Rupee Should Rise With India Shining, But The Reserve Bank Won’t Allow It

And there is one mantra they all repeatedly chanted since the rupee’s exchange rate became market-determined in the early 1990s. 

The mantra goes:

      Rupee is market-determined I
      RBI only controls market volatility II

The much practised virtue is reticence on all matters ‘Rupee’. 

Rarely have the RBI governors spoken about the exchange rate policy or tactic beyond repeating this mantra. So, it was a big surprise when the present Governor, Shaktikanta Das, went off script in his televised address to detail the decisions taken by the Monetary Policy Committee last month. 

Das said the central bank’s focus has been on building a substantial amount of foreign exchange reserves, even though the country’s reserves hit a record high of $648.5 billion on April 5, 2024. 

It was a dangerous thing to say for Das, even as he has been trying to ward off the infamous currency manipulator tag, which the US Treasury Department is using to call out countries that allegedly use exchange rates for unfair trade practices. 

So, what was Das indicating? 

The central bank will absorb any dollar inflows to build reserves and let the rupee depreciate mildly in the coming months. The exchange rate could reach 84 rupees to a dollar by the end of the year from the current rate of 83.40 to a dollar. This is if no new crisis emerges in India or abroad. 

But given that many things are going good for the Indian economy, should the rupee actually depreciate?

Rupee and Macros

Several times in April, the rupee hit record lows against the dollar. 

As always, the media feels, much to the chagrin of the policymakers, it is duty-bound to contextualise the rupee’s level as being at a record low or a Sensex level being at a record high. 

The authorities would have us believe, and rightly so, that the rupee’s level does not mean much in itself as long as it moves in an orderly fashion in either direction, giving firms and investors time to adjust. 

The rupee should rise as India is one of the fastest-growing major economies in the world. It is all set to overtake Germany and later Japan within the next six years to emerge as the third-largest world economy. 

The NSO’s latest estimate placed real GDP growth at 7.6 per cent for 2023-24, the third successive year of a 7-per cent-plus growth. The trend is widely expected to continue in the current financial year. 

As per a commerce ministry statement, India’s overall exports for 2023-24 are estimated to top last year’s record high of US$776.4 billion. Provisional numbers for the year are at US$776.6 billion. 

The trade deficit in 2023-24 is estimated to have eased to US$78.12 billion from US$121.62 billion.

If the trend holds, all this augurs well for the rupee in 2024-25.

Foreign portfolio inflows have been strong, totaling US$41.6 billion in 2023-24 – the highest since 2015-16. Debt portfolio inflows were US$16.4 billion, the highest since 2018-19. Net FPI inflows in equity at US$25.3 billion were the highest among emerging market peers.

FDI inflows in 2023-24 were marginally lower than last year, but according to Kearney’s Global Business Policy Council Research, India ranked fourth among emerging markets in the 2024 FDI Confidence Index.

According to the RBI, India’s current account deficit was 1.2 per cent of GDP in 2023-24, lower than the previous year's 1.3 per cent. Governor Das expects the CAD for the current year to be viable and manageable. 

Again, these factors should ideally boost the rupee.  

The biggest factor going in favour of the rupee is India’s inclusion in global bond indices. 

In September, JP Morgan said it would include Indian government bonds in its Global Bond Index – Emerging Markets suite from Jun 28 over a 10-month period. Bloomberg Index Services also decided to start adding Indian bonds to its index from early 2025.

About US$30 billion could flow into government bonds on this account, potentially giving the rupee a big boost. 

Dollar’s Strength

The strength of the domestic economy does not drive the rupee’s exchange rate alone; a key driver is how its peers and, importantly, comparable economies are doing. 

In the case of the dollar, the US currency is experiencing strong tailwinds thanks to the American economy's resilience in the face of one of the most aggressive rate-hiking campaigns by the Federal Reserve.

The Fed has raised the target rate for federal funds by 525 basis points to 5.25-5.50, the highest level for the key policy rate in two decades. The Fed has maintained the rates there since July 2023.

The US central bank was hoping to start cutting rates in June, but the expected softening of inflation, GDP growth, and employment has not materialised. 

Markets are calling it US exceptionalism, where the economy is not dancing to the central bank’s tunes, unlike in most countries, where inflation has come to heel due to interest rate increases. 

