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1. Index
1. Brief introduction
2. Factors affecting INR
3. Major crisis related to INR
4. Liberalization in 1991 and its impact on INR
5. Exchange rate policy of India
6. Rupee movement graphs after independence
7. Rupee depreciation and its impact
8. Outlook on INR.
2. Brief Introduction
The persistent decline in the value of INR is of great concern to the nation. Even if now that we are in
the stage of reform we need to strengthen INR against major currencies of the world. The following
report is a brief analysis of the possible causes of currency depreciation, its impact and the current
outlook of INR. For last few years for reasons like withdrawal of FIIs, widening current deficits, decline in
other capital flows like FDI, ECBs, and FCCBs. Along with these factors the report also emphasizes on
major crisis in the history of India related to the INR. Exchange rate policy is also one of the greatest
determinants of the INR depreciation. These movements are shown by graphs and data of REER, NEER
and BOP. Also it discusses about how can the depreciation of the currency can be used to draw
advantage.
The recent reforms like rate hike of diesel and allowing 100% FDI in retail and aviation have shown a
good appreciation in the currency but still the political instability and the uncertain climate about the
coalition govt is posing hurdles.
3. Factors affecting INR
In the following section we are discussing the factors which are affecting the currency. There can be
many reasons for the depreciation of the currency, but we need to categorise them into various
headings. Further it is being discussed in detail with the help of data extracted from the various sources
ranging from RBI, SEBI etc.
The factors affecting INR:
I. Market Situation
II. Economic Factors
III. Political factors
IV. Special Factors
As we know that Forex market for Indian currency is highly volatile where one cannot
forecast exchange rate easily, there is a mechanism which works behind the determination
of exchange rate. One of the most important factors, which affect exchange rate, is demand
and supply of domestic and foreign currency. There are some other factors also, which are
having major impact on the exchange rate determination. After studying research reports on
relationship between Rupee and Dollar of last four years we identified some factors, which
have been segregated under four heads. These are:
Market Situation:
I. FIIS
II. Demand/Supply situation of currency
III. Buying/selling in forex markets
IV. Floating rate of currency
Economic Factors:
I. Internal Factors
a) Industrial Deficit
b) Fiscal Deficit
c) GDP & GNP
d) Foreign Exchange Reserves
e) Inflation Rate
f) Agricultural Rate and production
g) Different types of policy impacts (EXIM, Credit policy etc.)
h) Infrastructure
II. External Factors
a) Export Import
b) Loan sanctions by World Bank and IMF
c) International oil and gold prices
d) FDI & Portfolio investments
Political Factors:
4. I. Political instability
II. Delay in implementation of policies
III. Delay in sanctioning of budget
Special factors:
Events contributing in the appreciation and depreciation of the currency e.g
I. Indo –China War (1962)
II. Indo-Pak War (1965)
III. Bofors Scandal (1985)
IV. Pokhran Nuclear Test(1998)
V. Kargil War (1999)
VI. CWG Scam
VII. Anna Hazare Campaign
VIII. Recent Credit Rating
Now that we have categorised each factors, we’ll be discussing them in detail.
Market situations: India follows the “floating rate system” for determining exchange rate. In this
system “market situation” also is pivot for determining exchange rate. As we know that 90% of the
Forex market is between the inter-bank transactions. So, how the banks are taking the decision for
settling out their different exposure in the domestic or foreign currency that is impacting to the
exchange rate. Apart from the banks, transactions of exporters and importers are having impact on
this market. So in the day-to-day Forex market, on the basis of the bank and trader’s transactions
the demand and supply of the currencies increase or decrease and that is deciding the exchange
rate. On the basis of this study we found out the different types of the decisions, which is affecting
to market. These are as follows:
In India, there are big Public Sectors Units (PSUs) like ONGC, GAIL, IOC etc. all the foreign related
transactions of these PSUs are settled through the State Bank of India. E.g. India is importing
Petroleum from the other countries so payment is made through State Bank of India in the foreign
currency. When State Bank of India (SBI) sells and buys the foreign currency then there will be
noticeable movement in the rupee. If the SBI is going for purchasing the Dollar then Rupee will be
depreciated against Dollar and vice versa.
Foreign Institutional Investor’s (FIIs) inflow and outflow of the currency is having the major impact
on the currency. E.g. U.S. based company is investing their money through the Stock markets BSE
or NSE so her inflows of the Dollars is increasing and when it is selling out their investments
through these Stock markets then outflows of the Dollars are increasing. However if the FIIs
inflowing the capital in the country then there will be the supply of the foreign currency increases
and Demand for the Rupee will increases and that will resulted appreciation in the rupee and vice
versa.
