The US Fed releases a ‘Major Currencies Index’ that summarises movements of the US dollar against major floating exchange rates of the world. This dropped by 38.5% over the six-year period from January 31, 2002 to March 18, 2008. Countries like China and India tried to have a pegged exchange rate against the dollar. When the dollar dropped, trying to hang on to the dollar was tantamount to engineering depreciation. This required unprecedented market manipulation by RBI. After the dust had cleared, the Indian rupee appreciated by 17.6% against the dollar over this period, which implies a depreciation of 21% against major floating exchange rates of the world. The market manipulation that was required to achieve this led to a build up of excessive reserves, which gave distortions to monetary and fiscal policy. In particular, we now suffer from high inflation. The drop of the dollar imposed massive losses on countries which held dollar reserves or dollar denominated assets. For each $100 billion reserves held by India in dollar assets, for each 10% decline of the dollar, India suffers a loss of $10 billion. Unfortunately, RBI’s opacity has implied that estimates of these losses cannot be made. We can only know that India has suffered enormous losses on this portfolio.
Finally, the drop of the dollar led to export growth in the US. Fairly large changes in exchange rates can only generate slow, long-term changes in exports. In the case of the US, while the decline of the dollar started in January 2002, it is only from 2005 that an impact on US exports was visible. Over the three-year period of 2005-07, US exports grew by 25%. What does the future hold? While its exports have risen, the US continues to have a large deficit of $700 billion a year. Fundamental economic reasoning suggests that such a large deficit cannot persist. The dollar has to drop further so as to induce a further decline in the US current account deficit. There is now a large and growing interest rate differential, which is sucking capital into India. And, if the US dollar resumes its decline, it will once again be hard for RBI to hang on to the dollar. Putting both factors together, the outlook for the rupee is positive.