At the time of independence of India, the dollar was at par with 3.30 INR; the exchange rate was 44.91 INR at the beginning of the century, and as of 18th November 2019, it is 72.62 INR. This shows that the rupee has depreciated enormously from the time of our independence, and recently the issue of depreciation has come under a lot of debate.
Depreciation means that the rupee is losing its value with respect to the dollar. Whether it is good for an economy or not is subject to discussion. Depreciation of a certain currency makes the exports of that particular nation cheaper in the international market, and this improves the balance of trade. On the other hand, individuals and institutions that have to make payments in a foreign currency have to pay more in terms of the domestic currency, thus making transactions like imports, remittances abroad, payment of loans abroad, international travel more expensive. The impact of depreciation depends on the current economic scenario of a country, and even minute changes in exchange rates can have far-reaching consequences.
Within a period of a month, the rupee jumped from ₹68.9 to the dollar at the end of July ‘19 to ₹72 by the end of August. The country has been put through a number of destabilizing crises in the past year, which have resulted in a sharp fall in the value of the rupee. Lagging domestic consumption demand in the face of the NBFC crisis and the resultant fall in GDP growth, equity outflows triggered by the imposition of a tax surcharge on the super-rich, and a nasty trade war have not created an environment conducive for maintaining a strong currency; moreover, the constantly changing policies of the government have only added to economic uncertainty.
It is pretty clear that the rupee has been following a downward trend for quite some time now, and it is unlikely to change in the face of adverse global circumstances. The obvious question is: Is depreciation of rupee good for the Indian economy? There are diverse views in this matter, and it is not possible to stick to one side in this discussion, but coming to a conclusion by weighing the positives and the negatives are the most prudent option.
The most direct effect of depreciation is on the trade balance of a country. The Marshall Lerner condition states that a currency depreciation can improve the trade balance, provided that the sum of the absolute values of export and import elasticities is greater than one. In simpler terms, depreciation leads to an increase in exports (and maybe a fall in imports), which is quite intuitive. India has a trade deficit of $11.01 billion (October 2019), less from the $18 billion of last year. Both exports and imports have contracted, in the face of a slowdown in global demand, and that has improved the deficit to some extent. On the face of it, depreciation can boost exports and further improve the trade deficit; but, it will also increase import prices.
Textbook economics argues that with the increase in import prices, domestic residents will reduce their demand for imported goods, and the volume effect will be greater than the price effect, in the long run, thus bringing the deficit down. But, oil imports account for over 25% of India’s imports, and this cannot fall unless oil sources are discovered within our domestic territory. The most worrisome aspect of rupee depreciation is, therefore, a rise in the import prices of oil, which has led to an overall increase in fuel prices in the country.
Oil being an Edgeworth complementary good, the rise in fuel prices is likely to permeate to various other sectors of the economy, and the retail price index would rise considerably too, leading to inflation. In its monetary policy report in April, the RBI estimated that for every 5% fall in rupee, retail inflation will increase by 20 basis points. Now, India’s retail inflation was 4.62% in October, rising above the RBI’s medium-run target of 4% for the first time since July 2018. The rising trend in inflation coupled with demand slowdown is detrimental to our already suffering economy. According to the theory of Relative Purchasing Power Parity, a difference in the inflation rates of two countries drives an equivalent difference in their exchange rates. Applying this concept to our discussion, the 2% difference in inflation between India and the US (US inflation rate is around 2% on an average) will drive up the exchange rate between the two and further run down the value of the rupee.
Depreciation does not encourage capital inflows from abroad. Foreign investors will not invest in a country where they might suffer capital losses due to the risk of that currency losing its value. FPIs have been moving out of India for the past year, due to tensions of a trade war, pessimist sentiments worldwide, and more recently due to the imposition of a tax surcharge on the super-rich (which has been repealed, but not before causing much harm to the net investments in the country). Amidst all problems facing the country, India cannot face the added burden of falling foreign investments. With huge capital outflows, the balance of payments situation will worsen further, and the country will face deeper troubles.
The Prime Minister announced his target of making India a $5 trillion economy by 2024, starting with a base of $2.7 trillion today. This target is highly ambitious, but probably not unachievable, provided certain conditions are fulfilled. In PPP (Purchasing Power Parity) terms, India has surpassed the $5 trillion mark twice over, but this target is in terms of nominal metrics.
Calculating GDP on a PPP basis means expressing the exchange rate in terms of a basket of goods, and not the prices of goods in each country; it neutralizes the effect of differences in living standards of nations. The PPP basis is a more useful measure, but it is not widely used because of the difficulty in gathering relevant information. GDP is calculated on a nominal basis, by equating prices of commodities in different nations at the prevailing exchange rates.
Now, at the current exchange rate, in order to reach the $5 trillion target, we should have annual real GDP growth of 7.5%. And in case the rupee depreciates, the benchmark for real growth will rise further. With growth rates falling this year, the goal seems too far-fetched; depreciation of the rupee can only render the government’s ambition futile.
Having weighed numerous factors, the odds definitely weigh against depreciation. The current scenario of lagging demand, pessimistic sentiments and the probability of a looming period of recession after the longest-running bullish phase further substantiate the need for a stable and strong currency. Although the rupee has fared much better than other emerging market currencies, it cannot override the fact that this is not the best time for the economy, and the government has to be extremely cautious in meting out new policies, and should carefully consider their consequences.