BCom Devaluation in India Notes Study Material

BCom Devaluation in India Notes Study Material

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BCom Devaluation in India Notes Study Material
BCom Devaluation in India Notes Study Material

BCom Devaluation in India Notes Study Material

INTRODUCTION

Since its independence in 1947. India has faced two major financial crises and two consequent devaluations of the rupee. These crises were in 1966 and 1991. In recent years, the Indian Rupee has continued to depreciate in value. In 1990, we could buy $ 1 for 16 Indian Rupees. By 2015 (Oct.) the value of a Rupee had fallen so that we would need 65.19 Indian Rupees to buy $ 1. This shows there has been a substantial fall in the value of the Indian Rupee against the US dollar. (BCom Devaluation in India Notes Study Material)

When there is a devaluation in the Indian Rupee it means that Indian exports become cheaper, but imports are more expensive for Indians to buy. In particular, the devaluation of the Rupee is bad news for Indians who need to import raw materials, such as oil and gold.

INDIAN RUPEE’S DEVALUATION SINCE THE TIME OF INDEPENDENCE

There were a few major events that changed the currency rates:

  1. June 4, 1966: It was the first major devaluation. For the first two decades, India had almost a constant peg against the dollar at Rs.4.75/$. In 1966, the Government of India had a budget deficit problem and could not borrow money from abroad or from the private corporate sector, due to that sector’s negative savings rate. As a result, the government issued bonds to the RBI, which increased the money supply, leading to inflation. (BCom Devaluation in India Notes Study Material)

India had just fought 2 major wars (with China and Pakistan) and had 3 prime ministers in 3 years (Nehru, Shastri, Indira) after 17 years of one-man rule. Then a major drought shook the country. Thus, the Indian government announced a 57% depreciation of the rupee overnight from Rs.4.75/$ to * 7.50/$. (BCom Devaluation in India Notes Study Material)

  1. 1980s Inflation: From 1966 to 1980, the rupee stayed constant. However, the 1979 energy crisis and gold’s skyrocketing prices in the early 1980s left India with no place to go (oil and gold were historically our primary imports). Indian rupee started to slowly decline. From about Rs.7.85/$ in 1980 we reached about 17/$ by 1991. (BCom Devaluation in India Notes Study Material)
  2. 1991 Crisis: In July 1991, we hit another major crisis. It was the biggest event in the modern Indian economy. What exactly happened to the Indian Economy in 1991 in layman’s terms: Overnight rupee was devalued by another 50% from about Rs.17/$ to about Rs. 25/$.

In 1991, India started having balance of payments problems in 1985, and by the end of 1990, it found itself in serious economic trouble. The government was close to default and its foreign exchange reserves had dried up to the point that India could barely finance three weeks’ worth of imports. In 1966, India faced high inflation and large government budget deficits. This led the government to devalue the rupee.

  1. 1993 Liberalization: In 1993, Indian Finance Minister Manmohan Singh let the rupee float a little freely. The rupee was allowed to be traded by traders without a forced peg. The rupee value started to slide as the government was no longer controlling the prices, fully and started to reflect the reality. From about Rs.27/$, it slid to Rs.35/$ by 1997. (BCom Devaluation in India Notes Study Material)
  2. 1997 Asian Financial Crisis: One of the biggest events in East Asia as economies such as Thailand and Indonesia collapsed. Panic was all over the place. From about Rs.35/$, the rupee went down to Rs.39/$ as investors were quitting Asia.
  3. Pokhran-II 1998: Indian Prime Minster announced the nuclear testing. US, Japan, and other countries immediately imposed restrictions on India. In just a couple of months, the rupee sunk to Rs.43/$. Then the rupee started moving sideways and the lowest point was reached in 2002 at Rs.48/$ (when BSE was its lowest and real estate was listless).
  4. Good Times (2000-07): Rupee started recovering its losses and started moving up and reached about Rs.39/$ by 2007.
  5. Financial Crisis of 2007-08: The financial crisis caused investors to quit all emerging markets, including India, and pushed the rupee from Rs.39/$ to Rs.51/$ by March 2009. In the next 2 years, the rupee recovered most of the loss due to economic optimism and a rebound in US markets.
  6. European Sovereign-debt Crisis: By the fall of 2011, the world noticed another financial crisis. This time in Greece, Spain, and other places. Just like other times, investors started pulling out. Another reason was that the Indian government’s budget position was getting worse (due to profligate overspending). Indian rupee sunk from Rs.44/$ in August 2011 to about Rs.56/$ by June 2012.

