Every decade, the rupee depreciates significantly. We wonder whether such corrections are a market response that is overdue or merely weather. Certainly, there are other factors at work. But the question is, how should we arrive at a fair value of the rupee? The answer depends on various factors, including inflation, the current account deficit, the capital flows, the interest rate differentials, and our economy’s productivity and growth prospects.
If this recent depreciation is simply business as usual, it may be fair to assume that the future path of the rupee-dollar exchange rate will follow its long-term trend of slow depreciation. However, if we believe other factors are at play that will cause the rupee to depreciate further, we need to understand what is going on.
The Government of India's (GoI’s) response in Parliament on 16 December indicates that the recent developments surrounding US-imposed tariffs have played a role in the rupee's depreciation. If this is correct, and if the geopolitical turmoil and disruptions in international trade that have occurred during the last year are likely to continue over the next year or two, then further depreciation of the rupee can be reasonably expected.
The Big Question
The question arises whether a continued depreciation of the rupee will be beneficial to the Indian economy. Since India faces multiple challenges in its export markets, combined with China's record trade surplus in 2025 and the increasing risks of retaliatory tariffs (such as from Mexico), we can expect the export competitiveness of Indian goods and services to be a key factor in retaining, if not growing, India's share of global exports.
In this context, a further depreciation of the rupee can be a helpful trend in restoring India's slackening export growth. However, as the government stated in parliament, such a depreciation of the rupee will lead to higher import costs.
Our view is that, in the current benign inflation environment, which is well below the RBI’s 2 to 6 per cent band (CPI inflation was reported at 0.7 per cent YoY in November 25), any inflationary pressure from higher import costs can be easily absorbed by Indian producers and consumers. Therefore, a depreciating rupee will be a welcome development for the Indian economy in the short to medium term, because it can promote exports.
A contrary view would be that a depreciating rupee is of little or no benefit to India because the economy’s export capacity is limited, and higher prices for imported fuels, fertilisers and consumer goods will hurt Indian consumers, including the poor. This argument rests on a decades-old ‘bottleneck’ view of constraints on India’s production capacity, driven by three factors: lack of technology, shortage of skilled workers, and financing constraints that limit investment and working capital.
None of these constraints is binding for a large number of sectors in India today, including manufacturing, construction, IT-enabled services, food and agriculture, healthcare, or tourism. The question is whether India can now convert its economic, financial and technological prowess into an export powerhouse.
Several economies have done this before. Japan, Taiwan, South Korea, Asean and China are all examples of export-led growth. When we examine the ‘four pillars of growth’ that enabled these Asian Tigers to catapult into middle-income or developed-economy status, we can see that it is neither too late nor inappropriate for India to follow their example. Today, India has established these four pillars: a stable and disciplined fiscal policy, a conservative monetary policy, free trade, and an open economy to investment and business.
In addition, we have come a long way in improving skills, building enterprises and investing in infrastructure, all critical factors for modern export-led growth. Now is the time to put all these enabling factors to work in an environment of a weaker currency that gives a fillip to India’s exports.
The Complexities
Market forces determine exchange rates, and attempts by governments to influence or manage foreign exchange markets have usually failed, causing disruption and adverse consequences for price inflation, investment, and trade. The recent attempt by the Argentinian government to peg its Peso to the US dollar is another example. In this scenario, should India attempt to create a national strategy for export-led growth based on a low exchange rate? If so, what should be the components and safeguards of such a Strategy?
Economists believe that although exchange rates can be volatile and vary widely in the short run, in the long run, the domestic rate of price inflation determines the exchange rate between any two countries. In other words, the real value of a currency or the Real Exchange Rate (REE), after adjusting for changes in the price level, should remain roughly the same in the long run.
However, in the short run, a currency may deviate significantly from its fundamental value due to several market factors, such as the current account deficit and net capital inflows. Expectations about fiscal policy (inflation), monetary policy (interest rates), tariffs, trade barriers, investment opportunities, and other factors can also influence exchange rates. The complexity arises because a single exchange rate has to work out the balance between supply and demand in two very different markets: the market for trade in goods and services and the market for capital flows.
Thus, most modern governments have adopted a hands-off approach to managing their currency’s exchange rate. Government intervention is often limited to three situations: ‘calming’ the spot market on days of high volatility by ‘leaning against the wind’; intervening in the forward market if the arbitrage between sovereign bond interest rates and forward exchange premia is not functioning (due to illiquidity or market disruptions); and ‘shoring up’ the domestic currency on days when it may depreciate excessively or suddenly.
Beyond these short-term considerations, it is difficult for a government or a central bank to influence the value of its currency, with notable exceptions such as China. The large trade surplus China has generated over the last 40 years, combined with its centralised control over foreign exchange holdings, has enabled it to amass substantial reserves, mainly US Treasury bonds and US financial assets. This large ‘sovereign wealth fund’ gives the Chinese government the leverage to manage the Yuan’s exchange rate. It has usually pegged the Yuan to the dollar at a rate that many economists estimate is well below its free-market value, thereby sustaining its export competitiveness and trade surplus.
Way Forward
In these circumstances, India’s exports face what we may call ‘unfair’ competition from Chinese exports, due to the consistent, long-term undervaluation of the Yuan. Can India remedy this situation on its own by consistently depreciating the rupee? The answer is yes, and in three ways. First, given market forces, if India imports more, the rupee will depreciate. The government can encourage higher imports by opening the economy to free trade, eliminating tariffs, and removing non-tariff barriers.
Second, more overseas investment by Indian entities will depreciate the rupee and also help build Indian assets overseas. A policy to encourage foreign direct investment by Indian entities across all sectors, such as minerals and infrastructure, will enhance employment, facilitate technology transfer, and support future repatriation of profits. It will also expand the basket of assets owned by Indians, thereby increasing returns for Indian savers.
Third, a strong push towards capital-intensive manufacturing and FDI in sectors like shipbuilding, aviation, hardware, electronics, and nuclear power will increase short-term imports of capital goods and enhance long-term economic growth. If the rupee can depreciate significantly over a decade, it will provide breathing space for Indian exports to compete and for the economy to become competitive, mature, and modern.
Also, we should leverage the current cycle of low petroleum product prices (Brent crude has been trading close to USD 60 per barrel, well below the USD 139 per barrel that it reached in March 2022). With petroleum products accounting for nearly one-third of our imports, such low prices significantly soften the impact of rupee depreciation on our import bill and inflation. Fortunately, the current low inflation of about 0.7 per cent means the economy has space to absorb some currency-driven cost pressures without destabilising effects.
We believe that, in a depreciating-rupee scenario, the strategy comprising the triad of an open economy, increased overseas investment, and a push for capital-intensive manufacturing will raise employment, wages, and investment, while also reducing inequality by boosting demand for labour and skills. The current period of high growth, low inflation, a depreciated rupee, and low oil prices should be used to advance the export-oriented reforms and overseas investment suggested above, repositioning India as a major supplier of goods and services. The question is, will we seize this opportunity?
Disclaimer: The views expressed in this article are those of the author and do not necessarily reflect the views of the publication. |
