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Understanding Rupee Depreciation

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October 09, 2018

What is the issue?

  • The recent slide in the rupee’s value is particularly steep.
  • However, it is to be noted that it is part of a longer process of decline and requires holistic measures.

What are the recent developments?

  • The recent depreciation of the rupee worries those who need to buy foreign exchange.
  • It has also caused panic in the stock markets, the decline in which partly reflects the exit of foreign investors.
  • This, in turn, further contributes to the rupee’s fall. Click here to know more.
  • It causes further trouble for companies that borrowed heavily in foreign currency, encouraged by lower interest rates abroad.
  • It adds to domestic inflationary pressures that are already rising with higher global oil prices.

How has the depreciation trend been?

  • The period of the global financial crisis in 2008 witnessed rupee depreciation like many other emerging market currencies.
  • But this was relatively small and the recovery of the rupee was also relatively rapid.
  • Thereafter, the currency was relatively stable in nominal terms until late 2011.
  • From then on, it started declining relative to the US dollar once again.
  • It culminated in a particularly sharp decline in the middle of 2013.
  • This is famously referred to as the “taper tantrum” which afflicted all emerging markets.
  • It happened when the US Federal Reserve hinted that the Fed might soon start tapering off the extraordinary liquidity creation measures.
  • [Notably, the Quantitative Easing had marked the recovery strategy after the global crisis of 2008.]
  • Now, vis-à-vis the US dollar, the rupee is worth only around half of its value in January 2008.
  • This is a remarkably rapid nominal depreciation in just over a decade.

What happened thereafter?

  • Despite some slight recovery thereafter, the decline in the rupee’s value became a major political talking point.
  • The performance of the currency from 2014 has not been so favourable.
  • The rupee-dollar exchange rate had been deteriorating for the previous two years from the most recent sharp decline since January 2018.

How was growth then?

  • Despite the above, in this period, there were not much external headwinds to slow down the economic growth.
  • Evidently, the Indian economy was one of the major beneficiaries of low global oil prices.
  • It provided a windfall gain to the government since it did not pass on these declines to domestic consumers.
  • India was also a major recipient of portfolio capital inflows.
  • Also, more domestic companies took on external commercial debt.
  • Foreign exchange reserves also increased but the country continued to run a current account deficit.
  • So this was essentially based on short-term capital inflows.
  • Such a method of building up forex reserves is not sustainable or desirable.
  • Nevertheless, the significant level of reserves acts as a protection against capital flight and consequent rapid depreciation.

Can open market operations address depreciation?

  • Open market operations (OMO) refer to the buying and selling of government securities in the open market.
  • This is primarily to expand or contract the amount of money in the banking system, to control liquidity.
  • It is argued that open market operations by the RBI could operate to stabilise exchange rates.
  • It is said to prevent excessive appreciation as well as protect against sharp depreciation.
  • However, previous episodes of currency volatility do not provide clear signals on the effects of OMOs.
  • Once market expectations have turned adverse, no amount of OMOs and no level of forex reserves had been “enough”.
  • Indeed, the very running down of reserves in the process of such intervention can further erode trust in the currency and undermine its value.
  • Thus OMOs are only more suitable in the “good times”, when it is necessary to prevent excessive appreciation of the currency.

What are the other measures?

  • Given the above, a wider range of measures is required to tackle the depreciation crisis.
  • It makes more sense for policies to address the current account deficit.
  • E.g. controls on gold imports beyond those required for jewellery exports
  • On the other hand, capital account measures could seek to prevent outflows through transaction taxes.

 

Source: BusinessLine

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