The current situation in the foreign exchange market is reminiscent of 2013 when worries about the US Federal Reserve tapering its quantitative easing had sent all emerging market currencies spinning lower. The rupee has lost 4.5 per cent against the dollar so far this year, along with other emerging market currencies such as the Brazilian real, the Philippine peso and the Russian rouble. The sharp appreciation in the dollar, causing foreign portfolio outflows from equity and debt markets are the prime cause of currency depreciation this time too. While India has been adding to its forex reserves, and appears better positioned to tackle volatility in forex market this time, it might be better to limit interventions in the currency market and allow the currency to trade at market-determined levels.
The current turbulence in the global financial market could last for a while. After staying in a somnolent range through the early part of 2018, the dollar index suddenly spiked over 3 per cent last fortnight and there are expectations that the dollar could continue to rally. With the yield on US 10-year bonds moving close to 3 per cent, the interest rate differential is clearly tilted in favour of the US, making foreign funds flow into dollar-denominated assets. Besides, the results of President Trumps’ policies to rationalise taxes and addressing the country’s trade imbalances are also perceived as beneficial to the dollar. If the dollar continues to strengthen, emerging market currencies will remain under pressure. With India’s external account largely buttressed by foreign portfolio flows, such periods of global risk-off phases have been quite detrimental to the rupee. The rupee is further impacted due to rising crude oil prices affecting the trade deficit and the increasing core inflation.
The RBI should, however, adhere to its stated objective of not interfering in the foreign exchange market, except to contain excessive volatility. The central bank has been buying dollars through 2017, in a bid to build its forex reserves. While the foreign exchange reserves at $423 billion are much improved from the level in 2013, they are still not enough to shield the economy if there are sustained fund outflows; when the forex cover for external debt is considered. Core inflation is moving higher and with high crude oil prices adding to inflation, the RBI’s policy stance may turn hawkish. However, higher domestic interest rates, coupled with measures to check foreign fund outflows from debt, akin to the actions taken last month, can be more beneficial to the rupee than direct market intervention. The RBI should also not lose sight of the fact that a weak rupee is conducive for exporters who have been impacted by the uncompetitive value of the currency; as reflected by the real effective exchange rate of the rupee. Market intervention will only make the rupee more vulnerable by eroding the reserves.
via Rupee rumbles – Business Line