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The Indian rupee has recently experienced sharp devaluation against the US dollar after a period of relative stability. This shift is attributed to several factors, including capital outflows, rising import costs, and RBI’s evolving policy stance.

Understanding Exchange Rate Regimes

Exchange rates are classified into:

• Fixed Exchange Rate: The central bank maintains a constant exchange rate by actively managing reserves.
• Floating Exchange Rate: Market-driven rates with minimal intervention.
• Managed-Floating Exchange Rate: A blend of market forces and central bank intervention.

India has largely pursued a managed-floating exchange rate regime. The RBI has historically responded to excess demand by depreciating the rupee while selling forex reserves and, under excess supply conditions, resisted rupee appreciation to maintain export competitiveness.

Post-COVID Exchange Rate Shift

Between 2022 and November 2024, the RBI temporarily adopted a strategy resembling a fixed exchange rate regime to stabilize the rupee. However, amid rising capital outflows and increased import costs, the RBI recently reverted to its managed-float approach, allowing the rupee to depreciate.

Causes of Rupee Depreciation

• Internal Factors:
  • Rising inflation reduced the rupee's real value and increased production costs.
  • A widening trade deficit due to higher crude oil imports heightened demand for foreign currency.
  • Persistent fiscal imbalances further pressured the rupee.
  • Policy ambiguity in the RBI’s stance added market uncertainty.
• External Factors:
  • Capital outflows driven by global uncertainties and rising US interest rates.
  • Geopolitical tensions (e.g., Russia-Ukraine war) increased India’s import bill.
  • The US dollar's strength amid aggressive Federal Reserve rate hikes further weakened the rupee.

Implications of Rupee Devaluation

• Positive Effects:
  • Boost to Exports: A weaker rupee makes Indian goods cheaper, enhancing export competitiveness if supported by real exchange rate depreciation.
• Adverse Effects:
  • Inflationary Pressures: Higher import costs increase consumer prices.
  • Reduced Purchasing Power: Increased costs are often passed on to consumers.
  • Foreign Debt Servicing: A depreciated rupee raises debt repayment costs for Indian firms and the government.
  • Investor Sentiment: Currency instability diminishes foreign investor confidence, triggering further capital outflows.

Structural Constraints in the Indian Economy

• Divergence between NEER and REER:
  • Since the mid-2010s, India's Nominal Effective Exchange Rate (NEER) depreciated while the Real Effective Exchange Rate (REER) appreciated. This divergence undermines export competitiveness, as rising domestic prices offset nominal depreciation benefits.
• Rising Markups:
  • Non-financial firms increased their markups on variable costs, contributing to inflation and nullifying the advantages of currency depreciation for exports.

Policy Responses and Recommendations

• RBI Interventions:
  • Forex market interventions to manage demand-supply imbalances.
  • Interest rate adjustments to attract capital inflows and stabilize the rupee.
  • Enhanced forex reserve management to mitigate excessive volatility.
• Fiscal Strategies:
  • Reducing Import Dependency: Boost domestic production of high-demand goods like crude oil substitutes.
  • Export Incentives: Strengthen export sectors through subsidies, incentives, and improved infrastructure.
  • Encouraging Long-Term FDI: Promoting stable investment environments for sustained capital inflows.
• Structural Reforms:
  • Policies that enhance domestic production, reduce reliance on volatile foreign portfolio investments (FPIs), and maximize remittances can stabilize the rupee in the long term.