Index1. Brief introduction2. Factors affecting INR3. Major crisis related to INR4. Liberalization in 1991 and its impact on INR5. Exchange rate policy of India6. Rupee movement graphs after independence7. Rupee depreciation and its impact8. Outlook on INR.
Brief IntroductionThe persistent decline in the value of INR is of great concern to the nation. Even if now that we are inthe stage of reform we need to strengthen INR against major currencies of the world. The followingreport is a brief analysis of the possible causes of currency depreciation, its impact and the currentoutlook of INR. For last few years for reasons like withdrawal of FIIs, widening current deficits, decline inother capital flows like FDI, ECBs, and FCCBs. Along with these factors the report also emphasizes onmajor crisis in the history of India related to the INR. Exchange rate policy is also one of the greatestdeterminants of the INR depreciation. These movements are shown by graphs and data of REER, NEERand BOP. Also it discusses about how can the depreciation of the currency can be used to drawadvantage.The recent reforms like rate hike of diesel and allowing 100% FDI in retail and aviation have shown agood appreciation in the currency but still the political instability and the uncertain climate about thecoalition govt is posing hurdles.
Factors affecting INRIn the following section we are discussing the factors which are affecting the currency. There can bemany reasons for the depreciation of the currency, but we need to categorise them into variousheadings. Further it is being discussed in detail with the help of data extracted from the various sourcesranging from RBI, SEBI etc. The factors affecting INR: I. Market Situation II. Economic Factors III. Political factors IV. Special Factors As we know that Forex market for Indian currency is highly volatile where one cannot forecast exchange rate easily, there is a mechanism which works behind the determination of exchange rate. One of the most important factors, which affect exchange rate, is demand and supply of domestic and foreign currency. There are some other factors also, which are having major impact on the exchange rate determination. After studying research reports on relationship between Rupee and Dollar of last four years we identified some factors, which have been segregated under four heads. These are: Market Situation: I. FIIS II. Demand/Supply situation of currency III. Buying/selling in forex markets IV. Floating rate of currency Economic Factors: I. Internal Factors a) Industrial Deficit b) Fiscal Deficit c) GDP & GNP d) Foreign Exchange Reserves e) Inflation Rate f) Agricultural Rate and production g) Different types of policy impacts (EXIM, Credit policy etc.) h) Infrastructure II. External Factors a) Export Import b) Loan sanctions by World Bank and IMF c) International oil and gold prices d) FDI & Portfolio investments Political Factors:
I. Political instability II. Delay in implementation of policies III. Delay in sanctioning of budget Special factors: Events contributing in the appreciation and depreciation of the currency e.g I. Indo –China War (1962) II. Indo-Pak War (1965) III. Bofors Scandal (1985) IV. Pokhran Nuclear Test(1998) V. Kargil War (1999) VI. CWG Scam VII. Anna Hazare Campaign VIII. Recent Credit RatingNow that we have categorised each factors, we’ll be discussing them in detail.Market situations: India follows the “floating rate system” for determining exchange rate. In thissystem “market situation” also is pivot for determining exchange rate. As we know that 90% of theForex market is between the inter-bank transactions. So, how the banks are taking the decision forsettling out their different exposure in the domestic or foreign currency that is impacting to theexchange rate. Apart from the banks, transactions of exporters and importers are having impact onthis market. So in the day-to-day Forex market, on the basis of the bank and trader’s transactionsthe demand and supply of the currencies increase or decrease and that is deciding the exchangerate. On the basis of this study we found out the different types of the decisions, which is affectingto market. These are as follows: In India, there are big Public Sectors Units (PSUs) like ONGC, GAIL, IOC etc. all the foreign related transactions of these PSUs are settled through the State Bank of India. E.g. India is importing Petroleum from the other countries so payment is made through State Bank of India in the foreign currency. When State Bank of India (SBI) sells and buys the foreign currency then there will be noticeable movement in the rupee. If the SBI is going for purchasing the Dollar then Rupee will be depreciated against Dollar and vice versa. Foreign Institutional Investor’s (FIIs) inflow and outflow of the currency is having the major impact on the currency. E.g. U.S. based company is investing their money through the Stock markets BSE or NSE so her inflows of the Dollars is increasing and when it is selling out their investments through these Stock markets then outflows of the Dollars are increasing. However if the FIIs inflowing the capital in the country then there will be the supply of the foreign currency increases and Demand for the Rupee will increases and that will resulted appreciation in the rupee and vice versa.
