Analysis of reasons behind the recent rise of Dollar against Rupee

By:

Shivam Srivastava

CS10B051

Abstract:

This paper analyses the reasons behind the recent rise of Dollar against Rupee as shown in the chart below.

Chart showing the fall of Rupee against Dollar in the year 2013 (Credits: XE.com)

Contents:

Introduction What happened to Rupee recently? Why did that happen? A detailed analysis. The impact of the fall in rupee. What actions have been taken to curb it Conclusion and References

Introduction

The rupee has recently fallen to an all time low against the dollar in the foreign exchange

market which has led to several debates, discussions and reforms in the Indian economy. The

exchange rate of a currency has always been a topic of discussion as it indicates a number of

things ranging from the condition of the economy of a country to the policies that the country

has followed over the time.

Trend of Rupee in the past:

Before diving deeper into the most recent trend let us have a look at how the rupee has

performed in the past.

Rupee-dollar post independence:

When India achieved independence in 1947, there were no external borrowings in the balance

of payments sheet. Hence, the exchange rate on 15th August, 1947 stood at $1 = Rs1. But to

reform the poor economy, the Five Year Plans (FYPs) were introduced. The

aim was to bring about a reform in various sectors such as agriculture,

transport, communications, industry etc.

For the reforms, government needed to raise money. Hence, it needed

foreign borrowing and this devalued `. The foreign borrowing was further

reinforced due to the Indo-China (1962) and Indo-Pak (1965) war. India

borrowed mainly from the US and under pressure from the US to continue

providing further aid, the rupee had to be devalued against the dollar. So

rupee stood at $1 = Rs7 by the end of 1966.

Rise of dollar in 1970s and 80s:

Due to incompetence of Indian politics (ex: assassination of Mrs. Indira Gandhi) coupled

with robust economic growth in the US the exchange rate fell to $1 = `12.36 by year

1985. By 1990, it rose to $1 = Rs17.5

Post liberalization:

India was in huge debts as the forex reserves fell to new lows post

liberalization. So, India borrowed large amounts from the IMF at the

expense of devaluing the Rupee. As a result, the rupee hit new lows of $1

= Rs24.58 during early nineties.

Rupee today:

Fast forward to 2013 and rupee stands at $1 = Rs68.85 on August 28th

2013, it’s lowest ever.

This paper analyses the reasons behind this sudden fall in recent times.

Reasons for fall in Rupee in recent times:

Going by the fundamentals of economics, the price of something rises if the demand rises but

supply does not.

So, if the demand of dollars rises (red lines) more than the increase in supply of dollars (blue

line), the price of dollars rises from P1 to P2. This is the general reason behind the rise in

dollar against the rupee.

Relation of fall in rupee to demand and supply:

Suppose a customer wants to import something from the US. For this he would need dollars

as rupee will not be accepted by the US. So the customer goes to the foreign exchange market

to exchange rupee for dollar. But he is not alone in the market. And given India’s imports are

larger than India’s exports, there are more people demanding dollar than there are people who

are demanding rupee. Hence the demand for dollar is higher and rupee is devalued.

The major reasons behind the fall:

Following are some of the relevant points. The points shall be explained in terms of demand

supply later on.

1) Huge Trade and Current Deficit: India imports more goods than it exports. This

results in a trade imbalance, known as a trade deficit. The figure was around $185

billion in March 2012.

2) Reduction in capital inflows: Lately, India has become an attractive destination for

foreign investors. India received $30 billion through FDI, in addition to $18 billion

through FII in 2011-12. But due to uncertain conditions in the Indian market, policy

paralysis within the government and other domestic issues, the inflows have started

reducing in 2013.

3) High inflation: Due to high inflation, most foreigners and NRIs tend to keep money

abroad. This is because keeping the same money in the country reduces its value due

to inflation.

