19 Dec

Exchange Rates and its Implications

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Content

• Why does depreciation take place?
• Why the recent depreciation in rupee?
• Negative Impacts
• Positives of declining rupee

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Why does depreciation take place?

• Core Reason – Demand supply gap of foreign currency (US$)
  • Increasing Current Account Deficit (More imports, less exports).
  • Monetary and Interest rate hikes by the US Fed
    • This makes US treasury investment more attractive and leads to FII’s moving funds from emerging economies back to US.
• Other traditional factors affecting India’s exchange rates
  • • Mounting External Debt
    • Tightening global liquidity
• Further, since India is an emerging market, inflation rate here would be higher when compared to developed countries and there will be a long term depreciation.

Why the recent depreciation in rupee?

• Since March 2022, the US Federal Reserve has been raising its benchmark interest rate causing investors seeking higher returns to pull capital away from emerging markets such as India andback into the USA. This puts pressure on emerging market economies.
• India’s Current Account Deficit is expected to hit a 10-year high of 3.3% of GDP in the current financial year.
• Consistently high domestic inflation

Negative Impacts

1. Decline in forex reserves

2. Negatively impacts Current Account Deficit -> Vicious Cycle

3. Pulling out of Foreign Portfolio Investments

4. Inflation: Increased prices of imported products

• Further, increases the cost of crude oil import.

5. Negatively impacts business’ taking loans from abroad

• With banks already not willing to lend because of increasing NPAs depreciating rupee makes it difficult for business’ to borrow from abroad.

6. Difficulty in financing external debt

7. Increase in RBI’s monetary policy rates

• Thus impacting economic growth negatively

8. Challenges for students studying or wanting to study abroad

Positives of declining rupee

• Depreciation helps in increasing exports as exports become cheaper for importing foreign country.
  • Therefore, some sectors like IT, Pharma, hospitality can actually benefit from
    depreciating rupee.
  • This may help in chipping away of trade deficit imbalance.
  • Tourism and hospitality sector may get a boost
  • Remittances tend to increase during the depreciating phase

Sectoral Impact

1. Export based industry would benefit.

• Depreciation acts as booster for IT and Pharma sector which are export based. Further hospitality sectors such as tourism, hotel etc can benefit as foreign tourists would now
  find in cheaper to visit India.

2. Problems for Oil Marketing Companies

• Rise in crude oi prices and depreciation of rupee is a double jeopardy for oil marketing companies. The lack of pricing power during major elections further exacerbate the problems for OMCs.

3. Auto sector

• Companies having high export shares will benefit from this depreciation.
• On the other hand, operating procedure margins of vehicle manufacturers such as Maruti Suzuki which import most of their components and focus on domestic market are
  going to face problems.

4. Aviation sector will be hit

• Increasing cost of Crude oil (thus Aviation Turbine Fuel)
• The big capacity additions on the anvil will also face problems.

Conclusion

• Most of the reasons for depreciation in rupee are not due to development internal to India and thus the problem is not India specific.
• Further, though a depreciating rupee may be beneficial for a few sectors, but it doesn’t bode well for the country’s macro-economic stability, unless export growth increases.
• In long run, India should focus on decreasing its energy dependency, expanding its manufacturing sector to reduce current account deficit, and to make India less vulnerable to these external factors.
• We will need to remove policy barriers that are impeding the growth of export oriented sectors.

And finally, there is a need of reform in the monetary policy framework of RBI to reduce the continuous inflationary pressure on rupee