Don’t Rue The Rupee’s Fall

The Indian rupee has continued to weaken, moving from one record low to the next. It breached 79 against the U.S. dollar on Friday.

With the exception of a few days here and there, the depreciation has come in carefully measured doses, true to the “managed float” regime that the rupee operates in.

For the year-to-date, the rupee is down 5.8% from 74.34 against the U.S. dollar at the start of 2022 to 78.97 as of Wednesday’s close. Over this period the dollar index has risen 9.4% from 95.67 to 104.66, the U.S. 10-year treasury yield has moved from 1.51% to 3.15% and crude prices have risen 50%.

The combination of these three factors — which have significant influence on emerging market currencies —means that the Indian rupee is not an outlier in the near 6% depreciation it has seen. The Philippines peso has fallen over 7%, while the Malaysian ringgit has fallen about 5.3%, though the Indonesian rupiah has fallen a lesser 4% so far this year.

The ‘Balance’ Shifts

As QuantEco Research explained in a note dated June 29, India’s balance of payments position is a crucial macroeconomic variable impacting the domestic currency. A surplus balance of payments is a necessary but not sufficient condition for currency appreciation. In contrast, a deficit in the balance of payments may accelerate depreciation.

India’s balance of payments may swing to a deficit for the first time in four years this fiscal — the fourth such instance after FY09, FY12, and FY19, the note said.

The net balance of payments deficit could be at $35 billion in FY23, economists Shubhada Rao, Vivek Kumar and Yuvika Singhal wrote. “As a ratio to GDP, this would stand at 1.0% — the worst balance of payments position since the Global Financial Crisis, that saw a deficit of 1.8%.”

The balance of payments is a combination of current account and capital account flows.

On the current account, India is facing an increased import bill due to higher crude prices and a strengthening local economy. Exports, while strong, could run into global growth headwinds. Whether these headwinds will also lead to as steep a correction in oil prices as we have seen across industrial commodities is unclear.

“Recent easing of palm oil, met coal and fertiliser prices helps, but the outlook on oil and thermal coal is still uncertain (global demand supported by subsidies, supply response uncertain, and high geopolitical risk),” wrote Credit Suisse India Strategist Neelkanth Mishra in a note dated June 24.

On the capital account, foreign portfolio outflows have persisted.

The March 2022 quarter was only the third quarter this century to have total capital outflows, Mishra pointed out. The December 2008 and September 2013 quarters were the other two. The balance of payments deficit of $16 billion thus recorded was the highest this decade and second-highest ever after the global financial crisis. "Going forward, a bigger concern would be the current account deficit, he said.

“India has sufficient foreign exchange reserves to fund this deficit for a while, but reserves are best to smoothen the devaluation (say 2-3% a quarter) rather than obviate it,” Mishra wrote.

The RBI’s Intervention Playbook

As such, just on account of the expected balance of payments deficit, the rupee's depreciation is justified. The extent, pace and timing of it depends, to a considerable extent, on the RBI.

With $600 billion in reserves, the central bank has arsenal to defend the currency but not as much as the headline number would suggest. Indranil Sen Gupta, economist and head of research at CLSA, in a report in March, had estimated that the RBI could spend about $80 billion of its then reserve pile of $680 billion (spot plus forwards) to defend the rupee.

Between valuation losses and sales to slow the rupee's fall in recent months, those reserves, including the central bank's forward book, stands at about $650 billion.

While reserves are no doubt more adequate compared to previous years, the benchmarks of adequacy are far from exact. As such, the central bank may be careful about expending its firepower.

In recent weeks, traders have spoken of the RBI’s intervention moving from the spot market to the forward market. The reason for the shift could be a combination of keeping the spot forex reserves from dwindling too fast but it could also be to prevent a quick wind-down in rupee liquidity.

Whatever the reason, the shift led to a fall in the forward premia and accelerated the rupee’s weakness. It also have created some dollar shortages.

“With onshore forward premiums crashing to decadal lows, rupee weakness could become self-fulfilling as market participants (speculators, real sector agents) re-adjust their carry [trade] and hedging strategies,” wrote Madhavi Arora, lead economist at Emkay Global Financial Services in a note dated June 28.

According to Arora, the dislocation in forward rates, falling forex reserve cover, persistently high commodity prices, limited exchange rate pass-through to inflation and elevated rupee valuations may call for RBI to re-orient its forex intervention strategy. “We believe the RBI may eventually let the exchange rate adjust to new realities, albeit orderly, letting it act as a natural macro stabiliser to the policy reaction function,” Arora said.

In recent days, the market is sensing just this and a view is taking hold that the central bank is letting the currency go a little bit. This, in turn, may extend the depreciation trend till the RBI steps in and draws a new line in the sand.

Will that line be at 79? 80? 81? We'll know it when we see it.

Ira Dugal is Executive Editor at BQ Prime.