Dollar, Ruble, INR and Indian Markets

The RBI on Wednesday raised its key lending rate by 40 basis points to 4.40% with immediate effect. The central bank also hiked the cash reserve ratio by 50 basis points. The decision was taken by the monetary policy committee (MPC) in an off - cycle meeting with the central board held on May 2-4, 2022.

The  RBI governor Shaktikanta Das said the decision was taken in view of rising inflation, geo-political tensions, high crude oil prices and shortage of commodities across the globe, which have impacted Indian economy

As a response to the repo rate high, the S&P BSE Sensex dropped 1,306.96 points or 2.29% to 2.29% to 55,669.03. The Nifty 50 index lost 391.50 points or 2.29% to 2.29% to 16,677.60. The NSE's India VIX jumped to 7.86% to 21.88.

[Update: Expectedly, the domestic bourses have opened in positive note. The BSE Sensex was last seen trading at 56,119.924 up 50.89 points (+0.81%) while the Nifty was seen at 16,816.20 up 138.60 points (+0.83%)]

In MPC's view, monetary policy response at this juncture would help preserve macro-financial stability amidst increasing volatility in financial markets.

The latest surprise hike by the RBI completely reverses the Covid-support off-cycle rate cut in May 2020.

However, most analysts believe that improved home buyer attitude, preference for owning a house and strong wage growth will continue to support the housing and other markets. This move will also help stem, the flight of hot money from Indian shores.

Meanwhile, the US central bank has announced its biggest interest rate increase in more than two decades as it toughens its fight against fast rising prices.

The Fed hike was the largest since 2000 as policymakers urgently tried to clamp down inflation. But later at the press conference, Chair Jerome Powell said Fed members aren't actively considering 75-basis-point moves in the future. The US dollar index toppled from a five-year high and fell 0.9% overnight to 102.450, as a post event reaction.

The euro rose nearly 1% and last bought $1.0606. The yen fought its way back to the stronger side of 130 per dollar for the first time in a week, last trading at 129.26.

Sterling rose more than 1% to $1.2605 and swaps markets are fully pricing a 25 bp hike from the Bank of England later in the day.

The RBI governor said the monetary policy stance is still accommodative and with the receding pandemic and economic growth, it expects that consumer demand will remain buoyant in the near term.

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Fed’s more aggressive rate path continues to be the main driver behind the robust bullish stance in the dollar, which also appears reinforced by the current elevated inflation narrative and the solid health of the labour market.

US Dollar Index relevant levels according to FXstreet.com:

Now, the index is retreating 0.02% at 103.57 and faces the next support at 99.81 (weekly low April 21) seconded by 99.57 (weekly low April 14) and then 97.68 (weekly low March 30). On the upside, the breakout of 103.92 (2022 high April 28) would open the door to 104.00 (round level) and finally 105.63 (high December 11 2002).

US Fed's rate hike spree:

With inflation running around 40-year highs for some time now in US, the Fed has already hiked its key benchmark rates by 25 basis points in March and this 50 - basis points hike is in like with market speculation, which helped the US dollar index to broke past the 101 mark on Tuesday, the first time that level was breached since March 2020.

Why the dollar index rose?

The prospect of higher US interest rates has pushed up yields on the country's bonds, making those instruments' returns more appealing to global investors and, as a result, increasing demand for the dollar.

The intensifying conflict between Russia and Ukraine has also contributed to the dollar’s strength as the global economic upheaval caused by Moscow’s invasion has sent investors rushing to the safety of the greenback. Typically in an environment of risk aversion, investors prefer debt instruments over equities as the former are considered to be safer.

Justification of the RBI's move:

The depreciation of emerging market currencies, including the Indian rupee, is a clear example of how a stronger dollar index affects domestic financial markets.

A weaker rupee reduces the returns that foreign portfolio investors earn from investments in Indian debt and equity instruments, and thus the possibility of the US dollar index strengthening raises the risk of further outflows.

Though the RBI’s large foreign exchange reserves provide protection from excessive volatility in the exchange rate, the RBI's rate high will support the INR and could provide it with some cushion as the US Fed starts hikes in earnest.

Another by product of the global dollar strength is that it makes imports of dollar-denominated commodities such as crude oil more expensive.

As it stands, crude oil prices have risen to multi-year highs in the aftermath of the Ukraine war, and a strengthening dollar would only add to India's trade deficit, given the country's reliance on oil imports.

Oil companies and other import-oriented firms stands to lose in this situation. For domestic stock markets, the steady rise in the dollar index is one amongst several headwinds.

