21 Dcc2OlI PrimarvDcalcrl.

Ld
Cm Rupee Depreciation: Probable Causes and Outlook
+91-22-66202234
The Indian Rupee has depreciated significantly against the US Dollar marking a new risk for Indian economy. Till the beginning
of the financial year (Apr 11-Mar 12) very few had expected Rupee to depreciate with most hinting towards either appreciation or
status quo in the rupee levels. Those few who had even anticipated may not have imagined the scale of depreciation with rupee
touching a new low of around Rs 54 to the US Dollar.
What is even more interesting to note is that when other countries are trying to play currency wars and trying to keep their
currencies devalued, India is trying to prevent depreciation of the currency. cad our previous report for a review of the situation-
Saying No To Currency Wars (20-Sep-I 1))
This paper reviews the probable reasons for this depreciation of the rupee and the outlook for the same. It also reflects on the
policy options to help prevent the depreciation of the Rupee
I. Economics of Currency
Predicting currency movements is perhaps one of the hardest exercises in economics as it has many variables affecting the market
movement.:
Balance of Payments: It is the sum of current account and capital account of a country and is an external account of a country
with other countries. Both current account and capital account play a role in determining the movement of the currency:
o Current Account Surplus/Deficit Current account surplus means exports are more than imports. In economics we assume prices
to be in equilibrium and hence to balance the surplus, the currency should appreciate. likewise for current account deficit
countries, the currency should depreciate.
o Capital Account flows: As currency adjustments do not happen immediately to adjust current account surpluses and deficits,
capital flows play a role. Deficit countries need capital flows and surplus countries generate capital outflows. On a global level
we assume that deficits will be cancelled by surpluses generated in other countries. In theory we assume current account deficits
will be egual to capital inflows but in real world we could easily have a situation of excessive flows. So, some countries can have
current account deficits and also a balance of payments surplus as capital inflows are higher than current account deficits. In this
case, the currency does not depreciate but actually appreciates as in the case of India (explained below). Only when capital
inflows are not enough, there will be depreciating pressure on the currency.
Interest Rate Differentials: This is based on interest rate parity theory. This says that countries which have higher interest rates
their currencies should depreciate. If this does not happen, there will be cases for arbitrage for foreign investors till the arbitrage
opportunity disappears from the market. The reality is far more complex as higher interest rates could actually bring in higher
capital inflows putting further appreciating pressure on the currency. In such a scenario, foreign investors earn both higher
interest rates and also gain on the appreciating currency. This could


21 Dcc2OlI PrimarvDcalcrl.Ld
lead to a herd mentality by foreign investors posing macroeconomic problems for the monetary authority.
Inflation: Higher inflation leads to central banks increasing policy rates which invites foreign capital on account of interest rate
arbitrages. This could lead to further appreciation of the currency. However, it is important to differentiate between high inflation
over a short term versus a prolonged one. Over short-term foreign investors see inflation as a temporary problem and still invest
in the domestic economy. If inflation becomes a prolonged one, it leads to overall worsening of economic prospects and capital
outflows and eventual depreciation of the currency.
Apart from this, inflation also helps understand the real changes in a value of currency. Real exchange rate = Nominal Exchange
Rate* (Inflation of foreign country/Inflation of domestic economy). This implies if domestic inflation is higher, the real change in
the value of the currency will be lower compared to the nominal change in currency.
Fiscal Deficit: Fiscal deficits play a role especially during currency crisis. If a country follows a fixed exchange rates and also
runs a large fiscal deficit it could lead to speculative attacks on the currency. Higher deficits imply government might resort to
using forex reserves to finance its deficit. This leads to lowering of the reserves and in case there is a speculation on the currency,
the government may not have adequate reserves to protect the fixed value of the currency. This pushes the government to devalue
the currency. So, though fiscal deficits do not have a direct bearing on foreign exchange markets, they play a role in case there is
a crisis.
Global economic conditions: Barring domestic conditions, global conditions impact the currency movement as well. In times of
high uncertainty as seen lately, most currencies usually depreciate against US Dollar as it is seen as a safe haven currency.
Hence even over a longer term, multiple factors determine an exchange rate with each one playing an important role over time.
II. Rupee Movement since 1991
If we look at Indias Balance of Payments since 1970-71, we see that external account mostly balances in I 970s. Infact in second
half of I 970s there is a current account surplus. This was a period of import substitution strategy and India followed a closed
economy model. In I 980s, current account deficits start to rise culminating into a BoP crisis in 1991. It was in the 1991 Union
Budget where Indian Rupee was devalued and the government also opened up the economy. This was followed by several
reforms liberalizing the economy and exchange rate regime shifted from fixed to managed floating one. Hence, we need to
analyse the current account and rupee movement from 1991 onwards.
India has always had current account deficit barring initial years in 2000s (Figure 1). The deficit has been financed by capital
flows and mostly capital flows have been higher than current account deficit resulting in balance of payments surplus. The
surplus has intum led to rise in forex reserves from USD 5.8 bn in 1990-91 to USD 304.8 bn by 2010-11 (Figure 2). In 1990-91,
gold contributed around 60% of forex reserves and forex currency assets were around 38%. This percentage has changed to
1.5% and 90% respectively by 2010-11.
2


