Why rupee has been depreciating against dollar: A historical Analysis

Indian currency i.e. rupee has been in news because of recent fall against the dollar. Rupee has fallen more than 15% in just 3 months time against dollar. India rupee has been depreciating against dollar for long time now. Post liberalization, the fall in the rupee against dollar has been rather steep. It is important to note that rupee has started falling against dollar more frequently after partial convertibility of rupee was introduced. The partial convertibility gave it more elbow room to automatically adjust against the dollar.

The history of rupee’s depreciation against dollar can be understood from the data given below:

It is very clear that rupee has fallen down against dollar substantially during last forty years, barring some exceptions. But have all currencies in the world fallen against dollar the same way as rupees. The answer is a firm no. In fact, China which is the fastest growing economy of the world has not experienced this kind of fall in it’s currency value. The data below shows this:

While Chinese currency fell against dollar from 1982 to 1994, it has almost got stabilized against dollar post that and has appreciated against dollar in recent times. So while Indian and China are often put in the same league as far as tow fastest growing economies of the world are concerned, the currency performance of rupee and Yuan has not been same.

So why it is that Indian rupee has fallen so fast against dollar? Second but the more relevant question that needs an answer. Why it is that rupee falls on some occasions so steeply against dollar, like the fall of rupee against dollar during last three months.  Let me give answer to the second question first. The factors responsible for fall of rupee were getting built over a period of time. Rising current account deficit, high inflation and policy paralysis were the factors that triggered fall in the value rupee all on a sudden, though they got built gradually over a period of time. The market needs a trigger for a value to appreciate and depreciate and traders often provide this trigger.

Now look at reasons behind long term fall of rupee. The most important factor to cause this fall is high inflation. Rising inflation makes our goods costlier. If the purchasing power parity has to hold good, which does hold good, the rupee has to adjust to the change in inflation against dollar. Let us look at an example to understand this. Imagine that only sugar is traded between India and USA. Suppose the price of sugar is Rs. 30 a kg in India and $1 a kg in USA. By this logic, $1=Rs.30. Now imagine that inflation in India is 10% per annum while in USA it is only 2%. So after one year sugar will sell at Rs. 33 a kg (10% of Rs.30 added to inflation) and $1.02 in per kg in USA.  These two new prices of sugar will set a new exchange rate which is 33/1.02. The new exchange rate after a year will be Rs.32.35.

The second factor causing long term depreciation in Indian rupee is the balance of trade position. International trade of a country shows how it is positioned in terms of demand for its currency. The demand for dollar happens in India because of the fact that Indians need dollar to import goods from all over the world. Rising demand for dollar adversely impacts rupee as people convert rupee into dollar to meet foreign exchange requirements. This puts Indian currency under stress.

The third important factor that impacts Indian currency is the flow of dollars in India in form of FDIs and FIIs. When the dollar flow increases in India, the value of Indian rupee appreciates. Indian rupee appreciated against dollar from 2002 to 2007 primarily because of this reason. This was the time when flow of dollar in India was very high due to booming stock market. But post 2008 crisis, this has not sustained.

While there are other factors which impact the value of Indian rupee against dollar, the three factors are key contributors in fall and rise of rupee against dollar.