Trump risk: The rupee could get caught in the crossfire of a currency

Even with the election now out of the way, economic uncertainty and volatility are here to stay, given fractures in society (and thus the polity) across the developed world.

The focus thus far has been on foreign portfolio flows, interest rates, the policy stance of central banks and at times their liquidity management. 

However, post the US polls, an important variable that will likely come under the spotlight is the Indian rupee’s exchange value and the US election might prove to be a game-changer for forex markets. 

The rupee may well have to bear a greater burden of adjustment to global economic volatility from here on, as emerging markets (EMs) get into the crosshairs of a gyrating dollar and US-China policy tangles.

Also read: What Trump's win means for the Indian rupee

The Reserve Bank of India (RBI) has done a remarkable job in keeping the currency steady in times of geopolitical and geo-economic upheaval. The rupee hit a series of record lows in October. 

In November, it has already depreciated 0.36% against the dollar, prompting intervention by RBI, which has managed to keep it one of the least volatile major Asian currencies. The rupee’s near-term volatility measured through the 7-day daily realized volatility was just 0.1%, the lowest in at least 30 years.

Might all that change with a change in the White House? The dollar is at its strongest in recent memory. Viewed through the prism of purchasing power parity, it is more overvalued than at any point since the mid-1980s. 

Its level is hard to justify even after accounting for US energy independence and its leadership in technology. Even in real effective exchange rate (REER) terms, going by Bank for International Settlements data, the dollar was overvalued by about 15.5% in September 2024, compared with 16.1% in August. 

Yet, it may just strengthen more with Donald Trump’s victory, as tariffs will raise inflation and result in higher-for-longer US interest rates, which would support the dollar.

The only issue that enjoys unanimity between US Republicans and Democrats is de-sinicization and the US trade and tariff policy vis-a-vis China. Sure enough, no Chinese policy pivot would put a floor under China’s economy, soften the US tariff impact and stabilize consumer prices faster than a weaker yuan. 

Thus, it may seem tempting for China to resort to ‘some’ devaluation to keep its export prices competitive against tariffs, minimize growth losses and maximize employment, while also reducing foreign capital outflows. 

Also read: US elections 2024 outcome is set to reshape India trade ties

During Trump’s first presidency, the yuan weakened about 5% against the dollar during the initial round of US tariffs on Chinese goods in 2018, and declined another 1.5% a year later when trade tensions escalated.

But then, nothing would unite Democrats and Republicans in their ire faster than China devaluing its yuan. A weaker yuan might prompt the US to raise China tariffs further. Or even try weakening the dollar in trying to beat China at its own game. 

Not surprisingly, as the odds shorten of China joining a race to the bottom on exchange rates, financial and political risks rise for the global economy.

All of this, in turn, will weigh heavily on EM currencies and even the rupee could suffer collateral damage in the process. In a world caught up in the weaponization of trade and currencies, RBI will find its way harder to keep the rupee ‘steady.’

The world’s largest central banks have already changed tack decisively during 2024. The US Federal Reserve cut its policy rate last week by 25 basis points, after its 50-basis-points cut in September. 

The European Central Bank has been cutting rates and the Bank of Japan has made a significant departure from its long-standing ultra-loose monetary policy. 

China’s central bank seems at the cusp of another change, and Trump’s assumption of power in the US next year could tip its currency and forex management policy.

Thus, RBI, more than others, would be closely monitoring monetary policy cycles elsewhere, apart from US policy shifts on trade and tariffs that could fuel a fresh round of American inflation, which in turn would circuitously affect emerging economies. 

In case there is a rise in imported inflationary pressure, RBI may keep its repo rate higher for longer. That would be positive for the rupee, but it must balance the interests of exporters as well as importers.

The other avenue that RBI will rely upon to tackle excessive volatility, sharp capital outflows or sudden forex moves is the drawing down of its war chest of forex reserves that it has been fortifying lately in anticipation of this very environment. 

Also read: Mint Primer | Rupee’s sharp slide: How much lower can it go?

With a relatively small current account deficit and high reserves, India will suffer less. Yet, it may have to burn some reserves to preserve financial stability and defend the rupee without falling afoul of a hawkish US administration.

Governor Shaktikanta Das and team RBI have come up trumps so far in their battles with global uncertainty and volatility and it will be interesting to see how they tackle the unfolding scenario.

These are the author’s personal views.