The RBI will have to use the forex kitty it has built over the past year to maintain stability in the forex market
There was a lot of nervousness in forex dealing rooms last week when the rupee hit 76.30 against the dollar. The Indian currency appeared poised to shatter the previous life-time low of 76.91, recorded last April. But some deft action by the central bank pulled the currency back from the brink and it seems set to close the year around 75.
The fault lines are already visible and the rupee has slid 2 per cent against the US dollar and 0.75 per cent against the British Pound so far this year. Going ahead, the rupee is likely to continue facing pressure due to FPI outflows, expanding trade deficit and strengthening dollar. The RBI will face a tough task maintaining stability in the forex market next year. It remains to be seen how well the central bank rides the perfect storm in currency markets in 2022.
A tough December
It has been extremely volatile for the rupee in December. It all began with the FOMC statement on December 15, which revealed that the Federal Reserve Board members expected the Fed Funds rate to be hiked at least thrice in 2022, by 25 basis points each time. With fresh liquidity infusions by the Fed to stop by March 2022, global liquidity could be impacted significantly in the coming months. Bank of England followed the Fed by commencing interest rate hikes in December. This made FPIs nervous, resulting in outflow of ₹17,147 crore from Indian stocks and ₹12,280 crore out of Indian bonds.
The rupee has been under pressure since the November meeting of the FOMC when it was first revealed that the taper schedule could be accelerated. It depreciated 2 per cent between mid-November and mid-December, but has recovered since then, strengthening to 74.5 levels.
The rupee’s strength over the last two weeks is despite the November trade deficit expanding to $177 billion, the highest since June 2019 and a host of other negative factors. The RBI has clearly been active in the forex market and this is seen in forex reserves declining from $641 billion in October 2021 to $635 billion this month.
The central bank became a net seller of dollars in the spot market in October 2021, after being a net purchaser in the previous six months. It is possible that the RBI also used its position in the dollar forwards market — amounting to $49.1 billion towards the end of October — to stabilise the rupee in December.
As the New Year commences, the odds are piled pretty high against the Indian currency. The US dollar has been strengthening ever since talks of Fed taper began in the April FOMC meeting, gaining 5.7 per cent since then. Higher demand for US treasury securities due to the rate hikes and reduction in fresh supply of US government bonds will keep dollar strong in 2022 too. The 10-year US government bond yield has already rallied more than 100 basis points since July 2020 lows.
Continued rally in US treasury yields combined with stronger dollar is bad for emerging market currencies since foreign portfolio investors tend to pull money out of emerging market debt securities in such circumstances, weakening their currencies.
Foreign portfolio investors have also turned wary of Indian equity since October 2021, pulling out ₹36,642 crore in the last quarter of 2021. The relatively higher valuation of Indian equity, with the benchmarks trading at significant premium to long-term average had made many foreign brokerage houses go underweight on Indian stocks.
While stock prices have corrected since November, the Sensex is still about 21 per cent higher since the beginning of this year, giving foreign investors ample scope to book profits and pull money out of Indian stocks.
India’s trade balance is dependent to a large extent on crude oil price, which is beginning to race higher again, after a dip caused by Omicron fears. If the Omicron variant is not severe enough to result in restricting domestic and international travel, then crude prices will continue to surge next year, adding to the pressure on the rupee.
Increase in gold imports is another straw on RBI’s back.
Does RBI have enough arsenal?
The question is, does the central bank have enough arsenal to fight rupee volatility next year. Thankfully, the RBI seems to have been preparing for such a situation over the last one year, accumulating foreign exchange reserves since April 2020, mopping up the excessive foreign portfolio inflows last year. This resulted in the forex reserves increasing by $56 billion or 33 per cent since last March.
While the reserves provide comfort, it is moot whether they are adequate to protect the rupee in excessively volatile conditions. The import cover of 15.8 months towards the end of June 2021 is good enough to protect our external trade. But the bigger fear currently is the risk of capital outflows.
The ratio of volatile capital flows, which includes cumulative foreign portfolio inflows and outstanding short-term debt to forex reserves, stood at 65.5 per cent towards the end of June 2021. The large FPI inflows in 2020 have expanded this ratio significantly.
Also, the ratio of reserves to external debt was 93 per cent in June 2021. Many Indian companies have made the most of low interest rates overseas to increase commercial borrowing, with this portion accounting for 37.4 per cent of external debt. As rates start moving higher in international markets, there could be repayment of some of these loans, thus creating more demand for dollars.
The RBI will have to stand ready to use some of its forex reserves and also increase interventions in the forwards market. The shifting of offshore rupee trades from Singapore to the GIFT City must be hastened so that overseas speculators do not mount downward pressure on the rupee. Initiating structural changes for internationalising the rupee such as paying for external trade in rupee and issuances of rupee denominated bonds in overseas markets are some measures that need to be expedited to provide more heft to the rupee.