Reason for Indian Rupee to Free Fall Against US Dollar and Other Foreign Currencies
Why is the Indian currency falling against the US dollar and also against other foreign currencies? Well, this is one hell of a question! Answering this question is not going to be easy because there are numerous things that contribute to the loss or gain of value of Indian Rupee. To be very honest, it requires a deep understanding of how world economy works, how international trades work, how equity market works, how the oil market works and more…
Luckily, we are not going to delve deep into these things because that will make this article annoyingly long. We will attempt to provide a brief explanation of the major factors that actually contribute to the depreciation or appreciation of Indian Rupee against US Dollar or other major foreign currencies like the Sterling Pound, Euro, Japanese Yen, Australian Dollar, Swiss Franc etc.
As of today, 1 US Dollar is equal to 66.35 Indian Rupees. Well, that’s kind of a disaster, or is it? Let us find out why the Rupee dropped against US Dollar and whether is a good thing or a bad thing,
First, let us understand the meaning of Rupee falling against US Dollar
When we say Indian Rupee is falling against US Dollar, we simply mean that the value of Indian Rupee has degraded. If that sounds confusing, let us try this explanation – when Rupee falls, more of Indian goods can be purchased using the same amount of dollar.
Now consider this scenario:
You have a RING (one that we wear on our fingers). Now many people have rings. So, if your ring is just an ordinary ring, most people won’t even bother looking at it because to them, it is just ordinary and hence, no real value.
However, if that ring that you have belongs to say Genghis Khan, what will happen? Almost every nation in this world will run after you to get hold of it because it is rare and extremely valuable.
Some people might actually offer your millions of Rupees just to get hold of that one single ring (or alternately, just steal it or kill you and take it). Will they pay millions of rupees to get the ring had it been ordinary? No, they wouldn’t. With millions of rupees they can possibly buy hundreds and thousands of ordinary rings.
Do you get it?
You can actually trade more of a less valuable thing with less of a more valuable thing! Let us take this concept to currency notes (like Rupee, US Dollar, Sterling Pound etc.).
In a pure barter economy where one good is exchanged against another good, a currency note holds no real meaning. A currency note is simply useless in such a scenario. However, in our modern economy, barter system no longer exists. We make use of currency note (and of course coins) to buy and sell goods (that is, exchange goods).
So in our economy, value of a good is expressed in terms of value of the currency note. Now, the value of a currency note is actually the denomination or the face value (that is the number) printed on a piece of paper.
So, when Rupee falls, it is value that actually falls. Don’t get us wrong. The number printed on a currency note or a paper note will not decrease. It is just that more of Indian currency will be required to one US Dollar.
Now, since the value of a good is actually represented by the value of the currency note, when Indian Rupee devalues or depreciates or falls, the value of Indian goods fall. When value of Indian goods fall, more of Indian goods can be purchased using less of US Dollar or just any other foreign currency against which Indian currency devalues.
Second, let us understand the implications of Rupee devaluation
Now that we have a decent understanding of what Rupee depreciation or devaluation really means, it is time we try to understand the implications of such devaluation of Indian currency.
As we said, when Indian currency falls, it actually means that the value of Indian goods fall. This is when foreign countries will want to buy more of Indian goods because they can spend less money to buy greater quantities of Indian goods.
This means that foreign countries like USA or UK will actually increase their imports from India and in turn means, Indian exports increase.
A bit of digression
What really is US Dollar? Did you know that US currency is considered as world’s Fiat currency or world’s Reserve currency? This simply means that other countries hold US Dollars. But why do they hold that? They hold it because major international trades take place in US Dollars. Whenever a country purchases something from another country, the purchasing country needs to pay in US Dollars. This is why every country in this world maintains US Dollar reserves.
Getting back to implications of Rupee devaluation
Okay, we just learned that when Rupee devalues, Indian exports increase. Since international trade takes place in US Dollars, when India exports, India accepts payments in US Dollars. This means that the supply of Dollar in Indian market increases. This increase in supply of Dollars is not really matched by the demand for Dollars. This is when price of Dollar starts falling. This means that less of Indian Rupee will be required to get hold of 1 US Dollar.
