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Business News/ Opinion / Online-views/  Is rupee depreciation a welcome adjustment for the economy?
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Is rupee depreciation a welcome adjustment for the economy?

Is rupee depreciation a welcome adjustment for the economy?

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Mumbai: The rupee ended at a record low on Friday, closing at 57.12 to a dollar. The Indian currency has been continuously losing ground in recent months, as nervous global investors fight shy of putting money into an economy that continues to run a large current account deficit, the most comprehensive measure of the gap in our trade with the rest of the world.

The rupee has fallen 17.6% against the dollar since 2 February, making it the steepest decline in the value of the Indian currency since it was floated after the 1991 economic reforms. The depreciation is far larger than what we saw during some of the other episodes of economic turbulence in the last two decades, such as the Asian financial crisis of 1997 (13.86%) and the global shock after the collapse of investment bank Lehman Brothers in late 2008 (9.2%).

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The rupee dropped to a new low on Friday, falling below the 57 mark. What’s causing the stubborn decline in the rupee and what does it mean? Mint’s Niranjan Rajadhyaksha tells us.

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The fall of the rupee has inevitably been like a blow in the guts for many, and why not? Its value is perhaps the single most important price in the economy today, for two reasons. First, India is now an open economy, with the total trade in goods and services equal to more than half the gross domestic product.

Second, domestic prices of several tradable goods are closely aligned with prices in the global economy. So the movement in the rupee has huge implications for most parts of the economy—from the landed price of oil to the input costs of steel companies to the export revenues of software companies to the cost of a foreign holiday.

Sandeep Bhatnagar/Mint

Despite the obvious pain it has caused, the fall in the rupee should be considered a welcome adjustment for an economy that has been living beyond its means, with large fiscal and current account deficits that are far higher than in most other major emerging markets. Look at one extreme example: Greece. The Hellenic Republic has been unable to adjust its economy through currency depreciation because it is locked into the common European currency. It may be forced to regain competitiveness by cutting real wages, which is far more painful than currency depreciation.

The sharp dive in the value of the rupee is thus an inevitable adjustment that should hopefully boost exports and curb imports. Some argue quite reasonably that demand for our 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 earlier devaluations—especially earlier adjustments in 1966 and 1991—suggests that depreciations do lead to better trade balances within a year or two.

Many worry that the decline in the Indian currency is a sign of a decline in national power. The long-term data offers a calmer explanation. The rupee has depreciated at a compounded annual rate of 3.78% over the past 21 years and 1.59% over the past 10 years. Economic theory tells us that the trajectory of currencies depends on the inflation differentials between two countries. The rate at which the Indian currency has fallen reflects higher inflation rates in the country.

The long view shows that the decline in the rupee has been modest. What has hurt many is the fact that this journey has not been a predictable one. Long periods of stability have been punctuated with sudden lurches into the valley. Companies and investors who have been lulled into a false sense of security during the long periods of steadiness have been caught on the wrong foot by the sudden lurches, exposing their unhedged positions. Their pain has been the most intense.

RBI has done well to brush aside pressure to support the rupee. The economics driving the value of the currency is too compelling; the recovery in the rupee will be dependent on a host of factors—from a lower fiscal deficit to lower global oil prices to higher export revenues to a strong revival in foreign capital inflows.

The history of central banks trying to defend a particular exchange rate is littered with tragedies, from the Bank of England in 1992 when the pound was part of the European exchange rate mechanism to the Bank of Thailand in 1997 when it burnt its foreign exchange reserves while trying to defend a fixed exchange rate. These central banks also had to push domestic interest rates sky-high to maintain a fixed exchange rate. In fact, the decline in the rupee in recent months has been equivalent to an interest rate cut, and has eased domestic monetary conditions.

It is next to impossible to credibly forecast where the rupee will be in three months. Much depends on the state of the global economy, especially crude oil prices and the ability of global institutions to prevent a blowout in Europe. If you are not a currency speculator, the best ploy is to play safe—and hedge.

niranjan.r@livemint.com

Also Read | Rupee hits all-time low as dollar gains on banks’ ratings downgrade

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Published: 23 Jun 2012, 12:41 AM IST
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