Managing the rupee

News: Due to Russian Invasion of Ukraine, US imposed a ban on energy imports from Russia and its other allies could do the same. Their corporations in the energy sector are moving out of Russia. It could permanently reshape the dynamics of energy sector.

Energy prices might stay elevated in the foreseeable future even if a diplomatic solution is reached in the coming days and weeks.

All this will result into a weaker rupee, which will add to inflationary pressures. Inflation reduces the purchasing power and will be reflected in the external value of the currency as well.

Challenges to India Rupee (External Value of Rupee)

Due to a number of global backdrops, the Indian Rupee is under pressure.  A pressure is borne by Indian Rupee from both the current and capital accounts.

Impact of Higher Commodity Prices: India is a large importer of crude oil and several other commodities. Since beginning of this year, Oil prices have gone up by over 70 per cent. Thus, Indian Rupee slipped to an all-time low recently. On the other hand, due to the current scenario, the demand for US dollars may increase, pushing up its price.

Foreign portfolio investors: They are moving out of Indian markets. For instance, foreign investors, have sold Indian stocks worth over Rs 26,000 crore. Funds are flowing to the US, which has led to a decline in government bond yields, and is pushing up the dollar. Thus, dollar demand is increasing.

Increasing Interest Rate in USA: The Federal Reserve is expected to start increasing interest rates. It will tighten financial conditions in the coming months. In fact, risk aversion started much before the Ukraine crisis. It is because markets began to adjust to the possibility of higher-than-expected rate hikes by the Fed.

Suggestions for monetary policy adjustments

The Reserve Bank of India (RBI) should not use large forex reserves to contain Rupee volatility. Obstructing this currency adjustment could create bigger imbalances.

An orderly adjustment in currency should be undertaken. It would actually help stabilize the current account. A stable and manageable deficit on the current account would, in turn, make the currency more stable.

The RBI should reassess its inflation outlook and act accordingly. RBI’s earlier projections for the next fiscal year are outdated. They need to be updated as ignoring inflation could increase risks, including external.

Source: This post is based on the article “Managing the Rupee” published in Business Standard on 09^th march 2020