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The main financial headlines in Mumbai recently have centred on the continued fall in the value of the Indian Rupee- now down by over 20% against the dollar in the last month. But what causes a currency to fall in value so sharply and so quickly?

India’s problem (much like the UK and the US) is its twin deficit model. It is running a budget deficit again this year to try and prop up a declining rate of economic growth with new infrastructure projects and also a new minimum price on rice and other essentials. It needs to finance this by selling bonds, many of which have been bought I the past by financial institutions from overseas.

Second, India is a large net importer, notably of white goods, cars and precious metals. It is the world’s largest exporter of mineral oils but the burgeoning Indian consumer prefers to buy cars, clothes and other branded goods made abroad. This was fine during the period of greater liquidity caused by the world’s major Central Banks boosting the money supply through quantitative easing. India saw a net inflow of capital searching for value; FDI increased as the Indian government has sought to encourage competition in the retail sector, with WalMart and Ikea.

However, the Federal Reserve’s recent comments that it might start to wind up QE has sent the foreign exchange and stock markets into panic. The interest rate on US government bonds has risen and, as India’s economy has slowed, foregn capital has left the country, pushing the value of the currency down and pushing up domestic inflation.

This is all pushing up imported inflation. Even worse, the price of onions has risen steeply, leading to a hold up of a lorry carrying the bulb this week and a man buying his wife a ring with an onion set into it…

So, what can be done?

The government recently announced restriction on the purchase of US Dollars from abroad as well as limits on gold imports to try to help reduce demand for foreign currency. Manmohan Singh says India’s Central Bank has another 6-7 months worth of foreign currency left to use to shore up the currency. When a similar decline in the Rupee took place in 1991, Indian had to call in the IMF and financial crisis set in.

The Indian government is also boosting domestic liquidity to try to encourage bank lending, though this may have unintended consequences for the balance of payments deficit.

Good news for GDP growth is the 20-30% expected increase in crop yields in rural areas- this shift to the right of the supply curve should reduce the price and help put downward pressure on inflation

Let’s hope Christine Laggarde’s comments at the weekend that Central banks should not withdraw QE too soon may provide some respite

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