The The Indian rupee jumped the psychologically significant exchange rate level of 80 to the US dollar in early trading on Tuesday. It recovered ground to close at 79.90. Since the start of the war in Ukraine and the rise in crude oil prices, the rupee has steadily lost value against the dollar. There are growing concerns about how a weaker rupee affects the wider economy and the challenges it presents to policymakers, especially as India is already struggling with high inflation. and weak growth.
What is the rupee exchange rate?
The exchange rate of the rupee against the dollar is basically the number of rupees needed to buy 1 dollar. This is an important measure for buying not only US goods, but also other goods and services (say crude oil) that are done in US dollars.
Generally speaking, when the rupee depreciates, importing goods and services becomes more expensive. But if one tries to export goods and services to other countries, especially to the United States, Indian products become more competitive as depreciation makes these products cheaper for foreign buyers.
How bad is it for the rupee?
Chart 1 shows the exchange rate of the rupee against the dollar. The dotted line shows the long-term trend of depreciation. If the rupiah depreciates at a faster rate than the long-term average, it crosses above the dotted line, and vice versa. Over the past two years, the Rupee has been more resilient than the long-term trend. The current decline has led to a correction.
Another thing to note is that, at least for now, the rupee is even more resilient (i.e., has remained relatively strong against the dollar) than it was in some previous crises such as the global financial crisis of 2008 and the Taper Tantrum of 2013.
Moreover, the US dollar is just one of the currencies that Indians need to trade. Looking at an entire basket of currencies, the data suggests that the Rupee has strengthened (or appreciated against that basket). In other words, as the US Dollar strengthened against all other major currencies including the Rupee, the Rupee, in turn, became stronger than many other currencies such as the Euro. .
“It’s important to remember that this is more of a story of a strengthening dollar than a weakening rupee,” said Pronab Sen, India’s former chief statistician.
This suggests that, as things stand, India still does not face an external crisis. Take, for example, the issue of foreign debt. Long-term data shows that India is in a relatively comfortable position.
That doesn’t mean there’s nothing to worry about. While India is doing well at the moment, trends suggest things are getting worse. For example, foreign exchange reserves have fallen by more than $50 billion between September 2021 and today. During these 10 months, the exchange rate of the rupee against the dollar fell by 8.7% from 73.6 to 80. For context, historically the rupee depreciates by around 3% to 3 .5% in one year. Worse still, many experts expect the Rupee to weaken further over the next 3-4 months and fall to as low as 82 to the dollar.
Why are the rupee-dollar exchange rate and foreign exchange reserves falling?
To understand the movements of these variables, one must understand India’s balance of payments (BoP) state. The BoP is basically a record of all monetary transactions between Indians and foreigners. Here it is expressed in US dollars. If a transaction causes dollars to enter India, it is indicated by a positive sign; if a transaction means dollars leaving India, it is indicated by a minus sign.
The BoP has two major subheadings (also called “accounts”) – current and capital – to classify different types of transactions. The current account is divided into the commercial account (for the export and import of goods) and the invisible account (for the export and import of services). So, if an Indian buys an American car, dollars will come out of the BoP and go into the trading account of the current account. If an American invests in Indian equity markets, the dollars will enter the BoP table and be counted under REITs in the capital account. The important thing about BoP is that it always “balances out”.
In 2021-2022, India had a trade deficit of $189.5 billion. In other words, the country imported more goods (like crude oil) than it exported, and the net effect was negative. But the Invisibles account showed a surplus of $150.7 billion. As a result, the current account, which was in surplus the previous year, turned into a deficit of $38.8 billion.
On the capital account, however, there was a surplus of $86.3 billion, largely due to foreign direct investment (FDI) providing more dollars in the form of loans and the like. Foreign portfolio investors (FPIs) withdrew $16.8 billion.
At the end of the year, the BoP had a surplus of $47.5 billion – that is, the net effect of all transactions on current and capital accounts was only $47.5 billion. dollars had entered India.
Now two things can happen from here. If left unchecked, such a huge surplus would lead to an appreciation of the rupee against the dollar. This will lead to a change in people’s buying and investing preferences. For example, Indian exports will become more expensive and imports cheaper. Over time, the trade deficit will change (shrink or turn into a surplus) to “balance” the BoP.
The other thing that can happen is that the RBI rushes in and withdraws all the excess dollars from the market and uses them to increase its foreign exchange reserves. It does this by buying dollars and replacing them with rupees. In 2021-22, for example, India’s foreign exchange reserves grew by $47.5 billion.
In fact, both of these things happen throughout the year. The RBI continues to monitor the BoP on a weekly basis and continues to intervene so that the Rupee exchange rate does not fluctuate too much. In other words, the rupee exchange rate and foreign exchange reserve levels are two sides of the same coin.
What will be the effect on the economy?
Since a large portion of Indian imports are denominated in dollars, these imports will become more expensive. A good example is the crude oil import bill. More expensive imports, in turn, will widen the trade deficit as well as the current account deficit, which, in turn, will put pressure on the exchange rate.
On the export front, however, Sen noted that it’s less straightforward. On the one hand, in bilateral trade, the rupee has become stronger than many currencies. In exports that are done through the dollar, “since the rupee is not the only currency to weaken against the dollar, the net effect will depend on the loss of the other currency against the dollar,” he said. Sen. “If the other currency lost more than the rupee, the net effect could be negative.”
Sen said that under normal circumstances, the depreciation of the rupee is good for the current account deficit as it leads to an increase in exports. But right now, India is already facing high inflation and continued depreciation could make matters worse. “More expensive imports (due to a weaker rupee) add to cost inflation and accelerate the domestic inflationary process,” Sen said.
Sudipto Mundle, president of the Center for Development Studies, pointed to another complication. “A weakening rupee hurts foreign investors, who have come looking for a good return, as well as Indians, who have overseas loans,” he said.
Should policy makers prevent the fall?
Mundle said it was neither wise nor possible for the RBI to keep the rupee from falling indefinitely. Defending the rupee will simply cause India to deplete its foreign exchange reserves over time, as global investors have much greater financial clout. Most analysts believe that the best strategy is to let the rupee depreciate and act as a natural buffer against adverse terms of trade.
What should decision makers do?
Mundle’s prescription is that “the RBI (which is in charge of monetary policy) should focus on controlling inflation, as it is legally mandated to do, and the government (which is in charge of budget) should contain its borrowing”. The increase in government borrowing (budget deficit) erodes domestic savings and forces the rest of economic agents to borrow abroad.
Sen said policymakers (both in government and in the RBI) must choose what their priority is: containing inflation or clinging to exchange rates and exchange levels. “If they choose to contain inflation (i.e. by raising interest rates), that will require sacrificing economic growth. So be prepared for that,” he said.