The Indian rupee is at its weakest since January 2017, and will probably keep falling

The rupee is in free-fall. And things will likely get worse before they get better.

The Indian currency closed at 68.11 to the US dollar on May 15th, following an uncertain result in the Karnataka elections. This marks a 6.7% depreciation against the US dollar since the start of the year, making the Indian rupee the worst performing Asian currency in 2018, followed by the Philippine peso - which has depreciated by 4.5% so far this year.

More importantly, this is the lowest level that the currency has dropped to since January 24th 2017, when it breached the 68 mark to close at 68.17. The currency performed well in 2017, gaining 6% to end the year at 63.85 amid a surge in capital inflows.

Winners and losers

In the short term, Indian consumers will directly feel the impact of a declining rupee as imports become more expensive. Higher import prices mean that imported raw materials will be more expensive, which in turn could mean higher inflation. In addition, Indian companies which have debts overseas or those that are required to make payments in dollars will also feel the strain. The Indian government’s current account deficit, which measures the value of exports against the value of imports, will widen, thereby hurting its finances.

There will be some winners, however. Companies that are paid in dollars like IT firms will experience a boost in revenues, while exporters will benefit from higher demand for their products. Even remittances, which India gets a lot of, will look bigger.

But why is the currency depreciating?

Barring the hung result of the state elections in Karnataka, the rupee is falling for a number of reasons - all of which are interlinked. Oil prices, which are measured in dollar terms, have risen consistently this year, adding to inflation as well as India’s bill for oil imports. The latter, in turn, is increasing the current account deficit even further.

A higher current account deficit means that the government has to try and plug the gap with its foreign exchange reserves. As its foreign reserves are deployed or dollars are bought to reduce the deficit, the rupee weakens.

A higher current account deficit also reduces investor confidence. Foreign portfolio investors have stopped making purchases of rupees and Indian bonds and equities, choosing to withdraw to safer havens like the US. Net outflows hit nearly ₹156 billion last month, a 16-month high.

Confidence in the economy is, in essence, a self-fulfilling prophecy. Foreign and domestic investors, people and companies alike, are expecting the rupee to fall, so they buy dollars instead - which makes the relative value of the rupee against the dollar fall.

Why it could get worse

Firstly, oil prices are expected to keep increasing, following the US’s recent decision to impose sanctions on Iran, the third-largest producer in the OPEC, which could curtail its oil exports. Russia and OPEC countries like Saudi Arabia have also decided to curb production till the end of 2018, which has led to higher prices. Additionally, output from another prominent global supplier, Venezuela, has been declining amid a political crisis.

Secondly, as the US is expected to raise its interest rates at least two more times in the remainder of the year, more assets will flow back from emerging markets like India to the US, where they are a guaranteed a higher return than before. In fact, the reason the rupee did so well in 2017 is because interest rates in the US and Europe were low, hence, a lot of cheap credit came flowing to India, where expected returns were higher.

In addition, since national elections are slated for next year, foreign entities will be cautious about investing in the country. The election of an incumbent can mean the continuation of the same economic policies but an unfavourable result can jeopardise an investment. So inflows are expected to decline until investors know what to expect from the next government.

Finally, if India’s GDP growth in the next few quarters proves to be subpar, it could hurt business and investor confidence even further - leading to more outflows.

What is the government going to do?

The Reserve Bank of India (RBI) has a sizeable pile of foreign exchange reserves, which reached $418.9 billion at the end of the first week in May. It can always intervene to arrest the decline in the value of the rupee by selling dollars and buying rupees. In fact, it is expected to purchase ₹100 billion of rupee-denominated bonds on May 17th.

As the short-term trajectory of India’s economy looks less uncertain and more dire, the central bank’s monetary policy committee can also raise interest rates. Inflation is on an upswing, reaching 4.58% in April, and crude oil prices are nearing the $80/barrel mark. As a result, the RBI could be tempted to increase interest rates to rein in inflation, which can increase the yields on Indian bonds and make the interest rate differential between the US and India higher.

However, it will likely stay the course until the effects of the monsoon play out. The central bank will not increase rates following a period of subdued economic growth, which could very well be the case if rainfall is lower than expected.