What Is Weakening The Rupee?

The US dollar has weakened since July 2024 with the DXY—the US Dollar Index that tracks the strength of the dollar against a basket of major currencies—now in the Rs 102-103 handle versus Rs 105-106 previously.

Despite this, the rupee has depreciated against the dollar, moving closer to the Rs 84-mark, led by depreciation pressures on the Chinese Yuan and more recently the Yen carry trade unwind.

RBI's two-way intervention has played a key role in limiting volatility in the USD-INR. The central bank's intervention has also focused on limiting overvaluation of the rupee (on the REER metric).

The relative stability of the rupee against the dollar masks the fact that on the REER metric against 40 trading partners, the rupee appreciated by 2.9% in 2024 (till June). This has resulted in the overvaluation of the rupee to 6.5% as of June 2024.

To limit the overvaluation of the rupee, RBI net sold dollars in the spot market in July 2024. This was subsequently followed by RBI net selling dollars in the spot market in August, to limit depreciation pressure on the rupee post the Yen carry trade unwind. We estimate a net dollar sale of $8.5 billion in the first nine days of August, based on reserve money data.

The RBI's intervention in FY25 till date also indicates that the balance of payments surplus has reduced. RBI net sold dollars worth $4.9 billion in FYTD25 (April-August 9) versus net dollar purchase of $19.2 billion in FYTD24 (April-August).

The reduction in balance of payments surplus is another factor, which has maintained depreciation pressure on the rupee. The reduction in surplus is led by a rise in trade deficit and slowdown in FPI inflows.

Merchandise trade deficit has widened to $85.6 billion in FYTD25 (April-July) versus deficit of $75 billion in FYTD24 (April-July). The rise in trade deficit reflects rise in crude oil prices and relatively stronger domestic demand conditions.

Crude oil imports are higher by 22%YoY in FYTD25, led by a rise in crude prices as well as lower discounts on imports from Russia. Based on two months of data in FY25, the imputed cost of crude oil from Russia is $84 per barrel, which is only marginally lower than the Indian crude basket average of $86.5 per barrel in April-May.

Slowdown in FPI inflows is another factor behind the reduction in balance of payments surplus. Net FPI inflows are tracking at $7.4 billion in FYTD25 (April-July) versus $20.2 billion net inflows in FYTD24, due to a sharp slowdown in equity inflows.

On the positive front, there are nascent signs of pick-up in more stable FDI inflows in the first two months of FY25. In FY24, there was a sharp decline in FDI inflows to $9.8 billion from $28 billion inflows in FY23. The decline in net FDI inflows in FY24 was due to jump in repatriation (55% rise), while gross FDI inflows were broadly stable.

Looking ahead, we expect the USD-INR to stabilise around 84-84.50 by March 2025. The factors, which will stabilize the rupee are a rise in balance of payments surplus and more than adequate forex reserves. The balance of payments surplus is expected to rise in the second half of FY25, supported by India’s inclusion into JP Morgan EM Bond Index, which has started from June-end 2024 and will be spread over 10 months.

The index inclusion has supported FPI inflows into central government bonds. Majority of the inflows will come in H2FY25. In fact, there has been front-loading of FPI inflows into G-Secs since the announcement of India’s inclusion into the bond index in Sept. 2023.

Other capital inflows such as FDI and ECB are also expected to pick up once the Fed rate cut cycle starts. Inflation pressures in the US are easing with the labour market in better balance. The Fed rate cut cycle is expected to start from Sept. 2024.

Finally, the most important factor will be the RBI intervention, which will continue to focus on limiting the USD-INR volatility and the rupee's overvaluation (on the REER metric). Forex reserves are adequate to support the RBI intervention, with import cover of more than 11-month months (spot FX reserves plus forward book).

RBI is expected to soak up the bond index inclusion related FPI inflows as these flows tend to be volatile.

Gaura Sen Gupta is chief economist at IDFC First Bank.

The views expressed here are those of the author, and do not necessarily represent the views of NDTV Profit or its editorial team.