US inflation has been stuck at a little over 3 per cent for the past few months having fallen from around 9 per cent two years ago due to the Fed’s rate hikes. The Fed aims to bring inflation close to 2 per cent. 

Expectations that the Fed will keep rates ‘higher for longer’ yet again have lifted the dollar. It rose against Asian currencies each month this calendar year. 

In mid-April, the dollar index hit 106.37, the highest level in about a year. Around the same time, the rupee hit its lowest level against the dollar, at 83.57. 

Indonesia's central bank had to raise interest rates to defend the nation’s currency, the rupiah. And the Japanese central bank intervened heavily last week to prop up the yen.  

The RBI, too, intervened. Its foreign exchange reserves fell by US$10 billion after hitting those record highs on April 8. 2024. The latest data puts India’s foreign exchange reserves at $637.92 billion. 

The fall could partly be due to valuation losses, with the value of foreign currency assets held in other currencies by the RBI falling in relation to the dollar and also the actual expending of the dollars in rupee’s support.

Once US rate cuts appear certain to the markets, the dollar could start to weaken. 

Release Valve

RBI Governor Das's explicit statement that the central bank would shore up its reserves is a departure from the famed virtue of reticence. But it appears to be a calculated move. 

India's inclusion in the bond indices of global bond index providers could be a boon, but it could also be a curse. Inflows into India could come thick and fast, and the outflows could prove to be thicker and faster, causing extreme volatility in the financial markets. 

Portfolio inflows expose India to vulnerabilities even if the Indian economy remains strong. A risk-off sentiment due to geopolitical tensions, election upsets, or an unexpected Fed rate hike could lead to outflows, putting pressure on the rupee. 

Economists often consider the rupee’s exchange rate to be the “release valve.” If something goes wrong domestically or internationally, pressure is first felt on the exchange rate, which falls dramatically before other macroeconomic parameters can be corrected.  

The challenge is disorderly correction. It can hurt economic growth and well-being. 

The RBI Governor sees a here-and-now problem. High government debts exist in large economies like the US and emerging market economies. Das is afraid that these dormant risks could erupt abruptly.

According to the International Monetary Fund, the gross public debt to GDP ratio of advanced economies is projected to increase from 112.3 per cent in 2022 and is projected to increase to 116.3 per cent by 2028, while that of India is expected to decline marginally from 81 per cent  in 2022 to 80.5 per cent in 2028.

Conventional wisdom suggests a combination of tight monetary and loose fiscal policy will suck in capital from emerging markets and drive up the dollar. That could precipitate financial crises in emerging markets, lending pressure on exchange rates and financial stability and lead to emergency interest rate hikes. 

India would want to avoid what Indonesia did to defend its currency. 

Other Rupee Mantras

For the RBI, the exchange rate and approaches around it are sort of sacred.

The RBI rarely uses the exchange rate as an obvious tool for some of its macroeconomic goals. For instance, it does not use the exchange rate to control inflation. 

If the rupee rises due to strong inflows and the RBI does not need to intervene, and if that brings down imported inflation, it would be a happy coincidence. 

The RBI would not sell dollars to engineer the rupee’s appreciation to bring down inflation even if oil prices are on the boil internationally. 

The central bank also would not like to use its reserves to fund other domestic needs, say for India’s burgeoning infrastructure requirements. 

The logic is that reserves won’t be reserves if they are spent. They are to be used for a rainy day and to lend confidence to the rest of the world about India’s ability to withstand stocks so that trade and investment flows continue normally. 

The impact of tinkering with the exchange rate for other goals is fraught with danger. If the rupee rises sharply, engineered or otherwise, it could hurt exports. The bulk of India's merchandise exports are managed by MSMEs that compete with similar firms in developing nations. 

A sudden and sharp rise in the rupee could hurt the smaller companies that employ lakhs of people in export clusters, causing severe economic hardships to citizens.  

It is unlikely that the RBI will change its rupee mantras in the near future. A gradual decline that benefits exports and growth would have a tacit central banking nod. 

(Kalyan Ram is a Mumbai-based journalist with 30 years of experience in driving coverage of central banking and macroeconomy. Views expressed are personal)