Rupee-dollar enigma

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: There is a lot of focus in India on the rupee dollar rate and on RBI’s foreign exchange reserves, as measured in dollars. However, the dollar is not a stable yardstick. The dollar has itself been fluctuating quite a bit. We should be careful not to read too much in changes in the rupee-dollar rate or in the level of reserves which merely reflect fluctuations of the dollar.

Figure 1 shows the familiar history of the rupee-dollar rate. It runs from April 2006 till the end of October 2008. This shows a depreciation of the rupee from roughly 40 to the dollar in early 2008, first to 42 and then a much sharper movement to 50 rupees a dollar. What was going on?

Many people think that in the global financial crisis, FII and other capital left the country, thus giving a sharp depreciation. This picture is mostly wrong. In order to get a better sense of what is going on, we turn to the ‘Major Currencies Index’ maintained by the US Federal Reserve (Figure 2). This is an index of the movements of the US dollar against the major floating exchange rates of the world. This index, which is abbreviated “USM”, shows a gradual dollar depreciation from the index level of 85 to 70 through 2007. In recent months, it shows a sharp appreciation of the dollar. The entire dollar depreciation of recent years has been reversed in a few weeks.

What has been going on is a ‘flight to quality’. In the global financial crisis, US and other investors are selling off many risky assets all over the world and shifting money back to US government bonds. This has given a sharp appreciation of the dollar and a decline in interest rates of US government bonds.

A good part of the recent rupee depreciation, then, is merely a dollar appreciation. It isn’t as if conditions in India changed that much; it was the yardstick (the US dollar) that shifted. To help clarify our minds, it is useful to re-express the fluctuations of the rupee in terms of the USM. This reflects the evolution of the rupee when expressed in the major floating exchange rates of the world.