The Rupee Is In Free Fall. Here's What India Can Do

A weaker rupee implies higher import costs, which could lead to a widening current account deficit (CAD). India's overall trade deficit increased to 3.4 per cent of GDP in Q2 FY 2025, up from 2.9 per cent in the same period last year, while the merchandise trade deficit rose to 8.2 per cent of GDP from 7.5 per cent. 

Macroeconomic Impact Of Rupee's Fall

Basic macroeconomic theory suggests that a widening CAD will fuel domestic inflation by raising the price of imported crude oil. This could have secondary effects, including a decline in foreign exchange reserves and foreign institutional investors (FIIs) pulling out of the Indian stock market. 

Interestingly, the depreciation of the rupee against the US dollar is not a recent phenomenon. Between 2005 and 2024, the rupee has, on average, depreciated by around 3.5 per cent annually. 

There are two ways to determine an exchange rate. First is the 'goods market' approach, which seeks to determine the value of the exchange rate based on the 'law of one price' (LOOP), using the concept of purchasing power parity (PPP). 

LOOP states that in the absence of transport and other costs such as tariffs, identical (similar) goods will sell for the same price. If LOOP holds true, then the real exchange rate is one. Therefore, if domestic inflation is higher than the US inflation, the rupee is expected to depreciate against the dollar. 

Second is the 'asset market' approach, where the exchange rate is conditional upon the inflow and outflow of capital into and from the domestic economy. 

Historically, the US has lower inflation rates than India. Much of the differential in inflation rates between India and the US can be explained by labour productivity alone, with more productive labour generating more real goods and services, thereby leading to lower inflation. According to ILO estimates for 2025, India is producing an output of US$ 25,431 per worker, significantly below America's average of US$ 153,446 per worker. 

Additionally, with Trump's promise of remaking the US economy, fund managers are pulling out of the Indian market, hoping that American assets and the USD will strengthen and yield greater returns. 

Foreign fund managers sold equities worth Rs 1,13,858 crore through exchanges in October, with an additional Rs 41,872 crore of equities sold through exchanges in November 2024. Therefore, the depreciation of the rupee is likely to continue, and one should not be overly concerned unless the annual rate of depreciation exceeds 4 per cent.

Interestingly, contrary to popular belief, a weaker rupee may not necessarily boost our exports. A look at our major export items suggests these are income elastic, that is, they tend to perform well when there is an upsurge in foreign income. 

Shifting Trade Dynamics & Future Outlook

In case of India, there is a change in composition of exports from price sensitive items such as leather footwear, dairy products, beverages, textiles and apparel products, to more income sensitive items such as refined petroleum products, iron and steel, chemicals, machinery and transport equipment (engineering goods), pearls and precious stones like diamonds.

For example, the share of refined petroleum products (high-speed diesel, motor spirit, aviation turbine fuel, naphtha, etc.) in India’s export basket increased dramatically from around 2 per cent in 1993 to around 21 per cent in 2023. 

In fact, India is now the second-largest exporter of refined petroleum, with exports valued at US$ 85 billion and a global market share of 12.6 per cent. Other major exports from India include insecticides and fungicides (10.5 per cent), steel (12.7 per cent), beet sugar (12.21 per cent), rubber tyres (3.31 per cent), and gemstones (36 per cent), with the global market share figures indicated in parentheses.

The above figure clearly shows that a weakening rupee helped to improve the trade balance between 2000 and 2014. However, this relationship is becoming increasingly irrelevant due to the shift in Indian exports from price-sensitive to income-sensitive items. 

A prolonged Russia-Ukraine war and the onset of weak global economic growth, especially in the Eurozone, led to lower demand for income-elastic items, which make up a significant portion of India’s export basket. 

In China, another major trading partner of India, GDP growth rate is likely to slow down from 8.1 per cent in 2021 to below 5 per cent in 2025. The US is also experiencing a surge in inflation, around the 3 per cent mark, which is higher than the long-term average of 2 per cent. Additionally, Trump's tariffs could pose a challenge for India’s exports.

Strategic Measures & Long-Term Opportunities

Government, on its part, has undertaken a series of interventions to make Indian industry and products competitive. Some of the key initiatives include establishment of the National Manufacturing Competitiveness Council (NMCC) in 2004, launch of the ‘National Manufacturing Policy’ in 2011, introduction of the ‘Make-in-India’ scheme in 2014 and ‘Atmanirbhar Bharat Abhiyan’ in 2020. 

However, the impact of these initiatives in making our exports competitive is yet to bear fruit. On the contrary, India’s CAD is likely to increase further as crude oil, precious metals and coal still contribute to bulk of our imports, and are necessary items for a growing economy like India. 

Despite the concerning outcomes associated with a falling rupee, there is some good news. A weaker rupee makes India an attractive destination for setting up businesses, as Indian labour, land and capital become relatively cheaper. The rapid growth of Global Capability Centres (GCCs) in India is a testament to this, with around 1,700 GCCs now operating in the country. 

India's GCC market is projected to grow to US$ 100 billion in 2030, with the number of GCCs reaching to around 2,200 and employing between 2.5 and 2.8 million Indians. Another significant beneficiary of a falling rupee is the remittances from Indians working and settled abroad. 

India received over US$ 111 billion in remittances in 2022, becoming the first country to ever reach that milestone. This figure is nearly 2.2 times higher than the US$ 49 billion in FDI inflows India received in 2022. 

Finally, India’s software exports are likely to get benefitted from a weakening rupee. In fact, when examining the largest component of India’s imports — mineral fuels, oils, and bituminous substances (HS Code 27) — the deficit in this category is offset by the proceeds from total services exports. That’s what makes India distinct from its South Asian peers, where their declining currencies is posing significant challenges to their long-term growth prospects.

(The author is professor, School of Management, Mahindra University. Views are personal)