Dollar Appreciation and India
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Dollar Appreciation and India
Subject: Economy
Context:
The US Dollar Index, which measures the greenback’s exchange rate against six major global currencies, recently surpassed its 20-year high and is currently trading at over 105.
Causes:
- Rise in Federal rate of interest-When inflation rises, interest rates in an economy generally catch up leading to large scale capital inflows and increase demand of currency.
- Higher bond yield-The yield on the 10-year US government bond has doubled from 1.4 per cent to 2.8 percent in a year. This makes bond investments in the country more attractive, leading to higher demand for the currency.
- Decline investment in bitcoins and other risky assets-withdraw from risky assets and repatriate their money back home, dollar demand increased, further strengthening the Dollar Index.
What does this mean for the Indian rupee?
- Flight of dollar and Depreciation of rupee–
- India relies on dollar-denominated imports for over 85 percent of its crude oil requirements and imports more goods than it exports.
- Therefore, India’s import bill usually shoots up when the dollar strengthens, increasing the local demand for dollars leading to rupee depreciation.
- Indians who remit money in dollars to support relatives will need more dollars as the exchange rate depreciates.
- Capital outflows–
- Foreign Portfolio Investor (FPI) pullouts worsen the situation because this further increases the domestic demand for dollars.
- Outflow of foreign investors leads to a fall in local stock and bond prices thus, increasing bond yield and cost of borrowing.
- Balance of payments deficit and imported inflation-
- A stronger dollar tends to increase India’s import bill and widen the deficit between its imports and exports.
- Many essential commodities and intermediate goods that India imports also get costlier, thus feeding into domestic inflation.
How is the RBI handling this situation?
The RBI has two main weapons to stem the slide:
- It can increase the interest rate to make domestic bonds and gilts more attractive to foreign investors, so that they rethink their pullouts.
- It can use its large foreign exchange reserves to intervene directly in the currency market by selling dollars in return of rupee thereby, increasing the supply of dollars relative to the demand.