Undervalued Rupee: Drivers, Opportunities & Challenges

The Indian rupee has shifted from overvaluation to undervaluation, offering fresh opportunities for exports, manufacturing competitiveness and external sector resilience.

Understanding an Undervalued Rupee

• Meaning: An undervalued rupee is one whose exchange rate is lower than its fair or equilibrium value, making Indian exports cheaper and more competitive, while increasing the cost of imports.

Key Exchange Rate Indicators

• Nominal Exchange Rate: Value of the rupee against a foreign currency. E.g., ₹96/US$
• NEER (Nominal Effective Exchange Rate): Weighted average value of the rupee against currencies of major trading partners; reflects nominal competitiveness without accounting for inflation.
• REER (Real Effective Exchange Rate): NEER adjusted for inflation differentials; the most reliable indicator of the rupee’s real external competitiveness.

Interpretation of REER

• REER > 100: Rupee is overvalued, making exports relatively expensive.
• REER ≈ 100: Rupee is fairly valued.
• REER < 100: Rupee is undervalued, improving export competitiveness and discouraging imports.

Recent Trend

• REER Decline: The REER declined from 108.03 (November 2024) to 91.26 (June 2026), indicating a shift from an overvalued to an undervalued rupee.
• Competitive Rupee: The rupee now outperforms the Chinese yuan on broad-based real exchange rate measures, enhancing India’s global trade and external competitiveness.

Drivers of Rupee Undervaluation

• The rupee’s undervaluation reflects a combination of global economic developments and domestic macroeconomic factors influencing India’s exchange rate dynamics.

Global Factors

• Oil Shock: West Asian tensions pushed Brent crude above $120/barrel, increasing dollar demand and weakening the rupee.
• Dollar Strength: Higher US interest rates attracted global capital, causing FPI outflows and depreciation of emerging market currencies.
• Trade Uncertainty: Supply-chain disruptions, shipping bottlenecks and protectionist measures reduced trade confidence, exerting pressure on the rupee.

Domestic Factors

• Import Dependence: India imports 85% of crude oil, raising dollar demand and widening the merchandise trade deficit.
• Inflation Differential: Higher domestic inflation than trading partners increased the REER, reducing India’s external price competitiveness.
• Managed Float: RBI follows a managed-float regime, permitting flexibility while intervening to curb excessive exchange-rate volatility.

Opportunities for the Indian Economy

• Export Competitiveness: A cheaper rupee boosts exports, with engineering goods contributing over 26% of India’s merchandise exports in FY26.
• Manufacturing Growth: Costlier imports encourage domestic production under ₹1.97 lakh crore PLI schemes, strengthening Make in India and Atmanirbhar Bharat.
• External Stability: Higher exports and moderated imports can narrow the US$280+ billion merchandise trade deficit (FY25), improving external sector resilience.
• Employment Generation: Rising exports can generate labour-intensive jobs through 8.7 crore MSMEs employing over 38.9 crore people.
• Services Advantage: A weaker rupee enhances the competitiveness of India’s US$280+ billion IT-BPM industry while increasing the rupee value of US$135 billion remittances (2025).

Challenges of an Undervalued Rupee

• Imported Inflation: India imports nearly 85% of its crude oil, making fuel, fertilisers and edible oils costlier, thereby fuelling inflation.
• Rising Import Bill: Costlier imports of electronics, machinery and semiconductors widen India’s US$280+ billion merchandise trade deficit (FY25).
• Debt & Fiscal Pressure: A weaker rupee increases external debt servicing costs and raises expenditure on fuel and fertiliser subsidies.
• Capital Volatility: Persistent depreciation may trigger FPI outflows, reduce investor confidence and increase exchange-rate volatility despite RBI interventions.
• Limited Export Gains: Currency depreciation alone cannot boost exports without stronger global demand, lower logistics costs and higher manufacturing productivity.

Way Forward

• Enhance Productivity: Increase R&D expenditure (currently ~0.65% of GDP) and accelerate Industry 4.0 adoption to improve global competitiveness.
• Strengthen Manufacturing: Expand PLI schemes worth ₹1.97 lakh crore and develop semiconductor and electronics ecosystems to deepen domestic value addition.
• Diversify Exports: Promote high-value exports such as electronics, pharmaceuticals, defence products and digital services, targeting US$2 trillion exports by 2030.
• Reduce Imports: Scale up renewable energy, domestic critical mineral processing and indigenous manufacturing under Atmanirbhar Bharat to reduce external vulnerabilities.
• Trade Competitiveness: Conclude FTAs, strengthen 8.7 crore MSMEs, and implement the National Logistics Policy to reduce logistics costs from 13–14% to 8% of GDP.

“Trade is the engine of growth.” An undervalued rupee must complement structural reforms to achieve globally competitive, export-led Viksit Bharat.

Reference: The Indian Express

PMF IAS Pathfinder for Mains – Question 765

Q. The transition of the Indian rupee from an overvalued to an undervalued currency has significant implications for India’s external sector. Analyse its opportunities and challenges for the Indian economy. (250 Words) (15 Marks)

Approach

• Introduction: Write a contextual introduction about the undervalued rupee and the Indian Economy.
• Body: Write about the undervalued rupee and its opportunities, challenges for the Indian economy, and the way forward.
• Conclusion: Emphasis on export-led growth, domestic manufacturing and external sector resilience to strengthen India’s global economic competitiveness.