Depreciation Of The Indian Rupee – A Short Commentary

On 28^th August 2013 the Indian Rupee plunged to an all time low of 68.85 to the US Dollar – a depreciation of nearly 25% since January 2013. Let’s examine some of the issues that brought the rupee to such a state.

We’ll start by going back in time when after independence in 1947, India adhered to socialist policies. Attempts were made to liberalise the economy in 1966 which was reversed a year later in 1967. Another attempt was made in 1985 by the then Prime Minister Rajiv Gandhi which came to a halt in 1987. In 1991, after India faced a Balance of Payment crisis, it had to pledge 20 tonnes of gold to the Union Bank of Switzerland and another 47 tonnes to the Bank of England as part of a bailout deal with the International Monetary Fund. Additionally the IMF required India to undertake a series of structural economic reforms. The economic liberalization of India started on 24^th July 1991 which included policies such as opening for international trade and investment, deregulation, initiation of privatisation, tax reforms and inflation control measures. These policies started showing results when in 2007 India recorded a GDP growth of 9%. However, the economy slowed to around 5% in 2012-13 as compared to 6.2% in the previous fiscal (considering that there was a global financial meltdown in 2008 the figure of 6.2% is comparatively okay). India’s GDP which had grown by 9.3% in 2010-11, went south by nearly 50% in 2012-13 in a span of just 2 years. (GDP Graph)

Until the liberalisation of 1991, India was largely and intentionally isolated from the world markets to protect its economy and to achieve self-reliance. Foreign trade was restricted and subject to import tariffs, export taxes and quantitative restrictions. Since independence, India’s Balance of Payment had been negative until 1991 (India's Balance of Trade Graph). After liberalisation, India’s exports have risen covering 80.37% of its imports in September 2013, up from 66.20% in 1990-91.

At this juncture a little history here is warranted. The British came to India in 1608 when the East India Company established a settlement in Surat, Gujarat . After the mutiny of 1857 the East India Company’s powers were transferred to the Crown. From 1858 till 1947 India was ruled by the Crown in what is now known as the British Raj. India got freedom from British rule on 15^th August 1947. The Rupee which was linked to the British Pound from 1927 to 1946 had its value at par with the US Dollar. After independence there were no foreign borrowings on India's balance sheet. To finance welfare and development activities, especially with the introduction of the Five-Year Plan in 1951, the government started external borrowings. This required the devaluation of the rupee. On 24^th September 1975, the Rupee’s ties to the British Pound were broken. India conducted a managed float exchange regime with the Rupee’s effective rate placed on a controlled, floating basis and linked to a “basket of currencies” of India’s major trading partners – the US Dollar, the British Pound, the Japanese Yen and the Deutsche Mark. The year 1993 is very important in Indian currency history. It was in this year when the currency was let free to flow with the market sentiments. The exchange rate was freed to be determined by the market, with provisions of intervention by the central bank under the situation of extreme volatility. In 1993, one was required to pay `31.37 to get a dollar. In the last decade, the rupee traded in the range of 40-50 to the US Dollar; touching a high of 44.61 in 2007. The Indian currency has gradually depreciated since the global 2008 economic crisis

Let’s now pay a visit to the final days of World War II. In an effort to create a new global economic order; 44 leaders from all the Allied nations met in Bretton Woods, New Hampshire, USA in what is now known as the Bretton Woods System. The Bretton Woods System of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid-20th century. The Bretton Woods System was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. With much of the global economy in tatters, the US emerged as the world’s new economic leader to replace a debt-ridden and war-torn Great Britain. The chief features of the Bretton Woods System were an obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the US Dollar and the ability of the IMF to bridge temporary imbalances of payments.

This historic meeting created an international gold-backed monetary standard which relied heavily upon the US Dollar. At this point, an appropriate question to be asking yourself is: ''Why would all of the nations be willing to allow the value of their currencies to be dependent upon the US Dollar?".

The answer is quite simple. The US Dollar would be pegged at a fixed rate to gold.

This made the US Dollar completely convertible into gold at a fixed rate of $35 per ounce within the global economic community. This international convertibility into gold allayed concerns about the fixed rate regime and created a sense of financial security among nations in pegging their currency's value to the Dollar. After all, the Bretton Woods arrangement provided an escape hatch: if a particular nation no longer felt comfortable with the Dollar, they could easily convert their Dollars holdings into gold. This arrangement helped restore a much needed stability in the financial system. But it also accomplished one other very important thing. The Bretton Woods agreement instantly created a strong global demand for US Dollars as the preferred medium of exchange. By the end of the war, nearly 80 percent of the world’s gold was sitting in US vaults and the US Dollar had officially become the world’s undisputed reserve currency. As a result of the Bretton Woods arrangement, the Dollar was considered to be “safer than gold.”

Initially, this Dollar system worked well. However, by the 1960s, the weight of the system upon the United States became unbearable. On 15^th August 1971, President Richard M. Nixon shocked the global economy when he officially ended the international convertibility from US Dollars into gold, thereby bringing an official end to the Bretton Woods arrangement.

Two years later, in an effort to maintain global demand for US Dollars, another system was created called the petroDollar system. In 1973, a deal was struck between Saudi Arabia and the United States in which every barrel of oil purchased from the Saudis would be denominated in US Dollars. Under this new arrangement, any country that sought to purchase oil from Saudi Arabia would be required to first exchange their own national currency for US Dollars. In exchange for Saudi Arabia's willingness to denominate their oil sales exclusively in US Dollars, the United States offered weapons and protection of their oil fields from neighbouring nations, including Israel.

