Critic Factors Fueling Devaluation:
- Capital Flight:
- Fall in foreign investments boosts the demand for foreign currencies.
- Higher Import Bill:
- The sharp hike in crude oil prices has worsened the current account deficit in India
- Change in RBI Policy:
- Shift to a managed-floating exchange rate system again allows rupee to drop.
- Structural Issues:
- An appreciating real exchange rate and increasing home prices erode export competitiveness in India.
Exchange Rate Regimes of India:
- The RBI intervenes by maintaining nominal exchange rate stability due to its foreign reserves under a fixed exchange rate.
- Floating exchange rate:
- Market-based and the RBI does not interfere.
- Managed-Float Exchange Rate:
- Preferable regime of India, whereby RBI balances exchange rate stability along with foreign exchange reserves.
Effects of Rupee Depreciation:
- Increases Exports:
- Depreciation reduces the price of Indian goods in the international market, thereby increasing export competitiveness.
- Increases Output:
- Increased demand for domestic goods may increase economic growth.
- Negative Impact:
- Higher domestic prices, reduced real incomes, and reduced export benefits.
Recent Structural Constraints:
- NEER and REER Divergence:
- Since 2019, India’s nominal effective exchange rate has depreciated, but real effective exchange rate has increased with domestic price inflation.
- Higher Markups:
- Non-financial firms increased markups that decrease the pass-through effect of depreciation to export competitiveness.
Policy Implications
- Exchange Rate Policy:
- Should India revert to the strategy of moderate depreciation pursued during the 2010s?
- Inflationary Cost Control:
- Cut the mark-ups as a cost control measure for controlling inflation and gaining competitiveness.
- Clarity of RBI Policy:
- Reversals of policies without adequate justification have eroded confidence.