21 Dcc 2011 Primary Dcalcr 1.td
Figure 1 Figure 2
Balance of Payments (in USD bn)
-100 -
- .A ,- - . ,. e -
Cuntnt Aonunt Capital Aceunt BoP
RitZ .SMflz RitZ
What is even more stunning to note is the changes in BoP post 2005 (Table 1). In 1990s, Balance of
Payments surplus is just about $4.1 bn and increases to $22 bn in 2000s. However if we divided the
2000s period into 2000-05 and 2005-Il, we see a sharp rise in both current account deficit and
capital account surplus. The rise in Forex reserves is also mainly seen in 2005-Il.
Table I: Balance of Payments (in USD bn)
Based on this, if we look at Rupee movement, we broadly see it has depreciated since 1991. Figure 3 looks at the Rupee
movement against the major currencies. A better way to understand the Rupee movement is to track the real effective exchange
rate. Real effective exchange rate (REER) is based on basket of currencies against which a country trades and is adjusted for
inflation. A rise in index means appreciation of the currency against the basket and a decline indicates depreciation. RBI releases
RIER for 6 currency and 36 currency trade baskets since 1993-94 and we see that the currency did depreciate in the I 990s but
has appreciated post 2005. It depreciated following Lehman crisis but has again appreciated in 2010-11.
Forcx Reserve (in $ bn)
350
300
250
ISO
. 1 I I I I I I I I I I I
a
3


Current
Account
Capital
Account
BoP Forex Reserve
1990-00 -3.8 7.9 4.1 23.5
2000-11 -11.6 33.6 22.0 174.8
2000-05 3.7 14.7 18.4 85.4
2005-11 -24.3 49.3 25.0 249.4
Sswnv: RItZ


21 Dcc 2011
Figure 3
S.n: RB!
Figure 4

Priman Dcalct 1.td
Sn?: RBI
Table 2 summarizes the findings of Balance of Payments and Rupee movement. In the I 990s, Rupee depreciates against its major
trading currencies as the average REER is less than 100. However, in 2000s we see Rupee appreciating against major trading
currencies. If we divide the 2000s period further to 2000-05 and 2005-Il, we see there is depreciation in the first phase and large
appreciation in the second half of the decade.
Table 2: Balance of Payments and Rupee
Hence, overall we see the Rupee following the path economic theories highlighted above have suggested.
As India opened up its economy post 1991, Rupee depreciated as it had current account deficits. Earlier current account deficits
were mainly on account of merchandise trade deficits. However, as services exports picked up it helped lower the pressure on
current account deficit majorly. Without services exports, current account deficit would have been much higher.
There was a blip during South East Asian crisis when current account deficit increased from $4.6 bn to $5.5 bn in 1997-98.
Capital inflows declined from $11.4 bn to $10.1 bn leading to a decline in BoP surplus and depreciation of the rupee. However,
given the scale of the crisis the depreciation pressure on Rupee was much lesser. There was active monetary management by RBI
during the period. Similar measures have been taken by RBI in current phase of Rupee depreciation as well (discussed below).
Till around 2005, India received capital inflows just enough to balance the current account deficit. The situation changed after
2005 as India started receiving capital inflows much higher than current account deficit. The capital inflow composition also
changed where external financing dominated in early I 990s and now most of the capital inflows came via foreign investment.
Within foreign investment, share of portfolio flows was much higher. As capital inflows were higher than the current account
deficit Rupee appreciated against major currencies.
Rupee major curenciuu
70
60
50
40
30
30
10 -
Real E&ctie Exchange Re 130
6 Rl-J-.R 36 RF.hR
C
. US PoSh, .-- UK Pound Hue, Jci Ye
4


BoP
(in $ bn)
6 REER 36 REER
1990-00 4.1 99.5 98.5
2000-11 22.0 103.4 100.6
2000-05 18.4 99.2 99.8
2005-10 25.0 107.0 101.2
Sown: RB!



