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Oil Prices and Fed Tightening Not the Whole Story of India’s Falling Dollar Exchange Rate

By Frances Coppola

The Federal Reserve’s interest rate rises and quantitative tightening are strengthening the U.S. dollar and making dollar exchange rates more volatile in developing countries worldwide. These factors are increasing businesses’ foreign exchange risk and clouding the outlook for international trade. But the strong dollar affects some developing countries more than others, depending on each country’s individual circumstances.

In India, the rupee’s dollar exchange rate has fallen steadily throughout 2018. In January, one dollar was worth 63 rupees, but by October the dollar’s value had risen to 74 rupees.1 What are the reasons for that fall, and what does the declining exchange rate imply for the country’s import-export businesses?


India’s Central Bank is Not Controlling the Rupee-Dollar Exchange Rate


The Indian economy has been performing well. The country’s real GDP growth in 2017-18 was 6.5 percent, according to the Reserve Bank of India’s (RBI’s) Bulletin for September 2018. Inflation is below target, at 3.6 percent (the RBI’s inflation target is 4 percent2)3. On that basis, at its October 2018 meeting the RBI opted to leave its benchmark interest rate unchanged, at 6.5 percent.4


This decision was disappointing to analysts, most of whom had expected the RBI to raise interest rates in line with the Federal Reserve.5 Consequently, the rupee fell to an all-time low of 74.2 to the dollar after the RBI’s announcement.6


The governor of the RBI reminded everyone that the bank does not target the exchange rate. “There is no target or band around any particular level of exchange rate, which is determined by market forces, demand, and supply,” he said. The rupee’s exchange rate officially floats against the U.S. dollar, and the RBI sets interest rates so as to meet its inflation target.7


So why did most analysts expect the RBI to respond to the dollar’s rise by raising interest rates?


India’s Growing Current Account Deficit Partly Explains the Rupee’s Weakness


In recent years, India has depended on low oil prices and plentiful supply to expand its economy.8 But the dollar price of oil has been rising.9 Additionally, because of the rupee’s falling dollar exchange rate, the price of oil in rupees has been rising, contributing to inflation in the Indian economy. Economic theory says that external cost-push inflation due to oil price shocks should be ignored unless the general price level starts to rise in response. The RBI’s September 2018 figures showed no sign of a significant increase in the general price level, so despite the rising price of oil, it left interest rates unchanged.


However, the rising price of oil increases the size of India’s current account deficit. If that deficit continues to widen, India may be at increasing risk of a “sudden stop”—whereby foreign investors abruptly withdraw their funds. India also has limited FX reserves, which raises the risk that it will simply run out of dollars. Its reserves dwindled from $424 billion to $400 billion between May and August 2018. If the RBI defended the rupee’s exchange rate, it could quickly burn through the rest of those reserves.


Investors tend to be uncomfortable with holding assets denominated in a currency whose economic fundamentals are worsening. Thus, India’s widening current account deficit and shrinking FX reserves may be contributing to the capital outflows that are causing the rupee’s exchange rate to fall. Raising interest rates could help keep capital in India, and hence arrest the rupee’s slide.


‘Fear of Floating’ Influences Policy Responses to Exchange Rate Falls


If the rupee’s exchange rate were allowed to fall freely, however, the current account deficit would tend to narrow, since a depreciating currency makes imports more expensive in domestic currency and exports more competitive in dollar terms. This would help to calm fears of a sudden stop or FX crisis, and thus slow or even stop the capital outflows that are driving the rupee’s fall. So why is there so much concern about the falling exchange rate?


Back in 2002, economists Guillermo Calvo and Carmen Reinhart examined the behavior of exchange rates, interest rates, and FX reserves in many countries in order to discover whether currency exchange rates really did float freely. They concluded that most countries that said their currency exchange rates were floating actually didn’t allow them to do so. They described this as “an epidemic case of fear of floating.”10


India may be suffering from such a fear. Both foreign analysts and Indian politicians have expressed concern about the rupee’s weakness.11 The government has imposed import duties to curb imports and narrow the current account deficit.12 Because this move would be unnecessary if the currency exchange rate were allowed to fall freely, analysts view it as an attempt to support the rupee.13 Additionally, the RBI seems to be under pressure to raise interest rates to stop the rupee’s exchange rate fall.14


The import duties imposed by the Indian government may raise inflation, to which the RBI could respond by tightening monetary policy. Perversely, therefore, the import duties may yet bring about the rises in interest rates that analysts expected. If so, then the rupee could stabilize against the dollar. However, this outcome could cause an economic slowdown, as higher import prices and interest rates feed through to India’s businesses and households.



India’s dependence on oil is causing its current account to widen as oil prices rise and the dollar strengthens. This is encouraging capital outflows, which are depressing the rupee’s dollar exchange rate. India’s central bank is allowing the rupee’s exchange rate to fall, but the government appears to be trying to support the rupee with import duties. This move may stabilize the exchange rate, but the price could be slower economic growth. Businesses may face increased FX risk due to exchange rate volatility and more difficult trading conditions.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.


1. INRUSD, Bloomberg;
2. “India adopts inflation target of 4% over next 5 years under monetary policy framework,” Economic Times of India;
3. “September 2018 Bulletin,” Reserve Bank of India;
4. “Fourth Bi-Monthly Monetary Policy Statement, 2018-19 Resolution of the Monetary Policy Committee (MPC),” Reserve Bank of India;
5. “Reserve Bank of India rate hike won’t help India’s rupee,” CNBC;
6. “Indian Rupee hits all-time low after RBI leaves rates unchanged,” Financial Times;
7. Ibid.
8. “Can India Break Its Oil Addiction?” Oil Price;
9. “Oil prices extend their rise to a four-year high near $82,” Financial Times;
10. “Fear of Floating,” Calvo & Reinhart;
11. “’Rupee’s not breaking, it’s broken:’ Rahul Gandhi on sinking currency,” Hindustan Times;
12. “India curbs imports to cut current account deficit and bolster rupee,” Financial Times;
13. Ibid.
14. “Indian Rupee hits all-time low after RBI leaves rates unchanged,” Financial Times;

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