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04
Jan,19

Currency depreciation and its impact on the economy

Currency depreciation and its impact on the economy

Currency depreciation is a fall in the value of a currency in a floating exchange rate system. Currency depreciation can occur due to any number of reasons – economic fundamentals, interest rate differentials, political instability, risk aversion among investors and so on.

Countries with weak economic fundamentals such as chronic current account deficits and high rates of inflation generally have depreciating currencies. Currency depreciation, if orderly and in a gradual manner, improves a nation’s export competitiveness and may improve its trade deficit over time. But abrupt and sizeable currency depreciation may scare foreign investors who fear the currency may fall further, and lead to them pulling portfolio investments out of the country, putting further downward pressure on the currency.

It is important that you should never get swayed by macro noise and short-term correction in the financial market. Always stay on course with their long-term financial plans. In this calendar year, the rupee has fallen a little over twelve percent against the US dollar.

India being a developing economy with high inflation, depreciation of the currency is quite natural. Depreciation of rupee is good, so long as it is not volatile. A random depreciation that we have seen in the last few months is bad and it has hurt the economy.

Persistent high inflation and fiscal deficit, increasing subsidies, faltering exports and slowing industrial production point towards an economy, which is moderating in growth. Monetary policy has so far been ineffective in reversing the inflation trajectory. Fiscal stimulus appears non-existent, especially when the government has added to the subsidy bill by giving a go-ahead to the food security bill.

The Indian rupee has witnessed high volatility this year, falling nearly 17.3 per cent between Jan’18 to Oct’18, as investors dumped the local currency in wake of global headwinds coupled with widening current account deficit led by higher crude oil prices. Adding to it, strong demand for the US currency from importers and foreign fund outflows also weighed on rupee movement. Though some recovery was seen post October high. Domestic currency recovered nearly 6.5% from Oct18 highs to 69.69 in Dec’18. The Indian currency had hit its all-time intra-day low of 74.45 against the US dollar on October 11th, making it one of the Asia's worst performers;

Sentiments in other markets – both equities and fixed income are affected by the challenges within the currency market. The equity market has seen a sharp correction in the past two, three months mirroring the actual phase of currency depreciation. India is no stranger to currency depreciation because we have seen sharp sell-offs a few times in the past couple of decades.

Here it is easy to get an idea to shape up the current situation by looking at the historical correlation between the stock market and rupee depreciation. The rupee had become overvalued because it had rallied sharply during 2016 – 2017. Despite the current sell-off, the rupee remains one of the top performing EM currencies over the past five years. Over the past 20 years, the Indian currency has consistently depreciated vis-à-vis the US dollar and the annualized depreciation rate comes to three percent a year. Depreciation has not been smooth when one looks at the trend in detail. The currency markets tend to be stable for a number of years and then witness a sharp depreciation episode (much like the current one) that resets the trading level of the country.

Effect of Depreciation

1. Trade deficit will widen because of costlier imports, worsening the current Account deficit.

2. Fuel price will keep petroleum subsidy in check, but fertilizer subsidy will rise. Spending on any kind of foreign exchange denominated spending will increase. Capital inflow will slow or reverse.

3. Spending on discretionary goods will increase.

4. Forex reserves could fall putting pressure on the rupee.

5. In case of weak demand, companies may not be able to pass on higher inputs costs.

6. The government and the RBI have issued a series of measures in recent days designed to reduce the current account deficit and bolster the rupee, including increases in the import duty on gold, the end of duty exemptions for flat screen televisions brought in by airline passengers and restrictions on outward direct investment by Indian companies and individuals.

7. Exports are unable to leverage the weak rupee fast enough given the speed of its descent. In fact, many exporters are caught out because of fixed-price contracts in rupees wherein they cannot get the benefits of its rapid fall. The balance of payments is tilting sharply against us.

8. The stock- market will take hiding as opposed to a beating.

9. Global rating agencies may revise the rating in the negative trajectory to “junk” status, making international borrowing difficult and even more expensive.

10. If the automated devaluation brought on by the rupee makes some asset classes attractive, there may be a slight recovery because of RBI trade opportunities and bottom fishing.

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