Factors Behind Indian Rupee’s Depreciation in 2025

The Indian rupee has faced challenges in recent months. In December 2024, it reached an all-time low against the U.S. dollar, breaching the 85 mark. This depreciation of approximately 3% throughout 2024 marks a continuation of a long-term trend. About the factors influencing currency depreciation is crucial for grasping the complexities of the foreign exchange market.

Currency Valuation Basics

Currency value is determined by supply and demand dynamics. When demand for a currency exceeds its supply, its value increases. Conversely, when supply outstrips demand, the currency depreciates. This principle applies to foreign exchange markets, where currencies are traded against one another.

Role of Central Banks

Central banks play a very important role in currency valuation. A central bank that adopts a looser monetary policy increases the supply of its currency. This often leads to depreciation against stronger currencies. Conversely, tighter monetary policy can strengthen a currency’s value.

Impact of Foreign Investment

Foreign investment influences currency demand. When international investors seek assets in a country, they must purchase that country’s currency. A decline in foreign investment typically reduces demand for the local currency, leading to depreciation. Recent trends indicate that foreign investors have been exiting the Indian market, exacerbating the rupee’s decline.

Inflation Dynamics

Inflation rates are critical in determining currency strength. India has experienced higher inflation compared to the U.S., primarily due to the Reserve Bank of India’s relatively looser monetary policy. Higher inflation often diminishes purchasing power, leading to currency depreciation.

Import Dependencies

India’s reliance on high-value imports, particularly crude oil and gold, has a direct impact on the rupee’s value. Increased demand for these imports raises the demand for U.S. dollars, thereby weakening the rupee. A lack of robust export growth further compounds this issue.

Reserve Bank of India’s Interventions

The Reserve Bank of India (RBI) has intervened in the foreign exchange market to stabilise the rupee. By using its dollar reserves, the RBI has aimed to increase the supply of dollars, helping to prop up the rupee’s value. However, this intervention has led to a decline in India’s foreign exchange reserves, which fell to $640 billion in December 2024.

Long-Term Trends

The rupee’s long-term depreciation trend is influenced by various factors. Structural issues in the economy, such as trade imbalances and inflation differentials, play roles. The RBI’s strategy of allowing gradual depreciation aims to avoid excessive volatility that could destabilise the economy.

Global Economic Influences

Global economic conditions also affect the rupee’s performance. Changes in monetary policies by major economies can lead to shifts in investor sentiment. As investors reassess their portfolios, funds may move away from emerging markets like India towards more stable economies.

Questions for UPSC:

1. Critically discuss the factors contributing to currency depreciation in emerging markets.
2. Examine the role of the Reserve Bank of India in managing currency fluctuations.
3. Analyse the impact of inflation on currency value in the context of global economies.
4. Estimate the consequences of high import dependency on a country’s currency strength.

Answer Hints:

1. Critically discuss the factors contributing to currency depreciation in emerging markets.

1. Supply and demand dynamics – A decline in demand for a currency or an increase in supply can lead to depreciation.
2. Monetary policy – Looser monetary policies by central banks increase currency supply, resulting in depreciation.
3. Foreign investment – Withdrawal of foreign investments reduces demand for the local currency, weakening it.
4. Inflation rates – Higher inflation in emerging markets compared to developed nations diminishes purchasing power and currency value.
5. Trade imbalances – A consistent trade deficit increases demand for foreign currencies, leading to depreciation of the local currency.

2. Examine the role of the Reserve Bank of India in managing currency fluctuations.

1. Intervention in forex markets – The RBI uses its dollar reserves to stabilize the rupee by increasing dollar supply.
2. Monetary policy adjustments – The RBI’s decisions on interest rates influence currency value through demand and supply changes.
3. Gradual depreciation strategy – The RBI aims for controlled depreciation to avoid excessive volatility that could harm the economy.
4. Managing foreign exchange reserves – The RBI monitors and manages reserves to support currency stability and economic confidence.
5. Market sentiment – The RBI’s actions can influence investor perceptions, impacting currency performance and stability.

3. Analyse the impact of inflation on currency value in the context of global economies.

1. Purchasing power – Higher inflation erodes purchasing power, leading to a decrease in currency value relative to stable currencies.
2. Interest rates – Central banks may raise interest rates to combat inflation, which can strengthen the currency.
3. Comparative inflation – Countries with lower inflation rates generally see their currencies appreciate against those with higher rates.
4. Investor confidence – High inflation can deter foreign investment, reducing demand for the local currency and leading to depreciation.
5. Global inflation trends – Inflation dynamics in major economies can influence capital flows and affect emerging market currencies.

4. Estimate the consequences of high import dependency on a country’s currency strength.

1. Increased demand for foreign currencies – High import dependency raises the need for foreign currencies, weakening the local currency.
2. Trade deficits – A higher import bill without corresponding export growth leads to trade imbalances, further pressuring the currency.
3. Vulnerability to external shocks – Dependence on imports makes the economy susceptible to global price fluctuations, impacting currency value.
4. Inflationary pressures – Rising import costs can contribute to domestic inflation, eroding currency value over time.
5. Investment attraction – High import dependency may deter foreign investment, as investors seek more stable economic environments.