Context:
The Indian rupee hit an all-time low against the U.S. dollar this week weakening past the 79 rupees to a dollar mark and selling as low as 79.05 against the dollar.
Relevance:
GS III- Indian Economy
Dimensions of the Article:
- What is happening with the rupee?
- What determines the rupee’s value?
- What is Currency Depreciation and what are its causes?
What is happening with the rupee?
The Indian rupee has been witnessing a steady decline this year, losing more than 6% against the U.S. dollar since the beginning of 2022.
India’s forex reserves:
- It has also dropped below $600 billion, plunging by more than $50 billion since September, 2021, when forex reserves stood at an all-time high of $642 billion.
- The drop in India’s forex reserves is believed to be largely due to steps taken by the Reserve Bank of India to support the rupee.
- RBI officials, however, have noted that the drop in forex reserves is due to a fall in the dollar value of assets held as reserves by the RBI.
- For instance, if a portion of the reserves are in euros and the euro depreciates against the dollar, this would cause a drop in the value of forex reserves.
Aim of the RBI’s policy:
- To allow the rupee to find its natural value in the market but without undue volatility or causing unnecessary panic among investors.
- State-run banks are usually instructed by the RBI to sell dollars in order to offer some support to the rupee.
- By thus selling dollars in the open market in exchange for rupees, the RBI can improve demand for the rupee and cushion its fall.
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.
- On the other hand, when the demand for a currency increases, its value rises.
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 rupees 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.
- So, for instance, 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 Currency Depreciation and what are its causes?
- Currency depreciation is a fall in the value of a currency in terms of its exchange rate versus other currencies.
- Economic fundamentals, interest rate differentials, political instability, or risk aversion can cause currency depreciation.
- Orderly currency depreciation can increase a country’s export activity as its products and services become cheaper to buy.
- Currency depreciation in one country can spread to other countries.
- Countries with weak economic fundamentals, such as chronic current account deficits and high rates of inflation, generally have depreciating currencies.
- Currency depreciation, if orderly and gradual, improves a nation’s export competitiveness and may improve its trade deficit over time. But an abrupt and sizable currency depreciation may scare foreign investors who fear the currency may fall further, leading them to pull portfolio investments out of the country. These actions will put further downward pressure on the currency.
- Easy monetary policy and high inflation are two of the leading causes of currency depreciation. When interest rates are low, hundreds of billions of dollars chase the highest yield. Expected interest rate differentials can trigger a bout of currency depreciation.
- Central banks will increase interest rates to combat inflation as too much inflation can lead to currency depreciation.
- Additionally, inflation can lead to higher input costs for exports, which then makes a nation’s exports less competitive in the global markets. This will widen the trade deficit and cause the currency to depreciate
Impact of the drop
- Depreciation in rupee is a double-edged sword for the Reserve Bank of India.
- While a weaker currency may support exports amid a nascent economic recovery from the pandemic, 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.
-Source: The Hindu
