RBI sets for a tightrope walk
Premium- In early 2021, the import cover was at over 18 months. This measure is now down to 12 months
- Dollar demand can be expected to stay firm and put pressure on foreign exchange reserves
As of 15 April, India’s foreign exchange reserves depleted to $603.7 billion from $631.5 billion at the end of February. From February till now, foreign institutional investors net sold stocks and bonds worth ₹98,988 crore. The money needs to be converted into dollars to move it out of India. This pushes up the demand for the dollar, and hence, the rupee loses value.
A weaker rupee makes imports expensive, especially crude oil, a commodity of which India imports around 85% of its requirements. Higher prices of petroleum products can push inflation further up. Hence, to control this, the Reserve Bank of India (RBI) sells dollars and buys rupees, ensuring that enough dollars are going around and the rupee does not lose value quickly. RBI’s foreign exchange reserves shrink in the process.
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Note that the demand for dollars is also coming from a burgeoning import bill. In FY22, the total goods imports rose 55% to $612 billion from the previous fiscal. Goods imports have risen primarily due to a surge in commodity prices over the past six months. The total oil import bill during FY22 nearly doubled to $161 billion. In comparison, the quantity of oil imported in the 11 months to February 2022 stood at 256 million tonnes, or just 9.4% more than in FY21. The same story plays out for coal as well. While the total coal import bill doubled, the quantity imported fell by 5%.
Imports require payments largely in dollars. Hence, as imports rise and the dollar demand rises, the dollar supply also needs to go up. However, goods exports in FY22 rose 44% to $420 billion from the previous year, clearly not enough to finance the jump in imports.
Also, things haven’t looked good when it comes to the net foreign investment flow, which brings dollars into India. It is the sum of the net foreign direct investment (FDI) and the net portfolio investment (NPI). Net FDI is arrived at by subtracting FDI by India abroad from the FDI by foreigners into India. Net NPI is left after subtracting the investment made by Indians into stocks and bonds abroad from the investment made by foreigners into stocks and bonds in India.
During the 11 months to February 2022, the net foreign investment flow stood at around $25 billion, a sharp drop from $80 billion seen in the year-ago period. Simply put, while there has been a demand for dollars, the supply hasn’t kept pace.
Now, while the drop in foreign exchange reserves doesn’t sound much in absolute terms, the falling import cover tells us the real story. In early 2021, it was at over 18 months. As of 1 April, it was down to 12 months. Import cover is basically the number of months of goods imports that a country’s foreign exchange reserves can finance at a given point in time. So, while the fall has been fast, we are still in safe territory. In fact, the import cover was around 10 months through much of 2019 and started going up only in 2020, when the imports crashed due to the pandemic.
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Finally, it is worth remembering that as long as the war in Ukraine continues, commodity prices will remain high, pushing up the import bill. Also, with rich-world central banks raising interest rates to control high inflation, foreign money invested in stocks and bonds will continue leaving India. This will keep the dollar demand firm and put pressure on foreign exchange reserves.
Hence, RBI may have to let the rupee depreciate gradually instead of defending it at all costs. Of course, as the rupee is allowed to depreciate, some imported inflation is likely to creep in. This will force the RBI to raise interest rates. All said, it would be a tightrope walk for the RBI this year.