Misgovernance leading to decline of the rupee
July 17, 2025
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Misgovernance leading to decline of the rupee

by Archive Manager
Nov 17, 2012, 12:00 am IST
in General
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Dr Bharat Jhunjhunwala
Exchange
rate of the rupee had been stable in the last decade years from 2001 to 2011. It has declined rapidly after last September and is presently hovering around Rs 55. The increase in the value of rupee in the last two months after initiation of the second bout of reforms has proven to be short lived. Inflation remains near double digits and rupee is weak. Basic problem is misgovernance. NRIs and foreign investors doubt the inner strength of Indian economy. This becomes clear if   one takes short walk in history.

Copper coins were in vogue earlier in our country. Initially, the value of copper in a 1-paisa coin was equal or less than 1 paisa. Thereafter aluminium coins were minted. Reason was that inflation led to an increase in the price of copper. Value of copper in a 1-paisa coin increased to, say, 4 paise, while the legal value of the coin remained at 1 paisa. Thus, operators bought 1-piasa copper coins, melted them and sold the copper for a neat profit. This forced the Reserve Bank of India to withdraw the copper coins and replace them with aluminium coins. Further inflation has led to even these 1-paisa aluminium coins becoming outdated. This is how inflation leads to debasement of a currency.

Average rate of inflation in India in the decade between 2001 and 2011 has been about 8 per cent. Prices have nearly doubled. The T-Shirt that was being produced in Rs 45 is now being produced in Rs 90. The value of rupee would have declined proportionally and fallen to about one-half had the American dollar remained stable. This would be necessary for the T-Shirt to continue to be exported to the United States. But inflation in America has been about 3 per cent in this period. Therefore, tendency for decline in the rupee was somewhat arrested and the rupee should have declined only to about Rs 70. Think of it like this. One car is accelerating at 8 per cent per minute while other is accelerating at 3 per cent per minute. The difference between them will increase by 5 per cent per minute. Similarly, prices are accelerating at 8 per cent per year in India while they are accelerating at 3 per cent per minute in the United States. The difference between them, therefore, will increase by 5 per cent per year.

Surprise is that the rupee remained stable at about Rs 45 to a dollar and did not decline as it should have. Why? Reason is that exchange rate of the rupee is also influenced by capital movements. The exchange rate is determined in our foreign exchange market which operates much like a vegetable street market. The price of potato declines if there is increase in supply. Similarly the price of dollar declines if there is increase in supply of that currency. Huge amounts of foreign capital have come into India in the last decade in form of portfolio and direct investments. This has led to increase in supply of dollars, decline in the price of dollar and a corresponding increase in the price of rupee. The decline in the exchange rate of rupee that should have taken place due to higher rate of inflation in the country did not take place because the increase in price of the rupee due to this inflow overshadowed that tendency. It is like continuous blood transfusion to a patient suffering from anemia would lead to the levels of haemoglobin remaining constant. Similarly, continuous inflow of dollars from foreign investments into the Indian economy suffering from inflation led to the exchange rate of the rupee remaining constant. The inflow of foreign investment has slowed down after global rating agencies have downgraded India beginning August 2011; and the rupee has started to decline rapidly since then. The decline, however, is not due to present events. The decline has been continuous since 2001—only it has manifested now after the inflow of foreign investment has petered out. It is, therefore, necessary for us to control inflation if we want the rupee to climb again.

Main reason for inflation is the increase in wasteful consumptive expenditures of the government. Idle government servants are being given huge pay packets. Revenue is being used in their consumption expenditures. Corruption is also leading to leakages of revenue. The money is lost to the economy if it is invested in gold or sent abroad through hawala. This has led to a slowdown in the economy; lower revenue collections; government resorting to heavier borrowings from the Reserve Bank of India and a corresponding increase in inflation.

On the opposite side, the exchange rate of rupee shows an increasing tendency due to technological upgradation. Indian industries have adopted modern technologies. The T-Shirt that was being produced in Rs 45 ten years ago is now being produced for Rs 30. This increase in competitiveness of the Indian economy is creating a tendency for the rupee to appreciate.

On the negative side, increase in oil consumption has become a drain on our foreign exchange earnings. It has become necessary for us to export larger quantities of goods to earn this foreign exchange. This has, in turn, required us to keep the price of rupee low. Also, Indian companies are making outward foreign investments in a big way in acquisitions as Tatas have bought Jaguar. The inflow of dollars on capital account has substantially reversed. Previously mostly foreign capital was coming into our country. Now, Indian capital is going out of the country. This is creating demand for dollars and leading to decline in value of the rupee. The ongoing global crisis has not helped. Foreign investors have turned risk-averse. They are moving their assets towards the United States. This is depriving us of the capital that could have come to us.

The overall situation is as follows. Technological upgradation and inflow of foreign capital are the two factors working towards increase in the value of the rupee. Domestic inflation, increasing oil consumption, outward foreign investment and global economic crisis are working in favour of decline of the rupee. The inflow of foreign capital has slowed down after downgrading of India’s rating by global rating agencies substantially due to domestic misgovernance and increasing fiscal deficit. This is the immediate cause of the decline in rupee in the last year.

The long run value of the rupee is determined by technological upgradation and domestic inflation. The exchange rate of the rupee would have been about Rs 70 against the dollar today had technological upgradation not taken place. Perhaps it will stabilize around Rs 55 because of technological upgradation. The long term decline in exchange rate of the rupee due to inflation has been compensated by the long term technological upgradation.

This long term tendency of the rupee to decline was overshadowed by the short run inflow of foreign capital till 2011. This favourable circumstance evaporated because of deterioration in quality of government expenditures; leading to increase in fiscal deficit; leading to downgrading of India’s rating and reduction in inflow of foreign investment.

Upshot is that improvement in governance and quality of government expenditures; and increased focus on technological upgradation alone will help revive fortunes of the rupee.

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