What explains the rupee fall and where is it headed?

In a span of just two trading sessions on 06th May and 09th May, the rupee lost 115 paisa against the US dollar. In the last few days, the fall in the rupee has been sharp and on Monday 09th May, the rupee touched an all-time low of Rs77.58/$. It has since bounced back due to RBI intervention, but the pressure is apparent.

Figure 1- USDINR movement over last 45 years, and this is the weakest level

Chart Source: Trading Economics

The pressure on the rupee since 2011 has been consistent as the USDINR has moved from Rs42.30/$ in the year 2012 to Rs77.58/$ in 2022. For a moment let us leave out the longer end of the story and stick to the immediate concern. What has triggered the sharp fall in the Indian rupee to a historic low? There are 3 principal reasons we focus on.

The US Federal Reserve has decided to go out all guns blazing to tame inflation. Consumer inflation in the US touched a 41-year high of 8.5% in March 2022. While the Fed had started implementing its hawkish strategy with a 25 bps rate hike in March 2022, the May 2022 rate hike was a full 50 bps. In its statement, the Fed hinted at another 175-200 bps rate hike by end of 2022 with multiple rounds of 50 bps hikes. The 10-year bond yields are above 3% and this hawkish policy has seen the hardening of the dollar against global currencies.

A popular measure of dollar strength is the Bloomberg Dollar Index (DXY); an index of the dollar against a basket of hard currencies. The DXY is currently at 104 levels, and this was last seen in November 2002. So, the dollar is at a 20-year high and that is one of the main factors putting pressure on the Indian rupee. RBI has also hiked rates, but it is still quite small if  you add up the Fed rate hike and the hawkish guidance.

Foreign Portfolio Investors (FPIs) turned net sellers in the Indian market in October 2021 and the selling has just intensified. The below captures FPI flows since October 2021.

Data Source: NSDL (May data is till 10th May only)

The above table is almost self-explicit. Since the start of October 2021, FPIs have sold Rs1.80 trillion in equities and they sold Rs1.97 trillion in equity and debt combined. That has put a lot of pressure on the rupee since FPIs convert redemptions into dollars and this creates dollar demand, pushing the rupee even lower. Despite the fact that domestic investors have been lending support, overall FPI selling of $25.50 billion is a big pressure point for the rupee. Moreover, selling has been persistent.

This is a well-accepted factor that tends to exacerbate the rupee fall during hard times. For example, when the rupee starts to weaken rapidly, the first to get worried are the importers and the foreign currency borrowers who have dollar payables. In the last two days, banks have reported heavy demand for dollars from oil companies. Technically, if the position is fully hedged then there is not much of a worry, but that is more of a theoretical situation. In reality, exposures are quite often partially hedged or even unhedged.

In India, the oil refiners import billions of dollars’ worth of crude and even a small change in the dollar can impact their exposures in a big way. This rush to buy dollars tends to sharpen the fall in the rupee. This is when the RBI intervenes in the market and sells dollars so as to defend the rupee. But, would the RBI really be keen to defend the rupee.

How long will the RBI defend the dollar?

One of the most obvious signals of RBI defending the rupee against a sharp fall is depletion in the forex reserves. The forex reserves of the RBI which stood at $647 billion in the last quarter of 2021 is now down to $597 billion. That is $50 billion depletion in forex reserves from the peak levels. That is largely an outcome of the RBI intervening in the forex markets by selling dollars. How long will the RBI defend the rupee. There are 2 considerations.

Firstly, the RBI normally differentiates between a global trend and an isolated trend. If there is a global trend towards weakening of EM currencies, RBI may not intervene beyond a point and will allow the rupee find its level. Secondly, a weak rupee is not bad after all. Southeast Asia adopted weak currency policies through the 1970s and 1980s to boost exports. With India having mega export plans, including Make in India program, as weak rupee may not be a bad idea.  RBI will look to strike a balance.

Can the USDINR weaken further to Rs80/$?

Forex market veterans like Jamal Mecklai are averse to making projections on the rupee in this volatile environment. After all, there are too many extraneous factors at play. However, Mecklai and other forex experts do believe that if the Fed continues to walk the talk on its hawkish stance, then Rs80/$ may be perfectly possible. That would also depend on how FPI flows and NRI flows pan out.

One way to assess the market outlook is to look at the USDINR futures prices. Here are the futures prices of the USDINR contracts.

Data Source: NSE (10th May prices)

For now, the markets are still betting on a worst case scenario of around Rs79/$ by December 2022, not before that. However, in these volatile markets, things can change rapidly. Markets need to be prepared for this new angle of currency risk.