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Day 15 – Q.1 What is the impact of exchange rate volatility on the Indian economy? In order to manage the exchange rate, what tools does the RBI use? Explain with the help of suitable examples. 

  • IASbaba
  • December 12, 2022
  • 0
GS 3, Indian Economy, TLP-UPSC Mains Answer Writing
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What is the impact of exchange rate volatility on the Indian economy? In order to manage the exchange rate, what tools does the RBI use? Explain with the help of suitable examples. 

भारतीय अर्थव्यवस्था पर विनिमय दर की अस्थिरता का क्या प्रभाव पड़ा है? विनिमय दर को प्रबंधित करने के लिए, RBI किन उपकरणों का उपयोग करता है? उपयुक्त उदाहरणों की सहायता से व्याख्या कीजिए।


Approach

Candidates can start the answer with highlighting recent exchange of words between executive and judiciary and then write about issues and share the views on existing system.

Introduction

Exchange rate volatility is the frequency and extent of changes in a currency’s value. It is measured by calculating the dispersion of exchange rate changes around the mean, expressed in terms of daily, weekly, monthly or annual standard deviations. The larger the number, the greater the volatility over a period of time.

Body

Impact:

  • Prices of everyday goods: India is also one of the top importers of edible oils. A weaker currency will further escalate imported edible oil prices and lead to a higher food inflation.
  • Importing: When the dollar strengthens against the rupee, importers will have to pay more for the same number of dollars. And since international trade is mostly in the US dollar, importers have to pay higher prices.
  • A weaker rupee directly impacts India’s trade balance and inflation through higher cost of imports. Costlier imports will widen the trade deficit as well as the current account deficit, which, in turn, will put pressure on the exchange rate.
  • For example, Indian solar plants depend heavily on imported solar cells and modules. Project costs would rise, tariffs higher in future bids Margin compression for upcoming projects Every Re 1 fall vs Dollar leads to 2 paisa/unit increase in tariff.
  • Positive impact: 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.
  • Investments: Currency volatility can also have a devastating impact on things like investments. When a country’s currency becomes weaker, this means that many people’s liquid assets, such as pensions and long-term savings accounts, will now be worth less on the world stage.
  • Employment: When businesses are faced with higher prices on imported goods, in order to maintain international trade relationships, they may choose to recoup those costs by making cuts to their workforce.

Role and tools with of Reserve Bank of India (RBI):

  • The RBI acts as the custodian of the country’s foreign exchange reserves and manages exchange control. It dominates the market as a regulator, a player and the jury.
  • During high volatility in the exchange rate, RBI intervenes to prevent the exchange rate going out of control.
  • For example, the RBI sells dollars when Indian rupee depreciates too much, while it purchases dollars when the Indian rupee appreciates beyond a certain level.
  • RBI has also proposed the rupee settlement mechanism, under which foreign companies can make foreign payments in rupees, unlike the US dollars.
  • This is expected to reduce the need for US dollars for foreign trade, stabilising its value.
  • The forex market is regulated by the RBI with impregnable exchange control regulations. For example, The RBI does not permit a bank to purchase dollars from the RBI and speculate in the interbank market. Selling these dollars in the overseas cross currency market is prohibited by the central bank.

Conclusion

Under normal circumstances, rupee depreciation is good for the current account deficit because it leads to higher exports.  But at present, India is already facing high inflation and continued depreciation may be making matters worse.

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