The RBI has done a fine job of managing the rupee’s fall

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The rupee has depreciated since the start of this calendar year (by 7 percent), but its fall has been less severe than most other currencies. What are the factors behind the muted decline of the rupee and what lies ahead?

Currencies across the world are weakening against the dollar as worried investors buy dollar assets due to its safe haven status in an uncertain global scenario. The Fed’s massive rate hikes have also helped to make US bonds more attractive.

Recognising this taper tantrum 2.0, the Reserve Bank of India took several steps on July 6 to mitigate the rupee’s woes. These included raising limits on external commercial borrowings, higher interest rate and CRR/SLR (cash reserve ratio/statutory liquidity ratio) exemptions on NRI deposits, relaxation of limits on foreign portfolio investments (FPIs) in debt securities, and settlement of international trade in Indian rupees.

As a result, even though the rupee has weakened, the RBI has ensured that the rate of decline has been arrested.

The chart below shows that while the rupee has clearly depreciated from a monthly average value of 74.5 (per USD) in January to above 79.5 (per USD) in July, the pace of change (calculated as the average of daily returns) as well as the volatility (calculated as standard deviation of daily value) have both come down in the past two months.

Therefore, while the RBI has not controlled the value of the rupee, it has done a fine job of ensuring that the rupee’s search for its own level happens at a managed pace. By doing so, the central bank has stuck to its oft-stated position of intervening in the forex markets only to ensure orderly conditions, i.e. to control volatility.

The RBI could achieve this using a combination of the July 6 measures, repo rate hikes (primarily to contain inflation) and by selling dollars in the forex market. The market interventions caused forex reserves to decline, but at $574 billion at the end of July, it still gives the RBI enough ammunition to keep fighting for a longer time if necessary.

How long the RBI will need to intervene will depend on the quantum of capital flowing in and out of the country. Among the components of the capital account (that records financial flows in the balance of payments), foreign direct investment (FDI) is usually stable and has averaged $10 billion every quarter since the first Covid-19 shock in the summer of 2020, as per RBI data.

Since April this year, FDI has surged to $5 billion every month. However, when it comes to short-term impact on the exchange rate, the main factor is FPI. The good news is that the nine-month trend of net FPI outflows was reversed in July (when FPIs clocked a net inflow of $239 million) and in August, it had already crossed $2 billion as of August 8, as per data available with the National Securities Depository Ltd.

This is a remarkable vote of confidence in the Indian economy by foreign investors when the interest rate differential with the US has been declining since June. What can explain this surprising U-turn by portfolio investors?

Firstly, FPI inflows have been led by equity investors instead of debt capital, therefore the rate differential has mattered less. Typical determinants of FPI include the inflation rate in the destination country indicating financial stability. Inflationary pressures in India are slowly abating with household expectations, commodity prices, food prices and crude oil prices coming down.

The exchange rate can have two types of effects on capital flows. Rupee depreciation makes Indian assets cheaper and hence more attractive, but the returns earned in India translate into lower proceeds in dollars. A more important role is played by exchange rate fluctuations which signal risks to foreign investors. With rupee volatility kept under control by the RBI, along with the continuing growth momentum in the economy, the risk-adjusted return has increased, bringing foreign capital back to Indian shores.

The only certainty is that the future is uncertain. With a protracted war in Ukraine and the US recession worsening, the rupee might breach 80 levels. In the case of an FPI reversal, the RBI would do well to let the rupee cross 80 in order to prevent speculative positions from setting in.

This would become pertinent if inflation continues to decline, obviating the need for the RBI to increase rates as fast as the Fed. In such a scenario, the RBI will be left cushioning the rupee’s fall using its forex reserves instead of protecting the currency with rate hikes. As the impossible trinity (sort of) tells us, the RBI cannot have its cake (prevent depreciation) and eat it too (monetary independence).