{News Analysis} Rupee value is dropping steeply - What RBI has done?

    In recent times, we have been hearing news about plunging rupee value against US dollar. As a layman, let's take a closer on 'what is happening?' in this article. Before that lets set some basic rules.

    In a market, items or commodities are sold and/or bought. So, the value of a commodity depends on three criteria,

1. Buyers
2. Sellers
3. Availability

With respect to the buyers, If there are more buyers for a commodity, then its value would be raising more likely. Otherwise its value may fall. [Demand]

With respect to the Sellers, if there are more sellers who want to get rid of a commodity they have by selling it off, then its value would be falling more likely. Otherwise its value may raise or sustain. [Supply]

The sellers and buyers can sell or buy a commodity if only it is available. So, with respect to availability, if an item is available scarcely then its value would tend to raise. If it is available abundantly its value may fall. [Supply Management]

With the above rules in mind, lets analyse the current situation. In our market, the commodity is money or currency (Rupee, Dollar ...etc). With respect to the demand and supply of a particular currency, its value may vary (There are hell lot of factors involved in determining a currency's demand and supply. Like, demand for a country's goods and services...etc. Now, we can simply assume that globally there are more demand for American goods and services, so the demand for dollar is more and thus its value is high). When the global economic variations affects a country's currency, the central bank of that country has a major role in managing that situation. In our country, it is the RBI.

What are the options that the RBI has in its hand to tackle the falling rupee value against dollar?
1. Making the US dollar easily available in Indian market by supplying/injecting more dollars into the market.

Result : Dollar is available easily in market, so its value would fall. If not, at-least the value of dollar will not raise in market for some time. But there is a drawback here. From where RBI would get dollar currencies? of course, from the external reserves. The dollar availability in reserve depends on our export earnings. Currently, our country is already facing current account deficit. So, decreasing the for-ex reserves to save the value of rupee will backfire badly. Moreover this option is temporary i.e., it can save rupee value for some time only.

2. Decreasing the availability of the rupee in market. So its value would raise. If not, at-least the value of rupee will not fall down further or it will ease.

How it is done?

• Make the interest rate higher (MSF-short term, Bank rate-long term). So borrowing rupee will become costly, thus less availability of rupee.
• Decrease the availability of rupee for lending to banks (i.e., limiting the LAF to 1%).
• Buy rupee from market by selling Govt securities (Open Market Operations).

Result : Less availability of rupee leads to less money to lend to the businessmen. This will lead to less GDP growth.

What is "Cheap Money Trap"? and What are all its ramifications?

Cheap Money Trap:

In an economy, to boost the growth the policy makers lower the interest rate of the central bank. So that the entrepreneurs would get money for lower rate and they produce goods and sell it. Thus the economy will grow. But in real world this have not been worked that perfectly.

During 'Great Depression' (1930), UK govt tried this cheap money regime. They targeted the entrepreneurs, but the people took advantage of cheap money and borrowed more loans for housing. So, less economic transactions lead to less growth. Thus, the cheap money regime was a largely unsuccessful one.

This cheap money policy becomes a trap, when the fear of depression/recession tend to keep the rates low always. This is like economy becomes addicted to 'cheap money'. If we try to stop the drug (raise interest rate), the sick guy (economy) may collapse and the safe way to do is unknown. Thus the "cheap money trap".

Ramifications:

As for as the rich countries are concerned, their problem would be like "If we raise the interest rate, will the economy collapse?". But, sooner or later, when the situation is most favorable they will surely raise the interest rate.

With reference to India, we are now(2013) largely depending on the foreign investments. Whenever we receive USD in any form (FII or FDI), we become happy that our reserve raises. But actually we are accumulating debt. During cheap money regime the foreign investor gets easy money and he would want to get more returns out of it. So he invests in India. But when the cheap money supply stops, the foreign investment flow also stops. In fact it would get reverse and investment flows out of the country (i.e., India). This effect would destabilize our economy and lead to another BoP crisis. The possible way out from these difficulty (for India) is to strengthen the domestic Industries. Because, only a competent domestic industry will ensure the export earnings.