The meaning of the falling rupee at 70

When the exchange rate between the U.S. dollar and the Indian rupee crossed 70, the headlines screamed “the rupee hits an all time low”. There is melodrama in such headlines, mostly fueled by the rhetoric of political parties. It is implied that when the rupee “weakens” against the dollar, it is a loss of national prestige and of economic power. Perhaps even the word “weakens” is a giveaway. For how can a national symbol, the currency and its international value be allowed to weaken? Isn’t that a failure of the government of the day? This was the campaign rhetoric used back in 2013, when the exchange rate had moved (or “collapsed”) from 54 to 68. The UPA government was severely castigated for mismanaging the exchange rate. Five years later it was the BJP led NDA which was at the receiving end of such jibes. Such political brickbats going back and forth just fuels tempers, and has nothing whatsoever to do with economic reasoning. One of the reasons for this time’s gleeful rhetoric was because of a prediction that the NDA government would soon strengthen the rupee to rise to 40 to the dollar.

Let’s step back from the rhetoric, and examine why the rupee crossed the psychological level of 70? To answer this question, it is important to note that the exchange rate is nothing but a price. And prices fluctuate with supply and demand. Just like potatoes can go from 5 rupees a kilo during a glut to 100 rupees during a shortage, the same is true for foreign exchange. When there is a dollar shortage it becomes dearer (as it has now), and when there is a glut of inflow of dollars, the rupee strengthens (which has happened infrequently). The demand for dollars comes from importers and those seeking foreign funds for investment or loans. And the supply of dollars is provided by export earners, as well as foreigners who wish to invest into India. On the current account (i.e. trade in goods and services), India is always short of dollars. That is our imports exceed our exports. The danger level for this current account deficit is 3 percent of the GDP which is what triggered a currency crisis back in 1991. It also reached an alarming level of nearly 5 percent of the GDP in 2013, but we avoided a currency crisis, thanks to the ample stock of foreign exchange and some deft macroeconomic management.  This year it is threatening to cross nearly 2.5 percent of the GDP and we should be worried.

Unlike potatoes which can go through shortage and surplus, on foreign exchange we are always in short supply. It is a testament to foreign faith in the Indian economy and government, that for decades the dollars have poured in to help us meet the difference between imports and exports. In fact after the 1991 reforms, there has generally been a net inflow of surplus dollars (called the balance of payments). In other words the current account deficit is more than compensated by capital account inflows (in the form of stock market investments or dollar loans which are repayable). During such excess periods, we would expect the rupee to strengthen, but usually the surplus dollars are absorbed by the Reserve Bank of India, leading to accumulation of foreign exchange.

India has among the six largest stock of forex in the world. It is held as a safety stock to meet sudden contingencies in case of capital flight, or of sudden stoppage of inflow of forex. At least from the Asian crisis of 1997 we know, that is it best to be self insured when it comes to foreign exchange obligations. We can’t always depend on the IMF to bail us out in emergencies.

In the medium to long term, the rupee will always depreciate against the dollar. The reason for this is that the rupee loses purchasing power domestically, due to inflation. At 5 percent inflation, 100 rupees reduces to 95 rupees value at the end of the year. So naturally the international value of the rupee too should have some parity with its domestic value. In the dollar world the inflation rate is barely 1 or 2 percent, whereas in the rupee world (in India) inflation is 5 to 6 percent. The difference is the rate of the relative “weakening” of the rupee dollar exchange rate. This is a thumb rule that has been confirmed over many decades. The only way the rupee will substantially strengthen against the dollar is if our inflation rate is lower than in America, and economic and productivity growth is so much stronger as to attract huge investment flows into India. The current macroeconomic conditions do not show this possibility.

The rupee’s sharp downward movement was also caused by the contagion effect of the downfall of Turkey’s lira. The lira has lost nearly 70 percent of its value against the dollar in the past twelve months. Turkey’s inflation is above 15 percent, the current account deficit is 6.3 percent of the Turkish GDP, and its dollar debt has ballooned to 53 percent of the GDP. So foreign capital is panicking and leaving. The country does not have enough forex stock to pay the fleeing investors, and hence it may face dollar bankruptcy or the need for an IMF bailout. Even the South African rand has been affected. Naturally the Indian rupee is not immune to a contagion afflicting all emerging market economies. The pullout of such funds is called a “flight to safety” which causes domestic currencies to plummet.

Thankfully the rupee’s decline is relatively gradual and orderly, and was overdue anyway. This is because in inflation and trade adjusted terms, the rupee had strengthened by more than 20 percent in the past four years. During these four years the cumulative inflation in the country was at least 20 percent. So, the rupee should have lost value, not gained. No wonder India’s export growth has been zero over the past four years. In the same period imports, especially from China have surged. Chinese currency had weakened relative to the rupee, giving it the import advantage. Hence the current gentle crossing of the (mental) barrier of 70 is to be welcomed. So long as the exchange rate movements are gradual and not volatile it is not a big worry. The downward movement is just keeping pace, belatedly with the inflation differential with the dollar world. And exporters and domestic industry besieged by cheap imports, will breathe easy at this new level. Don’t worry, the nation’s prestige is safe, and the exchange rate will certainly not harm it anyway!

(The author is an economist and Senior Fellow, Takshashila Institution)