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Making Sense Of The Fall Of The Rupee

What is happening to the Rupee. Where is the Rupee headed.

What is happening to the Rupee? Where is the Rupee headed?

(updated with additional information on 29 August 2013)

The last few weeks have seen an extraordinary drop in the value of the Rupee. Given the headlines, everyone is worried. Some of our investors have asked us to explain what's happening. In this article we try to give you a clear picture of why the Rupee has been so weak, the reasons behind the fall, possible direction of the Rupee and the data to watch out for.

What determines the dollar value of the rupee?

The currency markets is primarily driven by demand and supply for the currency. In order to understand the movement of the currency market, one needs to understand the factors affecting demand & supply.

The demand for the Rupee is driven by two sources:

A. Current Account or Trade (broadly speaking)

B. Capital account or investments

Current Account: India as a country is a trade deficit country. This means that we buy more physical goods from foreign countries than we sell to them. On the other hand, we export a lot of services (IT/BPO) as well as receive money from NRI's. This is called "invisibles".

The two together make up what is called Current Account Deficit.

Current Account Deficit (CAD) = Trade deficit - Invisibles = Imports - Exports - Invisibles

Current account deficit leads to demand for more dollars and therefore a weakening of the Rupee.

Capital Account: There are broadly three ways in which foreigners invest in India

1. FII – Equity: The money invested in Indian stocks through the markets

2. FDI (Foreign Direct Investment): The money invested directly into companies

3. FII / Foreign Debt, including ECB, etc.: Money borrowed by Indian entities

Investments into India or what is called Capital Account surplus leads to demand for more rupees and therefore a strengthening of the Rupee.

The value of the Rupee remains stable when the demand for rupees and demand for dollars remains balanced. For this to happen, the current account deficit must be matched by capital account surplus. If the demand for dollars is more, Rupee will fall. If demand for Rupee is more, dollar will fall.

This is what has happened over the last few years. The Rupee has depreciated gradually on account of the small ($1 billion or so, see next section) shortfall not made up for by capital flows. There were years where despite the current account deficit, the Rupee strengthened driven by capital inflows.

Let’s talk numbers

If you do not have an appetite for a large dose of numbers, you can skip the tables - you should still understand the logic.

Our CAD is currently at about $78 billion, which the government expects to decrease to about $ 70 billion this year. This translates to about $6 billion of CAD per month. Or in other words $6 billion is flowing out of India every month. Note that this has increased from about $3.3 billion per month ($38 billion for the year) in 2010.

In the past, of the required $ 6 billion per month to match this, about $ 3.8-4 billion per month of steady capital inflows have come from FII Equity and FDI. The balance came from debt. The following table shows the inflows since January 2012.

What triggered the steep fall in the Rupee since the middle of May 2013 is a sudden departure of FII Debt money. Look at the debt column in the table Capital Inflows for June and July 2013. Almost $10 billion of debt was suddenly pulled out of India accompanied by $2.9 billion of FII-Equity. This led to a sudden demand for dollars and the rupee collapsed. Since May 22, when the INR-USD was 55.6, the Rupee has depreciated to 64.5 today - a sudden depreciation of 16%.So what happened now to cause this fall?

Rupee vs Dollar Exchange Rate and FII debt

Why was the FII Debt suddenly pulled out?

For that we need to understand the background of how this debt money came into India. As of April 2013, the total FII Debt market investment was about $ 32 billion, a good part of which, we understand from anecdotal sources, was 'hot money'. What is hot money? This is essentially an investor who borrows money in USD at very low rates, invests money in India at high rates and hedges the currency risk. This is an arbitrage trade, which holds good as long as his borrowing rate holds. When the US started to make announcements on reversing its regime of low interest rates, the US 10 year bond yields went up from 1.5% to 2.6%. In other words, this investor could no longer borrow money cheap and the ‘hot money’ trade became unprofitable. The result was a sudden rush of money out of India (and other markets around the world).

