Despite having several favourable macroeconomic fundamentals, the Nepali Rupee (NPR) has been experiencing excessive volatility against foreign currencies, especially the US Dollar (USD), largely due to the sudden and sharp depreciation of the Indian Rupee (INR) against USD. Since NPR is pegged to the INR, the future value of NPR rests solely on the fate of INR in the foreign exchange market.To understand the future course of NPR, it is essential to flesh out the nature and causes of decline of INR and the ongoing developments in the international market which is likely to negatively affect the value of INR in the near future. The two primary causes leading to devaluation of INR are as follows;
Current Account Deficit: One of the primary reasons for the current freefall of INR is its widening current account deficit. As per World Bank definition, Current Account balance is a part of the measure of an economy’s savings. Along with net capital transfers and acquisition/disposal of non-produced, non-financial assets, the current account balance represents the net foreign investment or net lending/borrowing position of a country vis-a-vis the rest of the world.
India has a sizeable amount of current account deficit, which is comparatively higher than other Emerging Market Economies (EMEs). India’s current account deficit was USD 98 billion (4.9% of GDP) in the fiscal year 2012-13 compared to USD 58 billion of Brazil (2.4% of GDP) and USD 24 billion of South Africa (6.4% of GDP).
Capital Outflow: Postponement of committed Foreign Direct Investment (FDI) and capital outflow, i.e. pulling money out of Indian markets by the foreign investors, are the other key reasons for the ongoing freefall of INR. Foreign investors have been pulling money out of India, as the economy has slowed down and the cost of borrowing in dollars has risen sharply; moreover, the outflow has been accelerated as India faces risk of a downgrade by the international credit rating agencies.
Additionally, investors are focusing their attention to the US market as the yield on US Treasury bonds has increased. As on 30 August, the 10 year US Treasury bond yields 2.76% while a 30 year Treasury bond yields 3.71%. The possibility that the US Federal Reserve will continue its USD 85 billion in monthly bond purchases under quantitative easing for the foreseeable future is another reason investors are ploughing money in the US market.
The capital outflow is also the outcome of spill-over effects emanating from other volatile markets, an effect of growing integration of financial markets. For example, the origin of 2008 global crisis was the US economy but capital flows to EMEs, including India, was severely affected. Similarly the recent crisis in Europe has also significantly impacted the capital flows to EMEs, including India.
Outlook: In the backdrop of sluggish economic growth, high inflation coupled with fiscal and current account deficits and rapid integration to global financial markets, the Indian economy is highly vulnerable to volatility and sudden stops in capital flows.
The events of 2008 and 2011 indicate that sudden reversal of capital flows to India, leads to significant volatility in the INR exchange rate, especially during when there is limitations in borrowing in INR in international capital markets. Looking at the exchange rate of EMEs, the INR has fallen by around 20% since the beginning of the year while the South African Rand has fallen nearly 23% in the same period. Similarly, Turkey’s Lira has dropped 14% while Brazil’s Real has fallen over 17%. The Chinese Yuan has been the outlier, having gained nearly 2% in 2013.
The INR has depreciated by 22% during the last four months and is currently trading at 66.07 per USD. This trend could continue, whereby the INR may fall further and touch 68-70 per dollar mark by September 2013. The INR may strengthen against the USD by the end of the current fiscal year if the following prove to be true.
- If India’s current account deficit is corrected significantly with the help of falling global crude prices, curb in gold imports and improvement in exports. India is planning to contain its current account deficit at 3.7% of the GDP i.e. USD 70 billion in fiscal year 2013-14.
- If the Indian government’s plan to attract USD 11 billion in capital inflows (via attracting non-resident deposits, foreign borrowings by state-owned financial institutions and public sector oil companies) materializes.
- If the series of measures; i.e., increasing short term interest rates and tightening liquidity, adopted by the government of India in conjunction with Reserve Bank of India (RBI) bears fruit.
Analysing the above scenario it is evident that in the short run the NPR will further devaluate against USD and may touch NPR 110-112 per USD. Meanwhile, the bill, which aims to provide subsidized food to millions of Indians and is expected to increase India’s food-subsidy bill from USD 4 billion to about USD 20 billion a year, passed by the Indian Government this week expected to further devaluate INR. However, with the measures undertaken by the Indian government to recover the economy there is a good probability that the INR will strengthen against the USD by the end of current fiscal year 2013/14.