Depreciation is the decline external value of the domestic currency.
A depreciating rupee implies that more of rupee is needed to purchase on dollar or similar foreign currencies. For example, if the exchange rate of Rupee against Dollar was $1 – Rs 60 yesterday and moved up to 1$ = Rs 70 today, it means we have to pay ten more rupees to get one dollar.
Now, the depreciation produces effects on India’s trade transaction as well. Previously, an American importer was getting only Rs 60 worth of goods by paying one dollar. But now after depreciation he can get Rs 70 worth of goods. Depreciation makes Indian goods cheaper in the international market (in terms of dollar). Remember foreigners read price of Indian commodities in terms of Dollar.
This will make Indian exports competitive in the international market as more of the commodities from India has actually fallen due to depreciation.
On the other hand, price of a 1$ imported product goes up from Rs 60 to Rs 70 in Rupee terms. Depreciation increases the price of foreign goods in the Indian market. This effectively discourages India’s imports.
Now, the total effect of depreciation is that it increases exports whereas discourages imports.
So far is good; though depreciation is losing our currency’s value, it indirectly gives certain benefits to us in the form of an improved trade scenario.
Still depreciation may not bring this expected benefit because of certain features in our balance of payment account.
Why excess depreciation is counterproductive?
There are the two important factors that makes depreciation in India less attractive.
1. First one is that most of India’s imports are necessaries in the form of raw materials and capital goods. Bulk of India’s imports are crude oil, raw materials and machineries. These import items are necessary for us. Hence, even if the price of these goods increases (due to depreciation) we can’t reduce their imports significantly. On the other hand, when the price of these import item goes up, it will add to inflationary pressure in our economy. Theoretically this is called as exchange rate pass through effect on inflation.
2. Second factor lies outside the trade account. Large number of Indian corporate have sizable external debt. These debts were availed through External Commercial Borrowings. Due to depreciation, the burden of their external debt goes up in rupee terms. For example, a $1 billion loan means Rs 6000 crore repayment when exchange rate is 1$ = Rs 60. It increases to Rs 7000 crore when rupee depreciates to 1$= Rs 70.
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