What plunged the rupee to its lifetime low against the dollar

The world is right now an extremely uncertain place; Several factors are at play. Russia’s invasion of Ukraine and the West’s measures to counter it, in terms of boycotting Russian exports, including energy, have added to inflationary pressures across the world. The reversing of extra-accommodative monetary and fiscal policies adopted around the world, in response to the pandemic-inflicted shock to growth and employment, the potential of the covid-19 pandemic, seemingly on the retreat, to mutate into new variants and spread panic and disruption anywhere in the world, China’s refusal to abandon its Zero-Covid strategy that entails locking down entire cities at the outbreak of covid infections even in a tiny number of people — all these are additional sources of disruption and uncertainty.

Flight from risk is a big factor in the ongoing strengthening of the dollar. The dollar has strengthened against most currencies of the world. As compared to the level vis-à-vis the dollar a year ago, the British pound has weakened by 10%, the euro by 12.6%, the yen by 16%, the South Korean won, by more than 11%, the Pak rupee, 17%. The Indian rupee has depreciated less than 7%, as compared to the strongest level in 2021, which was 72.29% on 17 March. Curiously, there is only one currency that has actually strengthened against the dollar over the past 12 months, and that is the Russian ruble, but on the back of a steep – and unsustainable – rise in interest rates: the yield on 10-year government bonds has gone up by 315 basis points, or 3.15 percentage points in Russia, thanks to the Russian central bank’s steep policy rate increase in the face of western sanctions following Russia’s invasion of Ukraine.

The daily turnover in the world’s foreign exchange markets is close to $7 trillion. A lot of money is sloshing around the world on a regular basis, in other words. Footloose capital moves to and from the world’s markets for stocks, bonds and commodities. It is in constant search of higher returns than are available in its home economies but is also averse to risk. At the first sign of danger, the footloose bits of global capital take flight and go back to deemed safe-havens. A herd effect manifests itself, as well, and managers of portfolio flows shift their funds out of economies where their fellow money managers seem to perceive risk, even if the risk is not visible to themselves.

The dollar, meaning the bonds issued by the US government, is considered to be the safest of the world’s safe havens for assets. Whenever unforeseen risk is suddenly perceived, capital flees to the dollar. The effect is so strong that when, in 2011, Standard & Poor’s downgraded US government debt, following a government shutdown triggered by Republican legislators who wished to spite the then-president, Barack Obama, the world’s capital markets got a shock. In a panic, capital fled emerging markets and took shelter in the very asset that had just been downgraded, the US dollar, strengthening the dollar, pushing up government bond prices and pushing down yields. Gold is also considered safe. But it’s a relatively unwieldy option than the dollar.

Foreign portfolio investors have taken out more than $20 billion of investments from India since January 2022. The Reserve Bank of India’s (RBI) foreign exchange reserves have come down from $633.6 billion as of 31 December 2021 to $597.7 billion as of 29 April 2022. In other words, the RBI has utilized some $30 billion (some changes in reserves are attributable to valuation changes) of its reserves to smoothen the change in the exchange rate. That this intervention has not disruptively weakened the rupee, so as to artificially cheapen exports, is clear from the near static value of the rupee’s real effective exchange rate (REER), which suggests that the rupee is a bit stronger, in real terms, than it was in 2015-16, although a tad weaker than its level in 2019-20. The REER discounts for differences in the rate of inflation in India and the countries, whose currencies form the basket, against which REER is measured. The REER takes into account the different rates of inflation in India and the US and other economies, against whose currencies changes in the rupee are measured.

The exchange rate is also influenced by the rate of interest. If the interest rate is higher in India than in the US, it makes sense to put money into rupee assets than to hold them in dollar assets, and some money comes in, hedging for the possibility of the rupee depreciating and wiping out, in dollar terms, some of the additional returns to be obtained in India. Suppose the interest rate goes up in the US. Some of the capital that had come in could go back, now that the additional return promised by the interest rate differential has been pared. To depress this effect, India could raise its own rate of interest. And this is what happened at the off-cycle meeting of the Monetary Policy Committee on 4 May that increased the repo rate by 40 basis points, in the face of an expected Fed rate hike of 50 basis points. If the Reserve Bank of India had not increased its policy rate, the interest rate differential between the US and India would have narrowed, accelerating the pace at which dollar investors are pulling out from India, leading to a steeper fall in the rupee.

The rupee is at a neutral level for the Indian economy at present. If it is depressed to facilitate exports, then inevitably imports would also become more expensive, particularly oil, gas and coal, feeding inflation. It would also make the servicing of overseas debt that much more expensive. If it is kept overvalued so as to make imports cheap, that would make Indian exports non-competitive in the global market.

So long as the world economy remains in the thrall of war and resultant scarcity, inflation and risk, the rupee’s exchange rate would remain volatile. Strong spending by the government to boost investment and growth is more important for reinforcing investor confidence in the Indian economy and stabilizing capital flows and the exchange rate, than foreign exchange management by the RBI.