Rupee Dollar Dynamics

            Rupee Dollar Dynamics 
                ---By -- NSN Reddy

Foreign exchange reserves are extremely critical for the countries who deal with international trade to meet the foreign currency commitments. Normally, the international trade transactions take place in couple of major currencies of which US Dollar plays a predominant role.  

Exchange rates, like any other commodity, are based on supply and demand for particular forms of currency. Domestic currency supply changes as a result of a country's fiscal and monetary policies. Similarly, demand for currency can be influenced by a large number of factors, including interest rates, inflation, and views on impending government regulation.

A strong exchange rate (rupee appreciation) is often considered to be a sign of economic strength and can become a symbol of national pride. On the flipside, there are arguments that it can depress economic growth as it may tend to lead exports more expensive, therefore less demand for exports. At the same time it ignites more demand for imported goods on account of price competitiveness which pose threat to survival of domestic industry.

Evolution of Exchange Rate: The movement of exchange rates in India have undergone sea-change and the journey is quite interesting and fascinating. The evolution can be broadly categorized into three distinct phases viz., Regulated, Dual Rate, and Partial Deregulated.

i) Regulated Regime: The regulated exchange rate regime was in force in India for a very long period and the exchange rate ($USD vis-a-vis Rupee) movement from 1952 to 1990 is furnished in Table 1.

Table 1- Regulated Regime Exchange Rates
Year	Exchange Rate
1952	4.75
1966	7.50
1975	10.41
1980	7.89
1985	12.37
1990	17.50
Source: RBI Reports

ii) Dual Exchange Rate Regime: The country faced serious economic crisis in the year 1990 and the forex reserves were dried up completely. In the above backdrop, the government adopted a dual exchange rate regime where the importers were allowed to pay for some imports with foreign exchange valued at free-market rates and other imports could be purchased with foreign exchange purchased at a government-mandated rate. Subsequently, Floating Exchange Rate was introduced in the year 1993 where the exchange rate is determined ostensibly by market forces. During the transition period (1990 to 1993) the exchange rates witnessed sharp upward movements. However, the post floating exchange rate regime i.e. beyond 1993, witnessed gradual depreciation of rupee against US Dollar.  The year-wise movements are furnished in Table 2.

Table 2 - Post Liberalization Era Exchange Rates
Year	Average Yearly Exchange Rate
1990	17.50
1991	22.75
1992	28.14
1993	31.28
1994	31.39
1995	32.42
1996	35.51
1997	36.38
1998	41.35
1999	43.13
2000	45.02
2001	47.29
2002	48.56
Source: RBI Reports

iii) Partial Deregulated Regime: The Indian rupee has been highly volatile in the recent past driven by implementation of economic reforms which ignited cross country trade volumes. The exchange rates were moved in different directions during the last one decade i.e. 2003 to 2013 which is evident from Table 3.

The rupee appreciated from `46.63 level in 2003 to `44.05 in 2005. This again was short-lived as rupee depreciated continuously since 2007 and touched `48.36 in 2009 and later regained to `45.72 in 2010. The exchange rate has passed turbulent times from `45.72 to `54.83 during the last 3 years and traded at a lifetime low of `60.71 in the month of June 2013.

Table 3 - Partial Deregulated Era Exchange Rates
Year	Average Yearly Exchange Rate
2003	46.63
2004	45.27
2005	44.05
2006	45.27
2007	41.21
2008	43.49
2009	48.36
2010	45.72
2011	46.68
2012	53.43
2013	54.83
Source: RBI Reports

 The local currency is not only depreciating against the US Dollar but also other major global currencies too. The fall in rupee against US Dollar can be attributed primarily to the following major factors:

Ø  The investors across the globe are considering US Dollars as a safe haven for theirinvestments on account of turbulence in European markets and weak global economic outlook. This led to an increased demand for dollars vis-à-vis the supply for rupee and thus the depreciation.

Ø  The Indian economic scenario over the years has been plagued by high rate of inflation, hovering around 5% to 10%, and tardy growth in manufacturing sector. The cumulative effect of these factors is leading to a shift in investor sentiments towards dollar market.

Ø  Due to a sharp increase in the dollar rates, importers suddenly started gasping for dollars to hedge their position, which led to an increased demand for dollars. On the other hand exporters kept on holding their dollar reserves, speculating that the rupee will fall further in future. This interplay between the two forces further fuelled the demand for dollars while sequestering its supply from the market.

Ø  There has been shift of FIIs from the Indian markets in the recent years and this has triggered increased demand for dollars which is further leading to a spiralling rupee.

