Understanding Rupee Depreciation

What is the issue?

• The recent slide in the rupee’s value is particularly steep.
• However, it is to be noted that it is part of a longer process of decline and requires holistic measures.

What are the recent developments?

• The recent depreciation of the rupee worries those who need to buy foreign exchange.
• It has also caused panic in the stock markets, the decline in which partly reflects the exit of foreign investors.
• This, in turn, further contributes to the rupee’s fall. Click here to know more.
• It causes further trouble for companies that borrowed heavily in foreign currency, encouraged by lower interest rates abroad.
• It adds to domestic inflationary pressures that are already rising with higher global oil prices.

How has the depreciation trend been?

• The period of the global financial crisis in 2008 witnessed rupee depreciation like many other emerging market currencies.
• But this was relatively small and the recovery of the rupee was also relatively rapid.
• Thereafter, the currency was relatively stable in nominal terms until late 2011.
• From then on, it started declining relative to the US dollar once again.
• It culminated in a particularly sharp decline in the middle of 2013.
• This is famously referred to as the “taper tantrum” which afflicted all emerging markets.
• It happened when the US Federal Reserve hinted that the Fed might soon start tapering off the extraordinary liquidity creation measures.
• [Notably, the Quantitative Easing had marked the recovery strategy after the global crisis of 2008.]
• Now, vis-à-vis the US dollar, the rupee is worth only around half of its value in January 2008.
• This is a remarkably rapid nominal depreciation in just over a decade.

What happened thereafter?

• Despite some slight recovery thereafter, the decline in the rupee’s value became a major political talking point.
• The performance of the currency from 2014 has not been so favourable.
• The rupee-dollar exchange rate had been deteriorating for the previous two years from the most recent sharp decline since January 2018.

How was growth then?

• Despite the above, in this period, there were not much external headwinds to slow down the economic growth.
• Evidently, the Indian economy was one of the major beneficiaries of low global oil prices.
• It provided a windfall gain to the government since it did not pass on these declines to domestic consumers.
• India was also a major recipient of portfolio capital inflows.
• Also, more domestic companies took on external commercial debt.
• Foreign exchange reserves also increased but the country continued to run a current account deficit.
• So this was essentially based on short-term capital inflows.
• Such a method of building up forex reserves is not sustainable or desirable.
• Nevertheless, the significant level of reserves acts as a protection against capital flight and consequent rapid depreciation.

Can open market operations address depreciation?

• Open market operations (OMO) refer to the buying and selling of government securities in the open market.
• This is primarily to expand or contract the amount of money in the banking system, to control liquidity.
• It is argued that open market operations by the RBI could operate to stabilise exchange rates.
• It is said to prevent excessive appreciation as well as protect against sharp depreciation.
• However, previous episodes of currency volatility do not provide clear signals on the effects of OMOs.

• Once market expectations have turned adverse, no amount of OMOs and no level of forex reserves had been “enough”.
• Indeed, the very running down of reserves in the process of such intervention can further erode trust in the currency and undermine its value.
• Thus OMOs are only more suitable in the “good times”, when it is necessary to prevent excessive appreciation of the currency.

What are the other measures?

• Given the above, a wider range of measures is required to tackle the depreciation crisis.
• It makes more sense for policies to address the current account deficit.
• E.g. controls on gold imports beyond those required for jewellery exports
• On the other hand, capital account measures could seek to prevent outflows through transaction taxes.

Source: BusinessLine