Why A Weak Rupee Looked Strong In CY23

There are enough and more memes around the weakening of Indian rupee trending on social media in recent times, but the one with the wittiest lines goes like this: A Hindi movie actress is seen saying, "Mujhe nahi pata tha ki thode se rupaiyoo ke khatir tum itna neeche gir jaoge!" (I did not know that for a few rupees you will stoop to such a low) to which yesteryear Hindi movie villain Ranjeet remarks, "Jab rupaiya itna neeche gir sakta hai, toh mai kyu nahi?" (If the rupee can fall to such a low, why can't I?).

Hilarious as it reads, the reality is that the rupee has ceded ground against the greenback ever since the Reserve Bank of India (RBI)-induced devaluation in 1991. The currency kept heading south in the ensuing 33 years, though intermittently — 2002 to 2004, 2006 and 2007, 2009 and 2010, and 2017 — it managed to change course. Yet, over the past three decades, the currency has fallen 78.23% from 18.10 to end 2023 at 83.17. Though YTD (February 3, 2024), the currency has gained 0.31% to 82.91.

But, interestingly, for the first time, the rupee has shown the least percentage depreciation of 0.46% in a calendar year, a resounding performance considering the Indian currency came off by 10% in 2022. The primary reason for the turnaround was the weakening of the dollar, particularly in the latter part of 2023 with the U.S. Fed indicating that the rate hike cycle had peaked. "There is a general belief that beginning March 24, the Fed would start cutting rates," says Aditi Gupta, economist, Bank of Baroda. The weakening of the dollar index was also complemented by robust foreign portfolio inflows of $29 billion last year, with December seeing a record monthly inflow of nearly $10 billion. Benign crude oil prices also ensured that India's current account deficit was restricted to 1% of GDP in Q2FY24, lower than $9.2 billion (1.1% of GDP) in Q1 and $30.9 billion (3.8% of GDP) a year ago (Q2FY23). According to estimates, for every $10 increase in Brent crude prices, India's current account deficit rises by 0.5%. Incidentally, the biggest current account deficit India has seen was 6.7% in Q3FY13.

Though a sharp appreciation in the rupee is unlikely, given India's weak export growth, the factors that propelled the rupee last year are expected to continue well into the New Year. Besides, the anticipated increase in India's weightage in the JP Morgan Bond Index fund will also accelerate debt flows. "In the run-up to the inclusion we have already seen debt inflows of $7.3 billion last year," says Gupta. According to estimates, India could see debt inflows of $20-30 billion. "If the weightage in the Bloomberg index also increases, we could see even higher flows," says Gupta. While the AUM of international debt funds benchmarked to the JP Morgan index is estimated to be around $225 billion, the biggest bond index is the FTSE Russell Emerging Markets Government Bond Index, with an AUM of over of over $1,477 billion. If India makes it to the index, the inflows will be much higher.

In the current year, the rupee could break past the 83 mark and inch towards 82, though the RBI is unlikely to allow the rupee to appreciate beyond that given that exports are still facing headwinds owing to an uncertain global environment. "Right now, the rupee will probably appreciate because the dollar will weaken. Two-odd years ago, the dollar was at 1.17 a euro and then it swung to 0.98. Now it's at 1.10 again. So, as it goes weaker, the rupee will benefit in the immediate term," says Indranil Sengupta, chief economist at CLSA India.

However, over the medium term, Sengupta believes the rupee will see around 2.5% depreciation. In fact, in the coming year, a lot will depend on whether the Fed walks the talk, considering that consumer price inflation in December still grew at an annual rate of 3.4%. Though significantly down from a four-decade high of 9.1% in June 2022, inflation remains elevated, which could compel the Federal Reserve to maintain a restrictive policy stance and postpone any imminent rate cuts. The Fed, having begun aggressive rate hikes since March 2022, aims to stabilise the year-on-year inflation rate at 2%. However, considering that the last mile is always the hardest, reaching this target might take longer than anticipated amidst a volatile global economic landscape.

Against such a backdrop, it's crucial to note that the RBI's monetary policy report from October revealed that the rupee was overvalued by 5.7% at September-end, according to the 40-currency real effective exchange rate — the most significant overvaluation since November 2021. Surprisingly, the International Monetary Fund (IMF) in a report stated that India's exchange rate regime, from December 2022 to October 2023, had moved from a 'floating' to a 'stabilised arrangement', a change attributed to the RBI's interventions which, according to the IMF, sharply limited the rupee's move against the dollar to a very narrow band. Between December 2022 and October 2023, the rupee had moved between 80.88 and 83.42, but post-October, the band got narrower to 82.90-83.42, the lowest volatile period seen over a decade. The IMF report suggested that the RBI's intervention 'likely exceeded levels necessary to address disorderly market conditions.' However, with RBI governor Shaktikanta Das in October shedding light on the nuanced nature of forex intervention by mentioning that it was more than just a binary decision, a nosedive in the rupee seems off the cards. Moreover, with forex reserves at a staggering $616 billion, the RBI still has enough muscle to flex, that is unless Powell and Houthi rebels have something else on their minds which could well see the Ranjeet meme trending all over again!