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Why there is no reason to panic over the rupee

Soumya Kanti Ghosh writes: India's economic fundamentals are robust. Rupee crossing the $80 mark is a result of Ukraine war, decisions by major central banks

Soumya Kanti Ghosh writes: The rupee has depreciated by a modest 5.6 per cent since the Russian invasion of Ukraine. (Reuters/File)

The geopolitical conflict underway since February 24 has thrown financial and energy markets across the world into a tizzy. A direct casualty of the Ukraine war is that the Indian rupee has now depreciated by 5.6 per cent against the dollar. by 5.6 per cent against the dollar. In terms of relative performance, however, the rupee has done quite well compared to most of its counterparts — barring the Indonesian Rupiah.

In an ideal world, if domestic economic fundamentals are strong, the depreciation of the rupee should be accompanied by an appreciation of the Dollar Index (DXY) along similar lines. Between January 2008 and February 2012 and October 2012 and May 2014, on a cumulative basis, the rupee had lost a whopping 48.7 per cent against the USD, even as the DXY had appreciated by a modest 5.2 per cent. This indicates that much of the decline in rupee value then was purely because of weak domestic macro fundamentals.

Now, fast forward to the current situation. The rupee has depreciated by a modest 5.6 per cent since the Russian invasion of Ukraine, though the DXY has appreciated by 11.3 per cent. If we extend the period from March 2021 till July 2022, the rupee depreciation is 9.7 per cent and the DXY appreciation is a sharp 17.4 per cent. Thus, the recent decline in the rupee has been more because of the strengthening of the dollar and not because of weak fundamentals at home. This is a good omen and is also substantiated by the Indian economy navigating the Ukraine conflict rather well.

In fact, a one per cent change in the DXY (or an appreciation of the dollar) leads to a 1.7 per cent change in rupee exchange rate (depreciation of the rupee), considering the 15-year period ending July 2002. If we go by the regression result, the rupee should have been at 90/dollar currently.

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Having established that the recent decline in rupee value is mostly to deal with the DXY strengthening, the logical question is: Is there any possibility of an end to such unabated dollar supremacy in the near future? The answer is perhaps a “no” at this point even though several countries including India are attempting to diversify their foreign exchange reserves in favour of non-dollar currencies.

In principle, Bretton Woods ensured that the dollar would be a “trust” currency. The US can run current account deficits unimaginable for the rest of the world. The US sits at the centre of an international financial system where its assets have been in high demand. For instance, frantically growing Asian economies whose penchant for US government securities have also made them susceptible to sudden changes in expectations and economic sentiments sweeping the globe. The recent disturbances in the global supply chain and volatile commodity prices have only made the job more difficult.

As currencies reel under the weight of an unrelenting dollar, questions on the rupee’s performance and future are a natural corollary, more so in the wake of hitting the psychological mark of Rs 80/dollar. While most of the conversations in domestic circles have centred around the known knowns, a closer look at the behavioural changes and the undercurrents that eventually become megatrends in shaping the policy perspectives and directions globally are worth pondering over.

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The recent gains in the dollar have come along expectations of aggressive monetary policy by the US Fed compared to other major jurisdictions, particularly, the Eurozone and Japan. Markets expect the Fed to continue on its path of interest rate normalisation with multiple rate hikes.

On the other hand, the European Central Bank (ECB) appears behind the curve, its communication with markets is as uncertain as the political and climatic hot winds criss-crossing the Eurozone. The Bank of Japan has taken a completely divergent path, continuing its accommodative monetary policy despite the hammering of the yen. This has augured well for the dollar, obscuring the question of how the Fed failed to anticipate the surge in inflation.

Forecasters are indecisive about whether the ECB will go for a 25 bps or 50 bps hike in its July 21 meeting. The Fed looks set to raise rates by at least 75 basis points on July 27. A higher hike by the ECB should immediately cool off the dollar, bringing parity between two major central banks. Other currencies should gain ground ceded to the dollar. Even then, the short-term returns for the dollar look promising, with a precarious EU economy making the US the only credible investment avenue.

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Coming to the US multi-year high inflation print, our research suggests that the Fed was almost nine months late in raising the rates, even as the RBI has been able to get a grip on inflation — it has already hit a peak. The Fed is now caught in a situation of a high job vacancy rate and a low unemployment rate. Our technical analysis indicates that there is more than a 97 per cent chance that this will be the status quo for some more months. This, in turn, might create a wage-price spiral that will not be a pleasant scenario for emerging economies.

So, what’s next?

Interestingly, in 2013, when the rupee was in a free fall, stability was finally restored but it came at a cost — a debt buildup of $34.5 FCNR(B). This time, the RBI and government have taken a long-term view of bolstering dollar inflows, which is perfectly justified. This would mean that the rupee could still face headwinds in the short term. The enormity of the challenges can be gauged by these numbers: Since the beginning of war, foreign exchange reserves have declined by $51-billion, total portfolio outflows have been $23 billion, and the current account deficit is now certain to breach $100 billion. July, however, has been much better with the outflows till date only at $1.3 billion.

The RBI, in close tandem with the government, has been supportive of the rupee, and is also now embarking on an unprecedented journey to internationalise the currency. With the IMF Global Uncertainty Index currently at historical highs, we can only hope for the best.

The writer is Group Chief Economic Advisor at State Bank of India. Views are personal

First published on: 19-07-2022 at 10:33:37 pm
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