"This is what devaluation means. It is a confession of bankruptcy." ~ Henry Hazlitt
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Recently I read in the newspapers that a language enthusiast had suggested that the word "Rupeed" be introduced into the dictionary to describe a rapid fall and be used as a verb in conversations like, "I tripped and rupeed." It is nice to note that some Indian's haven't lost their sense of humour despite the economic pain that the tumbling rupee indicates. However I am appalled at the analysis that I come across in the financial press. They seem to attribute the blame for the rupee collapse to almost every factor... but the real one. The blame is billed on multiple factor such as "external shocks", the fiscal deficit, CAD, declining forex reserves, India's hunger for petrol and gold, global economic weakness, sentiments, growing exodus of funds from emerging markets etc etc etc... in short everything but the true reasons. The Indian government has reacted to this crisis through multiple mechanisms - which includes a ban on all gold coin imports, increases in capital controls, giving USD to oil companies, making appeals to citizens to reduce consumption of gold and petrol, requests to temples to sell their gold stockpiles, and a ban on duty free on imports of television sets (as if imported TV sets is what is really causing the decline of the rupee). In short the response has been everything that is shy of solving the true problem.

However the true causes of what has caused the real problem stills remains misunderstood by those who have little understanding of economic truths. The attempt I am making with this brief post is to illustrate the true reason for our currency debacle.

Inflation and Devaluation - Two Sides of the same (debased coin) 

To really understand what has brought about the crisis it is important to first understand a little bit more about monetary theory. While whatever I am going to discuss now is fairly rudimentary, I feel that most people have an endemic misunderstanding of this topic. My benchmark here is 95% of articles and comments that I see posted on Facebook... some of which even advocate a reduction in consumption of Pepsi and Coke as a way to stabilize our currency (*groan*).

There are two concepts that are in fact intrinsically interrelated - Inflation and devaluation of the currency. For starters, it is important to have a clear definition of what we call inflation. What we call inflation is in fact caused by an increase in the supply of money and credit. According to Austrian School economists inflation is always an increase in money supply and credit. When the supply of money is increased, people have more money to offer for goods. If the supply of goods remains unchanged, then prices of goods will go up. In this sense inflation is caused when the value of money falls because of an increased supply of money. Such a fall in the value of money does not happen instantly. This is a basic economic law... and I completely fail to fathom why there is so much ignorance in popular opinion around what has caused this current crisis. The manifestation of this phenomena also comes by way of movements in the FX rates vis-à-vis other currencies. For example, monetary inflation of the rupee could cause an increase in supply of rupees vis-à-vis other international currencies such as the US Dollar, the Euro, or the Yen.

However, to just attribute increase in money supply as the only factor for inflation may be an over-simplification. There are secondary factors as well... one of which is confidence in the currency which comes from the fear that the value of the currency would fall further. Once this fear sets is economic agents would prefer to exchange money for real goods as soon as possible. Another factor is that inflation tends to "feed on itself" i.e. the longer it lasts the stronger is the expectation that inflation will continue causing people to borrow, spend, and speculate more. There are several other factors... but never-the-less the primary cause for rising prices is monetary expansion engineered by the central bank.

However one must note that the effects of an increase in money supply and a rise in prices of goods and services within  the economy are not instantaneous. There is a time-lag (typically between 18-36 months) before this increased supply of money sloshes its way from the financial sector to the real economy increasing prices of goods, services and wages.

Having discussed basic economic theory, let's go and see what is the real cause of the rupee slide.

India's Record of Monetary Inflation

Sometimes charts speak better than words. Here is a graph of India's broad money supply growth since August 1998 till present.  
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During this period India's money supply (as measured by M3) has gone up by an astounding factor of 8x. During the same period the INRUSD exchange rate has gone from 42.50 to 67.70, INRGBP has gone from 69.58 to 105.14, and INRJPY has gone from 29.47 to 69.22. There are two major reasons why the INR has not collapsed more against other currencies is on account of two factors. The first is a dramatic increase in the quantity of goods available on account of increased productivity over the last 15 years or so which has masked the extent of price rise. The second is a fair share of monetary madness by the Federal Reserve, Bank of England and Bank of Japan who have also continued to steadily inflate their currencies over the years under the guise of boosting growth.

The bottom-line is this - the true reason for the "rupeed" rupee is reckless monetary expansion engineered by the RBI.

Note: I am curious to find out how many of the readers of by blog have come across this chart on telly or in the financial newspapers. Would be appreciated if you could let me know.

The Cure?

The cure for any disease is to treat the underlying cause. Similarly the cure for inflation and a weakening currency is to take away the cause i.e. stop the reckless expansion of money and credit.  However we have seen (and will continue to see) every other response but that. This is in part because we are swamped by the financial media and "experts" with false explanations of what causes currency devaluation (and inflation) and hence are also plagued by false remedies to the problems.

However the cure is usually tougher to apply in practice if the government continues to maintain a heavy deficit. Deficits are in part a bi-product of large governments... and the larger the government machinery the more would be the spending needed to keep the machinery working. Government spending is almost always unproductive in the sense that they either encourage direct consumption as compared to capital formation through numerous welfare schemes (notable amongst them are the MGNREGA, payments for subsidies, and the Direct Benefit Transfer scheme) or are outright wasteful (some examples are spending on wars, wastes in public resources through pilferage, and the numerous scams that we seen in India over the last few years). It is nearly impossible to fund these deficits using government revenue receipts from PSU (since almost every public sector undertaking makes losses) and taxation. Specifically taxes cannot be raised indefinitely given that they provide a disincentive for production and disrupt the functioning of the free market system. Hence deficits inevitably will continue to get financed through expansion of money supply since governments can "manufacture" the money out of thin-air to pay for their own expenditure.

Final Thoughts

With Elections 2014 looming, I don't think we are going to see a major cut-back in deficits. In fact they will get higher with the Food (in-)Security Bill. To cut-back any welfare transfers or subsidies significantly at this point will also result in a cut-back in vote share... which I honestly could be courageous for the government to do. Hence I would expect to see some patch-work in the near term which could be through direct intervention in the FX markets, attempts to discourage imports, and reduce capital outflows. However the chief cause is likely to go unchecked without which you won't see a strong rupee in the near future.

However the more significant lesson is that pronged inflation can cause FX rates to tank with ferocity. The rupee has lost around 20% of its value in around 3 months. It is just a matter of time before we would see these rapid spells of currency declines with some of the "strongest" currencies in the world such as the US Dollar, the British Pound, Japanese Yen, and the Euro.

The more I think about it, the only permanent solution for inflation and FX stability is through the use of commodity backed money - ergo the gold standard. For those interested in a deeper understanding of currency debasement and inflation, I highly recommend Hazlitt's book What You Should Know About Inflation.
5/3/2014 07:23:02 pm

Very informative post. Thanks for sharing.

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5/3/2014 07:24:06 pm

Nice post with great information.

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