THE RUPEE’S DEPRECIATION IS NEITHER UNUSUAL NOR INDICATIVE OF GREAT STRESS

The recent depreciation of the rupee against the dollar, particularly following the West Asia war, has triggered a familiar wave of concern about external vulnerability and macro stability.

- PRASANNA TANTRI

This framing, however, rests almost entirely on movements in the nominal exchange rate, which is the wrong benchmark. A look at the real effective exchange rate tells a very different story. The current real depreciation is neither unusual nor indicative of extraordinary stress. In fact, over the past 15 years, the rupee has experienced larger real depreciations on at least 16 occasions. By that standard, what we are witnessing today is well within the range of normal adjustment rather than a signal of crisis.

Before analysing the data, it is important to be clear about what the real effective exchange rate actually measures. Consider a simple example. Suppose an item 'X' costs ₹50 in India and $1 in the US, with an exchange rate of ₹100 per dollar. The real exchange rate is then 0.5, meaning an Indian X is half as expensive as an American X when expressed in a common currency.

Now, imagine that domestic prices rise by 10%, so X now costs ₹55 in India, and the exchange rate moves to ₹110 per dollar. The nominal exchange rate has depreciated, but the real exchange rate remains 0.5. Relative prices have not changed. There is no real depreciation. What matters is whether the exchange rate and domestic prices move differently.

A real depreciation occurs only when the exchange rate adjusts more than inflation, making domestic goods cheaper relative to foreign goods; a real appreciation is the opposite.