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.

Double Trouble

To maintain forex stability at the time of QE withdrawal and maturation of external debt is going to be a tough call for Government.

Reserve Bank of India recently reported that India’s external debt i.e. loans borrowed from foreign lenders has reached to as much as 21.2% of the GDP ($390bn) as of March end. The news has come in the backdrop of depreciating rupee which has already crossed the psychological 60 due to dearth of dollars in the country and might even go up given the series of internal and external structural challenges. Though the recent Current Account Deficit data standing at 3.6% of GDP for Jan-Mar quarter as compared to 6.7% of the previous quarter has rekindled the hope of strengthening rupee but rising external debt and their soon-to-come maturation period certainly spills water on this hope as repayment of these debts has to be made in dollars, thus causing upward pressure on rupee.

External debt mainly consists of External Commercial Borrowings (ECBs), NRI deposits and short-term credit. Worryingly, the share of short-term debt stands at 44.2% of the total debt which has to be repaid in the next one year. By the same time American Federal Reserve will also be tapering off quantitative easing (QE) as announced by Fed Chief Ben Bernanke few days ago. During American recession, under its QE policy, Fed was pumping $85 bn dollars in the economy on monthly basis which is going to be rolled back as American economy is back on the recovery path. India being the biggest beneficiary of American QE will now turn out to be the biggest loser as its major source of capital inflows i.e. Foreign Institutional Investment (FII) is likely to be ended by mid 2014. In fact, impact of this announcement is already palpable given the free fall of rupee for the past few weeks as many foreign investors have been selling out their bonds and stocks from Indian market. To maintain forex stability at the time of QE withdrawal and maturation of external debt is going to be a tough call for Government.

While Govt. has no say in decreasing or increasing FIIs inflow but it must try to control external borrowings. Cheaper foreign money prompts India Inc to borrow funds from other countries while lending rates in India are skyrocketing with no sign of coming down due to high inflation. Although external borrowings has a positive side too as it stimulates dollar inflow in the economy but relying on ECBs, short-term credit or NRI deposits etc. for forex stability is dangerous due to its being highly volatile. Now that the value of rupee against dollar has been sharply falling, it might lead Indian companies to pay their foreign debts sooner than later as their repayment amount in dollar terms is piling up due to exchange rate vulnerability towards rupee. Their dollar-demand for repayment will further cause rupee to weaken against dollar. Considering this, RBI along with Finance Ministry would better adopt measures to maintain internal stability rather than becoming victim to external sector vulnerability. Yet RBI recently eased ECB norms in order to attract dollar-inflows. It can be temporarily acceptable for short-term boost to rupee but certainly not a viable option given the risk factor associated with it.

India’s heavy dependence on imports is the root cause of its weak currency which is also the bedrock of rising inflation i.e. the prime cause of economic slowdown. India stands at fifth position among countries having largest coal reserves yet it is one of the biggest importer of coal due to poor coal-mining in the country. Also more than 80% of India’s oil demand is met via imports. It is also the biggest importer of gold which had raised India’s CAD to unprecedented level. However, gold import could be curbed by bumping up import duty on the same but it is difficult to divert people’s attention from this yellow metal for its being a sure hedge against inflation. Stringent measures have to be taken by Finance Ministry and RBI to mitigate India’s heavy reliance on imports as direct and indirect impact of rising commodity prices and services chargers not only surge inflation but also raise production cost thus making export products costlier leading India to lose in competitive export market from other countries offering cheaper products.

India is stuck in a gruesome vicious cycle. Solution of one problem works as the catalyst for another. In this backdrop, finding a balanced solution and thus shifting to virtuous cycle is a herculean task for Government. Tough times for Indian economy and the lesson must be learnt that heavy dependence on precarious global economy while being in throes of weak domestic economy is not prudent. A robust, domestically sustained economy can only bear the brunt of sudden emergence of internal and external turbulence.

Rupee's Rout

Rupee meltdown has now become a structural problem and has put the country in a danger zone, coming out of which anytime soon is a herculean rather near-impossible task. 

Rupee-meltdown against dollar reached to its 10-month low this week, extinguishing every glimmer of economic-revival-hope emerging out of recent green shoots. In an import-driven country having skyrocketing inflation, rupee-depreciation brings multi-pronged negative outcomes with very little or no means to roll back to tolerant level of INR against USD. Recent GDP data, released by Central Statistical Organization, coming at a decade’s low of 5% for the last fiscal year i.e. 2012-13 has aggravated the disturbing repercussions of falling rupee denting the hope of Reserve Bank of India (RBI) going for policy rate cuts during its next monetary review. The current economic sentiment has led the rupee to fall in a vicious-cycle trap, coming out of which demands rigorous policy measures.

Though global factors like Eurozone recession, Euro weakness, monetary easing in Japan etc. , to some extent, led to rupee-deflation but failure at home to revive exports and to control its headlong inflation are primarily responsible why the value of rupee is going down. Immediate impact of this value-erosion resulted into petrol and diesel price rise by 75 paise and 50 paise respectively though global crude oil price is less than 100 Barrel. In the aftermath, inflation will certainly move upward which has been taking a downward route for last three months.

It is peculiar that 1.3 billion dollar has come to Indian shores via portfolio investment since the beginning of this calendar year yet the imports are rising unabatedly due to Indians’ lure of gold and oil import which results into ballooning Current Account Deficit and imbalance of payment.  Economy cannot rely on this so-called ‘hot money’ which can anytime be drawn out of the market. India requires huge amount of foreign capital which is invested in its core economy weeding out the prospect of capital flight. Foreign Direct Investment on sustained basis can very well serve the purpose. India has already allowed FDI in multi-brand retail and aviation yet attracting foreign investors is a pipe-dream given the domestic uncertainties like lowering growth, higher interest rates, policy-paralysis, archaic laws, political logjam and upcoming Lok-Sabha election etc. Also, global rating agency Standard and Poor’s retaining its negative outlook for India has added into the misery of beleaguered Government trying to impress foreign investors to invest in Indian Economy. Adequate foreign investment seems impossible in near future as domestic investors themselves are shying away from investing in India something which foreign investors will surely pay heed to.

Thus, if INR is perceived as a depreciating currency amidst high inflation and low growth, it will dry up Foreign Institutional Investment and Foreign Direct Investment at a time when India’s exports are not up to the required level and imports are rising with no sign of decrement, leading to severe balance of payment crisis. This currency meltdown has now become a structural problem and has put the country in a danger zone, coming out of which anytime soon is a herculean rather near-impossible task.