Must-know: Why did the Indian rupee free-fall in 2013?

What caused the rupee free-fall in 2013?

The Indian rupee plunged to a record low versus the dollar, slumping to an intra-day value of 68.85 on August 28, 2013, based on a combination of factors before gradually recovering to 61.7710 by year-end. Foreign investors sold almost $1 billion of Indian shares in the eight sessions to August 27—a worrisome prospect, given that stocks had been India’s one sturdy source of capital inflows in the first half of 2013 in the face of policy paralysis with regard to foreign direct investment in several sectors.

Record current account deficit of $88.2 billion in 2012–2013

India’s current account deficit rose to 4.8% of GDP in 2012–2013, largely financed through hot money flows, and exceeded the government’s target level of 2.5% to 3% of GDP. The level was almost double the rate seen two years earlier. The government hopes to contain the current account deficit in the current fiscal year at $60 billion. With the CAD number in H1 2013–2014 clocking in at $26.9 billion, we expect that the government may manage to meet its target.

Bottlenecks in attracting foreign direct investment

FDI inflows in India registered a decline of 38%, to $22.42 billion, in 2012–2013, compared to $35.12 billion in 2011–2012. Markets were further spooked by the withdrawal of two of the largest projects ever announced in India by steel giants ArcelorMittal (MT), in Odisha, and POSCO (PKX), in Karnataka. The combined investment value of both projects was approximately $13 billion, or about 15% of the CAD in 2012–2013. While ArcelorMittal cited slow land acquisition approvals, POSCO said besides slow approvals, the unfavorable steel market influenced the decision as well. Policy uncertainty and uproar among the opposition political parties regarding approval of multi-brand foreign direct investment in the retail sector further impacted dollar flows and market sentiment.

The impact of the imminent Fed taper

Global funds cut holdings of Indian debt by $10.1 billion between May 22 and August 22, since Fed Chairman Ben Bernanke first flagged the paring on May 22, leaving the rupee vulnerable to the nation’s current-account deficit.

Outlook

In 2014, the Indian rupee is likely to stabilize due to two reasons.

1. Gradual trickling in of foreign direct investment flows: POSCO’s $12.6 billion Odisha project finally received environmental clearance after eight years, policy approvals in multi-brand retail (albeit in Congress-ruled states), and possible positive announcements in the infrastructure, railways, pharmaceuticals, and e-commerce sectors.
2. Projected improvement in CAD to less than 3% of GDP in 2013–2014, in part due to controls on gold imports (down by $9 billion in the first eight months of the current fiscal year) and partly due to improved exports targeted at $325 billion this fiscal year.

To learn more about the effects of the Indian rupee’s exchange rate, see The Fed taper and Indian rupee could still hurt potash companies.