4) US Fed’s Bond Buying programme: One of the most significant reasons is the

sudden withdrawal of FIIs from India. US Fed Reserve made an announcement

hinting at tapering off the fiscal stimulus programme (Quantitative Easing) which

they had introduced in 2008 to help the US recover its economy. In 2008, the US was

in an economic crisis. So, the then Central Banker of the US Fed, Ben Bernanke,

announced the idea of ‘Quantitative Easing’. As a result, billions of dollars were

released in the markets as the Fed bought government bonds and injected money into

the economy. Due to the higher liquidity, the interest rates went down leading to a

boom in the emerging economies such as India, China, Brazil, etc. But this fame was

short lived. Ben Bernanke in June 2013, hinted at the withdrawal of the quantitative

easing programme owing to the recovery of the US economy. Investors started

panicking, rates of interest in the US increased and the exchange rates of these

emerging economies once again started to decline. Due to this withdrawal, not only

rupee but several other currencies are at their own new lows as is shown by the figure

below. The picture shows the fall in the prices of the Asian countries in the past 52

weeks.

A different way to understand:

Lesser the dollar in the market, the more will be its value and hence lesser the value of rupee.

Let us see how excess imports impact Indian economy. The most important thing that India

imports is crude oil.

The countries from which India imports crude oil do not accept the Indian Rupee for

payments. They accept an internationally accepted currency such as Dollar or Euro. As India

can’t print either of the currencies, it has to rely on other methods to accumulate

dollars/euros. The three main ways in which India gets dollars are as follows:

I) By exporting goods and services.

II) Foreign investment in India.

III) Remittance

This tells us that in order to keep importing the oil we need to keep getting dollars from the

above resources. If India runs out of foreign exchange, it will not be able to import oil,

without which nothing will function. This balance of imports and exports is kept track of

using the Current Account Deficit. The CAD is the difference between the imports and

exports of goods and services of the country, which in India’s case is continuously increasing.

One of the biggest factors worsening India’s CAD is the ever increasing gold and oil imports.

The festival “Akshaya Tritiya”, for instance, contributes heavily to imports in gold which

made the CAD even worse. But given only a limited amounts of foreign exchange, India can

either buy more of gold or more of oil. If imports for gold go high, the available forex for

importing oil reduces. But demand for oil remains the same/increases, as a result it burdens

the economy even further.

One might suggest that eliminating gold imports can be the answer to improving rupee’s

condition. But a lot of people in the country earn their livelihood by selling gold. So, the

problem will be solved not by eliminating gold imports, but by eliminating the ever rising

demand for gold.

Another reason- Indian politics:

Several reasons are cited for the fall in rupee. One of them is the incompetence of the

government. The people who vote for the government largely belong to the lower and middle

class families which vote not to have a better economy but to benefit themselves. As a result,

instead of focusing more on the economic reforms, government focuses more on other factors

as it has to maintain its voter base. How does this affect in the long run? Warren Buffet’s

quote summarizes this well: Only when the tide goes out do you discover who has been

swimming naked. Basically, the investors are interested in the Indian economy only as long

as things are going fine. But as and when there is a crisis they move their money to the more

profitable markets. Here is what S&P (Standard and Poor’s) has to say about the economy:

“The combination of a weakening political context for further reform, along with economic

deceleration, raises the risk that the government may take modest steps backward away from

economic liberalization in the event of unexpected economic shocks”

Consequences of the fall in rupee:

Downgrading of economic status:

India is now at the verge of being downgraded to “junk” status. If this happens, India will be

the first in the BRIC category to lose the “investment grade”. A “junk” rating implies that the

country will be unable to repay back the debt it has incurred. India last had a junk rating in

early 90s. S&P has already revised its rating outlook to India from “stable” to “negative” in

April 2012.

Benefits to the traders:

Due to the fall, the exports to other countries will become cheaper. So the fall will make

India’s exports more attractive to foreign consumers. But the imports will suffer due to the

higher costs. This gives an edge to the domestic producers to compete with the international

sellers. So, the result is higher exports and lower imports which should reduce CAD to some

extent. But the increase in exports will be limited as the goods exported require inputs which

need to be imported.