5. Importer and Exporter’s trading is also affecting to the rupee. Like if an Indian exported material to
U.S. so he will get his payments in Dollars and that will increase the supply of Dollars and increase
of demand of rupee and that will appreciate the rupee and vice versa.
Banks can be confronted different positions like oversold or over bought position in the foreign
currency. So bank will try to eradicate these positions by selling or purchasing the foreign currency.
So this will be increased or decreased demand and supply of the currency. And that will cause to
appreciation or depreciation in the currency.
As we know that in India there is a floating rate system. In India Central Bank (RBI) is always
intervene in the trade for smoothen the market. And this RBI can achieve by selling foreign
exchange and buying domestic currency. Thus, demand for domestic currency which, coupled with
supply of foreign exchange, will maintain the price foreign currency at the desired level.
Interventions can be defined as buying or selling of foreign currency by the central bank of a
country with a view to maintaining the price of a given currency against another currency. US
Dollar is the currency of intervention in India.
2. Economic Factors:
In the Forex Market Economic factors of the country is playing the pivot role. Every country is
depending on its prospect economy. If there will be change in any economy factors, which will
directly or indirectly affected to Forex market. Here there are two types of economic factors. These
are as follows:
1. Internal Factors.
2. External Factors.
Internal Factors includes:
Industrial Deficit of the country.
Fiscal Deficit of the country.
GDP and GNP of the country.
Foreign Exchange Reserves.
Inflation Rate of the Country.
Agricultural growth and production.
Different types of policies like EXIM Policy, Credit Policy of the country as well reforms undertaken
in the yearly Budget.
Infrastructure of the Country
External Factors includes:
Export trade and Import trade with the foreign country.
Loan sanction by World Bank and IMF
Relationship with the foreign country.
Internationally OIL Price and Gold Price.
Foreign Direct Investment, Portfolio Investment by the country.
3. Political Factors:
6. In India election held every five years mean thereby one party has rule for the five years. But from
the 1996 India was facing political instability and this type of political instability has created hefty
problem in the different market especially in Forex market, which is highly volatile. In fact in the year
1999 due to political uncertainty in the BJP Government the rupee has depreciated by 30 paise in
the month of April. So we can say that political can become important factor to determine foreign
exchange in India.
Due to political instability there can be possibility of de possibility delaying implementation of all
policies and sanction of budget. So that will create also major impact on trade.
4. Special Factors:
Till now we have seen the general factors, which will affect the Forex market in daily business. And
on that factors the different players in the market have taken the decision. But some times some
event happened in such a way that it will really change the whole scenario of the market so we can
called that event special factors. However traders have to really consider those things and take the
decisions. We will see these types of factors in detailed:
In the year 1998, when Government of India has done “Pokhran Nuclear Test” at that time rupee
has been depreciated around 85 paise in day and 125 paise in seven days. Her main fear was that
U.S., Australia and other countries have stop to sanctions the loans So this type of event will have
major impact on the market. And due to this the decision procedure of the trader also varies.
In the year 2000,India has faced Kargil war, which is also affected to the market. By this war the
defense expenditures are raised and due to that there will be increase in the fiscal deficit. And
become obstacle in the growth of the economy. So this type of event has impact on the Forex
market.
7. Major Crisis in India related to INR
1966 Economic Crisis
From 1950, India ran continued trade deficits that increased in magnitude in the 1960s.
Furthermore, the Government of India had a budget deficit problem and could not borrow money
from abroad or from the private corporate sector, due to that sector's negative savings rate. As a
result, the government issued bonds to the RBI, which increased the money supply, leading to
inflation. In 1966, foreign aid, which had hitherto been a key factor in preventing devaluation of the
rupee, was finally cut off and India was told it had to liberalise its restrictions on trade before foreign
aid would again materialise. The response was the politically unpopular step of devaluation
accompanied by liberalisation. Furthermore, The Indo-Pakistani War of 1965 led the US and other
countries friendly towards Pakistan to withdraw foreign aid to India, which necessitated more
devaluation. Defence spending in 1965/1966 was 24.06% of total expenditure, the highest it has
been in the period from 1965 to 1989 (Foundations, pp 195). Another factor leading to devaluation
was the drought of 1965/1966 which resulted in a sharp rise in prices.
