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Currency Economy- A Case of Volatile Rupee

Dr. Aditi A. Mahajan , Associate Professor Atharva Institute of Management Studies, Mumbai Sanket Baheti, Student, (MMS, Semester-III) (Atharva Institute of Management Studies, Mumbai)

Abstract

The current exchange rate regime in India, known as managed float has evolved through long process of searching for an appropriate policy regime for India. However, the bubble arising out of speculation plays a major role in determing exchange rate in short run. the present scenario about exchange rate fluctuations in India has been caused to a large extent by deteriorating current account balance and the adverse expectations associated with it.

While India has side-stepped crises of this kind after 1990, it has periodically faced difficulties in managing the rupee in the face of such flows The rupee has found itself a new low level in relation to the US dollar and the British pound, and seems likely to depreciate even further. Few years ago, the Indian rupee stood at a then strong Rs 44.5 to the dollar. At that level, the rupee had appreciated by more than 13 per cent vis-a-vis the dollar over the preceding months This raises the question as to why the rupee is showing signs of growing weakness. Open doors to foreign financial investors are known to generate currency instabilities and crises in most developing economies. This seems to be true in the recent period as well, but in a rather peculiar way. Foreign capital inflows Among the main forms of foreign capital inflows that can influence the availability of foreign exchange in the country are gross inflows of direct investment, which are considered to be of the long-term kind, and portfolio flows, which are considered to be more short-term and purely financial in nature. If we consider the sum of both direct and portfolio investment inflows into India, RBI figures suggest that they stood at $62 billion in financial year 2007/08, collapsed to $28 billion during the year of global crisis 2008/09, and then bounced back to $70.1 billion in 2009/10, $64.4 billion in 2010/11 and close to $60 billion during the first 11 months (April-February) of 2011/12.

This point to a puzzle. If aggregate investment flows are seen as influencing the value of the rupee, the depreciation of the rupee in crisis year 2008/09, from less than Rs 40 to the dollar to Rs 59 to the dollar, is explained well by the figures, which point to a significant decline in the volume of capital inflows into the country during that period. Speculative flows However, it is observed - strong relationship between movements in short-term, and therefore more speculative, portfolio flows is interesting point. Portfolio inflows stood at $27 billion in financial year 2007/08, a negative $14 billion during the year of global crisis 2008/09, implying an outflow in that year, and then rose to $32.4 billion in 2009/10 and $31.5 billion in 2010/11 However, these short-term flows fell again to $18 billion during the first 11 months (AprilFebruary) of 2011/12. Thus, if at all foreign investment flows can explain the fall in the rupee in recent months, it is only one component of such flows that could be held responsible: short-term financial flows. One implication of this relationship between movements in speculative foreign capital and the depreciation of the rupee could be that changes in the value of the currency are being driven by speculative factors. Whenever the Reserve Bank of India intervenes in the market to buy or sell dollars to counter the influence of such speculative forces, the rupee displays some stability. When it does not, the rupee tends to fluctuate sharply, being overwhelmed by speculation. Consider, for example, the appreciation of the rupee that occurred when India experienced a sharp increase in capital inflows over the year before March 2011. The surge was explained largely by developments in the developed capitalist countries, where financial investors had access to the cheap liquidity that developed country governments had pumped into the system in response to the financial crisis. India was chosen as one of the favored investment destinations by those investors. Like many other developing country markets, India became a victim of the dollar carry trade, in which international players borrowed in dollar markets, where liquidity was ample and interest rates low, and invested in equity, debt and real-estate in developing country markets, where profit rates were high, in order to make huge profits from the differential between the cost of debt and the return on investment.

Sensex-rupee link The result of such speculative activity was that the rupee's appreciation was also associated with a boom in stock markets driven largely by foreign institutional investment. As a result of speculative investments in the market, the Bombay Sensex stock market index, which had lost much value during the global crisis, rose once again to touch the 18,000 level. The reason was clear. Net portfolio investment inflow into India had revived. Speculation had pushed up both the Sensex and the rupee. Scanning the relationship between the level of the Sensex and the rupee's value over the last five years, we do find a noticeable relationship, with the rupee ruling high when the Sensex is high and settling at lower levels when the Sensex is down. What is interesting, however, is that since early 2009, the gap between the level of the Sensex and the value of the rupee has widened, suggesting that factors other than the mere size of capital flows are affecting the rupee. One possible reason for this enhanced volatility in the rupee relative to the Sensex, which it earlier tracked, could be enhanced speculation in the currency market. To recall, India first permitted trading in currency futures (starting with Rupee-USD futures) on August 29, 2008. Subsequently, trading in currency options was also permitted. It being an instrument settled at a future date whose value is linked to the exchange rate, the perceptions of participants in the futures market influence the spot price or the market exchange rate as well. USA Impact Over the past twenty months, the Indian Rupee has ranged between 57 and 44 Rupees to the U.S. Dollar in the global Interbank market. That range equates to a 23% change in value for large banking transactions. For consumers, however, a typical cross-border transfer will also entail a number of additional fees, as well as a markup that can add another 1% to 10% percent, depending on the type of service used.

