Indian Rupee vs US Dollar: Why Currencies Depreciate and When We Should Worry

Indian Rupee at 78.39 has made an all time low against the US Dollar

(Photo: The Quint)

Currency depreciation is inflationary and directly reduces the purchasing power of individuals, it translates into more expensive overseas holidays, higher fees for overseas education of children, and higher spending on imported goods—food, medicines, wines, cars, mobiles, laptops etc.

However, at a country level it may serve different objectives and goals. Moderate and calibrated depreciation of currency is necessary for countries to provide for domestic inflation as well as for improving the cost advantage and competitive position of a nation. Runaway depreciation, though, can cause havoc and can become a nightmare. Unstable currencies are a big NO for international investors.

Indian Rupee at 78.29 has made an all time low against the US Dollar, but by and large it is a stable currency.

Rupee could remain volatile in the short term but should remain fairly stable beyond the next 6 months.

Manufacturing and service oriented economies looking to increase their exports, deliberately keep their currencies weak.

Dollar is holding strong on account of Capital flows. Being the Reserve Currency, much of the global trade is done in US Dollars.

Over the last few years, countries have been reducing the Dollar asset exposure in their foreign exchange reserves for a host of reasons.

Is Indian Rupee a Stable Currency?

Indian Rupee at 78.29 has made an all time low against the US Dollar, but by and large it is a stable currency, which has been progressively depreciating to factor in the traditionally high inflation in the economy.

The recent Rupee depreciation is on account of FII portfolio outflows and a higher Current Account Deficit. CAD is defined as the shortfall between the money flowing in on exports, and the money flowing out on imports.

India’s CAD is expected to deteriorate in the FY 2022 to 3% of GDP on account of increased import bill for Gold, Petroleum and other commodities. However, with a healthy Forex Reserve position (USD 601 billion as of last week), RBI governor is reasonably confident of India sailing through this storm with relative calm.

IT services and other remittances remain relatively strong, which has greatly helped in reducing the CAD. India is one of the fastest growing economies and is likely to be one of the favorite destinations for FII and FDI investments.

Rupee could be volatile in the short term but should remain fairly stable beyond the next 6 months, once the current global turmoil subsides as most of the Central Banks are trying to fix their economies.

High inflation, debt and currency volatility is a venomous cocktail, ask people of Venezuela, Pakistan, Sri Lanka, Turkey, Iran, and a host of other South Asian and European nations. One of the most important functions of a Central Bank is to optimise interest rates, inflation, GDP growth, employment, liquidity and the currency exchange rates.

The Curious Case of Currencies of Japan and China

What is good for geese may not be so for Gander. The Japanese Yen has hit a 24-year low against the US Dollar. Japan wants to keep the interest rates low whereas the US is compelled to increase interest rates. Countries like the US and the UK thrive on large capital inflows and are happy to keep strong currencies.

In contrast, manufacturing and service oriented economies looking to increase their exports, deliberately keep their currencies weak. As a a matter of fact, China had to be forced into appreciating Renminbi in the last decade.

At present, the world is in a state of flux as energy and commodity prices are at an historic high, causing a financial and economic crisis in many countries. High debt, low forex reserves, and the rising fiscal and trade deficits (CAD) are pushing quite a few countries towards financial bankruptcy and a free falling currency.

Many countries are hitting a CAD of 7% of GDP which is alarming. Portfolio outflows from emerging countries is also adding to the Currency woes. A prolonged deterioration could lead to a currency crisis and contagion like 1997.

The US Dollar Dichotomy 

Most of the global currencies are depreciating against the US Dollar as it is seen as a safe haven asset in these turbulent times. Having said this, over the last few years, countries have been reducing the Dollar asset exposure in their foreign exchange reserves for a host of reasons.

US sanctions against Russia—“Weaponisation of US Dollar”—are unnerving many countries. De—dollarisation is a theme gaining increased momentum as economic and geopolitical wars are getting entwined.

But, should the US Dollar be really appreciating? Clearly, the International Fisher Effect doesn't seem to be working! The IFE theory states that the "expected disparity between the exchange rate of two currencies is approximately equal to the difference between their countries' nominal interest rates".

With a 40-year-high inflation and unrealistically low interest rates, the real and nominal interest rate differential would require the US Dollar to depreciate. However, ultimately it’s the demand which determines the price, the Dollar is holding strong on account of Capital flows. And being the Reserve Currency, much of the global trade is done in US Dollars.

Yes, Dollar is Also Under Threat

The real threat to Dollar is emerging in form of De-dollarisation and bilateral trade arrangements. China, Russia, Saudi Arabia, and many Asian countries are moving in this direction. As the world is moving from a unipolar reign to multipolar dominance, currency wars are going to escalate. Currencies have become an important tool for shaping up and achieving economic as well as geopolitical goals.

So what should the Dollar depreciate against as it is the reserve currency? Against the old gold. Gold mining companies and their investors suspect that the prices are artificially kept low by vested interests. It is really important to align the currency with the financial strength and economic requirements of a country, an overvalued currency can have disastrous consequences.

(The author is Managing Partner at Alquimie Advisors. He tweets from @RakeshBorar. This is an opinion article and the views expressed are the author's own. The Quint neither endorses nor is responsible for them.)