The way it should be

"It should not escape notice that gold and silver after circulating in every other quarter of the globe, come at length to be absorbed in Hinduston"

                         ~Francois  Bernier

Rupee depreciation: History and current situation

Posted by VASUDEVA REDDY on Saturday, October 22, 2011 Under: economic articles


Now the on-going major economic problem that india is facing is not the inflation, as we got used to that, but it is the depreciation of rupee. I think I don’t need to explain who will benefit more with that and who will lose more. For those who don’t know, in simple terms, if a currency value is depreciated the importers will suffer more and the exporters will gain more. I just wanted to discuss the indian rupee devaluation history before getting into the current depreciation of rupee and its potential causes for that, here we go ( read with patience, this is the longest article among those I wrote, I just wanted it to be clear).

There is a difference between devaluation and depreciation of a currency. Devaluation is when a country makes a conscious decision to lower its exchange rate in a fixed or semi fixed exchange rate. While depreciation means fall in the value of a currency in a floating exchange rate. Simply devaluation is an intentional one while the depreciation is unintentional one. Depreciation of rupee is not a new thing for indian traders. Rupee has been devaluated many times but majorly two times in the history. The major devaluation took place in the year 1966, rupee has devaluated by 60% against dollar, from 4.76 to 7.50. India has suffered from severe balance of payments deficits since 1950's. Through the restrictions on currency trading and convertibility as well as export subsidization and quantitative restrictions on imports, india was unable to maintain its unjustified exchange rate while experiencing the inflation until 1966 when it faced a severe shortage of foreign reserves. Inflation has caused indian prices to become much higher than the world prices at pre-devaluation exchange rate. At fixed exchange rate, the country which experiences higher inflation rate compared to other countries, that country's goods will become more expensive and foreign goods will become cheaper. Simply, that means imports will become cheaper while the exports will become costlier. Furthermore, the government of india had a deficit problem and could not borrow money from abroad or any private sector, due to that sectors negative savings rate. To make imports costlier and to inject more money into the system with exports the government has intentionally devaluated the money exchange rate by 60%.


 

Second major devaluation of rupee took place at the time of liberalization of economy. Till 1991, india had been following the pegged exchange rate system, also called as fixed exchange rate system, in which the value of rupee was match with the basket of currencies of major trading partners. In 1991, government went very close to default and its foreign exchange reserves were able to meet only three weeks worth of imports. Moreover, it has faced the same situation as in 1966, that was higher inflation levels. The problems of balance of payment has started in the year of 1985. Though the exports grew, the imports and the interest payments grew rapidly to takeover the effect made by increased exports. The trade deficit became more and more so that india could not able to meet its obligations. The trade deficit in 1990 was $9.44 billion dollars, it may seems smaller amount to you but imagine the indian GDP value at that time. In july of 1991, indian government (RBI) devalued rupee by 19%.


 

I just want to note out similarities between those two situations and to relate it to the current depreciation of rupee. In 1966, india participated in a war with Pakistan and in addition to that india had faced a bad drought (coz of which we were not able to produce more subsequently export more) which two were caused the high trade deficit. While in 1991, gulf war made an impact on already sinking economy. Because of that gulf war oil imports became costlier which made higher trade deficit.

Coming to the current depreciation of rupee ( not the devaluation), I can say there are three main reasons for that. One is Foreign Institutional Investors (FIIs), second is high fluctuations in the prices of precious metals like gold and silver, and the third is the appreciation of dollar with several causes like Euro crisis.


 

Foreign institutional investors are those who invest in our stock markets or some other money making instruments for a shorter period of time. Usually they provide liquidity in the market. But the problem with the FIIs is that they just came here to earn money but not to do some social service to our country. When they feel they have enough returns on their investments they’ll take back their money from here which will cause the breakdown of the stock markets and slow down of the economy. You may think how can one or some investors can make such an impact on this great and big economy, they may be one or some but the investments they bring into the system is not small. For example an FII came to invest in capital market with some 1000 crore rupees, the stock that he chooses to invest will ramp up once he started to invest, as there will be a high demand. As the stock price is going up, the retail investors will also invest in that same stock which will add the further increase in the price of the share. Let us assume that the 1000 crore rupees has reached 1100 crore which was the FII target growth, he will take back all his money from the market by selling all the shares which will cause the sharp fall in the stock price and the market. Now let us see how it is going to effect the depreciation of rupee. If an investor wants to invest money in india, he needs to invest in rupees. For that he needs to “buy” rupee with their currency which will create the demand for the rupee so that the rupee value is appreciated. Similarly when he takes away his money from the stock markets or some other instruments, he needs to sell that rupees to convert into his own currency which will inject more rupees in the system causes lesser demand for those. This is one potential cause of depreciation of rupee.


 

Second one is high fluctuations in the prices of precious metals like gold and silver. Usually the investments on the precious metals are considered to be the safe investment with considerable returns and less risk, but the scenario has changed in the last few months. Let us see how it will effect the change in value of a particular currency. Take an example of silver, silver has fluctuated heavily in the last 6 months (even gold also). Silver has touched a new height of $48 per ounce in april and touched a low of $30 per ounce in the month of September. It became no more a safer investment as the prices were fluctuated heavily. The next alternative that was visible to an investor was DOLLAR. Yes it was dollar, why because it has not changed its value heavily even with the extreme conditions like economy default. Investors felt that the investment in dollars was a safe bet, which caused more demand for the dollar. If the demand for dollar increases the value of the dollar increases which will effect the exchange rate of foreign currency. That means if dollar value appreciates, I need to spend more rupees to buy a dollar.


 

The third cause is the Euro crisis. Euro is the second most traded currency ( in terms of foreign exchange with the total volume contribution of 39.1%) in the world. With the Greece crisis, which subsequently lead to the EU (European Union) crisis, investors started doubting the continuation of EU. Investors doubted that EU may collapse which will lead to no value ( or lesser value) of euro. So they took out their money from the euro currency and started investing in dollar, as it is the comparatively safer bet. As the dollar is the reserve and exchange currency, the appreciation of dollar value will cause the depreciation of other currencies; there is no exemption for rupee also.


 

There may be several many reasons for the depreciation, but the above stated are the major potential causes for the depreciation of rupee against dollar. Before coming to the comparison between previous devaluations of rupee with the current depreciation of rupee, you must remember one main point that is now the countries are following ( at least, india) ‘floating exchange rate’ system while the system was the ‘exchange rate regime’ before 1991. Coming to the comparison, you can say this is the third worst devaluation of rupee (>12% in one month). Inflation rates is more in all the cases, global economic factors caused depreciation/devaluation of rupee in all the cases, but only difference is we have plenty of foreign exchange reserves which will help us to get out of the situation without official devaluation of rupee.

I hope the article was useful, for any clarifications reply me back at d.vasudevareddy@india.com, your feedback is appreciated.

 

In : economic articles 


Tags: rupee euro crisis greece depreciation devaluation dollar 1966 1991 exchange rate 

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