RBI’s actions to bring down inflation would be crucial in determining the exchange rate. The RBI will need to tame inflation to strengthen the rupee

India and other emerging countries have far outperformed rich countries against the greenback. Finance Minister Nirmala Sitharaman’s take on the falling value of the rupee was not well received. Social media erupted in trolls and sarcastic comments on her statement that rupee is not weakening but dollar is strengthening.

Falling value of the rupee in terms of the greenback could be synonymous with a weakening rupee, but right now, the FM’s statement reflects logic. A weakening rupee would mean a fall in the purchasing power. And if there is such a phenomenon, the rupee’s value would plummet against all major currencies. Fall in currency rates against the dollar is now a global phenomenon and is triggered by increasing capital flight to the US.

Expansionary fiscal and monetary policy during the pandemic gave rise to high inflation numbers in the US. The US recorded inflation of 8.2 per cent this September compared to 5.39 per cent in September 2021. The Federal Reserve is now rapidly hiking interest rates to contain inflation which is being described as the most aggressive tightening run by the Fed in 40 years.

The Fed lending rates now stand at 3.25 per cent, up from 0.25% in January this year. This interest hike has been draining capital towards the US from all over the globe, which resulted in a greater demand for the greenback. Besides, a combination of factors such as the escalation of geopolitical tensions, especially in Ukraine and the impending recession warning by the IMF and other global agencies fuel the dollar’s recent surge. This results in a global move to the safe haven of the dollar as investors seek to protect their money, causing the dollar’s appreciation.

The dollar has been the most important currency for a long. It has strengthened by about 20 per cent against a basket of global currencies in the last 20 years, reflecting its dominant role in the global financial landscape. A study by the IMF also shows that around 40 per cent of the world’s transactions are carried out through dollars. The resilient nature of the US economy, along with the huge volume of trade and finance undertaken through its denomination, maintains the greenback’s superior position even though technological advancements like cryptocurrencies and digital payment systems could undermine the dollar’s role in transactions.

One year ago, in October 2021, one dollar equaled roughly 75 rupees. With the rates crossing the 83-mark last Wednesday, the rupee has depreciated against the dollar by more than eight per cent in 2022 alone. The RBI has also been stepping up its interventions to minimise the volatility in the Indian foreign exchange market. Since last September, India’s Forex reserves have gone down by about $110 billion, almost half of which accounts for dollar sales, and the rest is due to valuation loss triggered by falling global bond prices.

With the hawkish approach of the Fed, the fast-depreciating value of the rupee has been of great concern in India, owing to the huge import demand and the potential negative impact on the capital market. In contrast to the falling value of the rupee against the dollar, the rupee has been doing well against other major currencies. The rupee has strengthened by about 11.5 per cent against the British pound in the last year as the rate rose from rupees 104 per GBP last October to 92 per GBP now.

The rupee strengthened against the Euro, too, up from rupees 88 per Euro to rupees 82 per Euro in the same timeline. One Yen, valued at 65 paise last October, is now valued at 55 paise, also showing a strengthening of the rupee by about 15 per cent. Valuation of the rupee against the Canadian Dollar has been stable at around 60 rupees per dollar and hasn’t changed much in the last year. The Indian denomination has also strengthened against Swedish Krona and has remained relatively stable to the Chinese Yuan and Swiss Franc in the same period.

Pitching USD to other major currencies also shows strengthening dollar values. The dollar index, which measures the relative value of the USD against six major currencies of the world, improved from 93.8 the last October to 113 now. In other words, the dollar has appreciated 20.5 per cent against the six major currencies.

The Japanese Yen has fallen by about 20 per cent from January to September 2022. The British Pound and Swedish Kroner fell by more than 15 per cent and the Euro by more than 10 per cent. The Brazilian Real and Mexican Peso are the only major winners in terms of strengthening against the Dollar. Depreciation of the rupee in terms of the dollar can be therefore attributed to the strengthening dollar against all major currencies around the world rather than a weakening rupee. In fact, the rupee has outperformed the currencies of all major rich countries.

Even with the rupee remaining strong in adverse global conditions, it is still depreciating in terms of the dollar, which has its implications. A majority of international transactions are carried out in terms of dollars, and a depreciating rupee would mean higher import bills. With over a third of the CPI (Consumer Price Index) being imported, these higher import bills will certainly translate into higher inflation domestically. Rising import bills would also mean a wider current account deficit for India, which already does not look very good.

The falling exchange rate has also caused a loss of $110 billion worth of forex reserves, 67 per cent of which RBI claims is due to valuation changes caused by the strengthening dollar and higher US bond yields. The higher interest rate in the US is also triggering volatility in the Indian stock market, as the interest rate difference between India and the US has been narrowing in recent months.

The persistently high inflation in the US would push the Fed to announce higher interest rates to meet its aimed band of 4.25-4.5 per cent by the end of 2022. This would result in higher capital flight and subsequent depreciation. The RBI has already conducted dollar sales worth $45 billion to ensure a smooth decline of the rupee. The current forex reserves with the RBI are only enough to cover eight months of import bills, where six months’ worth of cover is a bare minimum.

The RBI’s actions to bring down inflation to the targeted range would also be crucial in determining the exchange rate. In the long run, the RBI’s plan to push for the adoption of rupee for international transactions through Vostro accounts will reduce India’s dependence on the dollar. Finally, lower dependence on the greenback, lower and stable inflation and sustained economic growth with higher exports would also ensure a strong rupee in the time ahead.

(Santosh Kumar Dash is an Assistant Professor at the Gulati  Institute of Finance and Taxation [GIFT], Thiruvananthapuram. Sidharth R. is an MA student in Economics at the University of Kerala)