21 Dcc 2011 - Irnntr I ) kr I
Figure 5
5ni: RBI
Other factors also led to appreciation of the rupee. First, India entered a favorable growth phase registering growth rates of 9%
and above since 2003. This surprised investors as few had imagined India could grow at that rate consistently. The high growth
led to surge in capital inflows mainly in portfolio inflows. Second, Indias inflation started rising around 2007 leading to RBI
tightening policy rates. This led to higher interest rate differential between India and other countries leading to additional capital
inflows as highlighted above. It is important to understand that at that time investors did not feel inflation will remain persistent
and thought it to be a transitory issue and could be tackled by monetary policy.
During Lehman crisis capital flows shrunk sharply from a high of $107 bn in 2007-08 to just $7.8 bn in 2008-09 and led to
sharp depreciation of the currency. Rupee plunged from around Rs 39 per $ to Rs. 50 per S. REER moved from 112.76 in 2007-
08 to 102.97 in 2008- 09 depreciating sharply by 9.3%. The current account deficit also declined sharply as well tracking decline
in oil prices from S 12 bn in Jul-Sep 08 to $0.3 bn in Jan-Mar 09. The currency also depreciated tracking the global crisis which
led to preference for dollar assets compared to other currency assets.
Indian economy recovered much quicker and sharper from the global crisis. The capital
inflows increased from $7.8 bn to $51.8 bn in 2009-10 and $57 bn in 2010-11. The higher
capital inflows were on account of both FDI and RI. External Commercial Borrowings also
picked up in 2010-11. The current account deficit also increased from $27.9 bn in 2008-09 to
$44.2 bn in 2010-11. REER (6 currency) appreciated by 13% in 2010-Il and 36 REER by
7.7%.
III. Depreciation of Rupee: 2011-12
Before we analyse the factors for the recent depreciation of the rupee, let us look at the survey of professional forecasters released
by RBI. Current account deficit is more or less same buy consensus expects capital inflows in 2010-11 to be lower in each
succeeding quarter. This leads to lower BoP estimate. However, the forecasters maintain their forecast for Rupee/Dollar
unchanged. This is surprising as with lower capital inflows, markets should have expected some depreciating pressure on Rupee
as well. BoP surplus of $10.3 bn would have been lowest (barring 2008-09) figure since 2000- 01. The lowest figure for
INR/USD is 47.1 in Q3 10-11,46 in Q4 10-11 and 45.6 in QI 10-11. It is
Composition of Capital Inflows
100/
90,.
II
70/. ____________
4fo
0,.
Dm1 HI C F.xtanal astistan C ICB NRI Dcposit
2000-Il
5

21 Dcc 2011

Primary Dcalcr Ltd
safe to say most of the participants missed the estimate by a wide mark. It was a complete surprise for most analysts.
Even the QI 11-12 numbers did not really sound an alarm (Table 4). The current account deficit was
at S14.2 bn and capital account was at $19.6 bn leading to a BoP surplus of $5.4 bn. BoP surplus in
Q4 2010-11 was S 2bn. More importantly, capital inflows had risen from $7.4 bn in Q4 2010-11 to S
19.6 bn in QI 2011-12 on account of foreign investment (both FDI and Fil).
The problems start to surface from Q2 11-12 onwards. In Table 4, we have put some of the data released by RBI and
Commerce Ministry for the period post QI 11-12. As we can see, current account deficits is likely to be higher but capital
inflows especially Fli inflows are going to be much lower. Compared to EAC projections, current account deficit is likely
to be higher and capital account lower leading to either a negligible BoP surplus or BoP deficit.
Table 4: Balance of Payments in 2011-12 (Actuals vs. EAC projections, in $ bn)
Apart from difficulty in capital inflows, Indian economy prospects have declined sharply. Just at the beginning of the year,
forecasts for Indias growth for 2011-12 were around 8-8.5% and have been revised downwards to around 6.5%-7%. It has
been a shocking turnaround of events for Indian economy. Both foreign and domestic investors have become jittery in the last
few months because of following reasons:
6

Table 3: Forecasts for 2011-12 (median values)
I Survey done in the
etiod

Q32010-
11
Q42010-
11
Ql2011-
12
Rupee/USD 43.5 44.5 44.5
Current Account Balance (US $ bn) -59.4 -56.9 -54.7
Capital Account Balance (US $ bn) 83 75 65
BoP (US $ bn) 23.6 18.1 10.3
Som,w: P.111


