Rupee depreciation could aggravate the current slowdown

August was a particularly bad month for the rupee. From ₹68.9 to the dollar at the end of July, the currency depreciated to cross the ₹72-mark by the end of the month (Chart 1). While India’s perennial current account deficit underlay the currency’s weakness, in August, the average of daily prices of the crude oil basket that India imports fell to $59.35 a barrel from $63.63 in the previous month and $71 in April 2019. This reprieve, combined with the depressing effect that slackening domestic demand would have had on imports, should have strengthened the rupee, not weakened it.

Global uncertainty

The rupee value declined in August, despite these beneficial economic developments, because of the exit of foreign portfolio investors, which resulted in a fall in net investments followed by an outflow of capital. In June, net portfolio investment fell sharply, and then turned negative over the next two months. This decline and outflow contributed to the fall of the rupee (Chart 2). Subsequently, when net portfolio investment turned mildly positive in September, the rupee too, stabilised and registered mild appreciation. This central role of foreign investment flows in influencing the rupee’s movements make the currency vulnerable for the near future.

Clearly, uncertainty with regard to global output and trade growth was the basic factor responsible for the deceleration and reversal in the volume of net portfolio investment inflows. Evidence that the Indian economy too has turned sluggish has not helped an already weakened investor sentiment. These determinants of the recent depreciation of the rupee suggest that the currency could lose further ground vis-à-vis the dollar.

With uncertainty and anxiety on the rise in the world economy, cross-border capital flows are likely to shrink further, as wealth-holders flee to the safety of dollar-denominated assets. This tendency will be aggravated if projections of a plunge of the Indian economy into recession prove to be correct.

In normal circumstances, a rupee depreciation resulting from such factors would come with a silver lining. By lowering the dollar value of India’s exports, a depreciating currency could enhance India’s external competitiveness and contribute to a rise in exports. However, given the depressed demand conditions in the world economy, this outcome has not materialised.

India’s exports over the April-September 2019 period fell by 2.4 per cent to $159.57 billion from $163.48 billion in the corresponding period of 2018.

External borrowing

While exports are not responding, the depreciation is likely to have an adverse impact on the health of Indian business, which has become more reliant on external borrowing. As Chart 3 shows, much of the volatility, especially the overall decline in net inflows, was on account of shifts in equity investment. However, during the June-September period, when investment inflows into equity markets fell and turned negative, flows into the debt market were relatively stable.

This reflected a larger trend in which Indian business, attracted by the much lower interest rate in global markets and encouraged by the relaxation of restrictions on external commercial borrowing (ECB), have increased reliance on funds borrowed abroad. Overall, net ECB, that had fallen by ₹653 crore during April-mid-September 2018, rose by ₹54,073 crore in the corresponding period of 2019. The total stock of ECB rose 11 per cent from $193.4 billion to $214.1 billion over the year ended June 2019.

An important contributor to the rise was the easing of restrictions on ECB by the Reserve Bank of India. In the past, funds could be accessed through the ECB route only by manufacturing companies, special economic zone units, software companies, non-banking financial companies, and other similar entities. This policy was revised to allow all entities that are eligible to receive foreign direct investments and other specified entities like port trusts and start-ups, among others, to borrow from abroad. Service companies and trading entities could also access funds through the ECB route.

The sources from which funds could be borrowed were also widened to include any entity that is a member of the Financial Action Task Force and the International Organization of Securities Commissions. This brought in private equity firms and venture capital funds as investors in debt instruments.

Foreign currency risk

The increase in borrowing that resulted from these policy changes has also increased the exposure of Indian business to foreign currency risk. The depreciation of the rupee would raise the rupee costs of servicing debt in foreign currencies. This would either reduce profits or create losses, unless the borrower had hedged the foreign exposure. According to market reports, many borrowing entities, aiming to save on the costs of hedging and betting that the rupee would remain stable — or even appreciate — had not covered their foreign exchange exposure.

Here too, the RBI played a role. In a bid to ease access to foreign funds, in November 2018 the RBI reduced the mandatory hedge coverage to 70 per cent of the foreign exchange payment commitment, from 100 per cent.

It also reduced the loan tenure required for exemption from mandatory hedging to five years from 10 years. This would have contributed to an increase in unhedged exposures, raising the possibility that the rupee’s depreciation has resulted in corporate losses.

To the extent that this occurs, rather than positively affecting growth by enhancing export competitiveness, the rupee’s depreciation could dampen investment and even worsen the ongoing growth slowdown. It has been argued that the exit of foreign institutional investors from the equity and debt markets can aggravate the credit slowdown by withdrawing liquidity from the system.

In addition, we now have further reasons for concern about a possible worsening of economic conditions on account of the impact that foreign investors’ exit would have on the value of the rupee.

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