A weakening rupee and its broad implications on our economy

The rupee is not alone: It could very well be said that the latest turn of events in currency markets is more of a dollar strengthening situation, as the US Federal Reserve’s rate-hiking spree has bolstered the dollar index by 9% this year, taking it to a 20-year high. The Indian rupee is not the only victim of it. From an emerging market currency such as the Turkish lira (weakened 30%) to developed-economy ones such as the Japanese yen (down 16%) to the euro (7%), almost all others have suffered. Even a controlled currency like the Chinese yuan has weakened by 5% against the US dollar so far this year.

Interestingly, this is not the first time the US dollar has wreaked havoc across the world. The 2013 ‘taper tantrum’ was one of the worst in history. It started with the US Fed indicating a withdrawal of its ultra-accommodative monetary stimulus (which was initiated after the financial crisis of 2008-09), resulting in huge capital outflows from emerging markets. To the Fed’s credit, it has been very cautious this time around in preparing financial markets for a post-pandemic monetary drawdown, so as to prevent market turbulence, but given the global uncertainties and risk-off sentiment, no amount of preparation is probably enough.

Adding to the trouble, the current strengthening of the dollar is globally accompanied by rising commodity prices. This is an anomaly. Usually, a stronger dollar goes with weaker commodity prices, but the Russia-Ukraine war and global supply-chain bottlenecks have turned the tables. This cocktail of a strong dollar and soaring commodity prices is not only pushing inflation to record high levels in net importing countries, but also widening their trade deficit, thereby exerting further downward pressure on their currencies.

India’s current account deficit is likely to widen to around 3-3.5% of gross domestic product (GDP) in 2022-23. Though it is less than what we experienced in 2013 (when this deficit widened to 4.8% of GDP), the fact that it has been accompanied by foreign portfolio outflows, estimated at $29 billion in the last six months, India’s balance of payments is likely to move into negative territory this fiscal year.

Where is the rupee headed?: With consumer price inflation in the US hovering at 8% and personal consumption expenditure inflation at more than 6%, the Fed has no choice but to hike rates further. This implies that the dollar’s upward trend is likely to continue. The Reserve Bank of India (RBI) has been intervening in the foreign exchange (forex) market to contain volatility in the rupee. But with other emerging market currencies weakening, RBI will likely let the Indian currency weaken gradually. Hence, we should be prepared for a rupee at 80 to the dollar. India’s forex reserves have fallen by $35 billion in the last three months. However, reserves at close to $600 billion (12 months of import cover) are sufficient for RBI to cushion the rupee’s fall.

Going by the real effective rate of exchange weighted by our trade with 40 countries, our currency is still around 2% overvalued compared to its long-term average. We can expect some more weakening. Yet, a sharp drop is unlikely, given that RBI is hiking policy rates in line with rate hikes by the US Fed. With the US-India interest rate differential maintained, a steep slide in the rupee’s external value can be avoided.

The economy’s rocky ride: The Indian rupee’s weakening will be supportive of our exports. However, many of India’s export items, such as gems and jewellery, pharma products and electronics, have high import intensity and hence will not benefit much. Moreover, in relative terms, Indian exports have less price elasticity and more income elasticity. Therefore, at the current juncture, our exports will feel the pinch of slowing global growth, specifically that of the US economy.

A weaker Indian currency will drive inflation up, which is already a grave concern due to high commodity prices. India’s dollar debt will also face the music. While India’s external government debt is at a low of around 4% of GDP, our non-government external debt amounts to 16% of GDP. Corporate debt denominated in dollars that has not been hedged will bear the brunt of a weakening rupee.

External commercial borrowing (ECB) inflows could also decline. ECB accounts for around 36% of India’s external debt, and with global rates rising and the dollar strengthening, such loans are getting more expensive. Portfolio inflows could also reduce as dollar returns for foreign investors are diminished by a weaker rupee.

Overall, with an uncertain geo-political scenario, high commodity prices and rising interest rates, the rupee is likely to stay under pressure. Its intensity, however, could be controlled by timely RBI rate hikes, forex market intervention and the Indian economy’s relatively better macro fundamentals.

Rajani Sinha is chief economist, CareEdge