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Project Report on

Rupee Volatility, Causes, Effects and Remedies

SUBMITTED IN PARTIAL FULFILLMENT OF THE REQUIREMENT OF
DEGREE OF MASTERS IN FINANCIAL MANAGEMENT (MFM) FROM
THE UNIVERSITY OF MUMBAI


SUBMITTED BY
Maitreya Rajendra Sheth
MFM Semester V (2011-2014)


UNDER THE GUIDANCE OF
Prof. Jyotsna Arya






N.L. DALMIA INSTITUTE OF MANAGEMENTSTUDIES AND
RESEARCH, MIRA ROAD (E)
THANE 401 104
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CONTENTS

Sr.
No.
Topic
Page
Number
1 Certificate 3
2 Acknowledgement 4
3 Executive Summary 5
4 Introduction 7
5 Price Data 10
6 Causes Behind The Volatility 12
7 Effects of The Volatility 17
8 Possible Remedies 21
9 Conclusion 25
10 Bibliography 26



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CERTIFICATE



This is to certify that Mr. Maitreya Rajendra Sheth, student of MFM
Semester V Finance, of N.L. Dalmia Institute of Management Studies
and Research, has successfully completed the Final Project on Rupee
Volatility, Causes, Effects and Remedies, under our guidance
and supervision as partial fulfillment of the requirement of MFM course,
2011- 2014.







Project Guide Director
Prof. Jyotsna Arya Prof. P.L. Arya



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ACKNOWLEDGEMENT


I would like to express my gratitude towards Prof. Jyotsna Arya, who
had been very supportive as a guide to my efforts in making the project
work a successful one.

I also extend hearty thanks to Prof. P.L. Arya, Director of the institute
for approving our efforts in making the project a success.

Last but not the least, I would also like to thank all our institute
faculties and friends, who were helpful to me in whatever little way they
would.









Maitreya Rajendra Sheth
Masters in Financial Management (MFM)
N.L. Dalmia Institute of Management Studies and Research
Batch 2011 2014.

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EXECUTIVE SUMMARY
The primary role of the central bank, as the Act suggests, is monetary
stability, that is, to sustain confidence in the value of the countrys money.
Ultimately, this means low and stable expectations of inflation, whether that
inflation stems from domestic sources or from changes in the value of the
currency, from supply constraints or demand pressures. (Dr. Raghuram Rajan,
Governor of The RBI in his opening statement after taking charge as the
Governor of RBI on 5
th
September 2013.)

One cannot over-emphasize the need for a stable currency for the overall
economic wellbeing and development of a country. Especially for a developing
economy like India, with its huge dependence on crude oil imports and FDI and
FII money to meet its capital requirements, it is imperative to have a stable
currency.

Steep depreciation of the currency increases the cost of imports thereby
fuelling inflation, which is already high in India. It also causes huge losses to
investors and results in their losing confidence in the country as an investment
destination.

Steep appreciation of the currency reduces the export competitiveness of
the industry which results in slower economic growth and loss of employment for
millions of workers.



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It becomes more expensive for corporations and industrial houses to
borrow from overseas markets to fund their capital requirements. Servicing the
debt as well as repayment can be severely impacted due to large swings in the
currency price.

There are various factors which are responsible for the unprecedented
volatility seen in the INR over the last few months.

I hope to identify and analyze the factors responsible, the effects on the
economy and also possible remedies for the volatility in the Indian Rupee over
the course of this report.
















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INTRODUCTION

The Indian Rupee has become the most volatile currency among the 48
currencies tracked by Bloomberg between May 2013 and September 2013.
Three-month implied volatility, a measure of expected moves in the exchange
rate used to price options, jumped 649 basis points this quarter to 19.14
percent, the highest among 48 global currencies tracked by Bloomberg. The
rupee has plummeted 18 percent this year in Asias worst performance.

From being one of the more stable Emerging Economies currency, to
have the dubious distinction of being the most volatile currency has shaken the
confidence of the investors and the common man alike.

From a low of 53.7355 against the USD in May 2013 to a high of 68.3611
in September 2013, the Indian Rupee has certainly travelled a long way. A
sudden depreciation of 27.21% over a period of just four months has
tremendous systemic repercussions.

Most of the economists were unable to predict the sharp fall in the INR
that began in May 2013. Former Deputy Governor of The RBI, Mr. S.S.
Tarapore was one of the very few who got it right when he said in a column
published in The Hindu Business Line on January 24, 2013: With the inflation
rate persistently above that in the major industrial countries, the rupee is clearly
overvalued. Adjusting for inflation rate differentials, the present nominal dollar-
rupee rate of around $1 = Rs 54 should be closer to $1 = Rs 70. But our macho
spirits want an appreciation of the rupee which goes against fundamentals.

