INTRODUCTION
The previous many months now have witnessed a significant fall of Indian currency against the dollar. The value of the rupee has fallen as much as 12% since the beginning of 2018 and is one of the worst-performing Asian currency this year.
The Indian rupee has touched an all-time low of around 73 to 74 against the dollar in October 2018. This free fall of the rupee is a serious cause for concern for economists and businesses.
Indian economy, as we all know, is imports driven rather than being exports driven. Consequently, with the purchasing power of the rupee going down, the Current Account Deficit (CAD) is becoming exceedingly unmanageable.
The Current Account Deficit is a measurement of a country’s trade, where the value of the goods and services it imports exceeds the value of the goods and services it exports.
The said gap between exports and imports, or trade deficit was $13.98 billion in September 2018. Exports were pegged at $27.95 billion in September, which were down 2.15% from a year ago, while imports rose 10.45% to $41.9 billion, which was lowest in five months.
India’s CAD is seen at 2.8% of GDP this year against 1.9% last year, mainly on account of increasing global oil prices and weak rupee for the import of other merchandises from abroad like electronics.
The Rupee-Dollar Equation
The value of currency is like all other traded goods in the market and is largely dependent upon its demand and supply, e.g. if the demand of dollar is higher in the currency market than the supply matched by the rupee, naturally, the value of rupee will depreciate and vice-a-versa.
In the Indian context, more goods and services are being imported, e.g. 80% of oil for domestic consumption is imported and the payment to the foreign exporters is being made in dollars and hence, the demand of dollars increases, with the result rupee depreciates against the dollar.
Furthermore, in case the foreign investors in India find the foreign markets, let’s say, United States more lucrative, they are likely to pull out their investments from India and reverse flow of capital (dollars) takes place, thereby creating further deficiency of dollars and rupee depreciates.
Basic Reasons for Depreciation of Currency
Creation of actual, as well as speculative demand of dollars, which may happen due to ambiguity in monetary policies, like unpredictability of policy makers, e.g. demonetization or hurried implementation of GST, etc may deter investors.
In case the foreign exchange reserves are low, as in the case of India, the RBI cannot aggressively intervene in the currency market. RBI data shows that India’s foreign exchange reserves fell by $5.14 billion to $394.46 billion in the second week of October, the biggest such decline in a single week in about seven years.
A drop in investor confidence due to continuously declining growth rate is making the Indian market unattractive leading to currency depreciation.
US President Trump’s policy of America first has resulted in easing out of financial stimulus packages being doled out to emerging economies which has also resulted in depreciation of their currencies.
RBI has recently imposed temporary restriction on the outward flow of capital, which has restricted the investments of Indian firms abroad. The profits earned by such companies in dollars are also adding up to India’s earning of foreign exchange.
Explicit Reasons for Free Fall of Rupee against Dollar
The explicit reasons that are being ascribed to the value of rupee falling against the dollar in the recent times are:
The decision of US Federal Reserve to tighten the monetary policy by slowing down the supply of currency has caused the depreciation of the value of currency, not only India, but also in other emerging economies like Indonesia, Argentina, Mexico and Turkey.
The depreciation of rupee is due to the restricted supply and availability of dollars in the global market and hence trading in dollars has become more expensive.
Furthermore, due to restricted supply of currency, the interest rates in the US will begin to rise as the demand for various other assets will begin to drop, e.g. the yield of 10 year US Treasury Bonds has already risen to 3% from 2% last year.
Consequently, investors world over are in a rush to sell their assets in other countries and invest in US causing a reverse flow of capital.
Secondly, an increase in the cost of commodities like oil, which is trading around $80 a barrel (increase of 46% over the last 12 months) and also electronics, which collectively constitutes 40% of the total imports made by India, has resulted in the rupee further depreciating.
