Looking at the current situation rationally and analytically, yes, it’s very likely that Indian rupee will drop further against US dollar in the coming days. And the paranoia (or joy) among traders and on foreign exchange will be really high. Moreover, this rise in INR-USD difference can have a negative impact on the Indian economy. For instance, high oil price can increase the price of vegetables and groceries by a significant margin.
But that all being said though, things are very controlled and there isn’t a lot to panic about. Yes, worry—but not panic. Like RaghuramRajan recently reiterated in his interview, RBI has its eye on the current market situation and it has all the right tools if Indian Rupee is to head for a free fall. The fact that it still is observing the market and focusing more in the inflation (by increasing interest rate), one can assume that falling INR price against USD is in control.
"It is very important that RBI continues to signal as it has done so far on its concern about keeping inflation on track, about raising interest rate whenever appropriate, to fulfill its inflation objective ... that gives investors confidence that rupee is not going to go in for free fall because ultimately inflation will be in control ...," Rajan said in his interview to CNBC TV18. (Source)
Here’s a fundamental explanation:
Reserve Bank of India increases and decreases the repo rate to primarily control the inflation and unemployment rate in the country. When it increases the interest rate, borrowing becomes expensive, it drops consumers’ spending, and this cascades to control the inflation rate. However, when economic growth slows down to control inflation, unemployment increases.
(Remember, there’s a trade-off between inflation and unemployment)
Similarly, when RBI wants to stimulate the economy – to drop the unemployment rate and boost growth rate – it decreases the interest rate, even it means increasing the inflation by a slight margin.
Now, when the central bank plays with the interest rate, it also has many other impacts on various ends of the economy, aside from the intended effect on inflation, unemployment, and GDP. It also impacts the country’s currency worth against other countries’ currencies.
When central bank increases the interest rate, the fixed income securities in the country becomes much more attractive, which paves way for more foreign capital in the country. This helps appreciate its currency. Similarly, when the bank decreases the interest rate, the securities become less appealing and the capital flows out of the country. This depreciates the home currency.
At present time, to control the rising difference between INR and USD, the Reserve Bank of India can increase the interest rate to attract more foreign capital. And it could also help it control inflation. Indeed, this measure can increase the unemployment rate and slow down India’s economic growth/GDP. But that’s an afterthought!!!
But since RBI has shown no signs of taking any such measure, it’s a clear indication that it’s not in panic mode, as is the rest of us. Even when INR drops further against US Dollar, which is very likely in the coming days, it feels like everything is under control of the RBI. Of course, how long this control intacts is uncertain. If the crude oil price continues rising and US-China trade war escalates, the Reserve Bank of India can find itself in hot water, desperately pulling the strings of economic tools to control the situation. But right now, INR is far from a free fall against US Dollar. Things are okay.
(Courtesy: Money Control)