CAUSES OF DEVALUATION IN RUPEE

There are so many causes of the devaluation of the Indian rupee. Among these, some are given as below:

  1. Higher Rate of Inflation: The long-term decline in the value of the Rupee reflects India’s relative decline in competitiveness. In particular, India has a higher inflation rate than its international competitors. In November 2013, Indian inflation reached 11.24%. Therefore, there is relatively less demand for the rising price of Indian goods; this reduction in demand causes a fall in the value of the Rupee. (BCom Devaluation in India Notes Study Material)
  2. Current Account Deficit: A consequence of poor competitiveness and high demand for imports is a current account deficit. This means India is purchasing more imports of goods and services than it is exporting. A large current account deficit tends to put downward pressure on a currency. This is because more currency is leaving the country to buy imports than is coming into buy exports.

In the first quarter of 2013, the Current Account Deficit was 18.1 billion. The deficit was over 6.7% in the last quarter of 2012, the deficit has fallen to 1.2% in 2013. However, the Economist notes that 75% of the deficit reduction is artificially related to reducing imports of gold through government restrictions. (BCom Devaluation in India Notes Study Material)

A current account deficit can be financed by capital inflows (on the financial account). But, recently, India has been struggling to attract sufficient long-term capital investment. Some major companies have recently pulled out of the foreign direct capital investment. This puts more downward pressure on the Rupee. (BCom Devaluation in India Notes Study Material)

  1. Price of Crude Oil: The price of crude puts tremendous stress on the Indian Rupee. India is the 4th largest importer of crude oil. Globally, the price of oil is quoted in dollars. India has to import a bulk of its oil requirements to satisfy local demand, which is rising year on year.

Therefore, as the domestic demand for oil increases or the price of oil increases in the international market, the demand for dollars also increases to pay our suppliers from whom we import oil. This increase in demand for the dollar weakens the rupee further. Therefore, rising oil prices worsen India’s current account and also weaken the Rupee. More Indian rupees have to be spent on buying oil.

  1. Trade Deficit: India is importing more goods and exporting fewer items, so the problem of trade deficit has arrived, currently the trade deficit is 4.8% of the GDP. (BCom Devaluation in India Notes Study Material)

Because of having high trade deficit demand for the dollar in India is more than its supply, the dollar appreciates and the rupee depreciates. Demand for dollars have created by importers requiring more dollars to pay for their imports and also by Foreign Institutional Investors (FIIs) withdrawing their investments and taking the dollars outside India, thus it is creating a shortage of dollar supply, due to which the prices of dollars as compared to Indian rupee is going up. (BCom Devaluation in India Notes Study Material)

  1. Low Capita Inflow: Although India has become an attractive destination that can invite foreign capital as well as money from non-resident citizens, it is not enough to make up for the trade deficit. In 2011-12, India received a foreign direct investment of more than $ 30 billion, in addition to a net inflow of $ 18 billion from foreign institutional investors in stocks and bonds.

But uncertainty about India’s commitment to economic reforms, high inflation, retrospective taxes, and policy paralysis within the government have forced foreigners to either postpone their investment decisions or take money out of Indian stock markets. At present in 2015, India received $ 44.9 billion from FDI. (BCom Devaluation in India Notes Study Material)

  1. Dollar Gaining Strength against the Other Currencies: The central banks of the Eurozone and Japan are printing excessive money due to which their currency is devalued. On the other hand, the US Federal Reserve has shown signs to end its stimulus making the dollar stronger against the other currencies including the Indian rupee, at least in the short term.
  2. Volatile Equity Market: Our equity market has been volatile for some time now. So, the FIFs are in a dilemma about whether to invest in India or not. Even though they have brought in record inflows to the country this year, if they pall out, it will result in a decrease in the inflow of dollars into the country. Therefore, the decrease in supply and increase in demand for dollars results in e weakening of the rupee against the dollar. (BCom Devaluation in India Notes Study Material)

Business Today reported that overseas investors pulled out a record Rs.44,162 crore (over $7.5 billion) from the Indian capital market in June 2013. The widening current account deficit and the depreciating rupee are definitely caused for concern. A weaker rupee further erodes the returns earned by foreign investors in the Indian market. (BCom Devaluation in India Notes Study Material)

