Context

• The Indian rupee hit an all-time low against the U.S. dollar this week weakening past the 77 rupees to a dollar mark. Many analysts expect the rupee to weaken further in the coming months to hit the 80 rupees to a dollar mark. In fact, the International Monetary Fund expects the rupee to weaken past the 94 rupees to a dollar mark by FY29.

What is happening?

• The Indian rupee has been witnessing a steady decline this year, losing almost 4% against the U.S. dollar since the beginning of 2022. India’s forex reserves have also dropped below $600 billion, plunging by about $45 billion since September 3, 2021, when forex reserves stood at an all-time high of $642 billion.
• The drop in India’s forex reserves is believed to be largely due to steps taken by the Reserve Bank of India to support the rupee. RBI officials, however, have noted that the drop in forex reserves is due to a fall in the dollar value of assets held as reserves by the RBI. For instance, if a portion of the reserves are in euros and the euro depreciates against the dollar, this would cause a drop in the value of forex reserves.
• The aim of the RBI’s policy is to allow the rupee to find its natural value in the market but without undue volatility or causing unnecessary panic among investors. State-run banks are usually instructed by the RBI to sell dollars in order to offer some support to the rupee. By thus selling dollars in the open market in exchange for rupees, the RBI can improve demand for the rupee and cushion its fall.

What determines the rupee’s value?

• The value of any currency is determined by demand for the currency as well as its supply. When the supply of a currency increases, its value drops. On the other hand, when the demand for a currency increases, its value rises. In the wider economy, central banks determine the supply of currencies, while the demand for currencies depends on the amount of goods and services produced in the economy.
• In the forex market, the supply of rupees is determined by the demand for imports and various foreign assets. So, if there is high demand to import oil, it can lead to an increase in the supply of rupees in the forex market and cause the rupee’s value to drop. The demand for rupees in the forex market, on the other hand, depends on foreign demand for Indian exports and other domestic assets.
• So, for instance, when there is great enthusiasm among foreign investors to invest in India, it can lead to an increase in the supply of dollars in the forex market which in turn causes the rupee’s value to rise against the dollar.

What’s causing the rupee to lose value against the dollar?

• Since March this year, the U.S. Federal Reserve has been raising its benchmark interest rate causing investors seeking higher returns to pull capital away from emerging markets such as India and back into the United States.
• This, in turn, has put pressure on emerging market currencies which have depreciated significantly against the U.S. dollar so far this year.
• Moreover, India’s current account deficit, which measures among other things the gap between the value of imports and exports of goods and services, is expected to hit a 10-year high of 3.3% of gross domestic product in the current financial year.
• This means that India’s import demand amid rising global oil prices is likely to negatively affect the rupee unless foreign investors pour sufficient capital into the country to fund the deficit. But foreign investors are unlikely to plough capital into India when investment yields are rising in the U.S. Yields on U.S. 10-year Treasuries, for instance, have risen from around 0.5% in mid-2020 to over 3% earlier this month.
• The rupee, it should also be noted, has consistently lost value against the U.S. dollar for several decades now. A major reason for this has been the consistently higher domestic price inflation in India. Higher inflation in India suggests that the RBI has been creating rupees at a faster rate than the U.S. Federal Reserve has been creating dollars.
• So, while capital and trade flows gain a lot of attention in discussions on the rupee’s value, the difference in the rates at which the U.S. Federal Reserve and the RBI regulate the supply of their currencies may play a much larger role in determining the value of the rupee over the long run.

What lies ahead?

• Analysts believe that, over the long run, the rupee is likely to continue to depreciate against the dollar given the significant differences in long-run inflation between India and the U.S. At the moment, as the U.S. Federal Reserve raises rates to tackle historically high inflation in the country, other countries and emerging markets in particular will be forced to raise their own interest rates to avoid disruptive capital outflows and to protect their currencies.
• It should be noted that inflation in the U.S. hit a 40-year high of 8.5% in March. The RBI too has been trying to rein in domestic consumer price inflation, which hit a 95-month high of 7.8% in April, by raising rates and tightening liquidity. As interest rates rise across the globe, the threat of a global recession also rises as economies readjust to tighter monetary conditions.

Reference:

1. https://www.thehindu.com/business/Economy/explained-why-is-there-a-fall-in-indias-foreign-exchange-reserves/article65413473.ece