Ajit Ranade, chief economist at Aditya Birla Group says the rupee was over valued according to the Reserve Bank of India (RBI) and “needed to fall a bit”. Hence, some depreciation was expected. A weakening rupee is helpful for the country’s exports and for creating jobs. But oil prices have also moved up and a steep depreciation would be inflationary. In short, it is a trade-off between benefiting exports, job creation and inflation.

Ashutosh Khajuria, executive director at Federal Bank says in calendar year 2017, the rupee had actually appreciated by 7 per cent. So, to some extent the present depreciation will help exporters and is required to keep exports competitive. The current volatility in the rupee does not seem temporary and India’s macro picture looks bleak. Here are explanations to some of the most stubborn rupee riddles.

Why is the rupee falling?

While strengthening of the US dollar on expectations of higher interest rates back home is one of the reasons, domestic factors are also playing out in each of the emerging market economies. India’s cyclical rebound is overshadowed by rising oil prices – Brent is near three-year highs and closer to $80 per barrel while the Indian crude basket is back at late-2014 levels. This risks widening the trade and current account balances and raising financing requirements.

A $1 per barrel change in crude oil price impacts India’s current account deficit (CAD) by $1.5 billion or 6 basis points of GDP. One basis point is one hundredth of a percentage point. For instance, CAD has been deteriorating since the last fiscal. The CAD was as high as 4.8 per cent of GDP in 2012-13 but it started falling subsequently and touched a low of 0.7 per cent in 2016-17. The CAD ended at 2 per cent of GDP in the quarter ended December 2017. It is most likely to have ended 2017-18 at 2 per cent of GDP.

The US Federal Reserve, in a widely-expected move on May 2, 2018 left interest rates unchanged at 1.50-1.75 per cent, acknowledging that inflation is near its 2 per cent target. The central bank also signalled that the gradual path of rate hikes will stay. However, it downplayed the recent slowdown in economic and job growth.

The cause of the recent dollar strength is the rise in the 10-year treasury bond yield to the 3 per cent level, and the related sell-off in emerging market debt, where the most vulnerable markets are those where foreigners have big positions in the local currency debt market. Going by this reasoning, the US dollar could get more of a bid if the 10-year treasury bond yield breaks above the 3 per cent level convincingly.

Support the RBI can lend

The central bank is buoyed by record forex reserves to the tune of $421 billion. A ratio of the reserves to gross external financing requirements reveal that there are limitations in the quantum of intervention that can be done by RBI, especially if US yields stay high and US dollar strength shows little signs of abating. Thus any escalation in capital flight from emerging markets can spook the rupee and there is no reason why there will not be a repeat of 2008, 2013 kind of a situation warned economists.

A ratio of the reserves to gross external financing requirements, that is current balance plus short-term external debt by residual maturity, signals the cushion that is in place to deal with any potential tightening of external funding.

“In this regard, India and Indonesia, which were hurt by the last dollar rally episode (in 2013), are not out of the woods this time either. While both countries’ central banks have diligently improved their reserves base, the funding cover has improved only marginally, especially in comparison with the large surplus economies in the neighbourhood,” says Radhika Rao, India Economist at DBS Bank.

There are limitations on the quantum of intervention, especially if US yields stay high and US dollar strength shows little signs of abating. This keeps policy tightening risks on the table, she says.

There are other signs like growing trade deficit. India’s exports crossed the $300 billion mark after a gap of two years in FY18 even as shipments declined in March and higher imports pushed the trade deficit for the full year to a five-year high. Exports declined nearly one per cent in March after four months of rise to $29.1 billion from $29.3 billion a year ago, data released by the government showed. India’s trade deficit widened to $156.8 billion in 2017-18 on account of a rise in oil and gold imports compared with $108.5 billion in FY17 amid rising global trade tensions. Imports were up 7.2 per cent to $42.8 billion in March, yielding a traded deficit of $13.7 billion against $10.7 billion in March last year.

India Ratings and Research (Ind-Ra) believes India’s trade deficit will widen to a four-year high of 6.4 per cent of GDP in FY19 (USD178.1 billion). Widening trade deficit, escalation in commodity prices, particularly oil, coupled with the expectation of the US Federal Reserve raising its rate further, is exerting pressure on the rupee. Even other emerging market currencies are facing headwinds, says India Ratings.

Secondly, foreign investors also poured money into the Indian financial markets in the past few years. But this trend is also expected to change as the markets look fully valued and the US is also recovering with interest rates expected to go up.

For India, measures have been taken to boost foreign inflows – that is increase in FPI investment caps and relaxation in rules. “On the policy front, RBI might change its policy stance at the June 2018 review, following up with a measured rate hike in Q3CY18. Sticky core inflation and a depreciating rupee add to the central bank’s concerns. The mood in the government bond markets has also been gloomy, as currency volatility has weighed on buyers’ appetite,” says Dhiraj Relli, MD & CEO at HDFC Securities in a report.

Foreign inflows touched a high of Rs 2,77,461 crore in 2014-15 but moderated subsequently. Inflows were negative the next year at Rs 18,176 crore and recovered to Rs 48,411 crore in 2016-17. They, however, jumped to Rs 1,44,682 crore in 2017-18. In 2018-19, the latest available figures upto May 11 show negative Rs 28,253 crore.