Saturday, 13 July 2013

Rupee and its Value Depreciation

Currency is the lifeblood of a nation’s economy. Where currency is affected, the economy is affected. And where the economy is affected, the currency experiences the repercussions. The Indian Rupee has experienced considerable depreciation of value in the recent times and that has affected every aspect of the economy of India. In this post we would will try to examine what depreciation is, what is causing it and what are the effects.

This post is divided into three sections which are hyperlinked below:

  1. Rupee Depreciation
  2. Causes
  3. Effects

Rupee Depreciation :

  • We can simply say that depreciation of currency is the reduction of its value. How do we really say that the value has reduced or depreciated? The purchasing power of a unit of currency decreases. What used to cost Rs. 10/- at an earlier time now costs Rs. 100/-. This is a reduction in value of the rupee as such. We perceive this reduction as price-rise or inflation.
  • There is another facet to this. If the exchange rate of the rupee with reference to another currency (say the GBP) increases for some reason, whenever we need to trade in GBP(£), we need to shell out more INR for the same amount in GBP. In such situations, rupee is considered as depreciated in value with reference to the GBP.  Exchange rate reflects the demand & supply of currency in which transaction takes place.

  • Thus, when the rupee exchange rate increases with reference to the USD($) then it has far reaching effects for the economy because :

    • We do a lot of business in USD.
    • The USD is the world’s reserve currency. This means all international transactions with any country will accept the USD as legal tender.

    There are other equally important currencies like the Euro(€) or the JPY(¥) which also have far reaching effects on the Indian Rupee.
Both these facets of rupee depreciation are interconnected and interrelated. Whether the root cause of depreciation is inflation or increase in exchange rate, it does affect the other and ultimately will lead to a general price-rise felt by all of us.

Causes :

Since the currency is the backbone of the economy, anything that affects the economy affects the currency as well. Let’s look at some of the causes of currency depreciation in the context of the rupee :
  • One straightforward cause is the comparative strengthening of the USD or the currency of any dominant economy with respect to the INR. This will immediately be perceived as a weakening of the rupee.
  • India is a net importer to the world.  As a nation we import many goods and commodities to meet the needs of domestic consumption thus leading to high expenditure but our exports do not balance the imports. So equal amount of money does not come into the economy. This devalues the rupee. At this point it is correct to point out that factors responsible for high Current Account Deficit (CAD) are also responsible for currency depreciation. Readers can refer CAD - How it affects India’s Economy for further reading on the topic.
  • Being an emerging economy, India attracts foreign investments. Due to the current difficult economic situation, if the foreign investors (FIIs) feel that investment options are more attractive elsewhere, there will be outflow of capital from the economy as FIIs exit their investments in India leading to more dollar demand and  depreciation of rupee. If currency appreciated due to the inflow of FII investments, then the opposite will also occur when the outflow of capital takes place.
  • Foreign reserve depletion as demand for dollar increases.

Effects :

Below is a list of some of the most important effects of rupee depreciation which is by no means exhaustive but only indicative:

  • Increase in the cost of raw materials that the country imports. This increases input costs of finished goods manufactured in the country which leads to increase in finished products prices.
  • Retail inflation increases.
  • Purchasing power decreases.
  • High domestic inflation depreciates the inherent  value of rupee and reduces the purchasing/spending power. This coupled with a situation of high demand and low supply and lower domestic saving as a percentage to GDP leads to tighter monetary policy to dampen rupee demand. This has an effect of slow economic growth.
  • Cost of borrowing in the international market increases.
  • Return on foreign currency decreases.
  • Investment climate deteriorates.
  • Fiscal deficit increases. You can read more in our post on Fiscal Deficit - Ringside View to India's Economic Problems.
  • Govt. spending on subsidies increases. If the situation continues, subsidies may eventually become unviable due to high cost.
  • Energy prices increase as we import majority of oil and gas to meet our consumption demands.
  • CAD widens..
  • We become a cheap and attractive destination for international consumers because we can export at competitive price.
  • Export-oriented industries and sectors like IT and Pharma will have a favourable climate.

Currency dynamics are very complicated as it affects and is affected by everything that happens in the domestic and international economies. What we have presented here is a simplified pared down version of a complicated and deeply interconnected economic subject. There is lot more to it than meets the eye and we hope that after reading this post, our readers will be in a better position to correlate things and make sense of all the buzz about rupee dynamics.

The Govt. and the Reserve Bank of India (RBI) can take various steps to control the value of rupee. To know more about the RBI and its role in regulating the financial system view our post on RBI and its Monetary Policy.

Update : In the months after we posted this writeup, the RBI and the Govt. of India have taken various steps to tackle the issue of currency depreciation. Some of these are short-term measures and some are long-term measures. Our post on Rupee Depreciation - Where We Stand Now details some of these important steps and how effective were they in stemming the rupee fall.