QI 11-
12
Jul 11-
Oct 11

PMsEAC
Projection
Trade Deficit -35.5 -54.5

-154.0
Exports of Goods 80.6 98.3

330.2
Imports of Goods 116.1 152.9

484.2
Net Invisibles 21.3

100.0
Services exports 31.0 45.0

Services Imports 18.9 26.4

Net Service Receivables 12.1 18.6

60.5
Transfers + Income 9.3

39.5
Current Account Deficit -14.2

-54.0

Q1
Jul-Il
to Aug-
11
Sep-il to
20-Dec 1

Capital Account 19.6

72.0
FDI 7.2 13.8

32.0
HI 2.5 0.6 1.5 14.0
ECB Borrongs 2.9

NRI Deposits 1.2 0.9

Others 5.8
Sm: Kill



21 Dcc 2011 - Primar Dcalcr lAd
Persistent inflation: Inflation has remained around 9.10% for almost two years now. Even inflation after Dec-Il is expected to ease mainly
because of base-effect. Qualitatively speaking inflation still remains high with core inflation itself around 8% levels. It is important to recall that
the episode of 2007-08 when despite high inflation and high interest rates, capital inflows were abundant. This was because markets believed this
inflation is temporary. Even this time, investors felt the same as capital inflows resumed quicldy as India recovered from the global crisis.
However, as inflation remained persistent and became a more structural issue investors reversed their expectations on Indian economy.
Persistent fiscal deficits: The fiscal deficits continue to remain high. The government projected a fiscal deficit target of 4.6% for 2011-12 but is
likely to be much higher on account of higher subsidies. The markets questioned the fiscal deficit numbers just after the budget and projected the
numbers could be much higher. This indeed has become the case. As highlighted above, persistent fiscal deficits play a role in shaping
expectations over the currency rate as well.
Lack of reforms: There have been very few meaningful reforms in the last few years in Indian economy. Moreover, the policies seem to be
getting increasingly populist. The government wanted to reverse this perception and announced FDI in retail but had to hold back amidst huge
furor from both opposition and allies. This has further made investors negative over the Indian economy. As Fil inflows are going to be difficult
given the uncertain global conditions, the focus has to be on FDI.
Continued Global uncertainty: This is an obvious point with global economy continuing to remain in a highly uncertain zone. This has led to
pressure on most currencies against the US Dollar.
All these reasons together have led to sharp depreciation of the rupee. The rupee has depreciated by nearly 20% against USD from Apr-Il to 20-
Dec-Il. In terms of 6 REER (Apr-Nov) and 36 RIJiR (Apr-Oct) Rupee has depreciated by 10.44% and 7.7% respectively. The later numbers of
R[.ER arc likely to show higher depreciation as well. During Lehman crisis, the two indices had depreciated by 9.3% and 9.9% respectively.
Figure 6 Figure 7
Swr: flCI P1) Rntan5 Sorn: RBI
IV. Outlook and Policy Measures
The above analysis shows that Rupee has depreciated amidst a mix of economic developments in India. Apart from lower capital inflows
uncertainty over domestic economy has also made investors nervous over Indian economy which has further fuelled depreciation pressures. India
was receiving capital inflows even amidst continued global uncertainty in 2009-11 as its domestic outlook was
55
Depreciation of Rupee against US Dollar
53 -
51
49
47
45
43
-5

Real Effective Exchange Rate
125
6REER 36REER
- .:.
.,- z
7


21 Dcc2OlI PrimarvDcalcrl.Ld
positive. With domestic outlook also turning negative, Rupee depreciation was a natural outcome. Depreciation leads to imports becoming
costlier which is a worry for India as it meets most of its oil demand via imports. Apart from oil, prices of other imported commodities like
metals, gold etc will also rise pushing overall inflation higher. Even if prices of global oil and commodities decline, the Indian consumers might
not benefit as depreciation will negate the impact. Inflation was expected to decline from Dec-I I onwards but Rupee depreciation has played a
spoilsport. Inflation may still decline (as there is huge base effect) but Rupee depreciation is likely to lower the scale of decline.
What are the policy options with RBI?
Raising Policy rates: This measure was used by countries like Iceland and Denmark in the initial phase of the crisis. The rationale was to prevent
sudden capital outflows and prevent meltdown of their currencies. In Indias case, this cannot be done as RBI has already tightened policy rates
significantly since Mar-10 to tame inflationary expectations. Higher interest rates alongwith domestic and global factors have pushed growth
levels much lower than expectations. In its Dec-Il monetary policy review, RB! mentioned that future monetary policy actions are likely to
reverse the cyde responding to the risks to growth. Indias interest rates are already higher than most countries anyways but this has not led to
higher capital inflows. Oin the other hand, lower policy rates in future could lead to further capital outflows.
Using Forex Reserves: RBI can sell forex reserves and buy Indian Rupees leading to demand for rupee. RBI Deputy Governor Dr. Subir Gokarn
in a recent speech (An assessment of recent macroeconomic developments, Dec-I 1) said using forex reserves poses problems on both sides
Not using reserves to prevent currency depreciation poses the risk that the exchange rate will spiral out of control, reinforced by self-fulfilling
expectations. On the other hand, using them up in large quantities to prevent depreciation may result in a deterioration of confidence in the
economys ability to meet even its short-term external obligations. Since lx)th outcomes are undesirable, the appropriate policy response is to find
a balance that avoids either.
Based on weekly forex reserves data (Figure 8), RBI seems to be selling forex reserves selectively to support Rupee. Its intervention has been
limited as liquidity in money markets has remained tight in recent months and further intervention only tightens liquidity further.
Figure 8
Forcx Rccrvcs (in S bn)
325.0
310.0
N
305.0
300.0
295.0
N .
Sn7: Kill
Easing Capital Controls: Dr Gokarn in the same speech said capital controls could be eased to allow more capital inflows. He added that
resisting currency depreciation is best done by increasing the supply of foreign currency by expanding market participation. This in essence,
8


