Accounting for the Rupee

Posted by: Deepa Vasudevan on Wed, May 23rd, 2012

Accounting for the Rupee

The rupee has depreciated steeply against the dollar. Newspapers often show a picture of the INR/USD exchange rate from August 2011 (45.3) to May 2012 (around 53-54) to highlight the 18% decline in that period. That is depressing enough. But if the exchange rate is viewed from the beginning of its managed float era, say, from March 1992, it becomes obvious what all the media fuss is about. The INR/USD exchange rate is at its lowest level ever (Pic 1 A and 1B).


Pic 1 A: INR/USD exchange rate based on RBI reference rate

INR/USD exchange rate based on RBI reference rate


Pic 1 B: Daily INR/USD rate from April 1, 2012 to May 21, 2012

Daily INR/USD rate from April 1, 2012 to May 21, 2012


Source: RBI, CCIL


The general view is that the high current account deficit- expected to be 4% of GDP in 2011-12 is responsible for this situation. This is the argument: India needs capital inflows to meet its current account deficit, but foreign inflows are declining. Domestic macro-policy issues and Euro area troubles suggest that the deficit will not improve in 2012-13. Anticipating that dollar inflows will remain poor in the near term, market forces have devalued the rupee against the dollar.


The exchange rate is determined largely by the demand for and supply of dollars at a point in time. From a current account point of view, exporters supply dollars and importers demand dollars. On the capital account, dollars flow in through FDI, FII inflows and foreign debt. The RBI is both the regulator and a participant. It can sell dollars to shore up supply; and it can buy dollars to mop up excess foreign exchange.


Dollar demand goes up for many reasons: a rise in crude prices, fall in INR/USD rate, or a sudden increase in gold investments by Indian savers. All of this happened to some extent in 2011-12. Dollar supply tightens when exports decline or foreign investment dries up. This also happened partly last year, though the full impact of the global slowdown on exports will show up in 2012-13. Logically, then, the rupee had to decline in 2011-12.


What about 2012-13? Various forecasts estimate the current account deficit at between 2.5-4 % of GDP. It may be less, if Europe and USA recover and exports pick up; or if crude prices decline significantly. It may be more, if crude or gold imports go up. A reasonable estimate of CAD is $80-100 billion. That means capital flows of about 1.5 -2 billion dollars per week are needed to finance the deficit*. Is that possible?  For that, let’s flip over to the capital account (Pic 2).


Pic 2: Capital Account of India’s Overall Balance of Payments


Capital Account of India’s Overall Balance of Payments

Source: RBI


The World Bank estimates net inward FDI to India at $28 bn in 2012-13**. In a good year, FII inflows tend to be around $30 bn; so total foreign investment flows are unlikely to be over $60 bn. Banking capital, which includes NRI deposit inflows, will probably be higher as NRI money flows in to take advantage of higher interest rates and favourable exchange rates. In 2011-12, NRIs remitted $11 bn into deposits, most of it in the last quarter***; one can reasonably assume that at least $10 billion will flow in this year.


The foreign debt component fluctuates depending on the interest differential between Indian and overseas lending rates. The 2012-13Union Budget encouraged ECBs by reducing withdrawing tax for infrastructure sector and allowing ECBs to part fund power projects.  But with industry slowing down, and domestic interest rates declining, demand for external loans may be subdued. Recent.


FCCB conversions have been hit by poor market conditions and rupee depreciation: any large FCCB defaults could raise the risk premium on corporate debt****. So let us assume that foreign loans bring in $15 billion.


That gives us a total inflow of $85 billion on the capital account, which neatly finances the estimated gap on the current account! Then why is the rupee falling? Because the market is not confident that capital inflows will actually be at this level.  FII inflows are volatile, and can turn negative at any point. NRI flows may dwindle if interest rates are reduced further. With the Euro crisis still continuing, risk averse investors may steeply increase dollar borrowing rates for Indian corporate.


The solution, therefore, is to work on investor confidence through actual policy. As many experts have been insisting in the press this past week: check demand for crude products by rationalizing prices, promote exports, focus on fast-tracking infrastructure projects. The recent sharp hike in petrol prices is a good starting point. By addressing the structural issues that have created a wide current account deficit in the first place, we will automatically attract inflows on the capital account. This is not wishful thinking; we saw it happen in 2004-07. It could be a reality again.