At the end of 1969, the Indian Rupee was trading at around 13 British pence. A decade later, by
1979, it was trading at around 6 British pence. Finally by the end of 1989, the Indian Rupee had
plunged to an all-time low of 3 British pence. This triggered a wave of irreversible liberalisation
reforms away from populist measures.
1991 Economic Crisis
By 1985, India had started having balance of payments problems. By the end of 1990, it was in a
serious economic crisis. The government was close to default, its central bank had refused new
credit and foreign exchange reserves had reduced to such a point that India could barely finance
three weeks’ worth of imports. India had to airlift its gold reserves to pledge it with International
Monetary Fund (IMF) for a loan.
he crisis was caused by currency overvaluation; the current account deficit and investor confidence
played significant role in the sharp exchange rate depreciation.
The economic crisis was primarily due to the large and growing fiscal imbalances over the 1980s.
During mid eighties, India started having balance of payments problems. Precipitated by the Gulf
War, India’s oil import bill swelled, exports slumped, credit dried up and investors took their money
out.[6] Large fiscal deficits, over time, had a spill over effect on the trade deficit culminating in an
external payments crisis. By the end of 1990, India was in serious economic trouble.
The gross fiscal deficit of the government (centre and states) rose from 9.0 percent of GDP in 1980-
81 to 10.4 percent in 1985-86 and to 12.7 percent in 1990-91. For the centre alone, the gross fiscal
deficit rose from 6.1 percent of GDP in 1980-81 to 8.3 percent in 1985-86 and to 8.4 percent in 1990-
91. Since these deficits had to be met by borrowings, the internal debt of the government
accumulated rapidly, rising from 35 percent of GDP at the end of 1980-81 to 53 percent of GDP at
the end of 1990-91. The foreign exchange reserves had dried up to the point that India could barely
finance three weeks worth of imports.
In mid-1991, India's exchange rate was subjected to a severe adjustment. This event began with a
slide in the value of the Indian rupee leading up to mid-1991. The authorities at the Reserve Bank of
India took partial action, defending the currency by expending international reserves and slowing
8. the decline in value. However, in mid-1991, with foreign reserves nearly depleted, the Indian
government permitted a sharp depreciation that took place in two steps within three days (July 1
and July 3, 1991) against major currencies.
With India’s foreign exchange reserves at $1.2 billion in January 1991 and depleted by half by
June, barely enough to last for roughly 3 weeks of essential imports, India was only weeks way from
defaulting on its external balance of payment obligations.
The caretaker government in India headed by Prime Minister Chandra Sekhar’s, immediate response
was to secure an emergency loan of $2.2 billion from the International Monetary Fund by pledging
67 tons of India's gold reserves as collateral. The Reserve Bank of India had to airlift 47 tons of gold
to the Bank of England and 20 tons of gold to the Union Bank of Switzerland to raise $600
million. National sentiments were outraged and there was public outcry when its was learned that
the government had pledged the country's entire gold reserves against the loan. Interestingly, it was
later revealed that the van transporting the gold to the airport broke down on route and panic
followed.[1] A chartered plane ferried the precious cargo to London between 21 May and 31 May
1991, jolting the country out of an economic slumber.[6] The Chandra Shekhar government had
collapsed a few months after having authorized the airlift.[6] The move helped tide over the balance
of payment crisis and kick-started Manmohan Singh’s economic reform process.[7]
P.V. Narasimha Rao took over as Prime Minister in June, the crisis forcing him to rope in Manmohan
Singh as Finance Minister, who unshackled what was then called the 'caged tiger'.[6] The Narasimha
Rao government ushered in several reforms that are collectively termed as liberalisation in the
Indian media. Although, most of these reforms came because IMF required those reforms as a
condition for loaning money to India in order to overcome the crisis. There were significant
opposition to such reforms, suggesting they are an "interference with India's autonomy". Then
Prime Minister Rao's speech a week after he took office highlighted the necessity for reforms, as
New York Times reported, "Mr. Rao, who was sworn in as Prime Minister last week, has already sent
a signal to the nation -- as well as the I.M.F. -- that India faced no "soft options" and must open the
door to foreign investment, reduce red tape that often cripples initiative and streamline industrial
policy. Mr. Rao made his comments in a speech to the nation Saturday night." [15] The forex reserves
started picking up with the onset of the liberalisation policies and peaked to $314.61 billion at the
end of May 2008.
A program of economic policy reform has since been put in place which has yielded very satisfactory
results so far. While much still remains on the unfinished reform agenda, the prospects of macro
stability and growth are indeed encouraging India.
