»The Daily Reckoning by Bill Borner

Why did the Rupee Crash in August?

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
August has been an exceptionally volatile month for the financial markets. Global factors such as the Eurozone debt crisis, and the US nearly defaulting and eventually having its credit rating downgraded, have both sent markets into turmoil. Stock markets around the world have crashed, while gold has made new highs. Markets have made some recovery towards the end of the month, but on the whole they have suffered.

While the financial press has been focused on the stock market and on gold, another market has also made a significant movement over the month, though it has largely been ignored in the financial press. I'm talking about the currency market, i.e. the rupee. Over the month of August, the rupee fell significantly against all its four traded counterparts. The rupee fell 4.2% against the dollar, 4.6% against the pound, 5.7% against the euro, and 5.3% against the yen.

The rupee's fall is interesting because it does not fit in well with the fundamental picture. Over the month of August, global markets have been concerned primarily with the debt crisis in Europe and America, yet both the dollar and the euro have gone up against the rupee. Additionally, the RBI has been raising interest rates (and is expected to continue doing so), yet the rupee has fallen instead of rising due to this.

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Thus, the fundamental analysis should have led to the rupee strengthening (or at least not weakening) over the course of the month. While there is a reasonable case for the rupee weakening against the yen due to increases in risk aversion, we can't fundamentally justify weakness against all currencies. So perhaps there is something else going on here. How can we explain the persistent weakness in the rupee over the last month?

What we are interested in knowing is whether the rupee weakness is due primarily to market sentiment or fundamentals. If it is due to market sentiment, then we can probably expect the rupee to recover its losses in the near future, once markets calm down. If its fundamentals, and it reflects some underlying issue in the Indian economy, then the rupee could continue to fall.

The first point to consider is whether other emerging market currencies have also weakened as much as the rupee. Over the month of August, the Brazilian real fell 2.7% against the dollar, the Russian rouble fell 4.5% against the dollar, while the Chinese renminbi actually rose against the dollar. In this context, there appears to be some negative sentiment against emerging market currencies, so it is possible that the rupee has suffered due to this.

The fact that other emerging market currencies fell over the month of August is good news for the rupee. It implies that there is no significant problem that specifically faces the Indian economy. Of course there are global concerns, but this affects everyone.

The next factor to consider is inflation. From a long-term perspective, high inflation is bad for the currency. This is very intuitive. If inflation is high, it means that the currency loses its real value (i.e. in terms of how many goods and services it can buy) more quickly. So higher inflation over the long-term leads to a weaker currency over the long-term. The current inflation rate ranges between 8% and 10%, while inflation rates for the dollar, pound, euro, and yen are considerably lower.

While inflation can be used to explain a long-term fall in the rupee, it does not explain the sudden sharp fall in the month of August. This is especially so as there was no change in inflation expectations, or any large fundamental change in the economy that would warrant a weaker rupee. So from a fundamental perspective, the movements in the rupee are not fully justified or explained.

So what do we have left to explain the sharp fall in the rupee over the month of August? One factor that is crucially important is the stock market. The Indian stock market has a strong positive correlation to the value of the rupee. That is, when the stock market falls, the rupee also falls, and vice versa.

The reason for this positive correlation is as follows: The stock market consists of a significant number of foreign investors. If there is turmoil in global markets, foreign investors sell their holdings, and then sell the rupees and buy their own local currency, thus pushing down the value of the rupee. Conversely, when foreign investors buy Indian stocks, they need to buy rupees first, thus this pushes up the value of the rupee.

Therefore, the most likely explanation for the fall in the rupee in August is that the stock markets fell significantly too, as foreign investors sold their holdings. A rebound in the rupee is likely to occur when foreign investors start buying Indian stocks again. This is likely to occur only when global markets stabilize and investors become less fearful. Crucially, it depends on global economic conditions rather than local economic conditions.

If the economic situation in developed economies (particularly America and Europe) continues to deteriorate, we can expect the rupee to weaken further. We may find some good buying opportunities if the rupee falls considerably, provided India's economy is not also suffering. However, if Western economies and financial markets improve towards the end of the year, then the rupee will benefit.

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author and Equitymaster, do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site.
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