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The Indian rupee has historically weakened against the US dollar, but bouts of volatility never fail to set alarm bells ringing. This time, they are particularly loud. The rupee plumbed 79.3 per dollar on 6 July, depreciating more than 5% in this fiscal year so far. The pace of depreciation, always a key concern, depends on the extent of the economy’s vulnerabilities and the potency of the external shock it faces, along with the timing and nature of policy action.

External vulnerability is mainly measured by the size of our current account deficit (CAD), short-term external debt and foreign exchange cover. A ‘shock’ could take the form of sharp interest rate increases by systemically important central banks, such as the US Federal Reserve, geopolitical developments, oil price volatility, or a financial crisis—all of which create a risk-off scenario, leading to capital flight from (and currency volatility in) emerging markets. In the past two decades, we have seen three major shocks: the Global Financial Crisis (GFC) of 2008, the ‘taper tantrum’ of 2013, and the highly complex global turmoil currently underway. What does the vulnerability-shock framework tell us in each of these events?

During the GFC, the Indian economy was less vulnerable—four years prior to it, India had strong economic growth averaging 7.9%. In the year-ago period (fiscal 2007-08), we had a low CAD of 1.3% of gross domestic product (GDP), even if inflation was somewhat high at 6.2%. But given the large shock, the rupee slid by an average of 14% in 2008-09. In contrast, India’s domestic vulnerability was much higher during the taper tantrum, when the Fed’s mere signal of tapering its asset purchases triggered a run on the rupee. Inflation was surging (9.3% in 2013-14), import cover was low, and the CAD touched a high of 4.8% of GDP in the year ago-period, making India part of the ‘fragile five’ group of economies. These, together with a strengthening of the dollar index, caused a 11.1% depreciation in the rupee-dollar exchange rate in 2013-14.

The external shocks facing the rupee today are piling up. The Fed’s aggressive rate hikes, to tackle multi-decade high inflation, has led to a reduced interest differential between the US and emerging markets such as India, prompting foreign fund outflows. Crude oil prices remain volatile above $100 per barrel, hiking the import bill and importing inflation into India. To top off this risk-off scenario, geopolitical shifts, sanctions and commodity price volatility amid the Russia-Ukraine crisis are changing trade and supply chain dynamics, even as we navigate the after-effects of a global pandemic that is down but not out.

On the vulnerability front, India is slightly better off than during the taper tantrum. The economy is recovering from covid, our forex reserves and import cover are relatively comfortable, external debt is lower and the CAD was still benign (at 1.2% of GDP) last fiscal.

So, despite the uniqueness and size of the global shock, our lower vulnerability going into the crisis and the Reserve Bank of India’s (RBI) interventions have warded off a sharper depreciation of our currency so far.

And the real effective exchange rate—a measure of the competitiveness of the currency—is still overvalued: it actually appreciated in May (over April) because our major trading partners had sharper currency depreciation and higher inflation. That said, our vulnerability is on the rise. India’s CAD is expected to more than double to 3% of GDP in 2022-23, owing to high crude prices amid sticky imports, a pick up in gold imports, and the effects of a global slowdown on exports.

To ease pressure on the current account and rupee, India’s government recently announced higher customs duty on gold in a bid to curb domestic demand for its imports. This is reminiscent of action taken in 2013.

Monetary policy, too, has stepped in. RBI has front-loaded interest rate hikes to combat inflation, which should help slow the speed at which the interest rate differential between the US and India was narrowing. It has also been intervening in spot and forward markets to support the rupee.

Apart from the interest rate channel and direct forex market interventions, RBI on Wednesday announced measures to attract foreign investor funds, exempting foreign currency deposits from statutory reserve requirements, easing provisions for remittances, allowing more short-term foreign portfolio investments in government securities and raising investment limits for external commercial borrowings. These changes are aimed at improving our supply of dollars.

This, at a time when RBI’s direct market interventions have shaved a part of its sizeable forex buffers (from $631.5 billion on 25 February to $593.3 billion on 24 June).

Indeed, the measures announced are prudent. The experience of other currency crises shows that forex reserves can quickly burn through in case of a run on the currency, and hence, alternative channels are required to shore them up.

Thus, we expect that RBI will allow an orderly depreciation of the rupee in line with evolving fundamentals, even as it will continue to intervene in forex markets to limit volatility.

The past two episodes of sharp depreciation tell us that while the rupee took a dive versus the dollar below its long-term trend, it also corrected once the risks subsided. However, the situation today is far more complex and evolving. Until the underlying factors stabilize, further volatility and depreciation can be expected.

Dharmakirti Joshi & Amruta Ghare are, respectively, chief economist and economist at Crisil

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