Rupee's weakness may persist

This year, the Indian rupee ranks 26th in strength among the top 30 currencies globally, and is one of the few to have depreciated against the US dollar. This weakness has gone largely unremarked if not unobserved, as Indian economic participants as well as commentators are anchored to the dollar-rupee exchange rate, which has not changed much. So far this year, the rupee has fallen in value against every other major currency: By 5 per cent against the euro, 6 per cent against the British pound, 9 per cent against the Japanese yen, and 6 per cent against the Chinese yuan.

We need not look far to understand what drives this weakness. India needs a continuous inflow of foreign capital to pay for its current account deficit (CAD) i.e. it imports more goods and services than it exports. Put another way, it consumes more than it produces, and so it needs foreigners to pay for the excess consumption. When capital flows exceed the CAD, the rupee has a tendency to strengthen; when they match the CAD, the rupee is stable; and when they lag the CAD, the rupee weakens. 

The recent vulnerability in the rupee comes from capital inflows struggling to keep pace with a sharp widening of the CAD, driven by an increase in the goods trade deficit. Over the past year, following a period of stability, the annual trade deficit has expanded by $52 billion, or nearly 2 per cent of gross domestic product (GDP). The oft-discussed culprit, an increase in crude oil prices, is responsible for only a third of this. 

Illustration: Binay Sinha
Instead, half of the increase comes from a worrying rise in net imports of precious metals and stones (that is, the import of gold, silver, precious stones and pearls, minus the export of jewellery). Even as gold prices have remained range-bound, gold volumes are up sharply over the past 12 months from a low base. While they seem to be stabilising in recent months, a potential surge remains a risk for the economy, particularly as they are a form of implicit capital flight: Citizens wanting to hold, instead of the local currency, a shiny metal that yields no returns, is a form of capital flight. What is much more worrying is that nearly $15 billion of the increase has been a rise in imports of precious stones and pearls, where capital flight cannot be ruled out as a factor, as they are generally hard to value objectively.

The non-oil and non-precious metals and jewellery trade deficit has so far been a smaller contributor, rising by only $9 billion over the past year. However, it is now at a record high $53 billion, and may continue to widen in the coming year, particularly as high utilisation levels in some sectors of the economy where new capex is necessary, such as airlines, telecommunications or steel, most of the equipment is imported. On the other hand, the sectors that contribute to the bulk of India’s export value-add, such as agriculture, textiles, leather, two-wheelers and pharmaceuticals, are not “high-beta” sectors, that is, they do not surge with global growth.

Therefore, Credit Suisse believes that India’s CAD is likely to continue to widen, and reach $75 billion in the next 12 months (2.6 per cent of GDP). This would be the second highest in history, after the record $88 billion in 2013, which preceded a sharp currency drop.

Concerns are emerging on capital inflows as well. A CAD up to the range of $50- 60 billion dollars a year can be funded comfortably with a mix of foreign direct investment (FDI), foreign portfolio investment (FPI), inflow of non-resident Indian (NRI) deposits, and dollar loans (external commercial borrowings, or ECBs). However, over the past 12 months net FDI inflows (this is inbound FDI minus outbound FDI) have slowed to $27 billion, after being at $40 billion a year for two years. FPI inflows have slowed as well, partly due to uncertainty and discomfort around near-term macroeconomic variables such as growth, inflation and the fiscal deficit (the “fog” that we have discussed in earlier columns), and partly due to the limits on foreign ownership of Indian bonds getting exhausted (these are set by the Reserve Bank of India). With the LIBOR (the inter-bank rate that drives the cost of external loans) rising steadily in the last six months, and trade-financing inflows hurt by recent banking scandals, ECBs may not rise much too.

In the next three months, the impact of these two trends: widening CAD, and stable to slowing pace of capital flows may become more pronounced, as the trade deficit rises due to seasonality. The only reason the dollar-rupee exchange rate, the indicator everyone watches, might not move as sharply as it would have otherwise, is that the dollar itself is expected to continue to weaken against other currencies. As the fiscal stimulus in the US comes at a time when the economy is close to full capacity, the demand push may only increase its imports. Coming at a time when the absence of big global risks has led to a reversal of the safe haven trade (when everyone wanted to hide in dollar-denominated assets), and thus outflows of investor capital from the US, this means a weaker dollar. 

This “stealth” weakening of the rupee in some ways is a win-win: Many have believed that the rupee has been too strong, and must depreciate to help Indian exporters. That the most-watched dollar-rupee rate has not changed meaningfully has allowed this depreciation to happen thus far without causing unnecessary volatility. However, the drivers of this weakness are unhealthy, with suspicions of capital flight, disappointing export growth and slowing capital inflows. Should the dollar strengthen, an abrupt change in the dollar-rupee exchange rate could drive volatility in the Indian markets and the economy. Unlike in 2013, the country’s foreign currency reserves are large enough to prevent unwarranted volatility, but policymakers perhaps need to act in advance to shore up capital inflows: These may be harder to attract once weakness becomes obvious.

The writer is India equity strategist for Credit Suisse