Strengthening of Rupee | 11 May 2024

Source: IE

Why in News?

The Indian Rupee depreciated by around 27.6% against the US dollar in the last 10 years.

• The currency has gained real value when considering its exchange rate against major global currencies.

How is the Decadal Journey of the Indian Rupee?

• The rupee fell from Rs 44.37 to Rs 60.34 (26.5%) from 2004 to 2014 against the US dollar.
• The rupee has further depreciated from Rs 60.34 to Rs 83.38 (27.6%) against the US dollar in the last between 2014 to 2024.
  • Appreciation and depreciation of currency refer to changes in the value of a currency relative to other currencies in the foreign exchange market.

• Between 2004 and 2024, rupee declined by 32.2% (from 133.77 to 90.76) as per 40-currency basket NEER and 40.2%, (from 139.77 to 83.65) as per 6-currency basket NEER and during the same period.
  • The rupee’s average exchange rate against the US dollar dropped by 45.7%, from Rs 44.9 to Rs 82.8.
  • Therefore, between 2004 and 2024, the rupee has undergone a smaller depreciation against the currencies of India's major trading partners compared to its depreciation solely against the US dollar.
• Also rupee’s trade-weighted REER for both 40-currency and 6-currency basket has increased in the last 20 years indicating that Rupee strengthened between 2004-05 and 2023-24.
  • Rupee has strengthened in real terms over time, while ruling at 100 or above most of the time in the last 10 years.

What is an Exchange Rate?

• About:
  • An exchange rate is the rate at which one currency can be exchanged for another currency. It represents the value of one currency in terms of another currency.
  • Exchange rates are typically expressed as the amount of one currency needed to purchase one unit of another currency.
• Types:
  • Fixed Exchange Rate: Governments or central banks set the value of their currency in relation to other currencies and maintain that value by buying or selling their own currency in foreign exchange markets.
  • Floating Exchange Rate: Value of a currency is determined by the forex market based on supply and demand. Most major currencies operate under this system.
  • Managed Float: A mix of fixed and floating exchange rates where governments intervene occasionally to stabilise their currency's value.
• Factors Affecting Exchange Rates:
  • Interest Rates: Higher interest rates in a country tend to attract foreign investment, increasing demand for that country's currency and strengthening its exchange rate.
  • Inflation: If inflation is higher in a country compared to its trading partners, its currency weakens as its purchasing power decreases.
  • Economic Growth: A strong and growing economy fosters confidence in a country's currency, leading to a stronger exchange rate.
  • Political Stability: Political instability can deter foreign investment and weaken a country's currency.
  • Supply and Demand: The fundamental principle of supply and demand plays a major role. If more people want to buy a particular currency (higher demand), its exchange rate strengthens.

What is Effective Exchange Rate (EER)?

• About:
  • The Effective Exchange Rate (EER) of a currency is a weighted average of its exchange rates against other currencies, adjusted for inflation and trade competitiveness.
  • The currency weights are derived from the share of the individual countries to India’s total foreign trade.
• Effect on Strength of a Currency:
  • Strength or Weakness of a Currency depends on the Exchange rate of that currency with the currency of all trading Partners.
  • For India, The strength or weakness of the Rupee is, hence, a function of its exchange rate with not just the US dollar, but also with other global currencies.
    • In this case, it would be against a basket of currencies of the country’s most important trading partners, termed as the rupee’s “Effective Exchange Rate” or EER.
• Types of Effective Exchange Rate(EER):
  • Nominal Effective Exchange Rate (NEER): NEER is a simple average of bilateral exchange rates between the domestic currency and the currencies of major trading partners, weighted by the respective trade shares.
    • NEER measures the overall strength or weakness of a currency relative to a basket of other currencies without adjusting for inflation.
    • The NEER indices are with reference to a base value of 100 and base rear as 2015-16.
    • The Reserve Bank of India has constructed NEER indices of the rupee against a 2 different baskets of Currencies:
      • 6 Currency Basket: It is a trade-weighted average rate at which the rupee is exchangeable with a basic currency basket, comprising the US dollar, the euro, the Chinese yuan, the British pound, the Japanese yen and the Hong Kong dollar.
      • 40 currencies Basket: It covers a bigger basket of 40 currencies of countries that account for about 88% of India’s annual trade flows.
• Real Effective Exchange Rate (REER):
  • REER adjusts NEER for differences in inflation rates between the domestic economy and its trading partners. It reflects changes in the relative price levels of goods and services.
  • REER provides a more accurate measure of a currency's trade competitiveness by accounting for changes in price levels.
  • REER is calculated by dividing NEER by a price deflator (such as Consumer Price Index) for the domestic economy and multiplying by 100.

What are the Implications of Currency Depreciation on the Indian Economy?

• Positive Impacts:
  • Boosts Exports: Indian exports become cheaper for foreign buyers, potentially increasing demand and boosting export earnings.
  • Inward Remittances: A weaker rupee will enable workers abroad to send more rupees back home when they convert their foreign currency earnings.
    • This can increase disposable income in India.
• Negative Impacts:
  • Higher Import Costs: Imported goods, including essential items like oil and machinery, become more expensive.
    • This can lead to inflationary pressures, where the general price level of goods and services rises, impacting the common man's purchasing power.
  • Costlier Foreign Debt: If India has borrowed money in foreign currencies, a weaker rupee means it has to pay back more rupees to settle the debt.
    • This can strain the government's finances.
  • Discourages Foreign Investment: A depreciating rupee can be seen as a sign of economic instability, potentially discouraging foreign investors from investing in India.

Devaluation and Depreciation of Currency