Weakening of Indian Rupee

The Indian rupee recently saw a sharp devaluation against the US dollar after remaining relatively stable for over two years.

What is an Exchange Rate?

• An exchange rate is the value of one country's currency in terms of another country's currency. It tells you how much of one currency you need to buy a unit of another currency.
  • For example: If 1 US Dollar (USD) equals 75 Indian Rupees (INR), the exchange rate between the US Dollar and the Indian Rupee is 75 INR per USD.
• Types:
  • Nominal Exchange Rate: This is the price of one unit of foreign currency in terms of the domestic currency. For example, how many rupees it takes to buy one dollar.
  • Real Exchange Rate: This reflects the relative prices of goods between two countries. It shows how cheap or expensive domestic goods are compared to foreign goods after considering the exchange rate.

The exchange rate is influenced by the supply and demand for foreign currencies in the market. If there’s a higher demand for foreign currencies (like the dollar), the domestic currency (rupee) may weaken or depreciate.

Exchange Rate Policies:

India follows a managed floating exchange rate regime. This means the Reserve Bank of India (RBI) manages the exchange rate by adjusting the supply of foreign currency in the market and intervening when needed. In this system, the RBI may let the currency fluctuate but can intervene to prevent excessive depreciation or appreciation.

• Fixed Exchange Rate: The central bank fixes the exchange rate and uses reserves to maintain it.
• Floating Exchange Rate: The currency value is determined by the market forces of supply and demand, and the central bank does not intervene.
• Managed-Floating Exchange Rate: A hybrid system where the central bank manages the currency, intervening when necessary but letting the market decide to some extent.

Since the 1990s, India has followed a managed-floating regime, with the RBI intervening in the market when there is excessive demand for foreign currency or excessive appreciation of the rupee.

Why Did the Rupee Depreciate?

There were two main reasons for the rupee's sharp depreciation:

• Higher Capital Outflows: With investors pulling money out of India, the demand for foreign currency (like dollars) increased, leading to depreciation of the rupee.
• Increased Imports: Rising crude oil prices increased India's import bill, further increasing demand for foreign currency.

The RBI allowed the rupee to depreciate to ease the pressure on its foreign exchange reserves.

Implications of the Depreciation:

A depreciation of the rupee can have both positive and negative effects on the economy:

• Positive Impact:
  • Exports may increase: A cheaper rupee makes Indian goods cheaper for foreign buyers, potentially increasing exports.
  • Competitiveness improves: Indian goods become more attractive in the global market as they become relatively cheaper.
• Negative Impact:
  • Rising Domestic Prices: As the rupee weakens, the cost of imported goods (like raw materials) rises, leading to inflation.
  • Cost of Living Increases: Imported goods and services, including fuel, become more expensive, which impacts consumers.

However, the effectiveness of depreciation in improving exports has been limited recently due to rising domestic prices. This is because the real exchange rate (which considers inflation and domestic prices) has been rising despite the nominal depreciation of the rupee. In simpler terms, domestic prices have been rising, making Indian goods relatively more expensive even though the rupee has weakened.

The Policy Question:

• What should India’s exchange rate policy aim to achieve?
  • Should India continue with its managed-float regime or switch to a more explicit exchange rate policy?
  • The recent shifts in the rupee’s value suggest that the RBI's policy stance might be inconsistent and has lacked a clear direction. For example, the RBI has often changed its approach without clearly explaining the reasoning behind these shifts.

The challenge lies in ensuring that the depreciation of the rupee does not lead to higher inflation or higher domestic prices while also trying to support exports and manage the current account deficit.