For Prelims: Inflation, Indian rupee, the difference between depreciation and appreciation, and devaluation and revaluation. 

For Mains: Effect of depreciation of rupee on the economy. 

Why in the news?

Due to the sharp increase in the value of the US dollar in 2022 and the tightening of interest rates by the US Federal Reserve to control inflation in the face of the unpredictability surrounding the Russia-Ukraine conflict, the Indian rupee lost roughly 10% of its value against the US dollar.

Why is it important for us to understand how currencies appreciate and depreciate?

• Market forces determine a currency's value in a system with floating exchange rates based on supply and demand for a particular currency.
• The value of one currency rising in relation to another is known as currency appreciation.
• For various factors, including governmental policy, interest rates, trade balances, and business cycles, currencies appreciate against one another.
• A country's export activity is discouraged by currency appreciation because its goods and services become more expensive.
• In a system with floating exchange rates, currency depreciation refers to a decline in a currency's value. 
• Weak economic fundamentals, political unrest, or risk aversion may bring currency depreciation.
• A country's export activity is boosted by currency depreciation because its goods and services are now more affordable.

Why is it important for us to understand devaluation and depreciation?

• Generally, the terms depreciation and devaluation are used synonymously.
• They both have the same result: a decline in the currency's value, which increases the cost of imports and the competitiveness of exports.
• There is a distinction in how they are utilized, however.
• When a nation's central bank intentionally lowers its exchange rate to a fixed or semi-fixed exchange rate, this is known as a devaluation.
• When the value of a currency declines at a floating exchange rate, it is said to be depreciating.

What happened to the rupee in 2022?

Compared to the dollar, the rupee had the worst performance of any Asian currency in 2022, falling by about 10%.

• The US dollar's appreciation primarily caused this decline due to its safe-haven appeal amid the global recession, inflation fears, and the Russia-Ukraine war.
• The rupee hit a lifetime low of 83.2 against the dollar during the year.  
• Other Asian currencies depreciated to a lesser extent than the rupee. 
• The value of the Chinese Yuan, Philippine Peso, and Indonesian Rupiah decreased by about 9% over the year. 
• The value of the Malaysian Ringgit and the South Korean Won fell by roughly 7% and 6%, respectively.

The Reserve Bank of India (RBI) actively intervened in the foreign exchange market to protect the rupee. 

• The nation's foreign exchange holdings have decreased by $70 billion since 2022's beginning. 
• According to the most recent RBI data, it was $562.81 billion as of December 23, 2022.

"Reserves have seen some erosion, but the central bank is now starting to build up its reserves again, and that would act as a buffer in times of uncertainty.

What caused capital outflows?

The US Fed aggressively increased interest rates in 2022 by 425 basis points (bps) to combat inflation. 

• Due to the increased interest rate difference between the US and India, investors began to invest in the US market instead of the domestic one to benefit from the higher rates.

Foreign portfolio investors (FPIs) made the highest-ever yearly net outflow in 2022 when they withdrew Rs. 1.34 lakh crore from Indian markets.  

• The rupee was under pressure in 2022 as they withdrew Rs 1.21 lakh crore from the stock markets and Rs 16,682 crore from the debt market. 
• According to analysts, the Russian invasion of Ukraine accentuated the FPI withdrawals and made inflows more difficult.

What is the rupee forecast for 2023?

Forex analysts claim that even though the rupee's outlook is still bleak for the near future, India's economy is still the one that is expanding at the fastest rate, so the decline in the value of the local currency might not last much longer.

"The US Fed's terminal interest rate is unknown, but it is improbable that their monetary policy will continue to tighten indefinitely.