6 January 2023

Table of Contents

Why the Indian rupee fell 10% against the US dollar in 2022

GS-3: Indian Economy and issues relating to planning, mobilization, of resources, growth, development and employment.

The Indian rupee depreciated by around 10 per cent against the US dollar in 2022 on account of sharp appreciation of the greenback as the US Federal Reserve tightened its interest rate to check inflation amid the uncertainties surrounding the Russia-Ukraine conflict.

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Rupee exchange rate

• Rupee exchange rate means how many rupees are required to buy a US dollar.

• To buy (import) a US product or service, Indians need to first buy the dollars and then use those dollars to buy the product. 

• If the rupee’s exchange rate “falls”, it implies that buying American goods would become costlier.
• At the same time, Indian exporters may benefit because their goods now are more attractive (read cheaper) to the American customers.

How exchange rate is determined?

• In a free-market economy, the exchange rate is decided by the supply and demand for rupees and dollars.
• Imagine that in the beginning, one rupee was equal to one dollar. After a year, Indians demand more dollars in comparison to Americans demanding the rupee. In such a case, the exchange rate will “fall” or “weaken” for rupee and “rise” or “trengthen” for dollar.
• The rupee’s demand and supply vis-a-vis other currencies is determined by India’s balance of payment (BoP), is divided into two “accounts” — current and capital. 

Fluctuation in Rupee exchange rate

• Suppose, crude oil prices go up sharply.

• Since, India imports 80% of its oil, it would need more dollars to buy crude oil in the international market.
• Consequently, it would weaken the rupee because India’s demand for dollars would have gone up while the world’s demand for the rupee stayed the same.
• This would show up as a trade deficit as well as the current account deficit in the BoP table.

• Suppose, the US central bank raises its interest rates and looks set to raise them further in the future.

• The global investors pulled out money from the Indian market and started investing in the US market to take advantage of higher rates.
•  Again, the rupee would weaken and such a transaction would be recorded in the Capital Account.

Role of RBI

• If there was no RBI to intervene, then as money started flowing out of India on account of oil and US interest rates, the rupee’s exchange rate would have fallen and continued to do so until buying from India and investing here became attractive again. 
• Thus, to soften the rupee’s fall, the RBI would sell in the market some of the dollars it has in its forex reserves.
• This will soak up a lot of rupees from the market, thus moderating the demand-supply gap between rupee and dollars.
• Thus, RBI’s forex reserves have gone down sharply in 2022.

Impact of fall in exchange rate

• Imports will become more expensive 

• This will result into either decrease in imports or increase in Current Account Deficit.
• Due to increase in price of imported raw materials, finished goods become costly.
• Thus, it will lead to inflation, unemployment, poverty etc.
• On the other hand, it will benefit the domestic firms promoting “Aatmanibhar Bharat campaign”, by increased sales and job creation.

• Exports will be cheaper

• This will lead to more export from the country.
• Benefit the domestic firms especially related to export goods
• Increased export will improve the current account deficit and ultimately BoP.

Performance of Rupee in 2022

• The rupee fell to a lifetime low of 83.2 against the dollar.
• Compared to rupee, depreciation of other Asian currencies was to a lesser extent. 

• Chinese Yuan, Philippine Peso and Indonesian Rupiah fell around 9 per cent whereas South Korean Won and Malaysian Ringgit declined by nearly 7 per cent and 6 per cent, respectively.

• The RBI heavily intervened in the forex market to defend rupee which resulted into fall of the country’s foreign exchange reserves by $70 billion. 

Reason for capital outflow

• The US Fed aggressively raised interest rates by 425 basis point (bps) in 2022 to fight against inflation.
• This led to a higher interest rate differential between the US and India, and investors pulled out money from the Indian market and started investing in the US market to take advantage of higher rates, putting pressure on the rupee.

• In 2022, Foreign Portfolio Investors (FPIs) pulled out markets – the highest-ever yearly net outflow – Rs 1.34 lakh crore from the Indian. 

• Russian invasion of Ukraine accentuated the FPI withdrawals with the global economic slowdown making inflows tougher.

Why the Dollar is higher than the Indian Rupee?

• Dollarisation of currency: Many countries around the world recognize and use dollar as a medium of exchange or legal tender alongside or in place of its domestic currency.
• International Currency: In international trade when the nations carryout exchange of goods and services among themselves, Rupee lacks the general acceptability while Dollar, Gold, Special Drawing Rights (SRD) of International Monetary Fund (IMF)  and some other hard currencies like Euro, Japanese Yen, etc. are accepted by almost all countries as a medium of exchange. 
• Current Account Deficit: The export from a country determines the supply of dollar as they will receive dollar from international market for their sold goods and services. Similarly, the imports determine demand of dollar.

• Since, imports from India are higher than the exports, the demand of dollar will be higher than supply and the Rupee will depreciate against the dollar. 

• Movement of Capital:  Since, there is net foreign capital outflow in India in the form of FDI or FII, the supply of dollar will be much lower than demand and Rupee will depreciate against the dollar.
• International reserve currency: Thus, it overpowers most currencies across the world. 
• Strength of US economy vis a vis Indian economy: Thus, Dollar overpowers the Rupee.

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