Economic problems in 2012 led to comparisons to the 1991 crisis in various media outlets.
9. Liberalization in 1991
Economic liberalization is a very broad term that usually refers to fewer government regulations and
restrictions in the economy in exchange for greater participation of private entities; the doctrine is
associated with classical liberalism. The arguments for economic liberalization include greater
efficiency and effectiveness that would translate to a "bigger pie" for everybody. Thus, liberalisation
in short refers to "the removal of controls", to encourage economic development.[1]
Most first world countries, in order to remain globally competitive, have pursued the path of
economic liberalization: partial or full privatisation of government institutions and assets, greater
labour-market flexibility, lower tax rates for businesses, less restriction on both domestic and foreign
capital, open markets, etc. British Prime Minister Tony Blair wrote that: "Success will go to those
companies and countries which are swift to adapt, slow to complain, open and willing to change. The
task of modern governments is to ensure that our countries can rise to this challenge.”
In developing countries, economic liberalization refers more to liberalization or further "opening up"
of their respective economies to foreign capital and investments. Three of the fastest growing
developing economies today; Brazil, China and India, have achieved rapid economic growth in the
past several years or decades after they have "liberalized" their economies to foreign capital.[3]
Many countries nowadays, particularly those in the third world, arguably have no choice but to also
"liberalize" their economies in order to remain competitive in attracting and retaining both their
domestic and foreign investments. In the Philippines for example, the contentious proposals
for Charter Change include amending the economically restrictive provisions of their 1987
constitution.
The total opposite of a liberalized economy would be North Korea's economy with their closed and
"self-sufficient" economic system. North Korea receives hundreds of millions of dollars worth of aid
from other countries in exchange for peace and restrictions in their nuclear programme. Another
example would be oil rich countries such as Saudi Arabia and United Arab Emirates, which see no
need to further open up their economies to foreign capital and investments since their oil reserves
already provide them with huge export earnings.
The impact of these reforms may be gauged from the fact that total foreign investment
(including foreign direct investment, portfolio investment, and investment raised on international
capital markets) in India grew from a minuscule US$132 million in 1991–92 to $5.3 billion in 1995–
96.
Election of AB Vajpayee as Prime Minister of India in 1998 and his agenda was a welcome change.
His prescription to speed up economic progress included solution of all outstanding problems with
the West (Cold War related) and then opening gates for FDI investment. In three years, the West
was developing a bit of a fascination to India’s brainpower, powered by IT and BPO. By 2004, the
West would consider investment in India, should the conditions permit. By the end of Vajpayee’s
term as Prime Minister, a framework for the foreign investment had been established. The new
incoming government of Dr. Manmohan Singh in 2004 is further strengthening the required
infrastructure to welcome the FDI.
Today, fascination with India is translating into active consideration of India as a destination for FDI.
The A T Kearney study is putting India second most likely destination for FDI in 2005 behind China. It
has displaced US to the third position. This is a great leap forward. India was at the 15th position,
only a few years back. To quote the A T Kearney Study “India's strong performance among
10. manufacturing and telecom & utility firms was driven largely by their desire to make productivity-
enhancing investments in IT, business process outsourcing, research and development, and
knowledge management activities”.
11. Exchange Rate Policy
The large and abrupt drop in the currency’s value has negatively impacted businesses and
households by pushing up costs in an inflationary phase, increased price uncertainty and volatility,
dented economic confidence, and worsened the critical macroeconomic aggregates. The near free
fall of the rupee and its disastrous fallout raises an important public policy issue: is it worth keeping
intervention as an additional tool at India’s disposal?
It is clear that intervention is no longer a policy option at the Reserve Bank of India (RBI) —
its belated and feeble intervention makes this apparent. But the current experience provides an
opportunity to critically examine the trade-offs of India’s macroeconomic policy choices in recent
years.
In 2010–11 capital inflows were buoyant, aggregating US$60 billion. The exchange rate adjusted fully
to this inflow with a nominal appreciation of an average of 4 per cent year-on-year each month, and
the adjustment in real effective terms was double this. Monthly inflation averaged a very high 10 per
cent, while both oil and non-oil imports grew briskly at an average of 20 per cent every month.
With nearly 80 per cent of oil supplies coming from abroad, there is little doubt about the role a
stronger currency might have played in restraining imported inflation. Exchange rate appreciation
also allowed authorities to lessen the weight assigned to interest rates for monetary tightening that
domestic inflationary conditions demanded.
