The foreign exchange market is now in the news, with newspapers informing us virtually every day about fluctuations in the external value of the rupee. Much of the public concern about this issue seems to stem from the fact that there has been a steep decline in the value of the rupee against the dollar. The magic figure of 50 rupees to the dollar was crossed quite a while ago. As I write this, the rupee has sunk to a new low of 52 rupees to the dollar. Does this depreciation of the dollar against the rupee signal a worrisome weakness of the rupee? Are we running out of foreign exchange reserves? Or can we simply consider these movements of the rupee to be largely inconsequential?

To some extent, these figures are misleading because the dollar is just one out of a large basket of important currencies. So, what is important is how the rupee is faring against a bundle of currencies. Such comparisons are much more reassuring because virtually all currencies have recorded steep declines against the dollar.

Consider, for instance, the fate of the British pound. Not so long ago, every pound used to fetch just a few cents less than two dollars. The current value of the pound is only one dollar and fifty cents! It is also not the case that the decline in the dollar value of the rupee has been sharper than that of other currencies against the dollar. For instance, the decline in the dollar value of the Korean won or the Japanese yen has been several times more significant.

The international situation is so fluid that it is foolhardy to make firm predictions about what is going to happen to the external value of the rupee in the immediate future. A year or so ago, the external value of the rupee surged upwards because of record inflows of foreign exchange due largely to huge investments by foreign institutional investors. With the Indian stock exchange on fire, India was then the favourite country amongst all emerging markets. Every foreign fund wanted a piece of the action and so the dollars flowed into the coffers of the Reserve Bank. The stock of foreign exchange reserves was also supplemented by relatively large remittances from Indians working abroad. In fact, the burgeoning foreign exchange reserves became an embarrassment of riches, and the RBI had to frequently intervene in the foreign exchange market in order to moderate the appreciation of the rupee.

The situation is dramatically different today. The Indian stock exchange has been amongst the worst performers in the world during 2008. Not surprisingly, foreign funds have been steadily withdrawing funds from India throughout the year. But what was earlier a trickle soon turned into a steady flow since the sensitive index seems to sink lower and lower. The worldwide financial crisis has also contributed to the outflow of foreign exchange from India — foreign funds have faced tremendous redemption pressures at home, and investors have had to withdraw funds from India and other emerging markets in order to meet their domestic payment obligations.

There are also ominous signs that remittances may dry up. The global economic crisis combined with protectionist tendencies in the more severely affected countries may result in significant cutbacks in employment for foreign workers. So, many Indians who are currently employed abroad may have to return to India.

One foreign financial institution predicts that the rupee will touch 54 to the dollar by the end of the year. To the extent that this reflects a weakness of the rupee rather than a strengthening of the dollar, this is cause for worry. The danger in big changes in the exchange rate is that they encourage speculative forces that can result in even bigger changes. For instance, if exporters expect a further fall in the rupee, then they might postpone remittance of their foreign exchange earnings in the hope of getting higher rupee amounts later on. Portfolio investment may also dry up if foreign investors have similar expectations since their rupee earnings (converted into dollars) would be worth less in the future.

As far as importers with the same expectations are concerned, they would much rather buy immediately even if they would have in the normal course bought much later. These actions, by reducing the current supply of dollars and increasing the current demand for dollars, push down the external value of the rupee. Hence, these expectations become self-fulfilling, and can — in the worst-case scenario — cause a run on the rupee.

Under normal circumstances, a depreciation of the rupee should act as a stimulus to Indian exports since these would be much cheaper in foreign markets. Correspondingly, imports into India will become more expensive and, so, that should act as a stimulus for industries which produce goods that compete with imported goods. But, of course, the international economic scene is far from normal. The economic slowdown and the corresponding drop in demand in international markets imply that it is unrealistic to expect sharp increases in Indian exports. Moreover, the currencies of some countries which compete with India in international markets have also depreciated. So, Indian exporters will probably not experience any cost advantage because of the rupee depreciation.

Fortunately, the size of India’s external debt is quite small given the overall size of its economy. So, unlike several other countries, India will not find it problematic to service its external debt even after a sizeable rupee depreciation — the debt service burden in rupees will remain within manageable limits.

Of course, it is an open secret that the RBI does intervene in the foreign exchange market if the value of the rupee moves outside an interval. The exact interval itself is a closely guarded secret and must also vary with underlying conditions in the domestic and world economy. Perhaps, the rupee is currently in this interval because there is nothing to suggest that the RBI has been an active player recently in the foreign exchange market.

This inaction is not due to any constraint on the RBI’s capacity to intervene — despite some depletion of reserves, its foreign exchange reserves are still at a very comfortable level. This gives the RBI a lot of elbow room. There has also been a gradual but perceptible decrease in the rate of inflation. All this suggests that there is very little reason for panic in so far as the external value of the rupee is concerned.