IAS Economy Practice Question . 24

Why is rupee declining against dollar despite India doing better than U.S in terms of economic growth?
1. Dollar is demanded by investors as a safe asset
2. The impact of Eurozone Crisis caused the Dollar fall against Euro
3. High Inflation in India caused rise in real exchange rate
4. Collapse of International Trade in commodity sector
Which among the above justify the question asked?
[A]Only 1
[B]1 , 2 & 3
[C]1, 3 & 4
[D]1, 2 3 & 4


Answer: 1, 3 & 4
1. Dollar is demanded by investors as a safe asset
This is a correct statement. Despite the crisis in the US, the demand for Dollars as a safe investment has lured the investors.
2. The impact of Eurozone Crisis caused the Dollar fall against Euro
This statement is incorrect. European debt crisis that led to relative appreciation in dollar (US$ rise against Euro), which was coupled with the domestic factors such as inflation, FII outflows, High Fiscal Deficit etc.
3. High Inflation in India caused rise in real exchange rate
This is a correct statement. The persistence of high inflation over a number of years is bound to impact the economy’s competitiveness, as already evidenced by the rise in the real exchange rate. Furthermore, latest estimates of India’s purchasing power parity based exchange rate also show that one needs substantially more local currency to purchase an internationally comparable set of goods
4. Collapse of International Trade in commodity sector
This is also a correct statement. Commodity prices are crashing at international level and the importers are trying to accumulate dollars, as they have to pay in terms of dollars and at the end demand is increasing against the rupee. Exporters have a very few orders from outside countries, so there is no matter of converting dollar into rupee thereby decreasing demand for rupee.
Bankers also say that the rupee is worst performing Asian currency having fallen nearly 10% in value in the last three months. The Reserve Bank of India has foreign exchange reserves amounting to $316bn which makes it the seventh largest. However, most of these reserves have been accumulated as a result of RBI buying dollars brought in by portfolio investors. The central bank therefore considers the forex reserves as a liability which may be required if foreign investors chose to exit. More importantly India is the only country with sizeable reserves and a current account deficit. Also this year the country’s total external debt has soared beyond the size of its forex reserves. All these factors add to the weakness of the rupee although prospects for the economy remain relatively good.

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