05-11-2012, 11:55 AM
Rupee Depreciation: Probable Causes and Outlook
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The Indian Rupee has depreciated significantly against the US Dollar marking a new risk for Indian
economy. Till the beginning of the financial year (Apr 11-Mar 12) very few had expected Rupee to
depreciate with most hinting towards either appreciation or status quo in the rupee levels. Those few
who had even anticipated may not have imagined the scale of depreciation with rupee touching a new
low of around Rs 54 to the US Dollar.
What is even more interesting to note is that when other countries are trying to play currency wars
and trying to keep their currencies devalued, India is trying to prevent depreciation of the currency.
(Read our previous report for a review of the situation- Saying No To Currency Wars (20-Sep-11))
This paper reviews the probable reasons for this depreciation of the rupee and the outlook for the
same. It also reflects on the policy options to help prevent the depreciation of the Rupee
Economics of Currency
Predicting currency movements is perhaps one of the hardest exercises in economics as it has many
variables affecting the market movement. However, over a longer term currency movement is
determined by following factors:
Balance of Payments: It is the sum of current account and capital account of a country and is
an external account of a country with other countries. Both current account and capital account
play a role in determining the movement of the currency:
o Current Account Surplus/Deficit: Current account surplus means exports are more than
imports. In economics we assume prices to be in equilibrium and hence to balance the
surplus, the currency should appreciate. Likewise for current account deficit countries, the
currency should depreciate.
o Capital Account flows: As currency adjustments do not happen immediately to adjust
current account surpluses and deficits, capital flows play a role. Deficit countries need capital
flows and surplus countries generate capital outflows. On a global level we assume that
deficits will be cancelled by surpluses generated in other countries. In theory we assume
current account deficits will be equal to capital inflows but in real world we could easily have
a situation of excessive flows. So, some countries can have current account deficits and also
a balance of payments surplus as capital inflows are higher than current account deficits. In
this case, the currency does not depreciate but actually appreciates as in the case of India
(explained below). Only when capital inflows are not enough, there will be depreciating
pressure on the currency.
Rupee Movement since 1991
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.
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.