10:24 pm - Monday December 18, 2017

What needs to be done to arrest the falling Indian Rupee?

In every country prices are expressed in units of its currency. The value of the currency itself however can be judged only against an external reference. This reference, the exchange rate, thus becomes the fundamental price in any economy.

Exchange rate management is in the domain of central banks or central monetary authorities the world over. The main objective of exchange rate policy should be to ensure that economic fundamentals are reflected in the external value of the rupee.

Indian Rupee is under attack as the exchange rate is out of alignment with fundamentals for a long time now. In recent weeks, our Rupee has hit a string of record lows, with the latest hit on 31 May when it dropped to 56.52 to the dollar, marking what so far has been a near-term bottom.

The unprecedented depreciation of Indian Rupee against US Dollar and thereby other currencies as well, has affected the economy very badly – widening trade deficit, ballooning oil bill,  galloping inflation,  free falling stock markets, etc.

Well. One can see clearly and write reasons for the downfall of Indian Rupee due to weakening economic fundamentals – policy reversals, deficit budgeting, new trend in rewarding electorates through freebies from the exchequer further widening deficit in budget. In free float exchange markets as in India, the governments and the policy makers won’t have much say in influencing currency rates. The markets will look for the fundamentals and revisit them regularly

Recalling fundamentals in exchange rate management

According to Dr Y.V.Reddy, former Governor of Reserve Bank  “There are mainly four parities one may have to deal with in exchange rate management – (i) purchasing power parity which links the spot exchange rate and inflation, (ii) international Fisher relation which links interest rates and inflation, (iii) foreign exchange expectations which link exchange rates and expected future spot exchange rates and (iv) interest rate parity which links spot exchange rates, forward exchange rates and interest rates”

Thus interest rate differential, inflation differential, forward discount/premium and exchange rate movement are the four critical variables that are often used in exchange rate management policies.

While interest rates in developed countries are being maintained at comparatively low levels, in India, interest rates were continuously hiked continuously in the last couple of years   and kept at a higher level. This resulted in widening interest rate differential with most of the major currencies of the world leading to Indian Rupee remaining at discount against them.

The authorities have now recognised the need for lowering the interest rates and there is a talk of interest rate cut by June 18, 2012. It is our humble view that token cuts of 0.25% won’t work wonders any more in this highly ‘one way’ market place. At least 0.75% to 1% will have the desired impact and leading to a ‘reversal’ in trend.

Capital flows cause a major impact

Combinations of external and internal factors have made Rupee the worst performing currency this year. Capital inflows into the country during January-March 2012 stood at Rs.103.57 billion, Rs.252.12 billion and Rs.83.81 billion respectively. However in April 2012 – a reversal in trend surprised us – capital outflows amounting to Rs.11.09 billion. And even in May 2012, capital outflows continue to baffle us.

During this period, trade and fiscal deficit was also widening. And this has lead to the unprecedented weakening of Indian Rupee.

There is an urgent need to set right the deteriorating macroeconomic scenario. We need to arrest the capital outflows at all costs. We also need to move away from ‘fair weather’ funds like Foreign Institutional Investments to more stable, productive avenues like Foreign Direct Investments.

Need to pursue reforms agenda without fear or favour

Recently Associated Chambers of Commerce and Industry of India (ASSOCHAM) conducted a survey on the economic situation. Out of the 58 economists and corporate chief executives participated, 53 opined the situation had suddenly worsened. According to ASSOCHAM the worst disaster is coming from a huge uncertainty on the Indian Rupee value and its freefall and everyone in the business world is feeling shaky.
Reforms are essential in a developing economy to create more space for growth and accelerate growth. And these reforms also have the ability to bring in the much desired capital inflows. And these capital inflows alone can bridge the gaping current account deficit in the short run.

Well. We have been hearing for a long time now on FDI in retail, FDI in insurance, Pension fund reforms. But unfortunately there is no improvement in the status. The market is watching the pulls, pressures and opposition exhibited by the ‘maverick’ politicians, even those remaining and sharing power in the government.

This is not the time for narrow minded, ‘federal’ approaches to managing the economic affairs of country. Our politicians have to learn many lessons from elsewhere. Just to quote a recent development in Germany.  Germany’s centre-right coalition government and the main Opposition parties have agreed in principle to introduce a finance market transaction tax in the EU to involve financial institutions in sharing the costs of present and future bailouts.

Ethics in Governance and policy assurance a minimum expectation

The way Vodofone was forced to put up with pressures due to ‘greedy’ government departments forcing the MNC to approach the highest court of the country for justice and the way the government tried to settle the score even after this judgement by going in for retrospective legislation have really brought down the image of the country in the comity of nations.

This has scared many a MNCs in doing business with India. And this Vodofone episode alone, it is widely rumoured caused the fear factor in the minds of foreign investors and forced them to withdraw from our market. It is yet another story these foreign investors were affected by the double whammy of falling rupee exchange rates and falling stock market prices.

Such policy U-turns and corruption scandals have brought down our image and we are only to be blamed for this sorry state of affairs. Only a sincere commitment from the government to stick to ethics in governance and to ensure adherence to policies and rules of law notified will restore the faith factor in our economy. In our view, even after this, it would take time to get back the previous position.

Never to overlook crucial focus areas

There are certain crucial focus areas which the foreign exchange markets keenly watch. They are

  • Revenue and expenditure position of government
  • Energy position – Oil pool and power
  • Buoyancy in industrial activity
  • Progress in manufacturing sector
  • Developments in trade and capital flows

There are intelligent operators who read developments and messages very fast in the market place who manage leads and lags and they in turn affect the market. In fact, leading and lagging operations cause much greater damage to the exchange rate management as they result in maximum swings.  The policy makers should ensure that such operations are not resorted for ‘other’ than genuine reasons.

Stable markets the need of the hour

There is a need to reduce excess volatility in the exchange rates as this can lead to stable markets. Stable markets and stable exchange rates are the business assurance and business continuity ‘hygiene’ factors. Even if there is a need for market correction of exchange rate at any point of time, it is facilitated in an orderly and calibrated manner. Of course, maintenance and operation of comfortable foreign exchange reserves would aid in this endeavour. All market constraints and policy impediments are to be identified and eliminated well in time to ensure stable market operations.

Summing up…
In the current scenario, structural reforms are essential to control further weakening of the Rupee. We need to pursue them on a war footing basis.

The markets will be watching out the international scenario particularly at the Greece re-election – whether Greeks favour exit from Eurozone or its further continuance – as this can cause additional external stress.

The need of the hour is for the German model for governance – our political parties should shed their ‘federal’ approach and come together to combat larger issues in the national interest.

From the short-term perspective, weakness in the Rupee is expected to persist as the currency has shown a subdued and short-lived reaction to the RBI`s interventions by way of OMO or by way of asking exporters to convert half of their foreign exchange reserves into rupees.

Indian rupee is set for further fall unless our policy makers and politicians move quickly to put our economy back on track. Extent, pace and manner of correction of exchange rate will have to be taken in conjunction with money supply since price stability will continue to be the dominant objective of monetary policy

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