CURRENCY

DEPRICIATION

CURRENCY DEPRECIATION
Executive Summary

The recent times have seen the sudden downward spiral of the value of rupee against other
reference currencies. This report delves into the factors contributing to currency depreciation. In
addition to that, it specifically aims to study the underlying drivers of the fall in the value of the
Indian rupee, the subsequent consequences, measures taken by the Indian central Bank and the
effect of these measures on the Rupee.

CONTENTS

OBJECTIVES AND KEY DELIVERABLES -------------------------------------------------06

STUDY, ACTIVITIES AND KEY LEARNINGS.--------------------------------------------07

REPORT ON CURRENCY DEPRECIATION--------------------------------------------08-19

CURRENCY DEPRECIATION------------------------------------------------------------08
DEPRECIATION VS DEVALUATION--------------------------------------------------08
CAUSES OF CURRENCY DEPRECIATION-------------------------------------------09
WHAT HAPPENED IN INDIA------------------------------------------------------------13
WHY DID THE RUPREE DEPRECIATE-----------------------------------------------13
REASONS FOR CONCERN ABOUT RUPEE DEPRECIATION-----------------16
STEPS TAKEN BY THE RBI-------------------------------------------------------------18
EFFECT OF MEASURES ON THE RUPEE--------------------------------------------19

Objectives And Key Deliverables

I took up this internship with Karvy to explore the various aspects of the equity stock broking
industry. The internship was structured to make me understand the varied stock market terminology,
stock price movements, methods to evaluate stocks and understand the customer mindset in portfolio
management.
As part of the internship I was advised to study and report the causes, concerns and consequences of
currency depreciation specific to the Indian currency. Furthermore, I also took note of the measures
taken by RBI in this regard and their effect on the Indian Rupee.

Study Activities And Key Learnings

My day in the office started from with a fresh market analysis by the Karvy morning equity reports
and by Mr. Sudarshan Sukhani on CNN-IBN. This routine, over a period of time, helped me
immensely in getting better insights into the equity market.
Once the market opened at 9:15 am my work consisted of watching the stock price movement and
making calls to customers to report the changes in their respective portfolios. Depending on this
information the customer would make hold, sell or buy decisions. Attending these calls helped me
get a basic understanding into the customers risk taking behaviour. I observed that customers can be
classified, as taught in class, into conservative, moderate and aggressive investor classes.
In addition to these activities, my mentor would take time out every day to clear our queries and talk
about various issues relating to the equity markets. I awaited these sessions everyday as they exposed
me to new dimensions of the equity markets.
Apart from these avenues of learning, my interaction with other interns during our coffee breaks
were a great time to brainstorm about our own analysis predictions and understanding of the equity
markets.

Currency Depreciation
The value of a countrys currency is often judged by weighing it against other countries
currencies. The loss of a countrys currency value with respect to other currencies, usually in a
floating exchange rate system is called currency depreciation. To explain further, if the Indian
rupee depreciates relative to the American dollar then it is said that the exchange rate has risen; it
takes more rupees now to purchase 1 dollar.

Depreciation vs Devaluation
Contrary to popular belief, there is a difference between devaluation and depreciation. A currency
loses its value both when it depreciates and when it is devalued. The difference, however, is that
devaluation is an official decision. This means that the lowering of the currency with respect to
other reference currencies is intentional. This may not be the case with respect to currency
depreciation.
Devaluation is the official lowering of the value of a country's currency with regard to goods,
services or other monetary units with which the currency can be exchanged. On the
contrary, depreciation is used to describe a decrease in a currency's value due to market forces.

Causes Of Currency Depreciation

Factors that can cause a nation's currency to depreciate include

Relative Product Prices

If a country's goods are relatively expensive, foreign consumers would not want to buy the goods.
Consequently, the demand for that nations currency will drop, thereby causing its currencys
value to depreciate.

Monetary Policy
Countries with expansionary monetary policies will be increasing the supply of their currencies,
causing their currency to depreciate. However, if a nation's central bank pursues an expansionary
monetary policy while its trading partners pursue monetary policies that are even more
expansionary, the currency of that nation is expected to appreciate relative to the currencies of its
trading partners.

Inflation
Inflation occurs when the general prices of goods and services in a country increase. Inflation
causes the value of the rupee to depreciate, reducing purchasing power. If there is unbridled
inflation, then a currency will depreciate in value. The causes of inflation can be:
Printing Money-Though printing money does not always cause inflation, inflation occurs when
the money supply is increased faster than the growth of real output.
Huge National Debt- To finance huge national debts, governments often print money, fuelling
inflation.

