Assessing the foreign currency market today is quite interesting because of a plethora of events taking place at the same time. As a regulator, the Reserve Bank of India has no view on the value of the currency, but as a central bank it would like to ensure that there is no undue volatility in the market as this can be destabilising.

If the rupee falls and there is no action from the RBI, the market will interpret it as being acceptable and that will encourage speculative forces. Exporters hold back their earnings and importers rush in with their demand thus exacerbating the depreciation.

In fact, today the market is always looking at the RBI for guidance. Excess flows of dollars, by definition have to flow to the RBI. Banks which receive foreign currency would only hold the amount that is productive and sell the rest to the central bank. But the market calls it ‘buying of dollars by the RBI’ when it is a normal process. Similarly, a shortage has to be met by dollar sales by the RBI to eschew extreme volatility. Yet the market reacts and drives sentiment.

Bangladesh impact

There is first the Bangladesh effect to consider. The prevailing political turmoil there has impacted economic prospects, especially exports of textiles. This could potentially be a positive for Indian exporters as the two nations compete in global markets on the cost front.

Here, it seems that there is an opportunity; and hence a weaker rupee helps. Competition also comes from China, Vietnam etc. and to ensure that this opportunity is leveraged, a weaker rupee makes sense.

On the other side, there are the whimsical FPIs. The inclusion of Indian bonds in the JP Morgan bond index, (and Bloomberg is likely to follow in early 2025), means that there are more than normal inflows of FPI funds in the debt segment. Quite expectedly these flows started coming from November 2023 as investors built positions before the actual event (which was June end 2024). This enabled them to make money potentially once the inclusion actually took place. Therefore, debt inflows have been positive.

But equity flows remain uncertain as investors regularly rebalance their portfolios and look at various markets for investment opportunities. Despite robust stock market indices, FPI inflows have been unpredictable.

A couple of weeks back there was a run on most currencies when Bank of Japan raised rates. Normally, the Fed decision on rates or statements made by their chiefs have a market impact. But the silent Japanese action led to carry trade players unwinding their positions.

Carry trade is where investors borrow in cheap yen and invest elsewhere. But the raising of rates caused the yen to appreciate which led to traders unwinding their positons by selling their portfolios. The rupee too was not spared.

Fed suspense

The Fed continues to keep markets in suspense. The rate hikes in the past had strengthened the dollar post Ukraine war. The RBI had explained at that time that around two-thirds of the rupee depreciation was caused by valuation issues as the forex reserves plummeted.

Now, the Fed is set to lower rates; and while the timing is almost certain the question is ‘by how much’? Will it be three cuts this calendar year of 25 bps each? Or will it be a 200 bps next year? These questions will be popping up continuously and the US inflation rate, which is now less than 3 per cent as well as unemployment rate, which is less than the benchmark 4.6 per cent but still showed a 10 bps rise in July, will dominate sentiment.

All these mood swings will influence the value of the dollar and the rupee too.

The Trump factor

And then there is the Donald Trump element which can never be ignored. Till November, the US election mood will also drive the dollar and hence other currencies.

The economics of Trump is not always consistent. He wants a strong dollar. For this interest rates need to be high. He does not favour a rate cut and he was critical of Fed chief Jerome Powell during his tenure. He favours tax cuts, which will lead to a rise in fiscal deficit, which has to be financed through borrowings. As the poll swings keep changing, the nature of the dollar would be fickle. This is a factor to also be watched.

Therefore, for market players it will always be tough to guess which way the tide is flowing. The daily swings will be driven by all these factors. But from the economist’s standpoint, the factor that matters are the fundamentals, which are basically the demand and supply of dollars. While there will be daily changes that are captured by the rupee movements, the indicator that reflects the strength of the fundamentals is the foreign exchange reserves.

At $670 billion the reserves are more than comfortable. Imports last year were $675 billion. There is almost 100 per cent cover based on the current reserves. In fact, India would rank fourth in the world in terms of reserves, after China, Japan and Switzerland.

Forex reserves have rise by $23 billion so far this fiscal (April-August 9). The rupee had moved down from around ₹83.40/$ to ₹83.90/$ which is around 0.5 per cent.

This is fairly modest and can be justified by both the external factors as well as the fact that appreciation at this point of time could have lowered the competitiveness of our exports.

Therefore, it can be said that the fundamentals driving the currency are quite firm as denoted by the net forex accruals. There would be short-term swings when the net inflows are volatile. There would also be the external influence where the dollar swings erratically which affect all currencies in general. India cannot be insulated from such forces.

The writer is Chief Economist, Bank of Baroda. Views expressed are personal

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