Fall in Rupee Value: Reasons, Concerns and Solutions – Explained, pointwise

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Introduction

There has been a consistent deterioration of Indian Rupee’s (INR) exchange rate with respect to the US Dollar ($) over the last few month. It breached the psychologically significant exchange rate level of INR 80 to a US$ in early trade on 19th July, 2022, although it recovered to close at 79.90. The fall in Rupee has been going on since the war in Ukraine began, and crude oil prices started going up. The deteriorating exchange rate poses another challenge to the policymakers; in addition to the high inflation and rising unemployment.

What has been the recent trend of Rupee’s Exchange Rate?

The Indian Rupee has been witnessing a steady decline this year, losing more than 6% against the US$ since the beginning of 2022.

In the last 10 months, the Rupee’s exchange rate with the Dollar has fallen 8.7%, from 73.6 to 80. However, historically the Rupee depreciates by about 3% to 3.5% in a year. 

Further, many experts predict that Rupee may weaken to ~US$ 82 in the coming 3-4 months. In fact, the International Monetary Fund (IMF) foresee the Rupee to fall to 94 Rupees to a US$ mark by FY2029.

Exchange Rate of Indian Rupee and US Dollar Trend Fall in Rupee UPSC

What are the reasons for fall in Rupee value?

First, the U.S. Federal Reserve has been raising its benchmark interest rate since March 2022. With higher interests rates in the US, investors can get better returns by investments in the US. Hence, they have started to pull-out their money from emerging markets such as India. This, in turn, has put pressure on emerging market currencies which have depreciated significantly against the US Dollar so far this year. 

Even developed market currencies such as the Euro and the Yen have depreciated against the Dollar and the Dollar index is up more than 9% so far this year.

Trend Exchange Rate of Major Currencies and US Dollar UPSC

Source: The Times of India. Major global currencies have depreciated in relation to the US$ since January 2022. The major reason is the increase in the interest rates by the US Federal Reserve. Russia-Ukraine war and the rise in commodity prices have also contributed to the trend. In fact, in relative terms, Rupee has performed better than Yen, Euro and British Pound. Rouble has appreciated because of increase in oil trade in Russian Rouble due to sanctions.

Second, India’s current account deficit is expected to hit a 10-year high of 3.3% of GDP in the current financial year. The import bill has been rising due to high oil prices since the Russian invasion of Ukraine. The war has also resulted in steep rise in prices of other commodities which has made the situation worse.

Third,  a major reason for Rupee depreciation has been consistently higher domestic price inflation in India. Higher inflation in India suggests that the RBI has been creating Rupees at a faster rate than the US Federal Reserve has been creating Dollars. 

Determination of Exchange Rate UPSC

How does the RBI respond to the fall in Rupee?

As a matter of policy, the RBI has usually tried to slow down or smoothen (rather than reverse or prevent) the fall in exchange value of the Rupee against the US Dollar. 

The aim of the RBI’s policy is 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 selling Dollars in the open market in exchange for Rupees, the RBI can improve demand for the Rupee and cushion its fall.

The RBI is also seen raising benchmark interest rates to defend the Rupee by preventing any rapid outflow of capital from India as done by it in May 2022.

What are the concerns associated with fall in Rupee?

First, forex reserves have fallen by over US$ 50 billion between September 2021 and June 2022. RBI officials 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. 

Second, when the Rupee depreciates, importing goods and services becomes costlier. Since a large proportion of India’s imports (like oil) are Dollar-denominated, these imports will get costlier. 

Costlier imports, in turn, will widen the trade deficit as well as the current account deficit, This will put further pressure on the exchange rate.

The Ministry of Finance has hinted that India’s fertilizer subsidy bill for 2022-23 (FY23) could rise to around INR 2.5 trillion against Budget Estimates (BE) of INR 1.05 trillion (almost 2.5 times). The rise is because of a global supply shortage in the midst of war in Ukraine and rising exchange rates.

India's Current Account Deficit and Forex Reserves Fall in Rupee UPSC

Source: The Times of India

Third, since Rupee is not the only currency weakening against the Dollar, the net effect on exports will depend on how much has the other currency lost to the Dollar. If the other currency has lost more than the Rupee, the net effect on exports could be negative.

