Capitalmind
Capitalmind
Actionable insights on equities, fixed-income, macros and personal finance Start 14-Days Free Trial
Actionable investing insights Get Free Trial
Concepts & Tutorials

Busting Six Myths About A Falling Rupee

I wrote this article for Outlook India, Sep 02.

Myth 1

Weaker currency means a weak country

Would you say Kuwait is stronger than America? After all, it’s now 3.52 dollars for one Kuwaiti dinar. Exchange rates don’t indicate weakness of countries. A weak currency can spur exports and cut impo­rts, a mechanism that helped China grow to a giant economy. A higher exchange rate will cause Indians to choose locally made goods because the foreign ones are now more expensive, and make our exports cheaper (and thus more desirable). These are not signs of weakness.

Myth 2

This is the end. We are going back to 1991.

While we are in a crisis, it’s not like 1991. We’re a much bigger economy now and we have more open markets. Currently, foreign investors are exiting; in 1991, we didn’t have any foreign investors. However, how we react to a relatively minor issue of a rupee collapse can set us back to the times before 1991, when we restricted both dollar inflows and outflows, when we created barriers because we wanted a “controlled economy”.

Myth 3

We need six months of ‘import cover’ as our foreign exchange reserve.

With a six-month emergency buffer, you can use it when you lose your job. But you’ll try to find anot­her job, or, much before the buffer runs out, accept a lower paying job which ‘stretches’ the buffer. That is how countries work too; our reserves don’t pay for our imports—’flows’ do. Someone wants to invest, or remit money; that money is rotated to pay for what we import. When inflows slow, the rupee falls. When the rupee falls, people import less and export more, and voila, our import cover suddenly increases. Reserves are not required to pay for imports as they are today. If we pass on diesel and lpg prices, and make the rupee convertible, we wouldn’t care about reserves. Indeed, India has much more foreign exchange reserves than France, Italy, Germany and the UK. It has the 10th highest forex reserves in the world; the top 9 are net exporters. (India is a net importer.)

Myth 4

The whole current account deficit is because of our massive purchases of gold.

A bigger problem is crude. Because we import that much crude oil, $170 bn worth last year (gold worth $60 bn). Yet, because we don’t pass on the price of oil through higher diesel and lpg prices, people use these fuels liberally. If we did let them go up, people would moderate their use, reduce frivolous consumption, cutting crude imp­orts. Gold is the refuge of people trying to save the­m­s­elves from inflation, a beast the state hasn’t tamed.

Myth 5

Rupee is falling because the RBI is allowing speculators to run amok.

A George Soros might have fought and won against the British pound in the ’90s, but he’d be very unwelcome here. The RBI limits trading avenues, also who can trade, and how much they can trade. Soros won not from his speculation influence but because the pound was fundamentally weak (the rupee is sliding for the same reasons). It would be strange to blame rup­ee-dollar trading when the real problem is: we export too little, we import too much.

Myth 6

Rupee is falling because the foreign hand wants to weaken it. Or a political party wants more rupees for its dollars that it has stashed away as black money all these years.

This is logic-defying beca­use we will import less from that foreign hand, or export more to it. Also blaming outside forces is the second line of defence by the RBI in the past. At best, the foreign hand wants its money back—the same money it had lent us many years back. On the political parties, sure, people will show you fancy graphs where it looks like the dollar went up just before elections in the past. The cynic in you might ask that if they truly did bring dollars back in, why didn’t the dollar fall dramatically just before polls? The rupee falls largely because there aren’t enough buyers for what we make and export. But, of course, that is not a glamorous answer.

  • sachin says:

    I agree with most of the article except the forex part. The countries that you have mentioned don’t have forex reserves, because their currencies are accepted worldwide. A large number of countries use Euros and Pounds in their forex reserves. The same is not true for INR. If given a chance, even Indians won’t hold INR and rather convert their savings to dollars, euros, pounds, dinars etc.

  • Vamsy says:

    Hi Deepak
    I do not agree with some of the points that you noted. I have good respect for you for your knowledge and analysis skills but I feel I should lay out some of my own points:
    Myth 1 (Weaker currency means a weak country):
    I agree that the number does not matter but it is important that currencies (especially that which is being used by 120 Cr people) should be stable enough. Wildly swinging exchange rates will diminish the confidence on the currency and as you know for any fiat currency lower confidence = death knell for it. Just image what would happen if currency is being seen as a radioactive waste that is useful only for exchange and not for saving. A currency that loses 3% in a single day is not a currency it is a joke!
    Myth 2
    This is the end. We are going back to 1991.
    I have never see the words ‘minor’ and ‘rupee collapse’ in the same sentence before (sorry for being blunt). A currency unit is like the share of a country, a falling currency will indicate bad fundamentals for any economy and that will trigger mass exit of foreign investments. A return of confidence will take lot of time and we definitely cannot represent human psychology as a graph, it will suddenly be a massive crisis quickly. Funny, I the words from MMS still ring in my ears – ‘Deficits do not matter if we can print our own currency’.

    • Honestly, we’ve seen worse times with the dollar, the pound and even “strong” countries like Russia. It is not really a matter of strength of the nation. Deficits are structural in India and we were paying for them through transient flows. When the flows stopped, we will pay for them through currency depreciation, that’s all.
      We are not like 1991, becuase this is in some ways much worse!

  • ctrl513 says:

    Hi,
    sorry to pose this question but what is “make the rupee convertible”
    I am not that good in accounts but trying to understand convertible in simple terms can you please provide simple example?

  • ctrl513 says:

    got the idea of rupeer convertible but making so will enable all indians to hold dollars they all reject the rupee i guess (its more like dollar will replace gold in india then) but that lowers rupee even more right?

  • Rajeev says:

    Hello Deepak,
    In addition to crude & gold; defence imports are huge and effect BOP & Rupee vaaluation. The government needs to encourage domestic manufacture in private sector of ships, aircrafts & helocopters, guns & ammo.
    Regards
    Rajeev