  1. Low Economic Growth and High Inflation: Annual economic growth nearly is 4.8% and inflation is 4.86% as per the wholesale price index. It is divided into three groups: Primary Articles (20.1 percent of total weight), Fuel and Power (14.9 percent), and Manufactured Products (65 percent). Food Articles from the Primary Articles Group account for 14.3 percent of the total weight. The most important components of the Manufactured Products Group are Chemicals and Chemical Products (12 percent of the total weight): Basic Metals, Alloys, and Metal products (10.8 percent); Machinery and Machine Tools (8.9 percent); Textiles (7.3 percent) and Transport, Equipment and Parts (5.2 percent). (BCom Devaluation in India Notes Study Material)

In this scenario, most foreigners, as well as Indians, tend to take money abroad or keep it away from India due to which the inflow of dollars is decreasing and demand for it is increasing due to which prices of dollars are going up.

As the devaluation of currency is affecting the Indian economy, Government and RBI are taking different actions to recover from this. The government is increasing the duty charges on the import of goods and supporting the exports by giving benefits on taxes. To control inflation RBI increases the different rates such as REPO rates, Bank rates, MSF (Marginal Standing Facility, etc. so that the supply of money to the economy can be controlled. (BCom Devaluation in India Notes Study Material)

IMPACT OF DEVALUATION ON THE INDIAN RUPEE

  1. Inflationary Pressures: India is trying to control inflation, which has been running into double digits. But, devaluation makes it harder to control inflation. The devaluation increases the price of imports, such as oil and fuels, leading to cost-push inflation. Also, devaluation is considered an easy way of restoring competitiveness, therefore devaluation may reduce the incentives for exporters to work on improving long-term competitiveness. Finally, devaluation can help boost domestic demand. Exports will rise and consumers will switch to domestic producers rather than imports. This can cause demand-pull inflation. (BCom Devaluation in India Notes Study Material)
  2. Economic Growth: Devaluation can boost domestic demand and short-term economic growth. However, this is not necessarily helpful for the Indian economy. India’s economy needs to concentrate on boosting productivity and long-term productive capacity, rather than relying on boosting domestic demand. The rapid devaluation has also caused a loss of confidence in international and domestic investors. With a history of quick depreciation, foreign investors will be more nervous about investing in India. The devaluation and inflationary impact will also discourage domestic investors, e.g. firms worried about future oil prices. This reduction in investment is damaging to long-term economic growth. (BCom Devaluation in India Notes Study Material)
  3. Devaluation Spiral: The concern is that high Indian inflation causes devaluation, which in turn feeds into more cost-push inflation. Thus it becomes difficult to escape out of this unwelcome negative spiral of inflation-devaluation-inflation.
  4. Loss of Reputation in International Market: If devaluation of currency e done frequently the image of the country in the international market gets affected. Under this situation, the foreign exchange dealers hold Indian currency with an expectation of devaluation to get more rupees in exchange. This results in again a shortage of foreign exchange.
  5. Increase in Burden of Foreign Debt: As a result of the devaluation of rupees, more rupees are required to pay off some outstanding foreign debt. The annual interest of foreign debt also increases because of the low value of Indian rupees.
  6. Increase in Foreign Exchange Reserve: However, devaluation has various hive impacts but in the short run it has some positive impacts, and its a requirement for developing nations like India. It is just sufficient to meet foreign exchange requirements. Devaluation results in an increase in exports, a decrease in imports, an increase in foreign investment, and an increase in the flow of foreign capital, and all of these results in an increase in foreign exchange reserves ultimately. (BCom Devaluation in India Notes Study Material)

POLICIES TO STEM THE DEVALUATION OF THE RUPEE

(i) Supply side policies to improve competitiveness.

(ii) Reduce dependency on foreign oil, through domestic and renewable energy.

(iii) Monetary policy to tackle inflation and reduce domestic demand. But, will conflict with lower economic growth and lead to higher unemployment.

(iv) Financial controls, e.g. limiting the number of gold imports to reduce the current account deficit.

(v) India should have to mobilize larger rupee resources to pay for the debt which remains the same in foreign currency.

(vi) To increase in production of many import substitute goods.

BCom Devaluation in India Notes Study Material

BCom Devaluation in India Notes Study Material

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