Finance Minister P Chidambaram has stated in an interview in Singapore that the underlying causes of rupee depreciation are inflation, the fiscal deficit and the current account deficit, and now that the underlying causes are being addressed, there is no reason why the rupee should not be reasonably stable over a period of time.
Rupee depreciation is not a new phenomenon. Currency depreciation is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system. It is different from devaluation. Devaluation is an official lowering of the value of a country's currency within a fixed exchange rate system.
After the 19 per cent devaluation of the rupee in 1991, resulting in an exchange rate of Rs 24.50 against the dollar, we have adopted the Liberalised Exchange Rate Management System (LERMS) or what is commonly known as floating exchange rate system. In a floating exchange rate system, the government (RBI) intervenes at some frequency to change the direction of the float by buying or selling currencies. LERMS was to make balance of payments sustainable on an ongoing basis, thereby allowing market forces to play a greater role in determining the exchange rate of the rupee. From 1992, the depreciation of the rupee shows a continuous trend with minor fluctuations in some years. From August 2011 to June 2012, there was an almost 18 per cent decline in the external value of Indian rupee. June 21, 2012 saw an all-time low of the Indian rupee at the exchange rate of Rs 57.30 against the dollar.
To most economists, a high current account deficit (CAD), or the deficit in balance of payments, is responsible for rupee depreciation. The CAD of 4.5 per cent of GDP in the last quarter of 2011-12 was an all-time high. It was only 1.3 per cent of GDP during the same period in 2010-11. Decline in foreign capital inflows, domestic macro policy issues and the Euro Zone troubles have contributed to high CAD.
Exchange rate is determined by demand for and supply of dollars. Dollar flow (supply) into the economy is through foreign direct investment (FDI), foreign institutional investment (FII) and foreign debt. Exports can also bring in dollars. In its capacity as the custodian of the foreign exchange reserves of the country, RBI can also supply dollars. Dollar demand is for imports. To build up dollar stocks, RBI also demands dollars.
During 2011-12, on the supply side, exports declined and foreign investments dried up, thereby reducing dollar inflows. On the demand side, dollar demand went up due to rise in crude prices and the sudden increase in gold investments. So, the fall in rupee value was inevitable.
Though, the fall in the rupee can theoretically discourage imports and boost exports resulting in reduced CAD, in practice it has not happened. Fall in imports did not happen mainly due to the inelastic demand for petrol. Lower demand from the major export markets of the USA and European Union disappointed Indian exporters. RBI's effort to strengthen the rupee is weakened by excessive pressure on foreign exchange reserves.
Since endogenous factors are the main reason for the slide in rupee value, the policy approach should focus on building up strong domestic fundamentals.
The problems transmitted from the Euro zone, USA and now China have also contributed to the rupee fall. The solution is to work investor confidence through actual policy by reviving the 'animal spirits' in the economy. We have to rethink our export promotion and import substitution policies. The emphasis should be on the production of exportables with inelastic demand. The direction and composition of our foreign trade also should undergo changes.
According to the Economics Division of Credit Analysis & Research Limited (CARE), the following could be the points of influence for the rupee in the coming months of 2013.
"Trade deficit may widen as exports are likely to be subdued given low growth in two major regions -- Europe and USA. The current account balance will be under pressure and would be in the region of 3.7-3.8 per cent of GDP for the year provided oil prices do not rise sharply. FII inflows may be expected to continue and the passage of certain bills in the Winter session of Parliament could stabilise these flows. FDI will continue to be weak this year as outflows from the developed world would be low given the economic conditions. FII funds will have to compensate for the same. RBI action will be critical. As of now, the RBI has maintained that it will intervene only in case there is extreme volatility. It is expected that the capital flows will help to cover the current account deficit and the rupee will remain in the range of Rs 54-56 to the dollar for the most part of the year. The deviations would be only temporary in either direction."
Steps should be taken to attract more NRI investments and FDI. Gold and coal imports should be restricted. A proactive role from the government is the need of the hour.
