Friday, June 28, 2013

Why is the Rupee declining?

The newspapers these days have been awash with news about the collapse of the Indian Rupee. From ₹44 to a USD, it has fallen to ₹60 today. And it is expected to keep falling; there's already talk about ₹70. Questions and confusion abound as to the reasons for its continuing fall.

There's been a lot of finger-pointing and blame apportioned over responsibility for this debacle. While the reason for the current sudden decline is the US economy's resurgence from recession creating demand for dollar assets, we need to take a long-term view here keeping the long-term trend of our currency in mind. The Rupee has been steadily depreciating since Independence. And for obvious reasons.


As this valuation chart on Wikipedia shows, from Rs.4 to a US Dollar in 1950, it had declined to Rs.18 to a Dollar in the 1980s. Then there was a massive forced depreciation due to the Balance of Payments crisis in 1991, and the Rupee fell to about 35 or so. Another decade, and it had fallen to Rs.44 in the 2000s. It is not surprising that it should fall again now to ₹60. And one can easily predict that it will fall further to the 70s, 80s and onward until the basic issue underlying a currency's value is resolved.


The fact of the matter is that India has continually run trade deficits since Independence. A trade deficit (or Current Account Deficit) is when our country buys more from abroad than it sells abroad. Why does this result in a trade deficit, you ask? It's quite simple.


Just as goods are priced in Indian Rupees in India, they're priced in foreign currencies abroad. So when you buy something from abroad and import it into India, you need to pay the foreign sellers in their own currency. For example, when India buys petrol from Saudi Arabia, it pays Saudi Arabia in US dollars. When Indian jewellers buy gold from abroad, they need to pay in US dollars. In order to pay in US dollars, India needs US dollars from somewhere. These are some of the ways the country acquires US dollars:

  • By selling goods priced in US dollars in the world market. This is called exporting goods.
  • It can borrow money from foreigners and pay them interest on their loan. This is done by issuing bonds and providing attractive interest rates.
  • When Indian expats send their money home, they exchange this for Indian Rupees. They do this either through a foreign exchange dealer or through a government bank. This entity acquires US dollars or whichever currency was sold in exchange for rupees.
  • When the Indian economy is growing healthily, foreign investors invest in India anticipating good returns. They bring in dollars, exchange them for rupees in order to invest within the country.
If India doesn't acquire sufficient US dollars through one of the means above, there ends up being a shortage of US dollars. This essentially means that there is unsatisfied demand for the US dollar. There are more buyers for the US dollar who are willing to pay more rupees for the currency. Since people are willing to pay more for the US dollar, you need more rupees to buy one US dollar.  Consequently, the US dollar rises in value and the rupee falls.

Given this understanding, it is quite easy to see how India can reverse the decline of the Rupee. There are two ways, both of which can be adopted:

  • Buy less abroad. This would mean cutting down on imports. Petrol import can only be avoided by developing indigenous energy sources, be it nuclear power, solar energy, switching to electric cars and so on. Imported goods will need to lose their attractiveness and that can only happen if locally manufactured goods are of equally good quality and brand caché.
  • Sell more abroad. For this to happen, India needs to manufacture goods that the rest of the world wants to buy. We need to develop local manufacturing capability for high-quality and high-margin goods that people abroad will pay for using their US dollars. As of now, there is nothing of real value that India exports other than basic foodgrains and raw materials which are low-margin goods. And IT skills, of course. We need to learn from our East Asian neighbours and start building a top-quality manufacturing industry. This will not only reverse the Rupee slide but will also provide jobs to all the unemployed people in the country.
The way out is fairly clear-cut. It is really up to people in India and our government to see the picture in its black-and-white simplicity and act accordingly.

Implications of a depreciating currency are bad all around. When a currency declines, it fuels inflation because all the things we need from abroad like petrol become more expensive in Rupee terms. Petrol is the underlying price basis for all goods within the economy and when it goes up in price, everything goes up in price. In contrast, when a currency rises in value, things we buy abroad become cheaper and this helps keep prices low. What cannot be manufactured within the country can be bought abroad cheaply thus improving quality as well as supply of all goods.

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