Dollar Hunger Eating Rupee Valuation

CA Arun Prakash

Swami Vivekananda had once said that “Strength is life and Weakness is Death”. Nowadays the dollar and rupee have become the synonyms for Strength and Weakness respectively. The dollar rich countries are able to survive and the others are proceeding towards the dead end of economic crisis. So if you are thinking about vacations outside India then think again as it is going to cost more to your pockets. Import intensive industry may shrink the size of its cheques. Oxford degree will be floating at premium. Your grocery bills will have more numbers as cash outflow but less for items inflow. Surprised about these!! Don’t be as these are the direct/side effects of the “dollar hunger eating the rupee valuation.”

Before starting the discussion let us understand the meaning of the rupee devaluation. Broadly speaking devaluation represents the decrease in the value of national currency as against the other nation’s currency. In simple words if by paying a fixed amount of domestic currency we are able to buy fewer amounts of foreign currency then it is a state of devaluation. Usually every country is having a foreign exchange market to deal with its forex requirement or to be more specific trade the currency. Indian foreign exchange system was based on the fixed rate model till 90’s. Afterwards it switched to floating rate model. Under the fixed rate model the central bank used to fix the equivalent rate against the foreign currency of dollar, pound etc. However in case of floating rate system the exchange rate is determined based on the free market forces of demand and supply. If demand increases as against the supply the value increases and if supply increases as against the demand the value decreases. So technically if 1$= 40 Rs in January and the same is Rs 50 in March it means that $ has become costlier by Rs 10 or rupee has devaluated as against the dollar.

Though as a concept it may be easy to understand but the effect of it has been very discouraging for our economy. Just peep into the historical outset you will find how much disastrous the devaluation was.

Historical Financial Crisis:

The first historical crisis broke in 1966 where despite of rigorous efforts the government failed to manage the payment deficits. As the imports were higher than exports and the inflationary conditions added more fuel to it the trade deficit was unavoidable. In simple words if the inflation in one country is higher than the other then domestic goods become more expensive as compared to foreign goods resulting into increased imports.

In addition to the abovementioned The Indo-Pakistani War of 1965 led the US and other countries friendly towards Pakistan to withdraw foreign aid to India, which necessitated more devaluation of rupee.

After 1966 the pace of financial crisis slowed down but it again knocked the door of India in 1991. The condition of balance of payment had worsened leading to serious economic trouble. India was almost at the verge of default as the forex reserves were close to end. This was the time when the financial crisis again hit the Indian economy and the damages were significant. It was the time when India needed to relook its economy and the policies framed to serve the economic needs. As recourse the government had imposed quantitative restrictions, provided export subsidy, and introduced floating exchange rate system.

Though the remedial measures may have reduced the risk and restricted Indian economy to reach to a vulnerable position but these were not permanent in nature. The fall in rupee valuation did not stop. And today the devaluation is such that it may paralyze the economy if the right measure at the right time and at the right place is not taken.
What is bothering rupee? Why dollar is gaining demand? What has caused the waterfall of India’s domestic currency? Are we back in 1966/1991 state? These are the few questions which are required to be established before we move ahead to decide the remedial measures to be undertaken. Just have a look at the rupee water fall trend:

Major Reasons cooking up the devaluation: Pinch of Euro Zone Recession:

The Euro Zone crisis has dampened the investor’s mindset and restricted them to make any risky investments. The uncertainty prevailing in the Euro zone and the recessionary global conditions have put immense pressure on the foreign investments. Even the Indian trade has been affected adversely on account of the same. Being a vital market for India the reduced demand conditions in the EU Zone has become a barricade for Indian Exports and the same has started declining. The Indian exports which used to make 16% of the total exports to EU in 2008 have declined to approx 13% in 2012. The downgrading of India’s credit rating to BBB has also contributed to the foreign investment sentiments resulting into devaluation of rupees.

Dollar shining like gold:

Dollar index is shining like gold. The US Federal is not in a mood to print more dollars. The global recessionary conditions including Euro Zone have built more confidence on the federal currency. For Investors also the capital preservation has become as important as the capital appreciation. Even Asian countries including India burdened with higher inflationary pressure and coupled with increasing current account deficits have given momentum to dollar which brought down the rupee to touch a historical low of Rs 64/$. So for investors the dollar heaven i e US has become the safer place to invest.

