Exchange rates are rarely conversation starters, but the recent slide of the rupee has generated huge public interest, even at a time when the fifth season of the Indian Premier League (IPL) gave us such so much to talk about thanks to the wonderful combination of skill and scandal.
The exchange rate is perhaps the single most important price in an open economy, but too many people see the declining value of the rupee as some sort of morality play rather than part of a welcome adjustment for an economy that is living beyond its means, as is evident from the large fiscal and current account deficits.
Here is a quick reality check about the state of the currency.
1. How severe has the fall been? The Indian currency has fallen by 11.55% since 2 February. One could compare this fall with two previous high-profile devaluations when India was struggling with a large trade deficit, high inflation and loss of competitiveness in the international markets.
The Indira Gandhi government had devalued the rupee by a huge 57.5% in 1966 and the Narasimha Rao government had brought down its value by 20%, in two stages. India had a fixed exchange rate regime at that time, so the sudden adjustments were very sharp.
However, the recent fall in the rupee is modest by comparison. Even the 18.15% fall over the past 12 months does not match what happened in 1966 and 1991.
2. What do the long-term trends tell us? The rupee was at 28.97 to a dollar in April 1992 and 48.92 per dollar in April 2002. This means that it has depreciated at a compounded annual growth rate of 3.25% over the past 20 years and 1.16% over the past 10 years.
Economic theory tells us that, in the long run, exchange rates move against each other based on the inflation differential in the concerned economies. India has had much higher inflation than the US over these time periods, and though the rate at which the rupee has depreciated may not exactly match the inflation differential between the two countries, the direction is broadly correct.
3. What should the Reserve Bank of India (RBI) be doing? Unlike countries such as China, our official policy is not to target any particular exchange rate. The Indian central bank has stuck with this hands-off policy, allowing the market to determine the value of the rupee.
One way of looking at the current slide is to consider it an overdue correction after a long period of overvaluation, when the strong capital flows into India sent the rupee soaring. RBI has done well to not target an exchange rate, because recent economic history shows us how difficult it is to defend the value of a currency in a world where capital flows freely across borders.
Famously, the UK had to push interest rates sky-high in 1992 in a bid to stay in the European exchange rate mechanism while Thailand blew up most of its foreign exchange reserves in a bid to protect the Thai baht.
4. So should RBI do nothing? There would be reason to intervene in case the rupee overshoots—as can happen in any financial market—and goes into a free fall. The Indian central bank should also step in if most trading positions have begun to resemble a one-way bet against the rupee. Otherwise, letting the market decide is sensible policy.
However, the central bank has perhaps erred in not building up its foreign exchange reserves adequately in recent years, as a result of which they today cover just seven months of imports compared with 13 months in March 2008. This import cover could halve over the next three years if imports keep growing at current rates. RBI may need to eventually use periods of strong capital flows to strengthen its reserves and buy insurance.
5. Will a cheaper rupee help or hurt India? That will always be a difficult question to answer. Some parts of the economy will benefit while other will get hurt. It is interesting that some of the loudest voices against depreciation come from economic agents that could get hurt—Indian companies that have large dollar debts or foreign institutional investors who have seen their dollar returns shrivel, for example.
But in general, the decline in the rupee should help narrow the trade deficit and boost competitiveness in traded goods and services. There are some who quite reasonably argue that India consumption of its two biggest imports—oil and gold—is not sensitive to prices. So imports may not drop despite a more expensive dollar. That’s a genuine concern, but the experience of 1966 and 1992 suggests that depreciations do lead to better trade balances within a year or two.
6.Will the rupee fall further? Most currency traders are expecting it to stabilize around these levels, or even rise modestly against the dollar. But frankly, nobody can tell for sure. Much depends on what happens in the global economy, and especially in Europe this summer.
Niranjan Rajadhyaksha is executive editor of Mint. Your comments are welcome at email@example.com
Also Read | Niranjan Rajadhyaksha’s previous columns