Devaluation (Depreciation) of Rupee: its Impact on Indian Economy

 Devaluation (Depreciation) of Rupee: its Impact on Indian Economy

                                                                                      -Dr. S. Vijay Kumar                                                                                                                                        

          In a fixed exchange rate regime the term ‘devaluation’ is used. It means a deliberate downward adjustment of a country's official exchange rate by its government i.e. central bank (RBI in India) relative to other currencies. Where as in floating or fluctuating exchange rate currency's value is allowed to fluctuate according to the foreign exchange market. In this, it is known as depreciation.

             There are two implications for currency devaluation. First, devaluation makes a country's exports relatively less expensive for foreigners and second, it makes foreign products relatively more expensive for domestic consumers, discouraging imports. As a result, this may help to reduce a country's trade deficit.

Revaluation: This term is used in a fixed exchange rate regime; it means a deliberate upward adjustment to a country's official exchange rate relative to other currencies. In floating exchange rate, it is known as appreciation.

The Liberalized Exchange Rate Management System: (LERMS) was introduced in March 1992 involving the dual exchange rate system in the interim period. The dual exchange rate system was replaced by a unified exchange rate system in March 1993. 

History of Devaluation:

The Indian rupee, which was on par with the American currency at the time of Independence in 1947, has depreciated by a little more than 65 times in the past 66 years. At the time of independence, there were no foreign borrowings on India's balance sheet. After independence, India had chosen to adopt a fixed exchange rate currency regime. The rupee was pegged at 4.79 against a dollar between 1948 and 1966.             Two consecutive wars, one with China in 1962 and another one with Pakistan in 1965; resulted in a huge deficit on India's budget, forcing the government to devalue the currency to 7.57 against the dollar. The rupee's link with the British currency was broken in 1971 and it was linked directly to the US dollar. In 1975, value of the Indian rupee was pegged at 8.39 against a dollar. In 1985, it was further devalued to 12 against a dollar.

             In 1991, India faced a serious balance of payment crisis and was forced to sharply devalue its currency. The country was in the grip of high inflation, low growth rate and the foreign reserves were not even worth to meet three weeks of imports. Under these situations, our currency was devalued to 7.90 against a dollar. So far two major rupee devaluations occurred in 1966 and the early 90s and the present one. The reasons for these devaluations are CAD, Fiscal deficit, soaring inflation, insufficient foreign ex­change reserves, decontrol and liberalization. It was mostly at around Rs.45 against a dollar. It touched a high of Rs.39 in 2007. The Indian currency has gradually depreciated since the global 2008 economic crisis. To day (15-11-2013) the dollar value is Rs. 63.13.

Reasons for devaluation of Indian Rupee:

Current Account Deficits (CAD): Deficit in the current account (more imports and fewer exports) is not good for a country, because the country needs to buy more foreign currency to fulfill its need. A country needs to manage its deficit within control; otherwise it will lead to an economic problem. More demand for the foreign currency would reduce the value of that country’s currency.

Government Deficit is high: The government finances are in a bad shape and the combined central and state government deficit has stubbornly stayed around 10 per cent of GDP. Due to high deficit, investors lost faith in our economy.

Inflation: As a general rule, a country with a consistently high inflation rate exhibits a falling currency value, as its purchasing power decreases relative to other currencies or vice versa.

High Interest Rates: At present in India, high interest rates are prevailing. High interest rates are not conducive for foreign investors to invest as their costs of production goes up.

Slow Growth Rate: At slow growth rate (4.8%), Foreign Institutional Investors (FIIs) won’t dare to invest.

Dollar is in Demand: “Exchange Rate is nothing but the price of a currency (like price of a commodity) in the International Market”. If the demand for the dollar is higher than its supply, the rupee should depreciate. If it is the other way round, it should appreciate. Risk Aversion on part of Currency Investors, which has caused the Demand for the US Dollar to go up world over.

Fall of Stock Markets: FIIs turning Net-Sellers and withdrawing funds from the Indian Market. Thus, leading to fall of Indian Stock Markets and leading to further devaluation of Indian rupee.

