Explained: How Indian rupee sank to a lifetime low

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Why is the rupee falling against the dollar? The answer is simple—it is due to the shifts in basic demand-and-supply equations of currencies. The demand for dollar is more than its supply, pushing the rupee to lose its value against the dollar so as to meet the demand. However, the question on why there is an increase in demand for dollar now, is what that requires greater introspection.

The Turkish fallout

Turkey, one of the major emerging market economies in the world, has been grappling with a crisis for quite sometime. It stems from a diplomatic feud with the United States, over an evangelical pastor's alleged involvement in 2016’s failed coup, and also due to the country’s huge borrowings in foreign currencies.

On August 10, US President Donald Trump announced he was doubling the US import tariffs on Turkish steel and aluminium after the standoff over the continued detention of the pastor. The US sanctions choked the Turkish economy which was already reeling under a high inflation rate of nearly 16 per cent and poor fiscal discipline. 

Meanwhile, Turkish President Recep Tayyip Erdoğan has tightened his control over the country's economic policy. Erdoğan appointed his son-in-law as finance minister and made a series of announcements that may curtail the independence of the country's central bank, which raised a red flag for investors.

Now, with the Turkish currency, lira, losing about 30 per cent value in August alone, there is a deepening concern among investors and lending agencies that Turkey is sliding towards a full-blown financial crisis.

Global spillover

The markets have witnessed a similar scenario before—a heavily indebted country finding itself in crisis, the currency plunges and talk quickly turns to contagion and, ultimately, a global financial meltdown.

If history is any indication, the crisis in Turkey has the potential to turn into a global one, or may be not.

Over the last one week, the fall in the value of lira has sent shockwaves across global financial markets, especially in other emerging market economies. 

In recent years, as the global economy limped out of the 2008 crisis, investors in wealthier parts of the world, like the United States, Europe and Japan, have lent billions of dollars to governments and companies in developing economies like Turkey, India, China and South Africa.

The investors parked their money in such countries because the emerging markets offered higher interest rates and acted as a magnet for foreign capital. Whereas, developed markets like the US had incredibly low interest rates, as the central banks tried to bring their economies back to health after the recession.

Now, with the US economy becoming strong again, the Federal Reserve has been raising interest rates over the past few quarters. As a result, keeping money invested in the US markets looks like a better and safer deal for the investors, which eventually strengthened the dollar.

A stronger dollar is indeed bad news for foreign countries and companies that borrowed dollars, because currency movements are always relative. If the dollar goes up, other currencies go down, and vice-versa. A stronger dollar makes it difficult for foreigners to pay back their dollar-dominated loans.

In Turkey's case, the scared foreign investors started pulling money out of the country, choosing a much safer bet—the dollar. In effect, that means the investors sell lira and buy dollars or there is an increase in demand for dollar, plunging the value of lira.

However, a Goldman Sachs spillover index report shows that the contagion from Turkey’s crisis will probably be limited. With the exception of Russia’s ruble, recent movements in currencies of developing nations have generally been smaller than what the gauge predicted despite the Turkish lira’s plunge, the report said.

But the global investors, lured by a stronger dollar, are now turning away from countries with economic challenges like bloated current account deficits, inflationary pressures or high debts denominated in foreign currencies. So, India could also be prone to the aftershocks.

India's concerns

The Turkish crisis added fuel to a sell-off in the rupee, which was already under pressure due to a widening current account deficit and concerns over the fiscal deficit.

In early trade on Tuesday, the rupee crossed the psychological 70-mark to hit an all-time low of 70.08 against dollar for the first time, amid concerns over the risk of contagion or spillover from Turkish crisis. However, the rupee recovered later in the day.

The rupee's landmark drop comes at a time when the Reserve Bank of India has been tightening its monetary policy so as to maintain the targeted inflation levels. A weaker rupee—Asia's worst performing currency in the year—complicates RBI's job of keeping inflation in check. Global risks, such as higher oil prices and trade wars, are also weighing on India's growth outlook. 

Despite the headwinds, a healthy foreign exchange reserve and robust fundamentals mean the Indian economy is in a strong position to withstand external shocks. The International Monetary Fund, in its recent report, likened the Indian economy to an elephant that has just started to run, garnering investor confidence.

However, factors such as broader emerging market currency movements, dollar strength, and the trend in crude oil prices are most likely to drive the outlook for the rupee in the immediate term.