The falling rupee story

$un raha hai na tu ₹o raha hu main. The lines of a song from the recent movie release Aashiqui 2 quite sums up the story for the recent sudden fall of the Indian rupee against the US dollar. As a layman, one might wonder how a currency (or for that matter its value) can fall and what could be the implications of the same. To understand it from a historical point of view, let’s travel back to the mid twentieth century. It was the month of July in the year 1944, when the Bretton Woods conference took place. This was on the heels of The Second World War and memories of the great Depression were still afresh. This conference marks a significant moment in the history of international trade as before this, there existed a gold standard era which had collapsed during the First World War. As per the gold standard, all currencies were pegged to (convertible) to gold. It was in this conference that all member nations decided to benchmark their respective currencies to US dollars at a fixed rate of exchange. US politicians in turn agreed to link the US dollar to gold. If you might wonder what prompted the representatives of the member countries to agree to such a vague provision. The United States, at that time owned half of the worlds gold reserve and the global economy was quite dependant on American goods like cars, steel and other industrial machinery. This agreement went on till 1971 when US owing to the pressure of their decreasing share in global production and depleting gold reserves delinked (the convertibility) of US Dollar to gold which brought in a regime of floating currencies based on their market demand and supply. The rest as they is history. Coming back to our quest to figure out the reason of fall in rupee, there are a number of reasons for it. Following are some of the relevant ones. Demand & Supply We live in an era of globalization and this means that there is a free flow (at least theoretically) of goods, services and people. There is a demand for a currency of a specific country based on the demand of goods and services from that country. Like any other freely traded commodity, the demand and supply of a currency determines its price, or to be precise its exchange rate against other currency. India has a huge and continuously increasing requirement of import of petroleum products, gold and edible oil whereas the exports have stagnated. Recently, the international demand and prices of some of the imported commodities have increased sharply which has raised the demand of foreign currencies, leading to appreciation in their exchange rates resulting in relative depreciation in the value of our currency, the rupee. In order to protect themselves against the risks of losing money due to unfavorable exchange rates in future, many exporters or importers get into forward contracts also called currency futures of purchase or sale of a foreign currency at pre determined rates. These forward contracts can also be traded and their price, again is determined by demand and supply. Though, the basic purpose of these contracts is to act as insurance (hedging) against unfavorable currency rates, they are used for making profit by speculators as well. Therefore, at times the exchange rates are not entirely based on the actual present demand and supply but also on the prevailing speculated rates of forward contracts. It is very important here to state the fact though as it might seem that the rupee is a freely traded currency at market determined price, it is not the case. In 1992, owing to the pressure of market fluctuations, partial convertibility of the rupee was introduced. As per which 40 percent of the foreign exchange has to be surrendered to RBI at a fixed rate and the rest 60% of the same has to be exchanged at market rate. Currency as an investment We all wish to multiply our wealth and are looking for investments which might give us better returns. The assets in which we invest vary from fixed deposits, bonds, securities, real estate, commodities and even currencies. Since there is a high fluctuation in their currencies exchange rate, there are possibilities of making fortunes if one is able to predict a right move (there are chances of losing fortunes as well even in a single wrong move). So, the level of confidence of investors in a currency also act as a determinant for its exchange rate Foreign investment In this age of globalization, the searches for better investment opportunities are not limited to one’s own country. People do look for investments in foreign enterprises, securities, government bonds and projects. During the last decade there was a large flow of foreign investment in India because of its excellent GDP growth rate and high expectations owing to a demographic dividend. But during the last few years, the coalition government on account of various political compulsions has failed to take important economic decisions to boost the growth of the economy; this is commonly referred to as policy paralysis. In order to control ever growing inflation, RBI, the central bank of India launched a series of money tightening measures and has made it difficult for the enterprises to raise money for their investments. Thus this has led to hampering production and growth. A slowing growth, increasing inflation, and series of revelations about corruption and scams have dented the investors’ sentiments and confidence resulting in poor performance of securities (shares) markets. To add to it, the government with an eye on the General Elections going to be held next year has launched a set of populist schemes. The stagnating growth in production resulting in lower than expected revenues of the government in the form of taxes and the increasing expenses on account of populist schemes have led to a fiscal deficit. The growing fiscal deficit and inflation, poor performance of economy and enterprises and the increasing political instability in the Asia Pacific region especially Syria and Middle East is leading to decrease in the amount being invested in India. This is resulting in lower demands and depreciation in exchange value of the rupee. Tapering of quantitative easing by US Federal Reserve After the economic crisis of 2008, the Federal Reserve which is the central bank of the US has adopted a series of measures to ease the money supply in their economy. This includes keeping the interest rates to near zero levels by buying government bonds. Recently, the Federal Reserve has expressed its intention to taper the quantitative easing. This means that the interest rates in US which were very low are bound to increase and therefore the money which was pushed into foreign economies (emerging markets like India) for higher returns would find a safe haven in the US only. This again had lead to drying up of foreign investment in India and depreciation of the rupee. If you are an NRI and remitting money to India, the news of the falling rupee should bring cheer to you as the same amount of foreign currency which you earn is going to yield higher amount of Indian rupees. If you are a resident Indian and involved in imports of foreign goods, this won’t be the best of news as you will have to pay more rupees for the same goods even though there is no change in their foreign currency prices. Well, this reminds me of a recent quote which became quite popular on social media and very beautifully explains the state of mind of different stakeholders in foreign trade. It goes like this- ‘Exporters meet at Taj Hotel, importers meet at Apollo Heart Institute’ For the young generation of resident Indians, the falling rupee also represents signs of gloom as they would have to incur higher costs of any foreign education or foreign tours. Also, the aspirational products like fancy cars, bikes, smart phones and tablets are also going to make a big hole in your pocket as most of these products are imported. So does the falling rupee, by any chance have any positive affect whatsoever on the residents and the economy? Yes. The falling rupee is going to make our exports competitive against other countries and this might promote setting up of new export oriented organizations in India. Higher exports would mean high demand of rupee in the foreign exchange market and would again take the value of the rupee to an equilibrium which is stable in the longer term. So is it time to just sit back and relax rather than worrying about the falling rupee? I would leave that question unanswered as no one can predict accurately.