CURRENCY DEPRECIATION AND ITS IMPLICATIONS

Economics of Currency

SUBMITTED TO
PROF. VIJAYLAXMI

SUBMITTED BY:
ANKIT JAIN ANKIT SHARMA ANKITA GUPTA SANDEEP KUMAR

SECTION FF7

DEPRECIATING RUPEE AND RBI INTERVENTION

Rupee Depreciation: Causes and Implications

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.

ECONOMICS OF CURRENCY
Predicting currency movements is perhaps one of the hardest exercises in economics as it has main 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: 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. 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

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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. INTEREST RATE DIFFERENTIALS: This is based on interest rate parity theory. This says that countries which have higher interest rates their currencies should depreciate. If this does not happen, there will be cases for arbitrage for foreign investors till the arbitrage opportunity disappears from the market. The reality is far more complex as higher interest rates could actually bring in higher capital inflows putting further appreciating pressure on the currency. In such a scenario, foreign investors earn both higher interest rates and also gain on the appreciating currency. This could lead to a herd mentality by foreign investors posing macroeconomic problems for the monetary authority. INFLATION: Higher inflation leads to central banks increasing policy rates which invites foreign capital on account of interest rate arbitrages. This could lead to further appreciation of the currency. However, it is important to differentiate between high inflation over a short term versus a prolonged one. Over short-term foreign investors see inflation as a temporary problem and still invest in the domestic economy. If inflation becomes a prolonged one, it leads to overall worsening of economic prospects and capital outflows and eventual depreciation of the currency. Apart from this, inflation also helps understand the real changes in a value of currency. Real exchange rate = Nominal Exchange Rate* (Inflation of foreign country/Inflation of domestic economy). This implies if domestic inflation is higher; the real change in the value of the currency will be lower compared to the nominal change in currency. FISCAL DEFICIT: Fiscal deficits play a role especially during currency crisis. If a country follows a fixed exchange rates and also runs a large fiscal deficit it could lead to speculative attacks on the currency. Higher deficits imply government might resort to using forex reserves to finance its deficit. This leads to lowering of the reserves and in case there is a speculation on the currency, the government may not have adequate reserves to protect the fixed value of the currency. This pushes the government to devalue the currency. So, though fiscal deficits do not have a direct bearing on foreign exchange markets, they play a role in case there is a crisis.

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GLOBAL ECONOMIC CONDITIONS: Barring domestic conditions, global conditions impact the currency movement as well. In times of high uncertainty as seen lately, most currencies usually depreciate against US Dollar as it is seen as a safe haven currency. Hence even over a longer term, multiple factors determine an exchange rate with each one playing an important role over time.

CURRENCY EXCHANGE RATE DETERMINATION

STOCK EXCHANGE RATE:

Market determination means that the demand and supply of foreign exchange in
any period is what determines the exchange rate. This is valuable to the extent that the prices realized by markets are equilibrium exchange rates. Flexible exchange rates prevent large deviations from the equilibrium real rates. A fixed exchange rate, by contrast, amounts to an implicit government warranty that encourages excessive un-hedged foreign borrowing, building up to crises. But a pure float also has problems. It can lead to excessive volatility in thin markets. In the context of fragile global markets, capital inflows could slow down or turn into outflows for reasons unrelated to domestic fundamentals. In the event, large deviations from equilibrium do occur, and can have unfortunate effects in terms of disrupting trade or working against the reduction of inflationary expectations. Depreciation only adds to inflation. A country with a current account deficit (CAD) need not always suffer depreciation of its currency to the extent foreign capital is willing to come in. Forward-looking markets recognize a small CAD to be sustainable for financing more investment and growth that could eventually be a source to generate future surpluses. But they forget these during global panics. No central bank can let its currency be affected by such short-term capital volatility. They have, therefore, intervened even in advanced markets such as Japan and Switzerland that are supposed to have full floats.

