The Indian Rupee (INR) has seen a massive downfall in its value in the past few months. Since January, the currency has dropped over 3% in its value against the dollar. Such downgrade was last seen four years ago, before the Lok Sabha elections, when Congress’s term was coming to an end.
In 2014, when the BJP came to power, Modi had promised better economic environment, improved trade and lower inflation. All these promises were met, and Indian markets saw a fairly good bull run in the following years. But now, the markets have once again gone bear, coincidently, as BJPs term comes to an end.
On Monday, 21st May, the rupee value hit a 16-month low, opening at 68.12 and is expected to fall further to 68.35. Analysts at Angel Broking say that this fall and the one in 2014 can both be attributed to higher oil prices, widening trade deficit, capital outflows, and the strengthening US economy.
Let’s explore how these factors affect the currency, in detail, and what it spells for the economy next.
Demand and Supply:
The basic laws of economics state that if demand for the dollar in India exceeds its supply, then its worth will go up and that of the INR will come down. Clearly, the need for dollars has risen in India, owing to increased imports for manufacturing. We could, in part, blame the PM’s ‘Make in India’ policy for this. But the truth is that the rupee depreciates every few years due to internal and external economic environment. This is referred to as the economic cycle. see image on left.
The world economy goes through these phases every few years, and the demand/supply for products, including currency depends on these cycles. Currently, the world economy is in recession.
Wider Trade Deficit:
A trade deficit occurs when a country spends more money on imported goods, but earns less from exporting them. While most nations’ trade bills are usually in deficit, there is a limit beyond which it can hamper economic stability. In India, the trade bill is dangerously close to that limit. In 2018, our imports exceeded the exports by $156.8 billion as compared to $105 in the previous year.
As explained earlier, the demand for dollar increases with rising imports. And when more dollars are spent in importing goods, the rupee’s value depreciates. This makes foreign goods more expensive, ideally, discouraging companies from importing. The government may also hike duties and tariffs, to reduce imports of raw materials. This is meant to increase the manufacturing costs, in turn leading to rising prices. For example, Consumer Price Index (CPI) rose to 4.6% in April this year, compared to the average CPI of 3.52% in the previous year.
However, efforts to dampen imports are pretty futile in practice. Aditi Nayar, economist at ICRA suggests that the trend of rising imports is unlikely to slow down in the coming months. In fact; the total trade deficit is predicted to be at 1.9% of the GDP by 2019.
The Oil Slip
Volatility in the Middle East and increasing demand for oil are two major reasons for rising prices. Oil prices are predicted to touch $100 per barrel by 2019, a mark not touched in six years. But despite such rise, India’s crude oil imports are higher than that of any other goods. In fact, in 2017, India imported a record 4.4 million barrels of oil per day, costing a total of $88 billion. And with oil prices soaring, this figure is pegged to rise by 25% in the next financial year.
If that happens, India will need more dollars to meet their growing demand, which will, in turn, affect the rupee value even more. Moreover, rising oil prices will also lead to increase in the cost of fuel based commodities like cars, electric appliances, big machines, etc. The RBI has predicted that if fuel costs increased by even 10%, the CPI will inflate by almost 25points.
US Bond Yields:
In order to boost its economy, US uses a policy called ‘Quantitative Easing’. Under this policy, the Federal Reserve prints more money to increase cash circulation in the market. This move can boost the economy by giving more power to the public and businesses to purchase goods and products. Thus companies can invest this money in manufacturing activities, and the public can invest it in bonds and debentures.
With this, the Federal Reserve also increases interest rates on the bonds, thus giving out higher profits. This is the reason why many Americans (public and business) are now pulling out their investments from emerging markets like India to reinvest them in US bonds.
The US treasury notes rate at 3.09% is less than half the rate of Indian bonds. Yet, the former provides safe investments, whereas Indian markets are more volatile and risky. US investments have thus become more attractive across the world leading.
The effects of the trade deficit and oil prices can be broken if other sections of the economy are earning dollars. For example, when foreign companies invest in local companies, it brings in more dollars. Increasing FDIs and FIIs can help the economy improve India’s balance sheets.
However, Indian capital markets have seen a decrease in investments in the last three months. Foreign investments stood at one fifth the value of that in the previous year. The reason for this is the strengthening of US markets and higher bond yields.
Increasing cash flows and reducing the imports are the only ways to improve the value of our currency. Otherwise, the normal economic cycle will continue and bear runs will turn into bulls eventually. But who’s to say how much time will that take.
When the RBI buys more foreign exchange (FOREX), the rupee’s value depreciates. This goes in line with the demand/supply point where an increase in the demand for FOREX leads to lower value of the rupee.
By December 2017, the RBI had bought $5.6 billion in FOREX, the highest purchase ever. This, of course, led to depreciation of the rupee in 2018. Now the RBI is planning to sell some of its dollars to prevent the rupee from falling more.
Of course, this will be a profitable sale, as the RBI will get more rupees in return for the FOREX than it paid when buying them.
The Central Government often indulges in such FOREX policy and it seldom leads to volatility in the currency.