Amid the geopolitical tensions and increases by the Fed to combat U.S. inflation, the rupee has been on a downward spiral. Slowing exports and an inflated import bill have also weighed down the local currency. In order to iron out sharp volatility in the rupee, the RBI has dipped into its reserves, which however has led to a fall in import cover
Amid the geopolitical tensions and increases by the Fed to combat U.S. inflation, the rupee has been on a downward spiral. Slowing exports and an inflated import bill have also weighed down the local currency. In order to iron out sharp volatility in the rupee, the RBI has dipped into its reserves, which however has led to a fall in import cover
Till recently, the rupee was recording fresh lows every other day. Persistent foreign portfolio outflows and a widening trade deficit are largely blamed. While the import bill balloons, the falling rupee has not helped boost exports either.
Taking a hit
Several currencies have taken a beating in the wake of a long-drawn war in Ukraine and the steep hike in interest rates by the U.S. Fed to rein in inflation. The rupee slid past the 80 mark earlier this month and has weakened by about 7.5% so far in 2022. Historically strong currencies such as the pound and the euro have also depreciated by more than 11%. Several Asian currencies such as the Korean won, the Philippine peso, and the Thai baht have weakened by more than 10% this year. Meanwhile, the dollar index, which gauges the greenback’s strength against six major currencies, rose to a 20-year high.
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Persistent outflows
With the increase in key interest rates by the Fed and advanced economies also tightening policy, foreign portfolio investors (FPIs) have been on a selling spree. When the Fed raises its rates, overseas investors withdraw from riskier emerging markets and opt for safe-haven assets. This exacerbates the demand for the dollar and leads to a corresponding excess supply of the rupee, weakening the local unit. So far, in 2022, FPIs have dumped Indian equities worth a net amount of $28.4 billion, more than double the $11.9 billion worth of equities sold during all of 2008, the year of the global financial crisis.
Widening gap
Amid a weakening rupee and rising crude and commodity prices since the war in Ukraine, imports have become costlier. This has further widened the trade deficit that peaked at a record high of $26.18 billion in June 2022. Import growth outpaced that of exports. While exports rose by 23%, imports jumped by 58% in June. In the first quarter of FY23, the trade deficit ballooned to $70 billion compared with $31 billion in FY22.
Deteriorating CAD
A widening trade deficit causes the current account deficit to deteriorate which in turn adds pressure on the local currency. Incurring a current account deficit itself means India is importing more goods and services and spending on servicing overseas borrowings than it is exporting or earning through remittances, which in turn creates more demand for dollars. In FY22, India incurred a CAD of $38.7 billion, or 1.2% of the GDP. It is expected to rise further this fiscal on the back of record-high trade deficits in May and June.
Muted exports
A weak currency bodes well for exports as it makes them more competitive. However, exports are also dependent on global demand which has been slowing. In June, India exported $40 billion worth of goods, sequentially a rise of just 3%. With slowing global economic growth and looming recession fears, a depreciating currency may not help spur exports which otherwise would have helped at least partly bridge the widening trade deficit.
Rising import bill
While, in general, a weak currency helps boost exports, it also makes imports expensive. India’s imports expanded primarily on account of crude, coal, fertilizers and gold which make up almost half of India’s import bill. These four are price inelastic (i.e. goods for which demand remains largely unchanged despite price rise). So even though prices of these goods remained elevated, rigid demand in India inflated the import bill. In FY23, imports have risen for the past five consecutive months and recorded a growth of 58% y-o-y in June.
Import cover
To prevent a runway depreciation of the rupee, the RBI deployed dollars to prop up the local currency. The drawdown of dollars to sell in the forex market has whittled reserves. From a high of $642 bn in Oct. 2021, reserves fell to $573 bn in July 2022. With the fifth largest forex reserves, RBI is well positioned to defend the rupee against undue volatility. However, the reserves are currently just enough to finance 9.5 months of imports compared with 19 months of import cover in June 2021.
Last word
Amid the geopolitical tensions and increases by the Fed to combat U.S. inflation, the rupee has been on a downward spiral. Due to concerns over rising local inflation and a deteriorating current account deficit, foreign portfolio investors have pulled out of Indian equities. Slowing exports and an inflated import bill have also weighed down the local currency. In order to iron out sharp volatility in the rupee, the RBI has dipped into its reserves, which however has led to a fall in import cover
Source: IMF, NSDL, CMIE, RBI
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