This represents a loss of a quarter of rupee’s purchasing power in terms of US dollar as well as the world’s other leading currencies such as Japanese yen and the Euro. The question then is why the rupee is depreciating. If we can answer this question then we will have an understanding of how to stop it and what needs to be done to promote a stable rate for the rupee over the years to come. [break]
cause of depreciation
The answer to this question can be framed only when currencies are floating, meaning that they aren’t tied to any particular currency or even to a basket of currencies. In such a situation, exchange rates of currencies are determined by what economists call a free play of market forces of supply and demand.
The Indian currency is a freely floating currency, although the government keeps an eye on its exchange rate to initiate preventive actions if there is a threat of wild fluctuations in the rate.
The Indian currency was trading at 45 rupees per dollar in 2011 which now has slipped to almost IRs 60 to a dollar—a decline in the exchange value of about a quarter. This is reflected by a similar decline in the dollar rate for Nepali rupee which is pegged to the Indian rupee. Rupee depreciation in both cases reflects market factors.
Inflation differential
A currency trader will explain the decline of rupee value in terms of the psychology of traders and temporary events like a surge in world oil prices, ensuing rise in the import bill, increase in the demand for foreign currencies, and expectation of a trade deficit. Trade and balance of payments outlook, indeed, have a major influence on current as well as future levels of exchange rate. However, from an economist’s point of view, the exchange value of a currency is determined over the medium- and long-term—a period usually of a couple of years to a couple of decades—by the relative inflation rates of each country.
Using this perspective—what economists characterize as the purchasing power parity theory—currencies of high inflation countries tend to depreciate and of low inflation countries appreciate over time if the exchange market has been allowed to operate freely, which is the absence of government controls. For example, Indian rupees’ massive deprecation over the past two years against the US dollar has been occasioned by no other reason than the two countries’ inflation rate differential. Over the three-year period from 2010 to 2013, Indian rupee depreciated from Rs. 45.5 per dollar to nearly Rs. 60 per dollar—a depreciation of 32 percent.
Not by coincidence, Indian price level on average increased exactly at the same cumulated rate over this three-year period. Nepal’s inflation followed suit, increasing at the cumulated rate of 30 percent. This means that, even if our rupee weren’t pegged to Indian rupee at 160/100 rate, its exchange rate with the dollar would have moved the way it actually did, which also means a free market rate of 160 Nepali rupees per 100 Indian rupees.
The implication of this is clear. There is no mystery or a conspiracy theory involved in the setting of exchange rates—bilaterally or multilaterally—except for the very brief period when noneconomic factors such as speculation and abnormal level of risk-taking by currency traders may move the market to set the rate differently than justified by economic fundamentals, like the differential inflation rates. When the dust settles—bursting of speculative bubbles or a re-examination of the countries’ economic outlook—rates veer back to reflect the underlying strengths of each country, principally their inflation outlook.
Supply and demand
Inflation’s impact on the relative purchasing power of currencies is an important consideration except that it looks at the exchange rate only from the demand side—how much of goods and services can be bought with a fixed amount of national currencies in each country. We can also look at the market determination of exchange rate from the supply side—how does inflation differential affect a country’s competitiveness in the markets for goods and services, domestically as well as internationally.
Generally, high-inflation countries are poor exporters and the reverse is true for low-inflation countries. This means that high inflation makes countries less competitive in the world markets and they earn less in terms of foreign exchange relative to the size of their economies than do low-inflation countries. Such an outcome makes high-inflation countries more prone to trade deficits and balance of payments crises than low-inflation countries. This phenomenon is evident from looking at the list of world’s 30 largest economies put together each week by The Economist, which shows almost all the trade surplus countries having low inflation rates while deficit countries show high inflation.
The effect of high inflation on a country’s competitiveness and on the subsequent weakness of its exchange rate is channeled principally through the domestic cost of production. We can cite just one element of the high production costs engendered by high inflation rate—the interest rate. Interest rate differentials between countries reflect, in most part, inflation differentials. For example, borrowing cost for businesses is in double digits in India and Nepal, compared to 4-5 percent in the US and in most of the stable (low-inflation) countries. Then, if an Indian or Nepali exporter has to take a bank loan at 15 percent interest, while an American or Japanese firm can borrow at 5 percent interest, this creates a huge wedge in relative production costs between the low- and high-inflation countries. High inflation also induces rise in other costs, such as labor and materials, all of which accumulate to shut the high-inflation countries’ exporters out of the world markets, cutting the supply of foreign currencies that helps anchor their exchange rates.
Why high inflation
So, if a country wants to promote a stable exchange rate for its currency—that its currency should hold its value against international currencies such as US dollar and the yen—it must lower its inflation rate to a comparable level to these countries. There are no short-cuts and easy ways of doing this. The strong-currency hawks—which is how I label those who lament the recent fall of rupee against the dollar—must look at the problem realistically—that is, they must focus on our high inflation rate and how to lower it to 1 or 2 percent from the average of 10 percent, that would help the rupee sustain its value against the dollar and other international currencies.
The problem is that inflation phenomenon is difficult to comprehend and even more difficult to solve. So why bother? But if that is the prevailing psychology—to accept and live with high inflation—then we should not complain about paying 200 or even 300 rupees to buy one dollar, which may happen in as little as five to ten years. Those who are unfamiliar with history should note that fifty years ago one dollar could be purchased for a mere seven and a half rupees.
At 96 rupees now, this represents depreciation of the rupee 13 times over. The implication then is that average prices in India and Nepal must have risen 13 times faster than average American prices over the past fifty-year period. Inflation differential also draws a line between poor and rich countries: a country chooses to be poor because it opts to sustain high inflation.
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