21 Dcc2OlI PrimalvDcalcrl.Ld
has been RBIs response to depreciating Rupee. Following measures have been taken lately:
o Increased the FlI limit on investment in government and corporate debt instruments.
o First, it raised the ceilings on interest rates payable on non-resident deposits. This was later deregulated allowing banks to
determine their own deposit rates.
o The all-in-cost ceiling for External Commercial Borrowings was enhanced to allow more ECB borrowings.
Administrative measures: Apart from easing capital controls, administrative measures have been taken to curb market
speculation.
o Earlier, entities that borrow abroad were liberally allowed to retain those funds overseas. They are now required to bring the
proportion of those funds to be used for domestic expenditure into the country immediately.
o Earlier people could rebook forward contracts after cancellation. This facility has been withdrawn which will ensure only
hedgers book forward contracts and volatility is curbed.
o Net Overnight Open Position Limit (NOOPL) of forex dealers has been reduced across the board and revised limits in respect
of individual banks are being advised to the forex dealers separately.
After these recent measures, Rupee depreciation has abated but it still remains under pressure. Both domestic and global
conditions are indicating that the downward pressure on Rupee to remain in future. RBI is likely to continue its policy mix of
controlled intervention in forex markets and administrative measures to curb volatility in Rupee. Apart from RBI, government
should take some measures to bring FDI and create a healthy environment for economic growth. Some analysts have even
suggested that Government should float overseas bonds to raise capital inflows.
V. Conclusion
Growing Indian economy has led to widening of current account deficit as imports of both oil and non-oil have risen. Despite
dramatic rise in software exports, current account deficits have remained elevated. Apart from rising CAD, financing CAD has
also been seen as a concern as most of these capital inflows are short-term in nature. PMs Economic Advisory Council in
particular has always mentioned this as a policy concern. Boosting exports and looking for more stable longer term foreign
inflows have been suggested as ways to alleviate concerns on current account deficit. The exports have risen but so have prices of
crude oil leading to further widening of current account deficit. Efforts have been made to invite FDI but much more needs to be
done especially after the holdback of retail FDI and recent criticisms of policy paralysis. Without a more stable source of capital
inflows, Rupee is expected to remain highly volatile shifting gears from an appreciating currency outlook to depreciating reality
in quick time.
9


21 Dcc 2011 - In:ntrv Dcalcr I
Primary Dealer Ltd.
A/Bl- 801, A Wing, 8th floor, Marathon Innova, Marathon Next Gen Compound,
Off. Ganpatrao Kadam Marg, Lower Parel (w), Mumbai 400013.
Dealing Room: (022) 66202217.20 Settlements: (022)66202262-64, Fax (022) 66202288
Delhi Office: (011) 47676555-570 Bangalore Office: (080) 22208891
Please mail your feedback to pd@ pd.com Websire: http://www.stdpd.com
TI-ITS COMMUNICATION IS FOR PRIVATE CIRCULATION ONLY. IT IS BASED UPON TI-IL
INFORMATION GENERALLY AVAILABLE TO PUBLIC AND CONSIDERED RELIABLE. ThIS REPORT
DOES NOT CONSTITUTE AN INVITATION OR OFFER TO SUBSCRIBE FOR OR PURCHASE OR SALE OF
ANY SECURITY AND NEITI-IER THIS DOCUMENT NOR ANYTI-IING CONTAINED 1-IEREIN SHALL
FORM TIlE BASIS OF ANY CONTRACT OR COMMITMENT WHATSOEVER WITH PRIMARY
DEALER
10

CARE recently released a report on the outlook for Indian Rupee with regard to other
currencies. The report is reproduced below :
Depreciation of Indian Rupee 2012
Volatility in the exchange rate is increasingly being recognized as a concern for the
Indian economy. After maintaining a range bound movement in Q1 FY12, the rupee
has registered depreciation against the dollar since August 2011. The question being
raised is whether this trend will be reversed or has volatility come to stay in this market?
Between August 1, 2011 and November 23, 2011, the rupee has depreciated
18.28% (point-to-point basis).
Rupee Movement in FY12 so far
In the first four months of FY12, the rupee had been stable, trading in the range
of Rs 44-45 to a dollar. A depreciating trend in the rupee has been observed since the
month of August.
On October 21, 2011, the rupee crossed the Rs 50/$ mark for the first time this year,
settling at Rs 52.10/$, as on November 23, 2011. During the same period, the rupee
has depreciated 10.41% against the Euro, settling at Rs 70.07/Euro.

Looking forward, it may be gauged that market participants expect little reversal in
this trend of rupee depreciation. Forward premium on the dollar is the cost of
carry of the dollar for specified tenure which may also be interpreted as the
expected movement in the exchange rate. Using the inter-bank forward premium
for different tenure as an indicative measure of the rupee rate, we may infer that
rupee depreciation may persist for a while.
The one month forward premium on the dollar has especially registered a
substantial jump of 454 bps between August and November (Table 1).


Causes of Depreciation
1. Withdrawal by FIIs
The main driver of rupee depreciation in the last three months has been the
withdrawal of funds by foreign institutional investors (FIIs) from domestic economy.
The rather pessimistic view of FIIs is being governed by global developments. FIIs have
registered a net sales position of US $ 1,581 million, between August and November so
far.

