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Sunday, August 4, 2013

Why Indian rupee is going down? (In simple words)


What so far prevented the fall of Indian Rupee?


Having written previous two posts on the fall of Indian currency earlier (1 & 2), I shall now capture salient reasons responsible for the Indian rupee’s recent steep fall.

First, we should know that earlier rupee was not depreciating against the US dollar because US dollar itself was falling due to continuous bouts of Quantitative Easing or QE.


Why US Fed Reserve cutting down on QE?

QE is supposed to boost an economy and when the US economy started recovering this QE was supposed to be shunned. This means no new dollar will be printing.
Not only that, but if US economy further improves then the printed money too shall be destroyed electronically.

Simply put, to boost the US economy, US Federal Reserve was printing dollars. Thus more dollars ensured that Indian rupee did not fall significantly against the US dollar.
But things started to change when US Federal Reserve chairman Ben Bernanke hinted on discontinuing the QE and discontinuing QE means USA will no more injecting the money into the financial system by buying its treasury products.
So, no more fresh inflow of dollars and as per the Demand & Supply rule Rupee started facing the downward pressure.

The Indian Rupee’s steep depreciation against the US Dollar started since May 2013
But US Dollar has not consolidated in this period!!!




The US dollar-index chart shows that there was no significant strengthening in the US dollar since May 2013.
Under the QE programme US Federal Reserve was injecting $ 85 billion of liquidity per month into the financial system by buying back its treasury products and this inflow of dollar was holding the Indian Rupee as a part of it was coming to India. 


Why Indian Rupee is Depreciating?

(1)   Rising CAD: The main reason for the weakening of the currency of a nation is the Current account deficit CAD. Simply put, when a nation imports more than what it exports CAD gets generated due to negative BOP.
India predominantly imports crude oil, gold and coal. To run its economy India needs to import crude oil and coal but the import of gold is not at all a productive one.
As dollar being the reserve currency, higher imports mean higher spending of dollar and as a result rupee keeps on weakening.
Great demand of dollars from importers especially OMCs pressurized the rupee.


(2)   Higher demand for gold: Rising corruption In India and generation of huge black money ensured the flow of funds into the real estate and gold.
This is why import of gold kept on increasing and it inflated the CAD. And to tame this, Indian government came up with hiking the import duty on gold and silver.
Rising gold prices and the weakening of a few major global economies made gold as a safe haven and Indians started hoarding gold in the anticipation of lucrative returns.

(3)   The Negative Spiral: When Indian economy was growing at higher levels, foreign money was flowing in and due to this inflow, Indian rupee was strengthening but when Indian economy started to struggle owing to higher interest rates, this foreign money started fleeing resulting in weaker rupee.

Not only funds from the equity market are being withdrawn but foreign investors have also started selling Indian debt instruments and this is why 10 year benchmark bond’s yield has started increasing. The yield of a bond increases when the price of that bond starts decreasing (due to the selling pressure).

The catch 22 situation:  Indian Economy shall grow when interest rates shall come down along with headline inflation falling to RBIs comfort level but the already fallen rupee prevents the RBI to cut policy rates and reserve ratios fearing further beating of the Rupee (Explained in detail here).

Simply put, a fall in policy rates reduces the price of bonds carrying higher coupon rates and this situation makes foreign investors to redeem their debt instruments fearing value erosion in their debt portfolio. Such redemptions take the dollars out of India and as a result rupee starts depreciating.
This was the reason despite inflation being tamed,no rates cut took place. 

(4)   Preventive Measures Going Awry

RBI not only retained the current policy rates but it also raised the short term lending rates to prevent  Indian commercial banks  from using this money to buy dollars as dollar buying weakens the Indian rupee. 
This was the RBIs way of curbing speculation in the currency market by the liquidity tightening.
RBI increased the MSF (Marginal Standing Facility) rate by 200 basis points to 10.25 %. At MSF rates banks can borrow up to 1 % of their Net Demand and Time Liabilities. Banks use this facility to meet their emergency liquidity needs.
RBI also capped bank borrowing limit from its Repo window to Rs. 750 billion.
But these moves deteriorated the sentiment in the market as this move was supposed to raise the fund cost for businesses and as a result economy could be further pressurized eventually resulting in further lowering of the GDP growth rate.
This move resulted in heavy selling in banking stocks by FIIs and with this departure of foreign money Indian Rupee continued its southern journey.


(5)   Infrastructural Growth:  For a growing economy, infrastructure growth is a must. But for this infrastructure growth a significant amount of imports are necessary.
Telecom and other equipments, various machineries etc demand for a substantial dollar outlay. Rising power demand in India translates into more and more dependence on the imported coal and natural gas and higher imports means higher trade deficit and weakening currency.

(6)   FDI Policy Paralysis:  To hold the rupee, foreign money that too FDI is a requisite but lack of timely FDI reforms hindered the inflow of foreign money in the country.
Now government is mulling to further liberalise the FDI policy but the fruits of this FDI easing shall come only in medium to long period. For the time being such move can only improve the market sentiment.

(7)   Money Outflow from the Capital Markets: In the month of June and July FIIs were net sellers worth around $ 2.83 billion. This outflow of dollars came heavily on the Indian rupee. 

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