RBI likely selling dollars to keep rupee off record low
- October 17, 2023
- Posted by: OptimizeIAS Team
- Category: DPN Topics
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RBI likely selling dollars to keep rupee off record low
Subject :Economy
Section: External Sector
In News: RBI activity keeps Rupee in a narrow band.
Key Points:
- The rupee was at 83.24 against the U.S. dollar, barely changed from its close at 83.26 in the previous session, despite the weakness its Asian peers and the jump in oil prices.
- Reserve Bank of India is likely selling dollars via state-run banks to ensure that the rupee does not fall to a record low.
Why are Asian currencies under pressure?
- Their weakness comes as the U.S. central bank maintained a hawkish stance, raising the prospects of further rate hikes and widening the rate differentials between U.S. and Asian economies.
Why is crude oil price linked with weakening of Rupee?
- India imports close to 85 per cent of its crude oil requirement and any increase in global prices causes the import bill to shoot up. Since large payments have to be made in dollars to buy crude, the rupee takes a hit vis-a-vis the American currency.
The falling rupee – Reasons for fall
Reason 1 – Interest rate hike in the US
- An indirect reason for the falling rupee is the Federal Reserve’s increasing interest rate in the US.
- Investors like to move to investment options where the interest rate is increasing. Assume you invested in the equity market because the fixed deposit rates were low. You made good returns on your equity investment, and at the same time, the fixed deposit rates are increasing. Would you not withdraw your money from equity and invest in fixed deposits?
- The same is happening in the US. The Fed has increased policy rates by 75 basis points for the third consecutive time. As a result, the funds from India are moving to the US. The demand for the local currency (rupee) has declined, and it has fallen.
- Second, we are witnessing a rare scenario where inflation is higher in the US compared with India. The Fed has no choice but to increase the interest rate. With rising interest rates, the interest rate differential between the US and India has come down to 2.6%. The difference has also led to the recent depreciation of the rupee.
Reason 2 – Crude Oil prices
- The crude oil prices have increased sharply in the last year or so. India imports 86% of its oil demand – millions of barrels a day and the crude oil transactions are done in the dollar.
- The equation is simple – when the crude oil prices go up, we need to buy more dollars to purchase oil by selling the rupee. The US dollar becomes stronger, and the rupee value depreciates. The same has happened recently and caused the rupee depreciation.
- What can RBI do to stop further rupee depreciation?
- We import crude oil in billions. Hence, the depreciation of the local currency is harmful to the economy. RBI has to intervene to stop the sharp depreciation. Below are some ways RBI can stop the rupee depreciation:
- Sell forex reserves: RBI can sell (it is already doing it) a part of its foreign forex reserves to control the falling rupee. In 2021, India’s foreign exchange reserves stood at $642 billion. The latest data (September last week) show that the forex reserves have fallen to $545 billion. It had prevented a sharp fall in the Indian rupee, unlike other currencies.
- Not everyone is happy about the depleting foreign forex reserves, but the purpose of having high forex reserves was to use them in situations like these, right? It is important to note that this measure is only to counter volatility and cannot be RBI’s policy.
- Boost capital inflows in NRI accounts: The RBI can take measures to encourage capital flows in NRI deposits. When the NRIs start to deposit money in India, they would be selling dollars to convert it to a rupee, which will help the cause. RBI can reach out to banks so banks can offer non-residents higher interest rates on deposits and short-term bonds.
- Buy/sell swap: In a buy/sell swap, the Indian currency is injected into the banking system, while taking out dollars. The swap will help the RBI keep the currency rates in check, although, in a limited way.
Can RBI continue to sell foreign reserves?
- Of all the measures mentioned above, the one that works in real-time is selling forex reserves. Can RBI continue to sell it? The answer is No.
- The RBI has to keep an adequate level of foreign exchange reserves. It is measured in relation to import cover and short-term foreign currency debt.
- India’s import bill in September 2022 was nearly $60 billion. As per a conservative estimate, India needs to have a reserve equivalent of 10–11 months. By this estimation, RBI won’t be comfortable selling further as we are down to 9 months reserve equivalent.
- Another way to look at adequate forex reserves is to check the country’s total short-term debt due in the next one year. For India, it is over $100 billion. According to this method, RBI will be comfortable.
Conclusion
The rupee-dollar equation is not simple, and one cannot take a side – falling rupee is good or bad? RBI’s role is to look at the Indian economy from all angles – not just the dollar-rupee equation.