Furthermore, the trade war between United States and China, where both countries have imposed higher tariffs on the commodities of each other, have raised speculations that China may devalue its currency Yaun to outdo the US and the same has had a ripple effect on
Lastly, US has imposed higher tariffs on Turkish steel, aluminum, and other commodities, delivering a big blow to the lira which has fallen by over 40% this calendar year. This, too, has dragged down currencies of other emerging economies, including India.
Consequences of Rupee Depreciation
The depreciation of rupee means that the import of all items is becoming costlier. Higher cost of oil is directly affecting the cost of every other commodity and the cost of living is going higher.
The goods that use imported components such as computers, smart-phones and cars have become more expensive. Also, education and holidays in foreign countries is costlier now.
The silver-lining to this dark cloud is that a weak rupee is good for all export based companies, e.g. information technology and Pharma Companies that have benefitted from a weaker rupee since most of their revenues come from foreign countries.
Steps Announced by the Government to Stop Further Depreciation of Rupee
The Prime Minister had called for a meeting to take stock of the economy on 17 September 2018 and announced measures to arrest further depreciation of rupee:
External Commercial Borrowing (ECB) for manufacturing companies was made easier. These companies can now borrow from financial institutions abroad up to $50 million with a minimum maturity of one year as against earlier limit of three years. The aim of the government behind this initiative is to bring in dollars quickly into the productive economy rather than just for finance, as also to improve the economic sentiment.
Added more Zing to Masala Bonds:Masala Bonds are rupee-denominated borrowings issued by Indian entities in overseas markets. The objective of Masala Bonds is to fund infrastructure projects in India, fuel internal growth via borrowings and internationalise the Indian currency.
Masala bonds should have a minimum maturity of five years, and there is a $750 million per year limit for borrowers which can be exceeded with the RBI approval.
Government has now proposed to remove the 5 per cent withholding tax on masala bonds. Cutting the tax on masala bonds will make it cheaper for issuers to raise funds via this route and allow them to tap overseas markets without taking currency risk. However, the impact of this move has not been as swift as expected by the government.
No Hedging for Infrastructure ECBs: The government proposed to review mandatory hedging conditions for infra loans through the external commercial borrowing (ECB).Hedgingis a financial technique to cover risk, or it may be called a form of insurance.
Presently, there is a RBI guideline saying that any infrastructure (finance) company going to do ECB borrowing shall have to do a 100 per cent hedge of the foreign currency.
ECB loans in the infrastructure sector are long-term and hence if they are not hedged there could be huge difference in pricing. Hedging cost currently ranges between 4 to 7 per cent of the total cost.
The move will reduce pressure on the rupee in the short term as external borrowing will become attractive. However, the negative implication may be that the foreign exchange risk for infrastructure companies would go up if there is fluctuation in currency.
Review of Foreign Portfolio Investors (FPI): FPIs were allowed to invest in government bonds treasury bills, state development loans and corporate bonds with a minimum residual maturity of three years.
The RBI has increased the FPIs cap on investment in government security to 30 per cent of the outstanding stock of that security, from 20 per cent earlier.
The central bank has now allowed FPIs to invest in corporate bonds with minimum residual maturity of even above one year.
However, it has kept a condition that short-term investments in corporate bonds by an FPI shall not exceed 20 per cent of the total investment of that FPI in corporate bonds.
Conclusion
Notwithstanding the steps ushered in by the government to check depreciation of rupee against the dollar, there seems to be no clearly defined way to arrest the free fall of rupee against the dollar.
The widening trade deficit, escalation in commodity prices, particularly oil, coupled with the expectation of the US Federal Reserve raising its rate further, is exerting pressure on the rupee.
The Reserve Bank of India will have to take proactive actions to prevent the rupee from further sliding. The actions suggested by economists include:
Regulate (controlled increase) the supply of rupee into the market, keeping in mind the danger of inflation due to excessive supply of currency.
Increase domestic interest rates to make investments more attractive.
Financial policies and initiatives to make investments in India more attractive.
JAI HIND
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