In News: C Rangrajan weighs in on the factors that are driving the depreciation of rupee, and why its essential to bring down domestic inflation to stop the slide.
Value of rupee:
Value of the rupee is determined using purchasing power parity theory.
The theory states that the external value of a currency is determined by its internal value — meaning that the rate differential between one currency and another depends upon the difference in the inflation in the two countries.
So long as inflation in our country is higher than the inflation in other countries, the value of the rupee will depreciate.
This theory was true when the balance of payments (BOP) of a country was dominated by the current account — that is, the export and import of goods and services.
Now, capital account in the balance of payments has become important — which means the inflow and outflow of funds.
The value of a currency can be strong even though it has a high current account deficit because there is enough capital flowing from outside into the country.
Therefore, the supply of foreign currency increases not because of [trade] but because of the decision of capital accounts i.e. to invest or because of the decision to keep deposits in our country.
Depreciation of rupee:
The main reason for the rupee depreciating in its value is due to the capital account of BOP.
It is because the funds inflow into our country started diminishing.
That is because the US Federal reserve, with a view to control inflation in the United States, raised the rate of interest.
Therefore, investors find the United States is more attractive, because of the higher rate of interest.
Instead of sending funds outside, they are keeping the funds inside and sometimes, they withdrew the funds from India and put them in the United States.
Simply put, when the investment becomes more attractive domestically, foreign countries do not send funds into other countries.
Effect of rupee depreciation:
An undervalued currency is better because it is more attractive for exports.
In current Indian context, this may be beneficial because we have a tough balance of payments situation and we need to export more and reduce the current account deficit.
But, depreciation against the dollar cannot be a continuous process because ultimately what we are essentially saying is that for getting $1 the amount of the resources that you need in India is becoming higher and higher.
