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Why is US dollar weakening and what is means for India?

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The US Dollar Currency Index is down 8% in the last one year and 4% from its 2021 peak. The dollar has underperformed against major currencies so far in the last quarter, except against the Japanese Yen.

USD movement against major currencies

Source: www1.oanda.com

The US Dollar Index (DXY) tracks the strength of the dollar against a basket of major currencies. DXY was originally developed by the US Federal Reserve in 1973 to provide an external bilateral trade-weighted average value of the US dollar against global currencies.

DXY goes up when the US dollar gains ‘strength’ (value), compared to other currencies and vice versa. The six currencies that are used to calculate the index are Euro (57.6% weight), Japanese yen (13.6%), Pound Sterling (11.9%), Canadian Dollar (9.1%), Swedish Krona (4.2%) and Swiss Franc (3.6%).

US Dollar Currency Index (Source: in.tradingview.com)

Meanwhile, the Indian Rupee appreciated about 4% against the Dollar from the peak this year and 5.5% in the last one year.

USD-INR chart (Source: https://in.investing.com/)

Why is the US Dollar weakening?

1) The US Federal Reserve System (the American central bank or, simply, Fed) policy of continuing with its bond purchase programme despite inflationary pressures is damaging the dollar's appeal. 

With interest rates at near zero and no short to medium term indication of raising rates to tame inflation, the dollar has been facing the heat.

When the Fed increases the interest rates, higher yields attract investors from abroad seeking higher returns on bonds. Global investors sell their investments denominated in local currencies in exchange for dollar denominated investments.

This results in a stronger dollar. Exact opposite of this is happening currently thus weakening the dollar.

The Fed has followed a policy of lower rates to spur the economy devastated by the pandemic and lockdowns. The interest rate cuts in 2020 have brought the US Treasury yields to a lower premium over those of other countries.

2) The expectations that US growth may peak while the rebound in Europe and other regions is only beginning are also hurting the dollar.

“The relative growth advantage enjoyed by the U.S. in the near term is likely to fade as COVID-19 vaccinations raise global GDP growth prospects,” economists at Citigroup wrote. “This is likely to…generate dollar depreciation pressures.”

3) A rise in prices on the Consumer Price Index indicates a weakening in the purchasing power of the country's currency. Inflation in the US surged to its highest level in 13 years since 2008, reaching 4.2%. This is impacting the exchange rate of the dollar.

4) Lower than expected recovery in US jobs data in early May also put a damper on hopes that a roaring economic recovery would spur higher rates and light a fire under the greenback.

How does it impact India?

1) India is a big importer of crude oil which hurts its current account balance as well as impacts the GDP negatively. A cheap dollar means we will need to shell out lesser rupees to buy oil which is good news for us. This will help to check the rise in petrol / diesel prices at the fuel stations.

2) Lower landed cost of commodities would also help reduce the inflationary pressures on the economy. This will help the RBI to maintain its accommodative stance and keep rates low fuelling credit growth.

3) A strengthening of the rupee against the dollar is not great news for exporters, especially the Information Technology sector. A cheap dollar means these companies will realise lesser rupees for their invoices for services provided. This could act as a double whammy at a time when exports have been under pressure for a while.

4) A stronger rupee could be used to improve the external debt situation by paying down debt. Alternatively, the country can examine refinancing costly foreign currency loans at lower rates, or pursue a combination of the two as suggested by V Anantha Nageswaran.

5) A strengthening rupee is good news for the Indian stock markets as the foreign institutional investors (FIIs) and foreign portfolio investors (FPIs) get better returns on their dollar investments. The pressure of flight of money from Indian bourses to the US is reduced.

A weaker dollar would make imports attractive and hence run counter to Atmanirbhar Bharat Abhiyan. The government would need to re-look and tweak this strategy as the world prepares for a prolonged period of dollar weakness.

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