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Rajeev Malik of CLSA said something along similar lines in a column
published on www. Firstpost.com on January 31, 2013. The worsening current
account deficit is partly signalling that the rupee is overvalued. But the RBI and
everyone else are missing that clue, he wrote. The current account deficit is the
difference between total value of imports and the sum of the total value of its
exports and net foreign remittances.

So why did anybody else, including The RBI and The GOI not see or
predict what was so clear to these two eminent economists? Why was
everybody caught unawares by the steep fall and volatility in the INR?

In all likelihood all the economists and analysts, including The RBI were
victims of the Herd Mentality prevalent in the financial markets. Everybody
wanted to stick to the majority safe view and ignored the views of the minority
who thought the INR was overvalued.

What triggered the fall was the statement by Mr. Ben Bernanke, Chairman
of The US Federal Reserve that they were likely to taper the massive asset
purchase program (QE3) in the near future.

This event triggered a fall which soon cascaded into a free fall due to the
Domino Effect. All the Macroeconomic and Microeconomic concerns suddenly
became visible to everybody and soon the panic started to spread among
investors, both in India and abroad. The Government of India and The RBI took
extraordinary measures to stabilize the INR but it kept falling to new lows every
day.

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The INR hit its all time low price of 68.83 against the USD on 28
th
August
2013, a depreciation of 27.21% to its highest value in May 2013. Since then it
has regained a lot of lost ground due to delay in tapering of QE3 by The US
Federal Reserve and various measures taken by The RBI and The GoI. It
currently trades at 61.90 against the USD, an appreciation of 10.06% from its all
time low price.

This kind of volatility in such a short span of time can be very damaging to
the economy and peoples confidence in the currency. We are going to look at
all the factors that played a part in the price movement of the INR against the
USD.
We will also try to identify its effects on the economy. Finally we will try to
explore possible remedies to prevent a repeat of this episode in the future.
















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PRICE DATA

Historical High / Low price chart USD/INR
From October 2001 to September 2013




As we can see from the above chart, the INR has been trading in a broad
range of 40 50 against the USD for the 10 year period between 2001 2011. It
has been fairly stable for the most part, except for a period of appreciation
between 2006 2007 due to massive capital inflows that fuelled the equity
markets rally, and a period of depreciation between 2008-2009 due to the Sub-
prime crisis.

From 2011 onwards, the INR started to depreciate significantly with
volatility levels also going through the roof. It culminated into the recent period of
extreme volatility between May 2013 September 2013.



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One Year High / Low price chart USD/INR
From October 2012 to September 2013





This one year chart from October 2012 to September 2013 shows the
sudden spurt in volatility from May 2013 onwards. The spread between high and
low prices has widened significantly.






CAUSES BEHIND THE VOLATILITY
1. Widening Current Account Deficit:

Occurs when a country's total imports of goods, services and transfers
greater than the country's total export of goods, services and transfers. This
situation makes a country a net debtor to the rest of the world.
CAD are not necessarily bad for a developing economy if the GDP growth is
strong. Weak GDP growth coupled with a high CAD is a recipe for disaster.


Indias Current Account Deficit (CAD), widened from USD 6.3 billion
in Q4 - 2010-2011 to USD 32.63 billion in Q3
boggling jump of 5 times over the period of less than two


CAUSES BEHIND THE VOLATILITY

Widening Current Account Deficit:
Occurs when a country's total imports of goods, services and transfers
greater than the country's total export of goods, services and transfers. This
situation makes a country a net debtor to the rest of the world. High levels of
CAD are not necessarily bad for a developing economy if the GDP growth is
owth coupled with a high CAD is a recipe for disaster.
Indias Current Account Deficit (CAD), widened from USD 6.3 billion
2011 to USD 32.63 billion in Q3 2012-2013. This was mind
boggling jump of 5 times over the period of less than two years.
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Occurs when a country's total imports of goods, services and transfers is
greater than the country's total export of goods, services and transfers. This
High levels of
CAD are not necessarily bad for a developing economy if the GDP growth is
owth coupled with a high CAD is a recipe for disaster.

Indias Current Account Deficit (CAD), widened from USD 6.3 billion
2013. This was mind
years.
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2. High Consumer Inflation:

Consumer Price Inflation (CPI) is the internationally accepted indicator to
monitor price levels in the economy. The purchasing power of a currency is
determined by the CPI.



