India is equipped to deal with currency volatility

On the value itself, foreign exchange markets are prone to overshoot, but even if they do so, they will correct in the near-term

It’sIt’s been over four months since the Russia-Ukraine war started, and the collateral damage has been extensive. The war has led to shortages and protectionism and sparked a wave of defaults. In addition, the world is also experiencing weakening growth, high inflation, and uncertainty. For India, the surge in prices of globally traded commodities has created trouble on two fronts. Typically, higher global commodity prices, especially energy prices, drive up inflation and negatively impact India’s current account deficit first, putting pressure on the Indian rupee. We estimate that more than 50% of India’s import basket has seen a price surge, leading to a significant increase in the import bill. As a result, trade deficits have consistently been over $20 billion per month for almost a year. We estimate that India’s goods trade deficit will amount to over $250 billion in the current year, exceeding the previous record deficit.

While the focus remains on the US dollar, it is worth pointing out that against other major currencies, including the euro, yen, and sterling, the rupee has strengthened, not weakened, this year (Shutterstock)

This is not to say India does not have buffers. The country’s services trade surplus has been improving, and there are early signs that remittances are also rising, especially from West Asia. Moreover, India’s foreign direct investment (FDI) inflows are robust; external debt is also manageable, despite global headwinds.

Still, in the past few weeks, as the rupee weakened — it closed at 79.90 against the dollar in Indian markets on Thursday but later breached the 80 mark in global markets — concerns have been expressed about India’s external balance sheet, and its ability to defend the rupee and avoid negative spillovers in an already complicated bout of inflation. What’s behind the recent currency volatility?

First, developing economies, including India, are experiencing shocks from the conflict in Europe, which has led to an unprecedented surge in food, fertilisers, and fuel prices. This has put pressure on inflation and the import bill. At the same time, the tightening in global monetary conditions is causing some portfolio flows to reverse, but that is a cyclical factor. In the past, India has dealt with portfolio outflows comprehensively; the same is happening now.

In the past two years, the Reserve Bank of India (RBI) has built large external buffers (foreign reserves) to tackle such scenarios. In a recent study, RBI showed that the reserves are adequate to deal with these outflows, and its actions have allowed for a stable adjustment in the value of the rupee through a period of high uncertainty. While the focus remains on the US dollar, it is worth pointing out that against other major currencies, including the euro, yen, and sterling, the rupee has strengthened, not weakened, this year.

Furthermore, India’s foreign reserves are still close to $600 billion, and while some reversals have been seen, the rupee has weakened by around 7% in 2022. In the past, when we had even smaller reversals, such as in 2013 when India was classified as one of the “Fragile Five,” the rupee weakened dramatically, which is not the case now. We need to acknowledge that even though global headwinds have intensified, India is better equipped to deal with it. However, policy needs to be nimble to control some of these external shocks.

Two questions arise.

First, when will the rupee stabilise? And, where will it eventually settle? For the first question, we need to acknowledge that as an emerging economy with limited means to tackle global shocks, we need to allow gradual adjustments of policy levers, while not losing sight of their policy commitments. In the near-term, RBI appears steadfast in providing liquidity and ensuring that there is no sharp fall in the value of the rupee. In addition, the government has increased several taxes, and is trying to manage the current account through targeted measures to contain the deficit.

But, over time, if global commodity prices remain high, India needs to contend with the prospect of a more significant current account deficit. This would mean that other macro variables must adjust to this new global reality. Hence, we need to prepare for an extended period of uncertainty, which may result in a cheaper, but also weaker rupee, since it takes time for demand to cool off and reflect in the current account balance. From a policy perspective, we can try to think about areas where imports can be reduced. However, since the bulk of the increase in trade deficit comes from energy, fertiliser and food prices, we cannot suddenly stop these imports since they are critical for growth recovery.

On the value itself, foreign exchange markets are prone to overshoot, but even if they do so, they will correct in the near-term. Hence, any sensationalism around exchange rates and big figures is unwarranted. In the medium-term, India’s attractiveness as an investment destination has increased in the past decade. This is evident looking at data on FDI inflows, the relocation of global supply chains, and India’s greater standing in the global community. Over time, this will reflect in all macro indicators, including the rupee.

Rahul Bajoria is managing director and chief India economist at BarclaysThe views expressed are personal