Exchange rates and their impact on Indian economy
As we have been reading in almost all dailies during recent times that Indian rupee has depreciated against dollar by 8% since May 2013.In this article an effort is being made to study and analyse this trend with some theoretical framework on Exchange rate regime in India, Real and Nominal Exchange Rates (REER), difference between currency depreciation/devaluation and currency appreciation/revaluation, concept of Current Account Deficit (CAD), Purchasing Power Parity, linkages between exchange rate policy and fiscal/monetary policy, and how inflation, interest rates are linked to exchange rate. Further advantages and disadvantages of recent developments on the economy as a whole and on some specific sectors will also be covered.
What is Exchange Rate?
Exchange Rate is a rate at which one currency can be exchanged into another currency. In other words it is value of one currency in terms of other. For example if one US dollar can buy Indian rupees 50, we can say exchange rate of one dollar in terms of Indian rupees is 50.
What is an Exchange Rate Regime/System?
An exchange-rate regime is the way an authority manages its currency in relation to other currencies and the foreign exchange market.
Fixed Exchange Rate Regime
A fixed exchange rate system or regime refers to the case where the exchange rate is set and maintained at same level by the government irrespective of the market forces. The Fixed Exchange Regime emerged post World War II with the establishment of Bretton Woods a new international monetary system.
The Gold Standard and the Bretton Woods System
The gold standard allowed a country to only print as much currency as there was gold to back it up. Under a gold standard, money was representative money backed by a fixed amount of gold. Some economists said adherence to the gold standard had prevented monetary authorities from expanding the money supply rapidly enough to revive economic activity.The Bretton Woods System, enacted in 1946 created a system of fixed exchange rates that allowed governments to sell their gold to the United States treasury at the price of $35/ounce because the United States at the time accounted for over half of the world's manufacturing capacity and held most of the world's gold. Under the Bretton Woods system, central banks of countries other than the United States were given the task of maintaining fixed exchange rates between their currencies and the dollar. They did this by intervening in foreign exchange markets. The Bretton Woods system lasted until 1971. By that time, inflation in the United States and a growing American trade deficit were undermining the value of the dollar. Americans urged Germany and Japan, both of which had favorable payments balances, to appreciate their currencies. But those nations were reluctant to take that step, since raising the value of their currencies would increases prices for their goods and hurt their exports. Finally, the United States abandoned the fixed value of the dollar and allowed it to "float" -- that is, to fluctuate against other currencies. The dollar promptly fell. At that point for the first time in history, formal links between the major world currencies and real commodities were severed". The gold standard has not been used in any major economy since that time.
Economists call the resulting system a "managed float regime," meaning that even though exchange rates for most currencies float, central banks still intervene to prevent sharp changes. Countries with large trade surpluses often sell their own currencies by buying excess dollars available in the market in an effort to prevent own currencies from appreciating (and thereby hurting exports). By the same token, countries with large deficits often buy their own currencies in order to prevent depreciation, which raises domestic prices. But there are limits to what can be accomplished through intervention, especially for countries with large trade deficits. Eventually, a country that intervenes to support its currency may deplete its international reserves, making it unable to continue buttressing the currency and potentially leaving it unable to meet its international obligations.
Floating Exchange Rate Regime
Floating exchange rate system means that the exchange rate is allowed to fluctuate according to the market forces without the intervention of the Central bank or the government.
Comparing Features of two exchange rate regimes
Floating exchange rate
Exchange rate is determined by demand for and supply of foreign currency, depreciation or appreciation of a currency is determined by the market forces, speculation in foreign exchange market is common, self-adjusting mechanism operates to eliminate external disequilibrium by change in foreign exchange rate.
Fixed exchange rate
The government fixes the foreign exchange rate by buying and selling of foreign exchange, devaluation or revaluation of a currency is determined by the government, speculation occurs when there is rumour about the change in government policy, self-adjusting mechanism operates through the change in money supply, domestic interest rate and domestic price.
