Why the rupee is falling against the dollar

September 23, 2008

These are extraordinary times. Analysts have described the events of the last few days as the worst
financial crisis ever to have hit the world. Imprudent financial decisions, fed by greed and bad luck, have
seen global financial markets collapse. The bankruptcy, sale, restructuring and merger of some of the
world's largest financial institutions has caused cataclysmic disruptions in the international stocks and
money markets.
In such a scenario, how could India have escaped unhurt? The global crises saw Indian stock markets
crash, but as soon as the United States funneled in $700 billion into the American economy to revive dying
markets, India too saw some stability. However, the forex market was a totally different ball game.
Even as the dollar strengthened, the Indian rupee began to fall alarmingly. The Indian currency has fallen
to the lowest level in almost two years. At a low of 46.99 to the dollar this year that it hit on September
16, the rupee lost almost 18 per cent against the US currency!
To put things in perspective, the rupee was trading at about 39.40 to the dollar in January this year.
So why is the rupee falling against the dollar, when the global financial crisis should impact the United
States the most?
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. 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 greenback has seen it strengthen, while
the rupee's exchange rate has depreciated dramatically during the same period.
India's stock market regulator, the Securities and Exchange Board of India, has said that foreign
investors sold more Indian shares than they bought.
Global funds are said to have sold Indian shares to the tune of over $9 billion more than they have
bought this year. As demand for dollars from importers increased and the US Treasury poured in
almost $700 billion into the US economy to bail out drowning financial giants, the Indian market
saw an outflow of a huge amount of dollars leading to a spurt in the dollar price against the rupee.
The growing Indian trade deficit and the large fiscal deficit are also contributing to the fall of the
rupee.
The higher price of imported goods, especially oil that is now ruling at over $107 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 demand-supply balance and the fundamentals are against the rupee
India has seen a large amount of outflows from its financial markets. India is a heavy importer of
oil and the current spurt in crude oil prices has impacted the rupee too.
Also, the decline in the value of the rupee has coincided with RBI discontinuing its direct sales of
dollars to oil firms in early July.

One more reason for the fall of the rupee, as propounded by some economists, is the overseas nondeliverable 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.

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.
A major problem with a falling rupee is that it will increase the Indian government's burden of
repaying and servicing foreign debt.
Another problem is that it might discourage foreign institutional investment from pouring funds into
the Indian markets.
Indian companies, which could borrow from the overseas markets at cheaper rates to finance their
import and export needs, will be badly affected.

How can India control the value of the rupee in the international market?
The Reserve Bank of India can sell dollars in the open market to bring down the value of the US
greenback, albeit slightly.
Normally, the RBI uses its Monetary Policy to defend the rupee's value. Short-term interest rates changes
do impact the value of the rupee against other currencies. But, the RBI has mostly used the policy to
stabilize internal conditions, like steps to control rising inflation.
However, if the Indian stock markets boom -- like they did in the last couple of years -- more and more
global funds would begin to invest in India thereby strengthening the rupee as the demand for the dollar
in the local markets drops.
What has the RBI done?
The Reserve Bank of India is closely monitoring the developments in the global as well as domestic
financial markets and stands ready to take such pre-emptive action as may be necessary to contain
excess volatility in the domestic financial markets.
In order to alleviate these transient pressures, which are related largely to external developments, the RBI
has decided to take the following measures:
(a) Forex Market
In the light of current developments in the foreign exchange markets, as on some previous occasions, the
Reserve Bank will continue to sell foreign exchange (US dollar) through agent banks to augment supply in
the domestic foreign exchange market or intervene directly to meet any demand-supply gaps. The
Reserve Bank would either sell the foreign exchange directly or advise the bank concerned to buy it in the
market. All the transactions by the Reserve Bank will be at the prevailing market rates and as per market
practice.
(b) Interest Rates on FCNR (B) Deposits
Currently, the interest rate ceiling on FCNR (B) deposits of all maturities has been fixed at
Libor/Euribor/Swap rates for the corresponding maturities minus 75 basis points for the respective foreign
currencies. In view of the prevailing market conditions, it has been decided:

To increase, with immediate effect, the interest rate ceiling on FCNR (B) deposits by 50 basis
points, i.e., to Libor/Euribor/Swap rates minus 25 basis points.
To increase, with immediate effect, the interest rate ceiling on NR(E)RA deposits by 50 basis points,
i.e., to Libor/Euribor/Swap rates plus 50 basis points.

But why do currency values fluctuate?

There are many participants in any foreign exchange market. These entities -- like banks, corporations,
and 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.
Is there any hope for the rupee?
The Indian currency, however, has in the last two trading sessions risen sharply against the dollar under
the hope that foreign investors will soon buy into the Indian stock markets.
With risk aversion among foreign investors declining, the Indian rupee is likely to strengthen.
A Temporary Aberration ?
Commerce Minister Kamal Nath has termed the Indian rupee's fall against the dollar as a 'temporary
aberration,' but said that the lower value of the rupee will help boost export growth.
But even as foreign funds withdrew money from the Indian markets and the oil prices kept going up,
India's huge foreign currency reserves -- pegged at $289 billion that is enough to cover for almost a year's
worth of imports -- have helped a lot, for even if FIIs take away funds India will not face a solvency crisis
like it did in the early 1990s.