Is the Rupee Overly Depreciated?

 

The rupee has been in a kind of free fall: it hit 85 to the US dollar on December 19, 2024, slipped to 86.62 on January 13, 2025, despite large-scale interventions by the Reserve Bank of India (RBI), and then touched a historic low of 87.1850 on February 3, a drop of 0.67 against the dollar.  

The Indian currency remained volatile throughout January 2025 as foreign portfolio investors sold stocks worth $6.7 bn and repatriated the proceeds during January alone. The two key market indices, Nifty 50 and BSE Sensex, which peaked on September 27, 2024, were down 11% by January 13, 2025, partly due to the relentless selling by foreign institutional investors during this period.

The depreciation of the rupee is not a new phenomenon; it has been depreciating by around 3.4% annually since 2005. However, the recent fall in the currency is largely attributed to the fear surrounding the tariff plans of US President Donald Trump, and the uncertainty that accompanied them. This was evident on February 3, when the Trump administration imposed tariffs on Mexico, China, and Canada, sparking a wave of risk aversion in emerging markets. As a result, the rupee touched a low of 87.28 at one point on that day.

 In response to tariff increases, the US dollar index—the value of the dollar relative to a basket of six currencies—rose from 107.8 on January 31 to 109.8 on February 3. The imposition of 25% tariffs on Mexico and Canada and 10% on China by the Trump administration indeed hammered markets globally. Tracking the global stock sell-off, the benchmark Sensex closed down 0.4% at 77,187, while the broader Nifty 50 index declined 0.5% to 232,61. Indeed, it was the intermittent intervention of the RBI in the dollar/rupee spot market that helped contain some losses.

Persistent outflows from the capital market and the demand for dollars from oil companies are putting continuous pressure on the rupee. As the impact of the US tariffs deepens, the rupee is likely to face even more pressure.  That aside, economic theory suggests that the tariffs imposed by Trump are expected to strengthen the dollar. If he proceeds with re-imposing the paused tariffs on Canada and Mexico, the dollar could further strengthen significantly.  The rupee is already one of the worst-performing Asian currencies. Furthermore, if the RBI, as anticipated by India Inc., cuts interest rates by 25 basis points, analysts fear that the rupee could soon hit the 88-per-dollar mark. 

Amidst this evolving scenario, analysts who once advocated for the RBI to let the rupee depreciate are now calling for it to defend the rupee. They fear that further depreciation of the rupee will increase the cost of commodity imports, which could, in turn, fuel persistent inflation. Exchange rate volatility also raises risk premia, which typically exceeds the actual depreciation in emerging markets. Indeed, such volatility harms the real sector as well. Over it, if depreciation continues at a faster pace, it may even affect the foreign investor sentiment. Given all this, some analysts are urging the RBI to intervene in the market to maintain a flexible nominal exchange rate that minimizes volatility. 

Raghuram Rajan, the former RBI Governor, stated that the central bank need not intervene in the market to protect the rupee, citing several reasons. He pointed out that the rupee is not the only currency depreciating against the dollar and that there is still room for the rupee to depreciate further. He believes that the rupee remains overvalued in real terms when compared to its peers. In fact, an estimate by the Bank of Baroda suggests that under ceteris paribus conditions—where only external factors are considered—there is still room for the rupee to depreciate.

In the last few months, foreign exchange reserves with the RBI have fallen from $705 bn to $635 bn as it sold dollars to protect the rupee from sharply depreciating. As a result, the appetite for further intervention has naturally diminished. Secondly, during the recent fall in the rupee against the dollar, the rupee has appreciated relative to the currencies of other trading partners. Therefore, exports to countries whose currencies have depreciated not only against the dollar but also against the rupee, and which are denominated in those currencies, are becoming less competitive. This may be another reason for the RBI’s recent muted intervention in the forex market.

That aside, managing both the exchange rate and inflation simultaneously is a challenging task for the RBI. Nevertheless, in the context of growing global uncertainty and weaponization of tariffs, RBI should use its reserves to reduce excess volatility in the exchange market, for reserves can be rebuilt over time.   

**