Is the worst over for the Indian Rupee?

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Indian rupee
The freefall in the Indian rupee is not a new event and measures must be taken by the government to make sure this does not occur again in the future, opines Zain Naeem.

It seems the Indian rupee is still susceptible to volatile price swings — first seen in the 1990’s — and that vulnerability was recently exposed when the rupee fell to an all-time low of nearly 70 rupees per dollar.

The exposure of the rupee to international markets seems to have left only hard choices for India’s central bank. India’s main capital controls balance the autonomy of its currency and control interest rates — while still attracting plenty of Foreign Direct Investment, but it seemed unable to stop the sliding depreciation that is taking place. Until recently, that is.

Prologue

As people started importing more goods and services from other countries, rather than buying them locally — the import bill surpassed the exports and so a current account deficit was financed with dollars. In addition to that, the gold trade in the country put downward pressure on the currency.

With downward pressures on the rupee, there was no way to relieve it, except by:

1) increasing interest rates to stabilize the rupee
2) increasing exports to raise the value of the currency

As the rupee continued to slide, investments in the country lost value and capital flight occured — which led to further depreciation.

This never ending cycle described above continued to feed itself until a total collapse of the currency was almost imminent.

or external support is provided to the economy.

India noted a higher inflation rate compared to other countries which also put downward pressure on the rupee. Although the country was insulated from the Global Financial Crisis of 2008, India, as one of the world’s leading emerging markets, had its downside where the constant GDP growth leads to inflation. During the financial crisis, the money that had once poured into the country, quickly began to be retrieved by foreign investors, leading to the fall in value.

Options

The Reserve Bank of India tried to do its best in order curb the slide, but with little success early on. It seemed that the country had three options available to it, in order to address the issue.

The first option was to increase interest rates which would invite more capital into the country and help to counter the inflation problem. However, the added cost to local businesses would mean that the current account deficit would persist, and GDP growth would be sacrificed. That zero-sum game, would lead India right back to the beginning of the downward cycle.

The second option was to support the rupee until conditions improved. Even though this is direct market intervention by a government, it promotes investor confidence that the country is concerned about the issue and is addressing it. The unknown factor in this option, is the time it takes for recovery to take hold — and spending huge amounts of reserve funds every single day until a recovery takes effect is a very high risk strategy indeed.

The third option was the encouragement of higher foreign portfolio investment and use of foreign remittances to mitigate the increase in the dollar price.

The third option was the solution that was eventually applied.

Epilogue

Consequently, the rupee is saw a jump in its value last week, so it seems that the support required by the markets has actually been applied.

Another positive sign is that previously removed investment from the Indian market, is starting to return.

As the Indian market had been in steady decline, a renewal of foreign investment at cheaper rates proved to be the jump-start the market and the rupee required. Still on the positive side, India is seen as a lucrative emerging market — and with the U.S. and Europe going through sustained economic slowdown, the present cycle is expected to continue for some time.

The complete turnaround in the Indian economy — by decreasing imports and increasing the country’s exports — has lowered the Indian deficit to its lowest level in the past five months.

The RBI now should realise that change is upon them and just because the worst has been avoided (this time) doesn’t mean a permanent course change isn’t required. The rupee has shown a certain weakness in this area, and considering its openness to the world economy, the government must ascertain whether foreign investment should be ever be encouraged with less capital controls, when actual experience has now proven that more market controls work to attain the desired result.

© Zain Naeem

Photo: Gopal Vijayaraghavan/Flickr

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