Importer and Exporter’s trading is also affecting to the rupee. Like if an Indian exported material to U.S. so he will get his payments in Dollars and that will increase the supply of Dollars and increase of demand of rupee and that will appreciate the rupee and vice versa. Banks can be confronted different positions like oversold or over bought position in the foreign currency. So bank will try to eradicate these positions by selling or purchasing the foreign currency. So this will be increased or decreased demand and supply of the currency. And that will cause to appreciation or depreciation in the currency. As we know that in India there is a floating rate system. In India Central Bank (RBI) is always intervene in the trade for smoothen the market. And this RBI can achieve by selling foreign exchange and buying domestic currency. Thus, demand for domestic currency which, coupled with supply of foreign exchange, will maintain the price foreign currency at the desired level. Interventions can be defined as buying or selling of foreign currency by the central bank of a country with a view to maintaining the price of a given currency against another currency. US Dollar is the currency of intervention in India. 2. Economic Factors: In the Forex Market Economic factors of the country is playing the pivot role. Every country is depending on its prospect economy. If there will be change in any economy factors, which will directly or indirectly affected to Forex market. Here there are two types of economic factors. These are as follows:1. Internal Factors.2. External Factors. Internal Factors includes: Industrial Deficit of the country. Fiscal Deficit of the country. GDP and GNP of the country. Foreign Exchange Reserves. Inflation Rate of the Country. Agricultural growth and production. Different types of policies like EXIM Policy, Credit Policy of the country as well reforms undertaken in the yearly Budget. Infrastructure of the Country External Factors includes: Export trade and Import trade with the foreign country. Loan sanction by World Bank and IMF Relationship with the foreign country. Internationally OIL Price and Gold Price. Foreign Direct Investment, Portfolio Investment by the country. 3. Political Factors:
In India election held every five years mean thereby one party has rule for the five years. But fromthe 1996 India was facing political instability and this type of political instability has created heftyproblem in the different market especially in Forex market, which is highly volatile. In fact in the year1999 due to political uncertainty in the BJP Government the rupee has depreciated by 30 paise inthe month of April. So we can say that political can become important factor to determine foreignexchange in India.Due to political instability there can be possibility of de possibility delaying implementation of allpolicies and sanction of budget. So that will create also major impact on trade.4. Special Factors: Till now we have seen the general factors, which will affect the Forex market in daily business. And on that factors the different players in the market have taken the decision. But some times some event happened in such a way that it will really change the whole scenario of the market so we can called that event special factors. However traders have to really consider those things and take the decisions. We will see these types of factors in detailed: In the year 1998, when Government of India has done “Pokhran Nuclear Test” at that time rupee has been depreciated around 85 paise in day and 125 paise in seven days. Her main fear was that U.S., Australia and other countries have stop to sanctions the loans So this type of event will have major impact on the market. And due to this the decision procedure of the trader also varies. In the year 2000,India has faced Kargil war, which is also affected to the market. By this war the defense expenditures are raised and due to that there will be increase in the fiscal deficit. And become obstacle in the growth of the economy. So this type of event has impact on the Forex market.
