What's causing the rupee to weaken

The Rupee has crossed the 70 to the Dollar mark and though it has pulled back, there is widespread noise and concern at what is being seen as a rather quick slide to new all time lows. Some have cited the collapse of the Turkish Lira to draw odious parallels to India, unmindful that Turkey suffers from high inflation, large capital outflows and insufficient forex reserves. The RBI has maintained what in this case is intelligent silence but has taken action in the spot as well as the forward market keeping in view its mandate to maintain orderly conditions by containing excessive volatility in the exchange rate without reference to any pre-determined level or band.

In analysing the situation, it is important to note that episodes of volatility are not a new phenomenon in India and this isn’t the worst of what has been seen in terms of volatility. The depreciation five years ago, precisely on August 28, 2013, remains a watershed as the Rupee touched Rs.68.3611 to the Dollar. Thus, the worst in terms of volatility in recent years was seen in 2013-14, which saw the highest standard deviation at 3.08 and the coefficient of variation at 5.10 per cent (See table1). Subsequently, even though the currency peaked at the level of 68.7775 (on February 26, 2016), this was again not the worst in terms of volatility measured by standard deviation and coefficient of variation.

Analytically, the movement in the exchange rate is influenced by demand for and supply of foreign currency liquidity (US $ liquidity). In the balance of payments framework, demand for foreign currency is broadly determined by import of goods and services and outflows of foreign capital whereas the supply of foreign currency is influenced by export of goods and services, worker remittances and inflow of foreign capital. In the Indian context, the current account deficit and net capital outflows influence the shortage of Dollar liquidity which result in Rupee depreciation (See table 2)

Evidence suggests that in all years except for 2015-16 and 2016-17, speculative capital flows (foreign portfolio flows) and debt capital flows (external commercial borrowings and NRI deposits) predominated the capital flows. However, during 2015-16 and 2016-17, there were debt capital outflows. Illustratively, there were net outflows in external commercial borrowings and NRI deposits to the tune of 6.1 billion US$ and 12.36 billion US$ respectively in 2016-17.

To the extent the debt capital flows constitute a major share in the total capital flows. India’s debt liabilities are higher at around 51 percent of GDP as on end-March 2018. The ratio of net international investment position (international financial assets minus international financial liabilities) to GDP as on end-March 2018 was negative at 16.3 per cent. The ratio of financial assets to GDP stood at 24.5 per cent and ratio of financial liability to GDP was at 40.8 per cent as of end-March 2018. Thus, we are a net lability country and should be cautious about building up reserves through debt. As such, there are three important elements linked to the weak Rupee viz. a) persistent current account deficit b) episodes of net capital outflow in terms of speculative and debt capital outflow and c) predominance of debt capital in forex reserves.

In the event of Rupee depreciation, the RBI intervenes in the forex market with the objective of containing volatility. During 2018-19, for the month of May and June for which data are available, RBI sold 9.9 billion US$ and 10.2 billion US$ respectively. As of August 10, 2018, the outstanding foreign currency reserves were at 400.9 billion US$, a decline of 23.63 billion US$ over end-March 2018. This decline could be on account of RBI selling Dollars to intervene in the market to manage Rupee volatility.

As alluded to earlier, some of the analysts have opined that Rupee depreciation has been contributed by the depreciation in the Turkish Lira with a contagion effect. This view is erroneous as India’s trade with Turkey in terms of exports and imports is miniscule. For e.g. during 2017-18, share of export was 1.68 per cent of total exports and 0.46 per cent in total imports. Latest data for 2018-19 (Apr-June) show that the export share was 1.78 per cent and the import share was 0.56 per cent with Turkey. In addition, India doesn’t have a large cross border financial transaction with Turkey.

Essentially, the depreciation of Rupee could be linked to current account deficit because of higher trade deficit contributed by higher import bills. According to latest available data, overall trade deficit (goods and services) during April-July 2018-19 was recorded at US$ 43.77 billion as compared with US$ 34.07 billion in the previous year. Oil imports during April-July 2018-19 amounted to US$ 46.98 billion, which was 51.5 per cent higher than the corresponding period of the previous year. In addition, there were outflows of speculative capital from India due to higher interest rates in US as the US Fed increased the Fed Fund Rate, alongside higher and a record US GDP growth in Q2 of 4 per cent, and lowest order of unemployment rate in the US in the past 60 years. In short, the US economy is firing away on all cylinders and there is the strengthening of the US Dollar as the intervening currency. Further, we have significant trade dependency with the US and so the strength of the Dollar also has a marked effect on the Rupee.

The moot question is will the Rupee have a mean reversal as it happened in 2017-18 from an average of 67.08 in 2016-17 to 64.44 in 2017-18? As the US Dollar is gaining  strength with all accompanying strong fundamentals, it looks difficult. However, our efforts to further strengthen FDI, promote exports by diversification and improved quality of our commodities and direction towards developing and emerging market economies could be helpful. That is the only long term sustainable and viable way to guard against the falling Rupee. Everything else is empty talk and diverts attention from the task at hand.

(Pattnaik is a former Central banker and a faculty member at SPJIMR)