Moneycontrol Pro Panorama | How much firepower does RBI have to defend rupee?

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The rupee slipped below 81 to a dollar for the first time today on relentless US dollar strength. The dollar index, which tracks the US greenback against a basket of currencies, has gained nearly 16 percent this year, putting a lot of pressure on everything from the euro to the rupee.

Now, the Bank of Japan has become the latest big-country central bank to try and push back against the stronger dollar. It is unlikely that there will be a let-up in dollar appreciation since the US Fed seems intent on crushing inflation and ready to sacrifice some growth in the process. Its dot plot showed rates to head higher and stay higher for longer than previously anticipated. That has spooked markets worldwide and in India, where we are seeing benchmark equity indices fall for a third straight day.

But how much can central banks spend in defending their currency?

The Reserve Bank of India has spent $90 billion in the past 12 months in trying to cushion the rupee’s fall. According to a Bloomberg report, this sharp drawdown has reduced the import cover these reserves provide to 9 months now compared to 19 months around January 2021.

That is still a comfortable position, although we might see the Indian central bank turn less interventionist in the coming days.

One big reason is the tightening liquidity in the local markets. The banking system liquidity is in deficit and if the RBI sells more dollars, it will absorb more rupees leading to a spurt in short-term interest rates. We have a chart based explainer on the root cause of the liquidity deficit here.

While trying to sail against a strong headwind (which is what the US dollar appreciation is) can be a thankless task, a strong currency is not a vanity metric for central banks. Most big countries are facing inflation problems and a weakening currency can lead to imported inflation. India also faces this same issue as a net commodity importer. A current account deficit in excess of 3 percent of GDP is expected this year, which will put further pressure on the rupee.

With inflation at 7 percent, a weakening rupee and less elbow space for defending the rupee, how will the monetary policy committee react when it meets next week?

In a Reuters poll of 51 economists, a slim majority (26) predicted that RBI would go for a 50 basis point hike. Read details here.

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