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Rupee hits six month high

Rupee touched the Rs 67.88 value on 24th March 2014, gaining 11.7% from its earlier value of Rs 68.83 on 28th August 2013. The factors which affects the rupee value on either side can broadly be listed as trade deficit, inflation, interest rate (central bank’s monitory policy), growth rate and geopolitical conditions.

Before looking at how these factors affect rupee, let’s understand appreciation and depreciation of rupee.

What is Depreciation?

It refers to fall in the value of rupee compared to other foreign currencies mainly the US dollar.

On August 2013, value was 1$ = Rs. 60.44, while on 28th August 2013 it changed to 1$ = Rs 68.83, which means one has to spend more money in terms of rupee to get that same one dollar. In other words value of rupee has depreciated.

What happens when Rupee depreciates?

  • Imports become costlier, as you have to pay more rupees to buy foreign goods and services.
  • Benefits exports side, as rupee has become cheaper, goods produced in India will also be cheaper compared to other foreign goods. Hence exporters can take this comparative cost advantage and increase export to the foreign countries.

What is Rupee Appreciation?

It refers to the rise in the value of rupee. As we have seen, value of 1$ = Rs. 68.83 on August 2013, and has changed to Rs. 60.44 on 24th March 2014, which means today I have to pay lesser money in terms of rupee to buy that same dollar.

What happens when Rupee appreciates?

  • Changes in the value of rupee mainly affect foreign as well as domestic trade.
  • Now imports will be cheaper, payments of goods you are going to buy will require less rupees.
  • In their similar product in domestic market will lose the comparative cost advantages.

On export side, let’s understand by an example, value of 1$ = Rs. 70 and cost of a pen manufactured in India is  Rs. 35, so foreign buyer was paying 0.5 $ (half dollar) for buying the pen. Now say, rupee appreciated and 1$ becomes Rs. 35. So that foreign buyer will have to pay whole one dollar to buy that same pen.

In other words, foreign buyer finding Indian made pen expensive and may not buy it. This in turn hampers our export industry. IT companies and textile exporters are the worst hit due to this rupee appreciation, as it reduces their profit margin and for textile industries, they lose their product competitiveness.

Different factors and their effect on value of Rupee:

Inflationary Pressure

Inflation reduces purchasing power of currency.

Price rise of commodities (goods) on domestic market causes increase in prices of exportable goods too. This in turn reduces comparative cost advantage of exportable goods in international market and hence less likely to earn foreign currency. We will see how availability of foreign currency affects value of rupee in next point.

Differences in interest rates

Let’s consider differences in the inflationary rate between two countries. For example, say in India inflation rate is 9%, while in US it is 5%. A foreign investor decides to invest his 20$ in the market. He invests 10$ in US market and remaining 10$ in Indian market. As we have seen inflation reduces the purchasing power of currency, foreign investor will receive higher returns from her US investment compared to Indian investment in India, again reducing inflow of foreign currency in the country.

Foreign Currency Reserves and Demand for Foreign Currencies

Every country exports its surplus commodities (goods) and imports those resources which it does not have. In India, for energy we are highly dependent on Oil Import from other countries and this demands large quantity of foreign currency to pay the import bills.

Being a capital deficient country, we need foreign capital to drive various infrastructural and industrial projects. Hence, central bank maintains the sufficient foreign currency reserve to pay import bill or return (repay) foreign capital investment. After opening up the economy, this foreign trade increased many fold and so the demand for foreign currency. Ultimately, this necessitates the maintaining of Balance of Payment. Uncontrolled imports and less exports can worsen the BOP problem and will eat up our foreign currency reserve. In that case government with the help of central bank may devaluate the currency.

Let’s say RBI (Central Bank of India) has 10000 $ as forex reserve. India’s oil import bill cost 8000 $ and India’s agriculture, textile and IT service export earned 5000 $ each. i.e. total export $15000 So even after paying import bill RBI still has 7000 $ with it. But, Global economic conditions changed. Due to economic slowdown demand for India’s export in US and European countries has decreased and also there is rise in oil prices in the international market.

Now, import bill costs 9000 $ and there is hardly any earning from export. This has threatened our forex reserve, as whole forex reserve will be used up for paying import bill and there will not be any forex left for next import purchase. No country can afford this situation, so Government decides to devaluate the rupee, so that to improve Balance of payment situation.

