Question
The article is taken from the Times of India dated 15th May, 2022 on The dynamics of exchange rate volatility. The article was authored by
The article is taken from the Times of India dated 15th May, 2022 on “The dynamics of exchange rate volatility”. The article was authored by Dr. Kembai Srinivasa Rao. Read the article and answer Q-1 and Q-2. In addition to the macroeconomic concern of spiraling CPI inflation cruising fast towards 8 percent mark, the depreciating tendency of INR is another risk that is poised to breach Rs.78 mark against $1. A fall in rupee worsens the returns for Foreign Portfolio Investors (FPIs). The value of any Indian holding is lower in dollar terms when the rupee falls against the greenback. The financial market volatility is interconnected with many factors, more importantly Sensex and exchange rate gyrations. Dollex computes the returns on the Sensex in dollar terms. The benchmark returns have consequently been worse for S&P BSE Dollex 30 index, compared to S&P BSE Sensex due to fall in rupee value versus US $. The S&P BSE Sensex had fallen 12.7 percent from its all-time high 62245 closed at 54364 on May 10.
On the contrary, the Dollex 30 index is down 15.4 percent in the same period exacerbating FPI outflows. FPIs were therefore net sellers by US $ 1.4 trillion since the beginning of 2022. As a result, the INR has been under pressure due to equity outflows compounded by higher crude prices and further exacerbated by impact of geopolitical risks. An increase in crude prices widens the current account deficit (CAD) and weakens INR. The recent spate of Chinese lockdown can also contribute to the depreciation of INR due to increased supply side disruptions either directly or indirectly as most parts of world are dependent on China for their manufacturing activities. The low interest rates, steady uptick of stock markets, stable investor-friendly policies, opening up more sectors for FPIs have added substantial scope for foreign investments in India. The increased FPIs and appetite of global investors increased the forex reserves to a high of US $ 642 billion during the week ending on September 3, 2021 that begun to descent.
Among many interconnected and granular reasons, the key risks of depreciation of rupee heightened with central banks across the globe fighting the inflation menace by raising policy rates. In the post pandemic normalization, the tendency is to unwind the easy money policies. With policy rates climbing in west and rising geopolitical risks due to ongoing war between Russia and Ukraine, ‘flight to safety’ has been the order of overseas investors. Under these stressful conditions and volatility of global financial markets, FPIs sold holdings worth US $ 4.46 billion of equities and there was additional selling of US $ 4.71 billion in February 2022. FPIs have already sold over US $ 10 billion in 2022. In February 2022, the selling spree was relentless, dropping indices down to new lows. The February sales worked out to $ 4.71 billion. The total assets under custody (AUC) of FPIs by February work out to US $ 603.39 billion. The demand and supply of foreign currency in the forex market influences the exchange rate at any given point of time. When the outflows exceed inflows of US dollar resources, as is the case now, the dollar value appreciates and INR value depreciates. When the inflows exceed the outflows, there could be a case for strengthening INR. The exchange rate policy followed in India allows INR to discover its value in relation to foreign currency – US $ based on the market dynamics of forex inflows/outflows. Because of outflows overwhelming inflows, the exchange rate of INR is under pressure leading to depreciation. Amid persistent foreign fund outflows, general dollar strength increased in relation to INR on the back of the prospects of Fed’s aggressive monetary tightening plans, and soaring energy prices. Oil prices impact India’s current account deficit and trade balance significantly as India imports more than 80% of its oil needs. As a result of the changed external sector dynamics, the exchange rate of INR to a US $ touched an all-time low of Rs. 77.936 on May 10, 2022 and RBI intervention in the forex market led to defending the value at Rs.77.50. Reports indicate that RBI had to sell close to US $ 500 to 700 million to avoid extreme volatility of the currency. The central bank has been intervening across foreign exchange markets – spot, futures, and NDF (non-deliverable forwards) markets to defend INR amid the ongoing global uncertainties.
This is intended to prevent steep depreciation of INR in near term. In order to alter the ecosystem – control spiralling inflation and to stem the outflows of FPIs, RBI, falling in line with the US Federal Reserve and other central banks in the west, raised the repo rate by 40 basis points to 4.40%, in its first change in the rate in two years and its first-rate hike in nearly four years. RBI also raised cash reserve ratio (CRR) by 50 basis points to 4.5%, effective from May 21, to absorb some part of liquidity on bank’s net demand and time liabilities (NDTL). The exchange rate was Rs.72.836 to a US $ a year ago on May14, 2021. The INR depreciated by 6.25 percent in a year putting the importers at risk. During the taper tantrums in 2013, INR depreciated very steeply from Rs.56 to Rs.69 in a matter of 3 months recording 25 percent depreciation. In order to avoid such declines, the CAD has to be contained. The government may also explore newer ways to seek more FDI flows by removing policy bottlenecks in investment. With crude prices rising steeply in the recent times and continuing supply side disruptions, importers have to pay more in INR to settle the costs in US $. It adds to the already higher costs of imports which again feeds into the inflation trajectory. There is still immense resilience in forex markets to withstand the volatility of exchange rate.
The forex reserves during 2022 so far depleted by US $ 40 billion but maintains reserves of US $ 600 billion sufficient for 14 month’s imports. The external debt to GDP ratio is manageable at 20 percent. The CAD is expected to end up at US $ 100 billion that can work out to 3 percent of GDP. The 4 percent interest differential compared to advanced economies is still a good arbitrage for FIIs/FPIs. With RBI set to increase policy rates in coming months, such arbitrage may sustain. As and when the war ends and inflation elsewhere in the world is controlled, we can foresee some part of recovery of INR value. In order to offset the fall, exports have to be ramped up and banks should galvanize NRE deposits and invite overseas remittances. It is good that the corporate sector is able to borrow $38.5 billion from abroad through external commercial borrowing (ECB) route during FY22. India is relatively better placed to fight the ongoing exchange rate volatility where inclusive efforts of stakeholders are important to handhold.
Questions:
Q-1 what is exchange rate volatility? Discuss the major reasons for the volatility of INR. (15 Marks, Maximum Word Limit –250)
Q-2 How will raising the repo rate help to curtail the exchange rate depreciation? (10 Marks Maximum Word Limit –200)
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1 Exchange rate volatility is a measure of the degree of fluctuation of a currencys value Exchange rate volatility is an important factor in determining the risk of international investments and trans...Get Instant Access to Expert-Tailored Solutions
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