Why is Rupee falling against US Dollar?

The Indian rupee has come under intense selling pressure in recent weeks amid a perfect storm of global headwinds that analysts say will continue to batter the currency in the coming months. It has already tested record lows twice in July, falling more than 80 to the greenback, only to recover after India’s central bank intervened to stem the slide. In a recent written statement to Parliament, Finance Minister Nirmala Sitharaman attributed the depreciation of the rupee to external reasons. Let us know about the rupee depreciation against US Dollar.

Rupee Depreciation against the US dollar

The Indian currency has recently been on a downward spiral against the US dollar. In July 2022, it even broke the historic low of 80 per dollar for one day. However, this downward trend has also been seen in the historically strong euro and the British pound sterling, which has weakened more than the rupee against the US dollar recently. This has prompted an official response that the falling rupee-to-dollar exchange rate is part of a wider international correction, however, this is a superficial explanation for the phenomenon.

While Finance Minister Nirmala Sitharaman in Parliament cited factors such as the Russia-Ukraine war and rising oil prices behind the depreciation, the Reserve Bank of India (RBI) governor spoke of simultaneous dumping of financial assets by foreign portfolio investors. (FPI). By July 2022, FPIs sold $29.6 billion worth of Indian equity and debt after three years of net positive investment in Indian financial markets.

Rupee falls to historic low! 

As one might guess, falling currency harmed our country’s economy, which is sort of right, but I had no idea that it wasn’t necessarily an indicator of a bad economy, at least in the short term run. Almost every country with long-term successful development (Japan and China are among the best examples) has used a “weak currency” policy to gain export markets. Rather, they devalue the currency. 

The reason is simple: If you compete primarily on price, a weak currency helps. Over time, as exports gain strength and the economy achieves external viability, the currency reverses its decline. 

Too many people tend to mistake this long-term cause-and-effect relationship between country and currency. A strengthening economy gets a strengthening currency, aided by capital flows. It is certainly not the other way around: A weak economy or an economy with high inflation does not become strong if you artificially strengthen its currency, such a policy would be unsustainable and risk capital flight. Therefore, the assumption of a strong currency as the best indicator of the economy would negate this fact. In addition, a country’s currency is not only influenced by internal factors, but external factors also play a major role in defining its value. When we talk about India, our monetary policymakers rather believed in a stable or strong monetary policy.

Reason for the fall

Some of the key reasons are briefly explained: 

• Geopolitical risks: Uncertain global conditions have created a risk appetite for a weaker rupee. The rupee has been under considerable pressure ever since the disruption of geopolitical situations due to the Russian invasion of Ukraine. The crisis deepened fears of global inflation, pushing up commodity prices worldwide. Oil prices are rising to record highs due to supply constraints, with India importing more than 80% of its oil and being the world’s third-largest oil importer – it has seen its import bills rise significantly. Since Russia invaded Ukraine in February of this year, the price of oil has consistently hovered at or above $100 a barrel. Inflationary pressures in the economy will only increase due to high oil prices and a falling rupee.

• Foreign funds outflow from domestic markets: There has been a large outflow of foreign funds from domestic markets as foreign institutional investors (FIIs) have sold $28.4 billion worth of stocks so far this year, surpassing the $11.8 billion sell-off seen during the global financial crisis in 2008. In addition, there was a significant outflow of foreign resources from domestic markets. As money flows out of India, the rupee to the dollar exchange rate is affected and the rupee depreciates. Such depreciation puts considerable pressure on already high import prices of oil and raw materials, paving the way for higher imported inflation and production costs in addition to higher retail inflation.

• US Interest Rate Increases: High-interest rates indicate the value of a country’s currency. It yields better returns in saving or investing in that country from a foreign investor’s perspective, the country’s currency demand increases. After the shock of Covid, interest rates in the US have been reduced to almost zero to support the economy. Low-interest rates in the US and other advanced economies have widened the interest rate differential and attracted dollar inflows in emerging markets such as India.
  In March of this year, the US central bank raised key interest rates by 25 basis points from near zero. The very first rate hike since 2018. In June, it also announced its biggest rate hike (75 basis points) in nearly 30 years as it stepped up its fight to rein in soaring consumer prices. (A week before that, India raised interest rates by 50 basis points).
  Speculation is that the US Fed could raise rates more aggressively, which could further dent the Indian currency. These factors alone do not determine exchange rates and the value of the currency in foreign exchange markets. Equally important are other factors such as domestic political stability, inflation, overall trade balance (the total difference between imports and exports across all its trading partners), gross domestic product (GDP), and government debt.

What are the views on this decline?

The decline in the rupee was mainly due to rising oil prices, a strong dollar overseas, and continued foreign capital outflows.

A backdrop of soaring inflation, a prolonged covid-19 lockdown in China, a campaign by key central banks to tighten monetary policies, and supply chain disruptions caused by the Russia-Ukraine war are clouding the outlook for global economic activity and leading to sharp depreciation. The rupee against the dollar has by more than six percent so far this year. The management said that-

• “The Indian rupee has continued its decline since the start of the year on the back of large outflows of foreign funds from domestic markets, safe-haven dollar strength towards two-decade highs, and strengthening oil prices.”
• “Indian rupee was adversely affected mainly by FIIs withdrawing funds from the equity market, rising oil prices, deteriorating trade balance and strengthening dollar.” 

So far in 2022, foreign institutional investors have sold $28.4 billion worth of local stocks and $2.3 billion worth of dumped bonds.

RBI intervention

The RBI could make more use of intervention in the spot market – which would reduce the central bank’s reserves- or it could decide to let the rupee weaken based on macroeconomic fundamentals, analysts and traders believe, according to a Reuters report.

How RBI plays its role? 

The Reserve Bank’s exchange rate policy focuses on ensuring proper conditions in the foreign exchange market. If necessary, it intervenes in the market by buying or selling foreign currencies. Market operations are conducted either directly or through public sector banks. The central bank reportedly sold dollars at 78.97-78.98 to the US dollar and significantly expanded its foreign reserves to protect the rupee from a sudden depreciation. There is a chance that the central bank may intervene further as the rupee sees a further decline.

Final words

What can be expected from this situation cannot be predicted with certainty because much depends on external factors beyond the control of the common man. “We believe that downward pressure on the rupee will continue in FY23,” QuantEcon Research said in a note, expecting “the rupee could weaken towards 81 to the dollar by the end of FY23,” the agency said to Reuters. It can be summed up that it is impossible to predict markets and currencies at the best of times, but volatility is so high, that you shouldn’t even try.