Basics explained: Why does the Rupee fall?

The rupee has been making headlines the past few months after it dropped to its lifetime-low of 68-to-a-dollar levels. Jokes were being forwarded that the rupee has retired.

The valuation of a currency is important, especially in an import-dependent country like India. It is always fixed against another currency and follows the basic demand-supply-price dynamics. Higher the demand, greater the value.

In such a case, to understand the rupee’s fall, one needs to identify stress factors that hamper demand.
Here are some:

1) Sentiment: A big part of trading is sentiment. This is nothing but investors’ expectation about the future prospects. A dampening of sentiment, thus, causes traders to sell and leads to a fall in the valuation.
India’s economy has grown at the slowest pace in a decade.

Growth in the economy has fallen from a peak of 9% to sub-5% levels. And this slowdown is expected to continue. In contrast, investors are happy with the recovery in the US economy. Hence, the preference for dollars over the rupee.

2) Speculation: Traders try to guess the rupee’s value over a certain period of time on the basis of various factors. This is called speculation. This is done so by betting using currency futures – a derivative instrument. Speculation affects the underlying value of the rupee.

3) Current account deficit: Current account deficit (CAD) is when a country’s payments to other nations exceed the amount it receives. This is predominantly led by a huge import bill. Since the payments are in foreign currency, it means sale of rupees. Higher selling leads to a fall in value. In the last five years, India’s current account deficit has risen more than 10-fold.

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4) Fiscal deficit: Fiscal deficit is when the government spends more than it earns. This means high debt. Fiscal deficit and CAD are together called ‘twin deficits’, which the government is frantically trying to curb. While developing countries are expected to have a higher deficits, too much debt increases risks.

5) Monetary policy: The Reserve Bank of India (RBI) regularly monitors India’s monetary policy by deciding lending rates and regulating the banking sector. This indirectly affects corporates, the economic growth, and thus, the valuation of the rupee.

The RBI’s first priority is to tackle high inflation. For this purpose, we have had a high interest rate regime for the past few years. In contrast, the US has had near-zero rates since the 2008 crisis to fuel demand and growth.

The RBI also regularly intervenes in the foreign exchange market to curb fluctuations. It sells dollars from its forex reserves. This is a temporary measure to halt the slide of the rupee by creating artificial demand.

Slideshow - Most traded currencies in the world
This currency is among the world’s dominant reserve currencies and is most used in international transactions. Abbreviated as US$, United States dollar is the official currency of the United States ... more 
This currency is among the world’s dominant reserve currencies and is most used in international transactions. Abbreviated as US$, United States dollar is the official currency of the United States of America. It is divided into 100 smaller units called cents and Greenback is the nickname of the currency.

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Yahoo Finance India
Fri 21 Dec, 2012 9:30 AM IST


6) Inflation: India has battled high inflation for many years. Retail inflation, measured by the CPI, has hovered in double digits. This hampers everything – from individual budgets to industry and economy. For this reason, investors prefer to buy the currency of a country with lower inflation. In the US, inflation is barely 2%. Another reason for the dollar-rush.

7) Economic growth: The economy is measured by the Gross Domestic Product (GDP). A growth in GDP signifies expansion. Higher the growth, greater the value of an economy, and consequently more demand for its currency. India’s GDP growth forecast has been downgraded by analysts worldwide from over 6%-levels to 5%-levels.

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