Understanding the Pros and Cons of depreciation in Rupee vis a vis US Dollar

August 31, 2018:

A bigger fall in the rupee at a time of rising oil prices is bound to increase this pain.

Economics textbooks, would conveniently tell us that a depreciating currency need not always be a bad thing. Currency depreciation can even help countries improve their trade balance. An example can help us understand this. Let us understand a test case scenario that Indians imported only iPhones and exported only shirts.

A fall in the rupee value would make our imports more expensive, because Indians would be paying more in rupee terms for the unchanged dollar price of the iPhone. This would lead to a reduction in demand for iPhones and hence reduce our import bill. Similarly, an US retailer importing shirts from India would be able to get more shirts for the same expenditure in dollars. This would make him reroute more of his orders to India and lead to a rise in exports. An increase in net exports means an increase in economic growth.

The above example raises questions on the validity of alarmist commentary every time the rupee reaches a new low vis-à-vis the dollar. Are such opinions driven more by warped notions of economic nationalism than actual economic interests? Not necessarily.

The real economic world is often drastically different from the abstract assumptions of economic textbooks. The argument for currency depreciation leading to an improvement in trade balance assumes price elasticity of imports and exports. In simple terms, a commodity is described as price elastic if its demand is responsive to a change in price.

One of India’s biggest imports into the country is crude oil. An upcoming economy cannot adjust its petroleum consumption with change in prices. Energy requirements are driven by level of activity and wealth in an economy. Herein lies perhaps the most important cost of a falling rupee for India. A fall in the rupee means a rise in price of India’s crude oil basket (COB). This implies a rise in fiscal deficit and inflation.

A rapidly devaluing currency also deprives the economy from exploiting the gains of fall in international oil prices. Chart 1 shows the annual change in prices of India’s COB in dollar and rupee terms. Since 2001-02 ie 12 out of 18 years, the change in the rupee price of India’s COB has been unfavourable vis-à-vis the dollar price. This means that when oil prices have fallen, the rupee price has fallen less than the dollar price and when prices have risen, the rupee price has risen more than the dollar price.

A bigger fall in the rupee at a time of rising oil prices is bound to further increase this pain. It could be argued that the logic of depreciation being beneficial applies to other sectors of the economy. Our non-petroleum trade balance could improve. Non Resident Indians (NRIs) could be sending more money in remittances because every dollar gets much more in rupee terms. Unfortunately, the argument does not lend itself to a simple empirical scrutiny.

The short take home point is, any attempts to trivialise the costs of falling rupee are unjustifiable. What is also true and understandable is the fact that there are no easy and quick solutions to such problems.

Source HT