How to Stop Fall of Rupee

Continuously declining for months rupee went to a record low at 52.7 rupees per US$, on November 22, 2011 and even further record low of rupees 54.3 on December 15, 2011. Government and the Reserve Bank are telling that Foreign Institutional investors are taking away foreign exchange abroad, which is causing weakening of rupee; as demand for foreign exchange has suddenly increased. Increased demand for foreign currencies from importers is also contributing to the spurt in demand for foreign exchange. More worrying is the fact that RBI had initially shown its inability to shore up the falling rupee. Rather the officials of RBI have been saying that any intervention by the Reserve Bank could be harmful. Department of Economic Affairs of the government also indicated that rupee might continue to remain weak in the coming weeks. Recent measures in the form of incentivising NRIs, increased limit on foreign investment in government and corporate debt instruments, raised ceilings on interest rates on non-resident deposits and also enhanced the all-in-cost ceiling for external commercial borrowings etc. are being adopted by RBI to shore up rupee.

How the Exchange Rate is Determined
Exchange rate of rupee vis-a-vis US$ (or any other foreign currency) is determined by demand and supply of US$ (or any other foreign currency). Demand for foreign currencies come from importers and sometimes also from FIIs who wish to take their funds abroad. Supply of Foreign Exchange comes primarily from exporters of goods and services, inward remittances by NRIs, foreign investors (both Foreign Direct Investment and Foreign Institutional Investment). These days an additional major item in outgo of foreign exchange is income outflow by MNCs. Therefore, when importers demand more foreign exchange or foreign investors increase their outgo, demand for foreign exchange grow and rupee weakens.

Country’s currency weakness could be a boon for exporters, because their benefits will increase significantly. However, for country at large this is not a good situation. Falling value of rupee, whether due to spurt in imports or increased transfer of funds by foreign investors is going to make life difficult who is already reeling under hyperinflation. Fall in value of rupee will not only increase price of crude oil in rupees, even raw materials and metals would also become dearer and may multiply the problems for industry. Inflation, which already is rallying in two digits, may further go up.
History of Devaluation of Rupee

Era of New Economic Policy, since 1990, has also been an era of depreciation in the value of rupee. Exchange rate of rupee vis-a-vis dollar, which was rupees 17 per US$ in 1990, reached rupees 44 per US$ in 2006-07. In 2007-08 it appreciated and reached near rupees 40 per US$. In the next year, it depreciated again due to big outflow of foreign exchange by FIIs in wake of deep recession in US and Western Europe and reached a historic low at rupees 52.21 in 2008-09. Outflow of foreign exchange by FIIs was not due to the reason that FIIs feared of any major losses in India, but was due to the reason that they were facing major liquidity crunch in their domestic countries.

After improvement in conditions in their respective domestic economies, these FIIs started bringing foreign exchange once again and rupee started improving and exchange rate reached Rupee 44.5 per US$ by March 2011. Indications of possible sovereign default by US government and subsequently downgrading in economic rating of USA by Standard & Poor’s increased problems of USA manifold and markets around the globe tumbled. India also felt the heat. Repeating the experience of 2008, FIIs once again started flight of capital (which is also called flight to safety) and rupee started tumbling again and reached its historic low at rupees 52.71 per US$ on November 22nd, 2011 and further rupees 54.3 per US$ on December 15, 2011.

Advantages of Strong Rupee
Many times, it is considered that devaluation of currency is advantageous for the domestic economy as it would encourage exports and discourage imports. This is so because devaluation of rupee will make our imports costlier and exports cheaper. However, the experience so far reveals that devaluation actually has been worsening the inflation, as prices of petroleum products, essential machinery and equipments, metals and other raw materials increase, which in turn raises the cost of production. Thus, the process of development is adversely affected due to devaluation. Therefore, strong rupee is in the interest of the nation because it helps in controlling inflation. Another advantage of strong rupee is that, the popularity of rupee in international market improves and therefore other nations would love to keep rupee instead of other currency. In the end, strong rupee would help us in raising international loans in term of rupee, which may reduce burden of repayment in terms of foreign exchange.

How to Stop Fall of Rupee
In the long run, strong rupee is definitely in the interest of the nation. However, at present the major challenge is to stop the fall of rupee. For this, it is imperative that the policy makers understand the reasons for weakening of rupee. It is true that FIIs are finding it safer to invest in US treasury and therefore they are disinvesting in Indian share market and putting their money in US Treasury bonds. There has been no decline in software export nor in the remittances from Indians from abroad, still India is facing a major decline in rupee due to the fact that FIIs are not only not bringing fresh investments, they are even taking their previously invested money abroad. However, this is not the only reason for weakening of rupee. In the recent past, there has been a big jump in Indian imports and the growth in imports has outpaced growth in exports. Imports of power plants, telecom equipments and consumer goods have increased manifold recently. As a result, trade deficit has soared to US$ 130 billion in 2010-11. In the first quarter of the present financial year, the trade deficit has been to the tune of US$35.4 billion, which is again a record. Increasing imports from China are raising our trade deficit significantly. Today trade deficit with China comprised of 20 percent of total trade deficit, which is alarming. Therefore, we can say that, FIIs, though are the major cause of weakening of rupee, and are not solely responsible for the same.

Though RBI’s has now started adopting some measures to stem the fall of rupee, previously it was saying that it has limited options in this regard. It is the responsibility of government and the RBI to adopt concrete measures in view of the challenge of weak rupee. Effective restriction on the imports, especially from China can help. This is possible by raising tariff and other barriers in the form of health standards and strategic issues. Apart from this taking a cue from Brazil, we can even tax the profits of FIIs. There should be a minimum three years lock-in period for investments from FIIs. All this will help us in imparting discipline among the FIIs and ultimately stop fall of rupee.