Why rupee fell and how RBI came to its rescue
The rupee reached 68.8375, close to the all-time low of 68.85 that was struck in 2013. The central bank probably sold over $500 million that day to steady the sliding rupee.business Updated: Nov 30, 2016 10:22 IST
On November 24, The Reserve Bank of India (RBI) intervened to stabilise the rupee as it neared a record low reportedly due to the strengthening US dollar, capital outflows, and the demonetisation drive.
The rupee reached 68.8375, close to the all-time low of 68.85 that was struck in 2013. The central bank probably sold over $500 million that day to steady the sliding rupee.
To a student of economics or a financial executive, the statement is self-explanatory, but to a layman, it may be gobbldegook! He or she may wonder why currency falls, what determines the money supply, and how much money can the RBI print.
To understand currency fluctuations, we must first know that ours is a managed floating currency. The government doesn’t set the exchange rate but doesn’t let it fluctuate freely either.
In order to find out how an exchange rate is determined, we must first know what determines the demand for foreign currency deposits.
Noted economist Paul Krugman says the demand for foreign currency bank deposits is influenced by considerations that influence the demand for any other asset. Among these, the most important factor is our view on what the deposit will be worth in the future.
Moreover, a foreign currency deposit’s future value depends on the interest rate it offers and the expected change in the currency’s exchange rate against other currencies.
In other words, the rupee rate of return on dollar deposits is approximately the dollar interest rate plus the rate of depreciation of the rupee against the dollar.
So if the rupee depreciates by 5% against the dollar in a year and the interest rate on dollar deposits is 5%, your expected rupee rate of return on dollar deposits will be 10%. And if the rupee interest rate is 7%, you will get a return of only 7% on rupee deposits.
So we can now understand that investors are buying the dollar as US interest rates are expected to rise with US President-elect Donald Trump planning to adopt a fiscal expansionary policy.
With more people buying the dollar, it becomes more expensive, and rupee supply increases in the market. This then leads to disequilibrium as investors won’t be willing to hold rupee deposits.
Rupee holders then try to entice the dollar holders by offering them a better price, resulting in a fall in the rupee. The dollar/rupee exchange rate falls till the time dollar and rupee deposits offer equal returns or achieve interest parity condition.
As the currency falls, importers and Indian businesses suffer and the government’s cost to service its international debt rises. Therefore, the RBI must keep a close watch on the exchange rate, intervening when the currency depreciates or appreciates too much.
On November 24, when the rupee fell, the RBI sold over $500 million, sucking out the excess rupee supply in the market as the money the RBI receives gets taken out of circulation. The move also increases the dollar supply, satiating the demand for it, and checking the rupee slide.
The RBI can either reduce the money supply or increase it. It reduces money supply by selling dollars or bonds, and increases it by purchasing them.
This leads us to the next question as to how much money the RBI can supply in the market. The central bank has a balance sheet of assets and liabilities. Its assets are either domestic or foreign.
Its foreign assets are mainly foreign currency bonds or gold that it owns. Its domestic assets include loans and bonds issued to citizens and domestic private banks. Its liabilities are the deposits of private banks and currency in circulation.
So the currency in circulation is decided by the amount of assets that the central bank possesses.
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The rupee’s fall is also testament to the pernicious effects of the demonetisation exercise. It has weakened output, which in turn, has lowered the rupee demand, and ultimately led to the depreciation of rupee.