The fall of the rupee: key things to know

By Prof. Rudra Sensarma

The crash of the rupee has dominated business headlines in the past month. Ironically, the fall is
characterised by the exchange rate surging to a record high of 71 in the end of August (see figure).
This is because we measure the USD-INR exchange rate as the price of one USD in terms of INR. The
outflow of USD from India has created a scarcity of the foreign currency causing its price to rise, which
we refer to as depreciation of the rupee. This has exporters cheering and importers worried. A weaker
rupee makes our products more competitive in the global markets (because exports can be priced
cheaper even while margins in terms of INR are protected) but makes imports costlier. But, why did
the rupee fall to a historic low? Is the situation alarming? What can we expect moving forward?

Three factors are mainly responsible for the rupee’s fall.

First, oil prices started rising in the last one year making
imported crude more expensive requiring USD outflows
to pay the import bill. Second, the tariff war engendered
by Trumponomics has created a cloud of uncertainty over
emerging markets which has caused a flight of financial
capital towards ‘safe haven’ currencies such as USD.
Third, the Turkish Lira meltdown since the beginning of
August has kept foreign investors away from emerging
markets including India due to fears of a contagion. While
each of these factors has made investors nervous, there
are reasons to believe that we in India should not be
unduly worried. Oil price going up is a short-term
phenomenon, and there are enough reasons to believe,
both due to falling demand for fossil fuels and rising supply of shale gas, that the crude rally will not
last. The tariff war certainly hurts China in the short-term, but if India can productively engage with
BIMSTEC and RCEP groupings we can hope to negotiate better trade terms with Asian partners while
simultaneously maintaining good relations with the US.

Finally, the case of Turkey is entirely different from India. Turkey had borrowed heavily from external
markets to finance a debt-fueled economic boom. While this kept GDP growth rate high (higher than
India’s and China’s for a while), concerns such as a twin deficit crisis (climbing fiscal deficit and current
account deficit) and galloping inflation (officially 20% and unofficially 100%) remained unaddressed.
A situation that demanded monetary tightening was made worse by keeping interest rates low in
order to keep the growth engine running. Worse, the Turkish President Recep Erdogan tried to
reassure markets by announcing that he would take greater control of monetary policy decisions,
which was met by another round of fall in the Lira. A good lesson in the importance of autonomy of
key institutions! India is in a much stronger position however. While our short-term external debt (of
around USD 200 bn) is similar to that of Turkey’s, RBI’s forex reserves are above USD 400 bn while the
Turkish central bank holds barely USD 75 bn. India’s current account deficit (the export-import gap) is
a little less than 2 percent of GDP while Turkey’s is 6 per cent.
 Therefore, in terms of macroeconomic
stability, we are relatively better off
compared to not only Turkey but also other
emerging market peers. Hence, the USD-
INR rate may stabilize at current levels.
Also, it is believed that a fall in the rupee
has been a good thing as the rupee has
been fundamentally “overvalued” for a
while. Consider the concept of a real
exchange rate which adjusts the nominal
exchange rate (such as the USD-INR rate)
with price differences in the respective countries and also takes into account a basket of currencies
instead of only one. In terms of the 6-country trade-weighted real effective exchange rate (compiled
by the RBI, see figure), the rupee is still overvalued by 20 percent and has scope of weakening further
to reach an equilibrium (at 100). Of course, that may not strictly happen as the real effective exchange
rate is only indicative than exact.

So how can we prevent a free fall of the rupee beyond where it is now? The RBI can intervene in the
forex market by releasing some part of its war-chest (the USD 400 bn reserves). The government can
proactively attract big bang FDI proposals and launch innovative securities to attract financial flows
(such as special purpose NRI bonds). A revival of exports can bring home precious forex and finally the
possibility of further repo rate hikes (the RBI has hiked the repo rate twice in the last two monetary
policy meetings) can keep foreign investors interested in India. However, these are short-term
solutions. In the long run, we have to invest in improving the competitiveness of the economy (lower
cost of capital, easier procedures, skilled manpower, higher R&D, greater use of technology, more
formalization of the economy, better infrastructure and ease of doing business). As the wise
economist said, only three things matter for the strength of the currency and long run economic
prosperity: productivity, productivity, and productivity!