Devaluation Vs Depreciation

Devaluation also refers to decreased in value of Rupee, however it differs from depreciation. Depreciation is much of market determined value of Rupee, whereas devaluation is, unnatural (not market determined) decrease (change) in value of Rupee by government to manage its BoP issue. By doing this, imports are discouraged (as imports become costlier) and exports are made competitive (as they became cheaper). Devaluation has its cost too. As foreign goods becomes costlier, person will look for domestic goods increasing their demand. And if this demand is not fulfilled with adequate increased production of goods (supply side) in domestic economy then it may result into inflation. This may drag the economy in the vicious Cycle of inflation-depreciation.

Besides above point, high foreign currency inflows push the Rupee value upwards (i.e. appreciation). We have seen how appreciation has its own problem.

Why Rupee depreciated in 2013?

Rupee touched lowest value 68.83 on 28th August 2013.

Low economic growth in world economy

This reduced demands for Indian goods in overseas market, lowering foreign currency inflow from export.

High import, especially import of gold

Heavy imports of gold along with oil increased the demand for foreign currency to pay the bill. This also caused increased in current account deficit further depreciating rupee.

Growth slowdown in domestic economy

India’s growth fall to 5% in 2012-13. This prompted foreign capital investors to withdraw their investment out of Indian market. In turn increased demand for foreign currency.

High inflation rate

High Inflation rate (WPI = 5.79% in July and CPI = 9.64% in July) in India reduced foreign investors profit margin, so they went for withdrawing their investment from India.

US Federal bank announced removal of fiscal stimulus

US Federal bank announced that it will stop pouring money (fiscal stimulus) in the US market. This money was used to invest in emerging markets including India. US Federal bank’s decision means foreign currency inflows in emerging markets like India will reduce. Government bonds buying program was the part fiscal stimulus provided by US federal bank to help US economy revive. Liquidity poured by US federal bank was used by US investors to invest in emerging economics of world including India. After analysing improved health of US economy, US federal bank decided to remove the stimulus it has provided earlier. Overall situation led to speculative trading in currency market. FII started withdrawing their investments from emerging market, hence in India too capital out flows increased.

What helped Rupee recovery to its new level of Rs 60.44?

Factors which helped recovery of Rupee (Rupee appreciation) are –

Revival of domestic economy:

  • Improved current account deficit (i.e. though imports were high, India has seen increase in its export, earning good quantity of foreign currency.)
  • Low inflation rate, mainly linked to reduced food prices (investors are expecting that RBI will keep policy rates steady, leaving interest rates and hence liquidity (availability of money) in the market unaffected.
  • This way domestic economy has created conducive environment for domestic as well as foreign capital investment. Government’s decision of curbing gold import has also contributed in reducing Current Account Deficit (CAD) (cutting import bills).

Increase in foreign Capital inflows

  • Domestic efforts: As mentioned earlier revived economic growth has attracted much foreign capital to the country. RBI’s move to improve interest rate on NRI deposits has helped bring foreign currency inflows.
  • External factors: Foreign investors are expecting that much debated issue of US tapering will be slow and gradual.

Geopolitical conditions

As mentioned earlier, geo-political conditions of the country also affects the value of currency. In India, 2014, Lok Sabha elections are due in next month. Foreign investors are highly optimist that stable government will be formed which will eventually bring investor-friendly policies.

Caution regarding the current appreciation

Too much appreciation of rupee over a short-term is not beneficial to economy.

Foreign inflows can be categorised in 4 different types based on stability linked to them.

FDI – it is foreign direct investment into establishing a business or expanding existing business. Mainly to take advantage of cheap labour and benefits offered on tax payment by the country. Hence it is less likely that FDI will be withdrawn based on market volatility, like change in exchange rate, rupee depreciation. Hence it is the most stable one.

Foreign inflows in Equities (Shares)

Market volatility does affect share/equities market. However any sudden withdrawal of investment in equities is more likely result into sharp fall of share prices and exchange rate, leading to a loss. Hence though weak market conditions investors don’t immediately opt for withdrawal of investment.

Foreign inflows into medium or long-term government securities

Considering the less risk linked to government securities foreign investors don’t really go for withdrawal before maturity. But if mass withdrawal is carried, then it most likely affects exchange rate and prices.

Short-term foreign debt – Most unstable form

Short term dollar-based debt matures quickly and hence too many inflows in this category will create high demand for foreign currency in near future, again affecting exchange rate and rupee depreciation.

Considering above points, any rupee appreciation triggered by short-term foreign inflows can be seen as gain over short-run but carries high risk of rupee depreciation in long run. Rupee will lose its competitiveness in the global market and may also create inflationary pressure in domestic market.

Hence, foreign inflows linked to export growth should be aimed for. This ensures export competitiveness and also current account deficit will remain under control.RBI while balancing competitive rupee-dollar exchange rate should incentivise long-term foreign flows, discouraging short one.

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