Simply put, when the Indian Rupee devalues, market corrections take place and gradually Rupee jumps back up, i.e. Rupee appreciates in value. This is pure demand-supply economics which states that when supply increases, prices fall and when demand increases, prices rise (considering that everything else remains constant aka ceteris paribus).
What happens when Indian Rupee appreciates?
Good question. Till now we looked into the scenario starting from the point that Indian Rupee devalued first and then market corrections happen to appreciate Indian currency again. What if appreciation of Indian currency takes place first?
Appreciation of Indian Rupee against US Dollar simply means that less of Indian rupee will be required to get 1 US Dollar. Alternately, more of foreign goods can be purchased using less of Indian currency. This is when India will increase its imports.
As before, foreign trade takes place in US Dollars. This means that when India imports or purchases from other countries, the payments are made in US Dollars. Increased imports mean increased demand in US Dollars. This means that the price or value of US Dollars increases. This means that getting 1 US Dollar means spending more Indian Rupee. That means, the value of Indian currency get devalued or depreciated.
Whether Indian Rupee is falling against US Dollar or is rising against US Dollar is all about demand and supply.
But the big problem…
Who the hell is going to track all those imports and exports? It is not just Indian government that engages in import and export with foreign countries. There are literally thousands of business (privately owned) that do most of the import and export thingy.
This where the concept of national Current Account comes in…
Well, the national current account or simply the current account is a record of all transactions across the border. These transactions (purchase or sale) can be for services and goods.
In the current account, the next exports are required to match the net imports. The big problem pops up when net imports exceed net exports. We just learned that when imports increase, Indian currency value falls.
This means that when imports EXCEED exports, a deficit situation shows up where demand for US Dollar is not met by the supply of US Dollar.
As the current account deficit (usually referred to as CAD) keeps increasing, the Indian currency keeps getting devalued. So, current account deficit is not good.
National Capital Account comes to rescue…
Okay, just like there are imports and exports across borders, there are also cross-border flow of debts and investments. This simply means that people living outside India (can be NRIs or foreigners) can actually invest in Indian markets. These investments and debts are all compiled into the national Capital Account or simply Capital Account.
When foreign investments come in India in form of US Dollars, it simply means an influx of USD. This USD helps to reduce the CAD or current account deficit. However, capital account may not always provide enough inflow of foreign currencies and hence, the current account deficit may not be reduced to the desired level. We know by now that if current account deficit is not taken care of or if it keeps increasing steadily, Indian Rupee will depreciate in value.
…we tried to understand how Indian Rupee appreciates or depreciates. We really did not answer why Indian Rupee has been falling free against US Dollar lately? It is time we answer this particular question using the concepts we just learned above.
Reasons for Indian Rupee to Free Fall Against US Dollar:
- Let us blame the Oil first
Indian economy, as of date is world’s fastest growing economy. This means that demand for natural resources like oil is at its highest in the entire modern history of India (since Industrial Revolution). Now increased demand for oil triggers the following chain of events:
Indian oil demand increases>>India imports more oil>>Oil producing countries export more oil to India>>India pays for the oil in US Dollars>>Demand for US Dollar in India increases>>US Dollar appreciates in value>>Indian Rupee depreciates in value.
India’s increased demand for oil triggers another set of events:
India’s increased oil demand puts pressure on international oil market >> Oil prices increase in international market >> India now imports oil at higher prices >> India pays more US Dollars >> Demand for US dollar further increases in India >> US Dollar further appreciates in value >> Indian Rupee further depreciates in value.
- US monetary policy
If we forget this, it will be a disaster. Remember the 2008 depression of US economy that brought the country to its knees? Remember how the century-old Lehman Brothers collapsed completely? Well, after that, the Federal Bank or the Feds (remember that it is a privately held organization unlike India’s Reserve Bank which is a government body) decided to kick start US economy using monetary stimulus. This simply means that the Feds started printing US Dollars and injected them in US economy. The idea was to give enough money in hands of US citizens to increase demand for goods and services. They printed so much money that US Dollar started losing its value in world market. This pushed the US economy to the brink of complete and irrecoverable collapse.
