The Depreciating Rupee

The newspapers are full of reports of the rapid depreciation of the Indian Rupee against the US Dollar in recent weeks. Government and RBI officials have also been saying that it is difficult for RBI to intervene in the market to shore up the value of the Rupee. Let’s look at some of the issues involved.

In economic theory, an economy which is facing a higher level of inflation should have a depreciating currency. This is on account of the well known theories of purchasing power parity (PPP) and interest rate parity (IRP). India for some time has been experiencing around 9/10% annual inflation rate and the RBI has been increasing domestic interest rates. So from a narrow economic perspective a depreciating rupee is welcome and should help exporters remain competitive.

The RBI is also worried about the current account deficit (CAD) crossing 3% of GDP. A depreciating rupee will hopefully increase exports, reduce imports and encourage more invisibles, especially a rise in remittance inflow from NRIs.

Various reasons are being extended to justify this large depreciation of the rupee. This includes large scale withdrawal by FIIs. Foreign exchange reserves data reveals that the forex reserves have increased from about USD 305 billion in end-March 2011 to about USD 318 billion in October. So even though reserves have not substantially increased, they have not fallen either.

What has been the quantum of rupee depreciation? Since April 2011, the Rupee has depreciated over 16% against the US dollar, over 13% against the British Pound, over 10% against the Euro and over 27% against the Yen. This means that rupee has been depreciating against all other major currencies, not only the dollar.

The RBI calculates a 6-currency index to show the movement of the rupee in comparison with other major currencies. According to RBI data, during the financial year 2010-11, the real effective exchange rate of the rupee showed a substantial upward increase of 13%, while between end-March 2011 and mid-October 2011, the rupee has shown a real depreciation of 6.3%. So, RBI could justify this deprecation by saying that the real appreciation of the rupee during 2010-11 needed to be reversed.

However, a depreciating rupee is contributing to inflation in a substantial way. The share of foreign trade in goods is estimated at over 30% of GDP. So a large deprecation of the rupee will increase input costs substantially, especially in the case of oil imports. The question that arises is the appropriateness of a large devaluation of the rupee at the present juncture when the economy is facing a high inflation rate, the fiscal policy is deteriorating, and monetary tightening appears to be ineffective in controlling inflation.

The view that RBI cannot effectively intervene in the forex market is surprising. India did not embrace full capital account convertibility only because experts felt that the role of RBI in forex market intervention needed to be continued. Forex market intervention along with open market operations enables RBI to manage both foreign exchange rates as well as liquidity in the market effectively.

Given the above, RBI would be well advised at present to intervene in the forex market to try and stem the rapid fall in the rupee, and thus mitigate the effect of rising input costs. Once inflation comes under control, the rupee can be allowed to continue its downward trajectory if RBI is of the opinion that there is real appreciation of the rupee.