Major Crisis in India related to INR1966 Economic CrisisFrom 1950, India ran continued trade deficits that increased in magnitude in the 1960s.Furthermore, the Government of India had a budget deficit problem and could not borrow moneyfrom abroad or from the private corporate sector, due to that sectors negative savings rate. As aresult, the government issued bonds to the RBI, which increased the money supply, leading toinflation. In 1966, foreign aid, which had hitherto been a key factor in preventing devaluation of therupee, was finally cut off and India was told it had to liberalise its restrictions on trade before foreignaid would again materialise. The response was the politically unpopular step of devaluationaccompanied by liberalisation. Furthermore, The Indo-Pakistani War of 1965 led the US and othercountries friendly towards Pakistan to withdraw foreign aid to India, which necessitated moredevaluation. Defence spending in 1965/1966 was 24.06% of total expenditure, the highest it hasbeen in the period from 1965 to 1989 (Foundations, pp 195). Another factor leading to devaluationwas the drought of 1965/1966 which resulted in a sharp rise in prices.At the end of 1969, the Indian Rupee was trading at around 13 British pence. A decade later, by1979, it was trading at around 6 British pence. Finally by the end of 1989, the Indian Rupee hadplunged to an all-time low of 3 British pence. This triggered a wave of irreversible liberalisationreforms away from populist measures.1991 Economic CrisisBy 1985, India had started having balance of payments problems. By the end of 1990, it was in aserious economic crisis. The government was close to default, its central bank had refused newcredit and foreign exchange reserves had reduced to such a point that India could barely financethree weeks’ worth of imports. India had to airlift its gold reserves to pledge it with InternationalMonetary Fund (IMF) for a loan.he crisis was caused by currency overvaluation; the current account deficit and investor confidenceplayed significant role in the sharp exchange rate depreciation.The economic crisis was primarily due to the large and growing fiscal imbalances over the 1980s.During mid eighties, India started having balance of payments problems. Precipitated by the GulfWar, India’s oil import bill swelled, exports slumped, credit dried up and investors took their moneyout. Large fiscal deficits, over time, had a spill over effect on the trade deficit culminating in anexternal payments crisis. By the end of 1990, India was in serious economic trouble.The gross fiscal deficit of the government (centre and states) rose from 9.0 percent of GDP in 1980-81 to 10.4 percent in 1985-86 and to 12.7 percent in 1990-91. For the centre alone, the gross fiscaldeficit rose from 6.1 percent of GDP in 1980-81 to 8.3 percent in 1985-86 and to 8.4 percent in 1990-91. Since these deficits had to be met by borrowings, the internal debt of the governmentaccumulated rapidly, rising from 35 percent of GDP at the end of 1980-81 to 53 percent of GDP atthe end of 1990-91. The foreign exchange reserves had dried up to the point that India could barelyfinance three weeks worth of imports.In mid-1991, Indias exchange rate was subjected to a severe adjustment. This event began with aslide in the value of the Indian rupee leading up to mid-1991. The authorities at the Reserve Bank ofIndia took partial action, defending the currency by expending international reserves and slowing
the decline in value. However, in mid-1991, with foreign reserves nearly depleted, the Indiangovernment permitted a sharp depreciation that took place in two steps within three days (July 1and July 3, 1991) against major currencies.With India’s foreign exchange reserves at $1.2 billion in January 1991 and depleted by half byJune, barely enough to last for roughly 3 weeks of essential imports, India was only weeks way fromdefaulting on its external balance of payment obligations.The caretaker government in India headed by Prime Minister Chandra Sekhar’s, immediate responsewas to secure an emergency loan of $2.2 billion from the International Monetary Fund by pledging67 tons of Indias gold reserves as collateral. The Reserve Bank of India had to airlift 47 tons of goldto the Bank of England and 20 tons of gold to the Union Bank of Switzerland to raise $600million. National sentiments were outraged and there was public outcry when its was learned thatthe government had pledged the countrys entire gold reserves against the loan. Interestingly, it waslater revealed that the van transporting the gold to the airport broke down on route and panicfollowed. A chartered plane ferried the precious cargo to London between 21 May and 31 May1991, jolting the country out of an economic slumber. The Chandra Shekhar government hadcollapsed a few months after having authorized the airlift. The move helped tide over the balanceof payment crisis and kick-started Manmohan Singh’s economic reform process.P.V. Narasimha Rao took over as Prime Minister in June, the crisis forcing him to rope in ManmohanSingh as Finance Minister, who unshackled what was then called the caged tiger. The NarasimhaRao government ushered in several reforms that are collectively termed as liberalisation in theIndian media. Although, most of these reforms came because IMF required those reforms as acondition for loaning money to India in order to overcome the crisis. There were significantopposition to such reforms, suggesting they are an "interference with Indias autonomy". ThenPrime Minister Raos speech a week after he took office highlighted the necessity for reforms, asNew York Times reported, "Mr. Rao, who was sworn in as Prime Minister last week, has already senta signal to the nation -- as well as the I.M.F. -- that India faced no "soft options" and must open thedoor to foreign investment, reduce red tape that often cripples initiative and streamline industrialpolicy. Mr. Rao made his comments in a speech to the nation Saturday night."  The forex reservesstarted picking up with the onset of the liberalisation policies and peaked to $314.61 billion at theend of May 2008.A program of economic policy reform has since been put in place which has yielded very satisfactoryresults so far. While much still remains on the unfinished reform agenda, the prospects of macrostability and growth are indeed encouraging India.Economic problems in 2012 led to comparisons to the 1991 crisis in various media outlets.
