What is the reason behind the fall of Indian rupee? Why is the Indian rupee falling? The value of domestic currency is an important ingredient for the good health of an economy. In fact, all other macroeconomic indicators depend on and are influenced by the value of the currency. The current fall in Indian rupee has taken everybody by storm. Not only are the economists concerned but masses are also wondering as to what are the reasons for the fall in value of Indian rupee.
Before I come to the reasons for the fall of the Indian rupee, let me briefly clarify some concepts which will be useful to understand the story behind it. The exchange rate of any currency depends on economy’s inflows and outflows of foreign exchange. The outflow of capital typically in developing countries occurs through imports and inflows take place in the form of Foreign Direct Investments (FDI), Foreign Financial Investment (FFI), loans and grants etc. which are accounted for in the balance sheet. In the country’s balance sheet the account is divided into two parts, current account balance and capital account balance. The current account balance includes current transactions mainly trade which are short term in nature and under capital account, long term inflows/outflows so mainly investments with lock-in period of more than a year are counted. Though the exchange rate depends on these indicators but the central bank can fix one particular rate which is known as the fixed exchange rate regime. Cases where the central bank works only as a regulator in the foreign exchange market is known as a flexible exchange rate regime. There is another exchange rate regime which is sometimes called managed exchange rate regime. In a managed exchange rate regime central bank often intervenes in the currency market through indirect measures to attain a desirable exchange rate for the economy. Developing economies mainly follow this type of exchange rate.
In a fixed exchange rate regime when the central bank increases the exchange rate or reduces the value of its currency it is called devaluation and when it decreases the exchange rate or increase the value of its currency it is called revaluation. In a flexible or managed exchange rate regime currency market works and through market mechanism the exchange rate changes. If there is increase or its value falls it is called depreciation and when it decreases or value rises is called appreciation.
Now let’s come back to the case of the Indian rupee. India usually runs a flexible exchange rate and does little intervention in the Foreign Exchange (Forex) market. Since May 2013, the Indian Rupee has been losing its value against the US dollar and starting from around 54 it has now reached at around 68 last week.
How long will it take to reinstall rupee and who are the people getting affected from its fall? Definitely the worst-affected people are the poor who are suffering from inflation and losing jobs induced by the inflationary pressure on wages. Generally, any depreciation in currency makes domestic goods cheaper in foreign markets and makes foreign goods costlier in the domestic market. The effect is increase in exports and decrease in imports. But, if the depreciation happens due to a reason which is beyond the control of the government and can’t be predicted in advances then the fruits of depreciation may not be enjoyed. And, this situation of Indian economy is beyond the control of government in short run though it is trying hard to stabilize it.
Why in short run this situation is beyond control of government is an important question to address. This currency problem of Indian economy can’t be segregated from the global financial crisis starting from 2008 in United States. Also, to explain sweet Indian over 9% growth story, we have to look back at the global economic situation. As the 2008 massive bubble burst, the financial capital started searching its way to get out to find new markets. China and India were two major playgrounds for this capital and they entered in huge volumes. China has been able to utilize the foreign capital properly in its infrastructure development whereas in India, it has mainly been concentrated in the domestic market. Nobody can disagree that, FDI played a major role in achieving this high growth rate in India. We can say that, Indian high growth performance is strongly correlated with the bursting of consumption bubble of the developed economies. And so the Indian growth history can be explained as a by-product of this consumption bubble.
The situation was fine until the developed economies were submerging in the crisis and were searching ways out for solutions. But problem started when these economies started recovering from the crisis. Usually in the recovery period the expectations of return to capital increases and capital starts to fly from the low return economy to high return economy. This capital flight imposes huge pressure on the current account balance which influences exchange rate and as a result domestic currency depreciates. Without an active macroeconomic policy, it is always difficult to tackle this problem. Currently Indian economy is facing the same.
We can look at some facts to visualize this situation. According to the Reserve Bank of India (RBI) report, India’s Current Account Deficit or CAD for the year 2011-12 was $78.2 billion. This swelled by 9.6 per cent, to $87.8 billion in the year 2012-13. Trends show that it may increase for the year 2013-14. Minimizing the CAD depends on the availability of funds. The growth target of 5.5 per cent is not enough to finance India’s increasing CAD. This is interesting that, the CAD problem starts with the inflows side which is related to investment and again this CAD problem affects the investment flow. The investors have started to believe from the past several months’ trend that Indian government may not be able to handle this problem due to lack of money. Now looking at a report published in Hindu Business Line we see that, the foreign investors have pulled out over $10 billion from India in June-July alone.
What is the solution of this Crisis?
There are two conventional ways of confronting this CAD to stabilize the exchange rate. The first one is austerity measure and the second one is privatization. The problems of applying the first measure are seen in Greece, France, and Spain in recent past. And for Indian economy, with around 3% unemployment rate along with large informal sectors and 30% people below income poverty level it is almost impossible. And the second measure-privatization- is more devastating and problematic while at the same time India’s growth performance is fuelled by its private sectors only.
So, India has to look for an alternative way to stabilize its economy. Currently IMF is also coming out with an alternative which has been creating a buzz in the last few years. The suggested solution is controlling the bullish speed of capital. In fact, it is interesting that when John Maynard Keynes was drafting the Bretton-Woods institutions, he was much concerned about this problem of capital and was suggesting ways to control it. If India wants to go for a sustainable solution for this problem it has to adopt policies regarding capital control, especially financial capital which always enters into any economy with beautiful spring but leaves behind a snowstorm cold.
So, it is clear that, the problem of depreciation of Indian Rupee is not an isolated one. In fact, this is one symptom of the upcoming crisis of Indian economy which may not be tackled. If measures for capital control can be taken, may be in the short run the situation will worsen but in long run it will help the economy against sudden shocks exerted by foreign capital. The developing and so called emerging economies should also take lessons from it.