Explained | Why are India’s foreign exchange reserves falling?


How is the devaluation of the rupee against the dollar affecting the economy?

How is the devaluation of the rupee against the dollar affecting the economy?

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

What’s happening?

The Indian rupee has been on a steady decline this year, losing nearly 4% against the US dollar since early 2022. India’s foreign exchange reserves are also below $600 billion, standing at an all-time high of $642 billion. India’s foreign exchange reserves fell by $1.774 billion to $595.954 billion in the week ended May 6, according to Reserve Bank of India data released on Friday. The decline in India’s foreign exchange reserves is believed to be largely due to actions by the Reserve Bank of India to support the rupee. However, RBI officials have noted that the decrease in foreign exchange reserves is due to a decrease in the dollar value of assets held by RBI as reserves. For example, if some of the reserves are in euros and the euro depreciates against the dollar, this would result in a decrease in the value of foreign exchange reserves.

It should be noted that for policy reasons, the Central Bank of India has usually sought to slow or smooth the decline in the exchange rate of the rupee against the US dollar, rather than reverse or prevent it. The aim of the RBI policy is to allow the rupee to find its natural value in the market but without excessive volatility or unnecessary panic among investors. State-owned banks are usually ordered by the RBI to sell dollars to provide some support for the rupee. By selling dollars in the open market in exchange for rupees, the RBI can enhance demand for the rupee and cushion its decline.

What determines the value of the rupee?

The value of a currency is determined by both the demand for the currency and its supply. When the supply of a currency increases, its value decreases. On the other hand, when demand for a currency increases, its value increases. In the overall 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. Therefore, when there is a high demand for oil imports, this can lead to an increase in the supply of rupees in the forex market and cause the value of the rupee to fall. Demand for rupees in the forex market, on the other hand, depends on foreign demand for Indian exports and other domestic assets. For example, when foreign investors have great enthusiasm to invest in India, this can lead to an increase in the supply of dollars in the foreign exchange market, which in turn causes the value of the rupee to rise against the dollar.

What Causes the Rupee to Depreciate Against the Dollar?

Since March of this year, the US Federal Reserve has been raising its benchmark interest rate, leading investors looking for higher yields to draw capital back to the United States from emerging markets like India. 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 yen have depreciated against the dollar, and the dollar index is up more than 8% so far this year. In fact, some analysts believe the RBI’s surprise decision to hike rates earlier this month may have been simply to defend the rupee by preventing a rapid outflow of capital from India. In 2013, the rupee fell 15% against the dollar in about three months after investors were spooked by the US Federal Reserve’s decision to cut its asset purchase program, which had helped keep long-term interest rates low.

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 hit a 10-year high of 3.3% of gross domestic product in the current fiscal year. This means India’s import demand is likely to weigh on the rupee amid rising global oil prices unless foreign investors inject enough capital into the country to fund the deficit. But foreign investors are unlikely to pump capital into India as US investment returns rise. Yields on 10-year US Treasuries, for example, have risen from around 0.5% in mid-2020 to over 3% earlier this month.

Also read | FX reserves fall by $28.05 billion in September-March: RBI report

It should also be noted that the rupee has steadily depreciated against the US dollar for several decades. A major reason for this was the persistently higher domestic price inflation in India. Higher inflation in India suggests the RBI has been creating rupees faster than the US Federal Reserve has been creating dollars. So while capital and trade flows receive much attention in discussions about the value of the rupee, the difference in the rates at which the US Federal Reserve and RBI regulate the supply of their currencies can play a much larger role in determining the value of the rupee play the rupee in the long run.

What lies ahead?

Given the significant difference in long-term inflation between India and the US, analysts believe the rupee is likely to continue depreciating over the long term as the US Federal Reserve hikes interest rates to combat historically high inflation in the country, particularly others Countries and emerging markets may be forced to raise their own interest rates to avoid disruptive capital outflows and 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 stem domestic CPI inflation, which hit a 95-month high of 7.8% in April, through rate hikes and liquidity tightening. As interest rates rise around the world, so does the risk of a global recession as economies adjust to tighter monetary conditions.

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