Introduction
Beginning with the Covid-19 pandemic, up to the ongoing Russian invasion of Ukraine, the world has been going through exceptionally tumultuous times in the last two years. Aside from its effect on all industries, the foreign exchange market has also been experiencing turbulence. Presently, the Indian rupee has depreciated to an all-time low of Rs. 79.11 against the U.S. dollar. The fall in the rupee comes at a time when the country is already reeling from inflationary pressures and rising crude oil prices. But what are the reasons that led to the depreciation of the rupee and what impact does it have on our lifestyles?
What is Currency Depreciation?
Let’s start with the basics. The Foreign exchange rate is the rate at which one currency is exchanged for another. Due to the changing market forces of demand and supply, these rates may depreciate from time to time. Simply put, a currency depreciation occurs when the value of the domestic currency falls in value with respect to a foreign currency. Let’s understand this better with the help of a hypothetical example.
There are two countries: Country A and Country B which produce only pizzas and burgers respectively. The currency of country A is ‘Pizzo’ and that for Country B is ‘Burg’. Both countries mint 100 units of their currency each. Now, during the 1st year, Country A produces 100 pizzas and Country B produces 100 burgers. Therefore, the exchange rate for these currencies is 1:1.
However, during the second year, say due to drought, Country A produces only 50 pizzas while Country B produces 100 burgers again. Now, the exchange value of 1 ‘Pizzo’ is reduced to half a pizza as the amount of currency remains unchanged. In other words, the currency ‘Pizzo’ has depreciated relative to the ‘Burg’ and the exchange rate now is 2:1. Therefore, you would need 2 ‘Pizzos’ to get 1 ‘Burg’. This is how currency depreciation occurs. So, when the value of the rupee drops from say, 76 per $ to 78 per $, then we say that the rupee has depreciated with respect to the dollar.
Why is the Rupee falling Now?
Though the rupee has continued to depreciate ever since India became independent, it hit an all-time low against the greenback this June. What has led to this scenario?
One of the main reasons for the fall in the rupee has been the selling spree by Foreign Portfolio Investors (FPIs) of Indian stocks who have pulled more than $21.2 billion from India. FPIs are those that invest in funds in markets outside their home turf. Their investment typically includes equities, bonds, and mutual funds. They are generally not active shareholders and do not exercise any control over the companies whose shares they hold. Hence, their passive nature allows them to enter or exit a stock at will and with ease. Normally, the promise of attractive returns on the back of economic growth draws the FPIs into a country's market. They also try to invest in bonds when there is a favourable differential between the interest rate offered in the country they plan to invest in and the U.S., the biggest economy in the world.
In India, the economic recovery post the lockdown has been uneven. The second and third waves caused more positive cases than the initial wave, and the economy was shattered again. With constant uncertainties looming over, it has led to a decline in investor confidence and since then, FPIs have been reducing their market investment in India. In addition, the U.S. Federal Reserve has also been raising interest rates continuously as it tries to combat inflation. These high-interest rates, such as those on U.S. Treasury bonds, have caused investors to dump the rupee and prefer to invest in safe havens with low risk. Consequently, they sell rupees in exchange for the dollar, which has translated into an increase in the supply of the rupee. With supply disproportionately increasing relative to demand, the value of the rupee has fallen significantly.
Moreover, the Ukraine-Russia war has caused a disruption in the global supply chain, causing surging prices for food crops, petroleum, and vegetable oil. Subsequently, commodity prices and overall inflation has accelerated the economy to almost 8%, well above the RBI’s comfort level. The high inflation has led to an increase in import costs of petroleum, coke, coal, briquettes, electronic goods, etc. by almost 30%. Since the payment for all this needs to be done in dollars, it has led to an increase in its demand, further weakening the rupee.
The Impacts of a Weakening Rupee
Though a falling rupee can help export-oriented sectors such as IT, pharmaceuticals, specialty chemicals and textiles boost exports and be more competitive in the global market, it will nevertheless make imports costlier. And since India is dependent on oil imports for meeting its energy needs, the high prices will mean India has to spend more per barrel of oil, leading to an increasing trade deficit. A weak rupee also affects production costs, thereby stoking inflation even further. Similarly, the falling rupee will also result in foreign vacations and education at universities abroad becoming more expensive as Indians will have to pay more amount of rupees for the same amount of dollars.
Future Outlook
As long as the war in Ukraine prolongs and developed countries like the U.S. continue to raise interest rates, investors will continue to pull out of emerging markets like India. As a result, the rupee may continue to weaken with some fearing that it may fall even further. Although the RBI has been selling U.S. dollars from its forex reserves to ease demand and keep the rupee from spiralling out of control, economists believe the rupee will remain under pressure in the times to come and consumers will have to bear the brunt of higher prices.
(Written by Sashank Rajaram and Edited by Anoushka Gehani)
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