Inflation Rate Differences

Inflation is associated with currency depreciation. Suppose the price level increases by 40% in
the India, while the price levels of its trading partners remain relatively stable, Indian goods will
seem very expensive to foreigners, while Indian will increase their purchase of relatively cheap
foreign goods. The Indian rupee will depreciate as a result.

Income Changes
Suppose that the income of a major trading partner with India, such as the United Arab Emirates,
greatly decreases, the Indian rupee will depreciate. To elucidate, the Arab consumers purchase less
of the Indian goods as a lower domestic income is associated with a decreased consumption of
imported goods. Consequently, the quantity of Indian rupees demanded will be less than the
quantity supplied and the Indian rupee will depreciate.

External Factors
Depreciation is basically the symptoms of an underlying problem, particularly disproportion in the
Balance of Payment (BOP), springing from excess demand for dollars. Occasionally, external
factors like currency speculations on the foreign exchange market can also contribute to
depreciation of the local currency

Supply And Demand

The principles of supply and demand apply to the appreciation and depreciation of currency
values too. If a country injects new currency into its economy, the money supply in the economy
increases. According to the principles of supply and demand, when there is more money
circulating in an economy, there is less demand for it. This depreciates the value of the currency.

Economic Outlook
If a country's economy is in a slow growth phase, the value of its currency depreciates. The value
of a country's currency also depreciates if its major economic indicators like retail sales and Gross
Domestic Product are declining. A high or rising unemployment rate can also depreciate currency
value because it indicates an economic hold up. If a country's economy is in a robust growth
period, the value of its currency appreciates.

Trade Deficits
A trade deficit occurs when the value of goods a country imports is more than the value of goods
it exports. When the trade deficit of a country increases, the value of the domestic currency
depreciates against the value of the currency of its trading partners.
The demand for imports should fall as imports become more expensive. However, some imports
are essential for production or cannot be made in the country and hence have an inelastic demand;
we end up spending more on these essential goods when the exchange rate falls in value. This can
cause the balance of payments to worsen in the short run (a process known as the J curve effect)
J curve

Collapse Of Confidence
If the confidence in the economy or financial sector crumbles, it will lead to an outflow of
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currency as people do not want to risk losing their money. Therefore, loss of confidence in an
economy causes an outflow of capital and consequently depreciation in the exchange rate.
Political or economic factors play a vital role in both building and destroying investor confidence
in a countrys economy.

Price Of Commodities
If an economy depends on export of raw materials, a fall in the price of these raw materials may
cause a fall in export revenue leading to a depreciation in the exchange rate.

Interest Rate Differential.

Under the assumption that a country with a higher interest rate will also tend to have a higher
inflation rate, the increased amount of inflation is expected to cause the currency in the country
with the high interest rate to depreciate against a country with lower
interest rates.

Market Speculations
Market speculations can contribute to a process of spiralling depreciation after smaller market
players decide to follow the example of the leading dealers and after they lost confidence in a
particular currency start to sell it in large volumes.

WHAT HAPPENED IN INDIA

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An emerging economy showing signs of sturdy growth attracts the attention of foreign investors.
Inward investment comes in together with nig money flows that circumvent capital controls.
Capital inflows shoot up the exchange rate, making imports cheaper and exports dearer. The trade
deficit bloats up, growth retards, structural flaws become more noticeable and the inflow of
funding slowly disappears. This is what happened in India.

Why did the rupee depreciate?

Apart from the speculations in the market which are aiding the rupee depreciation, the factors
which have caused the rupee to reach these lows are the external factors such as the quantitative
easing in the US and the internal structural challenges.
External factors:
The trigger for the run on the rupee has been the news that the Federal Reserve is considering
scaling back its bond-buying stimulus programme. This has consequences for all emerging market
economies: firstly, fear that a reduced stimulus will indicate weaker growth in the US, spelling
negative impact on exports from the developing world.

Secondly, speculation that policy tightening in the US will make the dollar more attractive and
subsequently the rupee less so.

Although other developing countries are also facing the heat of the situation with declining
currencies, it is India with its large trade and budget deficits that is more prone to the
consequences.

