The rupee’s move towards the 70 mark against the dollar in the recent bout of weakness triggered by contagion-risk in emerging market currencies helps highlight the risks faced by the currency from global events. The Turkish Lira’s 30 per cent decline since last Friday caused by the face-off between the leaders of Turkey and the US triggered fears that the country could default on its external debt; thus setting off a systemic crisis in global financial market. This resulted in safe-haven assets such as the US dollar moving higher while there was a broad-based sell off in global equity and currency markets, early this week.
While the Turkish crisis was instrumental in dragging the rupee lower in the first two sessions this week, it needs to be noted that the Indian currency is the worst performing Asian currency this calendar year, down 8.8 per cent against the dollar. We cannot blame the rupee’s under-performance on dollar strength since the rupee has lost ground against other major currencies too, including the Yen, Euro and Pound. It’s therefore obvious that there are inherent weaknesses that are exerting pressure on the rupee. All emerging market currencies have been under pressure over the past year with the Federal Reserve increasing interest rates and beginning to shrink its balance sheet. Tighter liquidity conditions overseas have made foreign portfolio investors move money out of riskier emerging market assets and investing it in dollar-denominated assets. The dollar’s strength — as a result of these inflows and growing risk-aversion due to the threat of the trade war unleashed by US — has been exerting pressure on the rupee this year. In addition to these factors, the rally in crude oil prices has further roiled the Indian currency. With the country’s current account deficit widening, the rupee traders have been growing increasingly pessimistic.
Continuing decline in the rupee, while conducive to exporters, can hurt importers and spike inflation. Also, companies that have made the most of the liquidity in global markets to borrow funds overseas will find it difficult to service this debt if the currency continues to slip. But the central bank might find it difficult to defend the rupee, if there is sustained fall. India’s forex reserves have declined from $426 billion in April 2018 to $403 billion by the first week of August; with the RBI intervening in forex market to support the rupee. The RBI has to be selective about its forex interventions going ahead, in order to prevent a steep erosion in forex reserves. Reduction in FPI inflows this year mean that the central bank will find it difficult to grow its forex reserves in the coming months. Increasing FPI inflows through special deposits targeted at NRIs can only be a short-term measure. It’s imperative that the Centre puts some serious thought into boosting exports and reducing the dependence on imported crude in order to address the structural imbalance in external trade to make the rupee inherently strong.