Is there a big problem if the USD has appreciated so that it’s Rs. 70 to a dollar? There are some implications, but it’s somehow not that dramatic as its made out to be. We wrote about a few myths about the falling rupee when it did a dive last time in 2013 (Read post: Six myths about a falling rupee). It’s time to look at the rupee in context again.

### Why should the rupee depreciate? Or stay strong?

The argument is actually quite simple. Consider you have a world with only two countries: India and China. Let’s say China has Indian rupees in its forex kitty. Now they can use those rupees to buy Indian items – let’s say they buy masala dosas if Rs 100 each, worth 100 cr. rupees and import them into China, and sell it at, say, 10 cr. Yuan Renminbi (let’s just call it CNY). The exchange rate is 1 CNY = 10 Rupees.

Effectively, the Chinese have bought 1 cr. masala dosas from India at 1 CNY = Rs. 10 and sold it locally at CNY 10 per dosa.

Let’s say Indian inflation is 10% but Chinese inflation is 5%.

Next year:  now Masala Dosa in India costs Rs. 110 after a year. If the Chinese buy 1 cr. masala dosas they have to pay Rs. 110 cr. = CNY 11 cr.

But they can sell 1 cr. dosas only for CNY 10.5 cr. (since inflation is only 5% in China) This is a problem because the trader will lose CNY 0.5 cr.

Now the trader can sell 1 cr. masala dosas for 10.5 cr. It costs 110 cr. rupees to buy it in India. Simple math: The exchange rate will become 110 / 10.5 = Rs. 10.48 per CNY. (That’s what the Chinese trader will use to buy the dosas otherwise he loses money)

The exchange rate for the Rupee moved up from Rs. 10 to Rs. 10.48.

This is a 4.8% depreciation in the rupee. (Or, the CNY has appreciated by 4.8% compared to the rupee)

Why did it happen? Because of relative inflation differences.

Phew.

If you got here, that ends the theory part. Typically the difference in inflation should be reflected in prices of relative currencies. If one country has 3% inflation and another has 7% inflation, then the second country’s currency should depreciate by about 4% a year.

However, this is theory, and in practice, people do strange things like trade currencies, set up forward contracts, use hedges etc. And it’s no longer just trade – people invest in other countries, take loans from abroad, send money to their home countries etc. Even central banks play a role, buying other currencies to keep the exchange rate at certain levels.

There’s interest rates too. If the interest rate in China is 4% and in India it’s 8%, people could borrow in China and put the money in Indian deposits. To offset that, the currency will depreciate to reflect that difference too. So if you raise interest rates, you *should* theoretically get more demand for your currency from other countries whose interest rates are lower. (Theory because countries place restrictions on who can buy their deposits and earn the higher rate, so it’s not always true practically)

So the demand for a currency is no longer just the demand for goods and services. So currencies don’t depreciate every day according to the inflation formula – there are ups and downs for long periods of time. But over the long term, the inflation differential will stick and cause damage.

### Has this happened earlier?

There’s this little country called England. 71 years ago, in fact, exactly to this day, India said dudes, go back to your little island. (Happy Independence day folks!)

After many years of wondering what happened to the British Empire, the British suddenly decided they wanted to be part of some other empire somehow. In 1990 they decided to join the European Exchange Rate Mechanism (ERM) which basically limited how much the UK Pound – German Deutchemark could be exchanged at – to a lower level of 2.78 marks to the pound. If it went below that, it would require the Bank of England to buy pounds until the level was maintained.

However British inflation was 7% but German inflation was 3%. Interest rates were kept high in the UK because otherwise the currency would devalue. And because of that, in 1992, there was a recession in England, and unemployment rates crept up to 10%. The UK pound was overvalued – the years of keeping it in the ERM had meant that they were uncompetitive from exports and interest rates couldn’t be lowered to stimulate local demand, because it would mean a drop in the currency and a break in the ERM rate.

There’s this guy called George Soros. He saw this coming. And bet a big ton of money against the pound by shorting it. Eventually, on a “Black Wednesday” the pound went into freefall, and the BoE tried to increase rates from 10% to as much as 15% on the same day. And even when that didn’t work, Britain left the ERM.

The Pound depreciated 15% against the mark. And then, found some stability in both rates and inflation since. But the point is: The fundamentals of relative inflation and flows were more important to the exchange rate even though the Bank of England tried its level best to maintain the currency at a certain level.

India also is prey to the same fundamentals.

### Is the Indian Rupee fall to 70 a very large one?

There’s a weird fascination with the 70 number. But let’s look at it from various angles. First, from the angle of relative inflation in the US. We mapped inflation from India versus inflation in the US, with a 5 year average of the difference in the two:

Why do we take five years? We could take 10 or 15 but it seems that typical cycles in India are five years. And every five years or so, there is a big change in the USD INR equation – in 2008 we saw a major fall in the rupee, and then in 2013. Here’s the rupee chart since 1992 (when the rupee got tradeable in any real sense) and how the 5 year average change has been:

In effect, while the average inflation difference in the last few years has been north of 4% a year between India and the US, the average currency change per year is just 2%. This is obviously a deviation from fundamentals, and therefore we are likely to see a correction.

