The Indian Rupee (INR) is one of the worst performing currencies in the world during 2013 (Table-1). At Rs.65/USD it slid by a whopping 17.5% in 2013 (so far) after sliding down by 4% during 2012. The month of August was especially devastating. Since 2000, the current rupee level is the highest ever seen (look at the graph). From a low of Rs.39/dollar in Feb 2008, the Rupee is close to Rs.65/dollar. Repeated efforts by RBI to stem the rot went in vain so far. The trigger for such a dramatic fall has been attributed to US decision to roll back the Quantitative Easing (QE) as US economy has started showing signs of a pick up.

The following questions emerge out of this:

1. Why did the rupee depreciate so fast?

2. How does it affect various people?

3. What is the further downside and where can it settle?

4. What is the long-term prospect of Rupee? &

5. What should be the strategy?

Let me try and answer them one by one:

1. Why did the Rupee depreciate so fast?

Technically rupee depreciates against the dollar when people sell rupee and buy dollars. And when people sell rupees and buy dollars, it results in negative capital flows and leads to downward pressure on the currency (and vice-versa). The following reasons can be explored:

a. US Monetary Policy

b. Slowing Indian Economy

c. Ineffective RBI

d. Corporate Debt and Hedge &

e. Weak domestic equity market

US Monetary Policy

The US Fed initiated a series of monetary easing programs more commonly known as Quantitative Easing (QE) which created copious amounts of liquidity in the global market. The simple idea behind QE is to purchase government bonds in order to keep the yields low, as low interest rate will then help economy recover. Now that the US economy is showing signs of recovery, the Fed has announced its intention to taper the QE i.e, stop buying the bonds. In response to this news, the bond yields started moving up and capital has started moving back to US in search of safety. In other words, capital left markets like India, Brazil, etc and is going back to US.

Result: Investors flee other currencies and take shelter in US Treasuries (the so called safe haven) causing USD to strengthen and other currencies to weaken

Slowing Indian Economy

The Indian economy, which was once heralded as the next big thing by economists around the world, has lost its sheen and grew by a decade low of around 5% in 2012-2013.

Indian economy’s deficit is spiraling out of control. Both the fiscal deficit (expenditure more than income) and current account deficit (imports more than exports at a simple level) are headed for further deterioration during 2013 and next. While the fiscal deficit is at 4.9% of GDP, the current account deficit is at 4.8% in the year 2012-13. The current account deficit is triggered primarily by trade deficit (Export-Import). Not only our imports exceed exports, but even within the imports the dominance is by oil and gold imports, something very difficult to control. Lack of progress in deficit reduction is causing poor foreign investor confidence which contributes to negative capital flows (meaning foreigners taking their money out of the country). The deficit is a long-term problem especially the fiscal deficit. No matter which government is in place, populist policies will continue as a tool to gain votes and this will ensure that the deficit does not come down. However, if they do not go up, then that itself will be good news.

Also, during the past few years, Indian government has attained notoriety for governance lapses (2G scam, etc) and policy missteps. Revising the IT Act retrospectively from 1962 in order to bring Vodafone to book was a huge blow to the confidence in our legal structure to foreign investors. Also, there were several governance failures that keeps India in the wrong side of the news globally (a good indication is the number of negative articles that appear in The Economist).

Result: Foreign investors exit by selling rupees and buying dollars

Ineffective RBI

Reserve Bank of India is tasked with ensuring the financial stability of the economy and hence is the sole inventor of the monetary policy. In the past, when currency encountered volatility or undue fluctuations, RBI used its foreign exchange reserves to intervene in the market (through purchase or sale of dollars) and thereby reduce the volatility of the currency. However, this time around, they raised their hand and declared openly their intention not to interfere in preventing the rupee slide. This may be due to limited foreign exchange reserves currently at $277 billion enough to cover only 7 months of imports. For China, it amounted to $3,500 billion and represented 21 months of import cover, a far comfortable situation to be in.

Instead, during the July and early August meetings, the RBI intervened by tightening the monetary policy. It increased the short term rates by hiking the marginal standing facility by 200 basis points. This further exacerbated the situation with the current economic conditions. During its latest meeting, it signaled a reversal of this tightening policy. Hence, we can clearly understand the predicament of RBI to intervene. While RBI has not interfered directly, it has taken several steps to contain the situation:

• It now requires exporters to repatriate 50% of export earnings placed in special accounts

• Restrictions on investments done abroad by Indian companies and citizens.

• Limits on intraday net open positions of foreign exchange dealers

• Restricting currency derivatives (to check speculation)

• Hiking the interest rate on NRI foreign currency deposits as well as rupee deposits

Result: RBI has no arsenal to arrest the slide immediately but is using other indirect means

Corporate Hedge & Debt

Many Finance Managers, while managing their foreign exchange exposure, turned quite easy and relaxed due to continued rupee strength during the last few years especially during 2010 when rupee was averaging say 45 (you don’t need to hedge when rupee is strengthening if you are an importer and vice-versa). They expected this to continue forever and hence did not bother to hedge their currency risk exposures. Also, many of them resorted to foreign currency borrowing mostly in short-term maturities from European banks disregarding the rupee depreciation danger. However, when rupee started falling (much against their expectations) they were caught off guard and ran for cover to hedge their exposure which led to intense buying of dollars leading to its appreciation. Now many short-term corporate debt is coming up for repayment which will also witness more dollar buying adding to the rupee pressure. Also, the ability to rollover the debt will be limited by European banks due to the European crisis.

Result: Companies will have to find dollars to repay their debt and incur loss due to unhedged positions

Weak Domestic Capital Market

The Indian equity market has not been able to attract investments from Foreign Institutional Investors (FIIs) due to the weak economy and the poor performance by Indian corporates. Although the equity market has seen FII inflow of around $12 billion till August 2013, it has witnessed net FII outflow of $3.1 billion from June till August 2013 which has exacerbated the fall in the rupee. If you look at Table 2 the outflow seem to be more on debt than on equity. If this trend continues, it will result in the further depreciation of the rupee.

Result: FIIs will continue to shun Indian equity unless the economic conditions become more favorable.

2. How does it affect various people?

A rupee weakness affects the following:

• Importers (as they have to pay more rupees for the same dollar)

• Economic image of the country (not able to arrest the fall)

• Exi