Liberalization in 1991Economic liberalization is a very broad term that usually refers to fewer government regulations andrestrictions in the economy in exchange for greater participation of private entities; the doctrine isassociated with classical liberalism. The arguments for economic liberalization include greaterefficiency and effectiveness that would translate to a "bigger pie" for everybody. Thus, liberalisationin short refers to "the removal of controls", to encourage economic development.Most first world countries, in order to remain globally competitive, have pursued the path ofeconomic liberalization: partial or full privatisation of government institutions and assets, greaterlabour-market flexibility, lower tax rates for businesses, less restriction on both domestic and foreigncapital, open markets, etc. British Prime Minister Tony Blair wrote that: "Success will go to thosecompanies and countries which are swift to adapt, slow to complain, open and willing to change. Thetask of modern governments is to ensure that our countries can rise to this challenge.”In developing countries, economic liberalization refers more to liberalization or further "opening up"of their respective economies to foreign capital and investments. Three of the fastest growingdeveloping economies today; Brazil, China and India, have achieved rapid economic growth in thepast several years or decades after they have "liberalized" their economies to foreign capital.Many countries nowadays, particularly those in the third world, arguably have no choice but to also"liberalize" their economies in order to remain competitive in attracting and retaining both theirdomestic and foreign investments. In the Philippines for example, the contentious proposalsfor Charter Change include amending the economically restrictive provisions of their 1987constitution.The total opposite of a liberalized economy would be North Koreas economy with their closed and"self-sufficient" economic system. North Korea receives hundreds of millions of dollars worth of aidfrom other countries in exchange for peace and restrictions in their nuclear programme. Anotherexample would be oil rich countries such as Saudi Arabia and United Arab Emirates, which see noneed to further open up their economies to foreign capital and investments since their oil reservesalready provide them with huge export earnings.The impact of these reforms may be gauged from the fact that total foreign investment(including foreign direct investment, portfolio investment, and investment raised on internationalcapital markets) in India grew from a minuscule US$132 million in 1991–92 to $5.3 billion in 1995–96.Election of AB Vajpayee as Prime Minister of India in 1998 and his agenda was a welcome change.His prescription to speed up economic progress included solution of all outstanding problems withthe West (Cold War related) and then opening gates for FDI investment. In three years, the Westwas developing a bit of a fascination to India’s brainpower, powered by IT and BPO. By 2004, theWest would consider investment in India, should the conditions permit. By the end of Vajpayee’sterm as Prime Minister, a framework for the foreign investment had been established. The newincoming government of Dr. Manmohan Singh in 2004 is further strengthening the requiredinfrastructure to welcome the FDI.Today, fascination with India is translating into active consideration of India as a destination for FDI.The A T Kearney study is putting India second most likely destination for FDI in 2005 behind China. Ithas displaced US to the third position. This is a great leap forward. India was at the 15th position,only a few years back. To quote the A T Kearney Study “Indias strong performance among
manufacturing and telecom & utility firms was driven largely by their desire to make productivity-enhancing investments in IT, business process outsourcing, research and development, andknowledge management activities”.
