The rupee has crossed the 70 mark against the US dollar, and though it has pulled back there is widespread concern at what is being seen as a rather quick slide to new all-time lows. Some have cited the collapse of the Turkish Lira to draw odious parallels to India, unmindful that Turkey suffers from high inflation, large capital outflows and insufficient forex reserves.
The RBI, on its part, has maintained an intelligent silence but has taken action in the spot as well as the forward market, keeping in view its mandate to maintain orderly conditions by containing excessive volatility in the exchange rate without reference to any predetermined level or band.
In analysing the situation, it is important to note that episodes of volatility are not a new phenomenon in India and this isn’t the worst of what has been seen in terms of volatility. The depreciation five years ago, precisely on August 28, 2013, remains a watershed as the rupee touched ₹68.361 to the dollar. Thus, the worst in terms of volatility in recent years was seen in 2013-14, which saw the highest standard deviation at 3.08 and the coefficient of variation at 5.10 per cent (Table1).
Subsequently, even though the currency touched 68.777 (on February 26, 2016), this was again not the worst in terms of volatility measured by standard deviation and coefficient of variation.
Analytically, the movement in the exchange rate is influenced by demand for and supply of foreign currency liquidity (US $ liquidity). In the balance of payments framework, demand for foreign currency is broadly determined by import of goods and services and outflows of foreign capital whereas the supply of foreign currency is influenced by export of goods and services, worker remittances and inflow of foreign capital.
In the Indian context, the current account deficit and net capital outflows influence the shortage of dollar liquidity, which result in rupee depreciation ( Table 2)
Evidence suggests that in all years barring 2015-16 and 2016-17, speculative capital flows (foreign portfolio flows) and debt capital flows (external commercial borrowings and NRI deposits) predominated the capital flows. However, during 2015-16 and 2016-17, there were debt capital outflows. Illustratively, there were net outflows in external commercial borrowings and NRI deposits to the tune of $6.1 billion and $12.36 billion, respectively, in 2016-17.
Debt capital flows
To the extent the debt capital flows constitute a major share in the total capital flows. India’s debt liabilities are higher at around 51 per cent of GDP as on end-March 2018. The ratio of net international investment position (international financial assets minus international financial liabilities) to GDP as on end-March 2018 was negative at 16.3 per cent.
The ratio of financial assets to GDP stood at 24.5 per cent and ratio of financial liability to GDP was at 40.8 per cent as of end-March 2018. Thus, we are a net liability country and should be cautious about building up reserves through debt. As such, there are three important elements linked to the weak rupee — persistent current account deficit; episodes of net capital outflow in terms of speculative and debt capital outflow; and predominance of debt capital in forex reserves.
In the event of rupee depreciation, the RBI intervenes in the forex market with the objective of containing volatility. During 2018-19, for the month of May and June for which data are available, the RBI sold $9.9 billion and $10.2 billion, respectively. As of August 10, 2018, the outstanding foreign currency reserves stood at $400.9 billion, a decline of $23.63 billion over the end-March 2018 figure. This decline could be on account of the RBI selling dollars to intervene in the market to manage rupee volatility.
As alluded to earlier, some of the analysts have opined that rupee depreciation has been contributed by the depreciation in the Turkish Lira with a contagion effect. This view is erroneous as India’s trade with Turkey in terms of exports and imports is minuscule. For example, during 2017-18, share of export was 1.68 per cent of total exports and 0.46 per cent in total imports. Latest data for 2018-19 (April-June) show that the export share was 1.78 per cent and the import share was 0.56 per cent with Turkey. In addition, India doesn’t have a large cross border financial transaction with Turkey.
Essentially, the depreciation of rupee could be linked to the current account deficit because of higher trade deficit contributed by higher import bills. According to latest available data, overall trade deficit (goods and services) during April-July 2018-19 was $43.77 billion as compared with $34.07 billion in the previous year.
Oil imports during April-July 2018-19 amounted to $ 46.98 billion, which was 51.5 per cent higher than in the corresponding period of the previous year. In addition, there were outflows of speculative capital from India due to higher interest rates in the US as the Fed increased the Fund Rate, record US GDP growth of 4 per cent in Q2, and lowest unemployment rate in the US in the past 60 years. Further, as we have significant trade dependency with the US the strength of the dollar also has a marked effect on the rupee.
Will rupee strengthen?
The moot question is: Will the rupee have a mean reversal as it happened in 2017-18, from an average of 67.08 in 2016-17 to 64.44 in 2017-18? As the dollar is strengthening and all accompanying fundamentals are strong, it looks difficult. However, our efforts to further strengthen FDI and promote exports — by diversification, improving the quality of our commodities, and focussing more on developing and emerging market economies — will be helpful. That is the only long term sustainable and viable way to prevent the rupee from falling.
The writer, a former central banker, is a faculty member at SPJIMR. Through The Billion Press.