Understanding the upside and downside of the depreciating rupee

Considered one of Asia’s worst-performing currencies this year, the rupee touched a historic intra-day trading low of 72.99 per U.S. dollar, this month. The rupee has depreciated due to varied factors. Depreciation refers to its fall against the U.S. dollar while appreciation means the opposite.

When the rupee depreciates, Indian buyers pay more to purchase a good or service priced in dollars and vice versa during appreciation. Although depreciation and devaluation have similar economic outcomes, depreciation occurs due to market forces whereas devaluation derives from a conscious act of a sovereign government.

Rupee exchange rate fluctuations depend on the demand and supply of dollars in the domestic, global commodity and financial markets. If dollar demand exceeds supply, it appreciates versus the rupee and vice versa. The Current Account Deficit (CAD) or the difference between values of imports over exports, spurs higher demand for dollars to pay for imports. India’s CAD stood at 1.9% of the GDP in 2017-18, rising from 0.6% in the earlier fiscal. It has further grown in FY2019 as per latest data releases. Consequently, net outflows rose from $15 billion to $48 billion.

The burgeoning CAD is one of the main reasons for the higher dollar demand and rupee depreciation. CAD is financed by the financial market’s forex flows or the capital account (FDI investments). If the former’s inflows and FDI flows are robust, the CAD is met through this surplus. But past experience shows forex flows can be very volatile, thanks to sudden withdrawals. However, net FDI inflows, portfolio investments and net receipts from non-resident deposits have saved the rupee further blushes.

The rising CAD is attributed to increasing commodity prices imported by India – crude oil, gold and electronics comprising the top three – where payments are in dollars or Euro. Moreover, monetary and interest rate hikes by the US Fed have made US treasury investments more attractive versus other riskier ones, the latter only being attractive when US interest rates were lower. FII have, therefore, moved funds out of emerging economies back to the US.

Approximately Rs48,000 crore has been withdrawn from India within 2018’s first half. The expanding trade wars between the U.S. and China have also spiked tension, worrying cautious investors and triggering a reverse flow of foreign funds. As per UNCTAD’s World Investment Report, global FDI flows fell 23% in 2017. India also witnessed declining FDI inflows– $44.85 billion in 2017-2018, a growth rate of 3%, the lowest in five years. The immediate pressures have come from the rub-offs of the Lira crisis in Turkey.

The million-dollar question: is the depreciating rupee good or bad for India’s economy? Some nations (like China) have undervalued currencies for extended periods to garner trade competitiveness. But the rupee’s strength holds psychological and emotional significance, as evidenced by the reactions on the street and in Parliament when the Centre devalued it twice in June 1991. Yet, the exchange rate is just a ‘price’ in the forex market. The nation’s relative strength and other short-term parameters drive the price just like other markets. Indeed, industries such as IT, hospitality, pharmaceuticals and automobiles with immense export volumes gain from a declining rupee, presuming their raw material imports are minimal.

Import-dependent sectors, though, face headwinds during depreciation (e.g., petroleum products and precious metals).

Officially, the RBI doesn’t intervene in managing exchange rates. Nonetheless, it occasionally sells dollars from its reserves to dampen rate fluctuations. A growing CAD would pressurize RBI’s reserves and progressively constrain its ability to intervene.

Besides, import-induced inflation can impact the nation’s fiscal health. As shale becomes economically viable and new oil sources like Libya reemerge, oil prices may stay in check. The renewable energy focus is meant to curb dependence on oil leading to lower oil imports in the long run. Likewise, to restrict gold imports, Sovereign Gold Schemes allow people to invest in paper gold rather than the physical one. Make in India scheme too boosts domestic manufacturing, controlling imports. Together, these may help control CAD.

Finally, there’s nothing like an optimal exchange rate. In the long term, purchasing power parity determines nations’ exchange rates. Overall, there are pros and cons to currency values, although some nations like China have been benefitting from deliberately depreciating their currency.

Views are personal.

The author is partner & leader – Public Finance and Economics, PwC India.