Rupee Depreciation, Pass-Through and the Trade Deficit
Over three months the rupee moved from ₹82 to ₹85 per US dollar. A Haryana auto-components maker imports $2 million of precision parts every month, invoiced in dollars, and sells to domestic vehicle manufacturers under annual contracts that let it pass on only about 60% of a cost increase, and only at the next quarterly review. At the national level the current account deficit is about $80 billion, crude oil imports respond weakly to price (import price elasticity about 0.3), and merchandise export volumes respond to price with an elasticity of about 1.2. The central bank holds $600 billion of reserves and has been selling dollars to slow the slide. Exporters' bodies are demanding that the rupee be 'stabilised' at ₹82, while the finance ministry worries that defending a level will exhaust reserves. The maker's board asks what the depreciation does to its costs and whether the exchange rate can be relied on to fix the external deficit.
1. Quantify the effect on the importer's monthly rupee cost, and explain how the 60% pass-through affects its margin.
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- At ₹82: $2 million × 82 = ₹16.40 crore per month
- At ₹85: $2 million × 85 = ₹17.00 crore per month
- Increase = ₹0.60 crore (₹60 lakh) per month, a 3.66% rise for the same dollar invoice.
With 60% pass-through, the firm recovers 0.6 × 60 = ₹36 lakh through its prices at the next quarterly review and must absorb ₹24 lakh a month until then. If the rupee stays at ₹85, that ₹24 lakh gap is permanent, because each contract resets from the new cost base.
Judgement: the first problem is working capital, not margin - the dollar bill is due monthly while the price reset is quarterly, so three months of ₹60 lakh sit in the gap. The firm should hedge the dollar exposure or negotiate a currency clause, rather than wait for the central bank to restore ₹82. Note also that pass-through of 60% means the firm's customers bear part of the shock, which feeds into domestic vehicle prices.
2. Using the elasticities given, assess whether the depreciation will narrow the current account deficit.
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Marshall-Lerner condition: a depreciation improves the trade balance only if the price elasticities of export demand and import demand sum to more than 1. Here 1.2 + 0.3 = 1.5 > 1, so the condition is satisfied and the balance should improve - but only once volumes respond.
Short run (volumes still adjusting):
- Rupee import price rises 3.66%; import volume falls 0.3 × 3.66 = 1.1%; rupee import bill still rises about 3.66 - 1.1 = 2.6%.
- Export volume rises 1.2 × 3.66 = 4.4%; rupee export receipts rise about 4.4 + 3.66 = 8%.
- In dollar terms, export earnings rise 4.4% and the import bill falls 1.1%: the deficit narrows slowly. This is the J-curve.
Constraint: crude, with elasticity 0.3, barely adjusts, so almost all of the adjustment must come from exports and from non-oil imports. The deficit will not close on the exchange rate alone; it needs export volume growth and lower import intensity (domestic energy, a broader export basket). The exchange rate helps at the margin and hurts the importer in the meantime.
3. Should the central bank keep selling dollars to hold the rupee near ₹82? Advise, with reasoning.
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Against defending a level: $600 billion of reserves looks large against an $80 billion deficit, but reserves are finite, and a sustained defence against a broad dollar move burns them quickly. Sterilised intervention - selling dollars and mopping up the rupees with securities - carries a quasi-fiscal cost. Holding the rate above the market level also keeps imports artificially cheap and delays exactly the export adjustment that the 1.2 and 0.3 elasticities say is needed.
For intervening: smoothing reduces volatility, prevents panic and disorderly pass-through into import costs (relevant to the firm facing a 60% pass-through cap), and preserves confidence in the currency.
Judgement: intervene to smooth, not to target; say so publicly, so that markets do not expect ₹82 to be defended; allow gradual adjustment; and pair it with measures that reduce import intensity. Set a reserve floor - for example six months of import cover - and stop defending if it is reached. Promising a level and then abandoning it is worse than never promising it.