Shrinking GDP Rising CAD:

The annual gross domestic product averaged at 5.84% from 1951 till 2013. The FY 13 figures for GDP managed to reach barely 5%. The declining GDP and rising Current Account deficits have always been a problem area for our economy. The reduced exports and increasing imports have caused huge trade deficit. The import of oil usually represented a larger part of the import bill. Other imports including coal increased significantly in last few years resulting into higher CAD. Slowdown in the global economy adversely affected the demand for the Indian goods. The increased unplanned expenditures also triggered the alarming situation of fiscal deficit.

Lower investor Confidence:

The economic growth figures are not very encouraging for India. The decreasing growth rate coupled with higher inflation is no boost to the global investor. This has added further selling pressure on rupee. The bleak fundamental outlook, depleting forex reserves and increasing CAD became the biggest barriers for rupee appreciation and capital inflows.

The above cited reasons are few important ones having direct impact on the rupee devaluation. Though the exporters will be very happy with depreciating currency but economy as a whole is facing the real challenge at this juncture. Though the fall in oil prices may have offset the depreciating effect of rupee partially but this is just a drop of water in the open ocean.

So what are the possible/ probable steps our policy makers can take?

Single Window for Oil Bills:

The major dollar demand is from the oil companies to pay off the imported oil bill. They are the largest domestic buyers of the dollar. As these companies buy or bid for dollars from

different verticals huge demand is created for dollars. As an instant measure even RBI announced that banks should not carry out proprietary trading in currency. Though the similar policy had been announced last year where the state run oil companies had been instructed to buy US currency from single public sector bank to reduce the amount sourced through competitive quotes from multiple banks but the same were never implemented. The policies with body without soul may provide first aid but not a permanent good health. There is immediate need to eradicate these policy paralyses to boost the Indian economy.

Review of Foreign Investment Limit:

At this point of time the capital inflow to Indian economy is a serious concern. The FDI reduction to US$27 billion in FY 2012 as against the US$ 32 billion in FY 11 has compelled the Ministry of Finance to review its policies in the context of foreign direct investment. Though with the liberalization policy the limits for investments changed from time to time but still the sectors like insurance, pension, aviation, retail and defense have scope for revision. The sectoral caps need to be revisited for enhancement to the maximum extent possible in order to make India an investment destination.

Exporters to liquidate their Open positions:

In a devaluating state the export intensive country stands to gain. But the same benefit does not extend to India where import bills are huge. The urge to gain more by the exporters in a country like India by holding their gain and not liquidating their open positions just because they smell further fall in rupee is a serious concern. But as the central body RBI needs to ask the exporters to convert the part or full foreign currency earnings to give immediate relief to the rupee fall story. It may be backed by certain tax incentives from the finance ministry for a particular time frame so as to encourage the dollar supply.

Holding the import payments:

In order to postpone the payment of import bills the short term restriction may be put by the policy makers. This will provide short term relief with lowering of the demand for dollars. Further the cushion of contract flexibility will help the importers to get the advantage for extended credit period.

Foreign borrowings and local lending:

The bankers and financial institutions may opt for dollar borrowings at a cheaper rate to lend the same locally. The dollar borrowing shall result in increased supply of dollar. In the past also these measures have proved to be effective. Even the corporate have opted for these dollar loans where their earnings are also linked with dollar to avoid the rupee mismatch.

Revisiting the norms for CAD to GDP ratio:

Earlier the Rangarajan committee had defined that the tolerance limit for CAD to GDP should not exceed 2-2.5% of GDP. However the same has been overlooked in the recent past. There is a real need to revisit the norms for CAD to GDP ratio and define the various check points as control measures when the same exceeds the tolerable limit. In financial year 201 2-13 the CAD rose to 4.8% of GDP and in December quarter it made a historic high of 6.7%.

Utilization of Black Reserves for White Purposes:

I may be calling it black reserve because the black money sitting in swiss accounts definitely are not in Indian currency so bringing back the black money will certainly increase the forex reserves of the country. Good part will be that it will not lead to further inflation as the surplus INR will not be injected in the economy. We do have enough opportunities for injection of capital for conversion of the same to product and services worth more than the capital that has been injected which shall result in sustainable growth supporting INR.