Relevance: GS-3: Indian Economy and issues relating to Planning, Mobilization of Resources, Growth, Development and Employment.

Key Phrases: Import dependent economy, US Dollar Index, Fed reserve’s hawkish monetary policy, Increasing CAD, BOP Crisis, Forex reserves, Sharp interest rate hike by RBI, FAME, EVs, NMEO-OP;

Why in News?

• The dollar has been strengthening vis-a-vis other currencies.
  • Significantly, against Rupee.
    • The rupee has fallen 5.6% y-o-y (7th July).
  • US Dollar Index has surpassed 20 years high and is currently trading at 105 (it began the year at 96).
• This surge in dollars will have a significant impact on the import-dependent economy like India.

Key Highlights

What is US Dollar Index?

• It measures the exchange rate of the Dollar against 6 major currencies.
  • Euro,
  • Japanese yen,
  • British pound,
  • Canadian dollar,
  • Swedish krona and
  • Swiss franc
• The aim is to judge the comprehensive performance of the dollar vis-a-vis several other currencies to insulate the effect of bilateral issues or issues pertaining to a single economy.

Why is the US dollar strengthening?

• The answer lies in 3 macroeconomic developments. These are
  • US Consumer price inflation
  • Federal Reserve’s hawkish monetary policy
  • West Central Banks have reduced easy money

US Consumer price inflation

• It has been increasing since October 2021.
• It hit 8.1% in May 2022 which is the highest in 40 years (Since 1981).
• Plausible reasons are - High fuel and food prices due to rising uncertainties as a result of the Ukraine-Russian War and the Pandemic hangover.
• Due to the rise in inflation, it becomes expensive to lend a loan
  • Why? Because money loses its future value. As the price rises, the creditor who lends the money will have to plan for an interest rate which protects him/ her from inflation. As the prices of the goods would have risen by the time he gets the payment for the loan he had given a year earlier.
  • Hence, interest rates in an inflationary economy catch up to the rising inflation rate.
• A rise in interest rates, makes Bond investments in a country more attractive, leading to higher demand for the currency. The yield on the 10-year US government bond has doubled from 1.4 per cent to 2.8 per cent in a year.

Fed reserve’s hawkish monetary policy

• Since March, the US Federal Reserve has increased the interest rates by 150 Basis Points.
• It is speculated by analysts that a further 75 basis point increase is possible in the current months.

West Central Banks have reduced easy money

• The easy money from these countries has reduced.
• These were earlier invested in risky assets like
  • Cryptocurrencies
  • Junk bonds (below investment grade bonds)
  • Equities in the private and public markets

Effects on India and Indian Rupee

• Increased import bill
  • A stronger dollar will make the import expensive.
  • The gap between exports and imports rose to USD 25.6 billion in June from USD 24.3 billion in May, as per the preliminary data.
  • Many essential Domestic imports (like crude oil and edible oil) will become expensive thereby fuelling domestic inflation.
    • India relies on dollar-denominated imports for over 85% of its crude oil requirements and imports more goods than it exports.
• Flight of Capital
  • Foreign Portfolio Investors’ (FPI) pull-outs have worsened the situation and this has further increased the demand for dollars and reduced the demand for the rupee.
  • They have pulled out Rs 2.15 L Cr in 1st Five months of 2022, which is more than what they brought in the last 12 years (2009-2021).
• Fall in local stock and bond prices due to flight of capital.
• It will become expensive to remit money outside to support foreign education/ businesses.
• Increased chances of Balance of Payment Crisis
  • Though there are fewer chances due to sufficient forex reserves.
  • But if things go out of control, such a thing cannot be brushed aside in the coming time due to the rising Current Account Deficit.

How can RBI stabilise this volatility?

• RBI can deploy 2 main weapons to stem the slide of the Dollar
  • Sharp Interest Rate Hikes
  • Use large foreign exchange reserves

Sharp Interest Rate Hikes

• This can be done to make domestic bonds and gilts more attractive to foreign investors.
• With sufficient hike and stabilizing of external issues (war and global demand), FPIs will prefer to stay invested for a longer term.

Using Forex reserves as rescue

• RBI had built up a favourable cushion against the potential external crisis over the last few years.
  • In fact, as per the RBI governor, India is better prepared than during the Global Financial Crisis of 2008.
  • As per Economic Survey 2021-22, RBI’s Forex Reserves were valued at $634 Bn in December 2021.
• The RBI has been using multiple routes to add to the supply of dollars in the market.
• So far this year, it is estimated to have spent over $40 billion out of its reserves to sell dollars and buy up rupees.

Conclusion

• The import dependence on crude oil and edible oil demands long-term measures to become self-reliant. For instance, shifting to EVs and NMEO-OP (National Mission on Edible Oil - Oil Palm) hold relevance.

Source: The Hindu BL

Mains Question:

Q. Why is Dollar strengthening vis-a-vis Rupee and other currencies? What is its implication for Rupee and the Indian economy? Suggest a suitable way forward.