Explained | Why is there a decline in India’s foreign exchange reserves?

The story so far: The Indian rupee hit an all-time low against the US dollar this week, weakening past 77 rupees to hit the dollar and selling at 77.63 against the dollar on Thursday. Many analysts expect the rupee to weaken further in the coming months to hit 80 rupees to the dollar. In fact, the International Monetary Fund expects the rupee to weaken past 94 rupees to hit a dollar by FY29.

What is happening?

The Indian rupee has been on a steady decline this year, losing nearly 4% against the US dollar since the start of 2022. India’s foreign exchange reserves have also fallen below $600 billion, plunging around $45 billion since September 3, 2021, when foreign exchange reserves hit a record high of $642 billion. According to Reserve Bank of India data released on Friday, India’s foreign exchange reserves fell by $1.774 billion for the week ended May 6 to $595.954 billion. The drop in India’s foreign exchange reserves is believed to be largely due to measures taken by the Reserve Bank of India to support the rupee. RBI officials, however, noted that the decline in foreign exchange reserves is due to a decline in the dollar value of assets held as reserves by the RBI. For example, if part of the reserves are in euros and the euro depreciates against the dollar, this would cause the value of the foreign exchange reserves to fall.

It should be noted that as part of its policy, India’s central bank has generally attempted to slow or mitigate, rather than reverse or prevent, the decline in the exchange value of the rupee against to the US dollar. The objective of the RBI’s policy is to allow the rupee to find its natural value in the market, but without excessive volatility or unnecessary panic among investors. Public banks are usually tasked by the RBI to sell dollars in order to offer support to the rupee. By thus selling dollars on the open market in exchange for rupees, the RBI can improve the demand for the rupee and cushion its fall.

What determines the value of the rupee?

The value of any currency is determined by the demand for the currency as well as its supply. When the supply of a currency increases, its value falls. On the other hand, when the demand for a currency increases, its value increases. In the wider economy, central banks determine the supply of currencies, while the demand for currencies depends on the amount of goods and services produced in the economy.

In the foreign exchange market, the supply of rupees is determined by the demand for imports and various foreign assets. So, if there is a high import demand for oil, it can lead to an increase in the supply of rupees in the foreign exchange market and cause the value of the rupee to fall. The demand for rupees in the foreign exchange market, on the other hand, depends on foreign demand for Indian exports and other domestic assets. So, for example, when there is great enthusiasm among foreign investors to invest in India, it can lead to an increase in the supply of dollars in the foreign exchange market, which leads to an increase in the value of the rupee. against the dollar.

What makes the rupee lose value against the dollar?

Since March of this year, the US Federal Reserve has raised its benchmark interest rate. This, in turn, has put pressure on emerging market currencies which have depreciated significantly against the US dollar so far this year. Even developed market currencies like the euro and the yen have depreciated against the dollar and the dollar index is up more than 8% year-to-date. In fact, some analysts believe that the RBI’s surprise decision to raise rates earlier this month may have simply been to defend the rupee by preventing any rapid outflow of capital from India. In 2013, the rupiah fell 15% against the dollar in about three months after investors spooked by the US Federal Reserve’s decision to scale back its bond-buying program that had helped hold rates down low long-term interest rate.

Additionally, India’s current account deficit, which among other things measures the gap between the value of imports and exports of goods and services, is expected to reach a 10-year high of 3.3% of gross domestic product. during the current fiscal year. This means that India’s import demand amid rising global oil prices is likely to negatively affect the rupee unless foreign investors inject enough capital into the country to finance the deficit. But foreign investors are unlikely to inject capital into India when investment returns rise in the United States. Yields on 10-year US Treasuries, for example, rose from around 0.5% in mid-2020 to over 3% at the start of the month.

Read also | Foreign exchange reserves fall by $28.05 billion in September-March: RBI report

It should also be noted that the rupee has been steadily losing value against the US dollar for several decades now. One of the main reasons for this is the steady rise in domestic price inflation in India. Higher inflation in India suggests that the RBI created rupees at a faster rate than the US Federal Reserve created dollars. So while capital and trade flows get a lot of attention in discussions of the value of the rupee, the difference between the rates at which the US Federal Reserve and the RBI regulate the supply of their currencies can play a much larger role in determining the value of the rupee. the rupee over the long term.

What awaits us?

Analysts believe that over the long term, the rupiah should continue to depreciate against the dollar given the large differences in long-term inflation between India and the United States. Right now, as the US Federal Reserve is raising rates to combat historically high inflation. within the country, other countries and emerging markets in particular will be forced to raise their own interest rates to avoid disruptive capital outflows and to protect their currencies. It should be noted that US inflation hit a 40-year high of 8.5% in March. The RBI has also tried to rein in domestic consumer price inflation, which hit a 95-month high of 7.8% in April, by raising rates and tightening liquidity. As interest rates rise around the world, the threat of a global recession also increases as economies readjust to tighter monetary conditions.

• The Indian rupee hit an all-time low against the US dollar this week, weakening past 77 rupees to hit the dollar and selling at 77.63 against the dollar on Thursday.

• The Indian rupee has seen a steady decline this year, losing almost 4% against the US dollar since the start of 2022

• The value of any currency is determined by the demand for the currency as well as its supply. When the supply of a currency increases, its value falls. On the other hand, when the demand for a currency increases, its value increases.

• Analysts believe that over the long term, the rupiah should continue to depreciate against the dollar given the large differences in long-term inflation between India and the United States.