December 3, 2022
  • December 3, 2022

The dynamics of exchange rate volatility

By on May 15, 2022 0

In addition to the macroeconomic concern of skyrocketing CPI inflation rapidly reaching the 8% mark, the depreciating trend of INR is another risk which is about to cross the threshold. bar of 78 rupees against 1 dollar. A falling rupiah worsens returns for foreign portfolio investors (REITs). The value of any Indian asset is lower in dollar terms when the rupee falls against the greenback. Financial market volatility is related to many factors, including Sensex and exchange rate fluctuations.

Dollex calculates Sensex returns in dollars. Benchmark returns were therefore worse for the S&P BSE Dollex 30 Index than for the S&P BSE Sensex due to the decline in the value of the Rupee against the US Dollar. The S&P BSE Sensex had fallen 12.7% from its all-time high of 62,245 which closed at 54,364 on May 10. On the contrary, the Dollex 30 index fell 15.4% over the same period, which exacerbated REIT outflows.

REITs have therefore been net sellers of US$1.4 trillion since the start of 2022. As a result, INR has been under pressure due to equity outflows compounded by higher crude prices and further exacerbated by the impact of geopolitical risks. An increase in crude prices widens the current account deficit (CAD) and weakens the INR.

The recent wave of Chinese lockdowns may also contribute to the depreciation of the INR due to the increase in supply-side disruptions, either directly or indirectly, as most parts of the world depend on China for their trading activities. manufacturing.

Low interest rates, steadily rising stock markets, stable investor-friendly policies, opening more sectors to REITs have added substantial opportunities for foreign investment in India. Rising REITs and global investor appetite increased foreign exchange reserves to a high of US$642 billion in the week ending September 3, 2021 which began to decline.

  1. Reasons for the volatility of INR:

Among many interconnected and granular reasons, the main downside risks to the rupiah have intensified as central banks around the world combat the inflationary threat by raising policy rates. In post-pandemic normalization, the trend is for easy money policies to unravel. With rising key rates in the West and rising geopolitical risks due to the ongoing war between Russia and Ukraine, “flight to safety” has been the order of foreign investors.

Amid these stressful conditions and volatility in global financial markets, REITs sold US$4.46 billion worth of equity holdings and there was an additional sale of US$4.71 billion in February 2022. REITs have already sold more than US$10 billion in 2022. In February 2022, the selling frenzy was relentless, sending indices to new lows. February sales were $4.71 billion. Total Assets Under Custody (AUC) for REITs in February stood at US$603.39 billion.

The demand and supply of foreign currency in the foreign exchange market influences the exchange rate at any given time. When the outflow exceeds the inflow of US dollar resources, as it is now, the value of the dollar appreciates and the value of the INR depreciates. When inflows exceed outflows, the INR may need to be increased. The exchange rate policy followed in India allows the INR to discover its value against the foreign currency – US$ depending on the dynamics of the currency inflow/outflow market. Due to overwhelming outflows of inflows, the INR exchange rate is under pressure leading to depreciation.

Amid continued outflows of foreign funds, the overall strength of the dollar has increased against the INR due to the prospect of aggressive monetary tightening plans by the Fed and soaring energy prices. Oil prices have a significant impact on India’s current account deficit and trade balance, as India imports over 80% of its oil needs.

  1. How INR gyrations are slowed down:

Due to altered dynamics in the external sector, the exchange rate of INR against the US Dollar hit an all-time low of Rs. 77,936 on 10 May 2022 and RBI’s intervention in the foreign exchange market led to defend value at Rs.77.50. Reports indicate that RBI had to sell close to US$500-700 million to avoid extreme volatility in the currency. The central bank intervened in the foreign exchange markets – spot, futures and NDF (non-deliverable forwards) markets to defend the INR amid continued global uncertainties. This aims to avoid a sharp depreciation of the INR in the short term.

In order to alter the ecosystem – control spiraling inflation and stem outflows from REITs, RBI, aligning itself with the US Federal Reserve and other western central banks, raised the repo rate by 40 basis points to 4.40%, in its first rate change in two years and its first hike in nearly four years.

RBI has also increased the cash reserve ratio (CRR) by 50 basis points to 4.5%, effective May 21, to absorb some of the liquidity on the bank’s net sight and term liabilities (NDTL). The exchange rate was 72.836 rupees per US dollar a year ago on May 14, 2021. The INR depreciated by 6.25% in one year, putting importers at risk. During the tantrums in 2013, the INR depreciated sharply from 56 rupees to 69 rupees within 3 months, registering a depreciation of 25%.

In order to avoid such declines, the CAD must be contained. The government can also explore new ways to seek more FDI flows by removing policy bottlenecks to investment. With the sharp rise in crude prices lately and continued supply disruptions, importers have to pay more in INR to settle costs in US dollars. This adds to the already higher costs of imports, which again fuels the path of inflation.

  1. Strengths of the external sector:

There is still immense resilience in the foreign exchange markets to withstand exchange rate volatility. Foreign exchange reserves in 2022 have so far been depleted by US$40 billion but maintain reserves of US$600 billion sufficient for 14-month imports. The ratio of external debt to GDP is manageable at 20%. The CAD should end up at 100 billion US dollars, which can represent 3% of GDP. The 4% interest differential versus advanced economies remains a good trade-off for FIIs/REITs. With the RBI set to raise its key rates in the coming months, such arbitrage could continue.

As the war ends and inflation elsewhere in the world is brought under control, we can expect some recovery in the value of the INR. In order to offset the decline, exports need to be accelerated and banks should galvanize NRE deposits and invite remittances abroad.

It is good that the corporate sector is able to borrow $38.5 billion overseas through External Commercial Borrowing (ECB) in FY22. India is relatively better placed to combat current exchange rate volatility, where inclusive stakeholder efforts are important.



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The opinions expressed above are those of the author.



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