Should INR be allowed to depreciate

What is Currency depreciation

According to the online platform Investopedia “Currency depreciation is a fall in the value of a currency in terms of its exchange rate versus other currencies. Currency depreciation can occur due to factors such as economic fundamentals, interest rate differentials, political instability, or risk aversion among investors.”

It further says that “Countries with weak economic fundamentals, such as chronic current account deficits and high rates of inflation, generally have depreciating currencies. Currency depreciation, if orderly and gradual, improves a nation’s export competitiveness and may improve its trade deficit over time. But an abrupt and sizable currency depreciation may scare foreign investors.”

What causes Currency depreciation

Any depreciation in currency has big consequences for an economy more so in the context of a developing economy like India, as any major fluctuation may have a deep impact on health of the economy including balance of trade, inflation, investment climate etc. As far as INR is concerned, factors contributing to depreciation can be enumerated as under -

(a) Inflationary pressures in domestic economy prompt an increase in interest rates (or rather no reduction in interest rates if they are already high) as a tool to bring down consumption and consequently inflation. High local interest rates may lead to low investment or stagnation in economy, keeping INR stable. It may be worthwhile to mention that although INR nay behave differently with different currencies like Euro or British Pound or Japanese Yen but basic emphasis of discussion on depreciation revolves around USD/INR parity as major transactions in goods and services are conducted in USD. 

(b) Geopolitical conditions such as Russia – Ukraine war or Middle East crisis involving Israel / Hamas / Iran etc put pressure on crude oil prices. As crude is traded only in USD , an increase in demand for USD  has a negative impact on other currencies, more so on Indian currency as we are a high consumption/ net deficit oil importing country. Increase in crude oil prices leads to higher import bill and increased USD outflows putting pressure on INR. In 2024, Crude has been oscillating between a low of USD 69 per barrel to USD 81/ barrel, finally settling at USD 74.64 per barrel on 31st December.  

(c) Higher import bill also leads to widening of trade deficit, resulting in currency depreciation as more INR is required to pay for imports. It also turns into a vicious cycle.

(d) Another recent factor is inflow or outflow of foreign investments in equity markets, which tend to have an impact on USD /INR parity. Apart from the state of Chinese economy (a direct competitor to India for Foreign investments in some ways), the investment outflows were also guided by the state of US economy. As against widespread doomsday predictions of an eminent recession, surprisingly the US economy has fared quite well in 2024. 

INR depreciation – historical perspective  

Earliest available records show that in 1913, 1 USD was equivalent to INR 0.09. This changed gradually with Indian economy getting affected by World wars and Droughts and of course British loot, which saw parity drop to I USD=1 INR on 15th Augus 1947. Between 1959 and 1965, exchange rate was fixed at 1 USD= INR 4.76. In 1967 exchange rate dropped to INR 7.50 which continued till 1973. Rupee kept on weakening gradually till 1990 when the rate was INR 17.50 to a Dollar. In two major devaluation cycles, INR dropped to 22.74 in 1991 and further of 30.49 in 1993. Next major slippage of 13 % took place in 1998 which took INR to 41.26 to a Dollar. From 2002 onwards Rupee started appreciating with conversion rate moving from 48.61 to 43.51 in 2008. After brief period of stability, INR has been continuously depreciating against USD, 2010 onwards.

But in the recent past, say in 2024, INR has shown considerable resilience against USD. It depreciated by 3 % as compared to other world currencies which suffered a deeper cut  like Brazilian Real (21.5%), Korean Won  (12.4%), Mexico Peso (17.8 %), Japanese Yen (9.9 %), Australian Dollar (8.6 %), Euro (5.7 %) etc.

Impact of depreciation on Indian Economy 

In current international trade scenario, world economies are closely interlinked. Any major variations in exchange rates anywhere can have wider impact. More so, in case of US Dollar as major part of international trade is conducted in USD. Depreciation in INR vis-à-vis USD has profound impact on the health of Indian Economy.  It’s a complex equation which could be both beneficial for the economy (better realisation for exports) or harmful (increased cost of imports thus pushing inflationary trends). 

Exports - A weaker rupee means either better unit realization for exports or the exporters can become more competitive by offering goods and services at a lower USD price while maintaining their profit margins. This may also improve the market for Indian goods and services vis-à-vis other global competitors. This can also have a cascading effect by boosting domestic economy with better job opportunities. But at the same time, if the exporting units depend on imported raw materials, then the gains could be nullified as their production costs will go up simultaneously.

Imports- India always had an adverse trade balance ie. imports have outstripped exports. Economy remains heavily import dependant in several sectors eg crude oil, heavy machinery, electronics etc. Any steep depreciation in INR can make these imports costlier. This can have twin effects, either increase local cost of production and thus build up inflationary pressures in economy or in exporting units, the increased cost of production can make exports uncompetitive.

Domestic Inflation - Any marked INR depreciation increases costs in the economy which is import dependent and this either builds up inflation or adds to an existing inflationary situation. For the last couple of years, Indian economy is facing a high inflation rate due to various domestic factors and any major INR depreciation in this scenario, may only worsen the situation. This has been prompting RBI to manage USD/INR parity through various measures.

Balance of Payments  - INR depreciation reduces returns for foreign investors in terms of real currency (USD) value and therefore makes India an unattractive destination for further investments. This may decrease inflows of foreign currency as well as expedite outflows, widening current account deficit and put pressure on country’s forex reserves. To maintain USD/INR parity within acceptable levels, RBI offloads USD to defend and reduce pressure on INR, thus further depleting the reserves. Between September 2024 and December 2024, country’s forex reserves fell from an all-time high of USD 705 billion to USD 640 billion because a large part was used by RBI for preventing a faster depreciation of INR. Although on the flip side a weaker INR may give fillip to country’s exports and may boost forex earnings, adding to the country’s forex kitty.

