Article: Rupee Fall is Only Natural

History is riddled with examples of kingdoms and countries devaluing their currency to get out of trouble. Some of the more contemporary instances have been of Great Britain devaluing the pound during the 1991-92 ERM crisis, another is the Indonesian Rupiah, Malaysian Ringgit and Thai Baht losing more than 80% of their value in the 1997-98 Asian crisis.

Sometimes, the devaluation is voluntary, as in the case of Great Britain, where the government realised that the situation was untenable and let the currency go. And sometimes the move is involuntary, as was the case with Asian tigers, where the markets forced the devaluation, as is the case with India.

The government has been in policy limbo and is unable to make the corrections required to boost market confidence. The markets have reacted by forcing the rupee to depreciate. There's nothing sinister about it, it's a natural response.

When a currency devalues, it does more than just rebalance the import-export equation of the country. It sets off a chain reaction with far reaching consequences in terms of financial and institutional reforms. At times, the process can get painful.

Yes, an increase in export earnings is a happy consequence. But on the flip-side, imports get more expensive as well. The weak currency hence forces painful internal inflation on its economy. Painful inflation then results in a cut back in spending, both government and personal.

Allocation of resources and capital is forcibly rethought and redirected to things that are either necessary or productive. Through this process of creative destruction, the economy becomes leaner and more efficient; it spends frugally and earns more at the same time. Hence, currency devaluation triggers the sort of reforms the government was unable to enact on its own.

So when and by how much will the rupee devalue? The timing and magnitude is hard to predict. Valuation methodologies, like purchasing power parity & real effective exchange rate place fair-value for the rupee in the 60-65 area against the dollar.

This would be a 15% fall from current levels. But in a crisis situation, markets tend to overshoot and a 30% drop could easily happen. So seeing the rupee at 75 should not be considered a zero-probability event. Or, the government could wake up and bring about reforms that arrest the rupee's fall and maybe even set it on an appreciating trend.

This article was originally published in the Economic Times dated 27^th June, 2012, written by Sankalp Singh, associated with the FX Concepts.