Why in news?

The Indian rupee has weakened against the US dollar, crossing the 85 mark. In April, the exchange rate was around 83, and a decade ago, it was approximately 61. This reflects a steady decline in the rupee's value relative to the dollar.

What’s in today’s article?

• Exchange rate
• Factors determining the demand for rupee in comparison to dollar
• Factors affecting the three kinds of demands mentioned above
• Falling Rupee
• Policy Recommendations for India

Exchange rate

• Understanding Exchange Rates
  • We use the Indian rupee to buy domestic goods and services, but for international purchases like an American car or Swiss vacation, we first exchange rupees for foreign currencies like the US dollar or euro.
  • The exchange rate determines how many rupees are needed to buy one unit of a foreign currency.
  • In the currency market, where currencies are traded like commodities, these rates often fluctuate over time.
• Factors Influencing Exchange Rates
  • Exchange rates are driven by demand and supply dynamics.
  • If Indians demand more US dollars than Americans demand Indian rupees, the dollar's value rises relative to the rupee, making it costlier.
  • Persistent demand imbalance strengthens this trend, causing the rupee to weaken against the dollar.

Factors determining the demand for rupee in comparison to dollar

• Trade in Goods
  • If India imports more goods from the US than it exports, the demand for US dollars exceeds that for Indian rupees.
  • This strengthens the dollar and weakens the rupee, requiring more rupees to buy one dollar.
• Trade in Services
  • Similarly, if Indians purchase more US services (e.g., tourism) than Americans buy Indian services, the dollar's demand rises, causing the rupee to weaken.
• Investments
  • If Americans invest more in India than Indians invest in the US, the demand for the rupee increases, leading to its appreciation against the dollar.

Factors affecting the three kinds of demands mentioned above

• Trade Restrictions
  • If the US bans or imposes high tariffs on Indian goods, demand for Indian rupees drops as Americans no longer need rupees to buy Indian products. This weakens the rupee.
• Inflation Differences
  • High inflation in India compared to the US erodes the rupee's value.
  • Investors may avoid or withdraw investments from India due to lower real returns, reducing demand for rupees and further weakening its exchange rate.

Falling Rupee

• About the news
  • The rupee recently slid to 85.11 against the US dollar, driven more by a strengthening dollar than a weakening rupee.
  • While the rupee has depreciated against the dollar since September, it has appreciated against other major currencies like the euro, pound, and yen.
• Global Factors Driving Dollar Strength
  • The dollar’s rise stems from US policy concerns, including potential import tariffs, deportations, and tax cuts.
  • These measures could boost inflation, prompting the US Federal Reserve to maintain tight monetary policy.
  • This has led to higher US bond yields and a stronger dollar.

Impact of falling rupee

• Negative impact
  • Impact on inflation management
    • The most crucial impact would be on inflation as the country imports nearly 80% of its crude oil needs.
    • This would mean that imports would become costlier and travel through the value chain to raise input costs.
  • Impact on current account deficit
    • Since a large proportion of India’s imports are dollar-denominated, these imports will get costlier.
    • 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.
• Positive impact
  • One positive impact could be that remittances from overseas could become attractive.
  • A fall in the rupee can also benefit India's exporters - unless they import raw materials, which would become more expensive.

Policy Recommendations for India

• Focus on the rupee’s effective exchange rate against a basket of currencies, not just the dollar.
• Avoid using interest rates to defend the rupee; adjust rates based on domestic inflation trends.
• Prioritize macroeconomic stability by addressing fiscal and current account deficits, adhering to inflation targets, and reinforcing confidence in India’s growth potential.