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Rupee Devaluation: Causes, Impacts, and Policy Challenges

Syllabus:

GS-3:

Fiscal Policy, Monetary Policy, Capital Market

Focus:

The Indian rupee has recently experienced sharp devaluation due to rising capital outflows, increasing import costs, and a shift in RBI’s exchange rate policy, raising concerns about inflation, export competitiveness, and economic stability in a global context of financial uncertainties.

Understanding Exchange Rate Dynamics:

Exchange Rate Concepts

• The nominal exchange rate refers to the price of one unit of foreign currency in terms of the domestic currency.
• The real exchange rate adjusts the nominal rate for price differences between domestic and foreign goods, indicating competitiveness.

Key Influences on Exchange Rates

• Foreign Exchange Market Dynamics: Determined by the demand and supply influenced by current and capital account flows.
  • Demand for Foreign Currency: Increases with lower net exports and higher capital outflows.
  • Supply of Foreign Currency: Rises with greater capital inflows and positive current account balances.

Exchange Rate Policy Frameworks

• Fixed Exchange Rate: Central bank stabilizes the currency by buying or selling foreign reserves.
• Floating Exchange Rate: The market determines the rate; reserves remain unchanged.
• Managed-Floating Exchange Rate: A hybrid system, combining reserve adjustments and currency devaluation.

Understanding Rupee Devaluation:

Definition: Rupee devaluation is the intentional reduction of the Indian Rupee’s value against foreign currencies to boost exports and control imports.

Causes

• Trade Deficit: Higher imports than exports increase foreign currency demand.
• Inflation: High domestic inflation reduces Rupee’s purchasing power.
• Policy Actions: RBI’s deliberate adjustments to stabilize the economy.
• Speculation: Investor behavior influencing currency value.

Effects

• Positive:
• Increased exports due to cheaper Indian goods.
• Boost to domestic industries via reduced imports.
• Negative:
• Higher inflation from costly imports.
• Increased foreign debt burden.

J-Curve Effect

• Initial Worsening: Rising import costs before export volumes grow.
• Subsequent Improvement: Improved trade balance as exports rise and imports fall.

Indian Economy Impact

• Short-Term: Increased trade deficit and inflation.
• Long-Term: Enhanced trade balance and economic growth.

India’s Exchange Rate Policy: A Historical Perspective

Managed-Float Regime in the 2010s

• The RBI adopted a managed-float exchange rate policy, asymmetrically responding to foreign exchange market conditions:
  • During excess demand: Devalued the rupee and reduced reserves.
  • During excess supply: Accumulated reserves while resisting nominal appreciation.

Shift Post-COVID

• From 2022 to November 2024, RBI temporarily adopted a fixed exchange rate-like policy:
  • Stabilized the rupee by selling reserves amid worsening current account deficits and capital outflows.
• Recent sharp devaluation signals a return to the 2010s strategy of balancing reserve use and depreciation.

Implications of Rupee Depreciation

Positive Outcomes

• Boost to Net Exports
  • Depreciation reduces the relative cost of domestic goods in foreign markets, potentially increasing exports.
  • Example: If the rupee-dollar rate shifts from ₹85 to ₹90, domestic goods priced at ₹1,000 become cheaper for foreign buyers.
• Improved Competitiveness
  • A weaker rupee may help industries reliant on export markets.

Adverse Outcomes

• Rising Domestic Prices
  • Depreciation increases input costs for firms relying on imported raw materials.
  • Higher costs are passed to consumers, inflating prices and reducing purchasing power.
• Pressure on Real Income
  • With higher consumer prices, real incomes shrink, affecting overall economic well-being.

Challenges and Structural Constraints:

Divergence Between Nominal and Real Exchange Rates

• Since the mid-2010s, India’s nominal exchange rate depreciation has not been accompanied by real exchange rate depreciation.
• Instead, real appreciation occurred due to rising domestic prices.

Markup Trends and Inflation

• Markup increases (profit margins over production costs) in non-financial firms contributed to price rises.
• From 2019 onward, firms consistently raised markups, amplifying inflationary pressures.

Comparison with Global Trends

• Analysis of 62 countries reveals that most witnessed synchronized nominal and real exchange rate movements.
• India’s divergence places it in a minority, with real appreciation despite nominal depreciation.

Policy Recommendations and Future Outlook

• Policy Stability: RBI should establish a transparent and consistent exchange rate policy to manage market expectations effectively.
• Export Competitiveness: Focus on reducing real exchange rate appreciation by controlling domestic inflation and enhancing export-oriented infrastructure.
• Inflation Management: Curb rising domestic prices through targeted fiscal measures and stricter monetary policies.
• Capital Flow Management: Introduce mechanisms to attract stable foreign investments and reduce reliance on volatile capital flows.
• Diversifying Imports: Encourage domestic production to lower dependency on costly imports, especially crude oil.
• Communication Strategy: Enhance RBI’s communication to stakeholders for greater clarity on policy shifts and long-term goals.

Conclusion:

Rupee devaluation highlights structural economic challenges and the need for a balanced exchange rate policy. Ensuring export competitiveness, stabilizing domestic prices, and managing foreign reserves effectively are crucial for mitigating inflationary pressures and fostering sustainable economic growth in a volatile global market.

Source: TH

Mains Practice Question:

Discuss the factors leading to the recent depreciation of the Indian rupee and its implications on the Indian economy. Suggest measures the RBI could adopt to ensure currency stability while fostering export competitiveness.