The global uncertainty: The global uncertainty and various economies crisis (Euro and recent Syria) has forced the investors, large banks and financial institutions to search for safe haven and they have now started selling Euros and buying dollars. Thus, the dollar has appreciated against all major currencies including rupee.

Stimulus Withdrawal to the US Economy: Federal Reserve minutes hinted that the United States was on course to begin tapering stimulus due to the U.S. economy strengthening —reaching some important signposts such as a fall in the unemployment rate.

Declining Foreign Investments: Due to less or weak demand for rupee foreign investments are decreasing thus leading to further depreciation.

Political Uncertainty and Scams: Weak central government, series of scams and slow economic reforms are not attracting and gaining the confidence of foreign investors.

Rating Agencies and Foreign Investors: Rating agency - Better Business Bureau (founded in 1912, a non- profit organization focused on advancing market place trust) downgraded India's rating i.e. not favorable for investment. Another rating agency Standard & Poor's also put India's rating at negative. Foreign investors take these ratings seriously and a drying up of inflows will further weakened the rupee.

Domestic Investors: It has also become more expensive for both the Government and corporates to borrow overseas; they have to offer higher interest rates to compensate for the perceived higher risk. Corporates are already reeling from a high interest rate regime in India. Even prime borrowers-leading corporates like Tatas and Reliance have to pay an interest rate of around 14-15 per cent. 

Lacking Political Will: In India Political will is lacking for concrete economic policies. The Government needs to look inward to end its policy paralysis. 

Weak Economic Fundamentals: The weak economy and no signs of quick fix solutions are weighing on the rupee. The UPA government is unlikely to deliver far reaching reforms to generate heavy capital inflows.

Impact of Rupee Depreciation on the Indian Economy:

Negative Impacts:

Inflation graph and Fiscal deficit to scale up: Currently, India is suffering from a two digit inflationary (CPI: 10.70%) pressure. A depreciating rupee would only add fuel to this. It would lead to high inflation, as India imports around 70 per cent of its crude oil requirement, government would have to pay more for it. Further, this higher import bill will lead to rise in fiscal deficit for the government and will push up the inflation.

Increasing Current Account Deficit (CAD): A frail rupee will add fuel to the rising import bill of the country and thereby increasing its current account deficit (CAD). A widening CAD is bound to pose a threat to the growth of overall economy.

Imported goods: Buying imported stuff will become very costly affair. You will have to shell out extra on imported goods.

Impact on Oil Imports: Oil imports consume the largest part of the FOREX reserves. Oil and gold imports account for 35 per cent and 11 per cent of India's trade bill respectively. Traders say there has been continuous demand for the dollars from oil importers, the biggest buyers of dollars in the domestic currency market, pushing the rupee lower. 

Stock Markets and FIIs: Depreciation of rupee affects the money flow in the Indian stock markets. FIIs start withdrawing their investments from the markets fearing loss of value. In terms of portfolio stocks in oil and gas, infrastructure, fertilizer or tyre business, will hit as the shares of these companies will fall when the rupee falls as they procure their raw materials from abroad.

Impact on Companies Balance Sheet: Corporate India is a net borrower of dollars and to that extent a depreciating rupee would impact its balance sheet adversely.

Impact on Companies foreign debt: Companies with foreign debt on their books would also be impacted. With the rupee depreciating against the dollar, these companies would need more rupees to repay their loans in dollars. This will increase their debt burden and lower their profits. As a result, investors would stay away from companies with high foreign debt.

NPA (Non-Performing Assets): Companies, which have borrowed in foreign exchange through external commercial borrowings (ECBs) but not expected the foreign exchange risks, will suffer enormously. Many banks will have to declare such loans as non-performing assets. Consequently, they will lend less to the productive sectors.

Foreign Currency Debt: Foreign currency debt will increase, especially linked to dollar.