The depreciation of rupee against US Dollar has cascading impact on the economy as we are operating in a liberalized environment dealing with multiple countries / currencies and this has bearing on the following sectors:

Exports - Businesses that rely on exports can find their products suddenly competitive in overseas markets as exchange rates fluctuate. The falling rupee has substantially appreciated the revenues for the exporters especially dealing with Information Technology, Pharma, Gems, Textile sectors as they receive more rupees for their dollar denominated export contracts. It is a boon to IT companies as it generates more than 80% of their revenue from overseas market and this will enhance their revenue realizations.

Imports – Companies that rely on imports can see the costs of these imports rise and fall with the exchange rate. India has been importing crude and petrol to meet the growing needs of the corporate sector as well as domestic consumption.  Despite drop in oil prices in international market, we are unable to take advantage due to weakening of local currency. Further, the increased gold imports added fuel to fire and widened the current account deficit. This has far reaching impact on increasing inflation with rise in energy cost to transportation cost.

Table 4 - Foreign Trade & Gross Domestic Product (Lakh Crore)
Year	Foreign Trade			Gross Domestic Product
	Exports	Imports	Trade Gap	GDP at Current Price	% Exports to GDP	% Imports to GDP	Total Exposure
2006	4.56	6.60	-2.04	32.82	13.89	20.11	34.00
2007	5.72	8.41	-2.69	37.79	15.14	22.25	37.39
2008	6.56	10.12	-3.56	49.87	13.15	20.29	33.45
2009	8.40	13.74	-5.34	56.30	14.92	24.40	39.33
2010	8.45	13.64	-5.19	64.78	13.04	21.06	34.10
2011	11.43	16.83	-5.40	77.95	14.66	21.59	36.25
2012	14.66	23.46	-8.80	89.75	16.33	26.14	42.47
2013	16.34	26.76	-10.42	100.28	16.29	26.69	42.98
Source: Economic Survey 2012-13 & Export & Import Data Bank

It is evident from Table 4 that while exports showing tepid growth and imports are on the rise both in absolute terms as well as percentage to GDP. Further, the total exposure of the country to the rest of the world (% Exports and Imports to GDP) has been increasing over the years from 34% in 2006 to 42.98% in 2013 is also a cause serious concern as any change across the globe has direct bearing on the economy.

Falling value of rupee brings cheer to the economy only when the exports surpass imports as loss on imports is neutralized by gain on exports. However, it is alarming situation for our country as trade deficit is looming large over the years – from `2.04 lakh crore in 2006 to `10.42 lakh crore in 2013.

Corporate sector – Indian corporates have been increasingly accessing international debt markets to raise resources to take advantage of low interest rates in international markets. As per Bloomberg reports, Indian corporates have borrowed more than $12 billion every year since 2010.The falling rupee has direct bearing on the interest burden as majority of the corporate borrow funds through ECB. For companies that have availed of foreign currency loans for implementation of projects, the rupee depreciation will stretch their balance sheets, as the amount of debt will increase in rupee terms. As these loans mature, the cash flows will also be impacted. The rupee depreciation especially in economic downturn scenario is compressing the corporate margins and creating difficulties in making repayments to the creditors.

Exchange rate movements can have a significant impact on corporate returns. Multinational companies may see significant shifts in their profitability, as foreign exchange rates may make locally held currency more valuable. Even local companies can be affected, as changing forex rates may substantially alter their material costs, or affect their ability to sell their goods in foreign countries at competitive prices.

Foreign investments - The rupee’s weakness may make foreign investors think twice before investing in India whether it is Foreign Direct Investment (FDI) or Foreign Institutional Investors (FII) or External Commercial Borrowings (ECB). Foreign capital inflows are typically at risk when the local currency weakens. Already, portfolio flows into both debt and equity have been gradually tapering, with investors subscribing to the view that the local currency could depreciate further. If the rupee touches a new low and stabilizes there, foreigners may then put in more money, as they would get more rupees for the same amount of dollars they would have put in earlier.

Impact on economy - The major impact of the falling rupee can be seen on the rising import bill as around 70% of country’s fuel requirements are being met by imports alone. The imports have severely impacted the bottom line of majority companies as well as the subsidy bill of the government. Of late, the gold imports have added the woes further which widening the trade deficit. Increasing imbalance in trade has adverse impact on country’s fiscal deficit, alarmingly stood at 5.4% of GDP, is a cause of serious concern. A falling rupee straightaway translates into an increase in the retail prices of all products across the board on account of imported fuel costs which also termed as “Imported Inflation”. The spiralling inflation in turn leads to stagnant growth of the economy.

Forex Management - Role of Banks

Banks have been playing a significant role by extending the required financial support to the corporates who are the backbone for economic development of the country. Of late, it is observed that the corporates have been availing foreign currency borrowings as the Banks/Financial Institutions are unable to meet their requirements on one hand and the cost of borrowings from the banking system is on high side on the other. Thus, the foreign currency borrowing has attained utmost importance to address the issue of access to funds and to take the advantage of interest arbitrage especially in stable/appreciating rupee environment.

