Rupee Depreciation and the Risk of a Currency Crisis

GS 3 – ECONOMY

 

Context: India’s economic framework exposes the rupee to long-term depreciation and the possibility of currency crises.

Rupee Depreciation

• Rupee depreciation refers to the decline in the rupee’s value relative to the US dollar, meaning the rupee weakens and holds less purchasing power against the dollar.
• Over the past six months, the rupee has fallen by 4%, crossing ₹86 per USD, mainly due to foreign investors pulling out of Indian markets.

The RBI’s Role

• The Reserve Bank of India (RBI) steps into the foreign exchange market to manage extreme fluctuations and stabilize the rupee. It does so by using its foreign exchange reserves to buy or sell dollars, balancing supply and demand.
• However, the RBI faces the challenge of maintaining currency stability without depleting its reserves or creating negative market expectations. Although it has controlled excessive volatility, it hasn’t been able to stop the rupee’s long-term downward trend.
• The rupee’s value has consistently declined, dropping from ₹45.56 per USD in 2010-11 to ₹86.95 per USD as of February 2025.

Effects of Rupee Depreciation

• Higher Import Costs: A weaker rupee increases the cost of imports, raising prices for goods and services and contributing to inflation.
• Impact on Exports: While a depreciated rupee can make Indian goods cheaper and more attractive in global markets, India’s heavy reliance on importing commodities like crude oil limits these benefits.
• Foreign Debt Burden: A falling rupee makes repaying foreign loans costlier, increasing the financial strain on the country.
• Costs of Foreign Travel and Education: Traveling abroad and pursuing education in foreign countries becomes more expensive for Indian citizens.

Understanding Currency Crises

• A currency crisis happens when a currency experiences a rapid and severe depreciation, often sparked by significant capital flight.
• Although India has managed to avoid such a crisis so far, underlying structural and policy challenges keep the risk alive.

Why India Is Prone to Currency Crises

• Market-Driven Exchange Rate: India’s floating exchange rate makes the rupee sensitive to global market dynamics and volatility.
• Chronic Inflation Differentials: Consistently higher inflation in India compared to global levels reduces the rupee’s purchasing power over time, leading to depreciation.
• Current Account Deficit (CAD): A continuous trade deficit, where imports exceed exports, makes India dependent on foreign capital inflows to stabilize its currency.
• Unstable Capital Flows: Global economic uncertainties, interest rate hikes in developed countries, and changing investor sentiment can result in sudden capital outflows from India.

Way forward

• Expanding Export Base: Diversifying exports can increase foreign exchange earnings and help narrow the trade deficit.
• Boosting Self-Reliance: Reducing dependence on essential imports, especially in critical sectors, can help insulate the economy.
• Enhancing Forex Reserves: Building stronger foreign exchange reserves can act as a cushion against global shocks and enhance investor confidence.
• Sound Fiscal Policies: Effective fiscal management can help control inflation and support long-term currency stability.

Mains Question:

“Discuss the underlying factors contributing to the persistent depreciation of the Indian rupee and analyze the potential risks of a currency crisis in India. Suggest policy measures to strengthen the rupee and safeguard the economy from external shocks.”