and Positive Feedback

What seems to be positive feedback in short term might actually be negative feedback if

looked broadly. For example, let us look at the currency example again. The general

belief that currency has fallen far below its true value caused it to appreciate through

positive feedback mechanism. But, at the same time it also prevented currency to

depreciate further and hence acted as negative feedback.

Existence of negative and positive feedback loops give rise to several interesting

phenomena in economics and in other areas. It is what economists say Impossible

Trinity.

Impossible Trinity

The concept of Impossible Trinity states that a country (or an economy) cannot

simultaneously have Fixed Exchange Rate, Free Capital Flow and Independent Monetary

Policy (which roughly means control over interest rate).

For example, suppose India pegs its currency to say Rs.60 per USD and intends to

maintain free capital flow. Now, if it sets interest rate that is higher than that of USA,

then money will start flowing in from US to bank on this arbitrage opportunity (as we

discussed earlier). So, in order to maintain its exchange rate, it will have to buy Dollars.

But it will have a limit to how much it can buy. Similarly, if it sets interest rates lower

than US, money will start flowing out. To prevent rupee from falling, it will have to

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sell off its dollar reserve. But that can last only till its reserves gets fully depleted. Thus

government will have to set interest rate equal to that of US.

If you look closely, India, in recent times, has tried to achieve this impossible trinity to

some extent. It kept currency undervalued, wanted foreign investors to come in, and had

to increase interest rate to contain inflation. What makes this more ludicrous is that it

was attempted when our premier is a trained economist.

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Causes of Depreciation

What is good for economy is bad for politics. India‟s trade balance is highly

unfavorable. What this means is India imports far more than it exports. Infact, Indian

export is only about 80% of its imports, a deficit of about $120 billion (2011). This

deficit is largely balanced by remittances (which stood at $69 billion in 2012), FDIs and

FIIs.

Economically it makes sense for India to let its currency appreciate because it will make

imports cheaper and help reduce its trade imbalance. But, appreciating currency will have

negative impact on its exports. Now, India mainly exports labor intensive goods and

services – Software services, polished diamond, textiles, processed cashew nuts, leather

goods. These sectors generate huge employment. Appreciation of currency causes fall in

the profitability in these sectors, leading to many people lose their jobs. Looked from

perspective of politicians, this is hugely unpopular.

Even though the overall gain from appreciated rupee is far more than the losses, gains

per individual are small in magnitude and distributed over a large population; whereas

losses per individual is large and concentrated in minority of the population. Such

policies are impossible to pursue in a democracy like India because those at loss will be

far more vocal while people at gain will not bother at all.

Under such political considerations, our government, a coalition of several parties cannot

afford to be bold. So, in last 5-6 years, driven by impressive economic growth of India,

when foreign investors flocked, there was upward pressure on the rupee. Government

was unwilling to let rupee appreciate and kept it artificially devalued. In the process it

amassed huge foreign exchange reserves (about $300bn).

Printing of more money causes inflation, another politically unpopular thing. So, in order

to curb the money supply, government issued bonds under Market Stabilization Scheme

(MSS bonds). It did curb the inflation to some extent, but when bond matures,

government has to pay the money along with the interest. So, this scheme does not

really curb inflation, it postpones it. When those bonds matured, government made

payments, again by printing more money, as government is running budget deficit and

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does not have income to pay. This caused inflation which you might have noticed

during recent times. Now to curb the interest rate Government will increase interest rate

to reduce the supply of money.

Increase in interest rate caused a slowdown in growth. Also, global economic slowdown

reduced demand for India exports and exports fell too (about 30% in last year). Import

however, did not fall by that amount because Oil, the major component of our imports,

is essential commodity. So the trade balance turned more unfavorable. Also, looking at

the slowing pace of growth new investor abstained from investing in India and older

investor too started to get uneasy. As they tried to pull back their money, it put

downward pressure on rupee.

If foreign investor expects the currency of a country to fall, it will withdraw its

investments because its investment value will fall with the currency. For example

suppose you invested $1000 at Rs.40 per USD. So your investment in India is Rs.40000.

Tomorrow if rupee falls to Rs.60 per USD then value of your investment has fallen to

$667. Foreign investors fearing further fall in rupee started to flee Indian market and

this put further downward pressure on rupee (Positive feedback). Government could

interfere, but owing to its huge budget deficit, had limited resources and rupee had a

free fall.

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

26

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 in

decision. 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%. Consequently, FIIs have withdrawn funds from emerging

markets and invested back in the dollar which has been strengthening.

Strengthening of Dollar:- As these downbeat forces have played strong over the

last few months, investor risk appetite 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%), the trade account has

deteriorated on unfavorable terms of trade. Current account deficit(CAD), in Q1

FY12 had widened by Rs.40,000 crore, over Q4 FY11. Furthermore on a

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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.

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Impact of Rupee Depreciation

Economists do not agree about impact of nominal exchange rate on real economy. Many

argue that nominal values do not have any impact on real economy while others claim

that the effect nominal variables have on human psychology and expectations of future

does hamper real economy.

Two very visible impacts are:-

increasing oil prices and

India gaining competitive advantage in certain export.

Why oil price is increasing is quite obvious. The later impact needs some elaboration.

What has made the devaluation of rupee more problematic is global slowdown.

Alternatively, it might well be that this downfall was brought about by the global

slowdown. But in either cases, the demand for goods and services in developed economy

is dwindling. But demand in certain goods like textile will not be impacted that much

(people are not going to shun wearing cloths because of slowdown). Main competitor of

India in such sector is China. During the same period when Indian rupee has been

falling, salaries of labors in China has been on the rise. This had made Indian export

more favorable.

Another impact, which may seem like silver lining in the dark cloud is that it has

forced government to bring certain economic reforms (FDI in retail and other sectors)

and has brought a near crisis like situation which can force unwilling government to

bring reforms (as it did in 90s). Three areas of concern that may be identified are:-

1. 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

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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, aluminum, iron and

steel would have eased, the depreciating rupee would keep the price of imported

commodities elevated.

2. 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 programed in H2 FY12 by Rs.52,000 crore, to bridge the

fiscal gap.

3. 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.

4. 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 jewelry. In case, imported raw material is used in these

industries they would be adversely affected. Therefore, exports may not be able

to leverage fully.

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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:-

1. 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.

2. 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.

3. 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.

4. 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.

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Policy Options Available with RBI

1. 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

March 2010 to tame inflationary expectations. Higher interest rates along with

domestic and global factors have pushed growth levels much lower than

expectations. In its December 2011 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.

2. Forex Reserves:- RBI can sell Forex Reserves and buy Indian Rupees resulting

in increased in demand for rupee. RBI Deputy Governor 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 self-fulfilling 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, 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.

3. Easing Capital Controls:- Dr. Gokarn in a 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:-

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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.

4. 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.

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CONCLUSION

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.

Government has tried several things to control downward spiraling rupee but those steps

are too little, too late and many are pointed in wrong direction; like curbing import of

gold. A government should not be telling people what to buy and what not to buy.

Demand of gold in India is culture induced. Also, demand of gold increases when

economic uncertainty increases. Trying to micromanage people‟s behavior will have

undesirable impact in long term.

There are not many options in short term, but in long term government needs to bring

reforms pending for many decades. Those reforms need strong political will.

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 deficit shave 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

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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.

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BIBLOGRAPHY

1. www.mapsofindia.com

2. www.wikipedia.org

3. www.omegagoons.com

4. www.iitk.ac.in

5. INDIAN ECONOMY by MISHRA & PURI

6. MACROECONOMICS by H.L.AHUJA