For a while, it seemed that the dollar was losing momentum at levels of over 105 for the DXY. That led analysts to believe that it was peaking. However, its recent move past 106 means that these bets are off. If it does stabilise at 105-106 and then softens a bit, as some anticipate, the rupee could find reprieve.
In analysing the rupee’s recent fall, we could remind ourselves of the somewhat obvious fact that
an exchange rate involves two currencies.
Then ask the question: how much of the fall in the exchange rate is because of shrinking demand for the rupee with exports falling massively short of imports, and foreign portfolio investors (FPIs) leaving Indian shores.
And how much of this movement is because of the dollar's rise, specifically its steady gains against almost all other currencies.
To put it more crudely: is depreciation being driven by the dollar's rise or the rupee's fall?
Enough beating around the bush. Let’s get to the burning question –
is there more depreciation ahead, or is the rupee close to the bottom? Viewed through the dollar lens,
it all depends on whether the dollar has peaked or not.
A good gauge of the dollar's strength (or weakness) is the US Dollar Index (DXY) that averages the dollar's exchange rate vis-a-vis major developed market currencies. This has gained over 10% from the beginning of 2022 moving from around 96 to 106. The movement of emerging market (EM) currencies not in the basket often mimics the DXY.
A quick review of what has driven the dollar's strength might help.
US government bonds have traditionally been a 'safe haven' for investors. The risks associated with the arrival of the Omicron variant of Covid-19 early in the year, China’s ‘zero-Covid’ lockdowns and the war in Ukraine have sent investors flocking to these dollar assets. Besides, the volte face in monetary stance by the US Federal Reserve has added to dollar appetite. It’s a full-on assault on domestic inflation, instead of a more calibrated withdrawal of monetary support that has pushed US interest rates up, and pulled money back into safe US debt away from other markets and risky assets like stocks.
Prima facie, the dollar should be set for a long climb.
After all, the Fed is likely to push up its policy rate by at least one-and-three quarter of a percentage point by the end of the year.
It will also suck out a whopping $1 trillion from the economy by next year. Thus, predicting a continuous northward march in the US currency seems like the proverbial no-brainer.
However, financial markets, particularly exchange and interest rates, are known to 'price in' policy prospects and economic events much ahead of them actually happening.
The question to ask then is: how forward-looking are exchange rates, and how much of future monetary tightening by the Fed is already priced in?
The Deviating Dollar
For a while, it seemed that the dollar was losing momentum at levels of over 105 for the DXY. That led analysts to believe that it was peaking. However, its recent move past 106 means that these bets are off. If it does stabilise at 105-106 and then softens a bit, as some anticipate, the rupee could find reprieve. Stability in the dollar could mean the slow return of risk appetite and revival of portfolio inflows into the Indian markets.
The view through the rupee lens shows a bloated trade deficit as prices of oil and other commodities like coal result in a massive import bill. In June, oil imports rose by a hefty 91% and coal by 241%. The trade deficit during the first three months of this fiscal widened to $70.25 billion from $31.42 billion last year. (The trade deficit measures the amount of dollars leaving our shores because of excess imports). If this continues, the depreciation pressure on the rupee will sustain.
Will the trade deficit continue to be so large? This depends on how quickly the main concern about the global economy shifts from fears of untrammelled inflation to that of an impending recession.
Alas, the only way central banks can smother inflation is by destroying demand by making consumer and company borrowing costs more and more expensive. As EMIs rise, for instance, consumers are likely to buy fewer cars. Car prices could steady, even fall.
Ironically enough, intensifying recession fears might just bring some succour to the rupee.
Metal prices (forward-looking much like exchange rates) have softened considerably on fears of low demand in the future. Copper prices, for instance, have come down by 28% over the last three months. For a net commodity importer like India, this is good news. If recession fears ultimately spill over to oil prices (they dipped briefly below $100 on Tuesday), India's oil import bill could compress.
But hold on! It might be a little callous to claim a global recession is the answer to the rupee's problems.
Recession may lead to another round of capital outflows and hit Indian exports. The initial reaction of the financial markets to the prospect of recession has been to make a grab for the US bonds, taking the dollar up yet again. The future of the rupee depends on whether the fall in imports outweighs these negatives, or it works the other way around.
Rubbing Re the Right Way
Finally, how much can the Reserve Bank of India (RBI) do to check the rupee's decline either through direct intervention in the markets or through policy measures? On Wednesday, it announced a slew of measures making NRI deposits cheaper to hold for banks, and lifting restrictions on foreign holdings of local government bonds. These could make a difference at the margin.
However, it is somewhat futile for central banks to lean against the wind. If global macroeconomic turbulence is set to push the rupee down, RBI can occasionally slow its momentum but is unlikely to reverse its direction.