Let It Slide, Let it Slide

The Indian Rupee's Historic Slide: Why the RBI Should Let It Fall Further

The Indian rupee recently crossed the psychologically significant level of ?84 against the US dollar for the first time in history, marking a new low for the currency. This milestone has reignited debates about India's exchange rate policy and the appropriate role of the Reserve Bank of India (RBI) in managing the rupee's value. While a weakening currency often sparks concerns, there are compelling reasons why the RBI should consider allowing further depreciation rather than aggressively intervening to prop up the rupee. This post will examine the factors behind the rupee's recent slide and make the case for a more flexible exchange rate policy going forward.

Understanding the Rupee's Recent Depreciation

To grasp why the rupee has fallen to record lows, we need to examine both domestic and global economic factors:

Global Factors

1. US Dollar Strength: The US Federal Reserve's aggressive interest rate hikes to combat inflation have made the dollar more attractive to investors seeking higher yields. This has led to broad dollar strength against most major currencies[1].

2. Risk Aversion: Geopolitical tensions and fears of a global economic slowdown have driven investors towards safe-haven assets like the US dollar[1].

3. Oil Prices: Rising crude oil prices increase India's import bill and put pressure on the rupee, as India imports over 80% of its oil needs[5].

Domestic Factors

1. Foreign Investment Outflows: Foreign investors have been net sellers of Indian equities in recent months, withdrawing capital and creating dollar demand[7].

2. Trade Deficit: India's widening trade deficit, particularly due to higher oil and commodity prices, has increased dollar demand from importers[5].

3. Inflation Concerns: While India's inflation has moderated, it remains above the RBI's target range, potentially deterring some foreign investors[4].

Historical Perspective on Rupee Depreciation

To put the current situation in context, it's useful to examine how the rupee has fared against the dollar over the decades:

| Year | USD/INR Exchange Rate |

| 1947 | 3.30 |

| 1966 | 7.50 |

| 1991 | 22.74 |

| 2000 | 44.94 |

| 2010 | 45.73 |

| 2020 | 76.38 |

| 2024 | 84+ |

This data reveals a clear long-term trend of depreciation, punctuated by periods of more rapid decline during economic crises or major policy shifts[3][8].

The Case for Allowing Further Rupee Depreciation

While a weakening currency can be politically sensitive, there are several compelling economic arguments for why the RBI should consider allowing further controlled depreciation of the rupee:

1. Boost Export Competitiveness

A weaker rupee makes Indian exports more competitive in global markets. This can help boost export-oriented industries, create jobs, and improve the trade balance over time. Historical data shows that periods of rupee depreciation have often coincided with improved export performance[6].

2. Attract Foreign Investment in Manufacturing

As global companies seek to diversify supply chains away from China, a more competitive exchange rate could make India a more attractive destination for foreign direct investment in manufacturing. This aligns with the government's "Make in India" initiative and could accelerate India's integration into global value chains.

3. Preserve Foreign Exchange Reserves

Aggressively defending the rupee through market intervention depletes India's foreign exchange reserves. While India's reserves remain substantial at over $600 billion, preserving this buffer is crucial for maintaining investor confidence and managing external shocks[5].

4. Allow Economic Adjustment

A flexible exchange rate acts as a shock absorber for the economy, helping to adjust to changing global conditions. By allowing the rupee to depreciate, the RBI can avoid more painful internal adjustments like higher interest rates or reduced government spending.

5. Reflect Economic Fundamentals

India's long-term trend of higher inflation compared to developed economies naturally leads to currency depreciation over time. Allowing this process to occur gradually can prevent the build-up of exchange rate misalignments that could lead to more disruptive adjustments later.

6. Encourage Import Substitution

A weaker rupee makes imports more expensive, which can incentivize domestic production of goods that were previously imported. This can support the development of local industries and reduce external dependence over time.

Historical Precedents and Lessons

India's economic history offers valuable lessons on exchange rate management:

The 1991 Crisis and Reforms

In 1991, facing a severe balance of payments crisis, India was forced to sharply devalue the rupee and implement wide-ranging economic reforms. While initially painful, this adjustment set the stage for higher growth and increased integration with the global economy in subsequent years[8].

Managed Float Since 1993

Since adopting a managed float regime in 1993, India has generally allowed gradual depreciation of the rupee while intervening to smooth excessive volatility. This approach has served India well, providing flexibility while avoiding extreme currency swings[8].

2013 Taper Tantrum

During the 2013 "taper tantrum," when the rupee faced severe pressure, the RBI implemented various measures to stabilize the currency. While successful in the short term, some argue that allowing more depreciation could have led to faster external adjustment[6].

