Syllabus
GS Paper 3 – Indian Economy and issues relating to planning, mobilization of resources, growth, development and employment.
What does this article provide?
This article discusses the recent sharp devaluation of the Indian rupee against the dollar, analyzing the reasons behind it and its implications. For UPSC CSE mains, students should focus on understanding India’s exchange rate policy and the structural constraints in the Indian economy.
Potential Topics for Prelims
Exchange rate, Falling Rupee, Rupee sliding, Trump Tantrum, Nominal effective exchange rate (NEER), Real effective exchange rate (REER), Bank of International Settlements
Potential Topics for Mains
India’s Exchange Rate Policy, Role of the Reserve Bank of India (RBI) in managing exchange rates, Impact of exchange rate fluctuations on the Indian economy, Structural constraints in the Indian economy, Impact of exchange rate changes on India’s trade and export competitiveness
Source
The Hindu | Economic Times
The impacts of rupee weakening
Introduction
The Indian rupee recently plunged to an unprecedented low of 86.63 against the US dollar, reflecting a robust dollar and a confluence of global economic pressures. Despite the Reserve Bank of India’s (RBI) measures to stabilize the currency, analysts foresee a further depreciation, potentially breaching the 90 per dollar threshold. This downward trend is primarily driven by US economic policies, escalating oil prices, and substantial capital outflows. Consequently, while export-oriented sectors such as IT and textiles stand to gain, industries reliant on imports are poised to encounter significant hurdles. This article delves into the multifaceted dynamics underpinning the rupee’s devaluation and its broader implications for the Indian economy.
Brief Description (Charts)
The above contains four charts that collectively illustrate the trends and implications of the Indian rupee’s exchange rate movements over the past two decades. It highlights the divergence between nominal and real exchange rates, the unique position of India compared to other countries, and the role of rising markups in domestic price increases. This information is relevant for understanding the broader economic implications of India’s exchange rate policy and its impact on competitiveness and inflation.
Summary and Inferences
Chart 1: Dollar Exchange Rate in India (₹)
- The chart shows the dollar exchange rate in India from April 6, 2004, to January 10, 2025.
- The exchange rate increased from 43.8 in April 2004 to 86.9 in January 2025.
- This indicates a significant depreciation of the Indian rupee against the US dollar over the period.
Chart 2: Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER)
- The chart shows the index values for NEER and REER from April 2004 to November 2024.
- NEER decreased from 118.5 in April 2004 to 91.8 in November 2024, indicating a depreciation of the nominal exchange rate.
- REER, however, shows a different trend, with values fluctuating but ending at 108.14 in November 2024, indicating an appreciation of the real exchange rate despite the nominal depreciation.
- This divergence suggests that domestic prices have risen, counteracting the nominal depreciation.
Chart 3: Countrywise Difference in NEER and REER Indices
- The chart compares the change in NEER and REER indices for 62 countries between January 2019 and November 2024.
- The chart is divided into four categories based on the direction of change in NEER and REER:
- Category 1: Both NEER and REER appreciated.
- Category 2: REER appreciated despite NEER depreciation (India falls in this category).
- Category 3: Both NEER and REER depreciated.
- Category 4: REER depreciated despite NEER appreciation.
- Most countries are in categories 1 and 3, indicating that nominal and real exchange rates moved in the same direction for the majority.
- India’s placement in category 2 highlights its unique situation where the real exchange rate appreciated despite nominal depreciation.
Chart 4: Markup of Non-Financial Firms
- The chart shows the ratio of nominal sales value to nominal variable cost for non-financial companies from 2005 to 2025.
- The markup declined until the mid-2010s but then started to rise, reaching 1.58 in 2025.
- This increase in markup suggests that non-financial firms have been raising their prices relative to their variable costs, contributing to the rise in domestic prices.
Exchange Rates and their Impact on the Economy
Exchange Rate Regimes
- Nominal Exchange Rate:
- The price of buying one unit of foreign currency in terms of domestic currency, influenced by demand-supply conditions and the central bank’s exchange rate policy.
- Real Exchange Rate:
- The relative price of foreign goods in domestic currency terms compared to domestic goods, indicating how cheap or costly domestic goods are relative to foreign goods.
- Demand and Supply Conditions:
- Depend on current account and capital account flows.
- Demand for foreign currency rises if net current account and capital account flows fall, and supply rises if they increase.
- Net current account flows are influenced by net exports, while net capital account flows are influenced by foreign investments.