Luckily for America, the Feds started quantitative easing (known as QE). This means that they started pulling out US Dollar from market in chunks. How did they do that? The Federal Bank of America is a private organization. All the money it pumped into the economy was merely a loan to US government against interest rates. Now when the US economy was to collapse completely, the Feds started retrieving the loan (along with interest, ending up with enormous profits). Good thing for US economy was that the US Dollar started gaining strength because of gradual decrease in supply and gradual increase in its demand.
A reduction in supply of US Dollars within America means a supply shortage in every other country in world and India is not immune to this problem. Hence, Indian Rupee started falling.
- Indian equity market is pretty volatile as of now
The Indian equity market is presenting a volatile and grim scenario for Foreign Institutional Investors such as Berkshire Hathway, IFC, Blackstone etc. Since they aren’t very confident in Indian market, they are not investing as much as they usually do. This means further shortage of US Dollars in Indian economy and hence, Indian Rupee is falling.
Pros and Cons of Indian Rupee Falling in Value:
Let us first take a look at the problems that arise when the Indian Rupee falls in value against the US Dollar:
- For Importers: Those who are importing are supposed to pay in US Dollars. Now let us assume that 1USD = INR 60. So, for an importer it means he needs to pay INR 60 for a product that is worth 1 USD. Now if the Indian Rupee depreciates to INR 70 for every 1 USD, the importer will have to pay INR 70 for the same product which is still priced at 1 USD. So, the importer is actually paying INR 10 more for the same product. This hurts the importers.
- Inflation: Building on the previous point, when the importers are hurt, they are actually forced to charge higher than their purchase price in Indian market. Put in other words, importers will actually sell the imported products at much higher price. This leads to inflation (rise in prices of goods and services).
- Companies having US Dollar debt: There are many Indian companies that have debt in US Dollars. When Indian Rupee devalues, they need to have more Indian currency available to pay off their debts. This means they need to pull out their reserve Indian money to pay off their debts. This means that their profits fall.
- Foreign investors invest less: This is natural. When Indian Rupee devalues, those who convert Indian currency in US Dollars are hurt because for the same Rupee amount, they will get less of US Dollar. This is particularly true for foreign investors who are hurt when they try to sell off their investments and convert the Indian currency into US Dollars.
Let us now take a look at the benefits of Indian Rupee being devalued against US Dollar:
- Exporters benefit: For exporters, the situation is really good. Since they need to accept payment in US Dollars, they can convert the US Dollar amounts into Indian Rupee and get more of Indian currency.
- People who earn in US Dollars: There are many Indian individuals who actually earn in US Dollars sitting right here in India. They are basically freelancers and usually use Internet as the medium of work and financial transactions.
So basically Indians who pay in Dollars are losers while Indians who earn in US Dollars are the ones who gain.
The Question is: What About Indian Rupee Against Other Foreign Currencies?
According to RBI, the institution actually keeps a tab on two currency baskets:
Basket 1: This contains 6 currencies – USD, GBP, Japanese Yen, Australian Dollar, Euro and Swiss Franc.
Basket 2: This contains 36 other currencies – they currencies of 36 nations that India frequently trades with.
Now these two separate baskets are designed to derive what RBI calls Real Effective Exchange Rate.
In each basket, Reserve Bank of India monitors how India Rupee is fairing against each of the currencies in individual baskets as well as how the currencies in a single basket are fairing or performing against each other.
Interestingly, RBI has said that ever since April of 2014, Indian Rupee has dropped by 4.5% (approximately) against the US Dollar. This is a considerable drop but at the same time, other currencies in Basket 1 have actually dropped way more against US Dollar. For instance, according to RBI, GBP (Sterling Pound) dropped a staggering 14%, Euro dropped even more, registering a drop of 24%. Japanese Yen registered around 16% drop in value against US Dollar.
Now when we see the relative drops, Indian Rupee has actually performed way better that other major currencies. So, Indian Rupee is not falling as much against other major currencies in the world as against the US Dollar. So chill! Things like these happen and market is very nasty. It loves to stay in equilibrium. Soon enough we will see Indian Rupee appreciating in value.