Exchange Rate PolicyThe large and abrupt drop in the currency’s value has negatively impacted businesses andhouseholds by pushing up costs in an inflationary phase, increased price uncertainty and volatility,dented economic confidence, and worsened the critical macroeconomic aggregates. The near freefall of the rupee and its disastrous fallout raises an important public policy issue: is it worth keepingintervention as an additional tool at India’s disposal?It is clear that intervention is no longer a policy option at the Reserve Bank of India (RBI) —its belated and feeble intervention makes this apparent. But the current experience provides anopportunity to critically examine the trade-offs of India’s macroeconomic policy choices in recentyears.In 2010–11 capital inflows were buoyant, aggregating US$60 billion. The exchange rate adjusted fullyto this inflow with a nominal appreciation of an average of 4 per cent year-on-year each month, andthe adjustment in real effective terms was double this. Monthly inflation averaged a very high 10 percent, while both oil and non-oil imports grew briskly at an average of 20 per cent every month.With nearly 80 per cent of oil supplies coming from abroad, there is little doubt about the role astronger currency might have played in restraining imported inflation. Exchange rate appreciationalso allowed authorities to lessen the weight assigned to interest rates for monetary tightening thatdomestic inflationary conditions demanded.A hands-off exchange rate policy was helpful on other counts as well. What, for example, might havebeen the fiscal cost of intervention in an inflationary phase?This cost arises from the RBI exchanging foreign currency purchases for rupee assets —called Market Stabilisation Bonds (MSBs) — to limit feedback into the domestic money supply.Because rupee interest rates are higher relative to foreign currency, the differential interest costdevolves onto the government balance sheet. Assuming RBI had bought half the net capital inflow in2010-11 ($30 billion) and sterilised the purchase, the quasi-fiscal cost would have been roughly Rs62.47 billion or 0.13 per cent of GDP.How much pressure would have been placed on the yield rate from additional issues of governmentbonds, in addition to the budgeted market borrowings of Rs 3.45 trillion? This is difficult to predictbut it is doubtful a bond supply of nearly Rs 4.8 trillion (US$98 million) would have resulted in anaverage long-bond yield rate of 7.9 per cent as it did in 2010–11. The current financial year can serveas a rough guide for expected borrowings of more than Rs 5 trillion (US$102 million) pushed bondyields beyond 8.75 per cent in November. This forced the government to lift caps on foreigninvestment in sovereign bonds and the RBI to regularly manage yields through open-marketoperations. So there is little doubt that a no-intervention policy averted pressure on the yield rate in2010–11.But the wheels of fortune can turn. The fuel subsidy bill is expected to overshoot the budgetedamount by Rs 1 trillion (US$20 million) due to higher fuel costs from the rupee’s depreciation. Andextra expenditure from revenue losses due to fuel tax cuts and additional interest outgo fromunscheduled market borrowings will impact the fiscal deficit that is expected to exceed by at leastone percentage point.Apart from the fiscal damages, the unrestrained fall of the rupee is pushing up domestic inflation,which is of serious concern to the RBI. Harder to quantify are the injuries to the private sector, viz.
sudden and large increase in external repayment obligations, shelved investment spending due todifficulties in raising additional financing and extreme price volatility.Against this outcome, was it worth keeping intervention as an additional policy tool?An extra firepower of some US$30 billion, accumulated when capital inflows were strong, may havefacilitated early and decisive intervention to mitigate the unanticipated shock of the capital flows’reversal in 2011–12. And adjusting the nearly Rs1.48 trillion (US$30.2 million) spent in over-generous subsidies could have reduced pressure on yields in 2010–11. This would have translatedinto a stronger fiscal position for 2011–12. In conjunction with a stronger reserves position, thiswould have provided greater policy room to manoeuvre unanticipated shocks.As with any macroeconomic story, this one, too, can be told differently. But since all trade-offsrepresent conscious policy choices, it is fair to question whether the hands-off exchange rate policywas a deliberate one to check imported inflation.
