Why does the dollar keep strengthening? A number of factors are at play, including a slowdown in global economic growth, the energy crisis in Europe and aggressive Fed rate hikes. Historically, these conditions have caused investors to flock to safe haven currencies, like the dollar. Experts recommend investing in US Treasuries and the greenback during times of financial uncertainty. Let’s look at the factors at play in the dollar-Rupee relationship.
INR is a global currency
The dollar has been gaining in value against most of the world’s currencies, including the INR, as investors pull their money out of developing countries and pour it into the US. The Fed has also been aggressively raising interest rates, which puts negative pressure on the INR. According to INR expert Rahul Bajoria, the rupee has been performing better against the USD than other currencies because of this.
The INR has been relatively stable against the USD over the past decade, though it has suffered in recent years. One reason for this is that USD demand has increased after the 2008 financial crisis and the Greek debt crisis. It has also risen since the Brexit Referendum. This has led to an overall decline in INR value, while the USD’s stability has remained relatively stable.
The RBI sold dollars from its forex fund in an effort to prevent the rupee from depreciating further. This move was necessary as India’s foreign exchange reserves fell by $3 billion during the week of August 26.
Crude oil imports devalue INR
The value of the Indian rupee against the USD has historically been affected by the price of crude oil. About 80% of the crude oil used in India is imported from abroad. This translates into a loss of value for the Indian economy. And this loss is passed on to consumers.
The recent sharp increase in crude oil prices has exacerbated this problem. As a result, the rupee has devalued by close to nine percent since the start of the year. While the RBI’s decision to sell some forex reserves to support the rupee gave the rupee a temporary respite, it was not able to hold its gains due to the widening trade deficit. This has been largely attributed to the rise in crude oil prices and slowdown in exports.
India’s economy is the largest emerging market in South Asia, and if its oil import budget remains uncontrolled, the country will face a major crisis. Not only is the country struggling with COVID-19 and the worst-ever economic contraction in the fiscal year 2020-21, but it is also facing a soaring inflation rate. A ten-percent rise in the price of oil will add about 10 basis points to the CPI. This could lead to further depreciation in the Indian rupee.
Interest rates affect INR/USD movement
The movement of the INR/USD pair depends on several factors, including interest rates and the rate of inflation. Rising interest rates encourage investors to invest in a country’s bonds. The difference between the yield of Indian bonds and the yield on the benchmark US bond is called the spread. As a result, the INR appreciates against the USD. Higher interest rates also lead to a higher spread on foreign bonds.
Another factor that affects the INR/USD exchange rate is the interest rate difference between India and other emerging markets. Besides interest rate differences, other factors that affect interest rates include the financial system and the central bank’s policies. Inflation, unemployment rates, and government spending are also important factors. The Reserve Bank of India has used high interest rates in the past during periods of significant pressure on the external value of the rupee. One study found that a one-standard-difference shock to the call rate led to a two-month appreciation of the rupee.
A weaker rupee will increase the cost of borrowing for everyone in the economy. Because loans cost more, everyone pays more in interest. A weaker rupee also makes it harder for businesses to expand capacity. Further, a lower INR/USD exchange rate makes emerging countries less attractive for currency carry trade. As a result, the INR/USD exchange rate could drop further in the future.
Exporters benefit from weaker rupee
The weaker rupee against dollar will help Indian exporters, especially the components sector. In the last financial year, the components industry reported a trade surplus of $700 million. Total exports in FY 2018-19 increased by 43% to $19 billion. However, the rupee’s fall is expected to eat into the export earnings of the steel sector, as 60% of its inputs are dollar-linked. Besides, the May export duty on steel has slowed down steel exports.
While a weaker rupee can boost exports, it also increases import costs. Fuel prices are directly linked to the cost of transportation. This means that a weak rupee will affect household budgets. Therefore, the government is happy to see the rupee fall. Moreover, the government can use this as an opportunity to encourage exporters and increase exports.
Exporters can also benefit from weaker rupee against dollar by making their products more affordable for foreign buyers. While a weaker rupee is good for the exporters, it hurts the average Indian. Hence, the government needs to encourage non-dollar invoicing in external trade and shift borrowing from dollar to rupee. This will help reduce the country’s dependency on the US dollar and reduce currency risk. Moreover, India should take advantage of the trade war between China and USA, and export high-quality products to the US market. This will reduce the trade deficit.