Clipped from: https://www.thehindubusinessline.com/blexplainer/bl-explainer-strong-dollar-and-its-implication-for-india/article65601882.ece
Three macro-economic developments have propelled the Dollar Index upwards
Why is the US dollar strengthening?
The US Dollar Index, which measures the greenback’s exchange rate against six major global currencies, recently surpassed its 20-year high and is currently trading at over 105. It began the year at 96. Three macroeconomic developments have propelled the Dollar Index upwards.
One, US consumer price inflation which was edging up since October 2021 hit 8.6 per cent in May 2022, its highest level since December 1981, driven by high energy and food prices. When inflation rises, interest rates in an economy generally catch up. This makes bond investments in the country more attractive, leading to higher demand for the currency. The yield on the 10-year US government bond has doubled from 1.4 per cent to 2.8 per cent in a year.
Two, after being in denial about the stickiness of inflation until early 2022, the US Federal Reserve has gone into overdrive to quell it with rate increases in recent months. Since March, the Fed has raised its policy rates by 150 basis points. With its recent hawkish pronouncements, market watchers expect it to put through a further 75 basis point hike in July.
Three, with Western central banks closing the tap to easy money and raising rates, the tidal wave of cheap global money originating from these countries, that propelled all risky assets from cryptocurrencies to junk bonds to equities in the private and public markets, has suddenly begun to recede.
This has led to sharp falls in risky assets, prompting a global flight to safety. A majority of global institutional investors are based out of the US. As they withdraw from risky assets and repatriate their money back home, dollar demand surges, further strengthening the Dollar Index.
What does this mean for the Indian rupee?
When the US dollar strengthens, the Indian rupee usually has no choice but to give in. India relies on dollar-denominated imports for over 85 per cent of its crude oil requirements and imports more goods than it exports. Therefore, India’s import bill usually shoots up when the dollar strengthens, increasing the local demand for dollars.
Foreign Portfolio Investor (FPI) pullouts worsen the situation because this further increases the domestic demand for dollars. Since the beginning of the year, the rupee has lost about 6 per cent in value terms against the dollar.
How will this impact India and its economy?
A stronger dollar tends to bloat India’s import bill and widen the deficit between its imports and exports. If this gap gets out of control, it can lead to a balance of payments crisis (though risks of this are low in the current context). Many essential commodities and intermediate goods that India imports also get costlier, thus feeding into domestic inflation.
Recent dollar strength has magnified the impact of recent crude oil and edible oil price spikes on the Indian consumer. Indians who remit money in dollars to support relatives will need to shell out more.
A flight to the dollar by foreign investors precipitates a fall in local stock and bond prices.
To stem capital outflows, a fast-depreciating rupee can also force the RBI’s hand in hiking interest rates more quickly or steeply than it originally intended.
How is the RBI handling this situation?
When the rupee slides against the dollar, the RBI has two main weapons to stem the slide. It can put through sharp interest rate hikes in India, to make domestic bonds and gilts more attractive to foreign investors, so that they rethink their pullouts.
Or it can use its large foreign exchange reserves, built up precisely for such contingencies, to intervene directly in the currency market. The RBI has been using multiple routes to add to the supply of dollars in the market. So far this year, it is estimated to have spent over $40 billion out of its reserves to sell dollars and buy up rupees.
It has also been taking sell positions in the dollar in the futures and forward markets. However, the RBI states it won’t stop the rupee from finding its true value through depreciation. Its main intent is to prevent shocks to the economy from a bout of unruly exchange rate volatility.
What is the prognosis for the US dollar and Indian rupee in the near term?
With the Russia-Ukraine conflict persisting, oil prices still on the boil, and no sign of relief on the FPI pullouts, most forecasters expect the rupee to slide further to 80 or even 81 levels against the dollar in the coming months. However, such forecasts can change very quickly if the conflict ends, oil prices cool off, or FPIs suddenly begin to find value at lower levels in Indian equities.
Published on July 05, 2022