2012 (May 21) 55.032012 (May 22) 55.3952012 (May 23) 56.252012 (June 22) 57.15 (All-time high to date)
Rupee Depreciation and Its ImpactIf we look at India’s Balance of Payments since 1970-71, we see that external account mostlybalances in 1970s. Infact in second half of 1970s there is a current account surplus. This was a periodof import substitution strategy and India followed a closed economy model. In 1980s, current accountdeficits start to rise culminating into a BoP crisis in 1991. It was in the 1991 Union Budget whereIndian Rupee was devalued and the government also opened up the economy. This was followed byseveral reforms liberalizing the economy and exchange rate regime shifted from fixed to managedfloating 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 hasbeen financed by capital flows and mostly capital flows have been higher than current account deficitresulting in balance of payments surplus. The surplus has inturn led to rise in Forex Reserves fromUSD 5.8 bn in 1990- 91 to USD 304.8 bn by 2010-11 (Figure 2). In 1990-91, gold contributed around60% of forex reserves and forex currency assets were around 38%. This percentage has changed to1.5% 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 ofPayments surplus is just about $4.1 bn and increases to $22 bn in 2000s. However if we divided the2000s period into 2000-05 and 2005-11, we see a sharp rise in both current account deficit and capitalaccount 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 3looks at the Rupee movement against the major currencies. A better way to understand the Rupeemovement is to track the real effective exchange rate. Real effective exchange rate (REER) is basedon basket of currencies against which a country trades and is adjusted for inflation. A rise in indexmeans appreciation of the currency against the basket and a decline indicates depreciation. RBIreleases REER for 6 currency and 36 currency trade baskets since 1993-94 and we see that thecurrency did depreciate in the 1990s but has appreciated post 2005. It depreciated following Lehmancrisis but has again appreciated in 2010-11.Table 2 summarizes the findings of Balance of Payments and Rupee movement. In the 1990s, Rupeedepreciates against its major trading currencies as the average REER is less than 100. However, in2000s we see Rupee appreciating against major trading currencies. If we divide the 2000s periodfurther to 2000-05 and 2005-11, we see there is depreciation in the first phase and large appreciationin the second half of the decade.
Hence, overall we see the Rupee following the path economic theories highlighted above havesuggested.• 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, asservices exports picked up it helped lower the pressure on current account deficit majorly. Withoutservices 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 bnto $5.5 bn in 1997-98. Capital inflows declined from $11.4 bn to $10.1 bn leading to a decline in BoPsurplus and depreciation of the rupee. However, given the scale of the crisis the depreciation pressureon Rupee was much lesser. There was active monetary management by RBI during the period. Similarmeasures have been taken by RBI in current phase of Rupee depreciation as well (discussed below).• 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 currentaccount deficit. The capital inflow composition also changed where external financing dominated inearly 1990s and now most of the capital inflows came via foreign investment. Within foreigninvestment, share of portfolio flows was much higher. As capital inflows were higher than the currentaccount deficit Rupee appreciated against major currencies.
Other factors also led to appreciation of the rupee. First, India entered a favorable growth phaseregistering growth rates of 9% and above since 2003. This surprised investors as few had imaginedIndia could grow at that rate consistently. The high growth led to surge in capital inflows mainly inportfolio inflows. Second, India’s inflation started rising around 2007 leading to RBI tightening policyrates. This led to higher interest rate differential between India and other countries leading toadditional capital inflows as highlighted above. It is important to understand that at that time investorsdid not feel inflation will remain persistent and thought it to be a transitory issue and could be tackledby monetary policy.• During Lehman crisis capital flows shrunk sharply from a high of $107 bn in 2007-08 to just $7.8 bnin 2008-09 and led to sharp depreciation of the currency. Rupee plunged from around Rs 39 per $ toRs. 50 per $. REER moved from 112.76 in 2007-08 to 102.97 in 2008- 09 depreciating sharply by9.3%. The current account deficit also declined sharply as well tracking decline in oil prices from $ 12bn in Jul-Sep 08 to $0.3 bn in Jan- Mar 09. The currency also depreciated tracking the global crisiswhich led to preference for dollar assets compared to other currency assets.Other factors also led to appreciation of the rupee. First, India entered a favorable growth phaseregistering growth rates of 9% and above since 2003. This surprised investors as few had imaginedIndia could grow at that rate consistently. The high growth led to surge in capital inflows mainly inportfolio inflows. Second, India’s inflation started rising around 2007 leading to RBI tightening policyrates. This led to higher interest rate differential between India and other countries leading toadditional capital inflows as highlighted above. It is important to understand that at that time investorsdid not feel inflation will remain persistent and thought it to be a transitory issue and could be tackledby monetary policy.
