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.
Why excess depreciation is counterproductive?
There are the two important factors that makes depreciation in India less attractive.
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.
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.