Currency values are in a fierce tango with interest rates

The EU’s euro just broke parity with the dollar for the first time in about 20 years. The Japanese yen has declined by nearly 20% since the beginning of this year and 30% since the beginning of 2021. The trade-weighted-dollar of the US has risen nearly 10% since its recent trough in June 2021. Large movements of this type among the world’s hard currencies are rare and usually signify a ‘retreat to a safe-haven’.

Peeling the onion skin on the US dollar’s recent moves would suggest that changes in its exchange value have generally mirrored an increase in US real interest rates. As the real yield of the US 5-year bond has risen from -1.5% at the beginning of this year to just about 0% now, the dollar has appreciated about 10%. This is as it should be. The principle of interest rate parity (IRP) suggests that a country’s currency will rise relative to another when its real interest rate rises in such a manner that hedged currency returns remain the same. Note that the US dollar has reversed nearly all the ground it lost to other currencies at the onset of the covid pandemic.

Even as Eurozone inflation has risen to 6.8%, the European Central Bank (ECB) has been slow to raise rates. The ECB’s first rate-hike of 25 basis points is expected in July. So, some of the dollar’s strength versus the euro can be traced to a lack of confidence in the ECB’s action to combat inflation. In 2022, the surprise factor for the ECB has been the war in Ukraine, which has simultaneously fuelled inflation and exerted pressure on EU economies to find alternatives to Russian oil and gas. This has made the ECB’s job tricky as it seeks to balance inflation and economic disruption. Markets have baked in a 180 basis points increase in euro rates over the next 18 months, but that trajectory may have to change if recession arrives early in 2023.

Japan’s central bank has categorically stated that it will not raise rates or engage in quantitative tightening. Along with interest rate differentials, this has meant that the yen has declined to its lowest level in 24 years against the dollar. In the context of today’s global inflation, Japan has been working to create modest, sustainable inflation over the last three decades. The Bank of Japan is reluctant to jeopardize that goal in its response to current threats.

The Bank of England (BoE) has already raised rates five times this year. Reflecting the UK’s particularly fragile relationship between higher rates and slower growth, the BoE warned British banks to shore up their capital base. It has signalled that it will likely ask lenders to hold more in risk-weighted assets, a so called “counter cyclical buffer”.

With the world’s big four central banks out of sync in terms of speed and direction, global currency markets are being roiled. Asian currencies registered their worst quarter since the Asian crisis of 1997. The Indian rupee is down about 7% for the year, the Pakistani and Sri Lankan rupees have declined precipitously, and even a commodity-propped currency like the Brazilian real has depreciated by about 13% in the last two months. This could be called Taper Tantrum 2.0, following a similar period in 2013. Of course, at that time inflation was not as much of a threat, so the possibility of large rate rises was limited.

The dollar’s relentless rise has broken the back of the Sri Lankan economy and is likely to accelerate a $1.17 billion International Monetary Fund (IMF) bail-out deal for Pakistan. This first tranche of an overall $7 billion package will mark a revival of the 22nd such IMF deal for Islamabad. The Turkish Lira has lost 23% this year on top of a 44% loss last year. Turkish inflation now is an annual 79%, mostly due the lack of a credible monetary response exacerbated by the rising dollar. Turkey is at risk of joining a club with Venezuela, Sudan and Lebanon. These countries have inflation rates in triple digits with sharply depreciating currencies.

The Indian rupee has depreciated at about 3% a year relative to the dollar over the past 10 years. Given that this incorporates two taper tantrums, this performance is better than usual for India and better than average for emerging markets.

The main reasons for the rupee’s better performance overall are the country’s 2016-adopted framework for a nominal policy anchor through a monetary policy committee (MPC) and the availability of a large cache of forex reserves (now about $600 billion) to help stabilize the currency in times of stress. These reserves of foreign exchange have stayed robust because India is among the world’s few large economies to have sustained rapid growth, which attracts inflows.

Even though the MPC has been able to rein in inflation below the mean target level of 4% only for a brief period, it has served to reduce inflation volatility.

If the Reserve Bank of India borrows some lessons from its own handling of the 2013 taper tantrum, there is no need for undue pessimism on the rupee. These lessons include the prudent raising of interest rates, increasing friction on imports of gold (duties have been raised), measures to attract more inflows of capital from overseas, establishing a forex swap window for oil firms thus reducing dollar demand, and reducing the outward flow of funds from both corporations and households.

If the government focuses on broad-based and inclusive growth strategies, then the Indian rupee can further slow its annual depreciation against the American dollar.

P.S: “If you get all tangled up, tango on,” said American actor Al Pacino.

Narayan Ramachandran is chairman, InKlude Labs. Read Narayan’s Mint columns at www.livemint.com/avisiblehand