An editorial in this paper, (IE, February 5, ‘RBI’s next move’) articulated the view that the RBI should let the value of the Indian rupee fall, intervening in the forex market only to prevent excess volatility, on the ground that the rupee is not exceptional in being under pressure. Rather, it is argued, the capital outflows that are the immediate cause of this pressure reflect a larger global phenomenon of capital seeking safer havens in uncertain times, which has led to a general strengthening of the US dollar. This is associated with actual and prospective actions of the Trump administration and the reactions they have or will evoke from other nations. The issue, however, is precisely what letting the rupee depreciate means, since the extent and speed of such depreciation are both variable and have a potentially self-accelerating nature.
The problem first arises from the simple fact that expectations about what will happen to the value of the rupee are themselves a factor in the decisions of foreign portfolio investors. A sharp and quick depreciation of the rupee means erosion of the value of foreign assets in India, and any expectation of such a movement of the rupee can be an additional factor triggering capital outflows. The result would be to create precisely the outcome whose expectation starts the process. Any actions of the RBI which signal that it will not intervene in the foreign exchange market to defend the rupee thus have the potential to generate such expectations. If and when this initiates capital outflows and accelerates the exchange rate depreciation, the scale of intervention required to check the process becomes greater, and also less effective. In letting the rupee decline, therefore, the RBI has to ensure that the tipping point is not crossed. Moreover, the interventions to moderate the decline of the rupee can also fuel adverse expectations, if they erode the foreign exchange reserves and the RBI’s ability to go on defending the rupee.
The difficulties and dilemmas that the RBI faces are the result of the conditions created since the 1990s, when the exchange rate became market-determined and India’s capital account was opened up in a larger global context of the increasing significance of volatile portfolio capital flows. These were different from FDI and even commercial bank lending, which previously dominated cross border capital flows because of their ability to enter as well as exit countries swiftly. Since that opening up, the value of the rupee in the foreign exchange market has fluctuated on the basis of the inflows and outflows of such capital. On the whole, however, barring a period of roughly five years preceding the 2008 global crisis, and a brief rebound from the post-crisis fall that ended in 2011, the long-term trend of the exchange rate of the Indian rupee has been one of a steady depreciation. If we consider the annual average value of the exchange rate expressed as rupees per USD, it has steadily increased (which means depreciation of the rupee) from 45.56 in 2010-11 to 82.78 in 2023-24, moving up in every year except 2017-18, a likely final outcome in 2024-25, too. In other words, the RBI’s defence of the Indian rupee has never meant that this trend of depreciation has been checked. Indeed, the monthly average of the Indian rupee’s value has also been steadily moving downward since September 2024.
The fundamental underlying factors behind the long-term trend are twofold. The first is that generally, inflation rates in India have been higher than those prevailing in international markets. Consequently, the purchasing power of the rupee in the domestic market depreciates faster than that of the dollar in international markets, also leading to a tendency for depreciation of the rupee vis-a-vis the dollar. Currency depreciation, by raising the prices of universal inputs like oil that India necessarily has to import, also in turn feeds into inflation.
The second is that year after year, our total foreign exchange earnings through exports of goods and services tend to be less than our expenditures for imports of the same — a gap that even large inflows of remittances from Indians working abroad cannot fill. Structurally, therefore, India is a foreign exchange deficit economy that depends on capital inflows from the rest of the world to cover that deficit and to accumulate foreign exchange reserves. The “market determination” of the exchange rate and the steady depreciation of the rupee have not succeeded in correcting this gap. Instead, the accumulation of foreign exchange reserves is dependent on capital flows in excess of that required to cover the current account deficit, and it is such reserves that RBI uses to intervene in the foreign exchange market to prevent large short-term fluctuations. The current account deficit, and the trade deficit underlying it, reflect the lack of competitiveness of Indian manufactured exports, which also means that India does not receive a significant amount of FDI of the kind that would generate such exports.
Thus, the eventual result of the liberalisation of capital flows has been that the Indian economy remains perpetually vulnerable to a currency crisis — a sudden and sharp depreciation of the currency — of the kind that has hit several countries in the last few decades. While India has escaped this fate so far, the risk of such a crisis has always revealed itself in the way in which the long-term trend of the Indian rupee’s depreciation has expressed itself. It has not been a steady decline but one marked by short periods of sharp and irreversible depreciation interspersed within periods of relative stability in the exchange rate. That the ever-present possibility has not turned into a reality is probably the only element of “success” that India’s exchange rate management can claim for itself.
The writer is professor of Economics, JNU
