Is that rupee strength or is that dollar weakness?

What exactly is driving rupee strength? Let us understand the factors driving the rupee to a position of strength.

Sep 03, 2020 08:09 IST India Infoline News Service

In the last few weeks, the Indian rupee has shown a burst of strength. Having touched a low of Rs77/$ in May this year, the rupee has since bounced back to the Rs72.80/$ levels. It is surprising because the macroeconomic situation in India continues to be grim and the latest GDP data at (-23.9%) is far from flattering.

USD INR chart for last 1 year (Sep-19 to Sep-20)

Chart Source: Trading Economics

What exactly is driving rupee strength? Is it just the weakness of the dollar or is there a fundamental shift in rupee value? In fact, there is an array of factors driving the rupee to a position of strength.

Yes, the dollar index has been weakening

Since the onset of the global lockdown in late March 2020, the dollar index (DXY) has fallen from 102.8 levels to 91.9 levels. That is a sharp fall of 11.6% in the dollar index over the last 5 months. The DXY is a consolidated valuation of the dollar versus a basket of major hard currencies in the world like the Euro, Pound and Yen, among others.

The dollar index had peaked at around 120 ahead of 9/11. Subsequently, the liquidity infusion resulted in the DXY falling all the way to below 75 by 2008. Too much liquidity infused by the central bank has never been good news for the DXY as it debases the dollar. Post COVID-19, the US has pumped in over $3 trillion into the economy and that is expected to weaken the dollar index further. That is surely one reason for the rupee strength.

FPI flows have been robust in August 2020

The INR has shown a sharp appreciation in the month of August 2020. That has been largely driven by robust inflows from foreign portfolio investors (FPIs).

Data Source: NSDL

The FPI net flows have come a long way since the aggressive selling in Mar-20. In that single month, FPIs sold Rs115,000cr of equity and debt combined. Aug-20 was significant from the perspective of FPI flows for two reasons. Firstly, the FPIs infused close to $5 billion into equities in August; one of the best months in recent memory. In addition, August saw the momentum of selling in debt abating. FPIs were still sellers in debt in August but the selling momentum appears to have bottomed out. Robust FPI flows into equities and FPI debt selling abating played its part in strengthening the rupee.

Atma Nirbhar Bharat raises prospects of FDI flows

As global manufacturers look to de-risk their manufacturing portfolio from China dependence, India is fast emerging as an alternative destination. Foxconn and Samsung may just be the tip of the iceberg. One thing it does indicate is that if the big shift happens and global manufacturers look to diversify their supply chain dependence, there is a huge opportunity that India is equipped to tap.

India had been the top FDI destination for a few years but the pace of FDI flows had tapered. This could be the big story to get FDI flows. The speed with which Foxconn and Samsung have announced their India plansgives a leg up for the India FDI story. That has been a critical factor in the rupee strengthening.

RBI policy trajectory has helped the rupee strengthen

There is an interesting link between the rate trajectory of the RBI and the currency value. Currencies normally strengthen when the interest rates are stable or have the potential to harden. When the RBI announced its monetary policy on 06 August, it was quite clear that they would not cut rates further unless there was a favourable inflation argument. As a result, the 10-year bond yields rallied sharply above the 6% mark.

That was a key trigger for the rupee strengthening. One can argue that the new Fed framework could soften yields and that is largely true. But the RBI has sent a signal by holding rates in the last two monetary policies. It has also hinted at a greater shift to fiscal measures as monetary instruments may be approaching their limits.

Finally, the RBI is not intervening to buy dollars

This is an important change that is palpable in the last few weeks. Normally, RBI has tried to maintain the rupee in a range. RBI has not been too comfortable with rupee strength as it hampers exports. However, that seems to have changed.RBI sees limited potential to boost exports by weakening the rupee in the current scenario. Instead, a strong and stable rupee would encourage FDI and FPI flows into India. It will also ensure that when the oil import bill picks up, the rupee hurts less.

The undertone of the rupee has definitely shifted. It remains to be seen if the rupee strength can be sustained.

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