
As rupee slides, a primer on how to manage an emerging market currency

Summary
No quick fixes are available, and superiority in trade may not be a sureshot recipe either. In the end, it boils down to investor confidence, as some election results last year proved.The past two years have been hard on emerging market (EM) currencies. A stronger dollar, higher interest rates, and geopolitical tensions caused most of them to lose value. The year 2024 should have been better—given easing inflation and lower interest rates—but Donald Trump’s election as the next US president has renewed uncertainty and plunged EM currencies into chaos again. Though most fell against the dollar, individual responses varied, driven by country-specific reasons. These factors provide useful lessons, as the Indian rupee has dropped below 86 to a dollar and continues to fall.
Forex markets factor in the fact that India normally runs a trade deficit (i.e. imports exceed exports). However, any unusual spike in the deficit can weaken the rupee, as it portends lower demand for the domestic currency. An unexpected 77% jump reported initially (now revised down to 55%) in the November trade deficit pushed the rupee down by 2.6% within a week. In the past decade, more than half the episodes of widening trade deficits were followed by a depreciation. Higher trade deficit shocks generally led to greater declines.
Also Read: Ajit Ranade: Rupee depreciation is inevitable but exchange-rate volatility is not
The rupee’s vulnerability to trade stems from three factors. First, about 30-40% of India’s imports are essential in nature, without easy domestic substitutes. Second, key imports (crude oil, steel, minerals, coal) are expected to rise strongly, in keeping with India’s growth prospects. Finally, our export cushion is low: essential imports amounted to over half of merchandise exports in 2023-24.
The solution? No quick fixes are available, but a focused effort to increase merchandise exports would be the best way to mitigate this risk.
Also Read: Rupee expected to weaken more in coming months
Fiscal matters
If a trade deficit is India’s problem, turn to Brazil: even a whopping $87 billion trade surplus in 2023 couldn’t help its currency prevent a 21% slide in 2024. Brazil’s problem is a rising fiscal deficit, fuelled by spending on welfare schemes, and a perceived lack of fiscal discipline in the present administration. Neither rate hikes nor central bank interventions have been able to help.
Investors will punish any slippage in India’s fiscal commitment with a similar run on the rupee. The present government has been fiscally prudent so far, but 2025 brings new challenges. One, some states have adopted cash transfer schemes either as a pre-poll sweetener or to compensate for stagnant real wages; these worsen state deficits. Two, tax revenue growth could potentially slow down with slowing consumption, but there is no fiscal space to stimulate spending by cutting tax rates. Finding the correct balance between stimulus spending and fiscal tightening will be key to retaining fiscal credibility.
Trade and tariff
The incoming US administration has made it clear that it will seek a greater balance in trade flows. This means that tariffs may be imposed on countries running trade surpluses with the US. In 2024, until October, China, Mexico and Vietnam led the way, and all three currencies depreciated last year. Vietnam, in particular, is doubly cursed. Its surplus with the US soared from $38 billion to $104 billion between 2017 and 2023; and China is its largest import partner, which leads to a suspicion that it is re-routing Chinese goods.
India also needs to be concerned for two reasons: it has a trade surplus, though relatively small, with the US, and Trump has accused India of high tariffs and threatened to reciprocate. The finance minister has already indicated a possible rollback of some tariffs. In addition, exploring new export destinations will reduce the surplus with the US, and facilitate new trade relationships.
Also Read: Vivek Kaul: Trump’s tariffs won’t kill the dollar’s exorbitant privilege
Confidence in the currency
Beyond growth, inflation, trade balance, and fiscal dynamics, the most important factor in currency markets is investor confidence. Currency sell-offs often represent a loss of confidence. Consider Mexico and South Africa, both of which held national elections in mid-2024. Mexico gave a sweeping victory to the incumbent party. In South Africa, for the first time since 1994, the African National Congress (ANC) lost its absolute majority. Yet in the days following the election, the Mexican peso lost value, while the South African rand strengthened against the dollar. The reason? The Mexican government, as was feared, has passed laws that undermine the judiciary, while the new South African coalition is expected to improve economic conditions.
Election results can be humbling, as the Indian government discovered in June 2024. However, as long as policy remains consistent with good governance and economic reform, the rupee will not be hit by a crisis of confidence.
The author is an independent writer in economics and finance.