In 1993, India shifted to a “market determined exchange rate”. While the rate is “determined” on a market, the price coming out of this market is not one which reflects supply and demand. RBI continues to trade on this market. The black market on the rupee largely died out. The objective of the exchange rate management has been to ensure that the external value of the Rupee is realistic and credible as evidenced by a sustainable current account deficit and manageable foreign exchange situation. Subject to this predominant objective, the exchange rate policy is guided by the need to reduce speculative activities, help maintain an adequate level of reserves, and develop an orderly foreign exchange market. RBI may not intervene. Recently Present RBI Governor said”The central bank has neither the intention nor the wherewithal to intervene in the foreign exchange market. The central bank is not targeting any rupee level but will come into the picture only to smoothen volatility.“In India, RBI does not target any exchange rate. It intervenes in the foreign exchange market only to manage the volatility and to manage the disruption to the macro-economic situation,” Moreover, India just does not have enough foreign exchange reserves to sell in the market to support the rupee and thus intervention is meaningless. Since 2008, RBI has sold about $60 billion in the market to support the rupee, bringing down the Forex reserve to $287.9 billion, enough to cover imports for about six months—dangerously low, say economists. One good outcome of that inability to intervene is that it won’t impact domestic liquidity which has been in the deficit of over Rs.1 trillion, on a daily average basis, for the last one year.
Real Effective Exchange Rate (REER)
REER is the weighted average of nominal exchange rates adjusted for relative price differentials between the domestic and foreign countries. REER appreciates if the nominal exchange rate appreciates or domestic inflation is higher than foreign inflation.
“From a competitive point of view and also in the medium term perspective, it is the REER, which should be monitored as it reflects changes in the external value of a currency in relation to its trading partners in real terms. However, it is no good for monitoring short term and day-to-day movements as ‘nominal’ rates are the ones which are most sensitive of capital flows. Thus, in the short run, there is no option but to monitor the nominal rate.” (Bimal Jalan, 2002). India’s real effective exchange rate (REER) must appreciate over time, as long as India maintains a higher growth rate than the rest of the world.
Currency Appreciation and Depreciation
The exchange rate for any currency usually fluctuates. When the value of the currency goes up as compared to other currency it is known as appreciation. A unit of domestic currency can buy more units of foreign currencies or Ratio of Domestic Currency to foreign Currency goes down. 10% appreciation means (Rs.50=110% of $ 1 or $1.1). Earlier Ratio 50/1=50:1, now 50/1.1=45.45:1. In other words now even Rs. 45.45 is capable of buying one dollar or Rs. 50 now can buy 10 % or 1/10th of a dollar more.
When the value of currency falls as compared to other currency it is known as depreciation. A unit of domestic currency can buy fewer units of foreign currencies or Ratio of Domestic Currency to foreign Currency goes up. 10% depreciation means (Rs.50=90% of $ 1 or $ 0.90). Earlier Ratio 50/1=50:1, now 50/0.90=55.55:1.In other words Rs. 55.55 will be needed to buy one dollar or Rs. 50 now can buy 10 % less or 1/10th of a dollar less.
Currency Revaluation and Devaluation
It refers to official changes in the price of a currency in a fixed exchange rate system.
Devaluation is when the price of the currency is officially decreased in a fixed exchange rate system.
Revaluation is the official increase in the price of the currency within a fixed exchange rate system.
