The sliding rupee
On Wednesday, July 13, we woke up with two miscellaneous facts. The first was that the US dollar hit a 20-year high at a dollar index (DXY) of 108.56 and the Indian rupee (INR) slipped to a new low of 79.60 against the dollar. For the first time in two decades, the dollar and the euro were at the same level. There was also a free fall in other currencies and the major currencies depreciated against the US dollar: the yuan by 4%; the yen by 24%; the euro by 17%; the rupee 7%; the rand by 11.5% and the pound by 15.5%. Historically, there are many reasons leading to the volatility of the Indian currency. Geopolitical issues, international factors, economic reforms, rising crude oil prices, flight of foreign capital, declining foreign investment, rising interest rates, as well as spiraling inflation in India contribute to the depreciation of the Indian rupee.
After World War II, the US dollar (USD) became the most powerful currency in the world. It dominated the financial market and became the de facto currency of international trade and transactions. Over 60% of global foreign exchange reserves are in USD, making it the most commonly held reserve currency in the world. Until today, countries, including India, peg their currency to the USD to determine their value in the global market. Before independence, the value of the Indian rupee was derived from the British pound with an exchange rate of 1 GBP = 13 INR. Based on the calculation that 1 GBP equaled $2.73, thus 1 USD equaled INR 4.76 in 1947. According to the Bretton Woods Agreement of 1944, each country was required to peg the value of its currency to the dollar, which itself was convertible into gold at the rate of $35 per ounce. India being part of this agreement, followed the system of parity (relative) value of exchange rates.
Independent India, however, found itself in a difficult position to finance its growing plethora of welfare and development activities as well as its five-year plans, and so resorted to intense foreign borrowing. Further aggravations followed with the Indochina War in 1962, the Indo-Pakistani War in 1965 and the Great Drought of 1965-1966. Although the exchange value of 1 GBP = 13 INR continued until 1966, in 1967 the INR was pegged to the USD on an individual basis and it was decided to devalue the INR to 17, 50 per usd. The nominal value system continued until 1971 until the collapse of the Bretton Woods system which suspended the gold standard/convertibility of the dollar by the United States. India also adopted a fixed rate system linking the INR to the British pound, but in 1975 the INR was pegged to a basket of currencies to ensure its stability and to combat the growing imbalances and disadvantages associated with a single monetary parity.
A severe balance of payments crisis ensued in 1991, caused by the collapse of the Soviet Union in the 1980s and the doubling of crude oil prices in 1990. The country’s foreign exchange reserves had dried up and to avoid impending bankruptcy, India had to borrow money from the International Monetary Fund (IMF) against its gold reserves. The exchange rate fell throughout the 1980s and at the end of 1990 the rate was 1 USD = 17.32 INR. The economic crisis called for a devaluation of the INR, which involved initiating a process of reducing the country’s exchange rate in the international market while keeping the internal value unchanged. This was done to encourage an increase in exports and an increase in the inflow of foreign currency. In 1991, the Reserve Bank of India (RBI) lowered the exchange rate by 11% and India ended the fixed rate exchange rate regime and moved to a market-determined exchange rate system or a floating exchange rate system. The effect of devaluation led to an exchange rate of 1 USD = 25.92 INR in 1992. The Indian rupee continued to decline thereafter.
In 2002, the rupee had fallen to Rs 48.99 against the US dollar. In 2007, the rupee appreciated and reached a high of 39.27 rupees per dollar due to sustained foreign direct investment (FDI) inflows into the country in terms of investment in the booming stock market , increased remittances and growth of exporters. IT companies and BPOs in the country. In 2016, the USD/INR exchange rate fell to 1 USD = 68.77 and the global economic crisis following the coronavirus pandemic in 2020 further contributed to the depreciation of the exchange rate to an all-time high which was of 1 USD = 76.67 INR in March 2020. Consequently, the Indian Rupee’s fall was the result of an economic slowdown, fear of large budget deficits, a sharp increase in US economic growth and the l risk aversion of global investors in emerging markets. The war in Ukraine, inflation and rising crude oil prices have further contributed to the current scenario.
The weighted average price of Indian crude oil imports increased by around 22% in one year. The weakening of the rupiah will therefore put immense pressure on the 80% crude oil imports and widen the trade deficit which has already reached $70.25 billion due to high imports in the first quarter. Although benchmark Brent crude edged down a barrel to $100.50, any escalation would have a further impact on the Rupee’s slide. A high current account deficit, which is expected to reach 3% of GDP this fiscal year, would also make foreign borrowing more expensive. Inflation in India has exceeded the 6% threshold set by the RBI. Retail price inflation was 6.01, 6.07, 6.95, 7.79, 7.04 and 7.01% respectively in the first six months of 2022. As expected , RBI resorted to raising interest rates to curb inflation. The reporate, ie the rate at which it lends to commercial banks, was raised by 40 bps and 50 bps in May and June 22 respectively.
Rising interest rates, however, would negatively affect the interests of exporters who may not be able to take advantage of the falling rupee to boost their competitive edge. As some advanced countries grapple with recession, demand for goods and services from India is also expected to see a resulting reduction in demand from international investors. The depreciation of the domestic currency would also trigger foreign portfolio investor (FPI) selling from emerging markets. On June 15 of this year, the US Federal Reserve raised interest rates by 75 basis points, signaling the shift to a higher interest rate regime to control inflation. The subsequent attraction of higher yields on US bonds has led to international capital flight from emerging economies to dollar investments. Foreign institutional investors (FIIs) found US bond prices more attractive and, sparked by the war in Ukraine which exposed the vulnerability of domestic markets, capital flowed back to America.
In this context, the RBI’s decision to carry out export and import transactions in Indian rupee with prior approval would indeed make the rupee increasingly tradable globally. With a likelihood of rising non-deliverable forward (NDF) volumes and growing acceptance of the rupee, this move could mitigate the long-term dollar impact. Another move by the RBI, in order to attract more NRI deposits, was to remove restrictions on deposits from Non-Resident Foreign Currency Accounts (FCNCR) in the form of interest rate restrictions and, in exempting additional CRR and SLR filings. terms. The RBI also used its Forex reserves to defend the currency and instruct public sector banks to sell dollars. This decision led to the depletion of the country’s reserves below the 600 billion dollar mark. To halt the rupee’s fall, the RBI also raised import duties on gold. The slide, however, continues.
Although currency depreciation makes imported goods expensive, and foreign travel and study abroad costs expensive, it is a mistaken assumption that the absence of a hard currency is necessarily bad. Rupee depreciation driving down the exchange rate has improved India’s trade balance in the past. Such depreciation is a natural consequence in emerging economies such as India and could continue in the years to come. The silver lining in this era of falling currencies is also that while the Rupee depreciated by 7%, other currencies such as the Euro and the Yen depreciated even more. This is of course not a reason for complacency, but a trigger that calls for proactive actions by the Central Bank and a pragmatic monetary policy in order to avoid new trade deficits and rising inflation.