How to arrest the depreciation of Indian currency?
Depreciation of currency is a fall in the value of a domestic currency in terms of foreign currency due to market forces of demand and supply. Globally, currencies have weakened sharply against the Dollar. Depreciation of the local currency means exports become cheaper, which is favourable. However, imports have become more expensive.
Why is the Rupee Depreciating?
The value of the Rupee against the Dollar is decided on the market forces of demand and supply. The Rupee is losing value against the Dollar because of Capital outflows from India, leading to a rising trade deficit in which imports are expanding considerably more quickly than exports. The significant spike in crude oil prices, followed by the Ukrainian conflict, is mostly to blame for the surge in imports. The cost of imports has increased due to the rise in coal and other commodities, particularly raw materials. These imports will be more expensive due to a depreciating Rupee, which will have a short-term negative effect on domestic output and GDP as a whole.
What should RBI do to arrest rupee depreciation?
RBI's main objective is to fight against inflation in the economy, which automatically appreciates the Indian currency. The currency's depreciation affects both the volume and rupee price of exports and imports. Currency depreciation causes exports to rise and imports to fall, both of which have a positive impact on the trade balance, i.e., they reduce the trade deficit or enhance the trade surplus. As a result, exports are not likely to change in the short run. The rupee price of exports depends on the domestic price level, and, in the short run, the depreciation of the Rupee will have only a very small effect on the domestic price level.
The RBI raised the interest rate by 25bps and reached 6.50%, which will lead foreign investors to invest in the Indian market as they are getting more returns in the Indian market as compared to the foreign market. So, they will withdraw the investment from the foreign market and invest in India. Hence, FDI will increase, leading to the appreciation of the Indian currency.
According to the most recent data, the central bank regularly sold dollars, reducing the nation's foreign exchange reserves by selling dollars in exchange for the Indian Rupee in a foreign market which will increase the supply of the Dollar in a foreign market and reduce the supply of the Rupee. A reduction in supply leads to a rise in demand for Rupee. Hence, the Rupee will appreciate in the foreign market.
What should government do to arrest rupee depreciation?
The government will examine the requirement for mandatory hedging on infrastructure loans. The need for hedging will decrease demand for dollars.
Government should encourage Indian borrowers to issue bonds with the Rupee as the unit of currency to allow dollar inflow and reduce the risk of exchange rate swings for the economy by exempting tax on all such bonds.
Government should impose barriers on imports of non-essential items and boost domestic product exports, both of which would aid in reducing the current account deficit. So, these are some steps to arrest rupee depreciation.
Kautilya, IBS Mumbai.