Continuing from the last post, let’s see how the price of rupee is determined vis a vis dollar.
The market determines the price of a currency vis-à-vis another based on its demand and supply. Some countries that permit exchange rate to be determined by the market do not impose any restriction on the amount of local currency to be exchanged for foreign currency. On the other hand, countries with a nonconvertible currency policy, fix the exchange rate by diktat. The Indian rupee is fully convertible on current account but there are restrictions on convertibility on capital account. This means that though foreign exchange for trade in goods and services is determined on the basis of market demand and supply, but the government has put in some restrictions on flow of different forms of capital in & out of the country.
Some of the probable causes of the rupee’s depreciation against dollar are –
Deficits in the trade of goods and services – India reported a trade deficit equivalent to $196 billion in October 2011 as compared with $104.4 billion in March 2011. The widening trade deficit poses downside risks to the weak Indian currency. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation’s economy and impact the value of currency. The decrease in growth of exports coupled with the increase in imports has contributed to a widening deficit in trade of goods and services.
Fiscal deficits – India has been running large fiscal deficits due to dwindling growth in tax revenues, rising subsidy bill and the government’s failure to raise funds through stake sale in state-run firms. The market usually reacts negatively to widening government budget deficits the impact is reflected in the fall in the value of rupee.
Capital flight – The government has attributed the depreciation in rupee to the withdrawal of funds from India by the Foreign Institutional Investors. A number of scandals, governance deficit, policy delays and slowdown of growth in India, have seen FII’s pull funds from India.
RBI has taken short term steps to stabilize rupee by reducing banks’ forex trading limits and curbing speculative activity resulting from exporters cancelling their earlier contracts and rebooking exports to take advantage of sliding rupee, thereby fuelling depreciation. To increase the supply of dollars, RBI may announce a scheme for overseas Indians to bring in their funds, or offer higher returns to NRI’s. RBI may also sell dollars to oil management companies to prevent spikes in demand for $ due to large imports. But there are limitations in selling dollars from capital reserves as India’s foreign exchange reserves are mainly created by purchase of dollars bought in by FIIs and may be needed if FIIs choose to exit.
While RBI might not introduce capital controls to prevent outflow of dollars from the country, as it is against India’s policy of moving towards full capital convertibility, but RBI may ease rates in future to bring in liquidity. This will boost the equity market & money will flow into the country as growth picks up.