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By HaleStewart October 9, 2013 11:10 am
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Why Is the Rupee Declining?
An explanation of the rupee’s current drop in value actually begins with the US Federal Reserve lowering interest rates to near zero and engaging in “quantitative easing” – the practice of buying US government bonds.  Not only does this practice lower interest rates but it also creates the “portfolio effect” – the act of forcing the investment community as a whole to take on more risk.  Here’s how it works.  Suppose an investment manager has a very conservative set of investment parameters; instead of buying junk bonds he can only purchase AAA rated securities.  When the Fed lowered rates to near zero and started buying government bonds, they started to take away the primary investment tool of our conservative portfolio manager.  As a result, he had to buy a different type of AAA securities – perhaps government agency bonds like those issued by Freddie Mac.  

Enter another portfolio manager who could take on a bit more risk, so he would usually buy the Freddie Mac bonds our very conservative portfolio manager is now buying.  This new manager must now move further out the risk curve to begin purchasing AAA corporate bonds.  And the second manager’s purchases are now competing with a third manager who can take on even more risk by buying AAA and AA corporate bonds…. At this point, the pattern is clear.  With the Federal Reserve now buying up a large quantity of the safest investment assets in the world, all other portfolio managers must now take on more risk to get the same investment yield.  Think of the Fed’s actions like a stone getting thrown into a pond, with the ripples being the effect on the international investment community.

When we look at a long term chart of the rupee we see that starting in 2009 and ending in 2011, its overall value increased.  The reason is the investment community started looking for higher yielding assets, leading them to invest in emerging markets.  This lead to an increase in rupee purchases, driving the currency’s value higher.   The Wisdom Tree rupee ETF increased from an extreme low of 17.38 near the end of 2008 to an extreme high of 24.08 in mid-2011 for an overall increase of 38.6%.  

However, the rupee has seen two periods of sharp declines since reaching its peak in 2011, with the first occurring later in 2011 and the second occurring in 2013.  Underlying both of these declines is an overall weakening of the Indian growth picture.  The annual GDP growth rate has been steadily declining from a high of 9.4% in early 2010 to 4.4% in the second quarter of 2013.  At the same time, the budget deficit, while improving, is still coming in between a negative 5.1% and 5.3% of overall GDP in the latest three readings.  The current account deficit has been steadily deteriorating over the last decade.  It was a positive 1.5% of GDP in 2004 but has continually increased, now coming in at -4.6% of GDP.  And finally, inflation is at uncomfortable levels.  While it decreased from 7%-4.5% in the first half of 2013, it has been increasing in the latest readings, printing at 6.1% in the latest monthly release.  

The sum total of all these numbers is that Indian growth is decreasing while inflation is increasing.  As a result, foreign investors are leaving the country to find more attractive growth opportunities.  And adding fuel to the fire is the US Federal Reserve announcing that it will scale back its asset purchase program which will increase US interest rates.  This makes US assets more attractive relative to Indian assets, adding further downward pressure on the rupee.  

The sum total of all these economic developments is this: India currently has a less attractive economic environment, leading investors to leave the country, thereby devaluing the rupee’s overall value.  It will probably take a fundamental change in the overall economic environment for the rupee to rally.

Hale Stewart is a former bond broker who has been writing about economics and financial markets since 2006 on Bonddad Blog.  He is also an tax attorney with a domestic and international practice while also forming and managing captive insurance companies for US companies.

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