Factors Influencing Exchange Rates
- Supply and Demand: Exchange rates are influenced by supply and demand dynamics.
- Higher demand for US dollars from Indians relative to the demand for Indian rupees from Americans raises the value of the dollar, making it costlier.
- Persistent demand imbalance can weaken the rupee against the dollar.
Influencing Factors on Demand
- Trade Restrictions:
- US bans or high tariffs on Indian goods decrease the demand for rupees as Americans no longer need rupees to buy Indian products, weakening the rupee.
- Inflation Differences:
- Higher inflation in India relative to the US reduces the rupee’s value.
- Investors may withdraw investments from India due to lower real returns, decreasing the demand for rupees and further weakening its exchange rate.
Determinants of Demand for Rupees Versus Dollars
- Trade in Goods:
- If India imports more from the US than it exports, the demand for US dollars exceeds that for Indian rupees, strengthening the dollar and weakening the rupee.
- Trade in Services:
- Higher purchases of US services (e.g., tourism) by Indians relative to Americans buying Indian services increase the demand for the dollar, weakening the rupee.
- Investments:
- More American investments in India compared to Indian investments in the US increase the demand for rupees, leading to its appreciation against the dollar.
Types of Exchange Rate Policy Frameworks
- Fixed Exchange Rate Regime:
- The central bank responds to higher demand for foreign currency by selling (decumulating) foreign exchange reserves, maintaining a fixed nominal exchange rate.
- Floating Exchange Rate Regime:
- The central bank responds to higher demand for foreign currency by devaluing the domestic currency, making foreign currency costlier, while keeping foreign exchange reserves unchanged.
- Managed-Floating Exchange Rate Regime:
- The central bank responds to higher demand for foreign currency by both selling foreign currency and devaluing the domestic currency.
Falling Rupee: An Analysis
- Global Factors Driving Dollar Strength: US policy concerns, such as potential import tariffs, deportations, and tax cuts, could elevate inflation and push the Federal Reserve to uphold a tight monetary policy, leading to higher bond yields and a stronger dollar.
- Impact of Falling Rupee:
- Negative Impact:
- Inflation Management: As India imports around 80% of its crude oil, higher import costs will escalate through the value chain, increasing input costs.
- Current Account Deficit: With a significant portion of imports being dollar-denominated, higher costs will widen the trade and current account deficits, thereby pressurizing the exchange rate.
- Positive Impact:
- Remittances: A weaker rupee could make remittances from overseas more attractive.
- Exporters: Exporters may benefit from a cheaper rupee unless they rely heavily on imported raw materials, which become pricier.
- Negative Impact:
- Reasons for Rupee’s Slide:
- Strengthening US Dollar: A better economic scenario in the US and expectations of moderate rate cuts by the Fed have led to a stronger dollar.
- Bond Yields: High US bond yields make the US more appealing to investors compared to emerging markets like India.
- Policy Uncertainty: Uncertainties regarding new US government policies have further contributed to the rupee’s decline.
- Oil Price Volatility: Geopolitical tensions such as the Russia-Ukraine war, Middle East crisis, and Red Sea shipping issues have caused volatility in oil prices.
- FPI Outflows: Substantial foreign portfolio investment outflows from equity markets have also impacted the rupee.
- Despite the Slide: The rupee has remained one of the world’s most stable currencies, depreciating by nearly 3% against the US dollar, as highlighted in an SBI report. Stability in early 2024 was due to capital inflows driven by Indian bonds’ inclusion in global bond indices, buffering the rupee against significant volatility.
Implications of Rupee Depreciation
Macroeconomic Impacts
- Positive and Negative Outcomes: Depreciation of the nominal exchange rate can result in both beneficial and detrimental economic effects.
- Central Constraint in Indian Economy: Since the latter half of the 2010s, the Indian economy has struggled to achieve the positive effects of nominal exchange rate depreciation.
- Worsening Trade Deficit: Higher import costs exacerbate the trade deficit, potentially dampening economic growth and creating upward pressure on interest rates.
- Debt Servicing Costs: Companies with overseas loans will face higher debt servicing costs due to rupee depreciation.
- Effect on Students and Travelers: Those studying or traveling abroad will incur higher costs with a weakening rupee.
- Challenges for RBI: Inflation control becomes tougher for the RBI, reducing the likelihood of rate cuts amidst a GDP growth slump.
