The assessment of rupee’s depreciation 

  • 1st December, 2022

(MainsGS3:Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.)

Context:

  • The Indian rupee has fallen more than 11 percent against the US dollar so far in 2022 and breached the much-feared 80-mark in July and went on to set record lows, touching 83 to a dollar late in October. 

Falling rupee:

  • The Indian economy should be  impacted by a falling rupee primarily on the trends in trade, the behavior of foreign investment, and the response of the Reserve Bank of India (RBI).
  • With the United States (US) on a warpath to curtail inflation and the supply side stifled by the conflict in Ukraine, even historically strong currencies like the euro and the British pound have plummeted against the raging dollar, more than the rupee.

Trade balancing:

  • Falling rupee has an impact on a rise in import costs, threatening higher inflation and a widening trade deficit.
  • However, there also exists a ray of hope–a depreciated currency implies cheaper, more competitive exports and therefore, a possible export-led boost to the domestic economy.
  • The net effect of these opposing forces would determine the impact of a depreciating currency on an economy.
  • Statistics point to a widening trade deficit, with the rise in imports far outstripping the rise in exports and the first quarter of FY 2022-23 seeing the highest current account deficit (CAD) in nearly a decade.
  • However, the import bill has risen not only on the back of a raging dollar and hardening crude prices but has also been spurred by strengthening domestic demand and manufacturing–as evidenced by a robust Purchasing Manager’s Index (PMI) of 55.3 in October.

Divergence in NEER and REER:

  • In recent years, India has seen a growing divergence in the values of the NEER and REER due to higher prices in India as compared to its export partners.
  • While the NEER has been falling, pointing to a nominal depreciation in the value of the rupee, the REER has risen, indicating an appreciating rupee in real terms.
  • The value of the currency is falling in nominal terms, making imports more expensive–but rising in real terms, essentially wiping out the possible benefits of cheaper exports.
  • The rising REER also points to an overvalued rupee–indicating the possibility of further depreciation so as to fall in line with macroeconomic fundamentals.
  • Therefore, while there is comfort to be found in the link between rising imports and a strong domestic economy, gains from the export side remain elusive.

Areas of concerns:

  • With the rupee losing value against the dollar, and interest rates around the world rising, NRI deposit flows also fell in the five-month period from April to August 2022, down to US$1.4 billion from US$2.4 billion a year ago.
  • Moreover, given the prevailing geopolitical uncertainty and rising interest rates around the world, the interest differential between emerging (‘risky’) economies such as India and developed (‘risk-free’) economies is narrowing, giving investors little incentive to invest in ‘riskier’ economies in the absence of higher returns.
  • These outflows can be hazardous–as foreign money moves out of India, rupee-denominated assets are sold, increasing the pressure on the rupee to depreciate.
  • And if investors see the possibility of further depreciation in the future, it is possible that they dump assets even faster, leading to a sharp fall of the rupee.

Conclusion:

  • Both the RBI and the government need to play a tricky balancing act by monitoring the current account deficit as a rise in imports could stem from robust domestic demand and if allowed to balloon unchecked, it could erode investor confidence and exert pressure on the rupee.
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