The exchange rate will soon have to play a bigger adjustment role

Source– The post is based on the article “The exchange rate will soon have to play a bigger adjustment role” published in the mint on 19th October 2022.

Syllabus: GS3- Economy

Relevance– Balance of payment

News- The article explains the factors behind depreciation of currencies of major economies across the world. It also exp[lains the scenario of India.

The currency of most major economies has depreciated against the dollar in the past year. Only the currencies of Russia, Brazil, Mexico and Peru have appreciated.

What are factors behind the depreciation of currency across major economies?

It depends on four factors- (a) Structure of its trade (b) Its Current Account Deficit (c) Foreign exchange reserves (d) Extent of borrowing in international rather than domestic currencies.

(a) A lot depends upon whether a country is a net exporter or importer of commodities. Countries like Russia, Peru have benefited from high energy prices. While other countries who are net importers of commodities have experienced depreciation in their currencies. India falls in this group.

(b) Countries with current account surplus are not impacted by sudden withdrawal of foreign capital. India has a current account deficit right now.

(c) Countries with high foreign reserves need not be worried about balance of payment shocks due to sudden withdrawal of foreign capital. India has a higher amount of foreign reserves.

(d) Countries with public debt in local currency need not to be worried much. India has borrowed mostly from local investors.

What is the scenario with India? Two factors are in favour of India and two are against it.

India has responded to depreciating Rupee by purchasing foreign exchange reserves. It has preferred to allow the depreciation of Rupee rather than using too much foreign exchange reserves.

India foreign exchange reserves soared to $640 billion in September 2021. This situation has reversed now. It has lost $110 billion in foreign reserves.

India still has adequate foreign reserves. But fall in reserves means that the exchange rate will play a bigger role in the economy.

What are possible options for India?

Looking at imports bills in the future and BoP deficit, India will have to do a careful balancing act.

India has the option of using interest rates to defend Indian Rupee. But we have an inflation targeting regime where interest rates can be only used to manage inflation. ITargeting two policy goals is not ideal option