The Dance of Exchange rate

What affects exchange rate?

The exchange rate is a function of demand and supply of currency. Basically, anything that increases the demand of your currency will appreciate it. For example, if a country imports lot of oil, it will require dollars to pay for the imported oil and therefore will increase the demand of dollar and consequently dollar will appreciate. This is what is happening in India, oil import and gold import has swelled the current account deficit and led to rupee depreciation.

Another major factor analysts attribute to rupee depreciation is outflow of capital account, with FIIs continuously pulling money out of capital markets. Since January this year, FIIs have pumped in close to Rs 70,397 crore into the Indian equity market. The analysts speculate that US Fed chairman Ben Bernanke’s comments about the ‘necessity’ of the stimulus programme for the recovery of the US economy will encourage FIIs to invest again in emerging market equities such as India. But with the fears of a pullback in US monetary stimulus, combined with the lack of economic pick-up in India and a falling rupee, overseas institutions have started to reduce their exposure to Indian Capital Market.

                           *till July 12 2013                                                                Source: SEBI

Effects of appreciation/depreciation of home currency

Different sectors are affected in different ways by depreciation of currency. Sectors having foreign exchange receivables (like IT companies and other exporters) tend to benefit from home currency depreciation. On the other hand, sectors that are exposed to forex payables (oil & gas, gems and jewellery) will benefit from the appreciation of home currency.  

         

Role of central bank in such a situation

The central bank didn’t intervene to influence exchange rate unless it saw a major threat to the macroeconomic stability via excessive volatility. Rupee losing its value by over 13.5% in past nine weeks triggered RBI to take preventive actions. The policy measures used to prevent downward movement of currency focus on the following:

·         Interest rates: repo and reverse repo

·         Quantitative variables:  Intervention, liquidity absorption or injection, and cash reserves.

·         Communication variables: Review and speeches.

Apart from this, it will also help to deter the rising inflation. The following are the measures taken by RBI to curb the phenomenon:

1. Gradual increase in import duty on gold, in stages, to 8%, to restrain import. The efficacy of the step is questionable: it may encourage smuggling and divert remittances from official channels to hawala channel, with small benefit to CAD.
2. The Reserve Bank of India (RBI) ordered state-owned oil companies to buy dollars from a single public sector bank as regulators on July 09, 2013. This helped in decreasing the demand of dollar as only one public sector bank would maintain the dollar reserve.
3.  The rupee advanced 0.8% to 60.15 per dollar late Monday after RBI barred banks from proprietary trading in currency futures and exchange-traded options with market regulator Securities and Exchange Board of India (SEBI) announcement that separately it will raise margin requirements and cap open positions in such contracts.
4. The Marginal Standing Facility (MSF) rate is recalibrated with immediate effect to be 300 basis points above the policy repo rate under the Liquidity Adjustment Facility (LAF). Consequently, the MSF rate will now be 10.25 per cent.Accordingly, the Bank Rate also stands adjusted to 10.25 per cent with immediate effect. The overall allocation of funds under the LAF will be limited to 1.0 per cent of the Net Demand and Time Liabilities (NDTL) of the banking system, reckoned to be Rs.75,000 crore for this purpose. The allocation to individual banks will be made in proportion to their bids, subject to the overall ceiling. This change in LAF came into effect from July 17, 2013.
5. The Reserve Bank will conduct Open Market Sales of Government of India Securities of Rs.12,000 crore on July 18, 2013, which will pull rupee liquidity out of the system.

As an immediate impact, overnight rate which is around 7%, will shoot up. Banks will now think several times before making fresh loans or even rolling over existing ones because they will want to conserve liquidity as much as possible. Already, the system has seen a deceleration of credit growth to a point where it has dropped below deposit growth. Further constraints could well bring credit flows to a crawl, making life even more difficult for businesses in an already sluggish environment.

The rationale for squeezing rupee liquidity is basically to make the rupee scarcer and, therefore, more valuable, both in terms of its procurement cost (the interest rate) and in relation to other currencies (the exchange rate). This seems to be sound theoretically, but for revaluation to happen, the higher domestic interest rates have to induce greater inflow of foreign currency into the economy. This may happen through higher investment in domestic debt by FIIs in short term. However, if we see to equity flow just the opposite will happen. Equity investors would see higher interest as a deterrent to growth impulses existing in the economy, leading to equity sell-off. This would put downward pressure on the rupee. Thus, it is not clear what has been achieved by the measures taken by RBI. The net result would actually increase the vulnerability by shifting the country’s international exposure towards debt.  

With all said and done, the right question to ask here is whether the current exchange rate is sustainable or not. Rajwade in his article (Economic & Political Weekly, 20 July 2013) has argued that present rate does not seem to be sustainable.  He cited a recent (July 2012) paper by Joseph Gagnon of the Peterson Institute for International Economics to address the issue of managed/ floating exchange rate:

“Currency manipulation occurs when a government buys or sells foreign currency to push the exchange rate of its currency away from its equilibrium value or to prevent the exchange rate from moving toward its equilibrium value. The equilibrium value of a currency is that which is sustainable over the long run.… An exchange rate is sustainable if the current account balance is not generating an explosive path for net foreign assets relative to both domestic and foreign wealth. Sustainability generally implies a small value of the current account balance, but fast-growing economies can maintain moderate current account deficits as long as the associated liabilities do not grow faster than their economic output.”

While nominal rate calculated by Rajwade came to be Rs. 70+, which matches with estimates of Nomura and SS Tarapore(in his speech, “Macroeconomic Perspectives in Volatile Forex Markets”), RBI is trying to maintain it around Rs. 60. As recently as 2006-07, the deficit was below $ 10 bn or around 1% of gross domestic product (GDP). It has since increased each year, to reach close to $90 bn by the end of 2012-13, or nearly 5% of GDP. In the process, net external liabilities have jumped from $40 bn (5.7% of GDP) in 2004-05 to $300 bn (16.2% of GDP) at the end of March 2013. Thus in case of India, conditions of sustainability is not met nor does the present rate seem sustainable.

References:

1. http://www.epw.in/system/files/pdf/2013_48/29/External_Sector_Growth_and_the_Exchange_Rate.pdf
2. http://www.business-standard.com/article/finance/rbi-moves-in-to-check-rupee-volatility-113071501064_1.html
3. http://www.business-standard.com/article/finance/rbi-squeezes-liquidity-113071600034_1.html
4. http://www.business-standard.com/article/finance/rising-inflation-dollar-demand-by-importers-keep-rupee-weaker-113071500142_1.html
5. http://www.business-standard.com/article/markets/fii-outflows-slow-on-fed-stimulus-talks-rupee-113071200880_1.html
6. http://www.learnwithflip.com/FLIP/FBNewsletter/Currency_Movements.pdf
7. http://www.business-standard.com/article/opinion/liquidity-trap-113071601109_1.html
8. http://articles.economictimes.indiatimes.com/2013-06-27/news/40233655_1_current-account-deficit-rupee-depreciation-monsoon-session

“This article is written by Anupriya, a PGPM student of 2012-14 batch of IIM Raipur. She can be reached at pgp12063.anupriya @iimraipur.ac.in".

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