Exchange rates fluctuate in most parts of the world where monetary authorities do not actively manage the value of a currency against one or more external currencies. Exchange rates are influenced by many factors: investor confidence, interest rate differentials between countries, inflationary differences between countries, growth prospects, changes in monetary policy, policy prediction and stock market volatility.
The world is a very uncertain place right now; Several factors are at play. Russia’s invasion of Ukraine and the West’s measures to counter it, in the context of boycotting Russian exports, including energy, have added to inflationary pressures around the world. The reversal of extra-accommodative monetary and fiscal policies adopted around the world, in response to the pandemic-induced shocks to growth and employment, the potential for the COVID-19 pandemic to retreat, mutate into new forms and spread panic and Disruptions anywhere in the world, China’s refusal to give up on its zero-Covid strategy, which includes shutting down entire cities over outbreaks of Covid infections even among small numbers of people – are all additional sources of disruption and uncertainty.
Risk-taking is a big factor in the dollar’s continued strength. The dollar has strengthened against most of the world’s currencies. Compared to the dollar level a year ago, the British pound 10%, the euro 12.6%, the yen 16%, the South Korean won, more than 11%, the Pak rupee, 17%. The Indian rupee has depreciated less than 7% as compared to its strongest level in 2021, from 72.29% on March 17. Curiously, only one currency has really strengthened against the dollar over the past 12 months, and that is the Russian ruble, but on the back of a sharp – and volatile – interest rate hike: the 10-year government yield in Russia. Bonds in Russia have risen 315 basis points, or 3.15 percentage points, due to a sharp increase in the Russian central bank’s policy rate due to Western sanctions following Russia’s invasion.
The daily turnover in the world’s forex markets is close to $7 trillion. In other words, a lot of money is being slowed down around the world on a regular basis. Footloose Capital travels to and from the world’s markets for stocks, bonds and commodities. It is in constant pursuit of higher returns than its domestic economies, but is also risk averse. At the first sign of danger, the loose pieces of global capital’s legs fly off and head back to the safe-haven. A herd effect also manifests itself, and managers of portfolio flows tend to shift their funds out of economies where their fellow money managers understand the risk, even when the risk itself is not visible.
Dollars, ie bonds issued by the US government, are considered one of the world’s safest havens for property. Whenever unforeseen risk is suddenly detected, capital rushes to the dollar. The effect is so strong that when, in 2011, Standard & Poor’s downgraded the U.S. government’s debt, following a government shutdown initiated by Republican legislators that shocked the world’s capital markets, despite then-President Barack Obama. In a panic, capital fled emerging markets and took refuge in the same assets that had just been downgraded, the US dollar, strengthening the dollar, pushing up government bond prices and slashing yields. Gold is also considered safe. But it is a relatively cumbersome option compared to the dollar.
Foreign portfolio investors have pulled out more than $20 billion from India since January 2022. The Reserve Bank of India (RBI)’s foreign exchange reserves have declined from $633.6 billion as on December 31, 2021, to $597.7 billion as of April 29, 2022. In other words, the RBI has used some $30 billion of its reserves (some changes in reserves are due to valuation changes) to facilitate exchange rate changes. That this intervention has not disincentively weakened the rupee, so as to artificially cheapen exports, is evident from the rupee’s near constant value to the real effective exchange rate (REER), which suggests that the rupee is depreciating in real terms. Slightly stronger than . This was in 2015-16, though slightly weaker than its level in 2019-20. REER discounts for the difference in the rate of inflation in India and the countries whose currencies make up 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 whose change in rupee is measured against their currencies.
The exchange rate is also affected by the interest rate. If the interest rate is higher in India than in the US, it makes sense to put money in rupee assets than keep it in dollar assets, and some money comes in, given the possibility of rupee depreciation and erasure in dollars. Hedging for Conditions, certain additional returns to be received in India. Suppose the interest rate rises in the US. Some of the capital that came in may go back, now that the interest rate differential has diluted the promised excess return. To mitigate this effect, India can increase its interest rate. And that’s what happened at the off-cycle meeting of the Monetary Policy Committee on May 4, which increased the repo rate by 40 basis points due to a 50 basis points hike in the Fed rate. Had the Reserve Bank of India not increased its policy rate, the interest rate gap between the US and India would have narrowed, driving dollar investors out of India, leading to a steep depreciation in the rupee.
Rupee is currently at neutral level for the Indian economy. If it is depressed to facilitate exports, inevitably imports will also become more expensive, especially oil, gas and coal, feeding inflation. This will make repayment of foreign debt more expensive. If it is priced higher to make imports cheaper, it will make Indian exports non-competitive in the global market.
As long as the world economy remains in the throes of war and the resulting scarcity, inflation and risk, the rupee exchange rate will remain volatile. Strong spending by the government to boost investment and growth is more important than foreign exchange management by the RBI to strengthen investor confidence in the Indian economy and to stabilize capital flows and exchange rates.