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Structural challenges:
The twin challenges which need to be addressed are the current account deficit and the fiscal
deficit.
Current Account Deficit
CAB = X - M + NY + NCT
Where
X = Exports of goods and services
M = Imports of goods and services
NY = Net income abroad
NCT = Net current transfers
A current account deficit is said to exist when exports are less than the imports and remittances
combined or when the current account balance amounts to a negative value.
From the year 2004 the government has increased imports of not only gold and oil but also other
goods which could be produced in India. Despite the fact that the government uses gold and oil
imports as alibi for the current account deficit, the import of capital goods contributed more to the
current account deficit than the import of gold and oil. Though import of capital goods is a sign of
a vibrant economy and in theory generates higher national production, the industrial production in
India saw a drastic fall causing a major trade deficit. This fall in the IIP can only be attributed to
the increase in import if capital goods which could otherwise be manufactured in India.
Furthermore, contrary to expectations, in the past 9 years the IIP was on a decline despite huge
investments into the country.
One of the major culprits is the reckless import of capital goods. It has killed the rupee through
current account deficit and hit both the domestic production and GDP.

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Fiscal Deficit
Fiscal deficit is the excess outgo of government over its revenues.
The deadly combination of huge current account deficits and high fiscal deficits has made the
rupee weak.Ill planned stimulus packages and tax cuts/benefits provided to the corporate s over
the last 9 years shot up the fiscal deficit of the government.

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Reasons For Concern About The Rupee Depreciation

Current Account Deficit Will Widen
With the increase in the exchange rate the imports become costlier, in turn worsening the current
account deficit.
CAD as % of GDP
FY12-4.2
FY13-4.8

Capital Flows May Slow Or Reverse

Current investors may look for an exit and potential investors might want to wait before plunging
in.
Apr-$1992m
May-$5176m
June- -$4160m

Companies With Dollar Debt To Come Under Stress

Companies with dollar debt find it difficult to pay interest as the real amount of interest to be paid
shoots due to the rupee depreciation against the dollar
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Costly Imports Will Hasten Inflation

Wholesale and retail inflation is expected to rise. Even if the import of discretionary goods is
controlled, large imports of goods such as fuel will contribute to the rising inflation.

Forex Reserves Could Fall, Putting Pressure On Rupee

Lower capital flows into India would mean that the government has to dig into its already low
forex reserves to sustain its foreign expenditure.

Corporate Margins May Fall Further

Two factors may contribute to the thinning of corporate profit margins: more expensive material
imports and weaker demand for their goods and services. Additionally, a weaker demand may not
allow the company to pass on the increase in imported material cost to its customers.

Deficit Target Difficult With Higher Subsidies

Though fuel subsides are partially offset by rising fuel prices, other subsidies such as fertilizer
subsidies will be a burden on the already existing deficit.

Foreign Studies And Holidays Will Pinch More

Spending on any kind of foreign exchange denominated spending will increase.

Demand Will Further Fall Due To Higher Prices

Spending on all discretionary and luxury goods will take a beating.

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Rate Cut To Stimulate Economy Difficult

If a rate cut is introduced to increase borrowing and therefore the money supply into the economy,
inflation, which is already at an unprecedented level, will shoot up. Therefore a rate cut cannot be
used to stimulate the economy.

Steps Taken By The RBI

The RBI has undertaken several measures to curb the downward spiral of the rupee. Some of
these measures were aimed at halting the excessive speculation which is adding to the volatility in
the Indian economic scenario. The main aim has been to squeeze the liquidity from the market
which will help in curbing the fall in the value of the rupee.

Measures

o Capping the Liquidity Adjustment Facility (LAF) to Rs 7500 crores starting from the
17th July, 2013. The Marginal Standing Facility (MSF) rate , the overnight borrowing
rate, has been raised 200 bps to 10.25 per cent.

o RBI also raised the minimum daily average holding of the mandated 4% Cash
Reserve Requirement to 99% from 70%. Banks have to comply with CRR norms on
alternate Fridays and are required to maintain a minimum daily Cash Reserve Ratio
(CRR) balance of 99% of the balance. That essentially sucks out an estimated
Rs.90000 crore from the financial system.
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o Restrictions on gold: The RBI set stringent conditions for importers, linking imports
to future exports by ensuring that at least 20% of the imported gold is made available
for exports.

Effect Of Measures On The Rupee

On one hand, by squeezing money from the financial system, the central bank has made money
costlier, raising the demand for the rupee. The scarcity of the rupee has helped to increase the
value of the rupee against the dollar.
On the other hand, the tight liquidity situation has put strain on the banks. Banks can borrow
limited amount from the RBI under the LAF, anything beyond that they would have to borrow at
the MSF rate which at 10.25% is quite steep.
To meet their cash requirements, banks and financial institutions have been selling government
bonds leading to the fall in bond prices across various categories and a rise in the yields. Debt
mutual funds will get affected since they invest in the Government bonds and the final prices have
led to the significant loss to the debt funds.

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