Trade Deficit/Current Account Deficit and Balance of Payments
The trade deficit is the deficit on the 'trade in goods' (Merchandise-exports and imports) section of the current account. If Imports exceed exports we observe a Deficit on trade account and if Exports exceed imports we observe a trade surplus. If we also include invisibles like incomes of Indians serving abroad and earnings from overseas investments and transfer payments (no quid-pro-quo) made abroad after netting and add to the figure of trade deficit or surplus we arrive at Current Account Deficit (CAD) or Surplus. Balance of Payments is still a broader term which includes transactions on Capital Account also. Here Capital flows are of two types autonomous and accommodating. Autonomous transactions are undertaken for their own sake, for the profit they entail. Accommodating transactions are the residual money flows (including flows of official reserves) that occur to fill any gaps left in balancing BOP by autonomous transactions. The deficit means that the country is losing net liquidity to others: it is running down its liquid foreign assets (including official reserve assets) and/or accumulating liquid foreign liabilities. Conversely, a surplus exists when autonomous money receipts exceed autonomous money payments. It follows that surpluses and deficits could be easily identified if we could simply place all autonomous transactions inside the main body of the balance of payments ('above the line') and all accommodating transactions outside it ('below the line'). Balance of Payments (BoP) statistics systematically summaries the economic transactions of an economy with the rest of the World for a specific period. The Reserve Bank of India (RBI) is responsible for compilation and dissemination of BoP data. Balance of payment (BoP) comprises of current account, capital account, errors and omissions and changes in foreign exchange reserves. Under current account of the BoP, transactions are classified into merchandise (exports and imports) and invisibles. Under the Capital Account, capital inflows can be classified by instrument (debt or equity) and maturity (short or long term).The main components of the capital account include foreign investment, loans and banking capital. Foreign investment, comprising Foreign Direct Investment (FDI) and Portfolio Investment consisting of Foreign Institutional Investors (FIIs) investment, American Depository Receipts/Global Depository Receipts (ADRs/GDRs) represents non-debt liabilities, while loans (external assistance, external commercial borrowings and trade credit) and banking capital, including non-resident Indian (NRI) deposits are debt liabilities. The depreciation of the rupee in the last two weeks has again highlighted the structural deficiencies in the Indian economy and continued dependence on capital account flows to finance the balance of payments.
Some policy issues for addressing CAD and Falling Rupee
The rupee’s level over the past year has reflected the constantly changing balance of opposing forces in the economy — a large current account deficit ($90 billion, 2012-13) and elevated commodity prices (Oil) kept it under pressure through 2012. This changed in 2013 when strong foreign flows into debt and equity ($17.3 billion) supported the currency and kept it in a broad 53 to 55 range. This has changed in recent weeks when sizable foreign institutional investor outflows were witnessed (circa. $2.8 billion from May 21 to June 10) driven by liquidation of bond positions. The result is the extreme volatility and depreciation in the rupee we are seeing currently.
The Reserve Bank of India’s intervention in such scenarios can only be viewed as an attempt to soothe sentiment and keep speculative activity at bay. It is unlikely to fix the core structural issues that need to be addressed, such as:
— Narrowing the current account deficit (CAD). Even though CAD is expected to drop from $90 billion (4.9 per cent of the gross domestic product) in FY 2012-2013 to $80 billion (3.9 per cent of GDP) in FY 2013-2014, 44 per cent of the country’s imports shall still be driven by crude/energy products and gold, which we cannot wish away despite recent policy measures to curb gold imports. Policymaking needs to foster an export-led revolution in the real economy by channeling investments suitably, replicating our success in the information technology industry.
— Financing the CAD sustainably by attracting sticky foreign investments. This will need to be driven by lowering transaction costs, simplifying access to Indian markets and having a fair and unambiguous tax regime. In this context easing rules for foreign investors in Indian capital markets are a step in the right direction.
— Improving the investment climate and ensuring policy changes lead to actual flow of funds in a reasonable timeframe. Changes in foreign direct investment and other policies can lead to real investment only if backed by fast track clearances, stability (and clarity) in the tax regime and effective labour and land acquisition laws.
— Ensuring India’s sovereign rating at least remains stable by continuing to focus on the stated fiscal deficit goals and other macroeconomic parameters.
---The risk management function in corporate India has been a challenging place in the last two years. Corporate India will need to accept the current currency ranges and higher volatility as the new normal and ensure their treasuries are governed by clearly defined risk management policies that provide flexibility around the hedging horizon, hedge ratios and product selection.
How Monetary & Fiscal Policies Affect Exchange Rates
The Indian Government initiates a personal income tax reduction plan (A measure under Fiscal Policy), leaving every tax-paying Indians with more disposable income/ India’s fiscal policies (Public Expenditure) lead to an increase in India’s real GDP.
What will happen as a result to trade between India and the United States?
Indians will buy more goods, including those imported from USA
What happens to the Indian Rupee? It depreciates-More Income facilitates Higher Imports-more dollars needed. Indians ready to part with more rupees per unit of dollar.
What happens to the US dollar? It appreciates-as demand for dollar will increase to buy US goods.
The GOI budget deficit increases, which causes increases in the interest rate as GOI will be forced to offer higher coupon on GILTS to finance their borrowing programme. (assume trade with USA)
What will happen as a result to trade between India and United States?
