Factors that keep the rupee under pressure

by Janaki Samant

The Indian rupee held steady against the US dollar in August 2022, after depreciating in the range of 1-2 per cent in the preceding three months. It was stable at being just short of Rs.80 per US dollar during the month. A turnaround in FII flows and likely interventions by the RBI helped arrest the earlier slide in the INR.

But, two factors could turn this into just a temporary respite. Trade deficit is likely to remain high. And, aggressive rate hikes by advanced economies can lead to weakening of net capital inflows into India. These are expected to drive the rupee below Rs.80 per dollar in the near future.

The Indian rupee averaged at Rs.79.55 per USD in August 2022. It appreciated by 0.06 per cent when compared to the average exchange rate of Rs.79.6 per USD in July. But, it has depreciated again as it averaged Rs.79.78 per USD during the first five days of September.

The factors that have been influencing the trajectory of the INR/USD exchange rate in recent times are India’s trade deficit and its FII flows. Till July, widening trade deficit and large FII outflows were exerting severe downward pressure on the rupee exchange rate. Within four months, from end-March to end-July, the rupee depreciated by Rs.3.36 or 4.2 per cent against the US dollar.

But in August, net FII flows turned positive after nine months of outflows, contributing to the reversal in rupee depreciation. The trade deficit, though, continued to widen.

FIIs recorded net inflows of USD 7.5 billion in August. FIIs had pulled out USD 14.4 billion during April to July 2022. This is close to the annual net outflows of USD 16 billion during 2021-22.

Trade deficit has continued to worsen. In July 2022, trade deficit hit an all-time high of USD 27.8 billion. In August, it worsened further to USD 28.8 billion. Exports dropped by 9.3 per cent, month-on-month, in July. In August, the decline worsened to 14.2 per cent. Imports, however, have not dropped that dramatically. These declined by 0.1 per cent in July and 6.9 per cent in August.

Capital outflows and trade deficit brought the INR under pressure, which in turn led to the RBI intervening to contain volatility and protect the rupee from sharp falls. As a result, reserves declined by USD 12.8 billion in August over the preceding month. In July, the decline was steeper at USD 19.4 billion.

Ongoing developments indicate that the pressure on the rupee to depreciate may continue.

Fears of global recession have led to a sharp correction in international crude oil prices. From a high of USD 115.3 per barrel in June, average price of Indian basket of crude oil eased to USD 97.7 per barrel in August. By September 8, price had dropped further to USD 88 per barrel. The POL import bill will shrink. But trade deficit is unlikely to ease significantly. Easing international commodity prices including crude oil, slowing global demand, and inventory pile-up in major markets are likely to weigh down on exports growth. This will be in addition to the adverse impact of export duties on iron ore and petroleum products. Therefore, exports are expected to shrink more than the contraction in imports. Thus, going forward, while the overall trade value will shrink, the trade deficit may not shrink much.

The European Central Bank (ECB) hiked its policy rate by 75 basis points (bps) on September 8 to reign in record high inflation. This is the first time in the history of ECB that it raised rates by such a large magnitude. It usually hikes rates by around 25 bps. Another hike of 60 bps is expected in October. The Chairman of the US Federal Reserve has reiterated the Fed’s stance to hike interest rates in order to bring down high inflation. It is expected to raise rates by another 75 basis points in its upcoming policy meeting. These developments can reverse the large capital inflows witnessed by India in August. Besides the rising trade deficit, this too will add to the downward pressure on the Indian rupee.

Further, external commercial borrowings are unlikely to pick up given the rising interest rates abroad and the strong dollar. FDI flows seem to have weakened as these were also down by 6.5 per cent in the first quarter of 2022-23 compared to the corresponding period of 2021-22.

There are two developments that bode well for capital inflows. But these might not materialise in the near future.

First, there is reportedly a possibility of Indian government securities (Gsecs) being added as a part of the global bond indices. This would reportedly bring USD 30 billion inflows in one year to India’s debt securities under the Fully Accessible Route (FAR). But, if this materialises, the funds may start flowing in only from the last quarter of 2022-23.

Second, India has moved to the second position in the MSCI Emerging Market (EM) index with a weight of 14.483 per cent. It has replaced Taiwan and is second only to China. This is likely to result in higher foreign inflows in the Indian equity market as foreign funds increase their exposure to India to match the increase in its weight in the index.

These favourable factors may moderate the impact of a rising trade deficit and the headwinds against the flow of foreign investments on the Indian rupee. But, on a net basis, the rupee is expected to remain under pressure to trade below the Rs.80 per USD in the near term.