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The literature on exchange rates recognizes a tendency of markets to deviate from equilibrium, whenever there is learning' and less-than-perfect information. So, the central bank has a more general role in focusing expectations. This it does through communication, whenever it creates news or reduces noise. Both are valuable functions, especially in emerging markets, where news is relatively scarce. In the past few years, the rupee-dollar exchange rates have tended to follow movements of the euro-dollar rates. That is, the rupee has gained, as the dollar has weakened globally and vice versa. In other words, capital flows were driving the rupee based on global and not on domestic patterns. The value of the rupee may have been determined by the demand and supply of foreign exchange, but the latter was driven by market sentiment and not economic fundamentals. A strong government can influence this sentiment towards local fundamentals.

MARKET MICROSTRUCTURE: The microstructure of the foreign exchange market is unlike any other market. It is a bilateral market, where traders do not know aggregate net demand, but infer it from their own order flows. The size of intra-bank transactions is many times the size of export-and-import-related goods market transactions. Banks unwind portfolios, explore the market, and use tiny arbitrage opportunities to make profits. These factors help to maintain robust trade with diverse buy-and-sell side positions. But in such a market, the central bank is a special agent and its buy-orsell position conveys important information affecting markets. The rupee is down 16 per cent this year. It is also the worst performer among major Asian peers in 2011.

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A bigger worry is a fast depreciating rupee. From its late July level of 43.86 per dollar. This is not the first time that the Indian currency is experiencing a sharp fall against the greenback. In March 2009, when the world was witnessing the worst ever credit crunch in the wake of the fall of US investment bank Lehman Brothers Holdings Inc., the rupee hit its lifetime low of 52.17 to a dollar, losing one-third of its value in 16 months. There was not much of noise at that time as inflation was low and economy was growing at a high rate. Resisting currency depreciation is best done by increasing the supply of foreign currency and by expanding market participation. For every dollar it sells, an equivalent amount of rupee is sucked out of the system. The banking systems daily average cash deficit is about Rs. 68,000 crore in past one week and the deficit will grow with RBIs dollar sale. The central bank wants the system to run a deficit of about 1% of the banking industrys deposit base, which works out to be around Rs. 55,000 crore currently. A higher liquidity deficit will disrupt the money market and RBI will probably have to buy bonds from banks through its so-called open market operation to infuse liquidity. Reserve Bank of India likely intervened in the foreign exchange market to sell dollars at around Rs 53.30 per dollar levels, four traders said. RBI likely intervened via state-run banks which were seen heavily selling dollars pushing the rupee up in late trade, they said. The local unit was under selling pressure on weak equities and
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dollar demand from oil importers and defense firms for month-end obligations for most of the session.

CAUSES OF DEPRECIATING RUPEE

Before we analyze 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 deficit was 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 data 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. When the rupee tumbled 20% against the dollar in four months, between August 9 and December 15, fingers were pointed at foreign institutional investors (FIIs), who were big sellers of Indian stocks. But data for the period shows that FIIs still brought in more money than they took out, though this net figure was about a tenth of the amount in the corresponding period a year ago.

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A reading of the other components of balance of payments which records Indias transactions with the rest of the world shows dollar inflows were reasonable during this period. Their velocity may have slowed because of a grim economic outlook, which would have put pressure on the rupee, but not enough to make it crumble. So, then, what explains the slump? On speaking to Forex traders, experts, exporters and bankers, a possible explanation emerges: on top of the general weakness, the equal and opposite actions of importers and exporters triggered a storm, and sent the rupee into a freefall. Initially, greed and fear drove down the rupee. Owing to greed among exporters, who did not convert their dollar earnings, when they saw the rupee falling, hoping the Indian currency would weaken further and enable them to realize more. And fear among importers, who had left their exposure un-hedged and who rushed to buy dollars when the rupee started falling. Importers sought dollars, but exporters held them back. The resultant shortage dragged the rupee down in the forward market. And the spot market, which takes its cues from the forward market, followed suit. It was history repeating itself.

1. WITHDRAWAL BY FIIS The main driver of rupee depreciation in the last three months has been the withdrawal of funds by foreign institutional investors (FIIs) from domestic economy. The rather pessimistic view of FIIs is being governed by global developments. FIIs have registered a net sales position of US $ 1,581 million, between August and November so far.

