25 Jul 2022
Any sharp decline of rupee, from current levels however, unlikely
Ascendant dollar weighs down currencies globally
INR likely to stabilize in the band of Rs 79-81 by Mar-23
Significant volatility in forex market has become a dominant theme across economies amidst simultaneous interplay of multiple headwinds such as lingering geopolitical conflicts, elevated prices pressures, and a concurrent monetary policy tightening across the major economies. Such high volatility was last seen during the onslaught of the pandemic during 2020. The turn in global monetary policy has gathered steam, with US Fed leading the pack in normalizing interest rates aggressively (Chart 1) thereby triggering the safe haven demand for the US dollars and causing persistent depreciation in all other currencies.
Chart 1: Fed remains the most hawkish DM central bank
The dollar index has appreciated by nearly 10% since the start of 2022 with a combination of high inflation (Chart 9, Annexure) and geopolitical instability driving the demand for the world’s primary reserve currency. The USD is further expected to continue deriving support from aggressive interest rate hikes and monetary tightening in the US along with geopolitical led risk aversion (Chart 2).
Chart 2: Rise in interest rate increases the USD appeal
High and persistent inflation has imparted a sense of urgency to monetary policy normalization by the US Fed. After hiking monetary policy rate by 150 bps so far in 2022, the US Federal Reserve is expected to hike interest rates by another 200 bps during the remaining months of 2022. Of this, there is a strong likelihood of 75-100 bps hike getting executed in the upcoming FOMC policy review in July. Cumulatively, this would be tantamount to about 350 bps rate hike during the calendar year 2022, making it the most aggressive rate hike cycle since the Volcker era. Additionally, the Fed has also begun quantitative tightening (QT) to further address inflation risks. The monthly pace of QT will involve USD 47.5 bn selling of securities (USD 30 bn USTs and USD 17.5 bn Agency MBS) before raising it further to USD 95 bn in Sep-22 (USD 60 bn USTs and USD 35 bn Agency MBS). The wind down of the Fed balance sheet will reinforce the impact of monetary policy normalization and would provide a supplementary tailwind to the USD.
Given the extraordinary accommodative policies rolled out during the pandemic by the developed economies (DMs) along with the lingering supply chain bottlenecks, these economies have been facing higher inflationary pressures than the emerging economies (EM), leading many hard currencies such as the Yen, GBP and EUR to depreciate significantly against the dollar in the current calendar (Chart 3).
Chart 3: DM currencies record higher depreciation
Yen has depreciated at an unprecedented pace of 19.5% in 2022 so far. The primary reason for Yen’s significant decline is the divergence in monetary policies of Japan and the US, leading the interest rates differentials between the two countries to widen. In the recent policy decision, Bank of Japan (BoJ) continued to remain an outlier in the era of global central bank policy tightening cycle. While it raised its inflation forecast, the BoJ maintained its ultra-low interest rates underscoring concerns over the fragile growth scenario. While rising fuel and commodity costs have pushed Japan’s inflation above its 2% target, the BoJ has repeatedly said that it was in no rush to withdraw stimulus as slowing global growth cloud the outlook for the still-weak economy. With BoJ being the lone major central bank adhering to an accommodative policy, the Yen is at risk of weakening further against the dollar for at least the rest of 2022. GBP in 2022 so far has depreciated by 11.6% on the back of deteriorating economic outlook amidst elevated inflation level, higher cost-of-living, stalling growth scenario and ongoing Brexit woes. On the other hand, while EUR has been currently trading at 1.02 against the USD, recently the currency had dropped below the psychologically important parity level against the USD for the first time in nearly twenty years. Going forward, while the delivery of extreme hawkish rhetoric by the ECB (raised interest rates by 50 bps after 11 years) would help support the currency to some extent, the intensifying recessionary fears (Chart 4) on the back of rising uncertainty about energy supply to the bloc is expected to lead the depreciation bias to continue.
Chart 4: Increasing fears of recession to keep USD demand high
While the emerging market currencies do not remain unscathed from the persistent strength in the USD, the INR seems to be better placed than most of the EM currencies such as South Korean Won, Philippines Peso, and Thai Baht. The continued intervention by the central bank in the spot market (leading the FX reserves to decline) and the forward market segment (Chart 12) has helped the rupee to keep its losses capped. As per the latest data, RBI’s FX reserves have fallen to USD 572.7 bn as on mid-July’22 from USD 593 bn as the end of Jun-22 (Chart 5). Although it’s still comfortable and will continue to provide the first line of defence against excessive volatility in INR, the overall import cover is slowly moderating (from its peak of over 19-months of in early 2021 to nearly 10 months currently).
Chart 5: RBI intervention moderates its reserves position
Interestingly, the rupee has appreciated against many other currencies during the same period such as the Euro (2.7%), GBP (4.9%), and the Yen (4.9%) (Chart 6). Consequently, India’s trade-weighted Real Effective Exchange Rate (40-country REER, Base: 2015-16=100) remained around 104 in June (Chart 13).
Chart 6: INR has actually appreciated against EUR, GBP and YEN