Rupee Depreciation: The Causes and Who It Hurts

A currency falls when more of it is offered than wanted at the old price, and the question worth asking is always why. More being bought from abroad, money leaving, a rate gap opening, and prices rising faster at home are four different events. The four can produce an identical headline number and behave nothing alike in the months after it.

Each term below arrives already finished, worked out at length earlier in this reading order: how a currency market arrives at a rate, how any single move in that rate carries two readings at once, what the current accountA period's tally of the trading a country does with the rest of the world: what it sells and buys, what it is paid for services, and money sent home by people working abroad. and the capital accountThe tally of ownership and lending moving between countries: shares and bonds bought, plants built, loans taken and loans repaid. each record, which flows reach a currency market through each of them, what the policy rateThe interest rate a central bank fixes as its own lever, off which most short dated borrowing in that economy then prices. Explained in full where monetary policy is taught. is, and how a price level moves.

A fall in a currency arrives in a headline as one number, and that number is the same number whatever produced it. Underneath it sit four quite different events, and the reason to tell them apart is not tidiness. Two of the four behave in opposite ways in the months that follow, and nothing about the number says which one is in view.

The rupee is the currency a reader in India actually has this question about, and the Reserve Bank of India is the central bank standing behind it. Whether the rupee is correctly priced on any given day is a question about a live market and a dated release, not about arithmetic.

Every figure that follows belongs instead to the Republic of Sankhya, an invented country, and its invented partner Marut. The Sankhya external account is fixed throughout: goods exports at Rs 2,75,000 crore, goods imports at Rs 3,85,000 crore, a goods balanceWhat is left once the value of goods shipped out is set against the value shipped in. A minus figure means more came in than went out. Taught where trade is covered. of minus Rs 1,10,000 crore, a current account of minus Rs 14,000 crore, portfolio investmentMoney placed in shares and bonds that can be sold on any day, as distinct from money sunk into a factory that cannot. The two kinds are separated where cross border investment is taught. of minus Rs 6,000 crore, and foreign exchange reservesA central bank's holding of other currencies and similar assets, which it is able to sell. The purpose of such a holding, and what it is measured against, is covered separately. of Rs 3,85,000 crore. The rate in question runs from 80.00 to 84.00, quoted in Sankhya rupees for one Marut unit. Every one of those is illustrative.

One thing to square first. Sankhya appears earlier in a much smaller trade example, built on one pair of products only, with income and transfers across the border held at nil so that a single contrast could be seen without noise around it. The smaller version reported a goods balance of minus Rs 250 crore. Here the same country is drawn whole, with every line running. The two sets of numbers are different sizes of one country, and neither is a correction of the other.

What actually causes a currency to fall?

Four things, and they are separated here by what moves rather than by what they are called. Everything that follows depends on holding the four apart, so each is taken one at a time.

The first is that more is being bought from abroad. Sankhya buyers want a larger quantity of imported goods than before, and to pay for them they must first obtain Marut units, so they offer rupees for Marut units. The goods deficit widens: on the illustrative figures used here, imports rise by Rs 20,000 crore, so goods imports of Rs 3,85,000 crore become Rs 4,05,000 crore and the goods balance of minus Rs 1,10,000 crore becomes minus Rs 1,30,000 crore. The extra demand for Marut units is what pushes the rate.

The second is that money is leaving. Nothing is being bought at all. A holder of Sankhya shares or bonds sells them, takes the rupees, and wants Marut units to carry the proceeds out. The portfolio line deepens: on the illustrative figures, minus Rs 6,000 crore becomes minus Rs 26,000 crore. The extra demand for Marut units comes to Rs 20,000 crore, exactly what the first cause produced. The rate is pushed by exactly the same amount, from exactly the same market, for a completely different reason.

The third is that a rate gap opens. The gap between what money earns in Sankhya and what it earns in Marut moves against Sankhya, and holders of rupee assets have a reason to move. The moving is itself demand for Marut units. The Sankhya rate of 6.00 per cent against the Marut rate of 2.00 per cent, and the expected move of 3.92 per cent that the gap implies, are worked out in full where that condition is built, and are borrowed rather than rebuilt here.

The fourth is that prices rise faster at home than abroad. The fourth cause does not need any flow at all. A basket of goods costs Rs 8,000/- in Sankhya and 100 Marut units in Marut. Let the Sankhya basket come to cost Rs 8,400/- while the Marut basket has not moved. The rate at which the two baskets still compare is Rs 8,400/- against 100 Marut units, or 84.00. The rate has fallen because the thing being priced changed, not because anybody queued at a counter. The purchasing power parityThe idea that a rate ought to settle at whatever level makes an identical shopping basket cost an equal amount on either side of a border, once converted. Tested against where it fails, and covered separately. route is built elsewhere and only applied here.

