Is the declining rupee a crisis or an opportunity?

Source: The post is based on the article “Is the declining rupee a crisis or an opportunity?” published in The Hindu on 5^th August 2022.

Syllabus: GS 3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.

Relevance: To understand the challenges with Rupee depreciation.

News: The declining rupee has several consequences. The rupee’s steep slide to the 79-to-a-dollar range is bound to impact importers, widen the current account deficit (CAD) and increase India’s external debt burden.

Why India will not reap the benefits of the declining rupee?

1) Despite depreciation in the nominal exchange rate, the real exchange rate has not really depreciated in recent times. This means domestic prices are rising faster than international prices. But, this matters for questions of trade balance and exports, 2) In the last two-three decades, the sensitivity of exports has been weak as far as changes in the real exchange rate are concerned, 3) The depreciation is concerning because it adds to the inflationary pressure and squeezes the purchasing power of those whose incomes are not linked to the crisis.

What are the long-term impacts of rupee depreciation?

1) Forex reserves has now fallen sharply as the import bill remains high and forex resources have depleted. The expectation of depletion of the reserves combined with currency depreciation can lead to instability, 2) Companies that have ECBs (external commercial borrowing) will face some squeeze in the balance sheets, 3) The relationship between output and inflation rate termed the Phillips Curve, has been flat and the inflation rate changes for reasons other than demand factors, 4) So far, the policy measure has been exclusively dependent on monetary policy. Higher interest rates or higher repo rates have an adverse impact on output, which affects GDP growth, 5) Fiscal policy targets a specific level of debt to GDP ratio, i.e., it targets debt stability, and the job of the monetary policy is to target the output gap and thereby control inflation. Fiscal policy needs to play a role in helping boost demand, but that is not exactly consistent with the present policy framework.

What India should do to limit the impacts of rupee depreciation?

a) India needs to find out whether India has adequate flows on the capital side to bridge the CAD, b) The RBI has to sell dollars in the spot market to contain the depreciation, c) To avoid the East Asian experience in the mid-1990s, the RBI must watch the import cover of forex reserves; The consequent impact on the rupee liquidity is another factor the RBI needs to watch, d) The government need to increase corporate tax in some form, to finance additional government expenditures, particularly in compensating labour’s income, e) India should also rethink fiscal policy rules and must review to what extent rules are relevant and useful in the current context, f) The government’s outstanding debt is large and increases in interest rates will raise the interest bill. Correcting the government’s fiscal imbalances will improve the overall macro atmosphere and offer a positive signal to the external world and provide comfort to investors.