The Indian rupee’s continuous depreciation against the US dollar has become a topic of growing concern, with the rupee recently breaching the 85-mark for the first time. As of December 26, 2024, the rupee stood at an all-time low of 85.25 against the dollar, further exacerbating concerns about the country’s economic stability. This marks a significant drop from earlier in the year, when the exchange rate hovered around 83. The weakening rupee, especially when compared to the relatively stronger US dollar, can be attributed to a combination of global and domestic factors, including capital outflows, inflation disparities, rising crude oil prices, and the strengthening of the dollar globally.
Global Dollar Strength
A major factor behind the rupee’s depreciation is the strength of the US dollar in global markets. The dollar index, which tracks the US dollar against a basket of six major currencies including the euro, Japanese yen, and British pound, has been consistently strong. As of December 2024, this index remained elevated at 107.90, reflecting the global preference for the US dollar. One of the key contributors to the dollar’s strength is the ongoing tight monetary policy in the US, led by the Federal Reserve’s interest rate hikes aimed at controlling inflation.
As the US economy struggles with inflation and high government spending, the Federal Reserve has kept interest rates high, leading to a flow of capital into US government bonds. The yield on 10-year US Treasury bonds, for instance, surged from 3.75% in September 2024 to 4.59% by December 2024. Higher bond yields make US assets more attractive to global investors, thereby driving up the demand for the dollar. As a result, the rupee has been under pressure, as investors pull their funds out of India to invest in US assets.
Rising Crude Oil Prices
Another key factor impacting the rupee’s value is the rising cost of crude oil, which India imports in large quantities. On December 26, 2024, Brent crude prices rose to $73.86 per barrel, further increasing the demand for US dollars to pay for these imports. As oil prices rise, India needs more dollars to purchase the same amount of oil, which puts additional strain on the rupee. This also leads to a widening trade deficit, as India imports far more than it exports to the US, further exacerbating the currency imbalance.
The pressure on the rupee is particularly high because India is one of the largest importers of oil globally. When oil prices rise, the demand for dollars increases, leading to a fall in the value of the rupee. This cycle worsens when there is no corresponding increase in exports, leaving India vulnerable to external shocks.
Foreign Capital Outflows
Foreign Institutional Investors (FIIs) have also been net sellers in the Indian equity markets, adding to the rupee’s woes. On December 24, 2024, FIIs offloaded shares worth ₹2,454 crore, contributing to the outflow of foreign capital. The outflow of funds from Indian equity markets occurs when investors perceive other markets, particularly the US, as more attractive due to higher returns driven by rising interest rates and bond yields.
The weakening rupee and the growing gap between Indian inflation and US inflation have made India less attractive as a destination for foreign investment. While the Indian stock market may be rising, the weakening currency makes Indian assets less attractive to foreign investors, as they expect to lose out when converting their returns back into their home currency.
Domestic Inflation Disparities
India’s inflation is significantly higher than that of its major trading partners, including the US. This disparity in inflation is another critical factor pushing the rupee down. As inflation erodes the purchasing power of the rupee, its relative value weakens. For instance, if inflation in India is 6%, while in the US it is 2%, the Indian rupee will lose its value more rapidly compared to the dollar.
The Reserve Bank of India (RBI) has tried to counter this inflationary pressure by tightening monetary policy, but domestic inflation has remained stubbornly high. When inflation is higher in India than in other countries, the value of the rupee declines relative to other currencies, including the dollar. This creates a self-reinforcing cycle where the weakening rupee makes imports more expensive, further fueling inflation.
Impact of High US Tariffs
Another long-term concern is the potential impact of trade policies under the US administration, particularly in the context of President Donald Trump’s approach to tariffs. If the US imposes higher tariffs on Indian exports, the demand for the Indian rupee could decrease, putting further downward pressure on the currency. With fewer goods being sold to the US, India would need fewer dollars to settle transactions, further exacerbating the rupee’s depreciation.
Trade Imbalances
The trade imbalance between India and the US also plays a significant role in the rupee’s depreciation. India imports far more from the US than it exports, creating a persistent deficit in its trade balance. The more India imports, the higher the demand for US dollars, which puts downward pressure on the rupee.
In the case of goods like crude oil, machinery, and high-tech products, India remains highly dependent on imports from the US and other advanced economies. With limited export growth, especially in sectors that would offset the high demand for imports, the rupee is more vulnerable to external market fluctuations.
The Real Effective Exchange Rate (REER)
While the rupee is weakening against the dollar, it has been appreciating in “real effective” terms. The Real Effective Exchange Rate (REER) is an index that measures a currency’s value relative to a basket of other major currencies, adjusted for inflation. As of November 2024, the REER index for the Indian rupee reached a record high of 108.14, showing that the rupee is, in fact, stronger against a broader basket of currencies, despite its fall against the dollar.
This divergence occurs because the US dollar’s appreciation against other currencies has been more significant than the rupee’s depreciation. The stronger REER suggests that while the rupee is weaker against the dollar, it is not necessarily overvalued relative to other global currencies. However, this creates a situation where imports become cheaper, but exports from India are less competitive, making it harder for Indian companies to sell goods abroad.
What Does This Mean for India?
The fall in the rupee is concerning for a variety of reasons. First, it increases the cost of imports, particularly oil and essential goods, which can lead to inflationary pressures. Second, it puts pressure on the Indian government to manage its fiscal deficit and trade imbalances more carefully. Third, it raises the cost of foreign debt, making it more expensive for India to service its external obligations.
However, the government and the Reserve Bank of India (RBI) are unlikely to intervene heavily in the currency markets unless the rupee’s decline becomes disorderly. The RBI’s current stance appears to be one of managing the depreciation rather than resisting it, as long as the real effective exchange rate remains within a competitive range.
Conclusion
In conclusion, the Indian rupee’s fall against the US dollar is driven by a complex mix of domestic and global factors, including rising crude oil prices, capital outflows, and the strengthening of the US dollar. While the rupee has appreciated in real effective terms against a basket of currencies, its weakness against the dollar raises concerns about inflation, trade deficits, and economic stability. As India navigates these challenges, the key will be balancing inflation control, foreign investment, and trade policies to stabilize the rupee and mitigate its impact on the broader economy.
