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Why is the rupee in a free fall? (Relevant for GS Prelims, GS Mains Paper III; Economics)

What’s the matter with the rupee?

The rupee has witnessed a significant fall in its value over the last few months. The value of the rupee against the dollar has fallen by more than 5% since the beginning of 2018, and the fall has gained further momentum in the last few weeks. The currency now trades at its lowest in more than a year. The rupee, however, is not the only currency to face depreciation. Other emerging economies like Indonesia, Argentina, Mexico and Turkey have seen a fall in their currencies. So the rupee’s fall is part of a sell-off across emerging markets.

Why the slide?

The depreciation of a host of emerging market currencies, not just the rupee, suggests that there is a global factor at play. The U.S. Federal Reserve is expected to tighten its monetary policy stance further in the coming months and years by taking steps towards slowing down the growth in U.S. money supply. This is considered the most likely reason for the sell-off. A slowdown in U.S. money supply growth affects the value of other currencies in two ways. For one, interest rates in the U.S. will begin to rise as the Fed’s demand for various assets begins to drop. The yield on 10-year U.S. Treasury Bonds has already risen to 3% from around 2% last year, amid the Fed’s increasingly hawkish monetary stance. This causes a rush among investors to sell their assets in other parts of the world and invest the money in the U.S., where they could earn higher returns. The consequent flow of capital from the emerging markets to the U.S. increases selling pressure on emerging market currencies and buying pressure on the dollar. Secondly, as the Fed begins to tighten money supply, the availability of dollars in the global market is likely to turn scarce, compared to other currencies. Both these factors affect the price at which traders, who try to speculate on future retail demand, are willing to buy the dollar using other currencies.

What does it mean for India?

The fall in the value of the rupee means that buyers are now having to shell out more rupees to purchase dollars. The fall in the nominal value of a currency in itself does not suggest that its holders are worse off. If the real value of the dollars bought with the currency were to increase sufficiently, their effective purchasing power would still be intact. In the present case, however, the depreciation of the rupee is due to a fundamental change in investor attitude to the rupee for the worse. So it reflects a fall in the rupee’s real purchasing power. Further, as far as the depreciation of the rupee or other emerging market currencies was previously unexpected, it could affect the expected returns of people who invest across borders. A stronger dollar will work to the favour of those who invested in the U.S., adversely affecting the returns of investors who were bullish on emerging markets.

What can be done?

One major factor determining a currency’s exchange rate is its relative scarcity vis-à-vis other currencies. Since central banks are the sole suppliers of national currencies, they can influence the value of their currencies by appropriately regulating their supply. Another factor that determines a currency’s exchange rate is the benchmark interest rate, which can be used as a tool to directly attract capital into the country and prop up the value of its currency. The Reserve Bank of India can affect both the money supply and domestic interest rates simultaneously through its monetary policy stance. Yet another common way to prop up a currency is through the direct intervention of the central bank in the forex market.

 (Adapted from The Hindu)

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