When America sneezes, the world catches a cold

The popular saying “When America sneezes, the world catches a cold”, never goes out of fashion. Emerging markets have always felt the heat of currency depreciation and the instability that it brings in. When Dr Raghuram Rajan took over as the governor of India’s central bank, the world was tormented by ‘taper tantrum’. This had led to capital outflows from India as well as other emerging economies causing their currencies to depreciate.On 28 May 2013, the Rupee was quoted at INR 55.97 for 1 USD. Three months later on 28 August, the Rupee had plummeted by 23 percent to INR 68.83 to a dollar.?

Fast forward to 2022, we are at the brink of another event where the central banker’s ability to prevent the currency depreciation will be rigorously tested. On 20 June, one US dollar was worth around INR 78. However, ten days later, on 30 June, it breached the INR 79 mark and it is the lowest that it has ever been. This means that the value of the rupee has been depreciating against the dollar at a fast pace.

In this article, we will focus on the following to understand the concern in today’s context.

1. What is the central bank doing to prevent currency depreciation?
2. Trade deficit and role of government.
3. The big picture.?

Role of central bank

The role of the central bank in managing the economy is quite critical. We are only going to touch upon the two main heads which concern us at the moment.

Accumulating FX reserves

Pandemic provided an opportunity to increase our foreign reserves. It was a win-win situation for us with oil imports being carried out at a low rate. Similarly, outward remittances and travel requirements were limited which helped in increasing reserves.

A high level of reserves provide confidence to the market and foreign investors about the sovereign integrity. It becomes all the more critical to address any crisis that may occur in future.

Currency management

The RBI is trying to maintain the stability in the foreign exchange market by selling dollars from its foreign exchange kitty and buying rupees. The objective of doing this is to ensure that enough dollars are circulating in the system and that the rupee doesn’t lose value at a fast clip. However, this comes at a cost and we will look into the FX reserves to understand this better.

As a result of this, FX reserves have reduced by over USD 11 billion since 27th of May to USD 526 billion on 17th of June. The volatility can be better understood when we realize that the FX reserves have gone down by USD 5 billion in comparison to the previous week.

In this scenario, the RBI will have to go slow in intervening in the foreign exchange market. This is simply because the RBI cannot create dollars out of thin air. Only the US Federal Reserve, the American central bank, can do that.?

Trade deficit and government’s involvement

The role of currency management is not limited to what the central bank is doing. This needs to be complemented by policy measures by the government. The country’s trade deficit in May ballooned to record high USD 24.29 billion. India imported gold worth USD 6.03 billion in May, a nine-fold rise from a year earlier.

Managing trade deficits can be a double edged sword and requires adherence to sound business principles and prudent practices.

Imports

Import tax on gold has increased from 7.5 percent to 12.5 percent. India is the world’s second largest consumer of gold and we are staring at a current account deficit which makes it worse.

A weaker rupee may help in controlling the trade deficit as importers will not be comfortable with the additional cost. If we look at non-oil non-gold non-silver imports, they have been growing rapidly. Between January and May, the non-oil non-gold non-silver goods imports stood at $188.4 billion, up almost 32% year-on-year. A weaker rupee will make these imports expensive and, in the process, hopefully, lower their demand and help control imports and the increasing trade deficit.

Exports

The western world is expected to grow at a slow pace and chances of recession cannot be ignored. Under such circumstances, it may not be possible to rely heavily on exports as a source of earning foreign currency. Moreover, inward remittances from Indians based overseas will also take a hit if global conditions don’t improve. This is already visible in the approach adopted by foreign institutional investors who invest in Indian stocks and bonds. The withdrawals during this year for such investors are expected to be around USD 30 billion.?

Currencies of other emerging economies have depreciated at a faster rate during the same period as per RBI data. Depreciation of currency will be helpful for exporters.

The big picture

The foreign exchange reserves at USD 601.1 billion as on 3rd of June, 2022 were equivalent to about 10 months of imports projected for 2022-23. The import cover was around 19 months at the same point last year.?

A lot depends on how the quantitative tightening plays out and continued geopolitical tension will make it even more difficult. India needs to play this out with caution and we shouldn’t mind seeing a depreciating currency in the near future. This will surely keep a check on the trade deficit when inflows through exports are not expected to support.

Disclaimer - The views expressed in this article are of the author and do not represent the firm’s views.

Source:

• https://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/01AR_16062021A1516AE949174BE49D86724A51AE50D4.PDF
• https://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/1STATEOFTHEECONOMY53E4388A1B544BE59B7F1D3306FD830E.PDF
• https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=53917