• During Lehman crisis capital flows shrunk sharply from a high of $107 bn in 2007-08 to just $7.8 bnin 2008-09 and led to sharp depreciation of the currency. Rupee plunged from around Rs 39 per $ toRs. 50 per $. REER moved from 112.76 in 2007-08 to 102.97 in 2008- 09 depreciating sharply by9.3%. The current account deficit also declined sharply as well tracking decline in oil prices from $ 12bn in Jul-Sep 08 to $0.3 bn in Jan- Mar 09. The currency also depreciated tracking the globalcrisiswhich led to preferencefor dollar assets compared to other currency assets.Indian economy recovered much quicker and sharper from the global crisis. The capital inflowsincreased from $7.8 bn to $51.8 bn in 2009-10 and $57 bn in 2010-11. The higher capital inflowswere 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 (6currency) appreciated by 13% in 2010-11 and 36 REER by 7.7%.DEPRECIATION OF RUPEE: 2011-12Before we analyse the factors for the recent depreciation of the rupee, let us look at the survey ofprofessional forecasters released by RBI. Current account deficit is more or less same buy consensusexpects capital inflows in 2010-11 to be lower in each succeeding quarter. This leads to lower BoPestimate. However, the forecasters maintain their forecast for Rupee/Dollar unchanged. This issurprising as with lower capital inflows, markets should have expected some depreciating pressure onRupee 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 issafe to say most of the participants missed the estimate by a wide mark. It was a complete surprise formost analysts.Even the Q1 11-12 numbers did not really sound an alarm (Table 4). The current account deficitwas at$14.2 bn and capital account was at $19.6 bn leading to a BoP surplus of $5.4 bn. BoP surplus in Q42010-11 was $ 2bn. More importantly, capital inflows had risen from $7.4 bn in Q4 2010-11 to $ 19.6bn 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 datereleased by RBI and Commerce Ministry for the period post Q1 11-12. As we can see, current accountdeficits 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 lowerleading to either a negligible BoP surplus or BoP deficit.
Apart from difficulty in capital inflows, Indian economy prospects have declined sharply. Just at thebeginning of the year, forecasts for India’s growth for 2011-12 were around 8-8.5% and have beenrevised downwards to around 6.5%-7%. It has been a shocking turnaround of events for Indianeconomy. Both foreign and domestic investors have become jittery in the last few months because offollowing 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 speakinginflation still remains high with core inflation itself around 8% levels. It is important to recall that theepisode 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 sameas capital inflows resumed quickly as India recovered from the global crisis. However, as inflationremained persistent and became a more structural issue investors reversed their expectations on Indianeconomy.PERSISTENT FISCAL DEFICITS: The fiscal deficits continue to remain high. The governmentprojected a fiscal deficit target of 4.6% for 2011-12 but is likely to be much higher on account ofhigher subsidies. The markets questioned the fiscal deficit numbers just after the budget and projectedthe numbers could be much higher. This indeed has become the case. As highlighted above, persistentfiscal 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 inIndian economy. Moreover, the policies seem to be getting increasingly populist. The governmentwanted to reverse this perception and announced FDI in retail but had to hold back amidst huge furorfrom 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 onFDI.
