rupee volatility, causes, effects, & remedies

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Project Report on

“Rupee Volatility, Causes, Effects and Remedies”

SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENT OF DEGREE OF MASTERS IN FINANCIAL MANAGEMENT (MFM) FROM

THE UNIVERSITY OF MUMBAI

SUBMITTED BY

Maitreya Rajendra Sheth

MFM Semester V (2011-2014)

UNDER THE GUIDANCE OF

Prof. Jyotsna Arya

N.L. DALMIA INSTITUTE OF MANAGEMENTSTUDIES AND

RESEARCH, MIRA ROAD (E)

THANE – 401 104

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CONTENTS

Sr. No.

Topic Page

Number

1 Certificate 3

2 Acknowledgement 4

3 Executive Summary 5

4 Introduction 7

5 Price Data 10

6 Causes Behind The Volatility 12

7 Effects of The Volatility 17

8 Possible Remedies 21

9 Conclusion 25

10 Bibliography 26

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CERTIFICATE This is to certify that Mr. Maitreya Rajendra Sheth, student of MFM

Semester V – Finance, of N.L. Dalmia Institute of Management Studies

and Research, has successfully completed the Final Project on “Rupee

Volatility, Causes, Effects and Remedies”, under our guidance

and supervision as partial fulfillment of the requirement of MFM course,

2011- 2014.

Project Guide Director

Prof. Jyotsna Arya Prof. P.L. Arya

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ACKNOWLEDGEMENT

I would like to express my gratitude towards Prof. Jyotsna Arya, who

had been very supportive as a guide to my efforts in making the project

work a successful one.

I also extend hearty thanks to Prof. P.L. Arya, Director of the institute

for approving our efforts in making the project a success.

“Last but not the least”, I would also like to thank all our institute

faculties and friends, who were helpful to me in whatever little way they

would.

Maitreya Rajendra Sheth

Masters in Financial Management (MFM)

N.L. Dalmia Institute of Management Studies and Research

Batch 2011 – 2014.

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EXECUTIVE SUMMARY

“The primary role of the central bank, as the Act suggests, is monetary

stability, that is, to sustain confidence in the value of the country’s money.

Ultimately, this means low and stable expectations of inflation, whether that

inflation stems from domestic sources or from changes in the value of the

currency, from supply constraints or demand pressures.” (Dr. Raghuram Rajan,

Governor of The RBI in his opening statement after taking charge as the

Governor of RBI on 5th September 2013.)

One cannot over-emphasize the need for a stable currency for the overall

economic wellbeing and development of a country. Especially for a developing

economy like India, with its huge dependence on crude oil imports and FDI and

FII money to meet its capital requirements, it is imperative to have a stable

currency.

Steep depreciation of the currency increases the cost of imports thereby

fuelling inflation, which is already high in India. It also causes huge losses to

investors and results in their losing confidence in the country as an investment

destination.

Steep appreciation of the currency reduces the export competitiveness of

the industry which results in slower economic growth and loss of employment for

millions of workers.

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It becomes more expensive for corporations and industrial houses to

borrow from overseas markets to fund their capital requirements. Servicing the

debt as well as repayment can be severely impacted due to large swings in the

currency price.

There are various factors which are responsible for the unprecedented

volatility seen in the INR over the last few months.

I hope to identify and analyze the factors responsible, the effects on the

economy and also possible remedies for the volatility in the Indian Rupee over

the course of this report.

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INTRODUCTION

The Indian Rupee has become the most volatile currency among the 48

currencies tracked by Bloomberg between May 2013 and September 2013.

Three-month implied volatility, a measure of expected moves in the exchange

rate used to price options, jumped 649 basis points this quarter to 19.14

percent, the highest among 48 global currencies tracked by Bloomberg. The

rupee has plummeted 18 percent this year in Asia’s worst performance.

From being one of the more stable Emerging Economies’ currency, to

have the dubious distinction of being the most volatile currency has shaken the

confidence of the investors and the common man alike.

From a low of 53.7355 against the USD in May 2013 to a high of 68.3611

in September 2013, the Indian Rupee has certainly travelled a long way. A

sudden depreciation of 27.21% over a period of just four months has

tremendous systemic repercussions.

Most of the economists were unable to predict the sharp fall in the INR

that began in May 2013. Former Deputy Governor of The RBI, Mr. S.S.

