GS Paper 3
Syllabus: Economy
Source: Indian Express
Context: The Indian rupee breached the exchange rate level of 80 to a US dollar recently for the 1st time.
What is the rupee exchange rate?
- The rupee’s exchange rate vis-à-vis the dollar is essentially the number of rupees one needs to buy for $1. This is an important metric to buy not just US goods but also other goods and services (say crude oil) trade which happens in US dollars.
Rupee depreciation impact: when the rupee depreciates, importing goods and services becomes costlier. But the export of goods and services to other countries, become cheaper.
Why are the rupee-dollar exchange rate and forex reserves falling?
- As investors are pulling money out of the Indian market, there is a fall in forex reserve and also less dollar in the Indian market would mean, the value of the dollar against the rupee would increase. Thereby depreciating the rupee.
- India has a capital account surplus but a current account deficit: The net effect of BOP in India had been a surplus of $47.5 billion last year.
- The RBI keeps monitoring the BoP every week and keeps intervening in such a manner which ensures that the rupee’s exchange rate does not fluctuate too much.
What will be the effect on the economy?
Under normal circumstances, rupee depreciation is good for the current account deficit because it leads to higher exports. But at present, India is already facing high inflation and continued depreciation may be making matters worse. Costlier imports (because of a weaker rupee) add to the cost-push inflation and bump up the domestic inflationary process.
- A weakening rupee hurts foreign investors, who came looking for a good return, as well as Indians, who have loans abroad.
Higher Inflation: Should the INR depreciate by 5 per cent from the baseline (76 per dollar), inflation could edge up by around 20 bps while GDP growth could be higher by around 15 bps through increased net exports, according to the RBI April Monetary Policy Report.
Should policymakers prevent the fall?
Experts say it is neither wise nor possible for the RBI to prevent the rupee from falling indefinitely.
- Defending the rupee will simply result in India exhausting its forex reserves over time because global investors have much bigger financial clout.
- Most analysts believe that the better strategy is to let the rupee depreciate and act as a natural shock absorber to the adverse terms of trade.
What should policymakers do?
- RBI (which is in charge of monetary policy) should focus on containing inflation, as it is legally mandated to do, and the government (which is in charge of the fiscal policy) should contain its borrowings”
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Practice Questions
Q. What is the depreciation of the Indian rupee? Examine the factors behind its recent depreciation and its impact on the economy in general.
Q . With reference to the Indian economy, consider the following statements: (UPSC CSE 2022)
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- If the inflation is too high, the Reserve Bank of India (RBI) is likely to buy government securities.
- If the rupee is rapidly depreciating, RBI is likely to sell dollars in the market.
- If interest rates in the USA or European Union were to fall, that is likely to induce RBI to buy dollars.
Which of the statements given below is/are correct?
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- 1 and 2 only
- 2 and 3 only
- 1 and 3 only
- 1, 2 and 3
Answer: (b)
Justification:
Statement 1 is incorrect: To control inflation, the RBI sells the securities in the money market which sucks out excess liquidity from the market. As the number of liquid cash decreases, demand goes down. This part of monetary policy is called the open market operation.
Statement 2 is correct: If the rupee is depreciating, RBI pumps the dollar into the market, this results in an increase in foreign currency supply and a decrease in Rupee supply, thus appreciating its value.
Statement 3 is correct: If interest rates in US and EU fall, investors would like to park more money in emerging markets such as India for better returns, thus Indian market would be flooded with foreign currency. To stabilize it, RBI would likely buy excess dollars.
