Dollar Index falls hard; and what it means for India?

Let us look at why the dollar index has fallen so sharply and what exactly could it mean for India?

Aug 24, 2020 08:08 IST India Infoline News Service

Recently, the Dollar Index (DXY) fell to a 2-year low as the dollar has continued to weaken over the last 5 months since the pandemic first began. The fall has been quite sharp and it has larger implications. Let us look at why the dollar index has fallen so sharply and what exactly could it mean for India? But first, a little about the dollar index!

What exactly is the dollar index all about?

The US Dollar Index, better known as DXY, is a quick measure of the value of the USD against a weighted basket of currencies of US trade partners. The index rises if the Dollar strengthens against these currencies and fall if it weakens. Started by the US Fed in 1973, the DXY is a popular basis for evaluating and trading the dollar. The 6 currencies in the basket include the Euro, Japanese Yen, Pound Sterling, Canadian Dollar, Swedish Krone and Swiss Franc. Euro has the highest weightage at 57.6%.

The dollar is the most widely traded currency in the world and is an indicator of the relative strength of the US Dollar around the world. There are a number of reasons for the importance of the USD. Firstly, most of the commodities in the world are denominated in USD. Secondly, for comparison most of the key macro parameters like market cap, forex reserves and GDP are compared across countries on USD values.

Why is the dollar index (DXY) so sharply down?

Chart Source: Bloomberg
As can be seen from the above chart, the Dollar Index has fallen sharply in the last 5 months since the pandemic picked steam since March 2020. Broadly, there are 3 reasons that led to the sharp fall in DXY.

Firstly, the COVID-19 scare has been much more violent in the US than in the rest of the world. The way growth has contracted and joblessness has risen in the US, the apprehension is that the rebound may be much slower in the US compared to EU and Asia. The one thing that has always favoured the dollar is the exorbitant privilege of being the currency of choice. Be it trade denomination, global capital flows or forex reserves; it has always been the US dollar. But that advantage will only work as long as the fundamentals of the US economy are sound. That is not supportive today for the US dollar.

The second factor triggering the fall in the dollar index is the short-dollar trade. It began in March and continues till date. With the Fed infusing liquidity to the tune of over $3 trillion, there is an automatic preference for safe havens like gold over the dollar. So the long gold trade, combined with the short dollar trade is only exacerbating the fall in DXY.

An important reason; Markets are worried about the US budget deficit

Chart Source: Manhattan Institute

Budget deficit has more than doubled since Trump took over. While Obama worked towards a consistent reduction of budget deficit, the reverse has happened in the Trump era. That is largely because the huge tax cuts that Trump announced for HNIs and corporates compressed revenues of the US government but did not yield volume or productivity benefits. Why is that a worry? It is estimated that this is just the beginning. The deficit could swell beyond the current level of $1.10 trillion over the next 4-5 years as the US economy spends its way out of trouble. That is hardly conducive for the US economy and that is likely to sustain pressure on the US dollar.

What does falling Dollar Index imply for India?

If you thought that a weak dollar would be favourable for Indian markets, you are bang on target. The chart below brings out this relationship.

Chart Source: Trading Economics

The chart captures the movement of the dollar index and the Nifty over the last 10 years. It is evident that Nifty and dollar index have moved in opposite directions. That means when the dollar index has weakened, the Nifty has strengthened and vice versa. Just for starters, consider the post Mar-20 scenario. The dollar index is down 12% but the Nifty is up 50%. Surely, a 10-year trend is almost indicative and real. There are two reasons for this divergent trend.

Firstly, the Nifty heavyweights have been largely driven by portfolio flows from FPIs. It has been seen that portfolio flows tend to gravitate towards emerging markets like India when the dollar shows signs of weakening versus the basket. Secondly, for an economy with a perpetual trade deficit, a strong dollar imposes a huge cost on India. Nifty has reasons to celebrate a weak dollar and that is exactly what the divergent trend means.

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