Tarapore was one of the very few who got it right when he said in a column

published in The Hindu Business Line on January 24, 2013: “With the inflation

rate persistently above that in the major industrial countries, the rupee is clearly

overvalued. Adjusting for inflation rate differentials, the present nominal dollar-

rupee rate of around $1 = Rs 54 should be closer to $1 = Rs 70. But our macho

spirits want an appreciation of the rupee which goes against fundamentals.”

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Rajeev Malik of CLSA said something along similar lines in a column

published on ‘www. Firstpost.com’ on January 31, 2013. “The worsening current

account deficit is partly signalling that the rupee is overvalued. But the RBI and

everyone else are missing that clue,” he wrote. The current account deficit is the

difference between total value of imports and the sum of the total value of its

exports and net foreign remittances.”

So why did anybody else, including The RBI and The GOI not see or

predict what was so clear to these two eminent economists? Why was

everybody caught unawares by the steep fall and volatility in the INR?

In all likelihood all the economists and analysts, including The RBI were

victims of the ‘Herd Mentality’ prevalent in the financial markets. Everybody

wanted to stick to the majority safe view and ignored the views of the minority

who thought the INR was overvalued.

What triggered the fall was the statement by Mr. Ben Bernanke, Chairman

of The US Federal Reserve that they were likely to taper the massive asset

purchase program (QE3) in the near future.

This event triggered a fall which soon cascaded into a free fall due to the

Domino Effect. All the Macroeconomic and Microeconomic concerns suddenly

became visible to everybody and soon the panic started to spread among

investors, both in India and abroad. The Government of India and The RBI took

extraordinary measures to stabilize the INR but it kept falling to new lows every

day.

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The INR hit its all time low price of 68.83 against the USD on 28th August

2013, a depreciation of 27.21% to its highest value in May 2013. Since then it

has regained a lot of lost ground due to delay in tapering of QE3 by The US

Federal Reserve and various measures taken by The RBI and The GoI. It

currently trades at 61.90 against the USD, an appreciation of 10.06% from its all

time low price.

This kind of volatility in such a short span of time can be very damaging to

the economy and people’s confidence in the currency. We are going to look at

all the factors that played a part in the price movement of the INR against the

USD.

We will also try to identify its effects on the economy. Finally we will try to

explore possible remedies to prevent a repeat of this episode in the future.

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PRICE DATA

Historical High / Low price chart USD/INR

From October 2001 to September 2013

As we can see from the above chart, the INR has been trading in a broad

range of 40 – 50 against the USD for the 10 year period between 2001 – 2011. It

has been fairly stable for the most part, except for a period of appreciation

between 2006 – 2007 due to massive capital inflows that fuelled the equity

markets rally, and a period of depreciation between 2008-2009 due to the Sub-

prime crisis.

From 2011 onwards, the INR started to depreciate significantly with

volatility levels also going through the roof. It culminated into the recent period of

extreme volatility between May 2013 – September 2013.

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One Year High / Low price chart USD/INR

From October 2012 to September 2013

This one year chart from October 2012 to September 2013 shows the

sudden spurt in volatility from May 2013 onwards. The spread between high and

low prices has widened significantly.

CAUSES BEHIND THE VOLATILITY

1. Widening Current Account Deficit:

Occurs when a country's total imports of goods, services and transfers

greater than the country's total export of goods, services and transfers. This

situation makes a country a net debtor to the rest of the world.

CAD are not necessarily bad for a developing economy if the GDP growth is

strong. Weak GDP growth coupled with a high CAD is a recipe for disaster.

India’s Current Account Deficit (CAD), widened from USD 6.3 billion

in Q4 - 2010-2011 to USD 32.63 billion in Q3

boggling jump of 5 times over the period of less than two

CAUSES BEHIND THE VOLATILITY

Widening Current Account Deficit:

Occurs when a country's total imports of goods, services and transfers


situation makes a country a net debtor to the rest of the world. High levels of


owth coupled with a high CAD is a recipe for disaster.


2011 to USD 32.63 billion in Q3 – 2012-2013. This was mind

boggling jump of 5 times over the period of less than two years.

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Occurs when a country's total imports of goods, services and transfers is


High levels of


owth coupled with a high CAD is a recipe for disaster.


2013. This was mind

years.

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2. High Consumer Inflation:

Consumer Price Inflation (CPI) is the internationally accepted indicator to

monitor price levels in the economy. The purchasing power of a currency is

determined by the CPI.

Persistently high CPI over the last four years is one of the major reasons

behind the depreciation of the INR. CPI levels of above 10% on a sustained

basis do irreparable harm to the economy in general and the value of the

currency in particular.

