Rupee Slips from ₹80 to ₹84: Current Account, J-Curve and Two Firms
A country's external accounts for a year show merchandise exports of $400 billion and merchandise imports of $700 billion; services exports of $200 billion and services imports of $50 billion; net remittances from nationals abroad of $120 billion; and net income from foreign investment and loans of −$20 billion. The current account deficit is financed by net FDI of $30 billion, net portfolio investment of $25 billion and external commercial borrowings of $10 billion, with the remainder going into reserves. During the year the currency moves from ₹80 to ₹84 per dollar. Central bank staff estimate that within twelve months a 1 per cent depreciation raises export volumes by 0.4 per cent and cuts import volumes by 0.25 per cent; over three years the corresponding figures are 1.1 and 0.8. A garment exporter earning $10 million a year and an auto-parts maker importing $1 million of components a month both want to know what the currency move means for them.
1. Compute the current account deficit and verify that the balance of payments balances. Which component keeps the deficit from being much larger?
Read the worked answer
Current account build-up (in $ billion).
- Merchandise trade balance = 400 − 700 = −300
- Services balance = 200 − 50 = +150
- Secondary income (remittances) = +120
- Primary income = −20
- Current account = −300 + 150 + 120 − 20 = −$50 billion, i.e. a CAD of $50 billion.
Financing and the BoP identity. Net capital inflows = 30 + 25 + 10 = $65 billion. Since the CAD is $50 billion, $15 billion is left over and must appear as an addition to reserves (65 − 50 = 15). The identity CAD = capital inflows − reserve accumulation holds exactly; if reserves had fallen, the country would have been drawing them down to cover the gap.
Judgement. The goods deficit of $300 billion is the structural gap - typically oil, gold, electronics and capital goods, all with inelastic demand. What keeps the CAD at a manageable $50 billion is the services surplus plus remittances ($270 billion), which covers 90 per cent of the merchandise deficit. This is why a policy that damages software services exports or Gulf employment would be far more damaging than its size suggests: it would remove the buffer that the goods deficit relies on.
2. Using the elasticities given, decide whether the depreciation will improve the trade balance within one year. State the Marshall–Lerner condition and explain your recommendation.
Read the worked answer
Elasticity sums.
- One year: 0.4 + 0.25 = 0.65
- Three years: 1.1 + 0.8 = 1.9
The Marshall–Lerner condition says a depreciation improves the trade balance only if |ηx| + |ηm| > 1. At 0.65 the condition fails in the first year, so the trade balance should worsen.
Approximate size. Change in trade balance ≈ (ηx + ηm − 1) × % depreciation × value of trade (using $400 billion exports as base) = (0.65 − 1) × 5% × 400 = −$7 billion, taking the deficit towards $57 billion. The reason: with inelastic volumes, the price effect dominates - each dollar of imports now costs ₹84, and export earnings in dollars do not rise enough to compensate.
Recommendation. Do not defend the currency. The first-year deterioration is the downward slope of the J-curve, not a policy failure; intervention to hold ₹80 would spend reserves to reverse the real depreciation that eventually delivers the improvement. Over three years the condition is comfortably satisfied (1.9) and the trade balance improves by roughly 0.9 × 5% × 400 ≈ $18 billion a year. The genuine risks are different ones: an inelastic import basket (oil, capital goods) passes the depreciation into domestic inflation, and foreign-currency debt servicing becomes costlier.
3. Quantify the effect of the rupee's move on the importer of $1 million of components a month and on the exporter earning $10 million a year, then advise each on a response.
Read the worked answer
Importer. Monthly cost of $1 million:
- At ₹80: ₹8.00 crore
- At ₹84: ₹8.40 crore
- Extra: ₹40 lakh a month, about ₹4.8 crore a year
Responses: (i) pass the cost into the selling price - possible only if competitors face the same cost; (ii) buy a forward contract at a rate such as ₹82.50, which fixes the rupee cost - but this is insurance, not a saving, because the forward rate already embeds the expected depreciation and the premium; (iii) create a natural hedge by exporting part of output or shifting to domestic suppliers; (iv) redesign the product to lower imported content. The worst response is to leave the exposure open while quoting fixed rupee prices to customers.
Exporter. $10 million a year:
- At ₹80: ₹80 crore
- At ₹84: ₹84 crore
- Gain: ₹4 crore, but only if dollar prices are held.
Firms in a competitive export cluster usually face pressure to cut dollar prices to win orders, in which case the gain shrinks or disappears while imported input costs still rise. Judgement: the exchange rate is a windfall only where the firm has pricing power and a low import content; for both firms the durable answer is a hedging policy and a deliberate choice about how much currency exposure to carry.