Rupee underwent a significant depreciation in the recent past. Increasing current account deficit (CAD) due to rising gold imports was deemed to be a big reason behind it. However, was gold solely responsible for the rupee fall or there were there other factors at work too? Preliminary evidence suggests that while rising gold imports accentuated the fall, other factors were equally responsible.
The value of rupee is determined by market forces. Basically, it's a demand supply game. Rising gold imports increase dollar demand because gold is bought and sold in dollars. At the same time it increases rupee supply since people buy dollars by selling rupee. Increasing supply of rupee causes depreciation. However, it may be noted that gold is not the only factor that influences the demand and supply of rupee.
Let us take a look at other aspects. India's export growth in the recent times has not been up to the mark due to weakening external demand. The oil imports are also on an increasing trend as India is not self sufficient in its energy needs. Both these factors have impacted rupee negatively.
Foreign flows are another factor that has an impact on rupee. Increasing foreign flows increases rupee demand resulting in appreciation. However, in the month of June 2013, when rupee witnessed significant depreciation, there was a net outflow of foreign money. Federal Reserve's indication to withdraw monetary stimulus led to foreign outflows and thus impacted rupee.
As such, gold was not the lone culprit in the recent depreciation cycle of rupee. There were various other factors that were at play as well.
So, what exactly must be done to arrest further fall in rupee?
Restricting gold imports is a step in the right direction. But as highlighted earlier gold is not the only factor impacting rupee. Government can do very little about exports as its demand is dependent upon the economic conditions in foreign countries. And the signs are not very encouraging now. Also, nothing can be done about oil imports since it is a necessity. Thus, we believe the only factor where government can exercise some control is with respect to foreign flows. Creating a conducive investment environment can attract higher foreign inflows. This can help support the rupee in the long run. Short term measures may provide temporary relief but not a permanent solution.