On August 5, 2024, the Indian rupee reached its all-time low of Rs 84.1, driven by escalating geopolitical tensions in the Middle East and recession fears in the United States. Though the Indian rupee has hit its all-time low multiple times in the past year, the fall has been marginal, thanks to intervention by the Reserve Bank of India, limiting the losses. 

High volatility can complicate trading and investing in the rupee, potentially increasing costs for businesses and investors. However, interventions by the central bank and optimism surrounding potential rate cuts by the US Federal Reserve (Fed) kept the rupee around the critical threshold of Rs 84. The chart above shows that over the past year, the Indian rupee has depreciated by only 0.8% against the US dollar, reflecting its relative stability compared to other currencies like the Brazilian real and the Russian ruble. The Euro and Australian dollar have risen over the past year driven by growing expectations that the Fed might soon begin cutting interest rates.

RBI Governor, Shaktikanta Das, said, “It is always the priority of the RBI to ensure stability of Indian rupee.” This stability the governor talks of has been hard-won – a decade ago, the Indian rupee was one of Asia’s most volatile currencies. US-based Global Finance magazine has ranked Das as the top central banker globally for the second consecutive year, a ranking based on his success in managing inflation, promoting economic growth, and ensuring the currency’s stability while overseeing interest rate policies. 

The governor’s job is a tightrope, in ensuring the economy’s stability while facing pressures from corporates and consumers around interest rates. And not everyone is pleased. The International Monetary Fund (IMF) says that excessive forex intervention has contributed to the rupee-dollar moving within a narrow range since December 2022 and reclassified India’s exchange rate regime to ‘stabilized arrangement’ from ‘floating’

This week’s Chart of the Week examines the rupee’s performance among global currencies over the past year and the factors contributing to its improving stability over the past decade. 

How does the Yen carry trade impact the Indian rupee?

The yen carry trade, a popular strategy for over a decade, has been undergoing significant unwinding recently, affecting global markets, including India. This trade involves borrowing Japanese yen at the country’s very low interest rates (around 0.1%) and investing in higher-yielding assets abroad. However, the strategy has become less profitable due to recent changes in Japan’s monetary policy.

On the 31st of July, the Bank of Japan (BoJ) increased interest rates by 25 basis points (bps) to 0.25% from near-zero levels, and hinted at further hikes this year. Analysts also expect the US Federal Reserve to cut interest rates by 75 basis points in 2024, squeezing the differential between US-Japan interest rates and impacting profit margins further for those engaged in yen carry trades.

The BoJ's rate hike has led to a sharp 8% appreciation of the yen over the past month. As the yen strengthens, it becomes more expensive for investors to maintain yen-funded positions, prompting a rapid unwinding of these trades. This shift has had a noticeable impact on India’s financial markets. Following the BoJ’s rate hike, India's benchmark index, Nifty50, experienced a significant sell-off, dropping over 1,000 points from its peak of 25,000 within just three trading days. This decline is partly attributed to the fact that 23% of total inflows into India since January 2023, amounting to $10.3 billion, were invested by participants in yen carry trades.

US rate cuts: Potential boon for the Indian rupee

The anticipated rate cuts by the US Federal Reserve, expected to be around 75 bps in 2024, could, however, prove advantageous for the Indian rupee. Lower interest rates in the US often lead to increased foreign investment in emerging markets like India. As the interest rate differential between India and the US widens, India may become a more attractive investment destination compared to the US. 

The expected inflow of foreign capital could further boost Indian markets. Foreign institutional investors, who had withdrawn from Indian markets as the US Fed started to hike interest rates, could return as the interest rate environment shifts.

The lower US interest rates would also increase the availability of dollars, potentially leading to a softer dollar and a stronger rupee. A stronger rupee could benefit India by reducing its import bill, particularly for oil, which constitutes more than 80% of its total imports. A stronger rupee would help lower import costs, alleviate the current account deficit, and improve the fiscal deficit. A fiscal deficit represents the gap between how much the government earns and how much it spends. It would also make it cheaper for India to service its foreign debt.

Strong economic growth coupled with RBI’s intervention has led to a stable rupee

Volatility in the Indian rupee has fallen to a decade-low

Even though the Indian rupee has consistently weakened against the dollar over the past decade, the volatility has significantly decreased over time. This relative stability can be attributed to robust economic growth, consistent policy measures, and political stability coupled with RBI intervention whenever needed. Continuity in the Central government after the recent elections in June has boosted the confidence of foreign investors. Key reforms, such as assigning an inflation-target mandate to the central bank and reducing the budget deficit, have further supported this stability. India now boasts the world’s fourth-largest pile of foreign reserves.

By buying dollars when the rupee strengthens and selling foreign exchange when it weakens, the RBI has moderated significant currency fluctuations. This intervention helps smooth out the value of the rupee by managing the supply of dollars in the market.

However, the RBI's approach has its limitations. The central bank's interventions can sometimes mask changes in economic fundamentals, meaning that strong growth, which usually supports currency strength, might not always translate into a stronger rupee if the RBI continues to buy dollars.