Decoding the Rupee-Inflation Tango

Kotak Insights | Date 15/09/2023

Buying a dollar could have cost you around ₹81.6 a year ago in September.

But that’s changed by a margin – you’ll need ₹85.4 today.

This means that our currency has lost somewhere near 4.7% of its value in a year. And that’s the reason why the Indian rupee has been making headlines of touching closing record lows (of 85.51), leaving traders and investors pondering their next move.

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Let’s have a closer look at what’s cooking…

It is good to start off with a very basic concept of demand and supply, because that’s how the value of the rupee and the dollar (and any currency for that matter) fluctuates.

Whenever the demand for the Indian rupee is high and it’s in short supply, its value rises. Just like any commodity or onions for instance. Conversely, when demand is low and the supply is abundant, the rupee’s value declines.

What’s happening today, you ask? Well, most of it has to do with the dollar’s rise.

You see, the rupee and the dollar are traded in the currency market. And because they are quoted in relevance to each other, a rise in the value of one currency can also mean the other currency (which it is pegged to) losing its value.

Here’s how it works, and this is what has been happening lately.

India imports a lot of oil. In fact, over 88% of its crude oil needs are met from imports.

The nail in the coffin is that oil prices are skyrocketing. And since almost every oil trade is settled in dollars, Indian importers have been wanting more dollars to make payments.

As the demand for dollar rises, it becomes stronger in the process. The rupee in comparison loses its value compared to the dollar.

Now, this is just one of the many reasons behind the rupee’s fall. There are many other internal as well as external factors that move the needle.

Some internal factors may include rising inflation and interest rate changes. As inflation rises, the purchasing power of a currency weakens, leading to depreciation. As for interest rates, the crucial role is that when interest rates are lower than those of other currencies, it makes holding rupees less attractive, causing capital outflows (i.e., investors moving to other currencies from the rupee to earn higher interest rates).

You may be wondering; how does this change in value of rupee affect the economy?

It does – and by a great margin. As per the data from the Reserve Bank of India (RBI), every 5% fall in the value of the rupee increases inflation by 0.15%.

Let’s quickly go over some of these effects:

• Imports & Exports: A falling rupee can boost exports, making Indian goods more competitive in the global market. Conversely, it can increase the cost of imports, impacting industries dependent on foreign goods.

• Foreign Debt: Companies with foreign debt obligations face higher repayment costs when the rupee weakens, potentially straining their financials.

• Investor Confidence: A falling currency can erode foreign investor confidence. When the rupee depreciates significantly, it may deter foreign investment in Indian assets.

That’s a lot of movement, and it’s palpable. After all, currencies are what trades, businesses, and households run on.

And because it’s so important, the country’s central bank has some significant measures to arrest the rupees’ fall. Here’s how…

Measures to Monitor Domestic Currency

The RBI plays a pivotal role in stabilising the rupee's value. To counter the fall, it employs several measures including:

• Forex Reserves: The RBI maintains a sizable forex reserve to intervene in the currency market when necessary. By buying rupees, it can bolster or hold its value.

• Currency Interventions: The central bank intervenes directly by buying or selling rupees in the forex market to influence its value.

• Monetary Policy: The RBI can adjust interest rates to attract or repel foreign capital, impacting the rupee's demand.

• Open Market Operations (OMOs): The RBI conducts OMOs to manage liquidity in the economy, influencing the rupee's value by buying or selling government securities.

• Regulatory Measures: The RBI may implement or adjust regulations on foreign exchange transactions to stabilise the rupee, such as altering limits on foreign investment or modifying currency trading rules.

Coming to the last bit, what can you, as an investor or trader, do to protect your portfolio from such major currency fluctuations?

To answer that, let’s have a look at how the inflation in India is holding up.

Inflation and the Rupee

The Reserve Bank of India (RBI) has set its inflation target for FY25 at 4.5%, with a tolerance range of 2 percentage points on either side, meaning the target range is 2% to 6%.

The persistent inflation has decreased in recent months; in July 2024, it stood at 3.54%, and in August 2024, it was slightly higher at 3.65%.

How does this make a difference for the rupee?

Well, the RBI has been arresting the rupee’s fall by carrying some of the measures we saw above. It is doing so to stop the brunt of inflation being felt by the consumers like us. So, with inflation being already high, it can’t let the rupee to fall further and strain consumer and business wallets.

But as the inflation eases (which is happening currently), the central bank gets a leeway to carry other equally important tasks. Like keeping interest rates unchanged, selling less dollars, buying less rupees – all of which can have a less strain on the central bank’s foreign exchange reserves. And a less strain on forex reserves could mean a lot good for the economy – because after all, they are regarded as the health meter of a country.

Mitigating Portfolio Impact

As for traders and investors, some of the time-tested approaches to navigate smoothly through currency value swings include:

• Diversification: Diversifying investments across various currencies and asset classes can mitigate the impact of rupee depreciation on a portfolio. Foreign investments, gold, and other assets could act as a good diversification options.

• Hedging: Traders can use hedging strategies, like forward contracts and options, to protect against adverse currency movements. These tools allow them to set exchange rates for future transactions, reducing uncertainty.

• Regular Monitoring: Continuously monitor economic indicators and geopolitical events that could affect currency values. Staying informed helps traders and investors like you make timely decisions to protect their portfolios.

• Currency Exchange Traded Funds (ETFs): Investing in currency ETFs can provide exposure to foreign currencies without the complexity of trading in the forex market. This can help manage currency risk while diversifying investments.

• Dynamic Asset Allocation: Adjust the asset allocation based on market conditions. By being flexible and responsive to changes in currency values, you can better manage potential losses and capitalise on favourable movements.

• Risk Management Strategies: Implement comprehensive risk management practices such as stop-loss orders and position sizing to limit potential losses due to currency fluctuations.

• Local Currency Investments: For investors concerned about specific currency depreciation, investing in assets that generate returns in the local currency can mitigate exchange rate risks.

• Professional Advice: Consulting with financial advisors who specialise in forex and international markets can provide valuable insights and strategies tailored to individual risk tolerance and investment goals.

So, while the rupee's recent fall presents challenges, it also offers potential opportunities for traders.

Conclusion

Understanding the drivers behind its decline, tracking global economic events and central bank actions, and employing effective risk management strategies are vital for navigating the current forex landscape.

As a trader, or investor, you must employ effective risk management strategies, including diversification, hedging, and regular portfolio reviews, to mitigate risks. By staying informed and agile, you can protect your portfolios from adverse movements and seize potential opportunities during volatile times. This proactive approach helps turn challenges into profitable ventures, ensuring long-term success in the dynamic world of forex trading.

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Until next time…

Happy Learning!

Sources: Kotak Securities, RBI, Moneycontrol, Trading Economics

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