The ongoing Euro-zone debt crisis seems to be intensifying and rescue
packages have been of limited assistance in truly resolving the crisis. While the risk
of sovereign default by individual Euro states is a concern, the risk of an impending
contagion is also significant. It is estimated that the IMF has about $400 billion available
to provide funding to the Euro-zone, but Italy alone has to refinance $350 billion worth
of debt in the next six months. The support by the IMF thus is a just fraction of the
cumulative financing requirement to resolve this debt crisis. Changes in political leaders
and finance ministers of these states, debates on the role and mandate of the
European Central Bank (ECB) and European Financial Stability Facility (EFSF)
and quantum of financial support to be provided by member states remain some points
of indecision.
The scenario in the US does not provide an upbeat picture either. Delays in policy
formulation on the setting of debt ceiling for the state have reflected some lacunae
in management of government finances. While housing starts, industrial production
and consumer spending are gradually showing signs of improvement, the rate of
unemployment remains uncomfortably high. Growth estimates for the US have
been revised downwards to 2.0% in Q3 from the earlier estimate of 2.5%.
The real estate problem, weakening local government finances, lack of transparency
in operations and systems of the government and deterioration the assets of the
banking system observed in the Chinese economy are further drags to the global
macro-economic outlook for the coming months.
Domestic macro-economic prospects as well are weighed by high inflation and
sagging industrial production, which have led to downward revision of growth
estimates to just 7.6% for FY12.
Consequently, FIIs have withdrawn funds from emerging markets and invested
back in the dollar which has been strengthening. In November (so far) itself, FIIs
have registered a net sales position to the tune of US $ 87 million.
2.Strengthening of Dollar
As these downbeat forces have played strong over the last few months, investor
risk-appetite has contracted, thereby increasing the demand for safe haven such as
US treasury, gold and the greenback. The Euro has depreciated 6.55% against the
dollar in the last three months which has in turn made the dollar stronger vis--vis
other currencies, including the rupee. With winter, the demand for oil and
consequently dollar is only expected to move further upwards. Domestic oil importers
have also contributed to this strengthening to meet higher oil import bills.
3. Widening Current Account Deficit
The current account balance is composed of trade balance and net earnings
from invisibles. While earnings from invisibles have been quite robust this year
(growth of 17% y-o-y), the trade account has deteriorated on unfavourable terms of
trade. Current account deficit (CAD), in Q1 FY12 had widened by Rs 40,000 crore,
over Q4 FY11. Furthermore on a quarterly basis, even invisibles earnings have
registered some decline. With contribution of exporters remaining on the sidelines
and earnings from invisibles continuing to decline, a further widening of the
CAD would result in outflow of dollars from the Indian economy accentuating the
depreciation in rupee. In particular software receipts would be under pressure given the
global slowdown.
4. Decline in other Capital Flows
Foreign Direct Investments (FDI), External Commercial Borrowings (ECBs)
and Foreign Currency Convertible Bonds (FCCBs) have maintained robust
trends this year, when compared with net inflows in FY11. However, on a month-
on- month basis, ECBs and FCCBs have registered slowdown. A prospective
decline in these other inflows on the capital account of the balance of payments
could cause further depreciation in rupee. While FDI has been increasing it has not
been able to make up for lower other capital inflows.
Impact of Rupee Depreciation
Three areas of concern that may be identified are higher import bills, fiscal slippage and
increased burden on borrowers
1. Higher Import Bills
A depreciation of the local currency naturally manifests in higher import costs for
the domestic economy. Assuming that both imports and exports maintain their current
growth rates through the year, higher import costs would widen the trade and current
account deficit of the country. We expect current account deficit to settle at 3.0-
3.1% of GDP by March 2012- end. Additionally, the domestic economy could be faced
with a problem of higher inflation through imports. Commodities prices that are
internationally denominated in US dollars would naturally be priced higher on the back
of a stronger Dollar. Also, while global base metals prices such as nickel, lead,
aluminium, iron and steel would have eased, the depreciating rupee would keep
the price of imported commodities elevated.
2. Fiscal Slippage
The fiscal deficit for FY12 was budgeted at 4.6% of GDP in February, with the
price of oil pegged at US $ 100 per barrel. Throughout FY12 so far, however, the price
of oil has been well above this reference rate, hovering at an average of US $ 110 over
the last three months. Oil subsidy for the year is about Rs 24,000 crore for FY12. This
will rise on account of the higher cost of oil being borne by the government. While
there have been moves to link some prices of oil-products to the market, there would
still tend to be an increase in subsidy on LPG, diesel, kerosene. The
government has already enhanced its borrowing programme in H2 FY12 by Rs
52,000 crore, to bridge the fiscal gap.
3.Increased burden on Borrowers
Higher rates will come in the way of potential borrowers in the ECB market. Today given
the interest rate differentials in domestic and global markets, there is an advantage in
using the ECB route. With the depreciating rupee, this will make it less attractive.
Further, those who have to service their loans will have to bear the higher cost of debt
service.
4.Impact on exports
Usually exports get a boost in case the domestic currency depreciates because exports
become cheaper in international markets. However, given sluggish global
conditions, only some sectors would tend to gain where our competitiveness will
increase such as textiles, leather goods, processed food products and gems and
jewellery. In case, imported raw material is used in these industries they would be
adversely affected. Therefore, exports may not be able to leverage fully.
Outlook on the Rupee
The RBI has maintained strong foreign exchange reserves, to the tune of US $ 320
billion as at October-end (with foreign currency assets accounting for about 89% of
these reserves). However, it has refrained from (and has neither indicated in near-
future) direct intervention in the forex market to curtail the depreciation of the rupee until
now.
Assuming that global uncertainty continues to prevail, exports growth is maintained and
capital outflows persist, it is expected that this depreciation would continue. A
worsening in any of the above variable would aggravate rupee depreciation.
Intervention by the RBI could maintain the rupee rate in its current range of Rs
50-52 to a dollar. In the event that the RBI maintains a non-intervention stance
under uncertain euro conditions, the rupee could move in a volatile range of Rs
52- Rs 55 to a dollar.
Disclaimer
The Report is prepared by the Economics Division of CARE Limited. The Report is
meant for providing an analytical view on the subject and is not a recommendation
made by CARE. The information is obtained from sources considered to be reliable and
CARE does not guarantee the accuracy of such information and is not responsible for
any decision taken based on this Report.




