When the rupee touched 76.30 against the dollar last week, there was a lot of panic in the forex dealing room. The Indian currency appeared on course to break the previous lifetime low of 76.91 recorded last April. But some clever central bank action pulled the currency back from the brink and looks like it will close around Year 75.
While a short-term crisis is averted, the factors behind the rupee’s recent weakness – the start of monetary tightening by the US Federal Reserve and other central banks – will continue to weigh heavily in 2022.
The fault lines are already visible and the rupee has slipped 2 per cent against the US dollar and 0.75 per cent against the British pound so far this year. Going forward, the pressure on the rupee is likely to continue on account of FPI outflows, widening trade deficit and strengthening of the dollar. RBI will face a tough task next year to maintain stability in the foreign exchange market. It remains to be seen how well the central bank rides out the perfect storm in currency markets in 2022.
a hard december
It has been extremely volatile for the rupee in December. It all started with the FOMC’s statement on December 15, which revealed that Federal Reserve board members expected the fed funds rate to rise at least three times by 25 basis points each time in 2022. With the Fed halting fresh liquidity flows until March 2022, global liquidity could be significantly affected in the coming months. The Bank of England followed the Fed by starting to hike interest rates in December. This upset FPIs, resulting in an outflow of ₹17,147 crore from Indian stocks and ₹12,280 crore from Indian bonds.
The rupee has been under pressure since the FOMC’s November meeting, when it was first learned that the taper schedule could be accelerated. It declined 2 per cent between mid-November and mid-December, but has since strengthened to the level of 74.5.
The rupee’s strength over the past two weeks is despite the widening of November’s trade deficit to $177 billion, the highest since June 2019, and several other downside factors. The RBI has clearly been active in the foreign exchange market and it’s forex reserves have come down from $641 billion in October 2021 to $635 billion this month.
After being a net buyer for the past six months, the central bank became a net seller of the dollar in the spot market in October 2021. It is possible that the RBI used its position in the dollar forward market to stabilize the rupee in December – amounting to $49.1 billion at the end of October.
what is next
As the new year begins, the odds become significantly higher against the Indian currency. The US dollar has been strengthening since Fed taper talks began at the April FOMC meeting, rising 5.7 percent since then. Higher demand for US Treasury securities due to rate hikes and a reduction in fresh supplies of US government bonds will keep the dollar strong in 2022. The 10-year US government bond yield has already risen more than 100 basis points since its July 2020 lows.
A continued rally in US Treasury yields, along with the strengthening of the dollar, is bad for emerging market currencies as foreign portfolio investors pull money out of emerging market debt securities in situations that weaken their currencies.
Foreign portfolio investors have also become wary of Indian equities since October 2021, withdrawing Rs 36,642 crore in the last quarter of 2021. The relatively high valuations of Indian equities, trading at a significant premium to the long-term average with the benchmark, have made many foreigners. Brokerage houses are underweight on Indian stocks.
Though stock prices have corrected since November, the Sensex is still up nearly 21 per cent since the beginning of this year, giving ample scope for foreign investors to make profits and withdraw money from Indian stocks.
India’s trade balance is largely dependent on the price of crude oil, which has again started reaching higher levels after falling due to fears of Omicron. If the Omicron version is not severe enough to restrict domestic and international travel, crude oil prices will continue to rise next year, adding to the pressure on the rupee.
Rise in gold imports is another straw on RBI’s back.
Does RBI have enough arsenal?
The question is whether the central bank has enough arsenal to fight the volatility of the rupee next year. Thankfully the RBI has been preparing for such a situation for the past one year, accumulating forex reserves since April 2020, preventing excessive foreign portfolio inflows last year. This has resulted in a $56 billion or 33 per cent increase in foreign exchange reserves since last March.
While reserves provide comfort, it is controversial whether they are sufficient to protect the rupee in highly volatile conditions. The import cover of 15.8 months till the end of June 2021 is sufficient to protect our external trade. But the bigger fear at present is the risk of capital outflows.
The ratio of volatile capital flows, which includes cumulative foreign portfolio inflows and outstanding short-term debt to foreign exchange reserves, stood at 65.5 per cent at the end of June 2021. Large FPI inflows in 2020 have significantly expanded this ratio.
Also, the ratio of reserves to external debt stood at 93 per cent in June 2021. Many Indian companies have made the most of low interest rates abroad to raise commercial borrowings, this share accounts for 37.4 per cent of external debt. As rates move higher in international markets, some of these loans may be repaid, thus creating more demand for the dollar.
RBI will have to be prepared to use up some of its foreign exchange reserves and also increase further market intervention. Shifting of offshore rupee trades from Singapore to GIFT City should be accelerated so that foreign speculators do not put downward pressure on the rupee. Initiating structural changes for rupee internationalization such as paying for external trade in the rupee and issuing rupee denominated bonds in foreign markets are some of the measures that need to be accelerated to provide further appreciation in the rupee.
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