(The article offers a detailed explanation of fixed and floating exchange rates/ Real Effective Exchange Rates (REER) and their effects on our Foreign Trade and Internal Economy on the devaluation or depreciation of the Rupee. The article also elucidates the advantages and disadvantages of devaluation or depreciation of a currency.)
There are two kinds of currency exchange systems viz. fixed-rate (pegged rate) exchange systems and floating exchange rate systems (also known as Real Effective Exchange Rate (REER) adopted by 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 its 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 a fixed exchange rate is to keep the value of the national currency within a very narrow band and not allow it to float against other currencies. However, when a country’s production costs are high, its goods and services become more expensive abroad than its competitors and lose competitiveness countries may officially lower the value of their currency. Such a strategy is used to gain a competitive edge in global trade and reduce sovereign debt burdens. The devaluation of a currency increases exports of the country because its goods and services will cost less in the international market. This process of officially lowering the value of a currency is called the devaluation of the currency. Devaluation prevails under the fixed exchange rate regime.
In 1975, India switched from a fixed exchange rate system to another system called a 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.
Currency depreciation refers to the country’s fall in exchange value compared to the other currencies in a floating rate system. The exchange rate between two currencies fluctuates based on demand for a particular currency. For example, if there is less demand for US dollars and at the same time there is an abundant supply of US dollars available in India, then dollars would be sold in India at a cheaper rate. On the other hand, if demand for US Dollar is outstripping the supply for any reason 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 a lower amount of Rupees to buy a foreign currency) we call it the value of the Rupee is ‘appreciated’ against a specific foreign currency or ‘Rupee gains against a specific foreign currency’. In the same way, when the value of the Rupee falls against a specific foreign currency (where we pay more Rupees to buy a foreign currency) we call it a Rupee is depreciated against a specific foreign currency.
Now we understood that depreciation or devaluation of a currency indicates 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 the Rupee:
The devaluation/ depreciation of a currency will be an advantage to the exporters and a disadvantage to the importers of that country. Let us take an example of the Rupee value devalued/depreciated from Rs.78/$ to Rs.83/$. In the above case, an exporter gets Rs.500/- more for the export of a commodity worth 100 dollars as he gets Rs.5 more for each dollar. In contrast, an importer has to pay Rs.500 more for a commodity worth 100 dollars imported by him. Thus, exporters having the advantage of the devaluation of the Rupee can afford to sell their products abroad at a lower rate in terms of foreign currency. Hence, the devaluation of the 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 to the capital flight of foreign investments.
Many studies by 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 the slowing down of global trade and not because of overvalued Rupee. Therefore, the devaluation of the Rupee may not help much to boost the exports of our country. In such circumstances, the weak Rupee does not guarantee an improvement in our exports or a dramatic shrink in the level of our trade deficit. (Trade deficit occurs when the value of a country’s imports exceeds its exports, which is also known as a 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.