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The daily fluctuations in the exchange rate of the Indian rupee against the dollar have kept the media busy, with many analyses trying to determine the reasons behind its depreciation. It is true that the rupee has been losing value month after month throughout 2024, but the overall decline has been only 2.68%. In the last three months alone, it has fallen by 2.2%.

Understanding Exchange Rates and Currency Value

The exchange rate between two currencies, such as the Indian rupee and the US dollar, refers to how much of one currency is needed to obtain a unit of the other currency. For instance, if the exchange rate of the rupee against the dollar is 50, it means that 50 rupees are required to purchase one US dollar. If the exchange rate increases, meaning one needs to pay more rupees for the same dollar, the exchange value of the rupee has depreciated against the dollar. However, this does not necessarily affect the rupee’s value against other global currencies.

Why is the Indian Rupee Falling against the Dollar?

There are five primary factors contributing to the rupee’s depreciation:

Improved US Economy: The US economy has shown signs of recovery, which has led to a strengthening of the US dollar.

Rising US Bond Yields: US bond returns have increased due to lower-than-expected interest rate cuts by the Federal Reserve, prompting investors to purchase US bonds, thereby raising demand for USD.

Political Uncertainty: The upcoming economic policies under President-elect Donald Trump have contributed to a rise in demand for dollars, driven by uncertainty.

Geopolitical Tensions: Ongoing geo-political crises, such as the Russia-Ukraine war, conflicts in the Middle East, and disruptions in global shipping (including the Red Sea), have led to commodity supply chain disruptions. This has increased volatility in prices for oil, food, and raw materials.

Foreign Portfolio Investment (FPI) outflows: A significant outflow of foreign portfolio investments from the Indian equity market in October and November increased the demand for dollars in the Indian market.

Why this is not a major concern

The compounded annual depreciation of the rupee between 2015 and 2024 has been just 3%, which is not alarming. Additionally, the rupee has appreciated against most other major global currencies. Many emerging market currencies have depreciated more sharply against the dollar. For example, in 2024, the Brazilian real fell by 20%, the Mexican peso by 18%, and the South Korean won by 11.6%. The Reserve Bank of India (RBI) must remain vigilant in monitoring the rupee’s exchange value and take appropriate action when necessary.

Could the rupee depreciate further? Experts weigh in

There is a possibility that the Indian rupee may depreciate further against the US dollar, as the rupee is still considered overvalued. A segment of the public seems concerned about this, but it is important to understand that the exchange value of a currency is determined by the Real Effective Exchange Rate (REER). REER is an index adjusted for inflation, which reflects a currency’s value relative to a weighted average of 40 foreign currencies. If inflation in India rises, the internal value of the rupee decreases, which can further affect its exchange rate, in addition to supply and demand factors.

A higher REER indicates a loss in trade competitiveness, as exports become more expensive and imports cheaper. According to the latest data from the RBI, the REER of the rupee stood at 108.14 in November, which suggests the rupee was overvalued by 8.1%. However, in December, the rupee depreciated by approximately 2%. Experts, such as Gaura Sengupta, Chief 

Economist at IDFC First Bank, have indicated that the REER of the rupee may have fallen to levels of 106 to 107, making the rupee still overvalued. Thus, further depreciation of the rupee against the US dollar may be expected. To mitigate this, the Indian government and the RBI must control inflation rates, as inflation contributes to higher exchange rates, which can

make imports more expensive. Given India’s dependence on imports from countries like China, the US, and oil-exporting nations, inflation would inevitably raise the cost of production for Indian goods and services, impacting the overall price level in the economy.