In a development that caught many by surprise, the rupee has depreciated significantly over August and September 2011. Measured by the RBI’s reference rate, its value fell by close to 13 per cent from Rs. 44 to the dollar on August 1, 2011 to Rs. 49.7 to the dollar on September 23, 2011. Though the currency has gained some value since, it still remains at a highly depreciated low when compared with it previous high vis-à-vis the dollar.

This would, of course, please exporters who would find the dollar value of their exports falling with possible positive effects on demand. And exporters locked into long-term contracts denominated in dollars (such as exporters of IT and IT-enabled services), would find their rupee revenues and profits soaring. But there are many losers in the domestic economy. Importers of capital goods, raw material, intermediates and components would be hit hard. India’s already high and persistent inflation could be aggravated, and those directly or indirectly consuming imported products varying from food articles to petroleum products would be adversely affected by rupee price increases. Finally, corporates who rushed to the international financial market to borrow funds because of lower interest rates abroad must be counting their losses. The rupee’s depreciation is, therefore, a matter for concern.

The significance of this depreciation comes through from a number of indicators. The rupee end-September was 20 per cent higher relative to the dollar when compared with the beginning of 2008, when the global crisis engulfed the world. Throughout 2011, till the beginning of August, the rupee had fluctuated in the Rs.44-45 to the dollar range. So the depreciation to close to Rs. 50 to the dollar was indeed sudden. And even in the middle of the crisis when foreign investors chose to book profits and exit from India to cover their losses or meet commitments in their home countries, the rupee touched a low of only 52 to the dollar.

This sudden and steep depreciation does, therefore, call for an explanation. One factor that has been stressed in the media is that this has been a period of growing uncertainty in the world economy that has seen a flight to the dollar as a safe haven. In an atmosphere of fear of sovereign defaults, banking crises and a return to recession, the dollar, which was expected to weaken because of economic circumstances in the United States and was indeed drifting downwards, is suddenly gaining in strength. A host of alternative assets—oil, gold and metals among them—which were targets of a bull run previously are all of a sudden being dumped in favour of the dollar. The rupee and other currencies, it is argued, suffer on account of this. But uncertainty has been with us for long, and those assessing the dollar’s recent rise do recognise the role of speculative investors in competing asset markets. So it is quite possible that speculation played a role in India’s liberalised currency market too.

Consider the factors that could be contributing to the rupee’s decline relative to the dollar. The first is, of course, the fact that (unlike China, for example) India has in a balance of payments sense been a chronically deficit country. Her software and IT-enabled exports success and her export strengths in chemicals, pharmaceuticals and engineering notwithstanding, it is not just the trade but also the current account that has recorded deficits. This balance of payments weakness provides the medium-term basis for a “corrective” downward movement of the currency, which reduces the dollar value of exports (that stimulates foreign demand) and increases the rupee cost of imports (that dampens domestic demand).

If this medium term dampening influence has not been too strong, it is because of the role of net capital inflows. India has in recent years been a favourite of international investors, resulting not just in net inflows that finance current account deficits but net inflows that are adequate to create a dollar surplus in the country. This imparts an element of upward buoyancy to the domestic currency. In fact, as a result of these large inflows the Reserve Bank of India has been intervening in the foreign exchange market to buy up dollars and prevent rupee appreciation, besides substantially increasing access to foreign exchange for investment purposes for resident individuals and corporates.

Which brings us to the second factor adversely affecting the rupee’s value in recent times. Through this September, when the rupee depreciated, India was no longer a recipient of the large capital inflows it had become accustomed to. According to SEBI figures, September 2011 in fact saw a net outflow of FII investments to the tune of $342.4 million. For a country that had begun shaping policy on the assumption that it was a large net recipient of financial flows this was indeed a setback. This too, therefore, was a factor imparting downward pressure on the rupee.

It was in this background that the appreciation of the dollar’s value relative to all competing “assets” occurred, due to increasing uncertainty in the global economy. The sudden rise of the dollar was paralleled by a fall in the value of a whole host of assets varying from equity to metals and gold, which had emerged as the preferred safe havens for investors. Copper, zinc, steel, silver, platinum and gold, all of which were preferred investment targets for wealth holders and speculators were suddenly being shunned. Silver fell by 34 per cent in value in three days, which was its sharpest, fall in thirty years, and copper fell by more than 13 per cent. Gold recently registered its sharpest four-day fall since 1983.

In the process, it has been argued, the rupee, which was holding up for long relative to the dollar, gave way. But the turn to the dollar was particularly sharp after the Federal Reserve announced the launch of its “Operation Twist” in late September, which involved selling shorter-term Treasury holdings, and buying long-term debt and mortgage-backed securities to the tune of $400 billion. The decline of the rupee, on the other hand, had begun earlier, for the reasons noted above.

A final factor contributing to the surprise weakening of the rupee was the decision of the central bank not to intervene in the foreign exchange market to an extent required to stop the currency’s slide. This was perhaps partly due to the judgement that some depreciation of the rupee was warranted from a balance of payments point of view and partly to the false expectation that the rupee’s slide would soon correct itself, resulting in it settling at a slightly depreciated level.

In practice, however, once the slide began, it persisted in the absence of central bank intervention. This was possibly because, besides the factors noted above, the dollar became a target for speculators, who were expecting the rupee to depreciate and therefore holding on to dollars or buying into it for subsequent sale at a profit. It is only when the RBI finally turned proactive and intervened in the market did the dollar’s rise vis-à-vis the rupee halt and marginally reverse itself.