Corrections don’t happen slowly. In India there will be a five year lull and suddenly one big change. That change is likely to be occurring now. It’s not just India, all other emerging markets are seeing major layers of depreciation, and we’ll come to that.

### Second: The Rupee Compared to Its Own Past: Not That Different

The rupee has an uptrend inbuilt in it. For looking at that we checked out the 200 day moving average of the rupee price and it tends to be upward sloping. The more the prices deviate away from this average, the more you can say the price is “abnormal”. For what it’s worth, there’s nothing really abnormal about the 70 number today. We have this chart:

Are things getting really bad? It’s nowhere as convoluted as 2008 or 2013, or indeed even 2011-12. We may have a problem with 70 from a numeric angle, but the natural trend of the rupee seems to take it in that direction, and we’re not actually too far away from the average.

### Third: The Emerging Market Currency Damage Includes Other Countries

Yes, we’ve seen a major damage in Turkey last week and it’s down some 40%+ in the year. But even other emerging currencies are in trouble.

Why should other currencies impact us?

• Brazil exports some things that India does, for instance. And it will even export to India
• When its exchange rate falls, it can export to other countries cheaper in dollar terms (and in rupee terms, if the rupee is not falling)
• That means Indian exporters face competition of lower prices from Brazilian exporters.
• And Indian domestic manufacturers have to face lower prices from Brazilian imports.
• If the rupee does not depreciate, we will therefore import more and export less.
• When you import more and export less your trade deficit goes up.
• India does have a trade deficit (160 billion dollars last year) but that was balanced by a few other things.
• We had \$78 billion of service exports (IT), about \$62 billion of NRI remittances, and had to pay dividends and interest of around \$28 billion. Net of all this we had a deficit of \$48 billion.
• This was financed by inflows from the other big thing : financial inflows.
• With FDI (\$30 bn), Portfolio investments (\$22 bn) NRI Inflows (\$10 bn), Loans (\$23 bn) and a bit here and there, we actually got \$100 billion last year from financial inflows!
• This was so much that the RBI had to buy \$43 billion of currency to keep the currency stable (as in, to not let it appreciate)

The RBI has probably spent around 20 to 30 billion dollars protecting the rupee from falling this year. Still less than it added last year.

Now if the rupee were to depreciate less than other currencies our trade deficit will WIDEN. And combine that with falling Portfolio investments, and this will result in a depreciation. Again, this is not a major problem.

Because the current account deficit is ALWAYS financed. If you don’t finance it through inflows, you will finance it through currency depreciation. The last time, in 2013, we started to see serious depreciation and then the RBI did the big NRI deposit FCNR scheme which brought in \$30 billion or so and that meant the rupee didn’t have to fall more. They could do that again, or they could let the currency fall.

A falling currency will actually help reduce this deficit for now. It does cause short term pain, of course, because we are net importers. (But how much? If you net out gold and goods and services, we import just \$15 billion a year. The rupee fall will maybe move that to \$30 billion – which is still nothing. India has a GDP of \$2 trillion – and this new deficit will still be less than 1%. I speak of “net of gold” because gold is actually a capital import, and can be harnessed later)

### What We Need: Getting On The Soap Box

One thing India does need is a way to make our brands more competitive locally and internationally so we don’t need to import so much. India doesn’t make toys anymore, and much of that is because imported toys are much much cheaper. But there’s a pretty good need for localization – our multiple states and cultures have local needs for toys that are based on folklore or local fads. Even Chota Bheem hasn’t been able to pull it off, or the awesome characters in Tinkle or Amar Chitra Katha. (Why don’t we have a toy set of Mahabharata with a build-it-yourself model? With things like little motors that move a character across a battleground etc? ) But getting toymakers to start in India isn’t only about a weaker currency.

The idea should be to massively reform labour laws and make manufacturing easier in India, for India. As in, we should create special economic zones with lower labour laws that aren’t forced to export – but to serve India better. That will reduce imports by just substituting for our imports, which is actually better than pushing exports. We should love our industries – we currently despise them because we believe all the private players are frauds, and we will get told that any labour reform is just going to benefit an Ambani and Adani, while it actually will benefit all Indian manufacturers a lot more.

Secondly, we should free the rupee. It’s going to fall anyhow. Let it be free so that inflows can be huge enough tomorrow when we become solid exporters. The Euro could be strong, but people don’t stop buying Lego. Because Lego is required regardless of how expensive it is. And India needs to have its own brands that have such demand, and for that we need lots of capital to come in. (Some of it has happened, but we need freedom of flows to make more of it happen)

My view on the Rupee fall is: It’s okay if it happens, and 70 or 75 is not a big number. We should learn to adapt to what is likely to happen anyhow. This could spike up interest rates in the short term, or have inflation. But in the long term, our consequent reforms – from labour to FEMA repeal to manufacturing or service growth – will create structures that require less depreciation in the future. Our control of inflation too has been impressive enough to reduce the relative difference with other countries.

That’s me off the soap box. I know this will get political, but I don’t care about the politics. The rupee fall, in context, is not a big deal, and we should expect more.