The weakening of the Indian rupee in recent months has brought it back into the spotlight. But is the depreciation of the indigenous currency a sign of bad or positive economic news?
In theory, every currency depreciation might have two opposing impacts on the domestic economy. The first is an inflationary effect caused by a rise in the cost of importable commodities. This can create headwinds for domestic growth by reducing buying power. The second consequence can be beneficial to the economy if currency depreciation makes exports cheaper in foreign markets and imports more expensive in local markets. This has the potential to increase net exports, creating tailwinds.
The first effect is caused by the nominal exchange rate, whereas the second is caused by the actual exchange rate. Which of the two impacts wins, in the end, relies on their relative strength. The three charts below demonstrate why the recent bout of rupee depreciation is bad news for the Indian economy.
The real and nominal values of the rupee are increasingly diverging. Since a country typically trades with multiple foreign partners, the relevant indicator for exchange rate analysis of the rupee is India’s weighted average bilateral exchange rates with respect to its trade partners. These are Nominal and Real Effective Exchange Rates (NEER and REER). NEER is the weighted average of bilateral nominal exchange rates of the home currency in terms of foreign currencies, whereas REER is defined as a weighted average of nominal exchange rates adjusted for relative price differential between the domestic and foreign countries.
One of the distinguishing features of the Indian economy since 2019 has been the growing divergence in NEER and REER. After moving in the same direction till the beginning of 2019, the real exchange rate registered appreciation despite a sharp depreciation in the nominal exchange rate. The real exchange rate has continued to remain above 100 ever since, indicating an overvaluation of the Indian currency.
One of the distinguishing features of the Indian economy since 2019 has been the growing divergence in NEER and REER.
The unusual fluctuation of India’s exchange rate
The gap in nominal and real currency rates differentiates India from the majority of developing countries. Chart 2 illustrates this by illustrating the fluctuations of 58 nations’ currency rates using data from the Bank of International Settlements (BIS). The horizontal and vertical axes measure the change in the trade-weighted indices of NEER and REER between April 2019 and June 2022, respectively. The positive change suggests appreciation, whereas the negative change suggests depreciation. Chart 2 is organized into four boxes or divisions based on how the nominal and real exchange rates fluctuate throughout a specific period.
Countries in Category 1 had nominal and real exchange rate appreciation. Countries in Category 2 experienced both nominal and real exchange rate declines. Countries in Category 3 had actual exchange rate appreciation despite nominal exchange rate decline. Countries in category 4 saw real exchange rate decline despite nominal exchange rate appreciation. The green spots represent developed countries. The blue dots represent the emerging countries in categories one, two, and four. The developing countries in category 3 are represented by the red dots.
What are the macroeconomic consequences?
The type of currency rate depreciation that India is currently experiencing has at least two ramifications. The first implication concerns how the Balance of Payments (BoP) responds in the face of capital outflow. Because a decline in the nominal exchange rate does not imply a decline in the actual exchange rate, the trade balance and current account do not improve through the exchange rate channel. By implication, capital outflows that cause a worsening in the capital account would result in the depletion of foreign exchange reserves (as the RBI has done) or a drop in imports due to a squeeze in production.
The second consequence is that the rupee’s devaluation has a negative impact on aggregate demand and GDP. While the depreciation of the rupee in nominal terms remains ineffectual in generating external demand, it has a negative impact on consumer demand by increasing the cost of imported products and putting upward pressure on pricing.
Given that the RBI’s policy rate rises are merely adding to the growth challenges, fiscal policy must focus more on the cause of safeguarding domestic growth and relieving structural constraints.
