From UPSC perspective, the following things are important :
Prelims level : Dollar Index
Mains level : Paper 3- Depreciation of rupee
Rupee hits the all-time low of 80 against US dollar recently. The enormity of the challenges can be gauged by these numbers: Since the beginning of war, foreign exchange reserves have declined by $51-billion, total portfolio outflows have been $23 billion, and the current account deficit is now certain to breach $100 billion.
Is depreciation of rupee sign of weak domestic fundamentals?
- In case of strong domestic fundamentals: In an ideal world, if domestic economic fundamentals are strong, the depreciation of the rupee should be accompanied by an appreciation of the Dollar Index (DXY) along similar lines.
- In case of weak fundamentals: Between January 2008 and February 2012 and October 2012 and May 2014, on a cumulative basis, the rupee had lost a whopping 48.7 per cent against the USD, even as the DXY had appreciated by a modest 5.2 per cent.
- This indicates that much of the decline in rupee value then was purely because of weak domestic macro fundamentals.
- Current scenario: The rupee has depreciated by a modest 5.6 per cent since the Russian invasion of Ukraine, though the DXY has appreciated by 11.3 per cent.
- Thus, the recent decline in the rupee has been more because of the strengthening of the dollar and not because of weak fundamentals at home.
Reasons for the dominance of dollar
- In principle, Bretton Woods ensured that the dollar would be a “trust” currency.
- The US sits at the centre of an international financial system where its assets have been in high demand.
- For instance, frantically growing Asian economies whose penchant for US government securities have also made them susceptible to sudden changes in expectations and economic sentiments sweeping the globe.
- The recent disturbances in the global supply chain and volatile commodity prices have only made the job more difficult.
What explains the recent strengthening of dollar
- High interest rates in the US: The recent gains in the dollar have come along expectations of aggressive monetary policy by the US Fed compared to other major jurisdictions, particularly, the Eurozone and Japan.
- Markets expect the Fed to continue on its path of interest rate normalisation with multiple rate hikes.
- Low interest rates in the Eurozone: The European Central Bank (ECB) appears behind the curve, its communication with markets is as uncertain as the political and climatic hot winds criss-crossing the Eurozone.
- Low interest rates in Japan: The Bank of Japan has taken a completely divergent path, continuing its accommodative monetary policy despite the hammering of the yen.
- This has augured well for the dollar, obscuring the question of how the Fed failed to anticipate the surge in inflation.
Measures by the RBI and the government
- As currencies reel under the weight of an unrelenting dollar, questions on the rupee’s performance and future are a natural corollary, more so in the wake of hitting the psychological mark of Rs 80/dollar.
- In 2013, when the rupee was in a free fall, stability was finally restored but it came at a cost — a debt buildup of $34.5 FCNR(B).
- This time, the RBI and government have taken a long-term view of bolstering dollar inflows, which is perfectly justified.
- The RBI, in close tandem with the government, has been supportive of the rupee, and is also now embarking on an unprecedented journey to internationalise the currency.
A direct casualty of the Ukraine war is that the Indian rupee has now depreciated by 5.6 per cent against the dollar. In terms of relative performance, however, the rupee has done quite well compared to most of its counterparts.
Back2Basics: US Dollar Index
- The U.S. dollar index (USDX) is a measure of the value of the U.S. dollar relative to a basket of foreign currencies.
- The USDX was established by the U.S. Federal Reserve in 1973 after the dissolution of the Bretton Woods Agreement.
- It is now maintained by ICE Data Indices, a subsidiary of the Intercontinental Exchange (ICE).
- The six currencies included in the USDX are often referred to as America’s most significant trading partners, but the index has only been updated once: in 1999 when the euro replaced the German mark, French franc, Italian lira, Dutch guilder, and Belgian franc.
- Consequently, the index does not accurately reflect present-day U.S. trade.
Bretton Woods Agreement and Systems
- The Bretton Woods Agreement was negotiated in July 1944 by delegates from 44 countries at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire.
- Thus, the name “Bretton Woods Agreement.
- Under the Bretton Woods System, gold was the basis for the U.S. dollar and other currencies were pegged to the U.S. dollar’s value.
- The Bretton Woods System effectively came to an end in the early 1970s when President Richard M. Nixon announced that the U.S. would no longer exchange gold for U.S. currency.
- An FCNR ( Foreign Currency Non-resident) account is a type of term deposit that NRIs can hold in India in a foreign currency.
- FCNR (A) was introduced in 1975 to encourage NRI deposits.
- The Reserve Bank of India (RBI) guaranteed the exchange rate prevalent at the time of a deposit to eliminate risk to depositors.
- In 1993, the apex bank introduced FCNR (B), without exchange rate guarantee, to replace FCNR (A).