GS-3, Indian Economy, Uncategorized

The neglected impact of a rate cut


Impact of a rate cut on the exchange rate

Problems before the Indian economy

  • A gloomy world economic scenario
  • Over-leveraged corporate balance sheets
  • An extremely weak rural demand.

How could rate cut depreciate the exchange rate?

  • Ninety-five per cent of India’s investment comes from domestic sources. Further, a significant portion of foreign direct investment (FDI) into India is believed to be domestic capital round-tripping via tax havens like Mauritius.
  • Hence, even a doubling of FDI may not suffice to bring about the stimulus needed.
  • The government is limited in its ability to inject a fiscal stimulus because of the threat of inflation.
  • In this situation, foreign markets offer a thin sliver of hope for Indian business.
  • Hence, the efficacy of the rate cut should be seen not in terms of its impact on domestic investment but on foreign demand, through the channel of its impact on the exchange rate.
  • Lower foreign demand for Indian assets following the rate cut would be the channel through which the rate cut would depreciate the currency.

Is Rupee overvalued?

RBI governor Raghuram Rajan has argued that if the growth of India’s productivity is factored in, the rupee ceases to be overvalued.

Impact of rate cut on Foreign Investment and Foreign Markets :-

Foreign Investment Foreign Markets
  • Central bank is keen to protect the value of the rupee in order to promote foreign investment, which might not be forthcoming if the exchange rate is left to depreciate a lot.
  • FDI has limited impact on the domestic investment cycle. Even portfolio investment, while it can prop up stock prices, is unlikely to promote primary investment, unless business conditions improve drastically.
  • Lower exchange rate will discourage Foreign Investment
  • The main advantage of lower interest rates is not the direct benefit of lowering cost of funds, but the impact on lowering India’s exchange rate, thus triggering demand for our exports.
  • It is time for India to focus on securing foreign markets instead of fishing for foreign investment.
  • Lower exchange rate will encourage exports, and thus good for foreign markets.


Author’s View

The argument that the rupee is already sufficiently weak in real terms, and does not require further depreciation may not hold water. The rupee should be left to depreciate further, as it will boost up our exports.

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