Relevance: GS Paper III (Economy)
Why has this cropped up?
The value of rupee has fallen precipitously against the dollar, and is now hovering around the 72 level; it was just under 64 at the beginning of the year.
Is only the Indian currency falling?
- The dollar has appreciated sharply against practically all other currencies too. For instance, it has moved up against both the euro and the pound.
- Countries such as Turkey and South Africa have experienced significantly higher rates of devaluation than India.
Main reason for fall of rupee
- External factors are the cause. In particular, global capital and perhaps currency speculators have been flocking to the American economy.
- This is not really surprising because the U.S. economy has become a very attractive option.
- Some months ago, U.S. President Donald Trump announced a massive decrease in corporate tax rates. More recently, the U.S. Federal Reserve has also increased interest rates.
- The icing on the global investors’ cake is the booming U.S. economy. and so provides a boost to exports by making them more competitive.
Is devaluation of rupee beneficial?
- A long time ago, the ‘standard’ or textbook prescription for countries with severe balance of payments deficits was to devalue their currencies.
- The underlying rationale was that devaluation decreases the price of exports in foreign countries and so provides a boost to exports by making them more competitive.
- Correspondingly, imports become more expensive in the domestic economy, in turn reducing the volume of imports.
- Unfortunately, this seemingly plausible reasoning does not always work. For instance, if several countries are devaluing at the same time — as it seems to be happening now — then none of these countries benefit from their exports being cheaper abroad
- In other words, there may not be any surge in Indian exports following the current round of devaluation. Neither will there be a huge fall in imports.
Corrective options
- Both the Central and State governments earn huge revenues from excise duties and value-added tax (VAT) on petrol and diesel. Now that the rupee cost of crude has shot through the roof, the Centre should certainly lower duties. Rates of VAT should also be lowered by State governments.
- The RBI could take the most direct route — of offloading large amounts of dollars. This would increase the supply of dollars and so check the appreciation of the dollar, but at the cost of decreased liquidity.
- The Central bank now has an explicit inflation target of 4%, a level that is almost certain to be breached if the rupee remains at its current level. This is very likely to induce the Monetary Policy Committee (MPC) of the RBI to raise interest rates again in order to dampen inflationary tendencies. But, the MPC must moderate any rate increase. Any sharp increase in interest rates can have an adverse effect on growth.
- Perhaps the best option for the government would be to borrow from non-resident Indians (NRIs) by floating special NRI bonds that have to be purchased with foreign exchange, and with maturity periods of at least three years.
Conclusion
Hopefully, the storm will pass over and the rupee will soon find an equilibrium. In the near future, the rupee is unlikely to return to anything below 70 to the dollar. This should not be cause for much concern because the economy will adjust to the lower value of the rupee. What must be avoided is any sharp fluctuation in the exchange rate — in either direction.
