But at this rate, the rupee could go to even 85/$ was what a fund manager quipped the other day. If the level of 85/$ looks to be too steep, then remember that the rupee has gone from 64/$ to 74/$ in this year itself. But, first, why does dollar strength really matter or why is it a worry for India? Check the rupee chart below.
Why dollar strength is a worry for India?
Dollar strength logically means rupee weakness. A weak rupee may be positive for stocks in the IT and pharma space because they are dollar defensives. A large chunk of their earnings comes in dollars and they benefit from a stronger dollar. But for most others, dollar strength is a worry. Here is a why.
- A strong dollar means that India’s trade deficit and current account deficit will go up sharply. India’s trade deficit already stands at $18 billion per month and the CAD is inching closer to 3% of GDP. India imports more than 80% of its oil requirements on a daily basis and this only aggravates the problems for the Indian economy. Importers are normally the worst hit when dollar strengthens because most of Indian trade is still denominated in US dollars.
- Indian companies have borrowed billions of dollars from abroad through the ECB and the FCCB route. The cost of these borrowings could go up as the borrower now needs to pay more in dollar terms. That can put tremendous pressure on the financials of these companies.
- A weak rupee also means that the FPI flows could taper as they would prefer to wait for the rupee/dollar equation to settle down before taking any call on investing in India. That is one of the reasons why India has been seeing consistent selling from the FPIs. In fact, in October alone these FIIs have sold close to $3 billion in equity and debt.
- A weak rupee also means that for the thousands of tourists and students who go abroad to spend time or to study, the costs could escalate much faster.
What can stop the dollar rise?
There are two ways to look at this issue. There is the short term approach and then there is the long term approach. The short term approach dictates that the dollar may eventually taper out as even the US cannot afford to have a strong dollar for too long because it negatively impacts exports. Most of the IT companies in the US are already complaining. Also, the dollar strength is more due to the consistently hawkish stance taken by the US Fed. There is already pressure from Trump and others to go slow on rate hikes as it is putting pressure on growth. That means sharp dollar strength from here on is quite unlikely. Let us now shift to the longer term trend.
What is the longer term trend for the dollar?
That will largely depend on how long the dollar continues to dominate as the default currency for world trade and also how long the US dollar remains the preferred world reserve currency. Here are few key points for you to remember when it comes to judging when the dollar rise will stop.
- Central banks globally remain cautious of the Yuan despite China being the second largest economy in the world. As of now, the Yuan with its narrow liquidity and opacity of its management is not an alternative to the dollar. That means that global central banks are not dumping US-dollar-denominated assets from their foreign exchange reserves any time soon.
- Let us now turn to the composition of global currency reserves. In the first quarter of 2018, global forex reserves stood at $11.59 trillion. Dollar-denominated assets dominate the forex composition at $6.5 trillion, or 62.5% reserves. Euro is less than 20%. That is still a long way to go before there can be reduction in dollar dominance.
- Let us not take a slightly historical perspective of the dollar. Since 1965, the dollar’s share of global reserves has fluctuated wildly, and the current share of 62.5% remains in the middle of the range. Ironically, even the financial crisis of 2008 post-Lehman hardly made any dent on the popularity of the dollar.
The answer to the long term question is that the dollar is staying as the central currency in the medium to long term too. As of now, there is no visible alternative. For the short term, even the US cannot afford to strengthen the dollar much further. The US realizes that a strong dollar is only enriching the export oriented economies of Asia and Europe and is working against the US companies. The last few months have seen a negative trend in emerging market currencies leading sharp corrections. They have reached a stage when most of the EM currencies are grossly oversold; the rupee included. That could be the good news for the Indian markets.