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Currency Depreciation: Where Will It Lead India to?

Posted in Finance Articles, Total Reads: 2140 , Published on October 23, 2012

The rupee ended at a record low of 57.12 a dollar sometime back. The investors are running crazy to dealing with an economy diving steeply into a large current account deficit. The fall by its magnitude and rate is the steepest since the 1991 reforms. While it has become a blow to many, analysts are also coming up with theories favouring a rainbow shade for this loss. A better insight into the trend can be easily carved out by observing the current account deficits of the country from the early 1970s and its sources.

In 1970, the BoP of India balanced with its external accounts because of the Indian import substitution strategy. The economy remained closed for a long period till the country entered a BoP crisis as the current deficits kept on rising from 1980s. The 1991 liberalization strategy the warm welcome given by the Indian policy developers to the liberalization policy gave an ease to the crisis. From then the exchange rate was managed as a floating rate depending on the global market. The country enjoyed surpluses after the phase of implementation of liberalization policy because of the increased capital inflows. The Forex reserves of the country also improved. But the constitution of the reserves exhibits a drastic change. In the 1990, Gold constituted 60% of forex and forex currency based assets were 38%. But by 2011 the gold reserves reduced to just 1.5% and currency based assets conquered 90% of the share.

The Real effective exchange rate (REER) of the Indian rupee fell over the years with respect to a basket of currencies the country is trading with. In 1991, the current assets deficit was mainly due to merchandise trade deficits. But as the service industry picked up mainly through outsourcing phenomenon the current deficit eased up. The South East Asian crisis also affected the country to a greater extent but the active monetary management policies implemented by the RBI smoothened the pressure imposed on the economy.

After 2005 the capital inflow increased heavily. This was because more and more expressed belief in Indian investments leading to greater volumes of foreign investment in the country. This was a phase during which the rupee appreciation was observed. The surge of capital inflow was enhanced by the constant growth rate of around 9% which was appealing to the investors. But the pest started originating soon. The Lehman crisis shrunk the capital inflows. Investors started preferring dollar over other currencies to avoid default risks. But Indian economy ensured a quick recovery from the global crisis which was well praised by analysts.

The year 2012, the situation engulfed a bigger maze. The capital inflows became lower due to low FII earning a higher deficit for the economy. Also the growth rate projections for the country has been re-estimated from 8-8.5% to 6.5-7%. The persistent inflation rate in the country of around 9-10% aggravated the problem. Though India follows a policy of fiscal consolidation, the persistent fiscal deficit is at a high end. The target fiscal deficit for the year 2011-12 is 4.6% can move higher due to high subsidies offered by the GoI.

The nervous investors were ready to take first hand confidence on India during 2009-11 due to the overall positive domestic outlook the economy shared. But the outlook has popularly turned negative adding more fears to the investors. The benefits which the economy could have gained due to the falling oil and commodity price is getting negated due to the depreciation effect. An effective and urgent strategy is alarmingly significant for the economy to avoid further losses.

Scanning through the options set before RBI, raising policy rates does not seem to be a welcoming option. This was earlier adopted in Iceland and Denmark to curb a similar situation. This focus on preventing sudden capital outflows. But as the growth level of the economy has been seriously afflicted this policy will only add flame to the situation. Also the interest rates in India have been at an all time high compared to other countries. Second option stands out to sell forex and buy rupees but the turbulence of control it creates can be unpredictable. This can also deteriorate the confidence in the economic ability of the country to pay short term obligations. The option possibly adopted by the RBI is to expand the market participation by measures such as raising the ceilings of non-resident deposits, increase in FII, and promote FDI etc. Other administrative measures such as to bring proportion of funds retained overseas to be used for domestic expenditure into the country immediately.

The global as well as domestic conditions indicate that this downward pressure on rupee will still remain in future. RBI is continuing to adopt different mix of control and regulatory measures to curb this uncertain volatility. It is high time that the Government take adequate measures complementing to the actions of RBI in developing the effective way-out. India will have to focus on boosting its exports and search for long term sustaining foreign investments. The recent big bang reforms by Indian government could guarantee more stable capital inflows. But for the moment volatility in the currency movement is very high. The words unwritten hold the naked truth of the rupee to remain volatile diving the economy deeper into dilemmas which could be unsolved on a later note.

This article has been authored by Neethu Thresa Jacob from Loyola Institute of Business Administration

Image: FreeDigitalPhotos.net

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