Potential Risks and Mitigating Factors

While there are strong arguments for allowing further rupee depreciation, it's important to acknowledge potential risks and how they can be mitigated:

Imported Inflation

A weaker rupee can lead to higher inflation through costlier imports. However, this risk is somewhat mitigated by the current global environment of moderating commodity prices. Additionally, the RBI has tools to manage inflation through monetary policy if needed.

External Debt Servicing Costs

Depreciation increases the cost of servicing foreign currency-denominated debt. However, India's external debt profile has improved in recent years, with a higher proportion of long-term debt and foreign exchange reserves providing adequate cover[5].

Investor Sentiment

Sharp currency depreciation can sometimes trigger negative investor sentiment. However, communicating a clear policy framework and demonstrating commitment to overall macroeconomic stability can help maintain investor confidence even in the face of currency weakness.

Policy Recommendations

Based on the analysis above, here are some policy recommendations for the RBI and government:

1. Gradual Approach: Allow for continued gradual depreciation of the rupee, intervening only to smooth extreme volatility rather than targeting a specific exchange rate level.

2. Clear Communication: Clearly articulate the benefits of a more competitive exchange rate for the economy and how it aligns with broader economic goals.

3. Structural Reforms: Complement exchange rate flexibility with continued structural reforms to improve India's competitiveness and attractiveness to foreign investors.

4. Export Promotion: Implement targeted measures to support export-oriented industries and help them capitalize on the more competitive exchange rate.

5. Domestic Manufacturing: Accelerate efforts to boost domestic manufacturing capabilities, reducing import dependence over time.

6. Hedging Awareness: Encourage greater awareness and use of currency hedging tools among businesses to manage exchange rate risks.

Conclusion

The Indian rupee's depreciation beyond ?84 against the US dollar marks a significant milestone, but it should not be viewed with alarm. Instead, it presents an opportunity for India to enhance its global competitiveness and accelerate economic transformation. By allowing for further controlled depreciation, the RBI can support export growth, attract foreign investment in manufacturing, and facilitate necessary economic adjustments.

Historical evidence and economic theory suggest that a flexible exchange rate policy, combined with sound macroeconomic management and structural reforms, can contribute to long-term economic growth and stability. While there are risks to manage, the potential benefits of a more competitive rupee outweigh the costs.

As India aspires to become a $5 trillion economy and increase its global economic influence, embracing a more market-determined exchange rate could be a key enabler of these ambitions. The RBI's role should evolve towards managing volatility rather than defending specific levels, allowing the rupee to play its natural role as a shock absorber and facilitator of economic adjustment.

In the words of former RBI Governor Raghuram Rajan, "The exchange rate is a price. It is not a policy instrument." By heeding this wisdom and allowing the rupee to find its appropriate level, India can position itself for sustained economic growth and increased global competitiveness in the years ahead.

Sources

[1] RBI expected to step up intervention if the rupee touches 84 level https://www.business-standard.com/finance/news/rbi-expected-to-step-up-intervention-if-the-rupee-touches-84-level-124080900094_1.html

[2] USD to INR Forecast for 2024-2025 | BookMyForex.com https://www.bookmyforex.com/currency-converter/usd-to-inr/forecast/

[3] 1 USD in INR in 1947 to 2024 - Track Historical Exchange Rate https://www.bankbazaar.com/currency-exchange/historical-value-of-1-usd-in-inr.html

[4] India Interest Rate - Trading Economics https://tradingeconomics.com/india/interest-rate

[5] Interventions In Forex Market To Curb Volatility: RBI To IMF https://www.outlookbusiness.com/news/interventions-in-forex-market-to-curb-volatility-rbi-to-imf

[6] RBI wages losing battle to stem rupee slide against dollar https://www.policycircle.org/economy/rupee-slide-against-dollar/

[7] Rupee Falls Below 84-Mark for the First Time in History: Why is Indian Currency Declining Vis-a-Vis Dollar? https://www.news18.com/business/economy/rupee-declines-below-84-vs-dollar-for-the-first-time-in-history-why-is-indian-currency-falling-9083002.html

[8] 1 USD to INR in 1947 till now, Historical Exchange Rates Explained https://www.bookmyforex.com/blog/1-usd-inr-1947-till-now/

[9] Understanding the Role of RBI in India's Foreign Exchange Market https://www.moneyhop.co/blog/role-of-rbi-in-indias-foreign-exchange/

[10] Rupee depreciation shows cracks in economy https://www.newindianexpress.com/editorials/2024/Aug/18/rupee-depreciation-shows-cracks-in-economy

[11] 1 USD to INR in 1947 to 2024 - Insight to History of Rupee & Dollar ... https://www.thomascook.in/blog/our-services-forex/1-usd-to-inr-from-1947-to-2024/

Crossposted on Substack and LinkedIN. These are my personal views and should not be construed as professional advice or views of my current employer.