Relevance: GS-3: Indian Economy and issues relating to planning, mobilization, of resources, Fiscal Policy

Key Phrases: Russia Ukraine conflict, Dollar Index, Depreciation of Indian Rupee, Crude Oil Prices, Aggressive monetary Policy of US, Cost-push Inflation, Export Competitiveness, Rupee Exchange rate, Real Effective Exchange rate

Why in News?

• The Indian rupee has depreciated by around 5.6 percent against the dollar and currently stands at Rs 80 to a dollar which is a direct impact of the Russia-Ukraine conflict.
• However, the rupee has done quite well compared to most of its emerging peers in terms of relative performance even though crude oil prices have risen sharply and foreign portfolio investors (FPI) have pulled out since the beginning of the conflict.

Background:

• The depreciation of the rupee should be accompanied by an appreciation of the Dollar Index (DXY) along similar lines if the domestic economic fundamentals are strong.
• Between January 2008 and February 2012 and October 2012 and May 2014, on a cumulative basis, the rupee had lost a whopping 48.7 per cent against the USD, even as the DXY had appreciated by a modest 5.2 per cent.
• This indicates that much of the decline in rupee value then was purely because of weak domestic macro fundamentals.

The current situation and reasons for the depreciation of the Indian rupee:

• The unprecedented gains in the dollar have come along with expectations of aggressive monetary policy by the US Fed compared to other major jurisdictions, particularly, the Eurozone and Japan.
• The recent decline in the rupee has been more because of the strengthening of the dollar and not because of weak fundamentals at home.
• In fact, a one percent change in the DXY (or an appreciation of the dollar) leads to a 1.7 per cent change in the rupee exchange rate (depreciation of the rupee).
• Considering the 15-year period, the rupee should have been at 90/dollar currently.
• Thus, it is established that the recent decline in rupee value is mostly because of the DXY strengthening.
• An aggressive monetary policy being followed by the US Fed compared to other major jurisdictions, particularly, the Eurozone and Japan has led to the strengthening of dollars and the weakening of other currencies.
• Foreign portfolio outflows due to the fears of a likely recession have also contributed significantly to the deadly outcome.

What are the likely impacts of the current depreciation of the rupee?

• The imports will get costlier since a large proportion of India’s imports are dollar denominated.
• This will in effect widen the trade deficit as well as the current account deficit.
• Costlier imports will add to the cost-push inflation.
• Weakening of rupee may hurt foreign investments.
• India’s current account deficit could widen to 3-3.5% of GDP or more this fiscal, depending on the oil prices.
• This will also directly impact inflation as India still imports over 85% of its oil requirements.
• A trade deficit of over $300 billion would be a concern.

Is there any possibility of an end to such unabated dollar supremacy in the near future?

• The possibilities are negligible even though several countries including India are attempting to diversify their foreign exchange reserves in favour of non-dollar currencies.
• The factors that have worked to drive up the dollar are unlikely to fade sooner.
• The US sits at the center of an international financial system where its assets have been in high demand.
• For instance, the rapidly growing Asian economies have a high inclination toward US government securities.
• Bretton Woods has already ensured that the dollar would be a “trust” currency.
• The US can run current account deficits unimaginable for the rest of the world.
• Crude prices forecasts for 2023 range from an average of $100-120.
• Under the circumstances, the dollar is likely to be a safe-haven currency, at least until inflation is controlled and the US Federal is done with most of its rate hikes.

Why is there no need to panic over rupee depreciation?

• The relative strength of the Indian currency has been attributed to intervention in the currency markets by the Reserve Bank of India (RBI) by
  • Relaxations on NRI deposits to ease investments in government and corporate bonds
  • Measures for settlement of international trade in rupees to ease pressures on the currency.
• Foreign direct investment (FDI) has been stable and is likely to continue to flow in at an annual level of a net $40 billion.
• Exports have been doing exceptionally well, but the slowdown in global growth and global trade could see some loss of momentum.
• Even after the freefall, the rupee remains overvalued in terms of the Real Effective Exchange Rate (REER).
• Services exports are doing exceptionally well and are expected to continue to do so.
• The recent fall in the rupee, therefore, should not be a cause for a panic.

What should be done now?

• In the present circumstances, it is neither wise nor possible to prevent the rupee from falling indefinitely, since, it will lead to the exhaustion of the country’s forex reserves.
• The better strategy is to let the rupee depreciate and act as a natural shock absorber to the adverse terms of trade.
• The RBI should contain inflation as it is legally mandated to do and the government should contain its borrowings which is in charge of the fiscal policy.
• Higher borrowings by the government consume the domestic savings and force the rest of the economic agents to borrow from abroad.
• A weaker rupee doesn’t give exporters a very big edge as they typically are price takers, over-valuation doesn’t help either.
• What the government can do is to upgrade infrastructure to make it easier for exporting units to operate more efficiently.

Conclusion:

• The RBI and the government have thus, taken a long-term view of increasing dollar inflows.
• The RBI, in close tandem with the government, has been supportive of the rupee and is also now embarking on an unprecedented journey to internationalise the currency.
• The government must also keep a close watch on the import bill and, if possible, decrease imports of at least some items without disrupting manufacturing.
• The rupee’s fortunes can look up if capital flows are strong.
• It is possible that FPIs will come back to the equity market once valuations turn more attractive.

Source: Indian Express

Mains Question:

Q. What are the reasons for the weakening of the Indian rupee? What are the likely impacts it will have on the domestic economy? What are the steps taken by the RBI to control the scenario?