The way that the US dollar has plummeted against some of the other major global currencies, particularly the Euro, has surprised many whose professions mandate that they not be surprised. Except for those whose livelihoods depend on the yo-yo-ing of the ?majors?, this might be perceived to be a bit of a storm in a teacup.

That the dollar is rapidly moving towards a 1.50 Euro is not likely to get the Hollywood moghuls salivating. Or will it? And should we care?

First, was the dollar weakening unexpected? The direction was not, but the speed and timeframe was. The dollar Index (DX), a trade weighted composite, used as a benchmark for currency trades, has fallen from around 79 levels at end-July to around 76 now. Not that this is a major fall in the context of the movements in the DX over the past six months (see chart); the DFX has fallen from 89 levels in early March 2009, and has occasionally fallen quite rapidly over short periods.

The broad reasons for the weakening of the dollar are more or less clear. First and foremost is the reduction in global investors risk appetite following the increasing evidence of recovery signals, however, weak, and the consequent quest to seek alpha from the enormous funds parked in US Treasury securities.

Although there are no formal figures available, there is increasing evidence of the emergence of a USD carry trade, which builds and leverages on this liquidity to invest in ?higher yielding currencies?, mostly in emerging markets.

Is any of this of material interest to Indian policy authorities? Yes. The most direct effect is on the rupee. We had expected the rupee to appreciate based on trade and foreign capital consideration; a weakening of the dollar will only reinforce this trend. If the rupee begins to appreciate rapidly, this will inevitably hurt India?s exports, operating as they already are on weak export markets.

Even worse is that increasing volatility will force them to hedge their exposures, impacting their margins further. The silver lining in this is that the rupee has appreciated less than the currencies of many of India?s export competitors over the past 6 months, imparting a slight competitive edge in the current environment.

A steep appreciation might force the RBI?s hand in the currency markets, to maintain export competitiveness. Other than the RBI?s stated goal of intervening in currency markets to contain volatility, it might be forced to control direction as well. This will lead to liquidity injections into domestic markets, exacerbating the already high levels of liquidity, thereby necessitating sterilisation measures including issues of MSS paper, adding to the already high supply of government securities and pushing up the sovereign yield curve.

The other big effect will be on the prices of commodities that are predominantly traded in the USD, chief amongst them being crude oil. It is no surprise that crude prices have more than doubled from the lows of USD 30 / bbl since end-February, not coincidentally, just before the time when the USD started weakening. (The other notable commodity, of course, as everyone now knows, was gold).

Although we do not think that buildups in speculative positions will drive up crude prices to levels anywhere close to the excesses of mid-2008, a sustained increase even to USD 90 / bbl levels will have significant effects on India. The first will be higher pass-throughs into inflation via unregulated petroleum products prices.

Next will be the pressure on realisations of oil marketing companies through sales of subsidised products, necessitating some oil bonds and other subsidy support, either worsening the fiscal situation or hardening interest rates.

How much might we expect the USD to weaken and how long might this persist? Remember that the weakening of the dollar has been particularly marked against the Euro and the Yen, amongst the majors and by remarkably similar magnitudes over the past three months.

The former was largely due to perceptions of economic recoveries and interest differentials and the latter also had an element of shifts in currency carry trades. It is unlikely that the dollar weakening trend will deepen significantly going forward, since considerations of competitiveness will lead to policy interventions, even if they are informal.

This implies that the drivers of the rupee movements will increasingly be driven more by our external interactions than by the dollar?s directionality. That, however, might change if the dollar decisively changes track with a quicker (and more vigorous) than expected recovery compared to the other major geographies and begins a sustained appreciation.

All of this uncertainty and volatility, though, will be very good for our currency futures markets.

The author is vice-president, business & economic research, Axis Bank. These are his personal views