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EDITORIAL ANALYSIS: The Free Fall of the Rupee

Source: The Hindu

  • Prelims: Indian Economy, Interest rate, IMF etc
  • Mains GS Paper III: Fiscal policy, Monetary policy, Impact of free fall of the rupee.

 

ARTICLE HIGHLIGHTS

  • The Indian rupee hit an all time low against the S. dollar this week weakening past the 79 rupees to a dollar mark and selling as low as 79.05 against the dollar on Wednesday.
  • Many analysts expect the rupee to weaken further in the coming months and move past the 80 rupees to dollar mark.
  • In fact, the International Monetary Fund (IMF) expects the rupee to weaken past the 94 rupees to a dollar markby FY29.

 

 

INSIGHTS ON THE ISSUE

Context

Depreciation:

  • Currency depreciation is a fall in the value of a currency in a floating exchange rate system.
  • Rupee depreciation means that the rupee has become less valuable with respect to the dollar.
  • It means that the rupee is now weaker than what it used to be earlier.
  • For example: USD 1 used to equal to Rs. 70, now USD 1 is equal to Rs. 77, implying that the rupee has depreciated relative to the dollar i.e. it takes more rupees to purchase a dollar.

 

Impact of Depreciation of Indian Rupee:

  • Depreciation in rupee is a double-edged sword for the Reserve Bank of India.
  • Positive:
    • Weaker rupee should theoretically give a boost to India’s exports, but in an environment of uncertainty and weak global demand, a fall in the external value of rupee may not translate into higher exports.
  • Negative:
    • It poses risk of imported inflation, and may make it difficult for the central bank to maintain interest rates at a record low for longer.
    • India meets more than two-thirds of its domestic oil requirements through imports.
    • India is also one of the top importers of edible oils. A weaker currency will further escalate imported edible oil prices and lead to a higher food inflation.

 

What is happening with the rupee?

  • The Indian rupee has been witnessing a steady decline this year, losing more than 6% against the U.S. dollar since the beginning of 2022.
  • India’s forex reserves have also dropped below $600 billion, plunging by more than $50 billion since September 3,2021, when forex reserves stood at an all time high of $642 billion.
  • The drop in India’s forex reserves is believed to be largely due to steps taken by the Reserve Bank of India to support the rupee.
  • RBI officials, however, have noted that the drop in forex reserves is due to a fall in the dollar value of assets held as reserves by the RBI.
  • The aim of the RBI’s policy is to allow the rupee to find its natural value in the market but without undue volatility or causing unnecessary panic among investors.
  • State run banks are usually instructed by the RBI to sell dollars in order to offer some support to the rupee.

 

What determines the rupee’s value?

  • The value of any currency is determined by demand for the currency as well as its supply.
  • When the supply of a currency increases, its value drops.
  • In the wider economy, central banks determine the supply of currencies, while the demand for currencies depends on the amount of goods and services produced in the economy.
  • In the forex market, the supply of rupee is determined by the demand for imports and various foreign assets. So, if there is high demand to import oil, it can lead to an increase in the supply of rupees in the forex market and cause the rupee’s value to drop.
  • The demand for rupees in the forex market, on the other hand, depends on foreign demand for Indian exports and other domestic assets.
  • When there is great enthusiasm among foreign investors to invest in India, it can lead to an increase in the supply of dollars in the forex market which in turn causes the rupee’s value to rise against the dollar.

 

What is causing the rupee to lose value against the dollar?

  • Since March this year, the U.S. Federal Reserve has been raising its benchmark interest rate causing investors seeking higher returns to pull capital away from emerging markets such as India and back into the U.S.
  • This, in turn, has put pressure on emerging market currencies which have depreciated significantly against the U.S. dollar so far this year.
  • Even developed market currencies such as the euro and the yen have depreciated against the dollar and the dollar index is up more than 9% so far this year.
  • Some analysts believe that the RBI’s surprise decision to raise rates in May could have simply been to defend the rupee by preventing any rapid outflow of capital from India.
  • India’s current account deficit,which measures the gap between the value of imports and exports of goods and services, is expected to hit a 10 year high of 3.3% of gross domestic product in the current financial year.
  • Foreign investors are unlikely to plough capital into India when investment yields are rising in the U.S.
  • Yields on U.S. 10 year Treasuries, for instance, have risen from around 5% in mid 2020 to over 3% now.
  • Consistently higher domestic price inflation in India. Higher inflation in India suggests that the RBI has been creating rupees at a faster rate than the U.S. Federal Reserve has been creating dollars.

 

Appreciation Vs Depreciation:

●    In a floating exchange rate system, market forces (based on demand and supply of a currency) determine the value of a currency.

●    Currency Appreciation: It is an increase in the value of one currency in relation to another currency.

●    Currencies appreciate against each other for a variety of reasons, including government policy, interest rates, trade balances and business cycles.

●    Currency appreciation discourages a country’s export activity as its products and services become costlier to buy.

Financial Action Task Force(FATF)

●    An inter-governmental body established in 1989 during the G7 Summit in Paris.

●    It assesses the strength of a country’s anti-money laundering and anti-terror financing frameworks.

●    It sets standards and promote effective implementation of legal, regulatory and operational measures for combating money laundering, terrorist financing and other related threats to the integrity of the international financial system.

●    Its Secretariat is located at the Organization for Economic Cooperation and Development (OECD) headquarters in Paris.

●    The FATF currently has 39 members including two regional organizations – the European Commission and Gulf Cooperation Council.

●    India is a member of the FATF.

 

Way Forward

  • Analysts believe that, over the long run, the rupee is likely to continue to depreciate against the dollar given the significant differences in long run inflation between India and the U.S.
  • At the moment, as the U.S. Federal Reserve raises rates to tackle historically high inflation in the country, other countries and emerging markets in particular will be forced to raise their own interest rates to avoid disruptive capital outflows and to protect their currencies.
  • The RBI too has been trying to rein in domestic consumer price inflation, which hit a 95 month high of 7.8% in April, by raising rates and tightening liquidity.
  • As interest rates rise across the globe, the threat of global recession also rises as economies readjust to tighter monetary conditions.

 

 QUESTION FOR PRACTICE

Why are countries increasing their interest rates? What are the ways in which the RBI has tried to cushion the fall of the rupee?

(200 WORDS, 10 MARKS)