DEPRECIATING RUPEE AND RBI INTERVENTION

The ongoing Euro-zone debt crisis seems to be intensifying and rescue packages have been of limited assistance in truly resolving the crisis. While the risk of sovereign default by individual Euro states is a concern, the risk of an impending contagion is also significant. It is estimated that the IMF has about $400 billion available to provide funding to the Euro-zone, but Italy alone has to refinance $350 billion worth of debt in the next six months. The support by the IMF thus is a just fraction of the cumulative financing requirement to resolve this debt crisis. Changes in political leaders and finance ministers of these states, debates on the role and mandate of the European Central Bank (ECB) and European Financial Stability Facility (EFSF) and quantum of financial support to be provided by member states remain some points of indecision. The scenario in the US does not provide an upbeat picture either. Delays in policy formulation on the setting of debt ceiling for the state have reflected some lacunae in management of government finances. While housing starts, industrial production and consumer spending are gradually showing signs of improvement, the rate of unemployment remains uncomfortably high. Growth estimates for the US have been revised downwards to 2.0% in Q3 from the earlier estimate of 2.5%. The real estate problem, weakening local government finances, lack of transparency in operations and systems of the government and deterioration the assets of the banking system observed in the Chinese economy are further drags to the global macro-economic outlook for the coming months.

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Domestic macro-economic prospects as well are weighed by high inflation and sagging industrial production, which have led to downward revision of growth estimates to just 7.6% for FY12. Consequently, FIIs have withdrawn funds from emerging markets and invested back in the dollar which has been strengthening. In November (so far) itself, FIIs have registered a net sales position to the tune of US $ 87 million. 2. STRENGTHENING OF DOLLAR: As these downbeat forces have played strong over the last few months, investor risk-appetite has contracted, thereby increasing the demand for safe haven such as US treasury, gold and the greenback. The Euro has depreciated 6.55% against the dollar in the last three months which has in turn made the dollar stronger vis--vis other currencies, including the rupee. With winter, the demand for oil and consequently dollar is only expected to move further upwards. Domestic oil importers have also contributed to this strengthening to meet higher oil import bills. There are also two critical reasons for weakening rupee:

CRITICALITY OF WEAKENING RUPEE OR STRENGTHENING DOLLAR FEAR AMONG IMPORTERS: Back in 2007, Indian exporters were the victims when the rupee appreciated 10% in five months to 39 against the dollar. Lulled by the belief that the rupee, and other currencies such as the Japanese Yen and the Swiss Franc, would not appreciate beyond a point, exporters used their receivables to buy complex currency derivatives. The rupee appreciated more, causing them huge losses. Since then, exporters have preferred to play it safe and hedge their receivables in other words, lock into an exchange rate. Say, an exporter is going to receive $1 after six months and the rupee is quoting at 50 to the dollar today. To protect itself from the prospect of the rupee rising, say, 10% to 45, it locks in at 50. For this, it pays a small fee, about 2% in normal times Importers, however, have not been hedging as a matter of routine, including those who borrowed abroad to finance expansion. Importers were not listening to advice at that time (the first half of 2011). They all believed rupee would not fall beyond the current level. Even companies that borrowed overseas kept their exposure

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uncovered. The thinking among this set was, why spend 2% on a forward cover when the rupee was stable. The Indian currency had been moving in the 45-46 range against the dollar for a year till September 2011, when it let go. Banks also reinforced the view that the rupee would appreciate. Many banks, especially foreign ones, were aggressively selling to clients that the rupee would appreciate. Importers placed reliance on their (banks) words. When the rupee started falling, importers feared it might sink further. They all rushed to the market; but there were no dollar sales from exporters to counter this. Exporters had taken cover much earlier for most of their dollar earnings at 4547 levels, and had little to offer. With demand for dollars exceeding supply, the rupee crashed.

