Devaluation of the Indian Rupee: Causes and Implications

The Indian rupee recently experienced a significant devaluation against the US dollar after a period of stability. This phenomenon can be attributed to several factors, including India's exchange rate policy and structural constraints in the economy.

Exchange Rate Basics

• Nominal Exchange Rate: The cost of buying one unit of foreign currency in domestic currency.
• Real Exchange Rate: The relative price of foreign goods in terms of domestic currency compared to domestic goods.

Factors Affecting Exchange Rates

• The demand and supply in the foreign exchange market depend on current and capital account flows.
• Increased demand for foreign currency occurs with lower net exports and higher capital outflow.
• Central bank policies influence exchange rate frameworks: fixed, floating, and managed-floating.

India's Exchange Rate Policy

• India has largely followed a managed-floating exchange rate regime over the past three decades.
• In this regime, the RBI devalues domestic currency and adjusts foreign exchange reserves based on market conditions.
• During excess supply conditions, the RBI accumulated reserves to avoid real exchange rate appreciation and loss of export competitiveness.

Recent Developments

• Post-COVID, the RBI briefly adopted a regime resembling a fixed exchange rate.
• Currently, due to capital outflows and high crude oil prices, the rupee's devaluation reflects a return to the managed-float system.

Macroeconomic Implications of Devaluation

• Positive Implication: Enhanced net exports due to cheaper domestic goods.
• Adverse Implication: Increased domestic prices from higher firm costs, affecting real income and affecting consumers.

Challenges in the Indian Economy

• Since 2019, a divergence emerged between nominal and real exchange rates in India.
• This contrasts with global trends, where most countries experienced aligned nominal and real exchange rate movements.

Domestic Price Increase

• Increased domestic prices in India are linked to rising markups of non-financial firms.
• Markup increases lead to higher prices, affecting variable costs and the nominal exchange rate.

Policy Considerations

• The RBI's shifting policy stance post-COVID raises questions about the need for a clear exchange rate strategy.
• There is a need for a systematic approach to address exchange rate policy challenges.

The discussion highlights the complexities of India's exchange rate management and poses critical questions about future policy direction. The need for a clear and explicit exchange rate policy framework is emphasized to address ongoing economic challenges.