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Picture Courtesy: https://www.policycircle.org/economy/economic-implications-of-rupees-fall/

Context:

The rupee hit a new low against the dollar, falling to 84.38 per dollar. 

About Stability of Rupee

The stability of the rupee means the stability of the exchange rate, which is defined as the value of rupee against the major foreign currencies. 

The exchange rate governs how goods, services, and capital flow between countries. High fluctuation in the exchange rate can create financial stress in a country as it affects the balance of payment and trading relations, which in turn also affect the domestic economic structure. 

If India is to become a high-income economy, the exchange rate must respond freely to market forces, sending proper signals to market participants about supply and demand.

Reason for the recent fall of the rupee against the US dollar

Rising Geopolitical Tension

The recent decline in the rupee value is mainly due to an increase in crude oil prices (West Asia crisis), which has raised India's import costs; increasing the demand for dollars. 

Capital outflow

Foreign Institutional Investors (FIIs) recently sold their Indian shares of value Rs 4,329.79 crore, which resulted in a net outflow of foreign capital from India. Many foreign institutional investors (FIIs) are diverting their investments to China, where the government has announced attractive financial incentives.

Structural Weaknesses

Domestic structural economic weaknesses include a large current account deficit, which is mainly caused by high dependence on imports of energy and critical materials. Despite efforts such as the 'Make in India' initiative, reliance on imports in sectors such as electronics, machinery, and chemicals has not decreased significantly, bringing pressure on the rupee.

Effect of weakening rupee 

The weakening rupee will increase fiscal stress, which can force the government to increase subsidies for imported energy and fertilizers to reduce the burden on citizens, this will increase the overall budget deficit, and limit growth potential.

As the rupee falls, industries that depend on imported inputs, such as electronics, automobiles, and pharmaceuticals, will face higher production costs, which will reduce their profit margins, and may result in higher consumer prices or production cuts, this situation will increase inflation and unemployment.

The falling rupee increases the cost of foreign borrowing for Indian businesses. As the rupee falls, interest rates on foreign currency loans rise, resulting in higher EMIs on existing loans and making it more difficult for businesses to access new credit. This could slow capital expenditure (capex) growth and halt infrastructure projects.

How RBI responded to the rupee's depreciation and what are the consequences?

The Reserve Bank of India (RBI) interrupted the currency market; selling dollars to protect the rupee from depreciation. 

The RBI's ability to intervene on a regular basis is limited, and using foreign exchange reserves to support the currency could indicate a lack of fiscal resilience in the Indian economy, that will affect investors' confidence and impact the overall business environment.

The RBI's intervention violates basic economic principles; in a free market economy, the government should not determine the price of goods, services, or assets. Instead, the market should set the price by supply and demand.

Way Forward

To address the rupee's depreciation, economists propose policy measures aimed at increasing exports, reducing oil dependency, and improving domestic production in important sectors. These measures would help to reduce the structural trade imbalance and strengthen the rupee in the long run.

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RUPEE IN THE LAST 10 YEARS

Source: 

Indian Express