GREED OF EXPORTERS: Exporters aided the fall with their actions. They speculated by holding on to their export earnings for a longer period. Forex Derivative Consumers Forum, a group of 40 exporters, who accused banks of miss-selling derivatives to them in 2007. Exporters have six months to repatriate their export proceeds. Between April and November, when the money from this export-import interplay came into play, exports stood at $22.3 billion and imports at $35.9 billion. As more exporters held back the conversion of their dollar earnings, the rupee fell further. If an exporter sold goods worth $100 to a US client, at an exchange rate of 45 to a dollar, it would receive Rs. 4,500. But if the rupee depreciated to 55 to a dollar, it would get Rs. 5,500 , 1,000 more for the same $100 it holds. Exporters did not have the speculative leeway they had in 2007. After the 2007 crisis, which triggered massive Forex losses to exporters and domestic companies with overseas borrowing, the central bank clamped down on complex financial products such as cross-currency derivatives. As a result, exporters could only take forward cover, that too only up to 75% of their average Forex turnover in the previous three years. But even this restricted market offered an opportunity to some exporters. When the rupee depreciated beyond the rate at which the forward cover was taken, exporters re-booked forward cover and cancelled the old one. Say, an exporter initially took forward cover at 47 to a dollar. Now, when the rupee is at 50, it sees the currency falling further, and books a new forward cover at 51. They paid cancellation charges and still made a profit.

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Speculators had a field day, as the trade deficit increased by 25%. This raised the demand for dollars disproportionately, even as overseas investors brought less money into India, putting pressure on the rupee. The Reserve Bank of India said it would not intervene. In mid-November, RBI Deputy Governor Subir Gokarn said, the central bank does not have the capacity to intervene. Terming this a failure of the RBIs communication strategy aided speculative tendencies.

3. WIDENING CURRENT ACCOUNT DEFICIT The current account balance is composed of trade balance and net earnings from invisibles. While earnings from invisibles have been quite robust this year (growth of 17% y-o-y), the trade account has deteriorated on unfavorable terms of trade. Current account deficit (CAD), in Q1 FY12 had widened by Rs 40,000 crore, over Q4 FY11. Furthermore on a quarterly basis, even invisibles earnings have registered some decline. With contribution of exporters remaining on the sidelines and earnings from invisibles continuing to decline, a further widening of the CAD would result in outflow of dollars from the Indian economy accentuating the depreciation in rupee. In particular software receipts would be under pressure given the global slowdown. 4. DECLINE IN OTHER CAPITAL FLOWS: Foreign Direct Investments (FDI), External Commercial Borrowings (ECBs) and Foreign Currency Convertible Bonds (FCCBs) have maintained robust trends this year, when compared with net inflows in FY11. However, on a month-on- month basis, ECBs and FCCBs have registered slowdown. A prospective decline in these other inflows on the capital account of the balance of payments could cause further depreciation in rupee. While FDI has been increasing it has not been able to make up for lower other capital inflows.

IMPACT OF RUPEE DEPRECIATION

Three areas of concern that may be identified are higher import bills, fiscal slippage and increased burden on borrowers

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1. HIGHER IMPORT BILLS: A depreciation of the local currency naturally manifests in higher import costs for the domestic economy. Assuming that both imports and exports maintain their current growth rates through the year, higher import costs would widen the trade and current account deficit of the country. We expect current account deficit to settle at 3.0-3.1% of GDP by March 2012- end. Additionally, the domestic economy could be faced with a problem of higher inflation through imports. Commodities prices that are internationally denominated in US dollars would naturally are priced higher on the back of a stronger Dollar. Also, while global base metals prices such as nickel, lead, aluminum, iron and steel would have eased, the depreciating rupee would keep the price of imported commodities elevated. 2. FISCAL SLIPPAGE: The fiscal deficit for FY12 was budgeted at 4.6% of GDP in February, with the price of oil pegged at US $ 100 per barrel. Throughout FY12 so far, however, the price of oil has been well above this reference rate, hovering at an average of US $ 110 over the last three months. Oil subsidy for the year is about Rs 24,000 crore for FY12. This will rise on account of the higher cost of oil being borne by the government. While there have been moves to link some prices of oil-products to the market, there would still tend to be an increase in subsidy on LPG, diesel, kerosene. The government has already enhanced its borrowing programe in H2 FY12 by Rs 52,000 crore, to bridge the fiscal gap.