* See a neat discussion on current account financing needs by Haseeb Drabu here

 Posted by Deepa Vasudevan on Tue, May 29th, 2012 11:50:18 am

Hi Jeeth, Apart from active intervention in the forex market, the RBI has issued the following directives to increase forex inflows: 1. Increase refinancing limits for power companies in respect of their foreign currency loans. 2. Allow companies to finance their ECBs with subsequent ECBs at higher rates. 3. Forex earnings of exporters are usually maintained in dollars in special accounts called EEFC accounts. Exporters were asked to convert 50% of the balance in their EEFC account into rupees. 4. Maximum interest payable on NRI deposits in Indian banks raised 5. Restrictions imposed on exchange traded derivatives and open positions of dealers in respect of these
 Posted by JEETH on Sun, May 27th, 2012 5:47:56 pm

 Posted by sri vallabh vyas on Fri, May 25th, 2012 10:19:25 am

Very useful article for cuurency traders as well as equity and commodity traders, In my view other aspect of rise in dollar is a surge in economy of us and weakness in euro economy .As far as measure to strenthen the rupee a drastic measure are awaited from goverment policy maker like boost in export, cutting unprodutive susidies, and expense and do somthing to curb un necessary gold import
 Posted by Venkatesh Bharadwaj on Fri, May 25th, 2012 6:35:59 am

The Govt's hands have finally been forced, not that it should have taken them so long, but ultimately events have overtaken it. It is likely that RBI will sell dollars directly to state owned oil companies, which need around USD 500 mn a day, to ease the pressure on the rupee. Strong signals by RBI that it would support the rupee coupled with the Govt's intent to take tough decisions are necessary. The Euro collapse was a fine opportunity for India to have emerged as a global economic power, truly, but alas.......
 Posted by Deepa Vasudevan on Fri, May 25th, 2012 3:15:48 am

Dear Roy, Thank you for your feedback. You are right, it is important for policymakers to consider the possibility of net FII outflows. For instance, in the Oct-Dec 2008 quarter- at the peak of the financial crisis- we had net outflows on the capital account. So our current account deficit was funded by drawing down reserves. Forex reserves are about $300 bn, so that can easily cover any gaps in FII funding. However, a better way to finance CAD is by curbing non-essential imports and promoting exports in a big way.
 Posted by Deepa Vasudevan on Fri, May 25th, 2012 3:03:22 am

Dear Mr.Nikhilendra, thank you for your feedback, we will keep your suggestions in mind next time. Perhaps the determination of petrol prices from crude to end customer could be the subject of a future blog entry!
 Posted by Deepa Vasudevan on Fri, May 25th, 2012 2:57:22 am

Dear Mr.Baid, I agree with your conclusions. In particular, a focus on production and curtailment of govt expenditure will do a lot to boost economic growth.
 Posted by Nikhilendra on Thu, May 24th, 2012 9:13:19 pm

Useful but a bit difficult to understand for a layman. Would like to understand how petrol prices are determined from crude to end customer. thanks
 Posted by Chandra Prakash Baid on Thu, May 24th, 2012 6:44:51 pm

Few conclusions that I could draw would like to share with: a. Indian Currency is on verge of major meltdown till the bottom of JCurve is reached. b. It was consumption story that fed our Growth (03-08) which is not sustainable in long run. c. As we reach the bottom of JCurve, prudence may preside and Govt shall initiate the following steps: # Impose import restriction on consumables that are contributing towards negative trade balance # Curtail Govt. Expenditure and austerity measures to the max possible which are therby retarding growth and evaporating taxpayers wealth # Augment Growth by focusing on Production i.e. Supply Side (not consumption) like our neighbor China did under the leadership of Deng Xiaoping (78-97) # Focus on Knowledge Capital that can spearhead the growth in agriculture, industry and trade (either borrow it or create it) # Remove red tape and simplify trade procedures in order to promote economy and entrepreneural spirit within population # Build infrastructure in every sphere for augmenting growth and proper utilization of resources # Promote Export of manufactured goods (80HHC) and ban export of natural resources # Promote technologies and systems that could cut green house effect and improve our trade balance: % Develop Bulk Water Transport system for inland sales within India's long coastline % Promote Railways for bulk transfer of resources within the hinterland % Promote use of renewable energy in every sphere possible: Solar Cookers, Air Conditioners, etc. d. Until the shifting of currency curve takes effect, securities markets shall remain volatile with negative bias
 Posted by I P Bharti on Thu, May 24th, 2012 4:10:08 pm

The exchange rate is majorly a function of Demand & Supply. The govt. policies especially with regard to GAAR, lack of initiative on the reforms front, subsidies etc are some of the reasons that is influencing the exodus of the $.. Hope we take some corrective steps early and hope that Rs 56 to a $ looks attractive to FIIs to start investing into the stock market :)

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