Why in the News?

In the last week of December 2024, the rupee dropped below 85 against the U.S. dollar, hitting a new low of 85.81. The rupee fell by about 3% in 2024, continuing its long-term decline against the dollar.

What has caused the currency to depreciate? 

• Exit of Foreign Investors: A significant driver of the rupee’s depreciation has been the exit of foreign portfolio investors (FPIs) from Indian markets. In 2024, FPIs pulled out substantial amounts from equities, leading to increased selling pressure on the rupee.
• Widening Trade Deficit: India’s trade deficit has widened due to high imports, particularly of crude oil and gold, compared to its exports. This increased demand for foreign currencies (like the U.S. dollar) to pay for these imports has contributed to the rupee’s weakening.
• Monetary Policy Differences: The Reserve Bank of India’s relatively looser monetary policy compared to the U.S. Federal Reserve has resulted in higher inflation rates in India. This inflation differential makes Indian assets less attractive to foreign investors, further reducing demand for the rupee.
• Global Economic Factors: Geopolitical tensions, such as the Russia-Ukraine war and rising global crude oil prices, have created volatility in the markets, leading to capital outflows from emerging markets like India.
  • The other reason is that the strengthening U.S. dollar amid higher U.S. bond yields has made investments in the U.S. more attractive compared to India.

What could be the impact of Rupee depreciation?

• Increased Import Costs: A weaker rupee raises the cost of imports, particularly for essential goods such as crude oil, fertilizers, and edible oils. This increase in import bills can lead to a higher overall trade deficit, which reached an all-time high of $37.8 billion in November 2024, exacerbating economic vulnerabilities.
• Inflationary Pressures: The rising costs of imported goods contribute to inflation, making everyday goods more expensive for consumers. This can lead to higher living costs and reduced purchasing power, as seen with the increased prices of food and fuel due to higher import expenses.
• Impact on Economic Growth: The combination of rising inflation and increased costs can dampen economic growth. Higher import bills can create upward pressure on interest rates, making borrowing more expensive and potentially slowing down investment and consumption.

Why made the central bank to intervene?

• Stabilizing Currency Value: The Reserve Bank of India (RBI) intervened in the forex market to stabilize the rupee and prevent excessive volatility that could disrupt economic stability. By selling dollars from its reserves, the RBI aimed to support the rupee’s value against the dollar.
• Preventing Inflationary Pressures: A depreciating rupee increases the cost of imports, particularly essential commodities like crude oil, which can exacerbate inflation domestically. The RBI’s intervention seeks to mitigate these inflationary pressures by maintaining a more stable exchange rate.
• Maintaining Investor Confidence: By actively managing the currency’s value, the RBI aims to instill confidence among investors regarding India’s economic stability and attractiveness as an investment destination. This is crucial for sustaining foreign investment inflows and supporting economic growth.

Way forward: 

• Diversify Export Markets and Reduce Dependence on Imports: India should focus on enhancing its exports to non-traditional markets while exploring alternatives to reduce dependence on high-cost imports, especially crude oil and gold.
• Monetary Policy Coordination and Strengthening Fundamentals: The RBI should work towards aligning its monetary policy with global trends while ensuring domestic inflation remains under control.

Mains PYQ:

Q How would the recent phenomena of protectionism and currency manipulations in world trade affect macroeconomic stability of India?  (UPSC IAS/2018)

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