Overseas investors, who from October 2021 to March 2022, had embarked on their largest sales of Indian stocks since the Global Financial Crisis of 2008, may now tentatively begun to show signs of interest again in May, with net purchases.

It is not only equity markets that have borne the brunt; higher US bond yields have also wreaked havoc on the sovereign bond market.

With investors fearful of an outflow of foreign funds from Indian bonds to US bonds, the yield on the domestic 10-year benchmark bond had risen in 2022. Bond prices and yields move in opposite directions.

As government debt yields are the benchmarks for a wide range of credit products, rising sovereign bond yields raise the cost of borrowing across the economy, including corporate borrowing.

Hence, the rate hike might stem the continuous selling by the FPI in Indian bourses. It's unfortunate that the market took it in negative strides.

Appreciation of Ruble:

The ruble has recovered most of its losses and is now the world's best-performing currency. It has continued to rise and is now up more than 60% against the US dollar since its lows in the first week of March.

The ruble rose to 67 to the dollar intraday on Thursday, from a low of 139 on March 7. Because of the recent rally, the ruble is more stronger than it was before Russia's invasion of Ukraine on February 24. According to Bloomberg data, the ruble was trading at around 76 before the invasion.

Analysts believe the ruble's post-invasion depreciation is modest, given the severity of European and American sanctions against Russia. Photo: The Borgen Project.

Sanctions against Russia:

The United States and the European Union froze nearly half of the Russian central bank's $640 billion in foreign exchange reserves held in banks outside Russia as part of the sanctions.

Russian companies and individuals have been barred from transacting in dollars and euros, and nearly 400 Western companies have closed their operations in Russia.

The majority of Russian banks have been disconnected from the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which facilitates financial transactions and payments between banks around the world. These actions have resulted in a reduction in Russia's financial and trade transactions with Western countries.

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Ruble as a Reserve Currency?

Though the Russian Ruble has gone for a stupendous appreciation during the last few weeks, but it hardly complies with any of the arduous demands for a reserve currency for international trade, having become convertible as late as July 2006.

Inspite of Kremlin hubris of the summer of 2008, Moscow needs many years of serious reforms to achieve this task.

Headwinds:

First, a reserve currency must be characterized by low inflation and macroeconomic stability, but Russia has had persistent double-digit inflation.

Inflation in Russia at the end of the current year may reach as high as 20%, Accounts Chamber chairman Alexei Kudrin said.

A reserve currency should preferably have a stable or rising exchange rate. At least, it should be freely floating. Yet the ruble exchange rate policy remains erratic.

4thly, only the world's biggest economies can produce a global reserve currency. Both the US economy and the eurozone are still 10 times larger than the Russian economy. In 2020, Russia's share of global GDP (in relation to PPP dollars) amounted to about a meagre 3.11%.

Lastly, the criterion of a reserve currency is what economists call network externalities, which include various international uses, for example, for pricing, invoicing, or transactions outside the country. But the ruble is not used for any purpose outside of Russia, except now.

The hyperinflationary ruble zone that collapsed in 1993 remains a bitter memory. Repeated Russian attempts to revive it have failed.

Dollar as a reserve currency:

The dollar survived even three years of double-digit inflation around 1980 as the dominant reserve currency because it had no competition.

Today, the euro has become a realistic alternative to the dollar, and the renminbi might eventually do so, if China changes many policies. But the ruble is disqualified.

If Ruble becomes a reserve currency, will it benefit Russia?

It'll NOT be beneficial for Russia if the ruble became a reserve currency, because higher demand for the ruble would drive up its exchange rates and reduce Russia's competitiveness.

For such reasons, Japan, Germany, and Switzerland have actively opposed their currencies being used in national reserves, and the European Union remains skeptical.

Dollar Hegemony:

The progress of the Russia-Ukraine war and the flurry of international actions increasingly bring to the fore the challenge being offered to the dollar hegemony.

India and Russia are trying to establish rupee-ruble trade settlement and this topped the agenda during visit of the Russian Foreign Minister Sergey Lavrov to India and his parleys with External Affairs Minister S Jaishankar and Prime Minister Narendra Modi.

Similarly, China and Saudi Arabia are exploring trade settlement opportunities in their respective currencies. If such trade settlement negotiations materialise, it would change the face of global trade where the US dollar and euro dominate presently.

According to a report, from 1999-2019, the dollar accounted for ~96% of trade invoicing in the Americas and ~79%  in the rest of the world. About 60% of the international and foreign currency liabilities and claims are denominated in USD ($). This share has remained relatively stable since 2000 and far exceeds that of the euro, which is at 20%.