Why the RBI’s forex umbrella is getting buffeted by dollar winds

Losing dollars

According to currency dealers, the resolve of the RBI to protect the rupee was strong at the 80-to-a-dollar level. Indeed, despite most Asian units weakening sharply in July and August, the rupee showed resilience, even appreciating briefly in August. However, the Fed’s latest dot plots, which were more hawkish than anticipated, have now turned the tide decisively against the rupee.

This onslaught comes at a time when the RBI has already spent more than a tenth of its forex reserves in defending the currency. It has sold $40 billion, half of which it did in just one month, July. Since the reserves are down by a massive $56 billion so far in FY23, economists are fretting about their adequacy levels. The import cover, one measure of reserve adequacy, is now down to 9 months from a high of 15 months a year ago.

Anubhuti Sahay, senior economist at Standard Chartered Bank, told Moneycontrol earlier this month that the RBI will need to slow down its intervention lest it depletes its firepower completely.

Also read: Why the US Fed's dot plot is spooking experts and what the latest rate hike means for India

Finding dollars

With its reserves depleted, India’s import bill is unlikely to come down significantly this year. Granted, oil imports are cheaper with the global crude price easing off and discounted imports from Russia helping. Even so, economists estimate that India will need to find roughly $30 billion to bridge its trade deficit every month. Sourcing these dollars will get tougher, notwithstanding the long-term bullish narrative for Indian markets.

“Capital inflows, while returning, are unlikely to be enough to meet funding requirements, which points to the BoP being negative for FY22-23. Even potential global bond-index inclusion is only likely to result in inflows 6-9 months further out, and is unlikely to be a source of help in the short term,” economists at Barclays said in a September 22 note. In short, the central bank has a tough call to make between continuously depleting its reserves or letting the rupee erode.

Also read: RBI likely sells dollars as rupee plumbs record low: Traders

Liquidity conundrum

A fallout of the RBI’s intervention is the tightening of rupee liquidity. As the central bank sells dollars, it sucks out rupees from the domestic banking system. This explains the emerging deficit in liquidity after a gap of more than three years.

While the liquidity deficit helps the central bank in reining in inflationary expectations as short-term rates go up, it will need to maintain a balance here.

The drain in liquidity coincides with the comeback of credit growth. As the private sector readies to raise its bank borrowings for investment, the RBI will need to ensure that those needs are met at a reasonable price. This will stymie its intervention efforts.