Rupee in a sweet spot as dollar loses lustre

In May 2022, when the RBI kicked off the current rate hike cycle with a sudden 40 basis point hike in the repurchase rate, there was a lot of volatility all around. As for India’s central bank, it stated categorically just a month ago that high inflation was temporary and that there was no need to start raising interest rates just yet.

The reason for the RBI’s reaction was the Fed meeting scheduled for the next day, where the Fed was expected to announce a significant increase in the federal funds rate. The Reserve Bank of India (RBI) has been a little behind the curve since the US Federal Reserve kicked off its rate-hiking cycle in February, and the FOMC’s forecasts had pointed to a series of aggressive rate hikes in 2022. Rate hikes and investors have been Foreign portfolios have already withdrawn Indian rupees worth of Rs 1.34 crore from the Indian stock and bond market in the first four months of 2022.

The sharp rise in the value of the dollar in the first quarter of 2022 led to turmoil in the currencies of emerging economies and the rupee was not spared either. The Reserve Bank of India had to act quickly to maintain the spread between US and Indian bond yields to support the rupee.

But the tables have turned on the dollar since then and the rupee is now in a much stronger position. This means that the RBI need not worry too much about protecting the rupee while framing monetary policy, moving forward.

rupee movements. Track the movement of the dollar against the rupee since the pandemic

Dollar weakness

The US dollar index, which captures the dollar’s movement against a basket of major currencies, rose from 95 at the start of 2022 to 113 by September 2022 as the Fed’s rate hikes sent Treasury yields higher. Five-year US Treasury notes traded at 4.2 percent in October 2022, up from 1.6 percent in January 2022. Higher yields along with a strengthening currency have led global funds to move into dollar-denominated assets, prompting a sell-off in emerging market currencies. including rupees.

But the dollar is losing its luster, with the dollar index currently down 11 percent from its peak in September. Several factors contributed to this slowdown. First, the US Federal Reserve’s war against inflation is negatively affecting growth with GDP growth expected at 1.3 percent in 2023, down from 2.1 percent in 2022. The Fed Chairman has reiterated in FOMC meetings that There is a marked slowdown in consumption and production due to higher prices.

On the other hand, growth prospects for the Eurozone and China have been improving as the epidemic subsides. This has reduced the relative attractiveness of US-denominated securities.

Secondly, the banking crisis in the United States caused by the collapse of the Silicon Valley bank made the Fed realize the problems of aggressive monetary tightening, which made it slow down the pace of raising interest rates. This resulted in the dollar losing ground against the euro and other reserve currencies. US Treasury yields also paused their upward march.

Third, even though the Fed has begun to slow down the pace of rate hikes, other central banks such as the European Central Bank and the Bank of England continue to aggressively raise interest rates, making these currencies appreciate against the dollar.

The tide turns for Rs

While the dollar is losing its mojo, the rupee is gaining momentum. The rupee is the second best performer against the dollar since the beginning of this year. The RBI’s decision to pause interest rate hikes in recent monetary policy worked in favor of the rupee as foreign portfolio investors turned net buyers in equity markets in April. The rupee also strengthened towards the 82 mark and the Reserve Bank of India (RBI) managed to weed out dollar inflows to boost its forex reserves.

Moreover, there is a consensus that the Reserve Bank of India can start to reduce interest rate hikes soon. According to the Bloomberg forecast model, interest rate hikes are expected to continue in the upcoming policy meetings of most countries including the US, EU and UK. But overnight interest rates point to a rate cut at the next policy meeting in India and Japan.

This bodes well for India’s growth, which is already the fastest in the world. Corporate earnings will also benefit, which will improve flows into the equity markets. Other factors working in favor of the rupee include weak crude oil prices which leads to lower imports of goods, strong service exports and NRI remittances from abroad.

Foreign investment in the footnotes flows into debt

Foreign portfolio flows into debt tend to be more sensitive to the movement of policy rates, and a pause in rate hikes or a reversal could result in money flowing out of Indian debt. But most emerging markets are now heading for a pause in the rate hike cycle or even a reversal. The search for higher returns is likely to bring foreign investors into emerging market debt, as risk aversion recedes.

This is already evident in the numbers. FPIs net bought $292m of Indian bonds in 2023 which means they are not too concerned about RBI’s decision. This is because there is still a spread of over 300 basis points in the real yield of US and Indian sovereign bonds.

Also, foreign financial institutions were strong sellers of Indian debt between FY 2019 and FY21 with average net sales of INR 46,000 crore in these three years. This has led to a significant drop in FPI’s holdings of Indian government and corporate bonds. So, FPI’s withdrawal from the debt market is not a physical threat anymore.

The tide appears to be turning in favor of emerging markets in general, and for India in particular, as the dollar begins to lose ground and the US grapples with the consequences of its monetary policy. Global investors are likely to turn their attention back to emerging markets as risk aversion subsides.

This makes the RBI’s job easier as it can formulate policy based on the needs of the Indian economy without worrying about FPI’s outflows and runs on the rupee.