Fuel price:

As petrol is deregulated and diesel is partly deregulated, the increase in exchange rate is

expected to be passed onto the consumers. If the Oil Marketing Companies (OMCs) increase

fuel prices, there will be increase in transport prices which will raise inflation.

Students studying abroad:

Because of the depreciating rupee, students abroad will pay higher fees and the barrier to

pursue education abroad increases.

Tourism:

Due to cheaper rupee, it will be easier for people to tour India than the other way round.

How RBI measures have helped recover the rates and why it is temporary:

The rupee has recovered from 68+ to sub 62 as of 14th October, 2013. Various reasons have

been cited. The main reasons being the following:

i) Introduction of a ‘subsidized’ FCNR (B) deposit scheme. FCNR (B) – Foreign Currency

Non-Resident (Bank). This simply means that India is seeking help from Indians residing

abroad for increasing the inflow of dollars to the country. An FCNR account helps NRIs

looking to invest in India without worrying about any currency risks. The currency which

comes into FCNR has to be from the ‘permitted currency’ which include USD, GBP, Euro,

Yen etc.

What really happens in an FCNR is that the deposit made in the foreign currency is promised

back to the depositor later (1year – 5 years) at a forward rate on the exchange rate. This

forward rate is fixed by the RBI. The more the forward rate, the worse for the banks as they

will need to return larger amount of rupees after converting them into the required currency

to return. What RBI has done is that it has lowered the FCNR rates from 7% to 3.5%. This

has given the banks the incentive to raise FCNR funds as a result dollars start flowing in.

But this is temporary as the FCNR deposit window is open only until 30th November.

ii) The RBI also allowed banks to raise 100% of their unimpaired tier-1 capital through

overseas borrowing and allowed them to swap the funds at 100 basis points below the

prevailing market rate. What this means is that a few banks which qualify (have a certain

minimum level of capital) can enter into dollar-rupee swaps with RBI for any currency

borrowed by the bank after 10th September. The RBI has made the swap more profitable for

the bank by making available the swaps at 100 basis points lower than the market rate. 100

basis points are equal to 1 percent. This scheme also lasts only till 30th November.

An estimated $5.6 billion have come in through the above two moves by RBI.

iii) Tapering of Quantitative Easing has been postponed by a few months by the US. But it

is estimated that very soon (estimate - December 2013) the policy of easing will be

withdrawn. After the hint of tapering early in 2013, $11.5 billion of FIIs have been

withdrawn. There is still an estimated $26.5 billion worth of investment which can exit once

the tapering starts. Hence, this is another reason that the stabilization of the rupee is only

temporary.

iv) The shutdown in the US slowed the growth of dollars.

v) The expected uncertainty due to upcoming elections in India keeps the investors wary of

investing in the market.

Conclusion

This term paper briefly overviewed the recent situation of rupee against dollar and justified

the possible reasons behind it. It also delved into the reasons leading to a recovery in rupee

after its fall.

References:

The following two papers were referred:

i) Hierarchical Integration: The Dollar Economy and the

Rupee Economy – Anirudh Krishna and Jan Nederveen Pieterse

ii) An analytical study on Indian Rupee depreciation against the dollar – S Singhal

The papers can be found at:

http://prj.co.in/setup/business/paper7.pdf

http://www.jannederveenpieterse.com/pdf/Hierarchy%20KrishnaJNP.pdf

In addition to the above the following sites were referred:

http://www.financialexpress.com/news/rajan-reforms-to-fuel-10bn-fcnr-inflows/1165190

http://www.financialexpress.com/news/fcnr-funds-to-be-used-for-shortterm-credit-

bankers/1185036

http://www.business-standard.com/article/finance/5-reasons-why-rupee-recovery-may-not-

last-113100400363_1.html

http://zeenews.india.com/business/news/finance/rupees-free-fall-how-it-will-impact-

you_82322.html

http://www.quora.com/Indian-Rupee/What-are-the-reasons-for-Rupee-falling-against-the-

Dollar