Rupee Depreciation 2013 Impact on
Country & Economy
Rupee depreciation has come to become one of the most crucial concerns for the
Indian economy, particularly in the last two months. There has been concerted effort at
limiting the depreciation from all quarters, be it intervention of the monetary authority
(RBI), the Government (Ministry of Finance) or the capital markets regulator (SEBI).
The RBI, specifically in the last two months, has been proactive in managing
depreciation of the rupee. While it has clearly stated that its flexibility to directly enter
the forex market is limited by the size of the countrys forex reserves, the monetary
authority has opted for a slew of ancillary measures to cap the fall of the rupee.
Despite such interventions, there have been only temporary relief bouts and the rupee
continues to remain in the range of Rs 59-60 to a dollar. This leads us to question the
effective change in the rupee rate that these measures have been able to induce.
Annexure 1 provides a snapshot of the slew of announcements that have been made in
the months of June and July and its impact on the rupee.
What do we observe?
The rupee during these two months has seen the sharpest depreciation (of 96 paise)
on a daily basis (based on RBI reference rate) on June 19, 2013, following early
indications of the FOMC tapering QE3.
o The absence of easy money and ample liquidity as provided by the Fed with its
unlimited bond-buying programme and accommodative monetary policy stance
sparked sudden fear in the minds of investors. Multiple rounds of the QE
programme had been supporting both advanced and emerging market
economies and an earlier-than-expected tapering of the same came as a shock
to global investors. While the Fed has now clarified that it will continue with the
QE programme, tapering cannot entirely be ruled out and investors appear to be
factoring in this uncertainty more explicitly now.
The highest appreciation of the rupee during this period (of 98 paise), on the other
hand, came a day after the RBI announced easing of rules for non-bank asset
finance companies to raise to overseas debt.
During this period of two months, there has been no clear-cut reversal in the
direction of change in rupee rate against the dollar (the exception being 25th July
where the rupee went into the Rs 58.90-59 range). Measures such as gold import
duty rise, restrictions on lending against and tightening of liquidity have caused the
rupee to inch up only marginally on a day-to-day basis.
Starting the first prominent series of announcements on June 6, 2013, when the RBI
reference rate for rupee settled at Rs 56.87 to a dollar, till the most recent measure
announced on July 24, 2013 when the exchange rate settled at Rs 59.44 to a dollar,
the rupee has depreciated 4.5%.
Capturing Sentiment
An obvious conclusion to draw here would be that these measures have had limited
impact on the rupee. But, to the extent these measures have worked they have
ensured that the pace of depreciation has been checked and the rupee has ranged
between Rs 59-60/$. However, the impact on sentiment has been more
discernible. Reactions of FIIs and banking stocks to rupee-related news have been
captured in the following two exhibits.
Exhibit 1 charts daily net FII inflows a day after announcements by RBI (most news
have been released after market hours and reactions of FIIs would be reflected on the
following day) and Exhibit 2 charts daily changes in BSE S&P Bankex (over the
previous day) on account of news

Net FII inflows have mostly been in the negative territory during the last two
months. FIIs withdrew substantially on days after the RBI announced extension in
buyback time period of FCCBs, tightened gold lending norms for RRBs and
restricted daily liquidity by capping available funds under the Liquidity adjustment
facility (LAF) to Rs 75,000 crore and raising short-term rates.
o Contrary to this trend, net FII inflows were positive a day after the July 23, 2013
announcement that allowed for further tightening of liquidity in the banking
system. It may be conjectured that investor expectations of earning arbitrage
profit on the back of tighter monetary policy and higher interest rates in local
markets could have prompted this move. It remains to be seen if such inflows
would be sustained in the coming months.
o The BSE bankex dipped as investors presumably exited banking stocks post-
announcements of RBI allowing deferment of payment of forex option premium,
easing norms for low-cost builders to raise ECBs and non-bank asset finance
companies to raise overseas debt. The bankex unexpectedly picked up, moving
to the positive zone once SEBI announced stricter exposure norms for currency
derivatives and stayed there seemingly on the back of some banks announcing
better-than-expected Q1 FY14
o With the July 23 announcement that further curtailed individual bank access to
LAF and increased CRR requirements, the bankex dipped substantially as the
move would directly impact banks business activity, which has already been
subdued over the past two years
Impact on Liquidity
Along with directly targeting the rupee rate, the RBI in its July 15, 2013 announcement
also looked at steps to squeeze out liquidity. The following three steps had been
outlined
1. The MSF rate was recalibrated upwards by 300 bps to 10.25%, also implying that
the bank rate automatically moved up to 10.25%
2. The overall allocation of funds available under LAF was limited to 1% of NDTL of the
Indian banking system i.e. to Rs 75,000 crore, each day (with effect from July 17,
2013), and
3. An OMO sale of Rs 12,000 crore was simultaneously announced
These measures suggested a withdrawal of liquidity from the banking system, which
immediately reflected in a drop in repo borrowings by banks from the RBI under the LAF
window (Exhibit 3).
A day prior to the restriction in available repo under LAF came into effect; borrowings by
banks were seen to shoot up, presumably in a rush to shore up funds before the
squeeze.
A conjecture in this scenario would be that volumes in the call and CBLO market would
have shot up during this phase of lower permissible repo borrowings. However data
does not clearly support this hypothesis. Volumes in both call and CBLO market
have maintained previous levels.

