Why the rupee is linked to jobs in the U.S.

July 10, 2013

(Any opinions expressed here are those of the author and not of Thomson Reuters)

It appears odd that an increase in job offers in the United States should pull the rupee down in India. After all, any improvement in the U.S. economy should benefit the rest of the world. It means an increase in imports by the U.S. and exports by other countries. But there is more to it than that.

It is the Federal Reserve that is at the back of this phenomenon. When the U.S. economy plunged after the financial crisis of 2008, the Fed had gone in for pumping in liquidity, usually called quantitative easing, in order to hold down interest rates that plunged to nearly touch zero. This went on for quite a while with cash pouring in at the rate of $83 billion a month. A part of this money found its way to international markets for commodities, such as oil and gold, and stocks and bonds in emerging market economies. The Fed’s expectation was that low rates of interest would stimulate investment activity in the U.S. and generate employment. The latter was made a benchmark to assess whether the strategy worked.

This investment increased the supply of dollars in international financial markets and resulted in the appreciation of a number of currencies – though not of the rupee.

The rupee had problems of its own. It depreciated internally for about three years because of sharp inflation that wasn’t there in other emerging market economies. With exports declining, the current account deficit rose steeply – reaching nearly 7 percent – and had to be funded with capital inflows from FIIs, FDI and external commercial borrowing (ECB). The rupee was inherently weak but was propped up by external funding. When that funding began to disappear, the weakness of the rupee became apparent. It dropped from 45 to 60 to the dollar.

The RBI did not intervene in the market partly because foreign exchange reserves could not be drawn down any further. But it did take measures to discourage speculation that in a falling currency market is inevitable. Other measures will reduce bunching of demand but cannot correct the underlying mismatch between supply and demand for dollars.

The immediate trigger for the fall of the rupee is the return of dollars back to the U.S. because quantitative easing, as the Fed Chairman Ben Bernanke explained, will be tapered down with improvement in employment. The bond rate in the U.S. has already climbed in anticipation.

This is what is bothering Finance Minister P. Chidambaram and he had to make a hasty trip to the U.S. to seek investment. The basic problem, however, is the trade deficit. With the fall of the rupee and the rise in currencies of other emerging markets, India has an advantage. It is not a calamity but an opportunity to reduce the huge trade deficit that has made the rupee weak.

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Interesting !

Posted by UmeshAhuja | Report as abusive