Exchange rate can be best understood as nothing more than a benchmark for a nation's money supply. When the rupee depreciates against the dollar, it simply means value of the Indian currency has gone down relatively against the greenback. This can happen because of two things: 1) increase in rupees in the market; or 2) decrease of dollars in the market.
So how does this affect money supply?
One of the major duties of the governor of the Reserve Bank of India (RBI) is to essentially continuously decide supply of the currency in India. However, Raghuram Rajan, the newly appointed RBI governor who will officially take over the reins on 5 September, has a difficult situation on his hands. With the rupee on a seemingly continuous free-fall, he could accomplish two tasks in one shot: control India's rising inflation, and control the depreciation of the rupee, simply by limiting supply of the currency.
Seems like a win-win situation, right? Unfortunately, Mr Rajan will be taking on one of the most challenging roles in the nation as RBI governor. Let's first look at how and why the rupee has gotten to its current position.
One of the most important questions that many are asking is why the rupee has fallen to its current state. It is important to know that the rupee's value is directly linked to the amount of US dollars available in the Indian market. India receives dollars in three ways: through exports, through foreign investments into India, and through NRI remittances into India. The less dollars there are in the market, the more the dollar is worth (basic laws of demand and supply), and, so, the rupee depreciates. India's main import is crude oil, and the countries it imports from unfortunately only accept US dollars or other major currencies.
Therefore, it is critical for India to always have a large supply of US dollars or other major currencies within its system. The current account deficit is a measure that easily tells us the difference between exports and imports, and, hence, is a good indicator for the the supply of US dollars and other major currencies. If a country's current account deficit is seen rising, it means that the country is importing more goods than it is exporting. In case of India, each successive month the current account deficit has been rising at a dangerously alarming rate. This is a worrying sign, and it very well could be the largest contributor towards the rupee's depreciation.
One of the reasons for the rising account deficit is the fact that India is a heavy importer of crude oil and, of course, gold. On 14 August, the government decided to impose a 10 per cent import duty on gold, a knee jerk reaction to the rising current account deficit. That did nothing to stop the rupee from further depreciation.
The current account deficit can be stimulated through other means, not just by controlling the money supply- and this will be Mr Rajan's biggest challenge. By limiting the money supply, inflation and, potentially, the rupee's value would be controlled- but it would severely impact the country's growth. India's gross domestic product (GDP) has dropped from 6.2 per cent to 5 per cent in latest fiscal year, so India's growth would be hampered by lowering its money supply. Instead, Mr Rajan should look at the past. Over the past 24 calendar months, India's money supply grew at around 29 per cent, while it's GDP grew at a much lower pace.
This essentially means that more rupees were printed than required, which caused a rise in inflation. To control India's high current account deficit, Mr Rajan should do the exact opposite of what the current RBI governor has done, which was to impose capital controls on local companies by limiting Indians' ability to sell rupees. Investors took this as a cue for panic, and the rupee began to spiral out of control.
Instead, Mr Rajan should let the markets remain open and democratic- eventually, Indian goods will be cheap enough to a point where they will be easily exported. India's urbanisation is not going to stop, wages will continue to rise, and inflation will be controlled since the money supply can be kept at par with GDP growth. The rupee will probably rise in the short term and very well could rise to 70- but at a certain point, equilibrium will kick in. There is a high level of pessimism in the markets. The government needs to address the rising current account deficit and slow growth until optimism finally settles in.
Raghu Kumar is the co-founder of RKSV, a broking company. The opinions expressed here are the personal opinions of the author. NDTV is not responsible for the accuracy, completeness, suitability or validity of any information given here. All information is provided on an as-is basis. The information, facts or opinions appearing on the blog do not reflect the views of NDTV and NDTV does not assume any responsibility or liability for the same.