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The Effects of Investments in India on the USD-INR Exchange Rate

Ashutosh Gupta, Vice President and Surbhee Sirohi, Manager
July 2011

The USD-INR exchange rate is an important indicator of investor sentiment and can significantly impact not only the fortunes of individual firms and sectors but also the government. While this exchange rate has been very stable overall for the last five years, there have been periods of significant volatility. For example, USD-INR moved from 40.0 to 51.5 from March 2008 to March 2009. We believe there is a significant downside risk to USD-INR exchange rate and will explore some of the risk factors here.

Inflation is at an all-time high; the Consumer Price Index (CPI) increased by 10.88% in 2009 and by 13.19% in 2010. The monetary policy changes to control inflation have been ineffective. We believe this is because inflation is being driven primarily by structural supply side challenges such as lack of agricultural infrastructure, low crop yields, low organised retail penetration, and lack of import buffer for staples such as pulses where India is one of the main producers worldwide.

Unforeseen circumstances; like drought and unseasonal rains, compounded by structural problems related to demand-supply imbalances are affecting upward movement in food prices. Monetary policy initiatives cannot overcome these challenges. For instance, food inflation declined to single digits in November 2010, but increased again owing to unseasonal rains and supply chain problems that resulted in a rise in vegetable prices. The main food items that have driven inflation in recent times have been vegetables and pulses. The supply of these items has been unable to match demand, causing imbalances. Given the rise in global food prices, importing these items is not a feasible long-term solution. India needs to focus on the development of agriculture-related business and reduce interstate trade barriers to ensure the removal of the supply-demand imbalance.

Also due to the lack of good agricultural infrastructure, India has not been able to sufficiently increase food production. Yields in India are significantly lower than in other emerging countries. Government investments in large irrigation projects have been marred by corruption and execution delays. The private sector has been unable to pick up the slack due to an uncertain regulatory landscape and intermittent ad hoc government interventions. For example, the government has banned futures trading in several agricultural commodities, thereby killing what seemed to be a promising new sector. There are also yearly interventions either in the form of import or of export bans. These lead to high price volatility and deter private investments.

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