Impacts of Rupee Weakening

Context: The Indian rupee recently registered a sharp devaluation with respect to the dollar, after remaining stable for over two years. Hence, there arises a need to review India’s exchange rate policy and study the structural constraints existing in the Indian economy.

Relevance of the Topic: Prelims: Nominal & Real Exchange Rate, Exchange Rate Regimes, India’s exchange rate policy. 

What is the Exchange Rate?

• An exchange rate is the rate at which one currency can be exchanged for another currency.
• Most exchange rates are defined as floating. Their values rise or fall based on supply and demand in the foreign exchange market.
• Some exchange rates are pegged or fixed to the value of a specific country’s currency.

What is the Nominal Exchange Rate?

• Nominal exchange rate is the general exchange rate of one country’s currency relative to another.
• It is the price of buying one unit of foreign currency in terms of domestic currency. 
• Factors influencing changes in nominal exchange rate:
  • Demand-supply conditions of the foreign exchange market 
  • Exchange rate policy of the central bank.

What is the Real Exchange Rate?

• The real exchange rate compares the general price level of certain commodities or baskets of commodities of the two countries.
• It is the relative price of foreign goods in terms of the domestic currency with respect to the prices of the domestic goods. 
• It describes how cheap or costly domestic goods are concerning the foreign goods.

Factors influencing Foreign Exchange Market

• Demand and supply conditions of the foreign exchange market depend on the flows ofcurrent account and capital account.
  • Current Account Flows: Related to exports and imports of goods and services.
  • Capital Account Flows: Related to foreign investments and capital inflows/outflows. 
• Demand for foreign currency would rise if the sum of net current account and capital account flows falls.
• Supply of foreign currency would rise if the sum of net current account and capital account flows increases. 
• The lower the net exports and greater the capital outflow, the greater would be demand for foreign currency and vice-versa.

Net Exports	Capital Outflow	Demand for Foreign Currency	Nominal Exchange Rate
Decrease	Increase	INCREASE	FALLS
Increase	Decrease	DECREASE	RISES

Exchange Rate Policy Frameworks

• There are three kinds of exchange rate policy frameworks, depending on how the central bank responds to the demand and supply conditions in the foreign exchange market:
  • Fixed exchange rate
  • Floating exchange rate
  • Managed-floating exchange rate

1. Fixed Exchange Rate:

• The central bank responds to the higher demand for foreign currency entirely by selling (decumulating) foreign exchange reserves (and vice versa).
• This is done while keeping the nominal exchange rate fixed at a predetermined level.

2. Floating Exchange Rate:

• Central bank responds to higher demand of foreign currency entirely by devaluing the domestic foreign currency (making foreign currency costlier in terms of domestic currency) and vice versa
• This is done while keeping the level of foreign exchange reserves unchanged.

3. Managed Floating Exchange Rate:

• The central bank responds to higher demand for foreign currency both by selling foreign currency as well as devaluing the domestic foreign currency.

RBI’s Exchange Rate Policy

• RBI has largely pursued a managed-float exchange rate regime in the last three decades. 
• RBI’s response under excess demand conditions in the foreign exchange market has been qualitatively different from excess supply conditions.
  • Excess demand conditions in the foreign exchange market: RBI simultaneously devalued the domestic currency and decumulated its foreign exchange reserves. 
  • Excess supply conditions:
    •  RBI accumulated foreign exchange reserves while largely resisting appreciation of the nominal exchange rate.
    • This was done to avoid appreciation of the real exchange rate or the worsening of export competitiveness. 
• Thus, while net capital outflow was associated with depreciation of the nominal exchange rate, the net capital inflow did not involve appreciation of the exchange rate to the same extent.  
• This asymmetry in the behaviour of the nominal exchange rate led to an overall devaluation of the rupee throughout the 2010s decade.

• In the post-COVID period: RBI momentarily shifted to a fixed exchange rate regime.
  • This is reflected by the flat segment of the dollar exchange rate in the above graph during the relevant period. 
  • Deterioration of the current account deficit and capital outflow during this period were met by selling foreign exchange reserves while holding the nominal exchange rate more or less at the same level. 
• Last month: The sharp devaluation of the rupee in the last month hints towards RBIreturning to its earlier regime of the managed-float exchange rate. 
  • Due to greater capital outflow and a rise in imports amid higher crude oil prices, RBI allowed the rupee to depreciate. This was done to put less strain on the foreign exchange reserves.

Implications of Devaluation

• Depreciation of nominal exchange rate can have both positive & adverse macroeconomic implications.
• Positive Effect: Boosting Exports
  • A weaker rupee makes Indian goods cheaper for foreign buyers.
    • For example: If 1 dollar = ₹85, a $100 foreign product would cost ₹8,500, while a ₹1,000 Indian product would cost just ₹1,000.
    • This makes Indian goods more competitive in global markets.
  • Certain conditions to be met for exports to benefit:
    • Export levels should increase when Indian goods become cheaper (real exchange rate falls).
    • Domestic prices should stay steady. If domestic prices rise, Indian goods could become expensive again, canceling out the benefit.

• Negative Effect: Rising Costs and Inflation
  • A weaker rupee increases the cost of imports, especially raw materials like oil or machinery that firms need.
  • Firms pass on these higher costs to consumers by raising prices, leading to inflation (higher prices for goods and services).
  • This reduces people's purchasing power, as their real income (what they can buy) decreases.

India’s Challenge since the 2010s

• For India, the positive effects of a weaker rupee (boosting exports) have been limited.
• This is because:
  • Domestic prices have been rising faster, making Indian goods less competitive even with a weaker rupee.
  • This unique problem means depreciation hasn't helped exports as much as it should.

Recent constraint: Diverging NEER & REER

• The period since the mid-2010s, particularly 2019 has been characterized by the growing divergence between the nominal and the real exchange rate.
  • These indices reflect the weighted average exchange rate of India with respect to its multiple trade partners.
  • Any increase or positive change of these indicators implies appreciation.
  • Any decrease or negative change implies depreciation.

• After moving in the same direction till the mid-2010s, they started moving in opposite directions with the real exchange rate registering an appreciation despite a depreciation in the nominal exchange rate.
  • Such a phenomenon distinguishes India from other countries. 
  • Chart 3 shows this by depicting the exchange rate movements of 62 countries using data from the Bank of International Settlements (BIS).

• Appreciation of the real exchange rate in India despite a depreciation of the nominal exchange rate indicates that the latter has been associated with counteracting rise in domestic prices. 
• Rise in domestic prices can be attributed to the recent increase in the markup of non-financial firms.
  • After registering a decline till the mid-2010s, the markup reversed its trend and started rising. 
  • Since prices are formed by a markup over variable costs, any rise in markup would push up domestic prices at any given level of variable costs and nominal exchange rate.

• Markup: 
  • Ratio between the output price and the variable cost per unit of output 
  • Ratio between the nominal value of sales and the total variable cost

Key Questions for India’s Exchange Rate Policy

• Should India go back to the 2010s strategy?
  • In the 2010s, the RBI followed a specific managed-floating approach where it used both reserve sales and currency depreciation to stabilize the exchange rate.
• Does India need a completely new exchange rate policy?
  • A fresh framework might better address today's economic challenges.

The response of the RBI in the post-COVID period has appeared somewhat arbitrary, as it has frequently shuffled its policy stance without providing adequate explanation. The recent challenges bring forth the need to address these questions in a more systematic way.