All four arrive at the same place: 80.00 becomes 84.00, the Marut unit is up 5.00 per cent and the rupee is down 4.76 per cent, and the headline reads identically in every one of the four cases. Two percentages for one event is not an error, and why one currency reads as 5.00 while the other reads as 4.76 is worked out where that asymmetry is built.

Why does the cause matter more than the size of the fall?

Because one of the four shrinks itself as it happens and the others do not, and the size says nothing about which of the four is in play.

Start with the fall caused by buying more from abroad. Sankhya buyers wanted an extra Rs 20,000 crore of imported goods at the old rate. The import bill went to Rs 4,05,000 crore. In Marut units that bill is 5,062.50 crore Marut units of goods. Now the rate is 84.00. The same goods, not one item more, now cost Rs 4,25,250 crore. The extra is Rs 20,250 crore for nothing extra at all. Every buyer of imported goods in Sankhya is looking at a rupee price 5.00 per cent higher than the one they decided to buy at. The fall makes the very purchases that caused it dearer, so the demand that produced the fall gets smaller while the fall is happening. How much smaller is a separate question, and answering it would mean inventing a number. The direction is the point.

Now the fall caused by portfolio money leaving. A holder wants to convert a holding and take it out. The size of the holding decides how many Marut units they want. The holder is not buying anything with those units, so what a Marut unit will buy has no part in the decision. The holder is converting a claim and leaving. Nothing in that reason for wanting Marut units depended on the price of Marut goods, so when Marut units become 5.00 per cent dearer in rupees, the quantity wanted does not shrink. There is no self limiting loop here at all. Two falls of exactly 4.76 per cent, one of which is working against its own cause and one of which is not, and the number 4.76 is identical in both.

Here is the everyday version. A queue forms at a street stall, so the stall raises its prices. The queue thins out, and the price has acted on the very queue that raised it. Now imagine the stall raised its prices because the landlord raised the rent. The queue thinning changes nothing about the rent. Same price rise on the board, entirely different next month, and a customer standing outside reading only the board cannot tell the two apart.

The other two causes sit closer to the second than the first. A rate gap lasts as long as the gap lasts, and nothing about the rupee falling narrows what money earns on either side of the border. A price gap lasts as long as the price gap lasts, and the fall in the rate is that price gap turning up in the rate rather than an event separate from it. A reader who knows only that the currency fell 4.76 per cent knows almost nothing about what happens next.

What happens when the same fall is run twice, under two causes?

The two runs show how little the rate reveals. Both runs start at 80.00 and end at 84.00. Both give the Marut unit up 5.00 per cent and the rupee down 4.76 per cent. One line of the Sankhya account differs, and so does what follows.

Read the last row against the four rows above it. Every reading a headline could carry is identical down the two columns, and the one row that differs is the one no headline reports. The Rs 20,000 crore of extra demand is stipulated to be the same in both runs precisely so that the rate lands in the same place. How much extra demand moves a rate by how much is a property of a real market on a real day, and no stipulated figure can stand in for it.

The same firm, standing in both

Now put one business into both runs and change nothing about it. Bhramari Looms is an invented fabric maker in Sankhya. Over a year it sells 30,000 Marut units worth of fabric abroad, buys 20,000 Marut units worth of imported yarn, and has an obligation of 10,000 Marut units falling due. All three quantities are quantities of Marut units, so they do not change when the rate changes. Only their rupee sizes change.

The net across the three lines comes to exactly nothing. Two separate points sit inside that nil. The first: Bhramari Looms sees precisely the same three numbers under cause one and under cause two, so the firm cannot tell which event it is standing in from the rate alone. The second: a net of nil is not the same thing as no effect. The obligation of Rs 8,40,000/- falls due on a date. The receipts of Rs 25,20,000/- arrive across a year. Netting to nothing in a table is not netting to nothing in a bank account, and a business that reads only the net can be perfectly hedged on paper and short of rupees in March.

Who inside a country is hurt, and who is helped?

Different people, in opposite directions, at different speeds, and the word country hides every bit of it.

Anyone carrying an obligation in the other currency is hurt immediately and cannot wait it out. Bhramari Looms owes 10,000 Marut units. At 80.00 that was Rs 8,00,000/-. At 84.00 it is Rs 8,40,000/-. The obligation did not grow: it is 10,000 Marut units in both worlds. The number of rupees needed to discharge it grew, by Rs 4/- for every Marut unit. And the date it falls due does not move because the rate moved. Waiting is not a strategy available to a fixed date.