Source: The Economic Times In May of 2011, the rate hit a bottom of 44, a high of 57 in June of 2012, and currently sits just below 54. The higher rate actually means that the Dollar has strengthened, while the Rupee has weakened. The Rupee has actually strengthened a bit over the past six months, but forecasts are mixed for 2013 (More about that later). The 23% weakening of the Rupee would also mean that foreign goods would cost more, but if someone in the United States sent Dollars to you, they would now convert to more Rupees, as well. Recent Scenario From the past few months the rupee is showing continuous fall against dollar, but from the month of March it has become quite volatile. Rupee has touched a new high of 61.80 against dollar recently. There has been expectation in the market that the demand of dollar may rise even further, so as to repay the debt. There has been an External commercial borrowing taken by various companies need to be repaid on March 31, 2014 (of around $ 21 billion). The Indian external debt stood $390 billion as on March 31, 2013. Nearly 44.2% or $ 172.4 billion need to be repaid March 31, 2014. RBI suggested that NRI deposits worth nearly $ 49 billion mature on or before 31, March 2014 and NRI are likely to repatriate them rather than renew them. The facts clearly indicate that there would be huge demand for dollar in coming months. On the other hand it has been seen that the source of foreign currency that are coming in India are majorly used to pay off our import bills. The import bill cover of India has just come down to the level of 6 months only, which is considered to be very low. There has been decline in production, the Indian Industrial Production (IIP) is dropping continuously, because of which exports have reduced drastically. Exports have felled to 1.1% to $24.51 billion. The rise in Inflation level as discussed above as also resulted in low growth rate in the country and affecting the currency. The growth rate has been dropped down to level of 5.5% from 5.7% by RBI and

below 5.5% too by many rating agency. The investors are losing confidence in Indian economy and the rating agency has downgraded the equity market of India Inflation raises prices, thereby decreasing the purchasing power of a currency. During 2012, the inflation rate in India hovered between 7% and 8%, a high figure when compared to North America or Europe where 2.5% is more normal. Inflation impacts are part of the reason that the Rupee has fallen in value over the past two years. Further,the Reserve Bank of India (RBI) adjusts banking interest benchmarks from time to time to combat inflation and to attract foreign investment into the country. A higher rate will encourage investors to transfer capital to India, increasing demand for the currency, which in turn strengthens it. The relative difference in rates between countries is what influences forex valuations. At the moment the benchmark rate in India is 8%, while in the U.S., the similar rate is near zero Moreover, GDP growth rates in India have been in decline over the past two years, falling from 8.9% to 5.3% on an annualized basis. India has had to gear back as the recession curtailed demand from most Western countries. Average GDP rates for developed countries over a similar period have been below 2% or flat. The relative change has again put pressure on the Rupee. There are many other factors, but these are the three main ones that drive forex rates. Investors will invest in India if they believe that their net return, the difference between the assets return and forex changes, is acceptable. Capital flowed out of India in 2012. Political shocks can impact currencies, too, but analysts expect the Rupee to remain close to where it is during the coming year. Predicting forex values, however, is very difficult. Measures need to be taken Going to the current economic and political environment of Indian economy there is need to take some crucial important decision so as to improve investment in the country. There is need to have both Green and Brown field investment in the country, for which there is need to reduce political influence. The government also needs to clarify various norms relating to FDIs. Measures need to be taken to improve manufacturing level in the country which will help to improve the growth in the country and also help in increasing export from the country. Measures need to be taken to diversify investment from Gold to other source of investment and also measures need to be taken so as to reduce import of gold in the country. A few measures taken by government and RBI were found to be inefficient to stabilize rupee. Decision should not be taken just to stabilize rupee in short run but these decision should also help in improving rupee in long run too. Norms on export should be liberalized and that on the imports should be tightened. Bibliography: Heinz Riehl, Rita M. Rodriguez, (1977), Foreign Exchange Markets, McGraw-Hill Book Company. Peter Bofinger, (2003), Managed Floating as a Monetary Policy Strategy, Economics of Planning, pg. no. 81-109 Robert Mundell, (2002), The significance of the Euro in the International Monetary System, published in Zegreb Journal of Economics. The RBI- VIII Assessment of Reforms, (2007), available on www.rbi.org.in

The RBI report, the Currency and Finance Report, RBI, (2007), available on www.rbi.org.in Vepa Kamesam, (2001), Forex Markets in India: Some Thoughts, address delivered at the inauguration of the 12 National Forex Assembly organised by the Forex Association of India at Goa on October 26, 2001.

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