A hands-off exchange rate policy was helpful on other counts as well. What, for example, might have
been the fiscal cost of intervention in an inflationary phase?
This cost arises from the RBI exchanging foreign currency purchases for rupee assets —
called Market Stabilisation Bonds (MSBs) — to limit feedback into the domestic money supply.
Because rupee interest rates are higher relative to foreign currency, the differential interest cost
devolves onto the government balance sheet. Assuming RBI had bought half the net capital inflow in
2010-11 ($30 billion) and sterilised the purchase, the quasi-fiscal cost would have been roughly Rs
62.47 billion or 0.13 per cent of GDP.
How much pressure would have been placed on the yield rate from additional issues of government
bonds, in addition to the budgeted market borrowings of Rs 3.45 trillion? This is difficult to predict
but it is doubtful a bond supply of nearly Rs 4.8 trillion (US$98 million) would have resulted in an
average long-bond yield rate of 7.9 per cent as it did in 2010–11. The current financial year can serve
as a rough guide for expected borrowings of more than Rs 5 trillion (US$102 million) pushed bond
yields beyond 8.75 per cent in November. This forced the government to lift caps on foreign
investment in sovereign bonds and the RBI to regularly manage yields through open-market
operations. So there is little doubt that a no-intervention policy averted pressure on the yield rate in
2010–11.
But the wheels of fortune can turn. The fuel subsidy bill is expected to overshoot the budgeted
amount by Rs 1 trillion (US$20 million) due to higher fuel costs from the rupee’s depreciation. And
extra expenditure from revenue losses due to fuel tax cuts and additional interest outgo from
unscheduled market borrowings will impact the fiscal deficit that is expected to exceed by at least
one percentage point.
Apart from the fiscal damages, the unrestrained fall of the rupee is pushing up domestic inflation,
which is of serious concern to the RBI. Harder to quantify are the injuries to the private sector, viz.
12. sudden and large increase in external repayment obligations, shelved investment spending due to
difficulties in raising additional financing and extreme price volatility.
Against this outcome, was it worth keeping intervention as an additional policy tool?
An extra firepower of some US$30 billion, accumulated when capital inflows were strong, may have
facilitated early and decisive intervention to mitigate the unanticipated shock of the capital flows’
reversal in 2011–12. And adjusting the nearly Rs1.48 trillion (US$30.2 million) spent in over-
generous subsidies could have reduced pressure on yields in 2010–11. This would have translated
into a stronger fiscal position for 2011–12. In conjunction with a stronger reserves position, this
would have provided greater policy room to manoeuvre unanticipated shocks.
As with any macroeconomic story, this one, too, can be told differently. But since all trade-offs
represent conscious policy choices, it is fair to question whether the hands-off exchange rate policy
was a deliberate one to check imported inflation.
15. Rupee Depreciation and Its Impact
If we look at India’s Balance of Payments since 1970-71, we see that external account mostly
balances in 1970s. Infact in second half of 1970s there is a current account surplus. This was a period
of import substitution strategy and India followed a closed economy model. In 1980s, current account
deficits start to rise culminating into a BoP crisis in 1991. It was in the 1991 Union Budget where
Indian Rupee was devalued and the government also opened up the economy. This was followed by
several reforms liberalizing the economy and exchange rate regime shifted from fixed to managed
floating one. Hence, we need to analyse the current account and rupee movement from 1991 onwards.
India has always had current account deficit barring initial years in 2000s (Figure 1). The deficit has
been financed by capital flows and mostly capital flows have been higher than current account deficit
resulting in balance of payments surplus. The surplus has inturn led to rise in Forex Reserves from
USD 5.8 bn in 1990- 91 to USD 304.8 bn by 2010-11 (Figure 2). In 1990-91, gold contributed around
60% of forex reserves and forex currency assets were around 38%. This percentage has changed to
1.5% and 90% respectively by 2010-11.
What is even more stunning to note is the changes in BoP post 2005 (Table 1). In 1990s, Balance of
Payments surplus is just about $4.1 bn and increases to $22 bn in 2000s. However if we divided the
2000s period into 2000-05 and 2005-11, we see a sharp rise in both current account deficit and capital
account surplus. The rise in Forex reserves is also mainly seen in 2005-11.
16. Based on this, if we look at Rupee movement, we broadly see it has depreciated since 1991. Figure 3
looks at the Rupee movement against the major currencies. A better way to understand the Rupee
movement is to track the real effective exchange rate. Real effective exchange rate (REER) is based
on basket of currencies against which a country trades and is adjusted for inflation. A rise in index
means appreciation of the currency against the basket and a decline indicates depreciation. RBI
releases REER for 6 currency and 36 currency trade baskets since 1993-94 and we see that the
currency did depreciate in the 1990s but has appreciated post 2005. It depreciated following Lehman
crisis but has again appreciated in 2010-11.
