Rupee's Fall and RBI's Tattered Safety Net

Rupee’s value is going down. Why? Let’s take classic demand and supply formula!

Rupee’s value is going down. Why? Because India’s Current Account Deficit is widening, it’s no more a prosperous investment-destination, Foreign Institutional Investors aren’t investing, whosoever have invested are moving out, speculative trading adds false pressure on rupee and the most  cited reason, Fed Chief Ben Bernanke intends to taper-off monetary-easing from US economy. Seems all Greek and Latin? Too much to dissuade you to understand rupee-economics? Be brave! Read on!

Let’s take classic demand and supply formula! At any given time if the demand of dollar is more than that of rupee, it creates dollar-scarcity and rupee-liquidity. Less is always expensive, plenty is cheap. That is why rupee depreciates i.e. you pay more in rupee against one dollar.

Now, who all are demanding dollar? Where do we need it?

1)    People like you and me have to pay in dollars for all our imported tech gadgets, luxury items, foreign education etc.

2)    India’s huge import business demands dollars. Importers have to be paid in dollars.

3)    Investors willing to invest abroad need dollars.

4)    To maintain country’s Foreign Exchange Reserves, dollar is needed

5)    To pay foreign debts incurred by corporate and Govt., dollar is needed

Who all are demanding rupee?

1)    Rupee is needed everywhere in domestic economy. In banks, households, companies etc.

2)    Foreign investors willing to invest in India

3)    Indian Exporters

4)    Opportunists ogle on rupee for speculative trading.

Why demand of dollars surpasses that of rupee?

Indian is an import-driven country. 80% of our oil demand and 100% of our gold demand is met through imports which are the largest two imports of India. For some reasons, indigenously produced materials and products like wheat, rice, coal etc. are also imported in the country. Given that India’s export business is bleak, dollar outflow is always more than its inflow. In the parlance of economics, this imbalance i.e. the difference between total imported and exported goods, services and transfers is known as Current Account Deficit (CAD). India’s CAD is currently 4.8% of GDP. So the logic is, as long as India’s import dependence doesn’t get controlled i.e. its CAD doesn’t go down, rupee’s value will remain volatile.

Now that you are aware with the sources of rupee and dollar demand and also know the most significant reason affecting rupee, let’s come to why sudden downfall in INR, why sudden fuss around it?

In the aftermath of global recession in 2009, in order to boost American Economy, American Federal Reserve Chief Ben Bernanke went for monetary-easing i.e. good chunk of dollars were minted and made available to Americans on zero or negligible interest rates. American investors invested their cheaply acquired funds in various countries and made profits thanks to higher interest rates in those countries. In India many foreign investors invested their money in Govt. securities and debt market and acquired gains through interest rates provided on securities and stocks. Investment by them is known as Foreign Institutional Investment. Recently Fed Chief announced that he will taper-off monetary easing i.e. no more cheap money will be available to American investors. Interest rates will rise. In that case they will have to pay interest in their own country. If gained interest in other countries is meager or less than the paid-interest in their own country, no point for them to invest abroad.  Differential between interest rates either leads to arbitrage advantage or arbitrage loss. FIIs are moving out of India after this announcement because they are wary of arbitrage loss. Foreign investors obviously moved out with funds in dollars, steep scarcity of dollar suddenly emerged and caused rupee to fall.

Now let’s understand what RBI is doing to perk up Rupee:

If rupee is to be strengthened, dollar-demand has to be reduced. Dollar-demand by foreign investors cannot be controlled by RBI, dollar-demand for import business cannot be reduced so easily, dollar-demand by consumers or corporate is also somewhat out of control of RBI and dollar needed for Forex can also be not compromised. That said, RBI can only control speculative trading creating false demand of dollar.

What is speculative trading in currency market and how does it affect rupee?

In currency market, predictions are made as to how much rupee will fall or gain against dollar. Sensing the market sentiment, investors rather speculators invest in the currency which wins them profit. Needless to say they sell rupee in order to buy dollars. As good number of these opportunist speculators seeks loans from banks to convert rupee in dollar, it unnecessarily boosts rupee liquidity and creates shadow dollar-demand.

Conclusion: Though RBI took few measures to suck this liquidity out of the banking system so that banks cannot easily lend but given that rupee is still hovering around above 60, RBI has to admit its measures have been failed in its core objective i.e. to strengthen rupee. On the other hand collateral damage of increasing lending rates is all set to dampen the growth prospect of the country which is already running slow.

INR 60-61 against dollar is perhaps the new normal which cannot be reduced as long as the major cause of its weakness i.e. import dependence isn’t reduced. To surmise, excessive dollar demand can only be curtailed through internal sustenance i.e. self-sustained economy at an optimum level can only protect currency.