Anyone selling abroad is helped, and this is where most commentary stops. The story does not end there. Bhramari Looms receives 30,000 Marut units for its fabric, and at 84.00 those receipts are Rs 1,20,000/- larger. But 20,000 Marut units of imported yarn go into producing that fabric, 66.67 per cent of what it sells by value, and the cost of that yarn rose by Rs 80,000/- at the same moment and for the same reason. An exporter is helped by a falling currency only to the extent that what it sells is not made of what it buys. The imported contentHow much of a product's cost is made up of parts and materials bought from outside the country. Taught where trade is covered. of what a country sells is the whole difference between an exporter that gains and one that stands still.

And a household that buys nothing from abroad directly is reached anyway, later, through the rupee price of anything with imported content inside it. The direction is certain. The size depends on how much imported content sits inside what the household buys, and on how much of the rupee increase a seller passes on rather than absorbs.

What does a central bank actually do about a falling currency?

Two things, and both touch the same thing, so it is worth being exact about what each one touches.

The central bank can sell reserves. Somebody in the market wants Marut units and is offering rupees for them, and the central bank meets that demand out of the stock it holds. The size of that stock, and what it is held for, is worked out where reserves are built. On the Sankhya figures, meeting Rs 20,000 crore of demand takes reserves from Rs 3,85,000 crore to Rs 3,65,000 crore. The central bank can also move the policy rate. Moving it changes what money earns in Sankhya against what it earns elsewhere, and the mechanism is built where monetary policy is taught.

Both of those act on the price of the currency, and neither of them acts on what is producing the fall. That distinction is the whole of this block. Selling reserves against a widening import bill does not reduce the quantity of goods Sankhya buyers want. Selling reserves against portfolio money leaving does not make the departing holder change their mind. Selling reserves supplies the Marut units they wanted, out of a stock, at the old price.

Which is fine, and often exactly the right thing, when the cause is temporary. A cause that persists gives a different picture. Meet the same Rs 20,000 crore of demand three years running and the stock goes Rs 3,65,000 crore, Rs 3,45,000 crore, Rs 3,25,000 crore, a reduction of 15.58 per cent. The outflow in the third year is exactly the size it was in the first. The stock has been spent and what produced the fall is sitting precisely where it was. How large a stock of reserves needs to be, and what it is measured against, is a separate question, worked out where reserves are taught.

What can a central bank not do about it?

Two things, and both of them are arithmetic rather than a limit of will, skill or determination. A great deal of commentary reads an unchanged rate as a failure of nerve. The distinction between arithmetic and will is what that commentary misses.

A central bank cannot make foreign goods cheaper in the other currency. Bhramari Looms needs 20,000 Marut units of yarn. The requirement is 20,000 Marut units whether the rate is 80.00, 84.00 or anywhere else, and no operation anywhere changes the Marut price of Marut yarn. An operation can change the rupee price, and only by changing the rate, the one price the instruments already reach.

And it cannot make an obligation in the other currency smaller. The 10,000 Marut units Bhramari Looms owes is 10,000 Marut units at every rate that has ever existed. Moving the rate moves the number of rupees needed to discharge it; it does not move the obligation. Both limits are the arithmetic of a quantity denominated in something else, and neither one is a judgement about anybody's competence.

What does an analyst establish before reading anything else?

Which of the four causes is operating. Not the size, not the speed, not the level. The cause, first, before any other line of the note gets written.

Under two of the four, the same fall means opposite things about what comes next, and the headline never says which one is in play. An analyst who opens with the number has already committed to treating a self limiting event and a persistent one as the same event. So the first move is to go to the account and see which line moved: the goods line, the portfolio line, or neither, in which case the price level and the rate gap are where to look. Which line moved is a question about published data rather than about opinion, and that is exactly what makes it a good first question.

A household does a smaller version of the same thing without calling it that. When an electricity bill goes up, the first thing worth establishing is whether the meter reading was high this month or whether the tariff changed. One of those two ends when the month ends and the other does not. Same bill, same number at the bottom, entirely different next month. Establishing the cause before reading the size is not analytical fussiness, it is the difference between a number that is about to reverse itself and a number that is not.

What would have to be known before drawing any conclusion?

Four things, and what follows is those four questions rather than an answer.

First, which cause is operating: more being bought from abroad, money leaving, a rate gap, or prices rising faster at home. Second, how persistent that cause is. A fall that unwinds and a fall that continues have almost nothing in common. Third, who holds the obligations in the other currency. Obligation holders are the people a fall reaches immediately and at a fixed date. Fourth, how much imported content sits inside what the country sells. Imported content decides whether an exporter is helped or merely moved.

For the rupee itself, those four remain questions rather than settled answers. Naming a currency does not license a judgement about it. Answering those four for a real currency needs live data, a real period, a real market and a defensible view about what would have happened otherwise. The four questions carry over instead, worked through on invented figures and ready to be put to the real data.

The Republic of Sankhya, Marut and Bhramari Looms are invented.
Educational material. Not advice on any investment, tax, budget or market position.