Number Theory: Why rupee depreciation is bad, not good news | Latest News India

The Indian rupee, thanks to the depreciation it has suffered in the past few months, is in the news once again. But is the weakening of domestic currency a harbinger of bad news or good news on the economic front?Any currency depreciation, theoretically speaking, may trigger two opposite effects on the domestic economy. The first is an inflationary impact which occurs through an increase in the cost of importable goods. This, via a squeeze on purchasing power, can generate headwinds for domestic growth. The second effect can involve a positive impact on the economy if a depreciation in currency makes exports cheaper in international markets and imports costlier in domestic market. This can potentially lead to a rise in net exports thereby generating tailwinds for the GDP.The first effect involves the nominal exchange rate, whereas the second effect involves the real exchange rate. Which of the two effects prevail in the ultimate analysis depends on their relative strength. The following three charts explain why the latest episode of rupee depreciation is more bad than good news for the Indian economy.There has been a growing divergence between the real and nominal value of the rupeeSince a country typically trades with multiple foreign partners, the relevant indicators for exchange rate analysis of the rupee is India’s weighted average bilateral exchange rates with respect to its trade partners. These are Nominal and Real Effective Exchange Rates (NEER and REER). NEER is the weighted average of bilateral nominal exchange rates of the home currency in terms of foreign currencies, whereas REER is defined as a weighted average of nominal exchange rates adjusted for relative price differential between the domestic and foreign countries.One of the distinguishing features of the Indian economy since 2019 has been the growing divergence in NEER and REER. After moving in the same direction till the beginning of 2019, the real exchange rate registered appreciation despite a sharp depreciation in nominal exchange rate. The real exchange rate has continued to remain above 100 ever since, indicating overvaluation of Indian currency.

One of the distinguishing features of the Indian economy since 2019 has been the growing divergence in NEER and REER.

The peculiarity in India’s exchange rate movementThe divergence in nominal and real exchange rate is a phenomenon which distinguishes India from the bulk of developing countries. Chart 2 shows this by depicting the exchange rate movements of 58 countries using data from the Bank of International Settlements (BIS). The horizontal and the vertical axis, respectively, measure the change in the trade-weighted indices of NEER and REER between April 2019 and June 2022. Positive change implies appreciation, whereas negative change implies depreciation. Depending on the manner in which nominal exchange rate and real exchange rate change during a given period, Chart 2 is divided into four boxes or categories.Category 1 includes countries where both nominal and real exchange rate registered appreciation. Category 2 countries are those which registered depreciation in both nominal and real exchange rate. Category 3 includes countries where real exchange rate appreciated despite depreciation in nominal exchange rate. Category 4 countries are those which registered depreciation in real exchange rate despite appreciation in nominal exchange rate. The green dots indicate the developed countries. The blue dots show the developing countries in categories 1,2 and 4. The red dots indicate the developing countries in category 3.Chart 2 shows three important features of the global economy in the recent period. One, in contrast to developing countries, most developed countries registered either appreciation or unchanged real exchange rate during this period. Two, bulk of the countries are located in categories 1 and 2, indicating a similar direction of change in NEER and REER. Thirdly, along with Argentina and Mexico, India parts company with all other developing countries as it is located in category 3.

The horizontal and the vertical axis, respectively, measure the change in the trade-weighted indices of NEER and REER between April 2019 and June 2022.

What explains appreciating REER along with depreciating NEER in India’s case?The phenomenon of REER appreciation despite NEER depreciation is a consequence of domestic prices rising much faster than the international prices. In terms of average inflation rate in CPI between April 2019 and June 2022, India ranked 5th in the list of 58 countries during the same period. Even if one compares India with countries that registered similar output growth rate during this period, India’s inflation rate has been higher on average. This is shown in figure 3, which depicts the scatter plot between average inflation rate and IIP growth rate for 51 countries.

In terms of average inflation rate in CPI between April 2019 and June 2022, India ranked 5th in the list of 58 countries during the same period.

What are the macroeconomic implications?There are at least two implications of the kind of exchange rate depreciation India is facing at the moment. The first implication pertains to the manner in which Balance of Payment (BoP) adjusts in the midst of capital outflow. Since depreciation in nominal exchange rate does not involve depreciation in real exchange rate, trade balance and current account does not improve through the exchange rate channel. By implication, capital outflow that brings about deterioration in capital account, would lead to depletion of foreign exchange reserves (what the RBI has been doing) or reduction in imports through a squeeze in output.The second implication pertains to adverse impact on aggregate demand and growth in the midst of rupee depreciation. While weakening of rupee in nominal terms remains ineffective in stimulating external demand, it has adverse effect on consumption demand by exerting upward pressure on prices via the rise in cost of imported goods.Given the fact that the RBI’s policy rate hikes are only adding to the growth headwinds, it is all the more important that fiscal policy pays more attention to the cause of protecting domestic growth and relaxing structural bottlenecks.(Zico Dasgupta teaches economics at Azim Premji University)Source:Figure 1: Database of Indian Economy, RBIFigure 2: BIS StatisticsFigure 3: BIS Statistics and UNIDO database