The rupee has depreciated breaching the Rs. 70 mark for 1 USD last week. The drop has been steep with Rupee losing 7.69% since April 2018. This has prompted the usual cabal of Lutyen’s ecosystem to question the very basis of Indian economic situation. Gleeful comparisons are being down with Rupees decline in 2013. Old tweets are being dug up to buttress their smug point. But what is the truth? Why is the Rupee falling? And is this similar to 2013’s decline?
Understanding currency exchange mechanism
The value in currency is reality is reflected by the purchasing power bestowed upon it. The difference is values of currencies is due to the inherent differences in the purchasing power of the currencies. On its own, it doesn’t show the strength of a currency. It is in-fact a measure of the inflationary aspect of the economy.
Let us take a simple example. Imagine two neighboring countries Alpha & Bravo with currency appropriately named as “Currency A” and “Currency B”. Let us take a common item – an apple and assume that it is grown in both countries. Let one apple cost 2 Currency A in Alpha and 1 Currency B in Bravo. The equivalence principle implies that the same product should be of same value in both the places. Assuming free movement of goods, If the products are differently valued, the sellers will rush to country where the apple has higher value and buyers would rush to the country with lower value and which will finally stabilize to ensure equivalence. Hence the exchange rates should be 1 B = 2 A.
Let us further assume that Alpha has reckless government headed by Sonia Gandhi and Bravo has responsible government headed by Modi. Because Sonia “mata” wants to fund ill-conceived welfare schemes, Alpha has to spend more than its source of tax revenues. Spending more than your source of funding is akin to printing simply more money out of thin air to pay for the difference [This is extremely simplistic explanation but serves for our purpose]. This creates high inflation resulting in loss of value in currency A. Hence now one apple costs 10 A in Alpha. On the other hand Modi pursues responsible fiscal and monetary policy and hence Bravo has moderate inflation with one apple costing only 2 B. As explained one product must have the same value, hence the new exchange rate between A & B is as follows 1 B = 5 A.
The above illustration is a very crude explanation of exchange value determination. In reality a complex factors of country’s current account deficits, fiscal and monetary policy of both the country and the reserve currency country determine the exchange rate. However, the long-term exchange rate is simple function of inflation rate differentials.
Hence we can estimate what should be the natural rate of exchange between USD and INR. 1 USD = 62.59 INR in 2013, if we take the inflation rates of US and India, we can calculate the natural exchange rate should be in 2018.
The average 5 year inflation in India has been 5.62% in the 2013-18 period compared to 1.32% for the US in the same period. Hence this difference in inflation rates would have implied a USD to INR rate of 82.27. The only way INR will appreciate in natural course of action is for India to have an inflation rate lower than the US.
Why then 2018 different than 2013?
While the long-term currency rates can be calculated as above, in reality the exchange rate is most cases different from it. This is due to the myriad factors at play at any given moment of time. In the short run, the primary determining factors are current account deficit and monetary flows, both of which are dependent on the strength of the domestic economy. [Again very crude approximation of the reality]
One of the other important factor is the dollar dominance in the global currency market as the world’s only reserve currency.
To measure anything, we need a standard unit of measurement against which we compare. In case of currencies, there is no implied standard unit after US exit from the gold standard in the 1970s. Hence the currency values are relative in nature and in today’s case it is relative to dollar. And as in any relative comparison, the differences can be because of change in either or both the units. [For example, if two cars are travelling at the same speed next to each other, there are three ways one car can overtake the other – the overtaking car speeds up, the overtaken car slows down and both of these to occur].
Hence the Rupee value can fluctuate in either of the two cases.
- India’s economic performance
- US economic performance
There in lies the difference between 2013 and 2018. Let me elaborate on how?
2013 – August:
The INR fell by whopping 8% in one month between July 2013 and August 2018. This drop was unprecedented and seen only in countries with eminent economic collapse like in Turkey, Venezeula and Iran. Did the exchange rate decline because the rupee’s underlying value declined or because the dollar strengthened? Let us look at the data.
In the chart below, we are comparing the value of the five major Asian currencies – INR, RMB (China), KRW (S.Korea), MYR (Malayasia) and SGD (Singapore). We will see exchange rate against the dollar and plot it from Jan 2013 to Aug 2013. We have normalized by taking the exchange rate at Jan as 100.
We can clearly see that the rupee was the only currency that was continuously depreciating between Jan to Aug. Most of the currency have held nearly steady against USD. While Malayasian did depreciate, it was 5% over the course of 6 months and not 20% as in case of Rupee (b/w April and August). Taking the car analogy, this is the case of Indian economic car slowing down.
This decline in Rupee value was driven primarily by the deteriorating economic condition in India. Chidambaram’s ruined fiscal and monetary policy combined with Sonia mata’s profligate ways had nearly bankrupt the nation. Current account deficit was at at 5.21% in 2012. Foreign reserves were depleting fast with our total external debt with reserves to debt ratio at 104%.
To make matters worse was the fact that the UPA government was ramrodding in introduction poisonous bills such as food security, land bill and other such pseudo welfare schemes. There were already murmurs of the NPA crisis in the Indian banking sector. All these made India just a whisker away from collapse in confidence from the global investors. This could have lead in foreign fund outflow, even greater currency depreciation and even a IMF bail-out. Only the possibility of Modi election victory restored investor confidence and stabilized the economy.
2018 – August
Let us plot the performance of currency between Jan 2018 and Aug 2018. Let us the same 5 currencies again.
We can clearly see that it is not just Indian rupee but the entire band of Asian and in-fact global currencies that have depreciated against. the dollar. If it was the case of economic deterioration in India, why would Korean Won, Singaporean Dollar, Malayasian Ringet and Chinese Yuan depreciate. This is the case of dollar strengthening. This is driven by the Fed’s unwinding of the QE. As the fed gradually increases its effective federal fund rate from 1.41% to 1.9%, global capital and funds are flowing back to US by higher yields on offer from relatively riskier markets. Hence from the car analogy, this is US car stepping on the accelerator overtaking the rest of the currencies.
India’s economic condition is much stronger. The GDP is expected to grow at 7.3%. The current account deficit is at 1.5% in 2017. The reforms of GST, IBC and massive infrastructure spending of Modi government are about to kick-in driving growth higher. The on-going currency volatility is troublesome but not as much as being called out for.
India primarily exports to US and EU, the depreciation of rupee actually makes our exports cheaper and competitive. This is net positive. And let us look at imports, the two major parts of the imports are as follows – China and oil.
As shown in the chart on the right, while both the Chinese RMB and Indian rupee have depreciated vis-a-vis the dollar, the relative value between them as held steady. Thus the cost of majority of our imports shouldn’t be affected.
Coming to oil, it is indeed true that the fall in Rupee value is exacerbating the cost of oil imports. But the global headwinds including trade wars and possible slow-down in China should give some respite to the oil price. Thus overall, the currency decline has negative implications on the Indian economy but nothing on the lines of what could have happened in 2013.
So even though one can expect a lot of hyper ventilating from the usual suspects on falling Rupee, we should be aware of the reality and counter the same with facts and figures.
So Sorry Nidhi, 2018 is not 2013!