Prices of Cars, Electronic gadgets and home appliances will go up: The depreciating rupee has pushed up the prices of electronic gadgets and home appliances. Car makers who import 10 to 40 percent of the components are contemplating increasing prices.

Impact on Indian students and travellers abroad: Traveling abroad becomes more expensive as travel cost could go up. Students studying abroad too have to pay more for their studies.

Expectation of Taping of US Bond-Buying Programme: Strong demand for US dollars from importers, banks, continuous capital outflows, widening current account deficit and dollar's strength against other currencies amid expectation that the Federal Reserve will soon taper its bond-buying programme may lead to further depreciation of rupee.

Burden on Subsidies: Burden on subsidies will further go up, for e.g. subsidy on crude oil, LPG and fertilizers. 

Doubts about General Anti Avoidance Rules (GAAR): 

GAAR is a new chapter introduced in the Finance Bill 2012. FIIs are so concerned about this. Broadly speaking, GAAR provisions will disallow a tax benefit if it is proved that the investor entered into the market with the intent of avoiding tax.

Impact on Common man: Depreciation of rupee will also trigger a chain reaction that would result in a higher burden on the common man in all walks of life. For e.g. Increase in transportation charges due to hike in fuel prices will lead to hike in the prices of several consumer commodities.

Positive Impacts:

Cheerful news for Exporters: When a currency depreciates, the exporters make more profit because they get more of the local currency for every unit of foreign currency though the quantity of trade remains unchanged.

Overseas Indians: Money saved is money earned. Depreciation of rupee is certainly good news for the overseas Indians. Those working abroad can gain more on remitting money to their homeland. 

IT sector: The depreciating rupee would be positive for the Indian IT sector which generates more than 85% of their $70 billion revenue from the overseas markets. But, “exporters gain only in the short term and after that overseas buyers seek price adjustment.”

Solutions to stop fall of Rupee:

Role of RBI: RBI on August 14 announced stern measures, including curbs on Indian firms investing abroad and on outward remittances by resident Indians. RBI will interfere in this area because a steady value of rupee is essential for the orderly growth of the economy. RBI will be watching the position and interfere to stabilize the currency value. In case depreciation continues, RBI will sell dollars directly to oil marketing firms from the reserve and this will help to a certain extent in arresting the fall of rupee.

           RBI allowing banks to set their own interest rates on NRE and NRO deposits (Non-Resident External deposits means the amount kept in rupees can be converted and repatriated back into foreign currency and on the other hand, Non-Resident Ordinary deposits means, the amount is kept in rupees and cannot be converted or repatriated back into foreign currency) and making these deposits tax free is a good example of a short term measure.

Cut in policy rates – Repo Rate, Reverse Repo Rate and MSF (Marginal Standing Facility - Under this scheme, Banks are able to borrow up to 2% of their respective Net Demand and Time Liabilities).

Other Possible Solutions:

·     Oil import demand could be staggered and purchases coordinated so that at no point there is undue bundling of imports.

·  The government can take initiatives which encourage and increase the flow of foreign investments into India. For e.g. Recent steps taken by government like –

·    Raising FDI limit in Pension fund or the increase in the investment limit of investors in government security and corporate bonds are the steps in the right direction.

·  The government can make investments attractive and invite long term FDI in infrastructure sector.

·    Government can consider temporary import compression.

·    FDI in the aviation industry retail can also attract foreign investors. 

Some Other solutions:

·          Maintaining favorable balance of trade

·          Containing Inflation

·          To strive for higher Economic Growth Rate

·          Solving Unemployment Problem

·          Accelerate Economic Reforms

·          Contain Public debt

·          Contain Fiscal Deficit

·          Conducive Interest Rates for robust economic growth

·          Creation of confidence among FIIs

        To conclude, Government needed to "cut spending" to reduce the deficit. But, still no sufficient measures are taken to reduce the fiscal deficit. Hence, our government should take strong measures to cut unproductive expenditure,  contain inflation, increase exports, reduce imports and re-impose confidence in the economy and investor interest, so that FIIs, FDI could soon return. To get these done, the Government needs a strong political will power.