Should INR be allowed to depreciate – Future outlook

From INR 83.19 to a Dollar as on 1st January 2024, the Rupee slipped to a level of 85.59 at year end on 27th December, 2024. The fall was more pronounced in the last 3 calendar months with breaching of 84 levels on 10th October and 85 levels on 10th December. On 5th January, 2025, INR was trading at 85.818 to a Dollar. INR had slipped a bit more sharply after the new RBI Governor has taken over.

In comparison, INR has not fared badly against other major world currencies. During the year 2024 it gained 9 % against Japanese Yen. INR was valued at  89.81 to a Euro on 1st January 2024, weakened to 93.75 on 27th August and then strengthened to 89.11 at year end on 27th December, 2024. (https://money.rediff.com)

Depreciation of INR vis-à-vis USD is very important as majority trade is conducted in USD, but a correct assessment should take into account USD’s parity with other world currencies as well. In case other currencies are weakening, a strong INR would not be beneficial as Indian economy would lose its competitiveness. 

To quote Madan Sabnavis, Chief Economist at Bank of Baroda  "China has introduced economic stimulus measures to counter the dollar's strength, allowing its currency to weaken and maintain its export competitiveness,(https://www.outlookbusiness.com).  He further says "With the Yuan weakening, India must let the rupee depreciate to remain competitive." 

Thus, INR depreciation is not as simple a mathematical exercise as it seems. Any sharp depreciation (above annual average of 5 %) may impact domestic production costs thus worsening inflationary trends in economy, which are already beyond satisfactory levels. But at the same time, keeping INR strong artificially ( as was done during the final 3-4 months of the earlier RBI Governor) may make the country’s exports uncompetitive and lead to stagnation in a very vast sector generating substantial employment and consumption behaviour. It may be specifically relevant in the face of China+1 initiative, wherein Chinese Yuan depreciates while INR remains stable, thus making Indian goods costlier in Dollar terms as compared to Chinese goods.

Thus, it may be inferred that although INR has depreciated a bit but it may still be overvalued against USD as compared to other world currencies. This situation may not continue for long as a Trump victory in US may make USD a safer bet then it has been till now, and may result in outflow of greenback to US economy. Future outlook for INR may depend on various other geo political factors as well like situation in Europe (Ukraine/Russia) and Middle East (Israel/ Iran) and handling of interest rates by US Fed.

In a report titled “US Presidential Election 2024: How Trump 2.0 Impacts India's and Global Economy”, (released in November 2024) State Bank of India, has opined that the rupee could further depreciate by 8-10 % against the US dollar with Trump's return to power. According to SBI, the rupee could have a brief spell of depreciation against the US dollar before strengthening again. The report discounted any fear of INR undergoing a sharp depreciation and estimated that INR would hover between 87-92 to a dollar.

Management of INR depreciation

We have discussed possible causes and impact of INR depreciation vis-à-vis USD. The moot point is, should RBI or Government allow INR to drift on its own and find its true value or manage the exchange equilibrium to serve various national objectives. In this context, let’s recall the RBI report of November 2024, where it pegged the Real effective exchange rate (REER) of INR at 108.14 (after adjusting nominal exchange rate for inflation). If the goal is to manage (as it is done), then following steps are generally taken by RBI towards this objective.

Interest rates - One of the most important and probably the most effective currency management tool employed world over by Central Banks, is to tinker with interest rates. By keeping interest rates high, the country looks like a better destination for investments, thus attracting USD inflows, keeping INR stable and depreciation under check.

Export promotion / Import substitution - Exports ensure continuous inflow of foreign currency and boost forex reserves. This stabilises INR and prevents any marked depreciation in exchange values. This is sought to be achieved by providing various incentives and subsides to boost exports. Similarly, Government had also initiated a major campaign “Make in India” to promote import substitution and preserve outflow of foreign currency, which helps in stabilising INR.

Foreign Investments on capital/current account - Government actively promotes foreign investment in local projects by simplifying and increasing transparency in policies. A major channel for forex inflow is investment by Foreign Institutional investors (FIIs) in equity markets. Though it works as a double edged sword, as seen in the past few weeks where heavy withdrawal by FIIs from Indian equity markets has put pressure on INR leading to its depreciation.

RBI’s intervention in Forex markets - As already discussed above, RBI regularly intervenes in forex market by selling dollars for controlling INR depreciation.  

Conclusion

So what does the future look like? Would we see a major depreciation in INR in 2025 or a small correction of 5-6 %. Honestly, there are no simple answers. The regulator ie. RBI has to strike a very fine balance so as to protect interests of both importers and exporters on one side and manage impact of depreciation / appreciation on domestic economy on the other side. Apart from the views of decision makers, a lot depends on emerging geo political situation. If other competing economies like China allow their currency to depreciate against USD, RBI will not have any option but to follow suit to maintain competitiveness of Indian goods and services. A lot may also depend on the policies of Trump government regarding imposition of massive 60 % tariffs on China and some other countries (as already threatened by him), which may force China to depreciate Yuan, having a ripple effect on INR.

Managing INR’s exchange rate is a very complex proposition which depends on interplay of Government’s economic policies, RBI’s inflation management, balance of trade, foreign investments guided by geopolitics etc. The policy makers have to build a model taking into account all these factors so as to insulate Indian economy from any adverse currency fluctuations and propel growth at the same time. In our minds, the million dollar question will always be – has the Rupee reached its realistic value? Probably nobody has any clear answer.