Fourth, India is already facing high inflation and continued depreciation may be making matters worse. Costlier imports (because of a weaker Rupee) add to the cost-push inflation and enhance domestic inflationary process.

Fifth, A weakening Rupee hurts foreign investors, who came looking for a good return, as well as Indians, who have loans abroad.

What are the mitigating factors?

First, the Rupee is still more resilient against the Dollar than it was in some of the previous crises such as the Global Financial Crisis of 2008 and the ‘Taper Tantrum’ of 2013, when the US Federal Reserve reversed ‘Quantitative Easing‘.

Second, India’s products become more competitive because depreciation makes these products cheaper for foreign buyers. This will give a boost to domestic producers and enhance exports.

Third, the US Dollar is just one of the currencies Indians need to trade. Comparing with a basked of currencies, data suggests the Rupee has become stronger than many other currencies such as the Euro.

Fourth, India is still not facing an external crisis (or BoP Crisis). The data show that India is in a relatively comfortable position.

In 2021-22, India had a trade deficit of US$ 189.5 billion. India had imported more goods (such as crude oil) than it exported, and the net effect was negative. But the Invisibles account showed a surplus of US$ 150.7 billion. As a result, the Current Account showed a deficit of US$ 38.8 billion.

However, there was a surplus of US$ 86.3 billion in the Capital Account. This was driven by foreign direct investments (FDI) providing more Dollars in the shape of loans etc. At the end of the year, the BoP was at a surplus of US$ 47.5 billion.

What is the Balance of Payment Account?

  • The BoP is a ledger of all monetary transactions between Indians and foreigners. If a transaction leads to Dollars coming into India, it is shown with a positive (+) sign; if a transaction results in Dollars leaving India, it is shown with a minus (-) sign.
  • The BoP has two broad subheads (also called ‘Accounts’) — Current and Capital — to slot different types of transactions. 
  • The Current Account is divided into the Trade Account (for export and import of goods) and the Invisibles Account (for export and import of services). 
    • So if an Indian buys an American car, Dollars will flow out of BoP, and it will be accounted for in the trade account within the current account. 
    • If an American invests in Indian stock markets, Dollars will come into the BoP table and it will be accounted for under FPI within the capital account. 
  • The Capital Account includes net foreign investments (foreign direct investment and foreign portfolio investments) and loans or money that countries borrow from each other.
What lies ahead?

First, it is neither wise nor possible for the RBI to prevent the Rupee from falling indefinitely. Defending the Rupee will result in India exhausting its forex reserves over time because global investors have much bigger financial clout. Most analysts believe that the better strategy is to let the Rupee depreciate and act as a natural shock absorber to the adverse terms of trade. Thus, RBI should focus on containing inflation which is its legal mandate.

Second, the Government should contain its borrowings. Higher borrowings (fiscal deficit) by the Government consume domestic savings. Hence, the Industrial and other sectors of economy are forced to borrow from abroad.

Third, over the long run, the Rupee is likely to continue to depreciate against the Dollar given the significant differences in long-run inflation between India and the U.S.

Fourth, the U.S. Federal Reserve has raised rates to tackle historically high inflation in the US that hit a 41-year high of 8.6%. This will induce other countries and emerging markets in particular to raise their own interest rates to avoid disruptive capital outflows and to protect their currencies.

Fifth, domestic inflation hit a 95-month high of 7.8% in April 2022. The RBI too has been trying to rein in the consumer price inflation by raising rates and tightening liquidity. 

As interest rates rise across the globe, the threat of a global recession also rises as economies readjust to tighter monetary conditions.

Conclusion

The exchange rate has fallen to its historical low of 80, however Indian Rupee has shown a better performance in comparison to currencies of emerging economies. The inflation divide between the U.S and India will continue to further depreciate the Rupee. Nonetheless, with proactive fiscal and monetary measures, India can stabilize its currency value.

Syllabus: Indian Economy and Issues related growth and development.

Source: Indian Express, The Hindu, The Times of India, Business Standard, Mint

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