(This article offers detailed explanation on fixed and floating exchange rates/ Real Effective Exchange Rate (REER) and effects on our Foreign Trade and Internal Economy on devaluation or depreciation of Rupee. The article also elucidates on advantage and disadvantage of devaluation or depreciation of a currency.)
You might have heard that the exporter lobby in India is pressing for the devaluation of Rupee as an answer to the continued decline in our exports for the past 20 months. What do they mean? Let us discuss here the effects on our Foreign Trade and Internal Economy on devaluation or depreciation of a currency.
There are two kinds of currency exchange system viz. fixed rate (pegged rate) of exchange system and floating exchange rate system (also known as Real Effective Exchange Rate (REER) adopted by the countries across the world.
In a fixed exchange rate system, the monetary authority of a country fixes the value of its currency. The central bank of the country will keep a high level of foreign reserves with it, by buying or selling own currency in the foreign exchange market to maintain the rate of national currency relevant to a specific foreign currency or Gold. The purpose of maintaining fixed exchange rate is to keep the value of national currency within a very narrow band and not allowing it to float against other currencies. The central bank, which is the monetary authority, may officially lower the value of its currency if it feels that the domestic currency is overvalued against a foreign currency or Gold. This process of officially lowering the value of a currency is called devaluation of the currency.
In 1975, India has switched from fixed exchange rate system to another system called floating exchange rate system or REER (Real effective exchange rate). The floating exchange rate means the rate of the currency is determined by the currency market depending upon the demand and supply of a specific foreign currency. For example, if there is a less demand for US Dollar and at the same time there is the abundant supply of US dollars available in India, then dollars would be sold in India at the cheaper rate. In the other hand, if demand for US Dollar is outstripping their supply for any reasons like our import (outflow of dollars) is more than our export (inflow of dollars) or Foreign Institutional Investors (FIIs) pulling out their investments from the Indian market, the dollars become costlier in India. Thus, when a foreign currency becomes cheaper (where we pay the lower amount of Rupees to buy a foreign currency) we call it as a value of Rupee is ‘appreciated’ against a specific foreign currency or ‘Rupee gains against a specific foreign currency’. In the same way, when the value of Rupee falls against a specific foreign currency (where we pay more Rupees to buy a foreign currency) we call it as Rupee is ‘depreciated’ against a specific foreign currency.
Now we understood that depreciation or devaluation of a currency indicate that the value of an official currency of a country is lowered against a foreign currency, but in different methods.
Effects on our Foreign Trade and Internal Economy on devaluation or depreciation of Rupee:
The devaluation/ depreciation of a currency will be the advantage to the exporters and disadvantage to the importers of that country. Let us take an example of Rupee value is devalued/depreciated from Rs.65/$ to Rs.70/$. In the above case, an exporter gets Rs.500/- more for export of commodity worth 100 dollars as he gets Rs.5 more for each dollar. In the contrast, an importer has to pay Rs.500 more for the commodity worth 100 dollars imported by him. Thus, exporters having the advantage of the devaluation of Rupee can afford to sell their products abroad at the lower rate in terms of foreign currency. Hence, devaluation of Rupee makes Indian goods cheaper in foreign countries (provided the country of peers of our exporters does not devalue their currency to compete with our products). Although devaluation/depreciation of national currency would some extent improve competitiveness in foreign trade, there is a danger that continuous downfall in Rupee value, together with high inflation in our economy can cause foreign investors’ loss of confidence in our currency, which may lead to the capital flight of foreign investments.
Many studies by the experts reveal that Indian exports were highly sensitive to global trade conditions and somewhat sensitive to the exchange rate. The people having knowledge of Indian export also opine that the current Indian export slowdown is perhaps due to slowing down of global trade and not because of overvalued Rupee. Therefore, the devaluation of Rupee may not help much to boost the exports of our country. In such circumstances, the weak Rupee does not guarantee the improvement in our exports or the dramatic shrink in the level of our trade deficit. (Trade deficit occurs where the value of country’s imports exceeds its exports, which is also known as trade gap/negative balance/trade imbalance). However it is unquestionable that the weak Rupee raises the cost of our imports particularly prices of Petrol, Gold etc. and that would stoke inflation in our economy.
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