Table 2 summarizes the findings of Balance of Payments and Rupee movement. In the 1990s, Rupee
depreciates against its major trading currencies as the average REER is less than 100. However, in
2000s we see Rupee appreciating against major trading currencies. If we divide the 2000s period
further to 2000-05 and 2005-11, we see there is depreciation in the first phase and large appreciation
in the second half of the decade.
17. Hence, overall we see the Rupee following the path economic theories highlighted above have
suggested.
• As India opened up its economy post 1991, Rupee depreciated as it had current account deficits.
Earlier current account deficits were mainly on account of merchandise trade deficits. However, as
services exports picked up it helped lower the pressure on current account deficit majorly. Without
services exports, current account deficit would have been much higher.
• There was a blip during South East Asian crisis when current account deficit increased from $4.6 bn
to $5.5 bn in 1997-98. Capital inflows declined from $11.4 bn to $10.1 bn leading to a decline in BoP
surplus and depreciation of the rupee. However, given the scale of the crisis the depreciation pressure
on Rupee was much lesser. There was active monetary management by RBI during the period. Similar
measures have been taken by RBI in current phase of Rupee depreciation as well (discussed below).
• Till around 2005, India received capital inflows just enough to balance the current account deficit.
The situation changed after 2005 as India started receiving capital inflows much higher than current
account deficit. The capital inflow composition also changed where external financing dominated in
early 1990s and now most of the capital inflows came via foreign investment. Within foreign
investment, share of portfolio flows was much higher. As capital inflows were higher than the current
account deficit Rupee appreciated against major currencies.
18. Other factors also led to appreciation of the rupee. First, India entered a favorable growth phase
registering growth rates of 9% and above since 2003. This surprised investors as few had imagined
India could grow at that rate consistently. The high growth led to surge in capital inflows mainly in
portfolio inflows. Second, India’s inflation started rising around 2007 leading to RBI tightening policy
rates. This led to higher interest rate differential between India and other countries leading to
additional capital inflows as highlighted above. It is important to understand that at that time investors
did not feel inflation will remain persistent and thought it to be a transitory issue and could be tackled
by monetary policy.
• During Lehman crisis capital flows shrunk sharply from a high of $107 bn in 2007-08 to just $7.8 bn
in 2008-09 and led to sharp depreciation of the currency. Rupee plunged from around Rs 39 per $ to
Rs. 50 per $. REER moved from 112.76 in 2007-08 to 102.97 in 2008- 09 depreciating sharply by
9.3%. The current account deficit also declined sharply as well tracking decline in oil prices from $ 12
bn in Jul-Sep 08 to $0.3 bn in Jan- Mar 09. The currency also depreciated tracking the global crisis
which led to preference for dollar assets compared to other currency assets.
Other factors also led to appreciation of the rupee. First, India entered a favorable growth phase
registering growth rates of 9% and above since 2003. This surprised investors as few had imagined
India could grow at that rate consistently. The high growth led to surge in capital inflows mainly in
portfolio inflows. Second, India’s inflation started rising around 2007 leading to RBI tightening policy
rates. This led to higher interest rate differential between India and other countries leading to
additional capital inflows as highlighted above. It is important to understand that at that time investors
did not feel inflation will remain persistent and thought it to be a transitory issue and could be tackled
by monetary policy.
19. • During Lehman crisis capital flows shrunk sharply from a high of $107 bn in 2007-08 to just $7.8 bn
in 2008-09 and led to sharp depreciation of the currency. Rupee plunged from around Rs 39 per $ to
Rs. 50 per $. REER moved from 112.76 in 2007-08 to 102.97 in 2008- 09 depreciating sharply by
9.3%. The current account deficit also declined sharply as well tracking decline in oil prices from $ 12
bn in Jul-Sep 08 to $0.3 bn in Jan- Mar 09. The currency also depreciated tracking the global
crisiswhich led to preferencefor dollar assets compared to other currency assets.
Indian economy recovered much quicker and sharper from the global crisis. The capital inflows
increased from $7.8 bn to $51.8 bn in 2009-10 and $57 bn in 2010-11. The higher capital inflows
were on account of both FDI and FII. External Commercial Borrowings also picked up in 2010-11.
