This post has been co-written by Roshan Venugopal and myself. This post over-simplifies many concepts to ensure easier understanding. This article may be cross-posted on the author’s own blog.

Prologue:

India’s rupee crisis is making news not only in India, but globally. It is cliché to point to the government and RBI, but how many of us really understand what the problem is? This post is an attempt to demystify and explain in simple terms.

The Basics

Every time we import something, we have to pay in the currency the seller is willing to accept. Oil and gold contribute to more than 50% of our imports — this combined with several other factors, we spend a lot of dollars.

Every time we export something, rupees are in demand (the buyers need them). So we get foreign currencies (primarily dollars or euros) in return. In another way of saying, we have to continue to export (which will bring us dollars), in order for us to import (which requires dollars). So if a country exports more than it imports, it will have a trade surplus and the opposite situation will have a trade deficit. Let us say the value of the trade balance is T.

Aside from this, foreign individuals and businesses bring capital to India with business interests. Lets call this C. People, such as NRIs, send money to India. Lets call this R (for Remittances). Finally governments borrow money from financial markets in the form of dollar denominated bonds, L.

The current account balance is a function of T, C, L and R. If the aggregate value is negative, we are in current account deficit. The value of this determines how strong our reserves are, and how long we can keep importing. We now have enough dollars to import for the next 7 months (compared to 3 weeks during the 1991 crisis).

What does this have to do with the value of the rupee?

The value of foreign exchange is simply a function of supply and demand. If I am desperate for dollars, the asking price for a dollar will shoot up. 3 months ago, India could afford to buy a dollar for ₹53, but given the demand and shortage of forex reserve, the value went down to over ₹64 [Went “up” or “down” is relative to how many dollars it takes to buy a rupee, not the other way round].

What does this have to do with yield rates?

The government from time to time issues bonds denominated in rupees. When the relative value of rupee goes down, the bonds become less attractive to buyers and as a result, their expectation on the interests go up and hence the yield rates go up. This further burdens the government, because they would now have to pay higher rates.

Why is the government unhappy with gold buying?

Pretty simple — we buy about $62bn worth of gold every year, almost all paid for in dollars. And unlike many other countries, gold in India has minimal economic value, since most of it goes to jewelry and jewelry has no utility. So the government wants you to discourage you from buying gold, thereby helping narrow the deficit a bit. The same funds, if applied to oil or other essential commodities, can help increase the export levels.

How did we get here?

We have always had debts, deficits, import burdens etc.…Last few years, we have been in this situation where investors found economies like US very unattractive (due to slow growth, risk of another recession, easy money etc.), and resorted to investing in emerging markets, such as India, for better returns.

When Ben Bernanke spoke last May of taking the foot off gas pedal, it sent a signal to the markets that US might, once again, be attractive for investments. The markets responded by retracting their capital from “risky” investments (such as the ones invested in India, Brazil etc.…). This had a huge impact on the “C” aspect of the TCLR illustration above.

Some more on this ‘foot off gas pedal’ speech:

Since November 2008, the Federal Reserve started an unconventional policy of buying financial assets (mortgage bonds, treasury bills, p-notes) known as Quantitative Easing .The mandate of QE is to buy 65–80 billion dollars of treasury bills (T-bills) every month and Bernanke was referring to a reduction in purchase of these bills.

The effect of this vacuuming of T-Bills was the yield on T-bills was net zero or even negative i.e. US government was able to charge people to lend money to it, leading to lowest rates for borrowers and migration of smart money to emerging markets like India, Brazil, Turkey etc. Suddenly after the May speech smart money wanted to play safe and bailed out of emerging markets to back home. This instability caused the rupee and its classmates like the Brazilian Real, the Turkish dinar to fall 16–18 percent since May 19 of this year.

So should we blame US for this?

Not really. While the latest announcement from Fed almost certainly caused this commotion, the fundamental issues always existed. The truth is we are still a very foreign-capital-dependent, import-burdened economy.

Can I send more money to India?

If you are a NRI, this is a good time to send money to India. Because dollar-for-dollar, it fetches more rupees and remittances are one of the best ways to transfer money to poor nations because this goes directly to the pocketbook of the consumers or builders. Obviously buying more gold with this wealth is not the way to move forward.

What is the way out?

There is no magic pill. RBI and the government always have this arduous task of striking the golden mean to balance inflation, unemployment, foreign exchange, balance of payments etc. An organization like RBI may have the experience and skills to maneuver this, but also under pressure from the political powers, because of upcoming elections in 2014. In addition, we are getting a new leadership for RBI — which the markets have thus far greatly welcomed. There are also several areas (such as import of coal, iron and other minerals) where we can expedite policy reforms and changes that allow us to improve the intrinsic strength of the economy. The current stopgap measures, such as limiting imports of gold and other goods, will have but a small effect on the problem we are trying to solve. The biggest risk we have is of a downgrade of our risk rating. This alone has the potential to send us in a downward spiral, which the RBI folks know pretty well.

How does this affect domestic economy?

On the positive side, this crisis makes India a better investment and improves the export climate for India (because of the cheapened rupee). However this will come at a cost — which is inflation. We already have inflation struggles — this crisis merely adds to that. We may see days of tight money, slow growth, and some increase in unemployment levels even.

References used:

  1. India’s trading partners and what it trades — The Guardian
  2. India’s External Debt — RBI
  3. Its an internal crisis, not a foreign one — Easy Money
  4. Foreign Exchange reserves — RBI

Originally published at www.sastwingees.org on August 22, 2013.