In today’s Finshots, we tell you about how a stronger rupee might be hurting the economy and if the RBI should just let it fall.

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The Story

India is a currency manipulator!

And it’s not us saying this. Back in 2020, the US Treasury actually added India to its watchlist for potential currency manipulation.¹ Sure, they changed their tune two years later and took us off it. But it didn’t end there.

Even the IMF (International Monetary Fund) thought the RBI (Reserve Bank of India) was doing a bit too much to control the rupee-dollar exchange rate.² And now, some experts, including former economic advisors and IMF folks, feel that the RBI is still over-managing the rupee to keep it stable.³

And if all this sounds overly complicated, let’s simplify things a bit and start with what the rupee-dollar exchange rate means and how the RBI manages it.

See, the rupee-dollar exchange rate is simply how many rupees you need to buy a dollar, or how much you’ll get in rupees if you sell a dollar in the market today. Right now, if you sold $1, you’d get about ₹84.

But this rate doesn’t stay fixed. It shifts based on various factors. For example, if foreign investors lose confidence in India’s economy and pull out their money, the rupee might weaken. Or if there’s a high demand for dollars, like when countries start building up their foreign reserves, the rupee could weaken, too.

On the flip side, if more foreign money flows into India or there’s a stronger demand for the rupee, the rupee strengthens.

That’s how the rate moves naturally, with no one stepping in. And when the rupee finds its value this way, we call it a flexible or “floating” exchange rate.

But sometimes, the RBI steps in to manage the rate and protect the economy from sudden shocks. For example, the RBI might buy foreign currency to increase its reserves, just to have extra funds for paying imports. When it does this, it’s essentially paying out rupees to buy other currencies, which can make the rupee weaker. The opposite happens if it sells foreign currency.

And despite a steady rise in its foreign exchange reserves, which peaked at $700 billion a couple of months ago, the RBI might be overdoing it in controlling the rupee-dollar exchange rate. It seems as if it’s using its foreign exchange reserves a bit too much, too often.⁴

The reason is simple. Until around 2019, the RBI mostly let the rupee find its own value, allowing it to fluctuate naturally. It would only dip into foreign exchange reserves during major crises. For instance, during the 2008 global financial crisis or the 2013 taper tantrum when the US Fed’s policies led to higher interest rates, the RBI sold dollars from its reserves to keep the rupee from dropping too fast. But in calmer times, it stayed hands-off.

Since 2019, though, the RBI has taken a more active approach. It boosted its reserves when foreign money flowed into India and started selling from these reserves whenever the rupee faced pressure to drop. For context, between February and October 2022 alone, it used up a massive $105 billion from its reserves to keep the rupee steady as the US Fed raised interest rates to control inflation.

This intervention didn’t just keep the rupee stable and cushion it from big swings, it did two other things, too.

One, it pushed up the rupee’s real effective exchange rate (REER). Think of it as the value of a country’s currency compared to a basket of other currencies, adjusting for inflation and  ties with its important trading partners. So if India’s inflation is higher than in the US, which it currently is, it means that our goods and services are pricier. This can make our exports less competitive in the global market. Ideally, if the REER is 100, the currency is considered fairly valued. Below 100 means it’s undervalued, while above 100 means overvalued.

Right now, Reuters says that the rupee may be about 5% overvalued, with the REER at around 105. And some think that’s because the RBI is propping up the rupee.⁵

Two, an overvalued rupee makes Indian exports even less competitive because foreign buyers need to spend more of their currency (like dollars) to buy Indian goods and services. This could slow our export growth. To put things in perspective, non-oil exports have grown slowly, averaging just 4.5% annually from 2019 to 2024, which is almost half the growth rate seen between 1994 and 2018.

So, should the RBI just let the rupee fall and find its natural value like it used to, you ask?

Well, in theory, that sounds pretty straightforward. But in practice, it’s not so simple.

Take China, for example. China’s central bank often steps in to keep its currency slightly weaker so exports stay competitive and cheaper. But that approach works for China because its economy relies heavily on exports, and inflation is usually low.

In India though, things are a bit different. Even if the RBI lets the rupee weaken, it might not boost exports as much as you’d think. If you’re wondering why, here’s the thing. India’s inflation has been high, especially with food prices surging due to unpredictable weather and lower crop yields. This rise in prices affects everything.⁶ And exporters who rely on imported raw materials still end up paying more to make their goods. So even if the rupee falls, Indian goods could still seem pricey in the global market.

Plus, if global customers demand discounts due to inflation, that eats into exporters’ profits too. In fact, an analysis by The Print shows that exporters might only benefit by about 0.1% to 0.3% with a weaker rupee.⁷ And that there’s really only a tiny statistical connection between competitive exports and a weaker currency. So, letting the rupee weaken doesn’t necessarily mean that our exports will suddenly become a lot more competitive. It’s just not a guaranteed fix for export growth.

And maybe that’s what the RBI realises too. Perhaps it feels that prices in India are way too high. So it’s using this method of dipping into reserves to keep the rupee stable instead of letting it fluctuate too much.

After all, that’s the RBI’s job, right? So, yeah, instead of calling it a currency manipulator, let’s just say that the RBI is just doing what it’s meant to do.

Until next time…

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Story Sources: Bloomberg [1], Livemint [2], Business Standard [3] [4], Reuters [5], Zerodha z-connect [6], The Print [7]

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