Given the strengthening dollar, the continuing capital outflows from the equity markets and the demand from importers, it is not surprising that the rupee fell through the 80-mark against the greenback, albeit for a brief period. The Reserve Bank of India (RBI) has been intervening in the currency markets to supply dollars, but only to a limited extent. That suggests the central bank is not averse to the currency depreciating and will not risk depleting its reserves kitty, which is already down from $640 billion to around $580 billion.
RBI believes the rupee is fairly valued and would not be uncomfortable with the rupee depreciating to levels just beyond the 80 mark, given the global financial environment. Such levels are a distinct possibility with the US Fed expected to hike rates by at least 75 basis points, if not 100 bps, later this month and more in the coming months as it fights a four-decade high inflation. That then could push up the dollar index to levels of 111-112, causing emerging market (EM) currencies to slide further. Should the dollar peak at these levels, the damage to EM currencies, including the rupee, would not be severe. However, if the fall in the rupee is exacerbated by a strengthening of the dollar index beyond 112, RBI may need to open up the capital account further to attract dollar flows.
Indeed, the central bank has already taken the first steps by relaxing the rules to attract more FCNR (B) and NRE deposits and eased the rules in the rupee debt market to attract investments into the bond markets. Moreover, it has allowed top quality borrowers to raise more by way of external commercial borrowings (ECB). To be sure, these measures may not attract large flows immediately; foreign portfolio investors (FPI), for instance, will wait for better visibility on both the interest rates and the currency. The central bank has also permitted the invoicing, payments and settlement of exports and imports in rupees. While this facility would be utilised largely for India-Russia trade, it would help conserve dollars.
The question is whether RBI will increase the interest rate hike just to defend the currency. Fortunately, domestic inflation looks like it is going to be running at lower-than-anticipated levels and will probably peak by September. Consequently, the quantum of repo rate hikes should now turn out to be smaller than penciled in earlier. The central bank should not try and defend the currency and should hike rates only to the extent needed to tame inflation.
A weaker rupee will make India’s exports more competitive; more importantly the economic recovery remains uneven, even fragile. With almost half the loans in the system linked to external benchmarks, transmission is rapid and rising interest rates could hurt small and mid-sized businesses. In the meanwhile, with interest rates firming up overseas and the amount of liquidity falling, it will become costlier, and a bit harder, for Indian companies to refinance their foreign exchange loans. But it is nothing impossible. Nonetheless, fears that repayments would be delayed or not made, appear exaggerated. To be sure, a falling rupee will mean a wider current account deficit (CAD) as imports become costlier because even though commodity prices are softening, crude oil prices remain above $104/barrel. However, there is no cause for panic. The forex reserves remain at a chunky $580 billion, and if the currency remains competitive vis a vis peer currencies, India’s exports should continue to do well, despite the global slowdown.