By 1975, all of the OPEC nations had agreed to price their own oil supplies exclusively in US Dollars in exchange for weapons and military protection. This petroDollar system, or more simply known as an "oil for Dollars" system, created an immediate artificial demand for US Dollars around the globe. And of course, as global oil demand increased, so did the demand for US Dollars. Today the most traded currency is the US Dollar having a share of 85% of the global foreign exchange market turnover.

India imports crude oil, precious stones, machinery, fertilizer, iron, steel and  chemicals. Since India is heavily dependent on coal and foreign oil imports for its energy needs; India's main import is crude oil (more than 35% of total imports), and the countries it imports from unfortunately only accept US Dollars or other major currencies. Therefore, India needs to have a large reserve of US Dollars and other currencies to pay for the crude oil (US$ 2,49,324.60 million of foreign currency reserves as on 4^th October 2013). India receives Dollars in three ways: through exports, through foreign investments into India, and through NRI remittances into India. The less Dollars there are in the market, the more the Dollar is worth (basic laws of demand and supply), and, so, the Rupee depreciates.

From 2003 to 2008, the Rupee appreciated against the US Dollar; thereafter, it has sharply depreciated. Between 2010 and 2012, the Rupee value had depreciated by about 30% of its value to the US Dollar in 2010. On 28^th August 2013 it plunged to an all time low of 68.85 to the US Dollar.

Historical Indian Rupee Rate V. US Dollar (Average exchange rate)
Year	INR/USD	Year	INR/USD	Year	INR/USD	Year	INR/USD
1973	7.66	1984	11.36	1995	32.43	2006	45.17
1974	8.03	1985	12.34	1996	35.52	2007	41.20
1975	8.41	1986	12.60	1997	36.36	2008	43.41
1976	8.97	1987	12.95	1998	41.33	2009	48.32
1977	8.77	1988	13.91	1999	43.12	2010	45.65
1978	8.20	1989	16.21	2000	45.00	2011	46.61
1979	8.16	1990	17.50	2001	47.23	2012	53.34
1980	7.89	1991	22.72	2002	48.62
1981	8.68	1992	28.14	2003	46.60
1982	9.48	1993	31.26	2004	45.28
1983	10.11	1994	31.39	2005	44.01

One of the most important questions that many are asking is why the Rupee has fallen to its current state. Exchange rate can be best understood as nothing more than a benchmark for a nation's money supply. When the Rupee depreciates against the Dollar, it simply means value of the Indian currency has gone down relatively against the greenback (US Dollar). This can happen because of two things: 1) increase in Rupees in the market; or 2) decrease of Dollars in the market.

Since the beginning of Quantitative Easing program the emerging markets have been the biggest beneficiaries of the Fed’s loose monetary policy, which has pumped extra liquidity since the global financial crisis of 2008. According to the IMF, emerging markets received nearly $4 trillion in capital flows from 2009 to early this year.

The recovery in the US economy is expected to prompt the central bank there to end the loose monetary policy by the year end. There is ample reason for concern that capital outflows from India and other emerging markets will rapidly accelerate if the Federal Reserve decides to curtail its bond-buying program on 17^th September 2013. This move would lead to higher interest rates in the US and investors may dump risky emerging markets assets in favour of safe havens. Anticipating this, foreign investors are pulling out their money from India to invest it back in the US, which is resulting in a scarcity of Dollars in India. This has created a shortfall in supply of the Dollar in India. This is not India specific. All emerging market currencies are witnessing a similar capital flight. US recovery is also boosting the dollar strength. The FIIs have also been heading to greener pastures like Singapore owing to the greater operational efficiency and lesser bureaucratic problems that have unsettled the Indian business fraternity and hampered its overall economic growth.

Secondly, importers (mostly oil companies since we import most of our crude oil) are the major entities who are in need of the Dollar for making their payments. This again creates a demand for the US Dollar.

This situation can only be addressed by exporters who can bring in dollars in the system. Secondly, if somehow the FIIs can be wooed back, then this situation can also be addressed to a certain extent. FII net investments have plunged from `1,78,537.80 crores in 2012-13 to `(-)37,062.40 crores as on 30^th September 2013. From June 2013 till September 2013 the FIIs have withdrawn from the Indian markets. Despite a modest recovery in the rupee’s value between 4^th and 12^th September 2013, the investors remain wary of India’s excessive dependence on volatile “hot money” flows to finance its current account deficit. The investors borrowed cheap short-term money in the US and invested in higher yielding assets in India, Indonesia, South Africa and other emerging markets. This resulted in more money flowing into debt, equity and commodity markets in these countries. In India, many companies resorted to heavy borrowings overseas (since interest rates were lower there). The massive capital inflows also enabled India to comfortably finance its trade and current account deficits rather than addressing the structural aspects of Current Account Deficit (CAD).

India's Gross Domestic Product grew only at 4.4 percent in the second quarter of 2013, the worst quarterly rate since 2002, hurt by a decline in mining and manufacturing. When a country’s imports far exceeds its exports the CAD increases which is a cause for worry. This certainly seems to be a large contributor to the depreciation of the rupee. Over the past 2 years, India's money supply grew at around 29 per cent, while it's GDP grew at a much lower pace. This caused inflation to go into the two figure realm. By limiting the money supply, inflation and, potentially, the rupee's value would be controlled- but it would severely impact the country's growth. India's GDP has dropped from 6.2 per cent to 4.4 per cent in latest quarter of this fiscal year, so India's growth would be hampered by lowering its money supply.

India should let the markets remain open and democratic- eventually, Indian goods will be cheap enough to a point where they will be easily exported. India's urbanisation is not going to stop, wages will continue to rise, and inflation will be controlled since the money supply can be kept at par with GDP growth. The rupee will probably rise in the short term but at a certain point, equilibrium will kick in. There is a high level of pessimism in the markets. It goes without saying that India needs to address the rising current account deficit and slow growth on a war footing to ensure that the rupee does not depreciate any further.