� CONTINUED GLOBAL UNCERTAINTY: This is an obvious point with global economycontinuing to remain in a highly uncertain zone. This has led to pressure on most currencies againstthe US Dollar.All these reasons together have led to sharp depreciation of the rupee. The rupee has depreciated bynearly 20% against USD from Apr-11 to 20-Dec-11. In terms of 6 REER (Apr-Nov) and 36 REER(Apr-Oct) Rupee has depreciated by 10.44% and 7.7% respectively. The later numbers of REER arelikely to show higher depreciation as well. During Lehman crisis, the two indices had depreciated by9.3% and 9.9% respectively.OUTLOOK AND POLICY MEASURESThe above analysis shows that Rupee has depreciated amidst a mix of economic developments inIndia. Apart from lower capital inflows uncertainty over domestic economy has also made investorsnervous over Indian economy which has further fuelled depreciation pressures. India was receivingcapital inflows even amidst continued global uncertainty in 2009-11 as its domestic outlook waspositive. 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 oildemand via imports. Apart from oil, prices of other imported commodities like metals, gold etc willalso rise pushing overall inflation higher. Even if prices of global oil and commodities decline, theIndian consumers might not benefit as depreciation will negate the impact. Inflation was expected todecline from Dec-11 onwards but Rupee depreciation has played a spoilsport. Inflation may stilldecline (as there is huge base effect) but Rupee depreciation is likely to lower the scale of decline.What are the policy options with RBI?• RAISING POLICY RATES: This measure was used by countries like Iceland and Denmark in theinitial phase of the crisis. The rationale was to prevent sudden capital outflows and prevent melt downof their currencies. In India’s case, this cannot be done as RBI has already tightened policy ratessignificantly since Mar-10 to tame inflationary expectations. Higher interest rates along with domesticand global factors have pushed growth levels much lower than expectations. In its Dec-11 monetarypolicy 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 countriesanyways but this has not led to higher capital inflows. On the other hand, lower policy rates in futurecould lead to further capital outflows.USING FOREX RESERVES: RBI can sell forex reserves and buy Indian Rupees leading to demandfor rupee. RBI Deputy Governor Dr. Subir Gokarn in a recent speech (An assessment of recentmacroeconomic developments, Dec-11) said using forex reserves poses problems on both sides. “Notusing reserves to prevent currency depreciation poses the risk that the exchange rate will spiral out ofcontrol, reinforced by self-fulfilling expectations. On the other hand, using them up in large quantitiesto prevent depreciation may result in a deterioration of confidence in the economys ability to meeteven its short-term external obligations. Since both outcomes are undesirable, the appropriate policyresponse is to find a balance that avoids either.”• EASING CAPITAL CONTROLS: Dr Gokarn in the same speech said capital controls could beeased to allow more capital inflows. He added that “resisting currency depreciation is best done byincreasing the supply of foreign currency by expanding market participation.” This in essence, hasbeen 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 laterderegulated allowing banks to determine their own deposit rates.� The all-in-cost ceiling for External Commercial Borrowings was enhanced to allow more ECBborrowings.ADMINISTRATIVE MEASURES: Apart from easing capital controls, administrative measureshave been taken to curb market speculation.� Earlier, entities that borrow abroad were liberally allowed to retain those funds overseas. They arenow required to bring the proportion of those funds to be used for domestic expenditure into thecountry immediately.� Earlier people could rebook forward contracts after cancellation. This facility has been withdrawnwhich 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 boardand 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. Bothdomestic and global conditions are indicating that the downward pressure on Rupee to remain infuture. RBI is likely to continue its policy mix of controlled intervention in forex markets andadministrative measures to curb volatility in Rupee. Apart from RBI, government should take somemeasures to bring FDI and create a healthy environment for economic growth. Some analysts haveeven suggested that Government should float overseas bonds to raise capital inflows.Growing Indian economy has led to widening of current account deficit as imports of both oil andnon-oil have risen. Despite dramatic rise in software exports, current account deficits have remainedelevated. Apart from rising CAD, financing CAD has also been seen as a concern as most of thesecapital inflows are short-term in nature. PM’s Economic Advisory Council in particular has alwaysmentioned this as a policy concern. Boosting exports and looking for more stable longer term foreigninflows have been suggested as ways to alleviate concerns on current account deficit. The exportshave 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 ofretail 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 todepreciating reality in quick time.