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3. Massive rise in Short Term External Debt:

Foreign Currency Debt having residual maturity of less than one year is

classified as Short Term External Debt. High levels can cause a mismatch in

liquidity flows and volatile currency movements.

India’s Short Term External Debt rose from less than USD 5 billion at the

end of 2004 to more than USD 60 billion at the end of 2012. Since the debt

has to be repaid over 2013, there was a sustained rise in demand for the

USD.

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4. Growth Slowdown:

Foreign portfolio investments via Foreign Direct Investment (FDI) and

Foreign Institutional Investment (FII) are dependent on the GDP growth of the

country.

From a peak of 11.40% growth in March 2010, India’s GDP growth has

nosedived to 4.40% in the quarter ended June 2013. This has resulted in a

significant reduction in foreign portfolio investment and subsequently reduced

the supply of foreign exchange in the market.

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5. High Fiscal Deficit:

A country’s fiscal health is measured by the Fiscal Deficit of the country. It

is a very important indicator for foreign investors to decide whether to invest

in a country or not. High levels of Fiscal Deficit discourage them from

investing in a country. A high Fiscal Deficit also causes inflation, higher

interest rates and lower GDP growth.

India’s Gross Fiscal Deficit surged from Rs. 1269 billion in 2007-08, to Rs.

5209 billion in 2012-13, an increase of 310% over a period of 5 years.

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EFFECTS OF THE VOLATILITY

1. Loss of Investor Confidence:

Investors, both domestic and foreign want a stable currency to encourage

them to invest in a country.

A volatile currency scares away investors from investing in the country.

Domestic investors look to invest in safer physical assets like Gold and Real

Estate if there is volatility in the currency.

Foreign investors avoid investing in a country with volatile currency and

divert their investments to other countries.

2. Rise in Inflation:

Depreciating rupee increases the cost of imports which has a direct

bearing on the inflation. Basically import of goods becomes costlier whenever

rupee depreciates and no wonder it makes impact on our day to day life as

we are consumer of imported products.

We have already felt the pinch of it as petrol and crude prices have been

increased in past few months. But the worst is yet to come. Cost of crude

import is bound to go up with the fall in value of Indian currency.

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Every fall in rupee is an invitation to inflation, unless managed well by the

regulator. Increased inflation means more expenses which in turn has

potential to impact the financial planning process.

3. Higher Interest Rates:

The Reserve Bank of India (RBI) has left no stone unturned to control fall

of rupee against dollar. The measures taken have been very harsh ranging

from limiting access to liquidity adjustment facility, to increasing rates on

marginal standing facility to higher average maintenance of cash reserve

ratio (CRR). Banks have been made to feel the pinch of shortage of liquidity.

The 10 year G-SEC yield has gone up from 7.10% to as high as 8.5%. Left

with very limited options now, if rupee continues to slide due to a combination

of internal and external conditions, RBI will have no option but to raise repo

rate.

Raising repo rate will tantamount to pressing panic button. If repo rate

goes up, banks will not hesitate to pass it on the customers unlike what they

do when rates fall. The situation seems to have just reversed from what it

used to be three months back when everybody was expecting interest rates

to fall. This transition is purely because of fall in the value of rupee.

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4. Slowdown and Job Loss:

Falling rupee is a recipe for slowdown in economic growth. If the fall

of rupee continues, the foreign investment will dry in India thereby creating

a gap between investment required for growth and the actual investment

made. This may not happen in immediate future, but this cannot be ruled

out altogether.

Consistent fall in rupee may also take hot money i.e. FII out of India.

While the domestic investment in slowing down at a fast pace, slowdown

of foreign investment at this juncture will strongly impact economic growth.

Slowdown does not just impact the creation of jobs it also has potential to

create job losses.

5. Increase in the cost of education:

Increasing cost of education is not just going to impact those who go

out of India to acquire post graduation qualification or specialized

education, but also to those Indians who want to be in India and acquire

higher education.

Today many students in India write examinations like CFA, CPA,

CAIA, ACAMS etc. to acquire educational qualifications. Many

certifications in information technology are also acquired through distance

learning and online mode in India which requires payment of money in

dollar terms.

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So the falling rupee may hurt plans of many India based students

who wish to acquire international qualifications based in India.

