Where will the rupee finally rest?

June 6, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

For nearly a decade, the rupee has been stable — moving in the narrow range of 44-45 to the dollar. But since August last year, the rupee began to slide and in less than six months was down 23 percent.

The fall was not without sound reasons though currency values, when market driven, can be exposed to speculation. The latter is not the basic cause, nor is Greece the principal culprit. The rupee declined for reasons which were very much internal, arising from imbalances in the economy.

There were apparently two factors that collectively contributed to the weakening of the rupee. First, the merchandise trade deficit in 2011-12 was the highest so far, amounting to $185 billion. This could not be covered by trade in services and the year ended with a current account deficit (CAD) which exceeded 4 percent.

Second, foreign investment which usually funded CAD dropped significantly. In the whole of 2011, there was a net outflow of hot money. January and February this year saw the return of FIIs but subsequent months saw the money draining out again, mainly because of budget announcements about GAAR and retrospective tax changes. The finance minister did subsequently try to retrieve the situation but the damage was done. Investor confidence was shaken.

The high demand for dollars for imports and low supply of dollars from exports and foreign investment caused a market mismatch and forced the rupee to fall. Unfortunately, these trends tend to have a snowballing effect. The fall in rupee discourages foreign investment which in turn forces the rupee to drop further.

Underlying these trends, however, is rampant inflation since March 2010. The purchasing power of the rupee declined 18 percent in 26 months. Since the external value of the rupee conditions its external value, the weakening of the rupee against the dollar could have been expected. It did not happen early enough though the FIIs sensed it much before the exporters did.

Inflation squeezes the margin between export price and cost of production. Eventually, the exporters are forced to price themselves out unless the rupee falls in the currency market. The drop in our export growth is not so much because the importing countries — the United States and the EU — have been stagnating as the loss of competitive edge in international trade.

The value of the rupee in terms of dollars will depend over time on the erosion of its value in terms of purchasing power internally. If inflation has been at say, 7 percent, the rupee will have to fall to that extent unless the importing countries are themselves victims of inflation. That is not the case. Hence, the rupee has fallen the most compared to other currencies because we had nearly the highest inflation.

Eventually, the rupee will stabilise, barring short-term disturbances, after correcting the loss in its domestic purchasing power. The rupee will not go back to 45 to the dollar; at best it will stabilise at 51-52.

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