Context: There has been a consistent deterioration of Indian Rupee’s (INR) exchange rate with respect to the US Dollar ($) over the last few month. It breached the psychologically significant exchange rate level. The fall in Rupee has been going on since the war in Ukraine began, and crude oil prices started going up.
What is Depreciation?
- Currency depreciation is a fall in the value of a currency in a floating exchange rate system.
- For example: USD 1 used to equal to Rs. 70, now USD 1 is equal to Rs. 77, implying that the rupee has depreciated relative to the dollar i.e., it takes more rupees to purchase a dollar.
Impact of Depreciation of Indian Rupee: Depreciation in rupee is a double-edged sword for the Reserve Bank of India.
- Weaker rupee should theoretically give a boost to India’s exports, but in an environment of uncertainty and weak global demand, a fall in the external value of rupee may not translate into higher exports.
- It poses risk of imported inflation, and may make it difficult for the central bank to maintain interest rates at a record low for longer.
- India meets more than two-thirds of its domestic oil requirements through imports.
- India is also one of the top importers of edible oils. A weaker currency will further
What determines the rupee’s value?
- The value of any currency is determined by demand for the currency as well as its supply.
- When the supply of a currency increases, its value drops.
- In the wider economy, central banks determine the supply of currencies, while the demand for currencies depends on the amount of goods and services produced in the economy.
- In the forex market, the supply of rupee is determined by the demand for imports and various foreign assets. So, if there is high demand to import oil, it can lead to an increase in the supply of rupees in the forex market and cause the rupee’s value to drop.
- The demand for rupees in the forex market, on the other hand, depends on foreign demand for Indian exports and other domestic assets.
- When there is great enthusiasm among foreign investors to invest in India, it can lead to an increase in the supply of dollars in the forex market which in turn causes the rupee’s value to rise against the dollar.
What is causing the rupee to lose value against the dollar?
- Since March this year, the U.S. Federal Reserve has been raising its benchmark interest rate causing investors seeking higher returns to pull capital away from emerging markets such as India and back into the U.S.
- This, in turn, has put pressure on emerging market currencies which have depreciated significantly against the U.S. dollar so far this year.
- Even developed market currencies such as the euro and the yen have depreciated against the dollar and the dollar index is up more than 9% so far this year.
- Some analysts believe that the RBI’s surprise decision to raise rates in May could have simply been to defend the rupee by preventing any rapid outflow of capital from India.
- India’s current account deficit, which measures the gap between the value of imports and exports of goods and services, is expected to hit a 10 year high of 3.3% of gross domestic product in the current financial year.
- Foreign investors are unlikely to plough capital into India when investment yields are rising in the U.S.
What lies ahead?
- It is neither wise nor possible for the RBI to prevent the Rupee from falling indefinitely. Defending the Rupee will result in India exhausting its forex reserves over time because global investors have much bigger financial clout.
- Most analysts believe that the better strategy is to let the Rupee depreciate and act as a natural shock absorber to the adverse terms of trade. Thus, RBI should focus on containing inflation which is its legal mandate.
- The Government should contain its borrowings. Higher borrowings (fiscal deficit) by the Government consume domestic savings. Hence, the Industrial and other sectors of economy are forced to borrow from abroad.
- Over the long run, the Rupee is likely to continue to depreciate against the Dollar given the significant differences in long-run inflation between India and the U.S.
- The U.S. Federal Reserve has raised rates to tackle historically high inflation in the US that hit a 41-year high of 8.6%.
- This will induce other countries and emerging markets in particular to raise their own interest rates to avoid disruptive capital outflows and to protect their currencies.
- As interest rates rise across the globe, the threat of a global recession also rises as economies readjust to tighter monetary conditions.
- Analysts believe that, over the long run, the rupee is likely to continue to depreciate against the dollar given the significant differences in long run inflation between India and the U.S.
- The exchange rate has fallen to its historical low of 80, however Indian Rupee has shown a better performance in comparison to currencies of emerging economies.
- The inflation divides between the U.S and India will continue to further depreciate the Rupee. Nonetheless, with proactive fiscal and monetary measures, India can stabilize its currency value.
MUST READ: Rupee Appreciation vs Rupee Depreciation
Source: The HINDU
Previous Year Question
Q.1) With reference to the Indian economy, consider the following statements:
- An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee.
- An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness.
- An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER.
Which of the above statements are correct? (2022)
- 1 and 2 only
- 2 and 3 only
- 1 and 3 only
- 1, 2 and 3
Q.2) Which one of the following is not the most likely measure the Government/RBI takes to stop the slide of Indian rupee? (2019)
- Curbing imports of non-essential goods and promoting exports
- Encouraging Indian borrowers to issue rupee denominated Masala Bonds
- Easing conditions relating to external commercial borrowing
- Following an expansionary monetary policy
Q.3) Consider the following statements:
The effect of devaluation of a currency is that it necessarily
- improves the competitiveness of the domestic exports in the foreign markets
- increases the foreign value of domestic currency
- improves the trade balance
Which of the above statements is/are correct? (2022)
- 1 only
- 1 and 2
- 3 only
- 2 and 3