The current account deficit also increased from $27.9 bn in 2008-09 to $44.2 bn in 2010-11. REER (6
currency) appreciated by 13% in 2010-11 and 36 REER by 7.7%.
DEPRECIATION OF RUPEE: 2011-12
Before we analyse the factors for the recent depreciation of the rupee, let us look at the survey of
professional forecasters released by RBI. Current account deficit is more or less same buy consensus
expects capital inflows in 2010-11 to be lower in each succeeding quarter. This leads to lower BoP
estimate. However, the forecasters maintain their forecast for Rupee/Dollar unchanged. This is
surprising as with lower capital inflows, markets should have expected some depreciating pressure on
Rupee as well. BoP surplus of $10.3 bn would have been lowest (barring 2008-09) figure since 2000-
01. The lowest figure for INR/USD is 47.1 in Q3 10-11, 46 in Q4 10-11 and 45.6 in Q1 10-11. It is
safe to say most of the participants missed the estimate by a wide mark. It was a complete surprise for
most analysts.
Even the Q1 11-12 numbers did not really sound an alarm (Table 4). The current account deficitwas at
$14.2 bn and capital account was at $19.6 bn leading to a BoP surplus of $5.4 bn. BoP surplus in Q4
2010-11 was $ 2bn. More importantly, capital inflows had risen from $7.4 bn in Q4 2010-11 to $ 19.6
bn in Q1 2011-12 on account of foreign investment (both FDI and FII).
The problems start to surface from Q2 11-12 onwards. In Table 4, we have put some of the date
released by RBI and Commerce Ministry for the period post Q1 11-12. As we can see, current account
deficits is likely to be higher but capital inflows especially FII inflows are going to be much lower.
Compared to EAC projections, current account deficit is likely to be higher and capital account lower
leading to either a negligible BoP surplus or BoP deficit.
20. Apart from difficulty in capital inflows, Indian economy prospects have declined sharply. Just at the
beginning of the year, forecasts for India’s growth for 2011-12 were around 8-8.5% and have been
revised downwards to around 6.5%-7%. It has been a shocking turnaround of events for Indian
economy. Both foreign and domestic investors have become jittery in the last few months because of
following reasons:
� PERSISTENT INFLATION: Inflation has remained around 9-10% for almost two years now.
Even inflation after Dec-11 is expected to ease mainly because of base-effect. Qualitatively speaking
inflation still remains high with core inflation itself around 8% levels. It is important to recall that the
episode of 2007-08 when despite high inflation and high interest rates, capital inflows were abundant.
This was because markets believed this inflation is temporary. Even this time, investors felt the same
as capital inflows resumed quickly as India recovered from the global crisis. However, as inflation
remained persistent and became a more structural issue investors reversed their expectations on Indian
economy.
PERSISTENT FISCAL DEFICITS: The fiscal deficits continue to remain high. The government
projected a fiscal deficit target of 4.6% for 2011-12 but is likely to be much higher on account of
higher subsidies. The markets questioned the fiscal deficit numbers just after the budget and projected
the numbers could be much higher. This indeed has become the case. As highlighted above, persistent
fiscal deficits play a role in shaping expectations over the currency rate as well.
� LACK OF REFORMS: There have been very few meaningful reforms in the last few years in
Indian economy. Moreover, the policies seem to be getting increasingly populist. The government
wanted to reverse this perception and announced FDI in retail but had to hold back amidst huge furor
from both opposition and allies. This has further made investors negative over the Indian economy.
As FII inflows are going to be difficult given the uncertain global conditions, the focus has to be on
FDI.
21. � CONTINUED GLOBAL UNCERTAINTY: This is an obvious point with global economy
continuing to remain in a highly uncertain zone. This has led to pressure on most currencies against
the US Dollar.
All these reasons together have led to sharp depreciation of the rupee. The rupee has depreciated by
nearly 20% against USD from Apr-11 to 20-Dec-11. In terms of 6 REER (Apr-Nov) and 36 REER
(Apr-Oct) Rupee has depreciated by 10.44% and 7.7% respectively. The later numbers of REER are
likely to show higher depreciation as well. During Lehman crisis, the two indices had depreciated by
9.3% and 9.9% respectively.
OUTLOOK AND POLICY MEASURES
The above analysis shows that Rupee has depreciated amidst a mix of economic developments in
India. Apart from lower capital inflows uncertainty over domestic economy has also made investors
nervous over Indian economy which has further fuelled depreciation pressures. India was receiving
capital inflows even amidst continued global uncertainty in 2009-11 as its domestic outlook was
positive. With domestic outlook also turning negative, Rupee depreciation was a natural outcome.
