Pressure on the rupee recedes

As RBI starts rebuilding its lost foreign currency reserves, there is an air of relief. The rupee seems to have stabilised, lending credence to the perception that the worst might be over for the external sector. Oil prices have moderated; so have prices of several other commodities, leading analysts to lower their current account deficit estimates. The US dollar’s weakening and the resumption of portfolio capital inflow, albeit at lower volatility, are adding helping hands for stabilising India’s external sector. The focus ought to be on further consolidation, to open space for both monetary and fiscal policies’ orientation towards domestic policy priorities, especially to support economic recovery.

The singular factor that made a material difference in managing the external account and the rupee was RBI’s forex reserves stockpile that, at its peak, stood at $642.4 billion. Unlike the ‘taper-tantrum’ episode in 2013, the central bank appeared more confident in using its reserves to guide down the rupee at a slower pace in the recent instance, even though it exhausted more than $110 billion within a few months; a large part of this was due to valuation loss. More tactical was RBI’s additional armoury of a $65.8-billion forward position (equivalent to potential reserves), which it used to meticulously intervene in the forex market for rupee support. Therefore, it is critical RBI rebuilds these reserves to prepare for future shocks.

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It is essential to record that much of those forex reserves (viz. the $642-billion spot plus $65.8-billion forward) were accumulated at a time when the current account was either a negligible deficit or even a surplus. That allowed RBI to accumulate foreign currency purchases from abundant surpluses flowing into the capital account. This past trajectory implies that India’s balance-of-payment (or BoP) accounts must turn exceptionally favourable once again. That is, the current account deficit must narrow, and the capital account surplus must substantially rise for RBI to accumulate forex reserves. Unfortunately, the current situation continues to be fluid. Even though analysts expect the current account to improve in the second half of FY23 with lower prices of oil and commodities, capital account uncertainties persist as net FDI has been slowly tapering off, turning negative in November 2022.

Then how would RBI restock its reserves? Some recouping could happen from revaluation gains if the dollar continues to weaken. The balance foreign currency will have to be bought from the markets, spot and forward. In the post-2013 period, India reduced its current account gap by smaller import bills from ultra-low oil and commodity prices. A repeat of that, or probability of international oil prices falling much below $80/barrel as happened in 2015, is highly uncertain with China’s reopening. Hence, the policy focus will have to be on how the other components of the current account evolve.

It is in this context that any prospective acceleration of merchandise export growth would be assuring. In 2021-22, a $89-billion jump in non-oil exports had renewed hope, but this was ironically outweighed by an even sharper leap in non-oil imports by $140 billion. It was unclear if the increased export growth was a discrete shift or one-off, possibly related to idiosyncrasies of the post-Covid recoveries across countries. Or, there could be an alternate hypothesis—that a part of India’s increased exports originated from high import-intensity sectors promoted by the PLI schemes. For example, India’s currently exporting $1 billion worth of iPhones each month, whose import content could be $800 million or even more, as the domestic value addition is less than 20% or even 10%. From a BoP perspective, the net contribution (inflow) will be a muted $100-200 million, not $1 billion. If this holds for the entire range of products covered by PLIs, then exports of such goods will have to be at a much higher scale to be able to reduce the trade deficit on a structural basis.

Software exports and remittances under the invisible accounts have maintained their robust growth trend, holding promise to bridge the financing gap on external trade. Both components though would depend upon the advanced countries’ performance that is potentially turning recessionary.

On the outflows’ side, the repatriation of investment income is growing at an average 8.5% annually in the last five years to reach $60 billion in 2021-22. A related element on the capital account side, which also missed sight is the increased repatriation of equity or disinvestments that reached $28.6 billion in 2021-22. Together, these two outflow components added up to a staggering $88.6 billion, exceeding the gross FDI inflow of $ 84.8 billion (see graphic). If its current trajectory maintains into the future, especially when India’s FDI is concentrated in non-tradable activities and the stock of foreign investment continues to grow, it could emerge as a new pressure point that could mostly nullify the gains accruing from the other or invisible account components.

It appears there’s no certainty if, and when, RBI will be able to replenish its forex reserve stocks. The process may turn out a long drawn one and dependent upon several domestic and global factors. And in the meanwhile, if oil prices were to rise again due to any unforeseen or geopolitical event, the central bank will have far lesser reserves to defend the rupee.

Prima facie, it shouldn’t worry RBI. In a column in this paper in 2015, I had cautioned that reserves’ accumulation was an insurance that would not yield long-term external sector stability (bit.ly/40vyyh6). Neither would lower domestic inflation ensure a stable rupee, as promised by inflation targeting advocates.

For a stable external sector, the current account must reflect fundamental enhancements from increased productivity or competitiveness. That will need time. The hope is that gains from several structural reforms carried out by the Centre would start accruing much sooner, the firms setting up shop under the PLI scheme will focus more upon domestic value addition, and that more FDI gets attracted to the tradable sector for building a resilient external account. Meanwhile, if the rupee comes under pressure, as it did in 2018 and 2022, let it adjust, carefully guided by forex intervention and taking note of reserve stock levels.

Senior fellow, Centre for Social & Economic Progress (CSEP), New Delhi