The Indian rupee recently experienced significant devaluation against the US dollar after maintaining stability for over two years.
The article explores:
Factors behind this phenomenon.
Implications of rupee devaluation.
India's exchange rate policy and structural constraints in the economy.
Exchange Rate Regimes
Definitions
Nominal Exchange Rate:
Price of one unit of foreign currency in terms of domestic currency.
Influenced by foreign exchange market demand-supply conditions and central bank policies.
Real Exchange Rate:
Relative price of foreign goods in terms of domestic goods.
Indicates the competitiveness of domestic goods against foreign goods.
Market Influences
Demand for foreign currency rises if:
Net current account and capital account flows decrease.
Supply of foreign currency rises if:
Net current account and capital account flows increase.
Influencing factors:
Current Account: Affected by net exports.
Capital Account: Affected by foreign investment flows.
Exchange Rate Policy Frameworks
Fixed Exchange Rate:
Central bank sells/buys foreign reserves to maintain a fixed rate.
Floating Exchange Rate:
Exchange rate changes freely based on market demand-supply.
Central bank does not intervene.
Managed-Floating Exchange Rate:
Central bank intervenes to stabilize the exchange rate using a mix of reserve sales and currency devaluation/appreciation.
India's Exchange Rate Policies
India follows a managed-float exchange rate regime:
Simultaneously uses reserve sales and nominal rate adjustments.
Focuses on preventing excessive real exchange rate appreciation to maintain export competitiveness.
Post-COVID Policy Shift:
Between 2022–2024, India adopted a fixed exchange rate-like approach, selling reserves to stabilize the rupee.
Recent sharp devaluation signals a return to the managed-float policy due to rising capital outflows and higher import costs.
Implications of Rupee Devaluation
Positive Impact: Net Exports
Nominal depreciation can boost net exports if:
Net exports respond positively to real exchange rate changes.
Real exchange rate depreciates alongside nominal rate depreciation.
Adverse Impact: Rising Domestic Prices
Nominal depreciation increases:
Cost of imported raw materials for firms.
Domestic prices as firms pass on higher costs to consumers.
Rising domestic prices negate benefits of nominal depreciation on real exchange rates.
Recent Constraints
Divergence Between Nominal and Real Exchange Rates:
Post-2019, real exchange rates appreciated despite nominal depreciation.
Caused by domestic price rises counteracting nominal exchange rate benefits.
Markup Trends:
Increased markups by firms (higher prices relative to costs) amplified domestic price rises.
Markup reversal since the mid-2010s contributed to inflationary pressures.
Global Context
India’s unique position:
Most countries saw nominal and real exchange rates moving in the same direction.
India experienced real appreciation despite nominal depreciation (Category 2 in global comparison).
Policy Questions
Challenges for the Reserve Bank of India (RBI):
Balancing inflation control with exchange rate stability.
Addressing divergence between nominal and real exchange rates.
Key questions for future policy:
Should India revert to the 2010s strategy?
Does India need a new explicit exchange rate framework?
What objectives should the exchange rate policy prioritize?
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