What drives the Rupee down ?

Indian rupee collection

Indian rupee collection (Photo credit: Wikipedia)

Global factors, local forces or animal spirits – what drives the Rupee down ?

As the Indian rupee nose-dived this past week, and stock markets were enveloped in gloom, pundits struggled to decode the answers to this question.

One thing however was painfully clear : the consequence of the lower rupee would be higher prices for all of us.

–       we would pay more for fuel, fertilisers and every item that had imported parts

–       we would pay more for our loans, as the Reserve Bank of India raised interest rates, in an effort to keep FII money from flowing out

How did the Indian economy, hailed as a roaring tiger just a few years ago, reach this sorry state ?  What triggered the fall  and what  sustains the rupee’s downward momentum ?

The first global trigger was the suggestion by Ben Bernanke on June 19, 2013, that the central bank of the USA was prepared to begin phasing out it’s Quantitative Easing (QE) Program.  As a result bond yields in the USA rose, and markets across the world fell, as Foreign Institutional Investors (FIIs), pulled money out of equities and emerging markets to invest in US treasuries.

Economies such as India, which had developed dependencies on FII inflows to fund their Current Account Deficits, faced immediate and painful adjustments.

A second trigger came earlier this week, as fears of military action against Syria escalated.  As the price of Brent crude spiked, markets assumed that rising oil prices would undermine growth – especially for countries highly dependent on oil imports.

However these factors affected many emerging markets. Why have the currencies of Mexico, South Korea and many eastern European nations held up so well, while the currencies of countries like Turkey, South Africa and India have plummeted ?

The answer is that FII’s are differentiating between countries.  They are looking at the fundamental factors driving each local economy and choosing where they wish to place their bets.

Countries that rely most on short-term foreign money to fund trade deficits have been the hardest hit. India has a Current Account Deficit (CAD) of  5.1 % of GDP (Turkey  is at 5.9%, S Africa  at 6.3%)

But even this does not fully why FII’s are pulling more money out of India, hence causing the Indian rupee to weaken more than other currencies ?

The answer lies with the elusive animal spirits.

There is a change in guard at the Reserve Bank of India. Markets will observe carefully to see if the new governor, Dr Raghuram Rajan, will take as strong a stance as his predecessor Dr D Subbarao, on inflation, monetary policy and the autonomy of the central bank.

More importantly it is clear to Investors that the Indian political establishment will cater to vote bank politics rather than focus on economics in an election year.

To quote the Wall Street Journal, dt Aug 29, 2013 :  “If India’s fiscally irresponsible “antihunger “ bill passes the Upper House, while needed structural reforms languish, don’t be surprised if pessimism over the country’s future deepens.”

What is the way out of this situation ?

The markets, like all of us, are looking to see decisive actions by the Government, that will help restore confidence in the Indian economy. Three simple steps will not only stem the fall of the rupee but also set the Indian economy back on the path of growth :

1)   Rein in Government Spending and bring the fiscal deficit under control

2)   Take quick measures to address the Current account deficit

3)   Start seriously undertaking pro-growth reforms

As Terrence Checki of the New York Federal Reserve stated “Fundamentals are Fundamental”. Three simple words that our Policy makers and politicians would do well to heed.