In the three months from September to December 2021, the Indian rupee depreciated by 2.2%. What is the reason for the Depreciation of the Indian rupee? What are its impacts? What is the role of RBI in controlling the depreciation of the Indian Rupee? Read further to know more about the Depreciation of the Indian Rupee.
The country’s stock market has seen $4 billion in foreign funds withdrawn, which has caused the currency to weaken. Due to this decline in the currency, the Indian rupee has had Asia’s worst performance. First, let us try to understand what Depreciation of Currency is.
Depreciation of Currency
Depreciation of currency refers to the decline in the value of a nation’s money in relation to one or more foreign reference currencies, most frequently occurring through an unofficial, floating exchange rate regime.
By making its goods and services more accessible to consumers, a country’s export activity may be boosted by a controlled currency devaluation. However, a country’s currency depreciation could spread to its neighbours.
Rupee depreciation in India means that the value of the rupee relative to the US dollar has decreased. It means that the rupee is today less strong than it was.
A dollar, for instance, used to be equal to 70 rupees; today, it is equal to 77, indicating that the rupee has declined in value relative to the currency and that it now costs more rupees to buy a dollar.
Numerous variables, such as lax monetary policy and excessive inflation, contribute to currency depreciation. Sudden currency devaluation, particularly in developing countries, frequently raises investor fears, and the majority of these currencies suffer similarly.
Let us move on to the various reasons for the Indian Rupee’s present depreciation.
Reasons for the Indian Rupee’s present depreciation
- Due to greater imports, India’s trade deficit grew to an all-time high of over $23 billion in November.
- This expanding trade gap is caused by the increase in oil costs.
- Policy differences between the Federal Reserve and the RBI: the strengthening of the US currency in reaction to the Federal Reserve’s low-interest rates and predictions of improved US economic development (the US central bank).
- In order to increase its reserves and be ready for any future turbulence, the Reserve Bank of India has been continuously purchasing US dollars.
- Due to a capital exodus from stocks, the benchmark S&P BSE Sensex Index has decreased by almost 10% from its all-time high set in October 2021.
- Currently, worries about the omicron virus type are unsettling the world markets.
- The conflict between Russia and Ukraine, rising crude oil prices, and tightening global financial conditions are some of the primary worldwide causes that have caused the Indian rupee to decline versus the US dollar.
- Significant demand for dollars from oil importers due to the high price of crude oil and worries about the widening trade deficit has also been major drivers of the sharp decline in the value of the Indian rupee.
- The increase in interest rates by the U.S. Federal Reserve (central bank), the European conflict, and worries about China’s economic development as a result of the Covid-19 rise all contributed to a sell-off in the global equity markets, which in turn caused the rupee to weaken.
- High crude prices and the slump in equities markets are both contributing to the dollar’s negative outflow.
- The RBI’s efforts to tighten the monetary policy in response to growing inflation have also resulted in devaluation.
Impact of the Depreciation of the Indian Rupee
The rupee’s depreciation is a double-edged sword for the Reserve Bank of India.
- Theoretically, a weaker currency should increase India’s exports, but given the current state of global uncertainty and the country’s weak demand, this may not be the case.
- It raises the possibility of imported inflation and may make it challenging for the central bank to sustain historically low-interest rates for a more extended period of time.
- Over two-thirds of India’s domestic oil needs are satisfied by imports. Among the major importers of edible oils in India. A weaker currency will drive up the cost of imported edible oil and increase food inflation.
- Imports will cost more because importers will have to pay more for the same amount of dollars when the dollar appreciates versus the rupee. Additionally, importers must pay more because most foreign trade is conducted in US dollars.
- Therefore, a falling rupee will make imports more expensive, putting further strain on household budgets in a nation where the economy is dependent on imports.
- Since India imports, more than 85% of the oil and 50% of the gas it uses, the oil and gas industry will be the one that suffers the most.
- Imported solar cells and modules are significantly reliant on Indian solar installations. Future bids would have higher tariffs and project expenses.
- Through rising import costs, a falling rupee immediately affects India’s trade balance and inflation.
- Costlier imports will increase both the trade and current account deficits, putting pressure on the currency rate. The nation’s current account deficit will increase.
