Why in News?

The Indian rupee recently witnessed a sharp devaluation against the dollar after a period of relative stability post-COVID.

This article examines India’s exchange rate policies, structural constraints in the economy, and the broader implications of rupee depreciation.

What’s in Today’s Article?

• Understanding Exchange Rate Regimes
• India’s Exchange Rate Policy
• Implications of Rupee Devaluation
• Structural Constraints in the Indian Economy
• Policy Questions and Challenges
• Conclusion

Understanding Exchange Rate Regimes:

• Nominal and Real Exchange Rates: The nominal exchange rate is the official exchange rate that doesn't account for inflation, while the real exchange rate is the nominal exchange rate adjusted for inflation.
• Determinants of Exchange Rates:
  • Current Account: Influenced by net exports.
  • Capital Account: Driven by foreign investment flows.
  • Impact: Demand for foreign currency increases with a higher current account deficit and capital outflow.
• Types of Exchange Rate regimes:
  • Fixed Exchange Rate: Central bank maintains a constant exchange rate by managing reserves.
  • Floating Exchange Rate: Market-driven exchange rate with no central bank intervention.
  • Managed-Floating Exchange Rate: A mix of market forces and central bank intervention.

India’s Exchange Rate Policy:

• Past trends:
  • India has primarily followed a managed-float regime for three decades.
  • From 2010, the RBI managed the rupee asymmetrically:
    • Under excess demand: Depreciated the rupee and sold foreign reserves.
    • Under excess supply: Accumulated reserves to avoid appreciation.
• Post-COVID shifts:
  • Between 2022 and late 2024, the RBI temporarily adopted a fixed exchange rate-like regime to stabilize the rupee.
  • Recent sharp devaluation suggests a return to the managed-float approach, driven by:
    • Capital outflows.
    • Rising import costs amid high crude oil prices.

Implications of Rupee Devaluation:

• Positive effects:
  • Boosting exports: Depreciation can make domestic goods cheaper, enhancing export competitiveness if:
    • Net exports respond positively to a weaker real exchange rate.
    • Nominal depreciation leads to real depreciation.
  • Adverse effects:
    • Inflationary pressures: Increased import costs raise domestic prices.
    • Reduced purchasing power: Firms pass on higher costs to consumers, squeezing real incomes.

Structural Constraints in the Indian Economy:

• Divergence between NEER and REER:
  • These indices reflect the weighted average exchange rate of India with respect to its multiple trade partners.
  • According to the definitions of these indices, any increase or positive change indicates appreciation, whereas any drop or negative change indicates depreciation.
  • Since the mid-2010s, the nominal effective exchange rate (NEER) has depreciated, while the real effective exchange rate (REER) has appreciated.
  • This divergence undermines export competitiveness, as higher domestic prices offset the benefits of nominal depreciation.
• Rising markups:
  • Non-financial firms have increased markups (ratio of output price to variable costs), contributing to domestic price inflation.
  • Key cost drivers include raw materials, labor, fuel, and indirect taxes.

Policy Questions and Challenges:

• Policy dilemmas:
  • Should India revert to the managed-float regime of the 2010s or adopt a new framework?
  • How can policy address inflationary pressures while maintaining export competitiveness?
• RBI’s role:
  • The RBI’s recent ad hoc policy shifts highlight the need for a systematic exchange rate strategy.
  • Clearer objectives and consistent communication are essential for addressing current challenges.

Conclusion:

• The devaluation of the rupee underscores structural vulnerabilities in the Indian economy and raises critical questions about the future of exchange rate policy.
• A nuanced approach that balances inflation control with export growth is vital for sustainable economic recovery.