Fall of Indian Rupee in the Global Market

I was discussing this current trend with one of my friends, and found that I had a naive understanding of the dynamics of the global market. So I did some basic research, and will list down my findings, so that others in my state can benefit out of it.

The discussion started when we saw the newspaper clipping which read that rupee had fallen to a 2 year low against US Dollar. What surprised me the most was "Why the hell is the rupee value falling, when it should have been the other way around? The US market is at its worst, India is not hit as badly as the US, Indian companies are still making a 2 digit growth, then what was the reason for the falling rupee." And to my surprise there was a perfectly valid reason for this.

As I write this, the rupee is trading at 47.2 to a dollar. To put this into some perspective, it was 39.3 to a dollar in January 2008. That is a 20% increase in the value of the dollar in 10 months. Just to illustrate this point, it was not too long ago, the Indian Software giants were sacking people, just because they could not cope with the increase in the value of the rupee to a dollar, which resulted in them getting lesser income for the same client billing.

Let me just give a small description of my understanding on how this index is created. It is calculated as the amount of foreign investment in another country, i.e Amount of Dollars invested in India to the amount of Rupee invested in US. There are many participants in any foreign exchange market. These entities -- like banks, corporations, brokers, even individuals -- buy and sell currencies everyday. Here too the universal economic law of demand and supply is applicable: when there are more buyers for a currency than sellers, its exchange rate rises. Similarly, when there are more sellers of a particular currency than buyers, its exchange rate in the global markets will fall. This does not mean people no longer want money; it only means that people prefer to keep their wealth in some other form or another currency

With this knowledge let me list out the main reasons for the fall in Rupee:

1. The main reasons behind the fall of the rupee are an increased demand for dollars due to a spurt in crude oil prices and the flight of foreign funds from the Indian market (the market situation in India is growing grim by the day, with the main index BSE going below the 12,000 mark as I write this). Demand for rupees, simultaneously, has dipped because capital inflows are down. The American sub-prime crisis that shook the global financial markets has seen unprecedented bailouts and infusion of dollars into the US economy. This infusion has been at a cost of many an emerging market, from where funds have been pulled out to plough back into America. India has been one of the worst hit countries on this count, as foreign funds took flight, thereby making dollars scarce. The sudden and colossal demand for the US dollar has seen it strengthen, while the rupee's exchange rate has depreciated dramatically during the same period. India's stock market regulator, the SEBI, has said that foreign investors sold more Indian shares than they bought.

2. The higher price of imported goods, especially oil that is now ruling at over $90 per barrel, has also led to an increase in domestic inflation and a fall in the value of the Indian currency. High inflation and a strong growth in the Indian economy have already forced the RBI to raise interest rates. The inflation is hovering around 12% mark for the past 2 months.

3. One more reason for the fall of the rupee, as propounded by some economists, is the overseas non-deliverable forward (NDF) market that is not sanctioned by the Reserve Bank of India. An NDF is a non-deliverable forward contract where financial institutions buy forward dollars (that is, they book dollars now for delivery at a predetermined future date) in the Indian market and at the same time sell a similar amount of dollars in an overseas market -- or vice-versa -- so that on the delivery date they make a profit or loss, which is the difference between both the rates.

So what is the conclusion of this? Who gets affected, and more interestingly who is under loss and who is gaining out of the current situation?

As the rupee falls, foreign investors will want bigger returns for their money to compensate for the higher risk. This means that the Indian government, companies and individuals will have to pay more for the money they borrow: in other words, higher interest rates. This will also mean that Indian Govt will have to pay that much more for the foreign loans, like from the World Bank. This could further deter foreign investment, which results in a cumulative effect (people stop investing because the rupee is devalued which is a result of foreign players divesting).

So how do we reverse this trend?

One measure that can be taken by the RBI, is to change the interest rates, so that value of the rupee is appreciated in the global market. Another thing is for RBI to sell US greenbacks in the open market, thereby getting this situation under control momentarily and stopping the spiraling downward trend.
But the best thing to happen is to hope for a bull run in the market, similar to the one we had in 2007. This will ensure that there is more foreign investment, and as a result the demand for dollar falls, and strengthens the rupee considerably.