Banking Concepts Reasons & Impact of Falling Rupee

Dear Aspirants,

With USD-Rupee touching all time low and making daily news headlines, we are sharing an extremely useful article for understanding the Reasons for falling Rupee and its impact. Article was featured in Times of India. Points from this article will also be helpful in Interviews.

Why is rupee weakening against the dollar? 

There are several factors. But the recent bout of weakness is fueled by the prospect of the unwinding of the bond purchase program of the US Federal Reserve.
The US Fed had been printing money to bolster its economy. Now that there are signs of some strength in the US economy, it may start winding down the program of adding more money into the system. 

A possible winding down of the asset purchase program of the US Fed and improvement in the health of the US economy will strengthen the US dollar. Investors will withdraw investments from emerging markets such as India in the short term and chase assets in the US, since assets in a strengthening US economy are seen as attractive. The outflow of money from emerging markets may lead to currency weakness. Concerns over the pace of economic reforms, the health of the domestic economy and a yawning trade deficit are also impacting the rupee. 

How will weaker rupee hurt the economy? A weak currency will make imports more expensive. Normally, theory suggests this should lead to a curtailing of imports. However, given the fact that some of India’s major import items, like crude oil, are immune to price changes, the theory does not quite apply in this case. 

What is current account deficit (CAD)? The CAD is effectively a measure of the amount of net capital inflows from abroad that an economy depends on, whether in the form of borrowings or investment. 

What impacts widening of CAD? Two factors have been blamed for widening of CAD. One is the import of gold. India is one of the largest consumers of gold and the heavy import of gold widens CAD as the government has to provide for dollars for every ounce of gold imported. The other factor is crude oil imports. India imports more than 75% of its crude oil requirement. A slowdown in inflows from foreign investors also leads to a weak currency. At a time when the rupee is depreciating, foreign portfolio investors are wary of investing in India since any rupee income they earn could get eroded by a higher exchange rate when they want to take back that income out of India. Thus, a sort of vicious cycle is triggered as the rupee dips, FIIs tend to pull out money and that in turn makes the rupee dip further. This can be offset by boosting longer term capital flows from abroad like FDI or overseas borrowings.