Ending of rate hikes in US to stem sharp rupee depreciation

With the US dollar gaining strength over the last several weeks, several currencies had weakened sharply. The rupee was no exception, although forex sales by the central bank, a host of measures to support the currency, and a period of relatively benign crude oil prices had contained the extent of its weakness. However, with crude oil rebounding to $105/barrel, the rupee slipped to a fresh intra-day low, and crossed the threshold of 80/$ on July 19, 2022.

In June 2022, India’s merchandise trade deficit widened to an all-time high $26 billion, and the WPI and CPI inflation printed at 15.2 per cent and 7 per cent, respectively. While commodity prices have corrected since then, the landed prices of imports will see a milder moderation following the depreciation of the rupee, which will somewhat limit the improvement in the domestic inflation readings going ahead. Moreover, strong domestic services demand may impart stickiness to domestic inflation readings. On balance, we no longer see an upside to our FY2023 inflation forecast of 6.5 per cent.

In any case, merchandise trade deficits in excess of $20 billion are set to be the new normal in the remainder of 2022. We project the current account deficit to more-than-double to an all-time high of $100-105 billion in FY2023. This translates to around 3 per cemt of GDP, the threshold after which alarm bells typically become more strident.

At the same time, India’s forex reserves dropped to $580 billion as on July 8, 2022, corresponding to 11.3 months of last year’s imports. Financing a sizeable current account deficit will pose a challenge, amidst the FPI equity outflows and likely moderation of inflows such as ECBs, following the increase in borrowing costs across the globe.

Fortunately, FII outflows have stemmed in July 2022, trickling down to $1.1 billion in the first half of the month, after averaging a gut-wrenching $4.7 billion in the previous six months. Moreover, FDI inflows did dip on a YoY basis in April-May 2022, but remain remarkably strong as compared to earlier years at $12.7 billion.

Unless there are fresh fears on global demand, crude oil prices may not revert below $100/barrel in 2022. With front-loaded rate hikes by the US Fed, the US dollar will remain relatively strong in the immediate term. Therefore, we expect the rupee may weaken further to 81/$ in Q2FY2023.

However, with commodity prices having retreated, we do expect inflation prints to eventually start trending downward, globally as well as in India. In our view, rate hikes in the US may end sooner than expected by the markets, which will prevent a further sharp depreciation in EM currencies such as the Rupee in H2 FY2023. We continue to expect rate hikes by the Monetary Policy Committee (MPC) to be limited to 60 bps over the next two reviews, followed by a pause.

In July 2022, the Reserve Bank of India (RBI) has introduced various measures to support the rupee, such as relaxations for NRI deposits, external commercial borrowings and short-term investments in FPI-debt securities, which should modestly boost inflows. Additionally, moves towards international trade settlement in rupees, should help enhance the internationalization of the INR over the medium term.   

As long as EM currencies are weakening, some INR depreciation is warranted to protect export competitiveness. However, if the rupee crosses 80.5/$ in a sustained manner, further RBI measures can’t be ruled out.

Aditi Nayar, Chief Economist, ICRA Limited