Persistently high CPI over the last four years is one of the major reasons
behind the depreciation of the INR. CPI levels of above 10% on a sustained
basis do irreparable harm to the economy in general and the value of the
currency in particular.





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3. Massive rise in Short Term External Debt:

Foreign Currency Debt having residual maturity of less than one year is
classified as Short Term External Debt. High levels can cause a mismatch in
liquidity flows and volatile currency movements.



Indias Short Term External Debt rose from less than USD 5 billion at the
end of 2004 to more than USD 60 billion at the end of 2012. Since the debt
has to be repaid over 2013, there was a sustained rise in demand for the
USD.




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4. Growth Slowdown:

Foreign portfolio investments via Foreign Direct Investment (FDI) and
Foreign Institutional Investment (FII) are dependent on the GDP growth of the
country.



From a peak of 11.40% growth in March 2010, Indias GDP growth has
nosedived to 4.40% in the quarter ended June 2013. This has resulted in a
significant reduction in foreign portfolio investment and subsequently reduced
the supply of foreign exchange in the market.


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5. High Fiscal Deficit:

A countrys fiscal health is measured by the Fiscal Deficit of the country. It
is a very important indicator for foreign investors to decide whether to invest
in a country or not. High levels of Fiscal Deficit discourage them from
investing in a country. A high Fiscal Deficit also causes inflation, higher
interest rates and lower GDP growth.



Indias Gross Fiscal Deficit surged from Rs. 1269 billion in 2007-08, to Rs.
5209 billion in 2012-13, an increase of 310% over a period of 5 years.


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EFFECTS OF THE VOLATILITY

1. Loss of Investor Confidence:

Investors, both domestic and foreign want a stable currency to encourage
them to invest in a country.

A volatile currency scares away investors from investing in the country.
Domestic investors look to invest in safer physical assets like Gold and Real
Estate if there is volatility in the currency.

Foreign investors avoid investing in a country with volatile currency and
divert their investments to other countries.

2. Rise in Inflation:

Depreciating rupee increases the cost of imports which has a direct
bearing on the inflation. Basically import of goods becomes costlier whenever
rupee depreciates and no wonder it makes impact on our day to day life as
we are consumer of imported products.

We have already felt the pinch of it as petrol and crude prices have been
increased in past few months. But the worst is yet to come. Cost of crude
import is bound to go up with the fall in value of Indian currency.
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Every fall in rupee is an invitation to inflation, unless managed well by the
regulator. Increased inflation means more expenses which in turn has
potential to impact the financial planning process.


3. Higher Interest Rates:

The Reserve Bank of India (RBI) has left no stone unturned to control fall
of rupee against dollar. The measures taken have been very harsh ranging
from limiting access to liquidity adjustment facility, to increasing rates on
marginal standing facility to higher average maintenance of cash reserve
ratio (CRR). Banks have been made to feel the pinch of shortage of liquidity.

The 10 year G-SEC yield has gone up from 7.10% to as high as 8.5%. Left
with very limited options now, if rupee continues to slide due to a combination
of internal and external conditions, RBI will have no option but to raise repo
rate.

Raising repo rate will tantamount to pressing panic button. If repo rate
goes up, banks will not hesitate to pass it on the customers unlike what they
do when rates fall. The situation seems to have just reversed from what it
used to be three months back when everybody was expecting interest rates
to fall. This transition is purely because of fall in the value of rupee.




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4. Slowdown and Job Loss:

Falling rupee is a recipe for slowdown in economic growth. If the fall
of rupee continues, the foreign investment will dry in India thereby creating
a gap between investment required for growth and the actual investment
made. This may not happen in immediate future, but this cannot be ruled
out altogether.

Consistent fall in rupee may also take hot money i.e. FII out of India.
While the domestic investment in slowing down at a fast pace, slowdown
of foreign investment at this juncture will strongly impact economic growth.
Slowdown does not just impact the creation of jobs it also has potential to
create job losses.

5. Increase in the cost of education:

Increasing cost of education is not just going to impact those who go
out of India to acquire post graduation qualification or specialized
education, but also to those Indians who want to be in India and acquire
higher education.

Today many students in India write examinations like CFA, CPA,
CAIA, ACAMS etc. to acquire educational qualifications. Many
certifications in information technology are also acquired through distance
learning and online mode in India which requires payment of money in
dollar terms.
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So the falling rupee may hurt plans of many India based students
who wish to acquire international qualifications based in India.