On July 23, 2013, the RBI made another set of announcements targeting liquidity in the
banking system
1. The overall limit for access to LAF by each individual bank is now set at 0.5% of the
banks own NDTL outstanding (as on the last Friday of the second preceding fortnight);
effective from July 24, 2013
2. The minimum daily CRR balance to be maintained by banks has now been elevated
to 99% on a daily basis (from the previous 70%); effective from the reporting fortnight
beginning July 27, 2013
3. Auction of cash management bills to the tune of Rs 6,000 crore
On examining the movement of repo borrowings, we notice repo borrowings increasing
once again on July 23 (a day before the measure came into effect). Liquidity visibly
dropped the following day on account of lesser access to repo under LAF. With the
auction of cash management bills a further withdrawal of liquidity is expected. The RBI
had last auctioned cash management bills two years ago in 2011, and were amply
subscribed.
The impact of the change in minimum CRR balances is not expected to be very
pronounced. Despite the earlier norms of 70%, banks in general have been maintaining
balances close to 98%, on certain days the same being even greater than 100%.
Hence, while the 99% stipulation would now have to be met mandatorily on a daily
basis, banks are not expected to run into a crunch of funds to be diverted towards CRR
requirements.
Where are yields and interest rates headed?
Short-term interest rates however, peaked on the day following RBIs announcements of
July 15, 2013. The weighted average call rate (overnight) rose 1.3%, while the 1 month
Tbills rate rose 2.0%. CP rates as well rose in the range of 1.5% 2.0%. The immediate
impact on the long-term 10 year GSec rate was less pronounced, rising just 0.5%. A
week after RBIs announcement too short-term interest rates remain elevated (although
lower than the immediate reaction noticed on July 16, 2013). The 10-year GSec yield
has remained stable at 8.0% (Table 1).
A similar surge in rates was observed a day after the July 23, 2013 announcements.
Given that this set of measures, was once again a direct hit on liquidity, the impact on
short-term rates was higher. The weighted average call rate rose 1.9%, the Tbills rate
rose 1.6% (for 1 month residual maturity) and 1.8% (for 3 months residual maturity). CP
rates rose in the range of 1.1% 1.2%, while the 10-year GSecs yield rose 0.3% over
the day.

Rupee Future Forecast 2013
Implications and Expectations
The path of sustained monetary easing appears less likely now, given that the RBI
has now turned hawkish in its stance to cap depreciation of rupee and limit the
widening of CAD. Inflation, particularly imported inflation is expected to move
upwards, but only at the margin.
o The rupee is expected to face pressure during the year and movement in
exchange rate would be range-bound; the Rs 59-60 to a dollar being the new
normal for the rupee rate.
o CARE expects a rate cut of 50 bps in H2 FY13, in two tranches (more likely
towards November- December), highly contingent on dynamics of rupee
depreciation, CAD and inflation. An adverse data input on any of these macro-
variables would be viewed strictly by the RBI and a rate hike scenario cannot
entirely be ruled out.
While these measures may be viewed as temporary, the hike in short-term interest
rates would defer banks decisions to cut lending rates in the immediate run.
o Credit disbursement may hence, be expected to continue in is subdued phase
for a while and would likely settle lower than expected in FY14 again.
Yields across maturities are expected to firm up and CP and CD funding rates would
be no exception. This could accentuate the problem of a low investment cycle at the
macro-level as firms once again move to sidelines in CP issuances, largely used to
finance working capital.
o The 10-year GSec could will be under pressure until further guidance is received
from the RBI and the rupee stabilizes. The range of 8.3-8.5% looks more likely in
the very short run and the Policy statement later this month will provide further
direction. While these measures appear to be temporary, with a motive to
stabilise the rupee; the RBI would be reviewing them from time to time. Hence,
the direction and magnitude of change in interest rates becomes crucial.
Attaining normalcy in terms of exchange rate and RBI policy reversals would
take the yield back to the 7.5- 7.6% range, though the timing is uncertain.
o Short-term rates for CP and CD in such a scenario could very well range in
double digits for some more time. Any reversal in current moves by the RBI is
almost immediately expected reverse the impact on both long-term GSec yields
and short-term interest rates.
Until such time that domestic interest rates remain high, Indian corporates could be
prompted to access the ECB/FCCB market to a greater extent depending on the
interest rate differentials and currency risk.
o This however, could pressure the countrys external vulnerabilities in coming
months; an impending threat to the CAD, especially in an environment of
withdrawals of foreign investments that could potentially finance the CAD.
Annexure 1