The Reserve Bank should let rupee appreciate to reduce imported inflation, a SBI Ecowrap report said on Wednesday. According to the report, the US dollar is expected to remain weak due to fragile US economic conditions.
"It would do no harm for the RBI to lean with the wind and let the rupee appreciate which would reduce imported inflation when metal prices are rising, and clear the liquidity overhang to some extent," it said. "In fact, the large supply of dollars will ensure that rupee will not appreciate significantly from the current levels and this could potentially play to the advantage of the RBI even if it takes a hands off approach to rupee appreciation for the time being."
Imported inflation is a general rise in price levels in a country because of an increase in price of commodities that are imported. While usually increase in oil prices, or gold prices could result in imported inflation, depreciation of the rupee could also impact imported inflation.
As per the SBI Ecowrap report, data from 1968 shows that dollar index has performed well under the Republican regime vis-a-vis Democratic regime and thus US election results have led to significantly improved capital inflows in emerging markets, including India.
In fact, India has already witnessed record inflows of $18 billion so far this fiscal.
"Interestingly, in the merchant market (in both spot and forward segment) there was an excess supply of $40 billion during Apr'20- Sep'20 (till 18th)," the report said.
"However, in the interbank market, the trend is quite opposite and there has been excess demand of $27 billion in the same period and this must have increased significantly by now."
Besides, the report pointed out that overall, merchant dollar supply is far higher than demand as they anticipate a stronger rupee and hence may be holding to long position in dollars, without even adequate hedging.
"This is being balanced by excess dollar demand in interbank market, but the net effect is a large supply of dollars," the report said.
“Thus, and also given higher domestic inflation, it would do no harm for RBI to lean with the wind and let rupee appreciate which would reduce imported inflation when metal prices are rising and clear the liquidity overhang to some extent. In fact, the large supply of dollars will ensure that rupee will not appreciate significantly from the current levels and this could potentially play to the advantage of RBI even if it takes a hands off approach to rupee appreciation for the time being,” it added.