The US Dollar Index, which measures the greenback’s exchange rate against 6 major global currencies, recently surpassed its 20-year high. Three macro-economic developments have propelled the Dollar Index upwards. 

Three macro-economic developments

1. US consumer price inflation which was edging up since October 2021 hit 8.6 per cent in May 2022, its highest level since December 1981, driven by high energy and food prices. When inflation rises, interest rates in an economy generally catch up. This makes bond investments in the 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.
2. After being in denial about the stickiness of inflation until early 2022, the US Federal Reserve has gone into overdrive to quell it with rate increases in recent months. Since March, the Fed has raised its policy rates by 150 basis points. With its recent hawkish pronouncements, market watchers expect it to put through a further 75 basis point hike in July.
3. With Western central banks closing the tap to easy money and raising rates, the tidal wave of cheap global money originating from these countries, that propelled all risky assets from cryptocurrencies to junk bonds to equities in the private and public markets, has suddenly begun to recede.

What does this mean for the Indian rupee?

• India relies on dollar-denominated imports for over 85 per cent of its crude oil requirements and imports more goods than it exports.
• Therefore, India’s import bill usually shoots up when the dollar strengthens, increasing the local demand for dollars.
• Foreign Portfolio Investor (FPI) pullouts worsen the situation because this further increases the domestic demand for dollars.
• Since the beginning of the year, the rupee has lost about 6 per cent in value terms against the dollar.

How is the RBI handling this situation?

• When the rupee slides against the dollar, the RBI has two main weapons.
• Interest rate hikes- The RBI can put through sharp interest rate hikes in India, to make domestic bonds and gilts more attractive to foreign investors, so that they rethink their pullouts.
• Usage of forex reserves- RBI can use its large foreign exchange reserves, built up precisely for such contingencies, to intervene directly in the currency market.
• So far this year, RBI is estimated to have spent over $40 billion out of its reserves to sell dollars and buy up rupees.
• It has also been taking sell positions in the dollar in the futures and forward markets.
• The main intent of RBI is to prevent shocks to the economy from a spell of unruly exchange rate volatility.