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Down goes the Rupee. Justified? - Views on News from Equitymaster
 
 
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  • Aug 24, 2000

    Down goes the Rupee. Justified?

    The Reserve Bank of India (RBI) must be surely heaving a sigh of relief. The central bank, which first seemed to have misfired by raising rates to quell the volatility in the forex markets, scored a goal by ordering companies to repatriate 50% of funds held abroad. The inflows of US$ 850 m calmed the markets, which saw the Indian Rupee fall briefly below the Rs 46 mark against the US Dollar.

    Was the depreciation in the value of the Rupee unwarranted? The markets surely do not think so. And we concur with this view. Despite the fact that the Indian Rupee has been on a downhill journey, several developments have undermined the value of our domestic currency in recent months. Subsequently, we look at some of these factors, which probably have had a significant role in weakening the currency.

    According to leading economists, three factors play a crucial role in determining the value of a currency –

    • Fisher’s equation, which basically looks at inflation differentials between the concerned countries
    • How the interest rate differential between the countries is moving, and
    • Lastly, the movement in the real exchange rates (i.e. purchasing power parity)

    Inflation in India, as also the US, has been on an uptrend. However, in India the increase has been more pronounced (320 basis points). The growth in wholesale price index (WPI) increased from 2.8% (YoY) in December 1999 to over 6% in July 2000. During the same period, inflation in the US rose by just around 200 basis points. The increase in inflation differential necessitated that there be a correction in the value of the Rupee (Fisher’s equation).

    Interest rate differentials too have been moving in favour of the US. In the last few months, the Fed has raised rates on five occasions. On the contrary the RBI had actually reduced rates in April. This reduced differential (between US and Indian rates) made it more attractive for investors to park funds in the US. As a consequence the inflow of funds into the Indian markets was adversely affected.

    A key factor that adversely affected India’s international trade account is the sharp rise in crude prices. Infact from the lows touched in early 1999, crude prices have rallied by over 255% to US$ 32. The rise in the oil import bill has taken its toll on the trade deficit, which in April and May exceeded US$ 1 bn. Even inflows from rising exports of software services have not been able to compensate for this, resulting in an increasing current account deficit. Therefore, to control this growing anomaly, depreciation in the Rupee was necessary, as a weaker currency would boost exports while adversely affecting imports.

    Looked at from another point of view, the value of the Rupee in FY00 was supported by large inflows on account of foreign portfolio investments. Despite the fact that crude prices were rising and so was inflation the Indian Rupee continued to hold ground. However, in recent months FII investment has trailed off. Infact there has been a net outflow of FII money. This has dried out a source of US Dollar supply in the markets. Consequently, even as the demand for the US Dollar was increasing (rising trade deficit), the supply began to contract. Contributing to this was the stagnating inflows on account of foreign direct investment. -

    Another key indicator that made depreciation an eventuality was the rise in the ‘Real Effective Exchange Rate (REER)’. The REER, in simple terms, indicates whether the changes in relative prices in two countries are reflected in the domestic currency or not. In case they are not, a currency becomes over valued (if domestic prices rise faster than prices in the other country) or undervalued (if international prices rise faster than prices in the domestic currency) and there is a risk of depreciation/appreciation at a future date. The Indian Rupee, which became overvalued as early as February 2000, when the REER began to appreciate sharply, faced the risk of depreciation.

    All these factors portended a downward correction in the value of the Rupee. And rightly so, we have witnessed a correction of over 2% (3% if you consider the all time low) over the last one month. So the next time you want to take a bet on a currency, go through this checklist and determine for yourself what lies in store for that currency!

     

     

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