Domestic Bonds

BL Explainer: A strong dollar and its implications for India

Why is the US dollar strengthening?

The US Dollar Index, which measures the greenback’s exchange rate against the world’s six major currencies, recently rose above its highest level in 20 years and is currently trading above 105. It started the year at 96. Three macroeconomic developments propelled the dollar index higher.

First, consumer price inflation in the United States, which had been rising slightly since October 2021, reached 8.6% in May 2022, its highest level since December 1981, due to high energy prices and food. When inflation rises, interest rates in an economy generally catch up. This makes bond investments in the country more attractive, leading to increased demand for the currency. The yield on ten-year US government bonds doubled from 1.4% to 2.8% in one year.

Second, the US Federal Reserve, after denying the stickiness of inflation until early 2022, has gone into overdrive to stifle it with rate hikes in recent months. Since March, the Fed has raised its key rates by 150 basis points. With its recent hawkish statements, market watchers expect it to pull another 75 basis points higher in July.

Third, with Western central banks turning off the easy money taps and raising rates, the tidal wave of cheap global money from these countries has propelled all risky assets from cryptocurrencies to junk bonds through private and public market equities, suddenly began to pull back.

This led to steep falls in risky assets, causing a global flight to safety. The majority of global institutional investors are based in the United States. As they withdraw from risky assets and repatriate their money home, the demand for dollars increases, further strengthening the Dollar Index.

What does this mean for the Indian Rupee?

When the US dollar strengthens, the Indian rupee usually has no choice but to give way. India depends on dollar-denominated imports for more than 85% of its crude oil needs and also imports more goods than it exports. Therefore, when the dollar strengthens, India’s import bill typically skyrockets, perversely increasing the local demand for dollars.

Withdrawals by foreign portfolio investors (REITs) are making the situation worse as it further increases domestic demand for dollars. Since the beginning of the year, the rupee has lost about 6% of its value against the dollar.

What impact will this have on India and its economy?

A stronger dollar tends to inflate India’s import bill and widen the deficit between its imports and exports. If this gap gets out of hand, it could lead to a balance of payments crisis (although the risks are low in the current environment). Many commodities and intermediate goods imported by India are also becoming more expensive, which can fuel domestic inflation.

The recent strength of the dollar has amplified the impact of recent spikes in crude oil and edible oil prices on the Indian consumer. Indians who send money in dollars to support their relatives will have to pay more. A flight to the dollar by foreign investors precipitates a fall in local stock and bond prices.

A rapidly depreciating rupee may also force the RBI to raise interest rates faster or more sharply than it originally expected, in order to stem capital outflows.

How does RBI handle this situation?

When the rupee slides against the dollar, RBI has two main weapons in its arsenal to stem the slide. It can force steep interest rate hikes in India, to make domestic bonds and gilts more attractive to foreign investors to rethink their withdrawals.

Or it can use its large foreign exchange reserves, constituted precisely for such eventualities, to intervene directly on the foreign exchange market. RBI has used several avenues to increase the supply of dollars in the market. So far this year, it is estimated to have spent more than $40 billion of its reserves to sell dollars and buy rupees.

He also took short dollar positions in futures and futures markets. However, the stated position of the RBI is that it will not prevent the rupee from finding its true value through depreciation. Its main objective is to prevent the economy from suffering shocks due to uncontrolled exchange rate volatility.

What is the prognosis for the US dollar and the Indian rupee in the short term?

With the ongoing Russian-Ukrainian conflict, oil prices still boiling and no sign of relief from REIT drawdowns, most forecasters expect the rupee to slide further to 80 or even 81 against the dollar in the coming months. However, these forecasts can change very quickly if the conflict ends, oil prices cool, or REITs suddenly start to find value at lower levels in Indian equities.

Published on

July 05, 2022