6. High Fuel Prices:

A weak rupee will increase the burden of Oil Marketing Companies
(OMCs) and this will surely be passed on to the consumers as the
companies are allowed to do so following deregulation of petrol and partial
deregulation of diesel.

If the OMCs increase fuel prices, there will be a substantial increase
in overall cost of transportation which will stoke up inflation.













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POSSIBLE REMEDIES

There is no Magic Wand to fix the current situation that India finds
itself in as said by Dr. Raghuram Rajan, Governor of The RBI.

Both the Government of India and The RBI need to make concerted
efforts and take concrete steps to tide over the crisis and prevent a
recurrence in the future.

We must undertake long term reform process for our economy rather
than looking for quick-fix solutions which do not solve the problem in the
long run.

As the Governor of RBI said, we must make our economy bullet
proof to prevent a recurrence of this crisis.












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1. Measures by RBI

A. Using Forex Reserves:

RBI can sell forex reserves and buy Indian Rupees leading to demand
for rupee. But using forex reserves poses risk also, as using them up in large
quantities to prevent depreciation may result in a deterioration of confidence
in the economy's ability to meet even its short-term external obligations. And
not using reserves to prevent currency depreciation poses the risk that the
exchange rate will spiral out of control.

Since both outcomes are undesirable, the appropriate policy response
is to find a balance. Recent data shows that RBI had indeed intervened by
selling forex reserves selectively to support Rupee.




B. Raising Interest Rates:

The rationale is to prevent sudden capital outflows and ultimately lead
to higher capital inflows. But Indias interest rates are already higher than
most countries. This was done to tame inflationary expectations. So further
raising interest rates would lead to lower growth levels.

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C. Make Investments Attractive- Easing Capital Controls:

RBI can take steps to increase the supply of foreign currency by
expanding market participation to support Rupee. RBI can increase the FII
limit on investment in government and corporate debt instruments. It can
invite long term FDI debt funds in infrastructure sector. The ceiling for
External Commercial Borrowings can be enhanced to allow more ECB
borrowings.


D. Separate Forex Window for Oil Marketing Companies:

The Oil Marketing Companies, (IOC, HPCL, BPCL) are the biggest buyers
of foreign exchange in India. Their persistent demand for USD creates
demand supply mismatch in the market and triggers volatility.

The RBI has already taken this step on 28
th
August 2013 and since then
the INR has appreciated by more than 10% against the USD. The volatility
index has also gone down from 28% to 22%.

This is not a long term solution for the core problem but it gives breathing
space to The RBI and The GOI to take more long term measures.





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2. Measures By The Government of India:

Government should take some measures to bring FDI and create a
healthy environment for economic growth. Key policy reforms that should be
initiated includes rolling of Goods and Services Tax (GST), Direct Tax Code
(DTC), FDI in aviation and retail, Companies Bill and diesel decontrol. Efforts
should be made to invite FDI but much more needs to be done especially
after the holdback of retail FDI and recent criticisms of policy paralysis.

The government took steps recently to loosen rules for portfolio
investment in the Indian market, indicating its desire to sustain external
inflows. The measure to increase External Commercial Borrowings (ECB) to
$10bn will help in borrowing in dollar at a less cost. It may take similar steps
to encourage FDI as well, helping sustain external funding.












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CONCLUSION

The recent depreciation and volatility in the value of the INR has hit the
country very hard. It has created additional problems for an economy which is
already grappling with a slew of problems of its own.

In a country where inflation is already running near double digits (CPI), a
falling currency makes imported goods costlier. With the kind of dependence
we have on imported crude oil, any fall in the currency makes it more and
more expensive to import crude oil. This is bound to result in higher inflation
going forward.

For a developing country like India, huge amount of foreign capital is
required to fund its infrastructure an industrial development. A depreciating
and volatile currency scares away the foreign investors and it starves the
country of its capital requirement.

We need to fix this problem with long term measures like higher GDP
growth, lower Inflation and increasing exports. We cannot be dependent on
short term portfolio investments as they are by nature volatile.

For a sustained, long term economic growth that benefits the entire social
strata, we must have a stable currency.




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Bibliography

S.
No
Name of the Author
/ Organization Title of the Book
Name of the
Publisher
1 Reserve Bank of India www.dbie.rbi.org.in RBI
2 Bloomberg www.bloomberg.com Bloomberg
3 Thomson Reuters www.in.reuters.com Thomson Reuters
4 Trading Economics www.tradingeconomics.com
5 Vivek Kaul http://www.firstpost.com/author/vivek Firspost.com