- Increased import costs are also contributing to domestic inflation.
- Depreciation benefits export-related companies like pharma and IT.
- The rupee will lose value and foreign exchange reserves as the current account deficit inevitably grows.
- When overall prices rise (inflation) as a result of rising costs for wages and raw materials, this phenomenon is referred to as cost-push inflation, also referred to as wage-push inflation.
- It’s possible that businesses won’t be able to fully pass on increased prices to consumers, which would have an impact on government dividend payments and raise concerns about planned fiscal deficits.
- As India imports a lot of raw materials, this could affect consumers by raising the cost of completed items.
- It will cost more rupees for travellers and students studying abroad to purchase dollars from banks.
- A weaker rupee could cause foreign investors to stop investing in Indian markets, which would lead to a drop in stock and equity mutual fund investments.
Role of the Reserve Bank of India
- The RBI keeps a close eye on the foreign currency market and steps in when there is too much volatility.
- Recent actions by the RBI to ensure foreign currency inflow and support the rupee include lowering restrictions on foreign ownership of government bonds and raising the borrowing limits for businesses. However, bond yields in the USA have yielded higher rates of return than any Indian investment.
- Additionally, the RBI has suggested the rupee settlement method, which would allow overseas businesses to make payments in rupees rather than US dollars.
- This should lower the demand for US dollars in international trade and stabilise their value.
What are the measures to prevent Rupee Depreciation? They are discussed below.
Steps to Prevent Rupee Depreciation
The following steps can be taken to reduce rupee depreciation.
- Allowing foreign central banks, sovereign wealth funds, and endowment funds to invest in government bonds.
- Increasing the cap on foreign investment.
- The RBI has the option to sell some of its foreign currency reserves in order to manage the weakening rupee, and it is already doing so.
- Boost the weak industrial growth.
- Increased export incentives and decreased imports
- Keep your foreign currency spending to a minimum.
- The RBI may take action to encourage capital inflows into NRI accounts in order to increase the amount of money going into those accounts.
- When NRIs start making deposits in India, they’ll be selling their dollars and exchanging them for rupees, which will help the cause.
- The RBI can speak with banks to persuade them to give non-residents greater interest rates on deposits and short-term bonds.
- In a buy/sell exchange, dollars are withdrawn while Indian rupees are injected into the banking system.The swap will help the RBI, however in a limited way, control currency rates.
Options open to policymakers and the RBI
- The RBI cannot and should not attempt to stop the rupee from sinking indefinitely.
- India’s foreign exchange reserves will eventually run out if it defends the rupee because international investors have considerably more sway in the financial world.
- The majority of analysts think that allowing the rupee to weaken and serve as a natural shock absorber to the unfavourable terms of trade is the wiser course of action.
- The government should limit its borrowing, and the RBI should concentrate on reducing inflation as required by law.
- Corporations’ inclusion in important global indices like MSCI and FTSE: The government should promote the inclusion of some of the large market cap companies (both in the public and private sectors).
- As investors are unlikely to be underweight on India, this will assist raise the weight of Indian equities in these indices, partially offsetting foreign portfolio outflows.
- Inclusion of India into bond indices. The government might potentially hasten India’s entry into bond indices like the Barclays Global Bond Index and the J.P. Morgan Emerging-Market Bond Index.
- Additionally, causing foreign inflows will have a favourable effect on interest rates.
- By taking these steps, the RBI will be able to maintain its FX war chest at a comfortable level and have the necessary tools at its disposal should there be a further weakness.
- The maintenance of the interest rate differential between the United States and India, together with timely interventions on the foreign exchange market by the central bank to control volatility, will prove beneficial in protecting the rupee’s value versus the dollar.
The currency’s decline is probably going to make exports more competitive, which benefits the economy. The rupee has remained more resilient than in other earlier crises, such as the Global Financial Crisis of 2008 and the Taper Tantrum of 2013.
The rupee has lost value when compared to the US dollar, but it has gained value when compared to other major currencies like the euro and the Japanese yen. However, India is now dealing with high inflation, and more depreciation could make problems worse. As the value of the rupee continues to fall, there is a potential that the central bank would interfere once more.
Article Written By: Atheena Fathima Riyas