What’s next for the rupee?

It is our hypothesis that the sharp fall in the Rupee was more due to the sudden rush of $10 billion of FII Debt outflow, rather than India’s inability to bridge the CAD. Once this outflow stops, we should see the Rupee stabilize.

The good news is, of the total of $ 32 billion of FII Debt money (as of April 2013), about $ 10 billion has already gone out. We are not sure how much of the remaining $22 billion is hot money, a guestimate is that about 50-60% of the $32 billion was hot money so a possibility of another $6-8 billion leaving exists. With luck it would be less. The outflow of FII Debt money should, therefore, slow down in the coming days, though we need to watch this closely. FII Equity flow has turned positive in August, or at least the negative flows have ebbed.

What can be done to stabilise the situation?

As we demonstrated above, the gap in demand for dollars (assuming FII/FDI flows remain constant) is only about $2 billion per month. This can be met in two ways:

1. Export pickup: The best way to reduce the CAD is for exports to pick up. With the Rupee weakening, exports become competitive (if we were selling something for 1$ or Rs 55, it's now only 87 cents so hopefully foreigners will buy more of it). We should therefore see exports pick up over time and result in reduced CAD. We have started to see early signs of a pick-up in exports, but this process will take some time. Although some industries like garments are already projecting a 15-16% increase this year.

2. Equity Inflows (FII & FDI): Note that FIIs own close to $ 200 billion of equities, nearly 18% of Indian equities. This source of funds is committed to India for the long run. FDI money is also money invested by MNC’s in India to build manufacturing plants and is a stable source of money. With a little bit more of liberalisation of investment norms and policy stability, a lot more FDI money is willing to invest in India.

3. Debt : Long term stable debt (not the kind that can disappear overnight) also remains a source of capital to bridge the deficit.

Can things go out of control?

One concern for the market has been the policy response to this problem, some of which seems to go against the principles of reforms. This could adversely impact investor sentiment and affect the equity flow. In an increasingly globalised world, where India has made its mark on the basis of it competence, liberalisation will have to be the way forward. We do believe policy response will be pro-liberalisation with time.


In simple terms, once FII Debt outflow reduces, the Rupee should find stability. Much of the hot money has already gone out and this trend cannot sustain for too long. The fundamental problem is not as big as the current sentiment makes it out to be. The gap between the CAD and Foreign inflows of less than $1 billion per month is small for a $ 1.7 trillion economy and can be fixed with the right policy action. Looking beyond the headlines helps.

Update to the post (29 August 2013)

Since we published this article on the rupee vs dollar movement, we've received feedback on facebook, twitter, right here, in personal conversations and on E-mail. Thank you all. We appreciate your taking the time to talk to us.

A few updates to the article:

  1. Mr Swapnil added the numbers in the table ($8.7 bn) and asked where our $10 bn number for outflows came from. The answer was that we'd also added the outflow from May 22nd (the day of the fed announcement) using the daily data published by SEBI.
  2. Mr Ramnik Bansal did a quick correlation analysis on the table and wondered whether our hypothesis was correct since correlation was negligible (his analysis here - Google sheet). Our thinking is that price is determined (among other factors) by cumulation and expectation. The cumulative FII debt outstanding on a given day has a high correlation to the currency rate (see the analysis here - Google sheet).
  3. An article by the former IMF Chief Economist Mr Simon Johnson published today in the New York Times (external link) follows a similar line of reasoning. He further goes on to make a very interesting observation of how CAD for the US has a different flavour than CAD for India. Recommended reading.
  4. Added a chart to visually understand the linkage of FII debt to Exchange rate (above)

Our main conclusion, which remains unchanged, was that the fall of the rupee in itself is not such a big thing. However, as many of you have agreed in your comments, the policy response (and economic policy in general) will determine whether we recover gracefully or get into more trouble.

Even more important than our conclusion, is that you understand the economic principles and can interpret the opinions for yourself.

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