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Business News/ Market / Stock-market-news/  Why a falling rupee should worry us

Why a falling rupee should worry us

With banks struggling to raise lending, a weaker rupee-dollar exchange rate might deter firms from borrowing abroad

Rupee’s troubles can be traced back to concerns about India’s rising current account deficit. Photo: MintPremium
Rupee’s troubles can be traced back to concerns about India’s rising current account deficit. Photo: Mint

Mumbai: The Indian rupee has been one of the worst performing major emerging market (EM) currencies in 2018, and the worst in Asia-Pacific. A Mint analysis shows that the rupee’s troubles can be traced back to concerns about India’s rising current account deficit. Given that the current account deficit is likely to remain under pressure, the rupee is likely to remain weak for some time, raising external funding costs for Indian firms even as it feeds into domestic inflation.

While almost all emerging markets have witnessed capital outflows amid interest rate hikes in the US, one pattern stands out. Countries with higher current account deficit appear to have been penalized more.

Even after excluding Turkey, which is an extreme case of a very high current account deficit (5.5% of GDP) and which has seen among the steepest currency depreciation this year, the emerging market currencies which depreciated the most were often the ones with weaker current accounts, the analysis shows.

Current account balance largely consists of the balance in trade with the rest of the world and in other incomes such as interest, dividend, etc.

The recent worsening of India’s non-oil trade deficit suggests that the current account balance is likely to be under stress. With oil prices expected to remain high, the outlook on the rupee appears bleak.

Even under a benign assumption of crude oil at around $70 per barrel, India’s current account deficit will reach a six-year high of 2.5% of India’s gross domestic product (GDP) in 2018-19. If crude oil prices touch $90 per barrel, this could push up the current account deficit to 3.6% of GDP.

Also, not much respite is expected from the export channel. The recent depreciation in rupee is unlikely to boost exports in the short-run as there are other structural factors, which are weighing on India’s exports sector, as an earlier Plain Facts column had pointed out. Besides, the looming threat of a trade war further weighs on India’s export prospects.

One silver lining for India is that foreign inflows seem to have picked up in recent weeks. According to data sourced from the Institute of International Finance (IIF), India has witnessed net foreign portfolio inflows since July, after having previously experienced significant outflows.

India’s external vulnerability metrics also look far more stable when compared with the taper tantrum of mid-2013, when India was among the worst-hit emerging markets. India’s foreign exchange reserves now provide around 10 months of import cover compared with six months in mid-2013. Besides, India has one of the lowest external debt ratios, when compared with the GDP size, among major emerging market economies .

While the Reserve Bank of India (RBI) has enough fire-power to prevent a rapid slide in the rupee’s value, a gradual and continued fall in the currency cannot be ruled out.

This also poses an inflationary risk given that imports are costlier when the currency depreciates.

This would only add to RBI’s reasons for raising interest rates further.

The central bank has been raising interest rates to match the rising interest rates in the US.

If RBI does not raise interest rates, the “yield differential" with the US might narrow, potentially prompting more capital outflows from India and further weighing on the rupee.

The central bank’s rate hikes have, however, complicated matters for India’s banking sector, already reeling under a massive bad debt problem.

With more hikes in the offing, the already low credit growth figures could dip further.

The slowing down of domestic credit flow had prompted many firms to borrow abroad, and external commercial borrowings (ECBs) had emerged as an important source of alternative funding for Indian companies over the past few quarters. But the rupee’s fall will make even that option more difficult, as it has raised external borrowing costs.

As the costs for hedging currency risks rise and as global interest rates rise, the external borrowing costs for Indian firms will only move up in the coming months.

This will dampen corporate borrowing and weaken economic activity at a time when domestic banks are not in the best position to raise lending.

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Published: 28 Aug 2018, 09:33 AM IST
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