(The writer is professor of economics at Christ University, Bangalore.)
Rupee depreciation is not a new phenomenon. Currency depreciation is the loss of value of a country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system. It is different from devaluation. Devaluation is an official lowering of the value of a country's currency within a fixed exchange rate system.
After the 19 per cent devaluation of the rupee in 1991, resulting in an exchange rate of Rs 24.50 against the dollar, we have adopted the Liberalised Exchange Rate Management System (LERMS) or what is commonly known as floating exchange rate system. In a floating exchange rate system, the government (RBI) intervenes at some frequency to change the direction of the float by buying or selling currencies. LERMS was to make balance of payments sustainable on an ongoing basis, thereby allowing market forces to play a greater role in determining the exchange rate of the rupee. From 1992, the depreciation of the rupee shows a continuous trend with minor fluctuations in some years. From August 2011 to June 2012, there was an almost 18 per cent decline in the external value of Indian rupee. June 21, 2012 saw an all-time low of the Indian rupee at the exchange rate of Rs 57.30 against the dollar.
To most economists, a high current account deficit (CAD), or the deficit in balance of payments, is responsible for rupee depreciation. The CAD of 4.5 per cent of GDP in the last quarter of 2011-12 was an all-time high. It was only 1.3 per cent of GDP during the same period in 2010-11. Decline in foreign capital inflows, domestic macro policy issues and the Euro Zone troubles have contributed to high CAD.
Exchange rate is determined by demand for and supply of dollars. Dollar flow (supply) into the economy is through foreign direct investment (FDI), foreign institutional investment (FII) and foreign debt. Exports can also bring in dollars. In its capacity as the custodian of the foreign exchange reserves of the country, RBI can also supply dollars. Dollar demand is for imports. To build up dollar stocks, RBI also demands dollars.
During 2011-12, on the supply side, exports declined and foreign investments dried up, thereby reducing dollar inflows. On the demand side, dollar demand went up due to rise in crude prices and the sudden increase in gold investments. So, the fall in rupee value was inevitable.
Though, the fall in the rupee can theoretically discourage imports and boost exports resulting in reduced CAD, in practice it has not happened. Fall in imports did not happen mainly due to the inelastic demand for petrol. Lower demand from the major export markets of the USA and European Union disappointed Indian exporters. RBI's effort to strengthen the rupee is weakened by excessive pressure on foreign exchange reserves.
Since endogenous factors are the main reason for the slide in rupee value, the policy approach should focus on building up strong domestic fundamentals.
The problems transmitted from the Euro zone, USA and now China have also contributed to the rupee fall. The solution is to work investor confidence through actual policy by reviving the 'animal spirits' in the economy. We have to rethink our export promotion and import substitution policies. The emphasis should be on the production of exportables with inelastic demand. The direction and composition of our foreign trade also should undergo changes.
According to the Economics Division of Credit Analysis & Research Limited (CARE), the following could be the points of influence for the rupee in the coming months of 2013.
"Trade deficit may widen as exports are likely to be subdued given low growth in two major regions -- Europe and USA. The current account balance will be under pressure and would be in the region of 3.7-3.8 per cent of GDP for the year provided oil prices do not rise sharply. FII inflows may be expected to continue and the passage of certain bills in the Winter session of Parliament could stabilise these flows. FDI will continue to be weak this year as outflows from the developed world would be low given the economic conditions. FII funds will have to compensate for the same. RBI action will be critical. As of now, the RBI has maintained that it will intervene only in case there is extreme volatility. It is expected that the capital flows will help to cover the current account deficit and the rupee will remain in the range of Rs 54-56 to the dollar for the most part of the year. The deviations would be only temporary in either direction."
Steps should be taken to attract more NRI investments and FDI. Gold and coal imports should be restricted. A proactive role from the government is the need of the hour.
(The writer is professor of economics at Christ University, Bangalore.)