US investors will want to buy Indian bonds.
What happens to the Indian rupee? It appreciates- as more dollars are now available for investment in Indian capital markets. This explains how investment by overseas investors in India till recently checked steep fall of rupee.
What happens to the US dollar? It depreciates
India’s interest rates are increasing, while US interest rates remain relatively constant.
Changes in Interest rate
Higher interest rate will attract more foreign investors to invest in the country and thus the demand for currency will rise, resulting in appreciation in value of the currency
What happens as a result to trade between the United States and India?
Indians will sell US bonds to buy Indian bonds
What happens to the US dollar? It depreciates-as dollar proceeds from sale of US bonds will demand rupee for investment in Indian Bonds.
What happens to the Indian rupee? It appreciates
There is a rapid increase in the Indian price level while the U.S. price level remains relatively constant.
Changes in Inflation rate
Higher inflation rate will make the country uncompetitive in the international market. The exports will fall resulting in decreased demand for the currency and hence lower value.
What will happen as a result to trade between the U.S. and India?
Indians will want to buy U.S. Goods
What happens to the US dollar? It appreciates
What happens to the Indian Rupee? It depreciates
Overvalued and undervalued currencies and concept of purchasing power parity (PPP)
In India Rs.25 can get one kilogram of good quality rice. In United States of America US$ 1 can buy one kg of comparable quality of rice. The rice being same in both cases, US$1 should be equal to Rs.25. But one can get in the banks or elsewhere about Rs.50 for 1 US$. This means that Indian Rupee is undervalued by 2 times. In some other cases 1 US$ may be equal to Rs.50 or Rs.20 or so. When we take the value of the total production of goods and services, i.e. GDP we get an idea of how much the currency of a country is undervalued or overvalued. International Financial organisations like IMF, compute the GDP of a country both in nominal terms i.e. on the basis of rates of exchange and on Purchasing Power Parity (PPP) terms. From these figures we find that while currencies of most of the developed countries are overvalued, the currencies of the developing countries are generally undervalued. If one examines The Economist Big Mac Index or IMF and World Bank estimates of India’s gross domestic product adjusted for PPP, the exchange rate should be around 20-22. In fact, according to the Big Mac Index, the rupee is the world’s most undervalued currency against the dollar. The rupee was grossly undervalued at 44 last year..
The impact of a sharp depreciation on the Indian economy and various sectors
Trade and fiscal deficits
A weak currency might worsen the already-stressed trade deficit. The rupee is not the only currency which is depreciating, so there is not much of an increase in export competitiveness at a time when global recovery is still fragile. Though the rupee has depreciated, the same in many other currencies (like Brazil real, South African rand, etc) is much higher and, therefore, competition from there may increase (TEXTILES).
At the same time, however, a weak rupee will weigh on the import bill, worsening the trade deficit.
A 2% (Real Effective Exchange Rate) REER depreciation of rupee will add 20 basis points (bps) to the current account deficit (CAD) as a percentage of the gross domestic product (GDP). A falling rupee also makes oil imports costlier despite the international benchmark Brent crude remaining stable for some time. A Re.1 depreciation increases the under-recovery (the losses on selling fuel below cost) bill by Rs.8, 000 crore. Assuming the government shares half of this bill, the fiscal deficit increases by 4 bps.
Inflation, interest rate cuts
A fast falling rupee offset the benefits of lower commodity prices. In the case of products such as fuel, a falling rupee straightaway translates into an increase in the retail prices. In case of other products, the depreciating currency will increase the price of imported raw materials. That impact on consumer prices will be seen when the companies pass on the costs, which again depends on the demand environment.
“The imported inflation component will go up,” “If the rupee depreciates by 10%, it will increase headline inflation by 1-2%.”
The interest rate arbitrage (between Indian government bonds and US Treasury yields) becomes less attractive, thus compromising the possibility of further capital flows. Recently yield on 10 year benchmark US bond increased from 2.16% to 2.36%.This made Indian Bonds less attractive. Hence a huge selling of Indian Bonds was seen in Indian Bourses and at one time trade was stopped. (20.06.2013).
