Rupee’s test

| Updated on October 13, 2021

Rising oil prices and US Fed taper moves are testing the rupee   -  Getty Images/iStockphoto

RBI has done well to build its forex reserves to face taper-induced volatility in rupee

The recent decline of the rupee below the 75 mark against the dollar may have caused a flutter in financial markets. But the Indian unit’s 3 per cent depreciation is relatively small when compared with other emerging market currencies such as the Malaysian Ringgit, Philippine Peso, Thai Baht and South Korean Won. The rupee has actually been quite stable so far this year, moving within a band of 72 to 76. The recent weakness is primarily due to two external factors — rising oil prices and imminent commencement of monetary policy normalisation by the US Federal Reserve. With the country dependent on imported oil to meet most of its requirements, the rupee has typically been very sensitive to price movements in the commodity. The 30 per cent gain in oil prices since the last week of August is partly responsible for the sharp slide in the rupee. Given that there are no quick fix solutions to address India’s dependence on imported oil, the central bank needs to buttress the rupee, until prices cool down.

Volatility caused by the US Federal Reserve’s taper of monthly bond purchases is however likely to persist longer. The taper is scheduled to continue until the first half of 2022 with interest rate hikes expected to begin in 2023. Risk aversion in currency markets is beginning to surge with other global central banks too moving towards liquidity tightening and interest rate hikes. The dollar has begun appreciating as global investors move money back to the safe haven of dollar-denominated securities. The dollar index which tracks the movement of the US unit against major currencies has gained 6 per cent since June. The dollar’s strength, along with hardening of yields in US treasury securities, is causing downward pressure on all emerging market currencies, including the rupee. The RBI however appears quite prepared to face taper related tantrums this time round. It has been gradually increasing the forex reserves, making the most of the copious portfolio inflows last year. Foreign exchange reserves have grown $161 billion since March 2020. The strong reserves along with good growth in exports puts the rupee on a relatively better footing compared with the conditions in 2013, when India was among the fragile five countries due to its weak external account. While portfolio outflows can cause turbulence in forex market, India is likely to continue to attract foreign investments over the longer term given the relatively higher growth prospects.

The central bank has had a difficult task since last year in buying dollars to build reserves, since this results in increasing the liquidity in the system. Shifting part of its forex interventions to the forwards market since the beginning of this year has helped address this issue, while providing additional arsenal which can be used to stem currency volatility. The pandemic and the actions of central banks to counter its impact have increased indebtedness of countries and money supply to unprecedented levels. Normalising these conditions will be disruptive to currency markets. Hopefully, we are better prepared this time.

Published on October 13, 2021

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