Understanding The Rupee Roller Coaster

Jun.24.13 | About: WisdomTree India (EPI)

The Indian rupee reached a record low last week and has depreciated significantly against the US dollar. Why is this happening and what does this signify? This post talks about the dynamics of the rupee and reviews probable reasons for this depreciation.

The movement of the rupee from 1991, when India changed from a fixed rate system to a managed floating rate system, is provided in the figure below.

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The time frame in consideration (1991 - 2013) can be divided into 4 distinct periods.

  • Pre-2001: This period sees a characteristic depreciation of the rupee.
  • 2001-2007: This is the appreciation phase of the rupee.
  • 2007-2010: A period of uncertainty due to the crisis that had an extreme effect on the US dollar.
  • 2010-2013: This period has seen a sharp depreciation and the rupee and has reached all time lows.

The exchange rate for any currency pair is determined by the buying and selling pressure of the respective currency with respect to the other. If the market does not think positively about a currency then there is a downward pressure on that currency. Such market expectations are determined by various macro-economic factors. The four periods mentioned above can help us understand these factors.

Balance of Payments: BoP is an account of all monetary transactions between a country and the rest of the world (it is the sum of current account and capital account). A positive BoP implies an appreciating pressure on the currency.

  • Current Account: A country running a current account surplus or positive net exports (exports - imports) exerts a positive force on the currency (likewise, the currency depreciates with a current account deficit)
  • Capital Account: Whereas the current account reflects a nation's net income, the capital account reflects a net change in the national ownership of assets. A capital account surplus means money is flowing into the country. Capital account, however, can more than offset the current account deficit or surplus of a country. This means that there can be a BoP surplus even if the current account is negative. The surplus in turn increases the forex reserves of the country. The currency of a country appreciates with the rising capital inflows.

The effect of BoP can be seen in the charts below. The period of 1991-2001 was marked by current account deficits and hence the rupee devalued. The first few years of the new millennium saw, for the first time, a current account surplus primarily due to the increased service exports. This, along with the increased FDI inflows backed by handsome growth rates, caused the rupee to appreciate during 2001-2007. The great credit crisis hit the US economy in 2007. The rupee appreciated as the market saw the US dollar to be riskier. The period of 2008-2010 saw a sharp decline in the FDI inflows and BoP started declining. Consequently, the rupee depreciated. The post 2010 period saw a deteriorating current account deficit. FDI remained low initially but has started picking up recently. However, this effect was negated by the high current account deficit and we saw the rupee tank.

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Inflation: Higher inflation leads the central banks to increase the policy rates which invites foreign capital on account of interest rate arbitrage. This could lead to further appreciation of the currency. However, it is important to differentiate between high inflation over a short-term versus a prolonged one. Over short-term foreign investors see inflation as a temporary problem and still invest in the domestic economy. If inflation becomes prolonged, it leads to overall worsening of the economic prospects of the country and eventual depreciation of the currency. In India, the inflation started rising in 2007 leading to the tightening of the policy rates by the RBI. This led to higher interest rate differential between India and US leading to additional capital inflows. During this time investors did not feel inflation would remain persistent and thought it to be a transitory issue which could be tackled by monetary policy. However, inflation remained persistent and became a more structural issue and the investors reversed their expectations on the Indian economy.

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Interest Rate Differential: Based on the interest rate parity theory,the currency depreciates for countries having higher interest rates. If this does not happen, there will be a case for arbitrage for foreign investors. The reality is far more complex as higher interest rates could actually bring in higher capital inflows putting further appreciating pressure on the currency. In such a scenario, foreign investors earn both higher interest rates and gain on the appreciating currency. This could lead to a herd mentality by foreign investors posing macroeconomic problems for the monetary authority.

Market Outlook: Apart from the factors mentioned above, there are some other fundamental market outlook factors that affect the rupee. The US dollar (movement of the US dollar index is shown in the chart below) backed by the improvement in the labor market has made the market more optimistic about the outlook for the US economy. Additionally, the persistent uncertainty over the Euro is just another reason the investors are snapping up US dollar.

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Note:The data used in the blog was sourced from the RBI website.Tags: EPI, UDN, UUP

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.