The rupee’s weakness may make foreign investors think twice before investing. Foreign capital inflows are typically at risk when the local currency weakens. Already, portfolio flows into both debt and equity have been gradually tapering, with investors subscribing to the view that the local currency could depreciate further. However, NRI remittances have also picked up in the past few days to benefit from the weak rupee. The average daily net FII inflows into equities tumbled to $27.22 million in June compared with $171.4 million in May, according to data from the market regulator, Securities and Exchange Board of India.
“The speed at which it is depreciating, it is only rational that investors wait and see where it holds,” “There is a pause for now as far as inflows are concerned. If the rupee touches a new low and stabilizes there, foreigners may then put in more money, as they would get more rupees for the same amount of dollars they would have put in earlier.”
The situation worsens in debt with FIIs pulling out $259.7 million in each session in June compared with a $23.6 million average daily inflows the previous month. The yield differential, between Indian 10-year government bonds and US treasury yields of the same maturity, has fallen by 1 percentage point since the beginning of this year.
In a country dependent on imports for many raw materials, a weaker rupee impacts the profits of companies at a time when they are already stressed. “Corporate profitability would be affected negatively as the input cost will increase for the companies that are importing raw materials.”
The interest burden would increase on foreign currency denominated debt. For companies that have availed of foreign currency loans for implementation of projects, the rupee depreciation will stretch their balance sheets, as the amount of debt will increase in rupee terms. As these loans mature, the cash flows will also be impacted.
According to government statistics, out of India’s $376 billion outstanding external debt, about 23% or $85.3 billion comprises external commercial borrowings, or ECBs (Dollar Denominated).
As most Indian software firms derive upwards of half their revenue from the US, a weaker rupee is good news for them. On average, one percent depreciation in the rupee translates into a 30-50 bps gain in operating margins for information technology (IT) companies.
“Most IT companies currently have hedges at Rs.53-55 per dollar but now the rupee is at Rs.57-58 to a dollar. If the average realized rate for the companies for the quarter is higher than their hedging rate, then it would lead to a Forex loss. Despite the Forex loss, companies would book a profit as operational gains would be even higher.”
“The Pharma sector will by and large benefit from the rupee slide as a majority in the industry is net exporters. But the companies who have large foreign debts in the books stand to lose at this advantageous position due to heavy interest burden,”
There is no single trend that can encapsulate the auto industry because of varying levels of imports from countries as diverse as Germany and Japan. Still, “the weakening rupee and volatility of the same has put severe strain and continues to be a concern for Auto Industry in India. May reconsider price re-positioning for specific models.
Struggling with a scarcity of coal, power firms are dependent on imports of the fuel to keep their plants running. A depreciating rupee will dent margins either by raising fuel costs or by making the economics of running the plant on imported coal unviable. In spite of drop in prices of international coal, the power sector was unable to take advantage because of the local currency weakening.“The drop in value of rupee by Rs.1 against dollar has impact of around 5-6 paisa on the variable cost of power generation utilities.”
The rupee depreciation will significantly impact airlines as their dollar revenue is less while most of their expenses are in dollars. “Low-fare carriers that have less international exposure in terms of flights will be adversely affected. Full service airlines will also be affected as they can’t stay out of maintenance and repairs,”
Travel Abroad for Studies or Leisure
If you are going abroad to study, it will become much more expensive. If you are planning a holiday abroad, there is inflation ahead for you in terms of your living there and other spending. It will be especially troublesome for those travelling to hard currency countries and, of course, it is going to make the import bill much more expensive. So, when oil becomes more expensive there is a cascading effect on inflation.
As economies grow is size the interdependence of economies also increase resulting into more and more cross border trade and movement of capital. The single most important factor that determines the size and direction of this is exchange rate between two currencies. Wealth creation is an outcome of movements in exchange rate as money is getting invested overseas. With collapse of Bretton Woods and its Fixed Exchange Regime even Central Bank’s intervention in Foreign Exchange market may not bring about desired results. The only remedy lies in hedging but that instrument is more used for speculative purpose than as a tool for risk aversion. Hence investors must consider the impact of exchange rate movements on specific sectors while investing in various Debt and/or Equity instruments.