When the rupee depreciates, buying (importing) something from outside India becomes costlier.
But if one is trying to sell (export) goods and services to the rest of the world (especially the US), a falling rupee makes India’s products more competitive.
Mains GS Paper III: Fiscal policy, Monetary policy, Impact of free fall of the rupee.
Why are countries raising interest rates? What measures has the RBI taken to cushion the fall of the rupee? (250 words)
What is the rupee exchange rate?
- The rupee’s exchange rate vis-à-vis the US dollar is essentially the number of rupees one needs to buy a single US dollar.
- This is an important metric not just to buy American goods but also a whole host of other goods and services (say crude oil) for which Indian citizens and companies need dollars.
- When the rupee depreciates, buying (importing) something from outside India becomes costlier.
- There is a flip side too. By the same logic, if one is trying to sell (export) goods and services to the rest of the world (especially the US), a falling rupee makes India’s products more competitive because depreciation makes it cheaper for foreigners to buy Indian products.
Why is the rupee weakening against the dollar?
- Simply put, the rupee is weakening against the dollar because in the market there is a greater demand for dollars than there is for the rupee.
- This increased demand for dollars vis-à-vis the rupees is, in turn, happening due to two factors.
- One, Indians importing more goods and services than what they export. This is what is called Current Account Deficit (CAD).
- When a country has it, it implies that more foreign currency (especially dollars) are flying out of India than what is coming in.
- Since the start of 2022, as crude oil and other commodity prices have started rising in the wake of the war in Ukraine, India’s CAD has widened sharply.
- This has put pressure on the rupee to depreciate (or lose value against the dollar) because Indians are demanding more dollars to import goods from outside the country.
- Two, falling investments in the Indian economy. Historically, India as well as most developing economies tend to have a CAD.
- But in India’s case, this deficit was more than made up for by foreign investors rushing to invest in the country; this is also called the Capital Account Surplus.
- This surplus brought billions of dollars and ensured that the demand for the rupee (relative to the dollar) remained strong.
- But since the start of 2022, more and more foreign investors have been pulling money out of the Indian markets.
- This has happened because the interest rates in the US are rising much faster than in India.
- The US central bank has been aggressively raising interest rates to contain historically high inflation in the US.
- This fall in investments has sharply reduced the demand for Indian rupees among investors wanting to invest in Indian stock markets.
- The net result of both these trends is that the demand for the rupee (relative to the dollar) has fallen sharply. That is the reason why the rupee has been depreciating against the dollar.
Is the rupee the only currency to depreciate?
- No, the dollar has been appreciating against all currencies including the euro and Japanese yen etc.
- In fact, the rupee has appreciated against several currencies such as the euro.
Does that mean the rupee is in safe territory?
- It is important to understand the role of RBI in “managing” the rupee’s exchange rate.
- If the exchange rate was fully determined by the market, then it would have fluctuated sharply — both when the rupee appreciated and when it depreciated.
- But the RBI does not allow sharp fluctuations in the rupee’s exchange rate.
- It intervenes to smoothen the fall or restrict the rise. It softens the fall by selling dollars in the market, a move that reduces the gap between the demand for rupees vis-à-vis dollars.
- This is what leads to a fall in India’s foreign exchange reserves.
- When RBI wants to hold back the rupee from appreciating then it takes away excess dollars from the market — this is what leads to a rise in India’s foreign exchange reserves.
- As things stand, the rupee is expected to fall further and could reach up to the 82 to a dollar mark in the coming months.
What factors influence the value of the rupee?
- The value of any currency is determined by both supply and demand for the currency.
- When a currency’s supply expands, its value falls.
- In the larger economy, central banks determine currency supply, while currency demand is determined by the amount of goods and services produced.
- The supply of rupee in the forex market is determined by the demand for imports and various foreign assets. As a result, if there is a high demand for imported oil, the supply of rupees in the forex market will increase, causing the rupee’s value to fall.
- In the forex market, demand for rupees is determined by foreign demand for Indian exports and other domestic assets.
- When foreign investors are eager to invest in India, it can lead to an increase in the supply of dollars in the forex market, causing the rupee’s value to rise against the dollar.
The Impact of the Indian Rupee’s Depreciation:
- The rupee’s depreciation is a two-edged sword for the Reserve Bank of India.
- Positive: A weaker rupee should theoretically boost India’s exports, but in an environment of uncertainty and weak global demand, a drop in the rupee’s external value may not translate into higher exports.
- Negative: It increases the risk of imported inflation and makes it more difficult for the central bank to keep interest rates at record lows for an extended period of time.
- India imports more than two-thirds of its domestic oil requirements.
- India is also a major importer of edible oils. A weaker currency will drive up the price of imported edible oil, resulting in higher food inflation.
The Way Forward
- Given the significant differences in long-run inflation between India and the United States, analysts believe the rupee will continue to depreciate against the dollar in the long run.
- At the moment, as the United States Federal Reserve raises interest rates to combat the country’s historically high inflation, other countries, particularly emerging markets, will be forced to raise their own interest rates in order to avoid disruptive capital outflows and protect their currencies.
- The RBI has also been raising interest rates and tightening liquidity to try to control domestic consumer price inflation, which hit a 95-month high of 7.8 percent in April.
- As global interest rates rise, the risk of a global recession rises as economies readjust to tighter monetary conditions.