Money is a very important part of our lives. And, when we look at the international level, the value of our currency ‘Rupee’ also holds a very significant place. Now, for the past many days, and months actually, the rupee has been falling continuously in value against the dollar. It has almost touched 80. If we look at the numbers, the rupee has fallen down 26 times since the start of the Russia-Ukraine war. So, why is it actually happening? How does the whole Rupee and Dollar mechanism work? And, what repercussions or effects it might have on the future course. Today, I will try to answer all these questions in this blog. And, for better understanding, I will also explain a few economic concepts, to better understand the whole issue.

Also Read: My Blog on the Union Budget 2022

Why only the Dollar is an International Currency?

After World War II, the world was trying to fix up the whole mess, both strategically as well as financially. In that process, institutions like World Bank and International Monetary Fund were set up. At this point, the need was felt that there should be a stable benchmark, against which the whole world can fix its currency. Since the US held the most gold reserves at that time, the dollar was quite stable, and the US too was a big developed country, it was agreed upon that all currencies will peg (set up the exchange rate) their currencies to the dollar.

Pic: Dollar and the Exchange Rate 

The System of Different Exchange Rates

Now, it’s not that there is just one type of exchange rate system. So, we need to understand what are the various types of exchange rate systems in the world:

1. Fixed Exchange Rate: In this system, a country fixes its currency at a certain value of the dollar (say $1=20). Now, as soon as the currency gets above or below 20, the central bank will intervene and do the adjustments. If the value had become greater than 20, then the central bank will devalue its own currency and bring the value down to 20. And, if the value dipped below 20, then the central bank will strengthen its currency to again bring it back to 20. So, as the name suggests, here the country wants to keep the currency ‘Fixed’.
2. Flexible Exchange Rate: The main issue with the Fixed exchange rate is that to do the necessary adjustments, the central bank must be having the capacity to print the currency and sell/purchase the dollar. It is not that easy for all countries, especially, developing and poor ones to do manage. That’s why some countries let their currencies ‘float’ naturally. Even if the currency becomes 30, or 10 or stays at 20, they allow it to happen naturally through the market factors. But, the issue with this system is that, there are chances of extreme volatility and shocks in the economy. That’s why there is a third method, which is the MOST preferred one.
3. Managed Floating Exchange Rate: This is the most widely used and accepted method in the world, even INDIA follows this system only. Here, the central fixes a limit up to which it can bear the fluctuations. For example, the central bank can bear if the exchange rate goes to 15 or comes to 25. But, beyond that, if there is any further fluctuation. The central bank will intervene and fix the exchange rate. So, it’s quite clear that it is a perfect mix of both the above systems. And, here the country gets better room to manage its currency amidst all the fluctuations.

Now, here there is a fact that I must make clear. People often confuse Depreciation and Devaluation and often use them in the same sense.  See, when a currency’s value gets down due to market conditions, it is called Depreciation. And, when a government deliberately lowers the value of its currency, it is called Devaluation.

Pic: Economic Recession due to the Russia-Ukraine war

The Effect of Change in FED Interest Rate

Actually, for countering the pandemic, the US printed Dollars, quite heavily. It was very assured that since it’s a global currency, it will not get blown. But, that didn’t turn out to be the case, as inflation spiralled out badly (9.1% currently) and the US is failing to control that. So, to manage, the US is continuously increasing its federal interest rates (the central bank in the US is called Federal Reserve System). Now, analyse this carefully, since the interest rates are higher now in the US as compared to India and many other countries. Many investors across the globe would like to invest their money in the US, as they will be getting a higher interest rate on their money. So, many investors are actually pulling out their money from other countries, including India and investing it in the US. Now, they are doing this whole thing in dollars So, the dollar is very much in demand currently. Because of this, the value of the dollar is increasing, which will automatically lower the value of all currencies that are pegged to it. Because of this very reason, the value of the rupee is also falling.

India’s Widening Trade Deficit

Since the start of the Russia-Ukraine war, the prices of many important goods have been skyrocketing. This has led to rising inflation across the world, including in India. Other than this, India’s trade deficit has got widened. While, India’s exports did rose by around 23%, but at the same time, imports too jumped by 58%. So overall, it took the trade deficit to a record high of $26.18 billion. Also, a widening trade deficit further puts pressure on the currency. As the demand for costlier exports rises in comparison to the cheaper exports, the demand for the dollar further increases. So, in a way, it creates a vicious cycle. Now, a weaker rupee means that imports become costlier and exports become cheaper. Also, the Exporters account for 18.7% of India’s GDP. So, the rupee weakening should actually be good news for exporters. But, unfortunately, due to strained global demand across the world after the pandemic, even Indian exports are not picking up much.

Also Read: My Blog decoding India’s Foreign Policy under the Modi Government

The Role of the FOREX Reserves

If we look at India’s trade composition, almost half of India’s imports comprise crude, coal, fertilizers and gold. These are such important goods, whose demand will anyway stay firm, despite all the price fluctuations. That’s what has happened in India all this price rise has also risen India’s import bill drastically. Now, normally to counter such a situation, RBI tries to keep a decent stock of Forex Reserves (A reserve of US dollars). What happens, is that, if the value of dollars rises too much, RBI will sell some of the dollars and take some Indian Rupee out from the market. This will increase the value of the Rupee (since it has gotten lesser in magnitude) and decrease the value of the Dollar (since it has increased in magnitude). But, now en route to countering the falling rupee, even the reserves have started dwindling. The reserves that had reached $642 billion in October last year, have now come down to $573 billion.

A Look at the Other Currencies

Now, when we are looking at the situation of the Rupee internationally, it becomes important that we also take a look at other foreign currencies. Since the start of the Russia-Ukraine war, Indian Rupee has depreciated by 6.6%. But, during this very same period, the British Pound depreciated by 12.2%, the Euro by 10.4% and the South Korean Won by 9.3%. Also, the Chinese Yuan has fallen by around 6.3% (almost the same as ours). Surprisingly, the currency which was expected to have performed the worst has come out as biggest the gainer. Despite all the sanctions and boycotts, the Russian Rubel has appreciated by a whopping 23%. So, two things are very clear here. Firstly, the strategy West adopted has completely backfired on them. Secondly, the fall in Indian Rupee is not that big when we compare it internationally.

Pic: Rupee falling against Dollar

Expect the Rupee to fall Further

Now, overall we looked at how the whole Dollar-Rupee is determined. And, due to the continuous hikes in the Fed interest rates, the value of the dollar is increasing. This has led to a significant depreciation in currencies across the world, including the Rupee. Also, it has widened India’s trade deficit bill as well, because imports have got expensive and exports haven’t picked up. Finally, the situation has also started taking its toll on India’s Forex Reserves. Although the reserves are still substantial enough to defend against volatility, but the future doesn’t look any less uncertain.

It is not the first time, that the Rupee has shown such a bad performance. During the 2008 Recession, Rupee depreciated close to 20%. Also, it depreciated by more than 6% in 2013.  It was then only, that our prime minister (then chief minister) gave an ‘Epic’ statement. So, big learning from this episode is that one should first educate oneself before making foolish statements. Anyways, the challenge is immense and the road ahead is not at all easy. We can just hope that the vicious cycle is managed properly and India’s potential growth doesn’t get too hampered.

JAI HIND