It is estimated that around 60% of relatively long term foreign currency exposure and 40% of the short term exposure up to one year maturity are unhedged. The probability of Indian companies defaulting on their dollar loans has increased significantly on account of rupee depreciation and may pose a systematic threat to the Indian banking system. The forex risks, if not addressed suitably by the corporates, may eventually lead to credit risk to the banks. Thus, it is also the responsibility of the banks to ensure that the borrowing companies should have a Board approved hedging policy in place and the policy guidelines are adhered scrupulously.

Inward Remittances - Indians settled abroad and NRIs working overseas temporarily are the major source of foreign exchange inflows to the country.  The inward remittances (private transfers) during the last one decade are furnished in Table 5.

Table 5 - Exchange Rate vis-a-vis Inward Remittances & NR Deposits
Year	Yearly Average Exchange Rate (`)	NR Dep* ($ bn)	Inward Remit ($ bn)
2004	45.27	NA	NA
2005	44.05	32.74	20.52
2006	45.27	36.28	24.49
2007	41.21	41.24	29.82
2008	43.49	43.67	41.94
2009	48.36	41.55	44.80
2010	45.72	47.90	52.04
2011	46.68	51.68	53.14
2012	53.43	58.61	63.49
2013	54.83	70.80	64.00#
Source: RBI & World Bank Reports         *cumulative           # provisional

Contrary to the common belief, the volatility of exchange rate has no significant impact on the forex inflows. India witnessed continuous flow of inward foreign remittances both in times of rupee appreciation as well as rupee depreciation which clearly demonstrates the fact that the inflows are not exchange rate sensitive.While NRIs' emotional connection to their country of origin is part of the explanation for this, the attractive domestic deposit interest rates also provide a powerful incentive. Inward remittances play an important role in bridging the current gap especially in falling rupee environment.

NR Deposits - It is observed that around 20% of inward remittances are being converted into bank deposits. From the above table it is evident that NRI deposits increased from $32.7 billion in 2005 to $ 67.6 billion in 2013 with compounded average annual growth rate of 13.40% despite volatility in forex rates. Banks can bank on this segment as it has potential to grow in the ensuring years due to increased migration to USA and Europe for education and employment purposes. 

Way forward

RBI has been extremely cautious in its intervention during the entire rupee depreciation crises and reacting with timely interventions by selling dollars intermittently to tame sharp fall of rupee. In order to curb the speculative forces, recently RBI introduced key policy initiatives such as intervening in the forward contracts policy whereby cancelled forward contracts cannot be rebooked. Further, RBI intermittently put trading limits for the banks in the foreign exchange market in order to tame the speculative forces and to manage the volatility and disruption to the macro-economic situation. However, the fact remains that India just does not have enough foreign exchange reserves to sell in the market to support the rupee and thus intervention is very limited.

External Commercial Borrowings (ECB) has become one of the major sources for corporates to meet their capital expenditure towards new projects and capacity expansion, which stood at $121 billion as on 31st March 2013. However, the end-use restrictions are coming into the way to the free flow of funds from abroad. Though, the recent relaxations announced by RBI to use ECB route to pay for imported services which include technical know-how and licence fee is a welcoming sign, there is an imminent need to relax the norms further to invite inflows of foreign currency to meet the emerging requirements of the country.

The increased foreign trade necessitating the corporates to deal with multiple currencies which are fraught with currency risks on account volatile forex market and this trend is likely to stay in the ensuing years also.

The adoption of proper hedging policy is the need of the hour to optimize their resources to focus on the core business for its competitive advantage. In this scenario, the Forex Risk Management policies of the corporates have to remain strong and have to be strictly adhered to protect the interests of all the stakeholders and in preventing system risks. However, the corporates can take best hedging decisions only when the risk managers acknowledge that market movements are unpredictable and hedging should always seek to minimize risk but should not represent a gamble on the direction of market prices.

Given global demand conditions and price competitiveness, there is no much scope to augment exports and at the same time imports are on the rise which is likely to widen the current account deficit further in the ensuing years. Reform in fuel and fertiliser price policies and fiscal consolidation may ease the situation. On the other hand, better growth and investment opportunities and lower inflation will enable our country a more attractive investment destination. Thus, it is imperative for policy makers to focus on medium to long-term measures to restore investor confidence to improve capital flows (FDI/FII/ECB) to bridge the gap.

The most potent symbol of a nation's economic strength is the soundness of its currency. If the decline in rupee continues then it will have adverse impact on all key sectors of the economy. It is therefore high time that government should push the second generation economic reforms so that Indian exports get the much needed boost and also encourage import substitute industries to augment the net trade inflows to ensure the stability and soundness of the rupee against all major currencies in the long run.