Rupee depreciation cannot be halted without increasing merchandise exports

The Finance Minister’s (FM) recent comment that “the Rupee has not depreciated but the US Dollar has strengthened” implies that the fundamentals that determine the value of the Rupee are strong and the strength of the Dollar is dictated by external factors. While the Rupee has depreciated by around 10% over the past 5-6 months, breaking through the 83 Rupees mark against the US Dollar on October 19, the FM’s statement highlights the dominating influence of external factors on which we have little control. Furthermore, the assertion that the depreciation of the rupee was much less than that of other currencies – euro, pound, yen, yuan – is yet another way of reassuring on the solidity of our fundamentals.

The growing interest in fundamentals is due to the fact that they determine macroeconomic objectives such as inflation, interest rates, growth/production rate and therefore policy choices. The Reserve Bank of India’s (RBI) interest rate balancing and exchange rate management are indicators of this focus on fundamentals.

Fluctuations in the exchange rate caused an increase in inflation, due to which RBI’s inflation target was not met. Unsurprisingly, the 190 basis point rise in interest rates since May 2022 has raised several questions regarding the need for monetary policy to support growth.

Is this rise in interest rates aimed at stemming the net capital outflows caused by the fall in the interest rate differential between the United States and India? Or is it to correct the domestic inflation rate in order to make exports competitive? In any case, it is an attempt to manage exchange rate fluctuations, using foreign exchange reserves to stem the depreciation of the rupee. The question that arises is: what are the fundamentals that determine the value of the rupee?

Technically, the stability of a currency’s exchange rate is determined by the country’s trade flows of goods and services. In the case of India, while exports drive the demand for rupees, imports play a role in determining the supply of rupees. When exports are less than imports, the supply of rupees exceeds the demand for rupees, causing the exchange rate to depreciate, and vice versa.

Moreover, exports are affected by the real exchange rate (inflation-adjusted exchange rate) while imports are influenced by the nominal exchange rate. Thus, trade and current account imbalances, as well as domestic inflation, together drive exchange rate fluctuations. On the capital account, which is debt-based (i.e. inflows are borrowings and outflows are foreign investments), currency appreciation will attract net inflows while depreciation will result in net outflows. Together they determine foreign exchange reserves under the administered exchange rate regime.

To put it simply, when net capital inflows exceed the current account deficit (CAD), foreign exchange reserves increase.

Reports say that the RBI intervened by selling $19 billion last month to stabilize fluctuations in the rupee exchange rate. It has also been argued that the 190 basis point rise in interest rates since May 2022 was aimed at reducing bond yield spreads between the United States and India, themselves triggered by the 275 basis point hike. interest rate basis by the United States.

The need to bridge the interest rate differential is primarily to stem outflows from FIIs (Foreign Institutional Investors), which could aggravate the Indian Rupee’s slide.

These interventions are apparently justified by the exogenous factors – high crude prices, food inflation following the Russian-Ukrainian war and interest rate hikes by the United States – which have also affected other major currencies, the US dollar serving as a reserve currency for international transactions. However, for India, this story takes a different turn when we look at the overall balance of payments situation, summarized in Table 1.


What the data suggests

There are three main takeaways from India’s balance of payments review. First, the CAD is determined by the large trade deficit because the net inflows of “Invisibles” (exports of services) have been canceled out by the large trade deficit in goods. Furthermore, exports falling short of imports of goods did not only occur in 2021-22 or the first quarter of 2022-23, but it did so in 2018-19 and 2011-12 as well. This trend highlights structural problems in merchandise trade where our exports have not been able to finance our imports. India’s development needs will require more imports, but we should be able to increase our exports to finance these increased imports.

This is currently not the case. This sluggish export trend needs to be corrected.

The second important point to remember is that the increase in net capital inflows, which is debt-based, needs to be looked at more closely. Foreign direct investment (FDI) inflows increased from $49 billion in 2011-2012 to $88.2 billion in 2021-22, indicating an improvement in economic activity. However, given the low level of exports, it would appear that FDI is focused on supplying the large domestic market. Moreover, the trend of net outflows of foreign institutional investment (FII) is evident from 2018-2019.

Therefore, extreme external conditions may not be the only reason for net FDI outflows. Finally, net commercial borrowings (medium and long term) remained high at $8.1 billion in 2021-22 and $10.3 billion in 2011-12. High commercial borrowing involves an outflow of interest payments (negative investment income) which is recorded in the current account. Negative investment income fell from -16.5 billion in 2011-12 to -40.6 billion in 2021-22. This shows how capital borrowing has had a negative effect on the current account balance.

An important implication of this trend is the need to increase FDI and thereby reduce our dependence on FII in the capital account. Additionally, this trend also underscores the need to reduce interest payments by reducing our dependence on commercial borrowing and paying down debt.

Domestic macroeconomic management and inflation control are equally important for exchange rate and overall balance of payments management. The upward trend in the real effective exchange rate (REER) against the notional effective exchange rate (NEER), as detailed in Table 2, indicates high domestic inflation leading to an overvaluation of the rupee. This would mean that Indian exports become expensive in foreign markets and hence, in order to correct this discrepancy, depreciation of the Rupee would have to be allowed, which will make imports costly.

The debatable question is whether a restrictive monetary policy, that is, an increase in interest rates, can bring about the necessary correction in inflation. Inducing a stronger supply response would be a possible solution in the medium to long term, given the high output gap (actual output being lower than potential output). Thus, the immediate short-term response would be to reduce inflation expectations. RBI’s current stance on inflation and exchange rate management is perhaps the best option in the given economic situation.

Table 2

Lessons to be learned


These turbulent external conditions provide lessons for India to adapt to and manage domestic economic conditions in the medium to long term. The priority, in my opinion, should be to increase exports. This involves developing a strategy for identifying and diversifying products and markets. Trade policy becomes essential as it projects a path for objectives and implementation. Niti Aayog’s recent State Export Performance Index report indicates a high concentration of exports from a few states. Decentralization of export activity, as in the case of district export hubs, requires strong political leadership.

It is also important to have a targeted industrial policy that aims to increase manufacturing value added (MVA). According to UNIDO data, India’s MVA per capita is $302 compared to $1,660 for Thailand, $857 for Indonesia, $620 for the Philippines, and $2,520 for Malaysia. These data indicate that India’s manufacturing value added is less than 25% of that of Thailand, Indonesia and Malaysia, with the difference being much higher for China and other developed countries.

UNIDO’s Industrial Production Competitiveness Index (CIP) assesses and compares industrial production in countries across various dimensions such as capacity to produce and export, technological upgrading and deepening, and global impact. India’s overall world ranking in the CIP is 39 in 2018, while China’s is 3. The score for “deepening and modernizing technology” is 12 for Thailand, 11 for the Philippines, 31 for Vietnam and 40 for India. export” is 46 for Thailand, 81 for the Philippines, 72 for Vietnam and 108 for India.

Therefore, developing competitiveness in the manufacturing sector is important for India to enhance its growth and exports. This is why a targeted industrial policy is necessary. Finally, a supportive monetary policy is necessary to successfully implement the aforementioned objectives of improving exports and targeted industrial policy. If these three lessons are designed and executed in parallel, India stands a good chance of achieving its growth objectives.

(The author is a professor at the Indian Institute of Foreign Trade)