Unless someone is completely oblivious to what’s going on in the world, we all are aware of the fact that the world is currently undergoing a phase of super high inflation. Exchange rates rising, governments increasing interest rates, cost of living crisis, blah blah blah.
Inflation, in layman terms, is defined as when most prices go up. So it is a sustained rise in prices, and inflation at the moment is high because demand is going up at the same time supply is going down and costs rising.
The supply had gone down obviously because of the pandemic. Countries simply stopped. They stopped production, china stopped shipping and so imported goods became scarcer and scarcer. On the other hand, there was a slight change in the pattern of demand. All those people who could work from home and earn money spent a lot less during the pandemic. No foreign holidays, didn’t replace their car, etc. now that we are coming out of the pandemic, everyone’s making up for lost time. They’re spending on foreign holidays, trying to replace their cars, etc. So demand is going up at the same time as there are pressures on the supply side, raising costs.
Second reason why supply has fallen, is the war in Ukraine. Russian oil supplies have gone down, Ukrainian supplies of wheat, sunflower or grain has plummeted. So you’ve got a double whammy of the effects and aftereffects of COVID reinforced by the Ukraine war. The difficulty is that every cause of inflation is operating in the same time and broadly in the same direction.
How do governments tackle this?
Interest rates.
Every country has got its own central bank to control inflation. For India, we have the Reserve Bank of India, for the US, we have the Federal Reserve, for the UK, we have the Bank of England, etc.
Let’s understand how they do it. Interest rates are basically borrowing costs. In a situation of high inflation, these rates are usually raised so as to make borrowings costlier for individuals and businesses ; in other words, to discourage people to make purchases and thus alleviate the pressure on supply.
This was just an overview. There’s much more to it.
In May 2022, the US consumer price inflation shot up to 8.6% due to high energy and food prices. As a result, the economy’s interest rates shot up as well. The Government’s bonds therefore, became much more appealing to global investors, and they started pulling out their money from different countries(including india) to park it in the US. Thus, increasing demand for the dollar and thus an increase in the US dollar price index.
The dollar index, which tracks the US unit against a basket of major currencies, rallied 11% this year to a 2 decade high—causing PERSISTENT depreciation of currencies around the world.
Let’s switch to the Indian perspective. The Indian rupee breached the psychological mark of 80.06 against the US dollar on 21 July, primarily because of the HUGE capital outflow by Foreign Portfolio Investors (they sold shares worth more than $30 billion so far in 2022). The widening trade deficit also leads to depreciation pressures on the exchange rate. The RBI has been intervening to defend the rupee against any sharp volatility, leading to forex reserves plunging to a 15-month low of $580 billion in July. The RBI has also raised the interest rates (current rate at 5.4%) to tame inflation and discourage spending.
BUT BUT BUT
While the rupee has lost nearly 7% in 2022, currencies of some advanced economies fared much worse. The euro is down 13%, British pound 11% and the Japanese yen 16%. As a result, rupee has appreciated against these currencies.
Recently, the surprising European central bank move to lift borrowing costs for the first time in a decade, and a second outsized increase in the Federal funds rate in the US, both crude oil prices and the US dollar have weakened. Oil has retreated about 6% in the past few days, while the dollar index has shed about 1% since the US fed raised rates last week. The biggest boost to the rupee has come in the shape of fund inflows into financial assets. Foreign portfolio investors have net bought more than $1 billion in local equities and debt securities since July, reversing the monthly outflow trend seen since November last year.
~Shagun Khetan
Operations Head, Ecofinlysis
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