The Indian Economy is suddenly faced with numerous issues, among them a sharp devaluation of the national currency, the rupee. And the rupee’s performance has been much in the news in recent weeks.
Reference currency
The value of a currency is its purchasing power – that is, what you can get for a unit of the currency in terms of goods and services. In today’s context when it is said that a currency is declining or being devalued, it is with respect to other currencies. Therefore, when speaking of the prevailing value of a currency, we use a reference currency and state whether the host currency – eg India’s rupee – is increasing or decreasing in value against the reference currency.
The Indian rupee’s value is closely monitored by the Reserve Bank of India and maintained within a range based on the market forces and the relative value of a basket of currencies. For the sake of simplicity, we can look at how the rupee has moved against the US dollar (USD).
The rupee’s report card
The Indian rupee has been steadily declining in value over the last half a century. From `7.5 to the USD during the 1960s, it reached a level of about `17.50 in the late seventies and early eighties. There was a sharp decline in the value thereafter and the rupee entered the nervous nineties at 32 to the USD. The early nineties saw further decline and the rupee entered the 40s while weathering the foreign exchange crisis of 1991.
Post ‘liberalisation’ the rupee was relatively stable for nearly a decade and, for possibly the first time in its history, was moving both ways (strengthening and weakening) against the USD. This was the time when the euro came into existence and the value of the rupee also responded to the Euro-USD cross rates. From a level of around `45 per dollar about two years ago, the rupee weakened to over 60 to a dollar, a devaluation of 33 per cent.
Why is foreign currency a player?
The value of a currency is affected by many things. A currency can be viewed as a commodity whose price (exchange rate) is fixed by the demand and supply of that currency.
Demand for foreign currency arises due to trade and due to capital outflows. Importers in India need dollars. Companies in India investing abroad need dollars. Foreign investments in India need to be serviced (via dividend payments). Foreigners employed in India and repatriating their earnings need dollars. All this creates a demand for foreign currency.
Supply of foreign currency comes from exports, foreign capital inflows, repatriation by Indians employed overseas and dividends received by Indian companies investing abroad.
The trade balance – difference between exports and imports – has always been negative for India, creating a huge demand for foreign currency over supply. This was made up by capital inflows and borrowings. Thus in the Indian context capital flows of foreign exchange into the country is a very important factor in setting the value of the currency.
What is FDI/FII ?
Capital inflow has two components: Foreign direct investment (FDI) and foreign institutional investment (FII). FDI is investment made by foreign companies to create specific productive assets. These typically create a more stable availability of foreign exchange. FII is primarily money flowing into the capital markets (investment in stocks etc). This can come in and go out quickly and thus represents a relatively temporary source of foreign exchange.
The current devaluation is attributed officially to excess demand for dollars. This, however, does not explain what is actually happening. The ever persistent excess of imports over exports calls for a continuous inflow of foreign capital. Even if the capital does not go out (as FII sometimes does), even if it stops coming in, India could face a decline in the value of the rupee. Since the early nineties, when India’s foreign exchange reserve was near zero, India has steadily built up its foreign exchange reserve, which is in hundreds of billions of dollars. The Reserve Bank of India normally uses this to ensure there is no undue turbulence in the value of the rupee.
It should also be noted that inflation in a country affects the value of the currency. India went through a period of high inflation without any appreciable fall in the value of the rupee. Hence the current phase could be seen as a late correction in the relative value of currencies.
The rupee has lost value with respect to almost all currencies. As a case in point, the rupee and the Thai baht were almost on par at the beginning of this century. Now the baht is almost twice the value of the rupee.
While reasons for the decline are many and difficult to assess precisely, the effects of the decline are foreseeable. Imports will become costlier and hence domestic producers will have a better run.
Exports will become cheaper – this will make domestic producers more competitive in the global market. Exporters of services, whose costs are in Indian rupees, will benefit by a combination of increased margins and greater competitiveness.
Indians living abroad will find Indian assets more attractive, particularly real estate investment. Foreign debt – if it is denominated in rupees – will become cheaper as repayment will be made in cheaper rupees. The government will find it easier to repay public borrowings. If the devaluation is followed by a cycle of high inflation, all debt will become cheaper.
Increased cost of imported products will affect those consuming them. Of common concern is the price of petroleum products, which is bound to increase. People with fixed incomes will be adversely affected by the inflation that is likely to follow the devaluation.
Studying or working abroad
Students aspiring to study abroad will find the entire exercise becoming more costly.
The same will apply to those planning to travel abroad. Indian salaries will become cheaper from the international viewpoint. This could result in greater investment in India and also in more Indians looking for employment abroad.
As can be seen, there are positive and negative effects to devaluation. As the saying goes, one cannot change the wind but one can adjust one’s sails!