6. High Fuel Prices:

A weak rupee will increase the burden of Oil Marketing Companies

(OMCs) and this will surely be passed on to the consumers as the

companies are allowed to do so following deregulation of petrol and partial

deregulation of diesel.

If the OMCs increase fuel prices, there will be a substantial increase

in overall cost of transportation which will stoke up inflation.

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POSSIBLE REMEDIES

There is no ‘Magic Wand’ to fix the current situation that India finds

itself in as said by Dr. Raghuram Rajan, Governor of The RBI.

Both the Government of India and The RBI need to make concerted

efforts and take concrete steps to tide over the crisis and prevent a

recurrence in the future.

We must undertake long term reform process for our economy rather

than looking for quick-fix solutions which do not solve the problem in the

long run.

As the Governor of RBI said, “we must make our economy bullet

proof to prevent a recurrence of this crisis.”

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1. Measures by RBI

A. Using Forex Reserves:

RBI can sell forex reserves and buy Indian Rupees leading to demand

for rupee. But using forex reserves poses risk also, as using them up in large

quantities to prevent depreciation may result in a deterioration of confidence

in the economy's ability to meet even its short-term external obligations. And

not using reserves to prevent currency depreciation poses the risk that the

exchange rate will spiral out of control.

Since both outcomes are undesirable, the appropriate policy response

is to find a balance. Recent data shows that RBI had indeed intervened by

selling forex reserves selectively to support Rupee.

B. Raising Interest Rates:

The rationale is to prevent sudden capital outflows and ultimately lead

to higher capital inflows. But India’s interest rates are already higher than

most countries. This was done to tame inflationary expectations. So further

raising interest rates would lead to lower growth levels.

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C. Make Investments Attractive- Easing Capital Controls:

RBI can take steps to increase the supply of foreign currency by

expanding market participation to support Rupee. RBI can increase the FII

limit on investment in government and corporate debt instruments. It can

invite long term FDI debt funds in infrastructure sector. The ceiling for

External Commercial Borrowings can be enhanced to allow more ECB

borrowings.

D. Separate Forex Window for Oil Marketing Companies:

The Oil Marketing Companies, (IOC, HPCL, BPCL) are the biggest buyers

of foreign exchange in India. Their persistent demand for USD creates

demand – supply mismatch in the market and triggers volatility.

The RBI has already taken this step on 28th August 2013 and since then

the INR has appreciated by more than 10% against the USD. The volatility

index has also gone down from 28% to 22%.

This is not a long term solution for the core problem but it gives breathing

space to The RBI and The GOI to take more long term measures.

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2. Measures By The Government of India:

Government should take some measures to bring FDI and create a

healthy environment for economic growth. Key policy reforms that should be

initiated includes rolling of Goods and Services Tax (GST), Direct Tax Code

(DTC), FDI in aviation and retail, Companies Bill and diesel decontrol. Efforts

should be made to invite FDI but much more needs to be done especially

after the holdback of retail FDI and recent criticisms of policy paralysis.

The government took steps recently to loosen rules for portfolio

investment in the Indian market, indicating its desire to sustain external

inflows. The measure to increase External Commercial Borrowings (ECB) to

$10bn will help in borrowing in dollar at a less cost. It may take similar steps

to encourage FDI as well, helping sustain external funding.

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CONCLUSION

The recent depreciation and volatility in the value of the INR has hit the

country very hard. It has created additional problems for an economy which is

already grappling with a slew of problems of its own.

In a country where inflation is already running near double digits (CPI), a

falling currency makes imported goods costlier. With the kind of dependence

we have on imported crude oil, any fall in the currency makes it more and

more expensive to import crude oil. This is bound to result in higher inflation

going forward.

For a developing country like India, huge amount of foreign capital is

required to fund its infrastructure an industrial development. A depreciating

and volatile currency scares away the foreign investors and it starves the

country of its capital requirement.

We need to fix this problem with long term measures like higher GDP

growth, lower Inflation and increasing exports. We cannot be dependent on

short term portfolio investments as they are by nature volatile.

For a sustained, long term economic growth that benefits the entire social

strata, we must have a stable currency.

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Bibliography

S. No

Name of the Author / Organization Title of the Book

Name of the Publisher

1 Reserve Bank of India www.dbie.rbi.org.in RBI

2 Bloomberg www.bloomberg.com Bloomberg

3 Thomson Reuters www.in.reuters.com Thomson Reuters

4 Trading Economics www.tradingeconomics.com

5 Vivek Kaul http://www.firstpost.com/author/vivek Firspost.com

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