20 February 2025 : Indian Express Editorial Analysis

1. RBI’s rupee challenge

(Source – Indian Express, Section – The Ideas Page – Page No. – 13)

Analysis of the news:

The RBI’s Dilemma on Rupee Depreciation

• It was earlier indicated that the Reserve Bank of India (RBI) should allow the Indian rupee to depreciate, intervening only to curb extreme volatility.
• The rationale behind this perspective is rooted in the global trend of capital outflows from emerging markets to safer assets like the US dollar.
• This shift is linked to policy uncertainties triggered by the Trump administration, which has led to a general strengthening of the dollar.
• However, the key question remains: how much depreciation is manageable, considering the unpredictable and potentially self-reinforcing nature of currency devaluation?

The Role of Investor Expectations in Rupee Depreciation

• One of the central challenges for the RBI is the influence of investor expectations.
• Foreign portfolio investors (FPIs) react not only to actual depreciation but also to anticipated future declines.
• A sharp depreciation reduces the value of foreign investments in India, prompting further capital outflows.
• This self-fulfilling cycle means that if the RBI signals a hands-off approach, it could unintentionally trigger the very crisis it seeks to avoid.
• Consequently, while permitting some depreciation may be necessary, the RBI must carefully manage market perceptions to prevent a runaway decline that could require massive — and potentially ineffective — interventions later.

The Risk of Depleting Foreign Exchange Reserves

• The RBI’s interventions to stabilize the rupee, if perceived as insufficient or unsustainable, could also backfire.
• Excessive intervention depletes foreign exchange reserves, reducing the RBI’s capacity to defend the currency in future crises.
• This vulnerability could exacerbate negative investor sentiment, accelerating capital flight.
• The RBI thus faces a balancing act: it must prevent rapid depreciation without exhausting its reserves, ensuring that its actions do not inadvertently erode confidence in the rupee’s long-term stability.

Historical Context: Market-Determined Exchange Rates and Capital Flow Liberalization

• The current challenges are rooted in policy decisions made during the 1990s when India adopted a market-determined exchange rate and liberalized its capital account.
• Unlike foreign direct investment (FDI), which is relatively stable, portfolio capital flows are volatile, capable of entering and exiting markets swiftly.
• Since liberalization, the rupee’s value has been largely driven by these flows, resulting in a long-term depreciation trend.
• For instance, the annual average rupee-dollar exchange rate rose from 45.56 in 2010-11 to 82.78 in 2023-24, indicating persistent depreciation despite RBI interventions.
• This steady decline reflects structural issues that cannot be fully addressed through exchange rate management alone.

Structural Causes of Long-Term Rupee Depreciation

1. Higher Inflation Rates

• A primary factor behind the rupee’s depreciation is India’s relatively higher inflation compared to global markets.
• Higher domestic inflation reduces the purchasing power of the rupee, necessitating a corresponding depreciation against stable currencies like the US dollar.
• Additionally, as currency depreciation raises the cost of essential imports such as oil, it further fuels domestic inflation, creating a vicious cycle.

2. Persistent Trade and Current Account Deficits

• India consistently runs trade and current account deficits, with foreign exchange earnings from exports falling short of import expenditures.
• Although remittances from Indians abroad help narrow this gap, they are insufficient to eliminate it.
• As a result, India remains dependent on capital inflows to cover its foreign exchange shortfall and build reserves.
• The structural trade deficit also highlights the lack of competitiveness in Indian manufacturing, limiting FDI inflows that could bolster exports and stabilize the rupee.

Vulnerability to Currency Crises

• The liberalization of capital flows has left India perpetually exposed to potential currency crises.
• Although India has avoided such crises so far, the pattern of rupee depreciation has been punctuated by short, sharp declines rather than a smooth, gradual fall.
• These episodes of abrupt depreciation underline the inherent risks in India’s exchange rate regime.
• The fact that a full-blown currency crisis has not materialized is perhaps the only testament to the partial success of India’s exchange rate management.

Conclusion:

• The RBI’s approach to managing the rupee’s value requires navigating a complex landscape of global capital flows, domestic inflationary pressures, and persistent trade deficits.
• While gradual depreciation may be inevitable given structural factors, the central bank must avoid triggering a crisis of confidence among investors.
• The RBI’s ability to strike a balance between allowing market forces to play out and intervening judiciously to prevent panic will determine the stability of the Indian rupee in the years to come.