Depreciation leads to imports becoming costlier which is a worry for India as it meets most of its oil
demand via imports. Apart from oil, prices of other imported commodities like metals, gold etc will
also rise pushing overall inflation higher. Even if prices of global oil and commodities decline, the
Indian consumers might not benefit as depreciation will negate the impact. Inflation was expected to
decline from Dec-11 onwards but Rupee depreciation has played a spoilsport. Inflation may still
decline (as there is huge base effect) but Rupee depreciation is likely to lower the scale of decline.
What are the policy options with RBI?
• RAISING POLICY RATES: This measure was used by countries like Iceland and Denmark in the
initial phase of the crisis. The rationale was to prevent sudden capital outflows and prevent melt down
of their currencies. In India’s case, this cannot be done as RBI has already tightened policy rates
significantly since Mar-10 to tame inflationary expectations. Higher interest rates along with domestic
and global factors have pushed growth levels much lower than expectations. In its Dec-11 monetary
policy review, RBI mentioned that future monetary policy actions are likely to reverse the cycle
22. responding to the risks to growth. India’s interest rates are already higher than most countries
anyways but this has not led to higher capital inflows. On the other hand, lower policy rates in future
could lead to further capital outflows.
USING FOREX RESERVES: RBI can sell forex reserves and buy Indian Rupees leading to demand
for rupee. RBI Deputy Governor Dr. Subir Gokarn in a recent speech (An assessment of recent
macroeconomic developments, Dec-11) said using forex reserves poses problems on both sides. “Not
using reserves to prevent currency depreciation poses the risk that the exchange rate will spiral out of
control, reinforced by self-fulfilling expectations. On the other hand, using them up in large quantities
to prevent depreciation may result in a deterioration of confidence in the economy's ability to meet
even its short-term external obligations. Since both outcomes are undesirable, the appropriate policy
response is to find a balance that avoids either.”
• EASING CAPITAL CONTROLS: Dr Gokarn in the same speech said capital controls could be
eased to allow more capital inflows. He added that “resisting currency depreciation is best done by
increasing the supply of foreign currency by expanding market participation.” This in essence, has
been RBI’s response to depreciating Rupee.
Following measures have been taken lately:
� Increased the FII limit on investment in government and corporate debt instruments.
� First, it raised the ceilings on interest rates payable on non-resident deposits. This was later
deregulated allowing banks to determine their own deposit rates.
� The all-in-cost ceiling for External Commercial Borrowings was enhanced to allow more ECB
borrowings.
ADMINISTRATIVE MEASURES: Apart from easing capital controls, administrative measures
have been taken to curb market speculation.
� Earlier, entities that borrow abroad were liberally allowed to retain those funds overseas. They are
now required to bring the proportion of those funds to be used for domestic expenditure into the
country immediately.
� Earlier people could rebook forward contracts after cancellation. This facility has been withdrawn
which will ensure only hedgers book forward contracts and volatility is curbed.
� Net Overnight Open Position Limit (NOOPL) of forex dealers has been reduced across the board
and revised limits in respect of individual banks are being advised to the forex dealers separately.
After these recent measures, Rupee depreciation has abated but it still remains under pressure. Both
domestic and global conditions are indicating that the downward pressure on Rupee to remain in
future. RBI is likely to continue its policy mix of controlled intervention in forex markets and
administrative measures to curb volatility in Rupee. Apart from RBI, government should take some
measures to bring FDI and create a healthy environment for economic growth. Some analysts have
even suggested that Government should float overseas bonds to raise capital inflows.
Growing Indian economy has led to widening of current account deficit as imports of both oil and
non-oil have risen. Despite dramatic rise in software exports, current account deficits have remained
elevated. Apart from rising CAD, financing CAD has also been seen as a concern as most of these
capital inflows are short-term in nature. PM’s Economic Advisory Council in particular has always
mentioned this as a policy concern. Boosting exports and looking for more stable longer term foreign
inflows have been suggested as ways to alleviate concerns on current account deficit. The exports
have risen but so have prices of crude oil leading to further widening of current account deficit.
Efforts have been made to invite FDI but much more needs to be done especially after the holdback of
retail FDI and recent criticisms of policy paralysis. Without a more stable source of capital inflows,
23. Rupee is expected to remain highly volatile shifting gears from an appreciating currency outlook to
depreciating reality in quick time.
