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Rupee Depreciation: Probable Causes and Outlook

The Indian Rupee has depreciated significantly against the US Dollar marking a new risk for Indian economy. Till the beginning of the financial year (Apr 11-Mar 12) very few had expected Rupee to depreciate with most hinting towards either appreciation or status quo in the rupee levels. Those few who had even anticipated may not have imagined the scale of depreciation with rupee touching a new low of around Rs 54 to the US Dollar. What is even more interesting to note is that when other countries are trying to play currency wars and trying to keep their currencies devalued, India is trying to prevent depreciation of the currency. (Read our previous report for a review of the situation-
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Fiscal Deficit: Fiscal deficits play a role especially during currency crisis. If a country follows a fixed exchange rates and also runs a large fiscal deficit it could lead to speculative attacks on the currency. Higher deficits imply government might resort to using forex reserves to finance its deficit. This leads to lowering of the reserves and in case there is a speculation on the currency, the government may not have adequate reserves to protect the fixed value of the currency. This pushes the government to devalue the currency. So, though fiscal deficits do not have a direct bearing on foreign exchange markets, they play a role in case there is a crisis. Global economic conditions: Barring domestic conditions, global conditions impact the currency movement as well. In times of high uncertainty as seen lately, most currencies usually depreciate against US Dollar as it is seen as a safe haven currency. Hence even over a longer term, multiple factors determine an exchange rate with each one playing an important role over time.

II. Rupee Movement since 1991
If we look at India’s Balance of Payments since 1970-71, we see that external account mostly balances in 1970s. Infact in second half of 1970s there is a current account surplus. This was a period of import substitution strategy and India followed a closed economy model.

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