Downward pressures on the rupee vis-à-vis the US dollar persist due to President Donald Trump’s 50% tariffs on India, which include a penalty for buying Russian oil. Tariffs hit the country’s export earnings, curb foreign exchange inflows, and boost demand for dollars in an energy import-dependent economy. Trump’s big beautiful bill—with tax cuts and higher spending commitments—will further drive up inflation. With the US Federal Reserve cautious on cutting interest rates, the consequent higher yields on US treasuries will attract inflows from foreign investors who are expected to pull out from emerging markets like India and weaken the rupee. Last fiscal, the Indian currency depreciated 2.1% on year to Rs 84.57 a dollar and is further weakening since then. Till early August this fiscal, it declined by 2.9% on year to Rs 86.07. The currency unit fell to Rs 87.88 last week—not far from its lows of Rs 87.95 in February—and closed at Rs 87.71 on Tuesday.
The rupee keeps on weakening
The rupee’s weakness persists despite the Reserve Bank of India’s (RBI) intervention through drawing down forex reserves. The obvious question is whether the central bank should instead allow the rupee to find its own level. This is perhaps the more efficacious policy option as those who welcome a depreciating rupee are exporters as it improves their competitiveness in selling their merchandise abroad—more so, when Trump’s tariff disruption is forcing them to seek alternative markets for their shipments. But a cheaper rupee is bad news for the oil import-dependent Indian economy as imports become costlier. If India chooses to stop buying cheaper Russian oil, its fuel bill will rise by $5 billion annually. The higher dollar demand for such imports weakens the rupee. The Indian currency unit will also not receive support from the plunging direct foreign investments and continuing net portfolio outflows which lower rupee demand.
In this milieu, the RBI should do what it has been mostly doing since 1993, notably to follow a flexible exchange rate policy. The central bank has regularly maintained that it doesn’t target any particular exchange rate of the rupee although it can and does intervene to smooth any sharp upward or downward movements. During the global financial crisis from mid-2007 to early 2009 or the so-called “taper tantrum” when it hit lows of Rs 68.8 to a dollar in August 2013, the RBI did not defend the rupee by drawing down forex reserves. Instead, it even built up reserves through these episodes. That should be the approach going forward as well as there are costs involved with intervention. Forex reserves were down by more than $9 billion in the week ended August 1. Subsequently, the RBI has reportedly sold $5 billion worth of US currency. Reserves are down to $688.9 billion from the highest levels of $704.9 billion last September.
Way forward
The best course of policy action is to allow fluctuations in the rupee in line with cyclical conditions. According to international finance theory, as the economy remains open to capital inflows and outflows and the central bank seeks a strong monetary policy to check inflation and boost growth, the objective of exchange rate stability cannot be simultaneously met. Seeking elusive exchange rate stability—which will only make the rupee overvalued—entails abandoning a strong monetary policy. This must be given up as the downtrend in the rupee is likely to intensify during the Trump presidency.