Effect on Net Exports
- Boost in Net Exports: Reduced cost of domestic goods can potentially increase net exports.
- Example Calculation: If the nominal exchange rate is ₹85, a $100 foreign item would cost ₹850 domestically, with the real exchange rate at 0.85.
- Conditions for Positive Impact:
- Positive Response of Net Exports: Net exports must respond favorably to the real exchange rate.
- Correlation with Real Exchange Rate: Depreciation of the nominal exchange rate should lead to a depreciation in the real exchange rate.
Impact on Domestic Prices
- Rising Domestic Costs: A weaker exchange rate can escalate domestic prices by increasing firms’ variable costs and squeezing real income.
- Oligopolistic Market Pricing: In markets with few competitors, firms set prices by adding a markup to their variable costs, which include imported raw materials.
- Higher Import Costs: Increased costs of imported raw materials due to nominal exchange rate depreciation lead to higher final prices for consumers.
Impact on Import Bills
- Increased Import Costs: A weak rupee raises import bills, especially for commodities like edible oils, pulses, fertilizers, and oil and gas, where India’s dependency on crude oil is nearly 88%.
- Inflation and Transport Costs: Higher oil prices elevate transport costs, making food and other items more expensive.
Sectoral Impacts
- Beneficial for Export-Centric Sectors: Pharmaceuticals, textiles, and IT sectors may see improved export revenues in rupee terms.
- Competitive Edge for Exports: A weaker rupee helps make exports more competitive, protecting domestic manufacturers from cheap imports.
- Negative for Import-Dependent Sectors: Sectors like energy, electronics, chemicals, and transportation face adverse effects.
Way Forward
- Focus on Effective Exchange Rate: Consider the rupee’s effective exchange rate against a basket of currencies.
- Interest Rate Strategy: Adjust interest rates based on domestic inflation trends rather than to defend the rupee.
- Ensure Macroeconomic Stability: Address fiscal and current account deficits, adhere to inflation targets, and reinforce confidence in India’s growth potential.
- Systematic Policy Framework: The RBI should adopt a more systematic approach, providing clear explanations for its policy decisions.
- Support Export-Centric Sectors: Provide incentives to sectors that benefit from a weaker rupee, such as pharmaceuticals, textiles, and IT.
- Mitigate Impact on Import-Dependent Sectors: Implement measures to support sectors negatively affected by rupee depreciation, such as energy and electronics.
- Monitor Global Trends: Keep a close watch on global economic trends and their impact on the rupee to make informed policy decisions.
Conclusion
India needs a balanced exchange rate policy that considers both short-term and long-term impacts. The RBI should adopt a systematic approach to policy decisions, providing clear explanations to maintain transparency and predictability. Ensuring macroeconomic stability and addressing structural issues are crucial for maintaining confidence in the rupee and supporting India’s growth trajectory. By focusing on effective exchange rate management, interest rate adjustments based on domestic factors, and supporting both export-centric and import-dependent sectors, India can navigate the challenges posed by rupee depreciation and bolster its economic resilience.
Related PYQ
How would the recent phenomena of protectionism and currency manipulations in world trade affect macroeconomic stability of India? [UPSC CSE – 2018 Mains]
Practice Question
Discuss the macroeconomic impacts of rupee weakening on India’s economy. Highlight both the positive and negative effects and suggest measures to mitigate the adverse impacts.
Guidelines to Answer
- Introduction: Start with a brief introduction to the concept of currency depreciation and its relevance to India’s economy.
- Positive Impacts:
- Boost to Exports: Explain how a weaker rupee makes Indian goods more competitive in the global market.
- Attraction of Remittances: Highlight how remittances from abroad become more valuable in rupee terms.
- Negative Impacts:
- Inflation: Discuss how import costs, especially for essential commodities like crude oil, increase, leading to higher inflation.
- Trade Deficit: Explain how costlier imports can widen the trade deficit and impact the current account deficit.
- Sectoral Impact: Mention the adverse effects on import-dependent sectors and increased debt servicing costs.
- Measures to Mitigate Adverse Impacts:
- Macroeconomic Stability: Emphasize the need to address fiscal and current account deficits and maintain inflation targets.
- Support to Export Sectors: Suggest providing incentives and support to export-centric sectors.
- Interest Rate Policy: Recommend adjusting interest rates based on domestic inflation rather than defending the rupee.
- Conclusion: Summarize the key points and reiterate the importance of a balanced exchange rate policy for economic stability.