3. INCREASED BURDEN ON BORROWERS: Higher rates will come in the way of potential borrowers in the ECB market. Today given the interest rate differentials in domestic and global markets, there is an advantage in using the ECB route. With the depreciating rupee, this will make it less attractive. Further, those who have to service their loans will have to bear the higher cost of debt service. 4. IMPACT ON EXPORTERS: Usually exports get a boost in case the domestic currency depreciates because exports become cheaper in international markets. However, given sluggish global conditions, only some sectors would tend to gain where our competitiveness will increase such as textiles, leather goods, processed food products and gems and jewellery. In case, imported raw material is used in these industries they would be adversely affected. Therefore, exports may not be able to leverage fully.

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On the whole, this is more Bad News for the General Public. The price
of oil and other materials which are imported from foreign countries are going to go up. This essentially means that Petrol, Diesel and other items are going to cost more. Already Petrol has crossed the Rs. 70/- mark per liter and the rupee depreciation may affect the situation further and drive the prices of petrol & diesel even further. This will mean that all items like vegetables, fruits, any and all items that are transported from one place to another before they are sold will get costlier. The cost of moving stuff from place to place is going to go up and the manufacturer/producer is going to pass on the extra cost to the end customer You and Me. So, as a whole this is

ROLE OF RBI
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 meltdown of their currencies. In Indias 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 dec11 monetary policy review, RBI Mentioned that future monetary policy actions are likely to reverse the cycle responding to the risks to growth. Indias 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

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confidence in the economical 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. Based on weekly forex reserves data (figure 8), RBI seems to be selling forex reserves selectively to support rupee. Its intervention has been limited as liquidity in money markets has remained Tight in recent months and further intervention only tightens liquidity further. 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,

TYPES OF INTERVENTIONS BY RBI Usually RBI does not strongly intervene in the currency market to achieve specific
exchange rate targets. However, in volatile market conditions that we see today, RBI intervention to keep markets orderly and prevent a downward spiral of rupee is justified, Our broad objective in such intervention is to ensure that we find a balance between the short-term risk of the rupee spiraling downward and the medium term risk of a loss of confidence in our ability to meet our external obligations. We do have instruments to do this in the form of strategic capital controls, which can be used to enhance supply of foreign exchange. These will be used when appropriate with the goal of ensuring that the availability of foreign exchange does not become a destabilizing constraint. Beyond this, if we do see the short-term risk of a downward rupee spiral escalating we will not hesitate to use all available instruments. Therefore, the central bank has many ways by which it can affect the exchange rate not just through buying and selling foreign exchange, and not just the traditional interest rate channel. The latter anyway is not fully effective, since many types of controls still hinder movement of capital in response to interest rate differentials. The central bank can choose what sort of signal it wants to send. It can choose to reveal the direction of intervention, but not the quantity or the target. Timing also

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matters. It can utilize market structure to get the maximum impact with minimal action. Just a few well-chosen words can move markets. If the markets think that the central bank is credible, they may implement its goals even without the latter actually intervening. In India, the range of capital controls gives further choices. Strategic relaxation is now being used to bring in more inflows.

RESERVE THRESHOLDS There is a perception that since Indian reserves just cover our international liabilities, they should not be used to finance a CAD. But it is only rarely that daily inflows will just finance the CAD. Banks and foreign exchange markets perform a buffering role, and the central bank must contribute to that buffer in periods of extended uncertainty. Saving its buffer for the future may turn a small shower into a sustained rainstorm, if a downward spiral sets in. But markets are fickle and tend to panic easily in emerging markets. So the level of reserves, however large, tends to become a threshold. Any substantial reduction is hence regarded as a sign of weakening. But central banks globally have formed clusters to strengthen themselves against sustained contagion. Bilateral and multilateral swap lines are available. Contingent capital lines that contain contagion across countries are much less expensive than full-blown or festering crises. Central banks have the ammunition even to give today's large markets confidence.

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SOURCES:
The economic time Business standard Security exchange board of India Live mint The Hindu www.thehindubusinessline.com Reserve bank of India

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