The Case of the Indian Rupee.

Shubhaansh Kumar

Misery loves company. The Indian stocks are set for an annual decline in seven years. Add to that the appreciation of the USD in terms of INR. All of this begs the question that what is the reason behind this chaos and what has INR got to do with the performance of the stock market?

To answer that, we need to understand the mechanisms behind the foreign exchange market. It is, in essence, a game of demand and supply, magnified to some extent.

When the demand for a commodity exceeds its total supply, its value/price goes up because, in this situation, it is the buyers who are competing to get a hold of that commodity. When the supply of the commodity outstrips the demand for it, its value/price goes down because, in this situation, it is the sellers who are competing to sell the commodity. 

The same principle applies in the case of foreign exchange. When the demand for a currency outstrips its supply, there is an appreciation in its value and when the opposite happens, there is a depreciation in its value. One of the major shifters of the foreign exchange value is the interest rate of the country.

Let’s dive deeper into the effect that interest rate can have on an economy and its currency value. When the interest rates, the repo rate (the rate at which the Central Bank lends to the commercial Bank), set by Central Bank is reduced then it is labeled as expansionary monetary policy. Under this expansionary monetary policy, the central bank wants to, in effect, increase the money supply in an economy. They simply want to put more money in the hands of citizens to stimulate spending levels. 

This is exactly what happened during the pandemic. With people locked away in their homes with a level of uncertainty about the future, the aggregate demand (the value of goods demanded by an economy at a given time) slumped to an all-time low. When Aggregate Demand falls, price levels in an economy fall. When price levels fall, companies make fewer profits and lay off workers to adjust to the change in the market conditions. All of this leads to a recession in the economy. To address this issue, not only the RBI but Central Banks worldwide (most notably the Fed), implemented aggressive expansionary monetary policy by announcing massive stimulus packages and lowering the interest rates to record levels. 

This led to an increase in spending levels, as well as investment levels. The Indian stock market rallied as retail participation increased with NIFTY touching record points. The waitlist extended by months upon months for various goods, as demand shot up.

But there is also another aspect to the low-interest rates. When the interest rates of Country A are lower compared to Country B, then foreign investors prefer to park their funds in the country with the higher interest rate, as they can expect a higher return on their funds, especially in the debt securities market. As they exchange their domestic currency for the currency of Country B, rather than Country A, the demand for the currency of Country A falls thereby leading to a depreciation of the currency. This can be seen in the case of the INR too. The RBI has been decreasing the interest rates since 2014, and as an effect, the value of INR has been depreciating since. Like most things in economics, this cannot be labeled as good or bad. It depends on the country’s goals and aspirations. If it wants to export more, then it's preferable to keep the currency cheaper. If it wants to import more, then it's preferable to keep the currency expensive. Now, this is an oversimplification of a vastly more complex mechanism. There are, of course, more factors that one needs to consider when deciding on the currency strategy of a country.

The expansionary monetary policies achieved their desired effect. There was an unprecedented increase in the spending levels of consumers and the borrowing levels of corporates. So, as a result, the Aggregate Demand increased by many folds. When Aggregate Demand increases, so do the average price levels. This leads to an increase in the profit levels of firms, who then expand their production and hire more employees. As these employees start earning, they simultaneously start spending, which again increases the Aggregate Demand levels, thereby leading to a further increase in price levels. This vicious feedback loop leads to inflation.

And when inflation strikes, Central Banks are compelled to raise the interest rates, to squeeze the money supply in the economy. As money supply contracts, the stock market adjusts to the change in monetary conditions. Only in this case, the low-interest rate party went on for too long. 

Now let’s look at the reasons behind the current fall of the INR.

When inflation hit double digits in India and the US, the RBI and the Fed, respectively, started increasing their interest rates. As both reduced the liquidity in their economy, there developed a risk-off sentiment in investors. Instead of investing in a risky asset class, such as stocks and equity, they turned towards the debt market. Remember, earlier, when we talked about the effect of interest rate on the flow of capital? Well, here it comes to application. Presented with the choice of investing in the Indian debt market or the US debt market, as both these countries were increasing the interest rates and making debt investment highly lucrative, investors chose the safer of the two. 

The debt market of the US is considered safer, primarily due to the existence of the US Treasury Bills. The US Treasury Bills are the safest investments that a person, company, or country can ever make. As the yield rate of these bonds increased, people and funds started exchanging their currency for dollars to invest in the American Debt market. As a result, the value of the dollar soared. As capital shifted/flowed from India to the US, it led to a fall in the demand for INR in the foreign exchange market. As a result, the value of INR depreciated. 

Further, the Russia-Ukraine war didn’t help. Crude oil prices touched record levels. As India imports 80% of its fuel needs, it had to shell out even more Rupees to get the Dollars needed for purchasing the oil. This further increased the supply of the INR in the foreign exchange market. 

A decline in demand, due to capital outflow, and an increase in supply, due to an increase in crude oil prices, have caused the INR to depreciate at a rapid pace and further strengthened the dollar.

Shubhaansh Kumar is a student of BSc (Economics and Analytics) at Lavasa, Pune Campus.