Impacts of Rupee Weakening and RBI’s Exchange Rate Policy

Impacts of Rupee Weakening and RBI’s Exchange Rate Policy

Sub: Eco

Sec: External sector

Why in News?

• The Indian rupee recently depreciated significantly, reaching a record low of ₹86.70 per dollar.
• The Reserve Bank of India (RBI) has reverted to its managed-floating exchange rate regime, allowing controlled depreciation to address capital outflows and rising import costs.
• Persistent structural issues, including real exchange rate appreciation and domestic inflation, have complicated recovery efforts.

Context:

The sharp devaluation of the rupee raises concerns about inflation, export competitiveness, and macroeconomic stability. The RBI’s policies and structural constraints in the economy have shaped recent exchange rate movements.

Key Points

1. Recent Trends in Rupee Depreciation

• The rupee hit a historic low of ₹86.70/USD amid rising crude oil prices and a worsening current account deficit.
• The current depreciation is driven by:
  • Capital outflows due to rising interest rates globally.
  • Higher import costs, especially for crude oil and essential raw materials.
  • RBI’s shift back to a managed-floating exchange rate policy after a brief fixed exchange rate-like stance post-COVID.

2. Implications of Rupee Depreciation

• Positive Effects:
  • Boost to Export Competitiveness:
    • Depreciation makes Indian goods cheaper globally, potentially improving net exports.
  • Support for Domestic Production:
    • Cheaper rupee could increase demand for domestically produced goods.
• Adverse Effects:
  • Inflationary Pressures:
    • Higher costs for imports (e.g., crude oil, raw materials) lead to rising domestic prices.
  • Real Exchange Rate Appreciation:
    • Despite nominal depreciation, rising domestic prices have made Indian goods costlier globally, limiting export benefits.
• Macroeconomic Instability:
  • Widening current account deficit (CAD) and declining forex reserves exert pressure on India’s balance of payments (BoP).

3. India’s Exchange Rate Policy

• Managed-Floating Exchange Rate Regime:
  • RBI allows controlled currency depreciation or appreciation based on demand-supply dynamics in the foreign exchange market.
• Key Approaches follows by RBI:
  • During excess demand: RBI devalues the rupee and sells forex reserves.
  • During excess supply: RBI accumulates reserves while resisting rupee appreciation to maintain export competitiveness.

4. Structural Constraints Affecting the Rupee

• Divergence Between NEER and REER:
  • Since 2019, Nominal Effective Exchange Rate (NEER) and Real Effective Exchange Rate (REER) have diverged.
  • This divergence has reduced the positive impact of nominal rupee depreciation on exports.
• Rising Domestic Markups:
  • Firms have increased markups (price over variable cost) to maintain profitability, further inflating domestic prices.

5. Policy Recommendations

• Short-term Measures:
  • Stabilize inflation by controlling costs of essential imports.
  • Maintain adequate forex reserves to ensure exchange rate stability.
• Medium to Long-term Reforms:
  • Promote trade in local currencies (e.g., INR) through initiatives like Special Rupee Vostro Accounts (SRVA).
  • Focus on export diversification to reduce dependency on volatile markets.
  • Align nominal and real exchange rates by controlling inflation through domestic structural reforms.

Real Effective Exchange Rate (REER) and Nominal Effective Exchange Rate (NEER)

The Real Effective Exchange Rate (REER) and Nominal Effective Exchange Rate (NEER) are crucial indicators used to evaluate a country’s currency competitiveness and trade dynamics.

NEER and REER: Definitions

• NEER (Nominal Effective Exchange Rate):
  • Reflects the weighted average of a currency’s bilateral exchange rates with multiple trading partner currencies.
  • Does not adjust for inflation or price level differences.
  • Indicates nominal appreciation or depreciation of the currency.
• REER (Real Effective Exchange Rate):
  • Adjusted version of NEER, accounting for relative price levels or inflation between domestic and foreign economies.
  • Provides a purchasing power parity (PPP)-adjusted measure of a currency’s competitiveness.

Economic Implications

• Overvaluation (REER > 100):
  • Makes exports less competitive globally and encourages imports due to cheaper prices.