Rupee sinks below Rs 67: Strong dollar, crude to put pressure on currency; RBI might have to intervene to restore sanity

A couple of months back the main worry was that the rupee was appreciating too fast for our liking, pressurising the Reserve Bank of India (RBI) to buy US dollars to keep exports competitive. However, in the last couple of weeks the rupee has been sliding quite sharply to cross the 67 to a US dollar mark, and the market is now talking of Rs 70 to a dollar. These movements are quite abrupt and has taken one by surprise as they pose all sets of problems for the economy.

The fall of the rupee is easy to comprehend. Balance of payments has been under pressure for various reasons. The trade deficit has been widening, which has accelerated of late with crude oil prices hovering over $70/bbl. As long as oil prices remain in this price bracket, the trade deficit will widen as export growth is not keeping pace. The ongoing prospects of a trade war, though diminished in probability are still a threat, which will keep this balance volatile.

The other factor affecting our fundamentals is the direction of capital flows. Foreign portfolio investors (FPIs) in particular have turned negative and that is a concern -- they provided support to the rupee even when the rupee fell in the past.

But this time around things are different. Interest rates in the US are rising with the 10-year US Treasury crossing the three percent mark and remaining within this range at present. The US Federal Reserve has indicated that there will be more rate hikes and the discussion now revolves around there being another two or 3.25 bps hike. This means that returns on bonds will be higher in the US. As such, investors in debt funds in India will no longer find it attractive to invest here as the gap between US returns and those in India would diminish. Further with a weaker rupee, the exchange rate risk rises, pulling down net returns. Therefore, the current withdrawal of funds from India can hasten over the next few weeks if this is the perception. Forward rates have started moving upwards and are in the region of five percent.

Interestingly, the recent measures announced by the RBI in tinkering with the tenure of FPI investment in debt was intended to increase such flows and also lower yields. Now, this is not desirable because if yields fall then bonds become less attractive and will drive away such investment!

The market always waits for signals from the RBI on the exchange rate even though the central bank has maintained that it does not target any such rate. That being the case, the rupee will continue to be volatile until some signal is provided. It has been believed that the acquisition of over $30 billion in forex last year, by the RBI, was done to prop-up exports, and hence there is some comfort in having a weaker rupee. But what exactly is that comfort level?

The problem with such a situation is that it becomes self-fulfilling. When the market expects the RBI to do something and that does not materialise, then speculative elements enter the market. Exporters will hold back their dollars expecting the rupee to fall further so that they can get better returns. Importers on the other hand will rush to buy dollars, especially the oil companies, which will increase the demand for dollars. This pushes the rupee down further. This has happened in the past and will happen again. The important question here -- how long will this last? At present, the volatility seems quite high and there are no signs of the rupee cooling down and that is a concern. The RBI probably has to provide some signal soon.

A falling rupee is not good news as several companies have exposure to imports and are hence vulnerable to such price movements. As the cost of hedging is still high and several companies carry the risk without such cover, it would affect the income and expenditure statements of these companies. The RBI has been urging corporates to hedge their forex risk and while some have done so, several have stayed away. The problem is that when the rupee is stable or appreciating, it does not make sense to hedge. Similarly, if the present volatility is seen as being a short episode, companies would sit back and hope that normalcy returns fast.

The second fear is of imported inflation, which will be sharp from the oil side. Crude oil prices are rising and with the exchange rate becoming unfavorable, the landed cost goes up further thus putting pressure on overall prices. This in turn affects monetary policy formulation as the CPI number is the indicator tracked closely by the central bank. The prevalence of such a trend will mean that interest rate cuts can be ruled out and therefore the question that crops up is -- when will there be a rate hike?

The volatile rupee is, hence, a concern now and this is still not as severe as the crisis in 2013, when crude spiked to the $140-150 levels. Forex reserves are quite robust at $420 billion to provide a cushion but the markets will remain jittery. However, they will still look for some guidance from the RBI, which may have to either speak up or intervene directly to assuage sentiment and restore sanity. But when is it a good time for the central bank to do so? That’s a call for the RBI to take.