Factors of falling exchange rate and Impact

Subject :Economy

Section: External Sector

Context:

Since the war in Ukraine and consequential rise in the crude oil prices, the indian rupee has steadily lost its value against the dollar

Details:

While the US dollar has become stronger against all other major currencies including the rupee, the rupee, in turn, has become stronger than many other currencies such as the euro.
Forex reserves have fallen by over $50 billion between September 2021 and now.
In these 10 months, the rupee’s exchange rate with the dollar has fallen 8.7% against a normal depreciation of 3-3.5% in a year.

Factors:

Rise in US rate of interest-The 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.
Rise in Current account Deficit-This means that India’s import demand amid rising global oil prices is likely to negatively affect the rupee unless foreign investors pour sufficient capital into the country to fund the deficit. But foreign investors are unlikely to invest capital into India when investment yields are rising in the U.S.
Inflation– 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. Thus, higher supply of rupee

Impact:

Imported inflation- when the rupee depreciates, importing goods and services becomes costlier. Costlier Imports add to the cost-push inflation .
- Since a large proportion of India’s imports are dollar-denominated, these imports will get costlier, for example-the crude oil import bill.
- Costlier 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.
Increase export competitiveness-if one is trying to export goods and services to other countries, especially to the United States, India’s products become more competitive because depreciation makes these products cheaper for foreign buyers.
- If however the other currency has lost more than the rupee, the net effect could be negative on exports from India.
Capital outflows- A weakening rupee hurts foreign investors, who came looking for a good return, as well as Indians, who have loans abroad
Implications on Balance of payments-due to deficit in current and capital account, can lead to overall BOP deficit.
Implication on Forex reserves-RBI swoops in and removes all the deficit of dollars from the market by selling forex reserves thus, reducing forex reserves and import cover.