Why sudden rupee dive hits harder than slow weakening

Finance

Rupee,Lira,Turkish Lira

The Turkish lira’s collapse following a US-Turkey trade spat has rippled across emerging economies. The rupee touched a record low of 70.09 per dollar on August 14. The crisis started hitting other emerging market currencies, such as the South African rand and Argentine peso. The lira itself has recovered after strong measures by Turkey. It’s not so much a gradual depreciation of the rupee, but sudden sharp falls and spikes that’s worrisome. It complicates the Reserve Bank of India (RBI)’s task of ensuring an exchange rate that is anchored to an acceptable level.

Issue
According to reference rates given on RBI’s website, the rupee has depreciated 9.4% against the dollar in 2018. The previous worst fall was in September 2013 when global markets threw a so-called “taper tantrum”. At the time, the phrase referred to global markets reacting negatively to the US’s winding down of a policy called quantitative easing (QE), deployed to manage the 2008 recession. Quite simply, QE is the injection of fresh money into the economy.

A falling currency makes imports costlier because more rupees are needed to buy the exact same good. This stokes inflation. India is a big importer of oil. A weakening currency also worsens the current account deficit. In a rough-and-ready sense, a country’s current account shows how much foreign exchange it spends abroad (mainly to fund imports) vis-à-vis how much foreign exchange it earns. When a country spends more foreign exchange than it earns, it is said to run a current account deficit. This deficit is mainly financed by a country’s foreign exchange reserves. India’s current account deficit increased from 0.7% of the GDP to 1.9% of the GDP between 2017-18 and 2018-19. Higher oil prices and depreciating rupee could add to this trend.

Significance
A currency strengthens, or becomes expensive, when there is more demand for it by investors. It loses value against the dollar when its demand falls, especially when investors sell assets held in that currency. By textbook economics, a weaker rupee should push up export earnings because exporters get more dollars out of every rupee worth of exports. But the real world often functions differently. According to a 2013 study — ‘Does Weak Rupee Matter for India’s Manufacturing Exports?’ by NR Bhanumurthy of the National Institute of Public Finance and Policy — a weaker rupee doesn’t always push up manufacturing export earnings. India is competitive when it comes to exports of services, such as IT support, but when it comes to manufacturing items, it’s beaten by others. So, this bout of the rupee’s fall may not bring sizeable exports gains.

Debate

India has sufficient foreign-exchange reserves to rein in extreme volatility in the rupee. However, there’s another debate going on — whether the rupee is undervalued or overvalued. In other words, do recent levels of ₹66-68 per dollar make the rupee too low or too high? Countries manage their exchange rates in three ways: fixed, float and managed float. Very few countries use the first option, which ‘fixes’ the currency to a certain level. Neither do nations use the second option, which is to allow exchange rates to ‘float’ freely, dictated only by market forces. RBI typically uses the ‘managed float’ option. This refers to a policy of allowing the rupee’s exchange rate to move up or down according to supply-demand conditions in the foreign exchange market. When needed, RBI intervenes mainly by selling dollars from its reserves to ensure the rupee does not stray too far. Last month, NITI Aayog vice-chairman Rajiv Kumar said the rupee was overvalued by 5-7%. There exists, on the contrary, a well-known school of thought that argues the rupee is undervalued. Settling this requires a reassessment of something far more relevant: India’s “real effective exchange rate” or REER. This is the inflation-adjusted, weighted average of India’s bilateral exchange rates with a basket of some 36 currencies it trades most with. REER shows how competitive the rupee is. Going by this trade-weighted rate, the Indian currency has actually gained strength between 2014 and 2018. That should be a sign of relief.

Written by admin