We have all heard stories about how, before Independence, the Maharajas used to live the good life abroad and wondered how they could do so when logic says everything foreign was so expensive. Instances of one such Maharajah, who bought a Rolls Royce or maybe a few who bought and used them as garbage trucks, defy belief. And this was at a time when India was seen as, and actually was, a very poor country.
Cut to the present.
India is an emerging superpower, ranks among the top economies in the world and is the fastest growing large economy. Yet, the Rupee nearly touching the 70 mark against the dollar is unnerving. But how does that affect us?
This fall in the rupee is akin to the dreaded diabetes – the silent killer. And it affects everything, some positive and a large number of negatives. Starting with the minuses: the first is the cost of import goes up; and what do we import the most??? OIL. In the Consumer Price Index composition table, Freight and fuel cumulatively account for nearly 15% of the total basket. In the Wholesale Price Index composition fuel and power account for 14% of the total. Thus for every 10 Rupees fall in the rupee against the dollar, prices of the above mentioned articles go up by that much leading to a 1%-1.5% rise in inflation.
So what happens when during inflation?
The purchasing power in our purse shrinks. The number of purchases we would have otherwise made, falls. Or maybe, in case of expensive purchases, the decision is deferred. In some cases, the purchase falls through completely. And why is this so important to us? As an economy, we all know that India is largely a consumption economy that is fueled by taxes. Of which, just a miniscule percent is by income tax and the rest is by taxes on goods and services. If we buy less, it means the companies are selling less too. And perhaps storing more or reducing production. In both the cases, it means that the cost per unit goes up as they will have reduced economies of scale or/and higher storage costs. Because of lower consumer off-take, the tax receipts of the government goes down, reducing spending on infrastructure and social welfare schemes. This increases the fiscal deficit and ultimately brings down the country’s ability to borrow from global lenders. To ensure the quantum of borrowings happen as planned, the government is forced to provide higher interest rates which have an adverse effect on the Balance of Payments (BoP). This is of course on top of the existing loans, for which the government has to organize more Rupees to ensure the same amount of dollars – which further reduces the BoP. The spiral is now so dangerous that it makes the finance, commerce and economy guys go haywire while trying to balance the various components of a very complex equation.
“The net result is that, out of nowhere, the possibility of a recession looms up. Because of the higher borrowings the government has to undertake, the cost of borrowings go up which leads to an inflationary spiral pushing up the costs of goods and services even higher.”
And what happens to companies? Lower consumption leads to higher per unit costs. This decreases profitability which depresses stock prices. The valuation erodes and raises further capital and servicing; existing borrowings become so much more expensive, further depleting valuation. The company is forced to defer expansion plans which affects the output of their suppliers, lowers the governments’ tax revenue and decreases employment opportunities. In a really bad situation, lowering of absolute employment numbers further reduces consumption, and the spiral into hell continues. Investors, seeing a fall in prices of their chosen stocks might go out of these companies and crowd the deposit market, leaving the prices to fall further. In turn, foreign investors will dump their Rupee stocks and convert these into Dollars. This drives up the dollar prices and adds to the stress on our currency.
Ask a tech owner or any exporter. He will tell you it’s the best thing that ever happened. Because of the higher USD, the rupee realization for him is much higher and this leads to a higher profit, higher payments (dividend or salaries), and better chances of employment generation, leading to higher taxes generated. Thus exporters of all kinds – software, pharmaceuticals, leather and jewelers – all hope to see a reduced Rupee vis-a-vis the USD.
The trick is to ensure the balance. Whether the INR-USD coming close to the 70 mark is going to help is going to be answered sometimes in the future. And the best indicator of that is going to be the reversal in the rates. Paradoxical, isn’t it?