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INR fell to record lows in 2018 and this note by Varshika, a 11th grade student, is timely.
Evaluating options to study in the US, I found that the cost of studying rose by over 10% over the last one year, without any university increasing fees. The Indian Rupee (INR) had depreciated sharply against the USD in 2018, and it has affected me directly, as I am funding my overseas education with Indian Rupees.
The economic student in me started to dwell on the reasons why the INR depreciated against the USD and after doing the research, I arrived at the primary reasons why the INR depreciated against the USD in calendar year 2018 and also found possible solutions to the currency depreciation issue.
Reasons why the INR depreciated against the USD
The Rupee witnessed sharp depreciation in 2018 against the US Dollar, moving from Rs 64 to Rs 74 and is now trading at Rs 70 levels. Chart 1.
Movement in the Rupee over the year
Source: INR Bonds.com
Demand – Supply
Economics is primarily assessing the reasons for demand-supply dynamics. The marketplace determines the price of an asset or goods and services based on demand and supply. The INR depreciating was due to higher demand for USD and these are the Reasons for the higher demand for USD IN 2018.
Balance of Payments
Balance of Payments turned negative briefly in 2018 on capital outflows and rising current account deficit . Negative BOP indicates that there is more USD going out of the country than it is coming in and this leads to INR depreciation.
The Balance of Payments (BoP) of a country is the well-defined statement that clearly expresses and measures the supply and demand for Dollars in the economy. The BoP can be split in two parts – the current account and the capital account.
On the Current account (Trade and services), any country’s demand for Dollars arises from importers who buy goods from abroad for which they have to pay in Dollars while the supply of Dollars would arise from exporters who sell their products abroad in return for Dollars. This gap between the demand and supply for Dollars on the current account is called the Current Account Balance. For India, this gap is negative. No country makes everything that is consumed at home domestically and every country makes what it is good at producing (cheapest to produce) whether it is consumed domestically or not. This is represented by the activity from importer and exporters. Within the wide variety of items that India consumes, oil is the most significant that is required for all activities while we do not produce any oil at home. Hence this is a very large source of Dollar demand within the imports of the country. Oil is followed by electronic items as the second highest category of imports.
The supply of Dollars in the Capital account denotes the amount that foreigners are willing to invest in our country while the demand for Dollars in the capital account denotes the amount that Indians would like to invest abroad. The difference between the two denotes the net capital account balance. India has been attracting foreign capital flows in the form of investments in businesses by foreigners (FDI), investments by foreigners in stocks and bonds (FIIs), External borrowings raised by companies abroad and so and so forth.
Rise in Global Crude Oil Prices
Price of oil was one of the biggest source of volatility in the changing demand-supply equation for Dollars in the current account last year. Chart 2
Movement in oil prices (Brent used as benchmark) over the year
While mostly all other commodities subscribe to the micro economic laws of demand-supply – i.e. higher the price lower is the demand – Oil is one of those rare commodities that is price inelastic. The demand for oil pretty much remained the same even when prices rise, leading to a higher deficit on the current account and the need for more Dollars to pay for the imported oil.
The country then has no choice but to fund this deficit by a higher net capital flow of Dollars from abroad. Unfortunately a higher deficit on the current account actually leads foreign investors to doubt the ability of the country to attract Dollar inflows. This leads them to actually delay investing as they wait for the price of the Dollar to appreciate against the INR (cheaper rupee). This becomes a vicious circle as not only does the deficit of Dollars go up due to the higher price of oil but the supply of Dollars too comes down due to less capital flows from abroad. The net result is a double whammy and hence an enormous increase in the demand-supply gap for Dollars leading to appreciation of the Dollar. This is exactly what happened in 2018 when oil prices touched 85$/barrel from 60$/barrel (and Dollar/Rupee rate moved from Rs 64 to Rs74). Inverse of this is what happened when the oil price touched 55$/barrel (Dollar/Rupee moved from 74 to 70).
We can hence see the impact that CAD (Current Account Deficit) has on the exchange rate.
Trends in quarterly current account deficit
What policies should we follow in order to bridge this gap?
India has had a perennial deficit on the current account and hence we have always relied on foreign flows to fund this deficit. Firstly we should try to institute measures which incentivize domestic industries to make goods and services that replace imports. Why do we need to import so much smartphones and other electronic items from abroad? Can’t we make the same phones indigenously at home?
Secondly, oil is something that we cannot produce domestically and hence long term measures are required to substitute away from fossil fuels and encourage green fuels. This has the added benefit of improving our fragile environmental outlook.
Thirdly, we should not be overly reliant on foreign flows that come through relatively short term investments in equity or bond markets. These flows tend to be very volatile. For example, 2018 saw huge outflows of such funds especially from bond markets, which made our balance of payment problem more acute.
Trends in foreign portfolio investments (equity and bond) with trends in current account deficit
Instead we should actively let foreigners deploy their Dollar savings in India by encouraging them to invest in industries rather than in markets. But of course care should be taken to generate employment opportunities using those investments which in turn will lead to higher national income which in turn would lead to higher domestic savings and consumption.
What is the link between the CAD and the savings-investment gap?
In a closed economy, savings of the economy is equal to its investment. If there is a fall in savings, it means people are consuming more (saving less) which in turn increases imports as in reality there are no closed economies (resulting in a CAD). And since savings are less than investment it needs to be financed by savings from abroad in reality (resulting in a capital surplus). Hence a CAD will need to be financed by capital flows. This is how CAD is linked to the savings-investment gap and any solution for narrowing the CAD will also involve steps to increase domestic savings.
A country like Japan has perennially had a current account surplus leading to excess of savings over investment leading to this savings being invested abroad. India on the other hand has always had a current account deficit leading to investment greater than savings requiring the country to attract capital flows from abroad.
Conclusion – Should India try to run a Current Account Surplus (CAS) instead of a deficit (CAD)?
As is obvious, for any country, all its investments have to be funded by the available savings during a given period of time. Domestic savings in an economy are contributed by households, private and public corporates and by the Government itself. However, in a country like India, the Government is unable to save (due to the fiscal deficit that it runs) and there is hence an excessive reliance on households and corporates to contribute to the major share of savings for our nation. Hence this available pool of domestic savings is often not enough to fund the entire investment needs and results in the need to borrow funds from the rest of the world in the form of capital flows.
Developing countries like India will require more investments in infrastructure and hence will require savings from abroad to compensate for the shortfall in domestic savings. Hence there is nothing inappropriate in running a CAD. However care should be taken to ensure that the CAD does not spiral higher leading to a trust deficit. If it were to happen then this trust deficit in turn will impair the ability to attract capital flows to fund the investment requirements leading to a dramatic depreciation of the currency.
So in a nut shell CAD and an orderly depreciation is good for a developing economy like India. The savings that we attract from abroad would then drive the growth in the economy. Only were the deficit to spiral up dramatically should care be taken to bring it back to order quickly. This was what we did in 2013 by instating steps to bring the deficit done. Fortunately for us, this time around the dramatic fall in the price of crude oil has done the job for us.
About the Author
Grade XI, International Baccalaureate Diploma Program, Dhirubhai Ambani International School, Mumbai