Free fall of rupee

  • July 1, 2022
  • Posted by: OptimizeIAS Team
  • Category: DPN Topics
No Comments

 

 

Free fall of rupee

Why in the news?

The Indian rupee hit an all-time low against the U.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

Details: 

  • 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.
  • The International Monetary Fund (IMF) expects the rupee to weaken past the 94 rupees to a dollar mark by FY29.
  • 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.

Causes of depreciation:

  • 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

Causes of decline in forex:

  • Fall in the dollar value of assets held as reserves by the RBI-For instance, if a portion of the reserves are in euros and the euro depreciates against the dollar, this would cause a drop in the value of forex reserves.
  • RBI Policy to correct currency Depreciation-
  1. 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.
  2. State-run banks are usually instructed by the RBI to sell dollars in order to offer some support to the rupee.
  3. By thus selling dollars in return in the open market in exchange for rupees, the RBI can improve demand for the rupee and cushion its fall.
Foreign exchange reserves 

Forex reserves are assets held on reserve by a central bank in foreign currencies, which can include bonds, treasury bills and other government securities. It needs to be noted that most foreign exchange reserves are held in US dollars.

India’s Forex Reserve include:

  • Foreign Currency Assets
  • Gold reserves
  • Special Drawing Rights
  • Reserve position with the International Monetary Fund (IMF).

Foreign Currency Assets

FCAs are assets that are valued based on a currency other than the country’s own currency.

FCA is the largest component of the forex reserve. It is expressed in dollar terms.

The FCAs include the effect of appreciation or depreciation of non-US units like the euro, pound and yen held in the foreign exchange reserves.

RBI intervention:

  • It can intervene directly in the currency market by buying and selling dollars.If the RBI wishes to increase the rupee value, then it can sell dollars and when it needs to bring down rupee value, it can buy dollars.
  • The central bank can also influence the value of the rupee by way of monetary policy. RBI can adjust the repo rate (the rate at which RBI lends to banks) and the liquidity ratio (the portion of money banks are required to invest in government bonds) to control rupee.
    • Increase rate of  interest  -capital inflows
    • Decrease rate of interest – capital outflows
  • Currency Swap agreements– to avoid dealing in currency with which the rupee’s value is depreciating.

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 (depreciation). 
    • When the demand for a currency increases, its value rises (appreciation)
  • Determinants of supply of currency: 
    • In the wider economy, central banks determine the supply of currencies
    • In the forex market, the supply of rupees is determined by the demand for imports and various foreign assets. So, if there is high demand to import oil (imported by India) , it can lead to an increase in the supply of rupees (dollar is paid for imports thus, relative supply of rupee rises) in the forex market and cause the rupee’s value to drop.
  • Determinants of demand of currency:
    • The amount of goods and services produced in the economy
    • The demand for rupees in the forex market, on the other hand, depends on foreign demand for Indian exports and other domestic assets. So, for instance, 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 (relative supply of rupee falls) the rupee’s value to rise against the dollar.
Tips:

As interest rates rise across the globe, the threat of a global recession also rises as economies readjust to tighter monetary conditions. As, higher interest rate raises the cost of borrowing and thus, reduces investment and national income/output.

Is a falling exchange rate necessarily a bad thing?- Indeed, YES!

  • The exchange is often taken as a marker of the relative strength of an economy and relative size of forex denotes a country’s ability to pay its external debts.As, depreciating currency increases external obligations to pay debt as value of external debt rises.
  • Most Developing Economies tend to run deficits on their trade and current accounts, which could lead to a rise in  India’s Exports—unless they import raw materials, which would become costlier.
Free fall of rupee