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Worry over a falling rupee

ByHT Editorial
Jan 14, 2025 08:20 PM IST

A strong currency is no reflection of a strong economy. Exchange rates are best left to economists to manage

It is widely and popularly believed that a strong currency is a reflection of a strong economy. This belief explains why there is a lot of hue and cry when a country’s currency is depreciating sharply, much like the rupee is right now. This is neither the first nor the last time such a frenzy is being whipped up. It is almost poetic justice that politicians who once used the exchange rate as a political weapon are going red in the face trying hard to discredit its use by their opponents.

FILE PHOTO: FILE PHOTO: The Indian Rupee logo is seen inside the Reserve Bank of India (RBI) headquarters in Mumbai, India, December 6, 2024. REUTERS/Francis Mascarenhas/File Photo/File Photo (REUTERS) PREMIUM
FILE PHOTO: FILE PHOTO: The Indian Rupee logo is seen inside the Reserve Bank of India (RBI) headquarters in Mumbai, India, December 6, 2024. REUTERS/Francis Mascarenhas/File Photo/File Photo (REUTERS)

To be sure, they are right: An exchange rate should not be a matter of national pride. But politics aside, the actual economics of what drives exchange rates is paradoxically simple and complicated at the same time. Exchange rates, like any other price, are determined by demand and supply in the market. If foreign investors/importers want to invest/import from India, they would have to buy rupees in exchange for dollars. An increasing demand for rupees, ceteris paribus, will push up its value vis-à-vis the dollar. If foreign capital wants to pull out from India or Indian imports from the rest of the world increase, we will need to buy more dollars in return for rupees, leading to a fall in the rupee’s value. This simple reasoning must navigate a lot of complicated trading and algorithms by private players as well as central banks in the real world.

What is mostly driving down the rupee’s value right now is a strengthening of the dollar as expectations of more interest rate cuts by the Federal Reserve diminish. With better returns in the US, it is natural for hot money to flow back to the dominant currency market. While the Reserve Bank of India has deployed some of its forex reserves to manage the exchange rate, it would have been foolish to try and keep it unchanged.

Does this make the ongoing volatility in forex markets a trivial affair? Not at all. This has significant trade-offs in terms of deployment of economic policy tools including interest rates, liquidity and trade competitiveness (a weaker currency helps exports but also raises the import bill). This is exactly what economists, both in government and markets, are likely thinking about at the moment. And while modern economics and its practitioners are a much-berated lot — some of the criticism is well-deserved — this is likely one instance where economics is best left to economists.

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