Runaway rupee, the next worry

Lokeshwarri SK | Updated on: Jun 08, 2022
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currency converter concept colored arrow with icons. | Photo Credit: anoopkrishnan

The external account looks quite vulnerable and the RBI must get its arsenal ready to defend the currency

Raging inflation may have been in the limelight in the June monetary policy, but the RBI Governor’s statement also flashed the other issue that is worrying him — the depreciation in the rupee. He highlighted the havoc being caused in currency markets by the rapid monetary tightening by central banks of advanced economies, and how the rupee along with other emerging market currencies is being buffeted in this volatility.

The RBI has a reason to be worried about the rupee since it has been prancing close to its life-time low of 77.92 since May. The central bank has been intervening actively in the forex market to keep the depreciation ‘orderly’. But the odds are currently piled high against the Indian currency.

In ‘A perfect storm awaits the rupee in 2022’, published in these columns in January, we had highlighted the risks awaiting the rupee this year due to monetary tightening by global central banks. The Russia-Ukraine war has made this already boiling cauldron, even more explosive.

While the RBI has been supporting the rupee through forex market interventions, it will have to begin looking at other means to support the currency. Hiking the repo rate to stem portfolio outflows is one way to that, but it may not be enough.

Cracks in the external account

India’s external account is beginning to look quite fragile of late. The forex reserve arsenal accumulated over the last few years may not suffice if the central bank has to wage a protracted war against rupee depreciation. Forex reserves have declined almost 7 per cent since October 2021, down from $642 billion to $597 billion. The continued fall in reserves combined with an increase in import bill due to elevated oil prices has resulted in lower import cover for merchandise imports to 10 months by April this year, down from a robust 15 months in May 2021. The ratio of forex reserves to external debt and to volatile capital flows is also deteriorating fast.

India’s current account deficit, which was at 2.7 per cent of GDP in the third quarter of FY22, is expected to have crossed the 3 per cent mark in the fourth quarter. But the bigger worry is that most of the factors weakening the external account are likely to persist over the coming quarters.

With the Russia-Ukraine war showing no sign of abating and the Iran nuclear deal getting delayed, most projections expect crude oil price to stay elevated at around $110 per barrel in 2022. This means that India’s trade deficit is likely to persist. Continued supply disruptions in global metals, chemical and agri commodities, due to the ongoing war, could add to the import bill.

There appears to be no respite in foreign portfolio outflows as well. Spike in global bond yields as well as rally in US dollar has resulted in funds flowing back to the safe haven of dollar-denominated securities. Both Indian equities as well as bonds have been witnessing continued outflows this calendar with ₹1.77-lakh crore being pulled out of equities and ₹14,157 crore pulled out of Indian debt securities so far. With the US Federal Reserve and other central banks set to continue aggressive tightening, portfolio outflows are likely to continue.

Rescue the rupee

The easiest way for the RBI to support the Indian currency is through market interventions. But this has several negative fallouts. One, it leads to depletion of forex reserves. It may be argued that the reserves are built for times such as these, but it sends a signal to the market that the currency is on unsteady ground. This emboldens speculators who begin taking short positions in the currency.

A point of solace is that most emerging economies are in similar straits as India, using up their forex reserves to protect their currencies. World foreign exchange reserves excluding gold is down 4 per cent since the beginning of 2022.

The other impact of forex intervention is that it sucks out liquidity from the system. As the RBI Governor pointed out in the statement, surplus in the system has reduced to around ₹2-lakh crore in May. Part of this decline could be due to the RBI selling dollars in the market.

Since market intervention has its limitation, the RBI is doing what it needs to do to stop FPI outflows and support the rupee – hike policy rates. The US Federal Reserve has signalled aggressive rate hikes for the rest of this year and the next. Other emerging economies have already hiked interest rates aggressively since the end of last year. As a result, 10-year government bond yields of Mexico (8.8 per cent), Brazil (12.75 per cent) and South Africa (10.3 per cent) are trading much higher than Indian 10-year sovereign bond yield. If rates are not moved higher aggressively, funds will continue flowing out of India into other economies.

What if the rupee continues to reel under selling pressure? The central bank can consider tapping Indians residing overseas once again, as in 2013, by offering them higher incentive to move their deposits back home. The FCNR (B) swap scheme was extremely successful in 2013, helping raise around $26 billion of inflows. While FDI takes time since it involves corporate decision-making, NRI deposits can be faster to garner.

Speculative activity in the currency also needs to be kept under check. If speculators sense that the Indian currency is getting weak, they can short the rupee futures traded on overseas Non-Deliverable Forwards (NDF) market, exacerbating the weakness. Since these NDF markets are located overseas, in Singapore, Dubai and so on, it is difficult to control the trades. The RBI had given permission to banks located in the Offshore Financial Centre in the GIFT City to trade in the NDF market recently. This should be encouraged so that the overseas trades can be influenced by the RBI. Also shifting trading of rupee derivatives from Singapore to GIFT City will also help check runaway speculation in the rupee.

Finally, the RBI should make conscious effort to internationalise the rupee. The Russia-Ukraine war and the disruptions to payments caused by it, is a good opportunity to insist on export settlement in rupee, beginning with some of the smaller export partners. As dollar domination is likely to reduce going ahead, the rupee can claim some of the ground ceded by the greenback.

Published on June 08, 2022
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