The crash of the Indian rupee against the US dollar, an all-time low of 86.71, has surprised many. This is because until recently, the Reserve Bank of India (RBI) was hailed for dextrously managing financial stability, and maintaining a resilient financial system and robust macro-economic balance.
But now, the sentiment is turning less sanguine. The rupee has depreciated over 3.2% since September 2024 and more is in the offing. And it entwines with the Indian stock markets (NSE) losing Rs 60 trillion or 12.6% market cap since the end of September 2024. The conviction on Indian markets being insular to the vagaries of global impulses has waned.
What’s in store is rooted to both structural and cyclical factors chained to global and domestic impulses. The RBI tried to suppress it with an overtly interventionist currency intervention. But, as it unwinds in the face of renewed dollar rebound, the pace of depreciation could be higher than historical averages.
Our multi-dimensional framework, including models for the US dollar index and INR-USD indicate that the dollar can depreciate to 90-92 levels in the next six to 12 months; the bias is towards a higher and quicker depreciation.
From long-term perspective, the performance of the INR/USD is pro-cyclical, appreciating during cyclical up-turn (for example, 18% during 2002-2009) and depreciating during downturns. Indexed to 2008, the INR-USD has depreciated (90%) more than other currencies (38% dollar emerging markets index, and 21% AE dollar indices) because of the narrowing growth differential versus global.
A mercantilist approach
Trends since 1993 show structural depreciation during the downcycle rising to 7% YoY (year over year) with one standard deviation ordaining a range of 13% and 1%. However, since October 2022, the trend depreciation has mellowed to 4% and an annualised average depreciation of 0.5%, contributed by the suppression of volatility resulting from aggressive interventions by the RBI following the Ukraine-Russia war.
Also read: RBI Is Buffering Against Impending Volatility, Rate Easing Can Wait
Our currency inflexibility measure shows that while at 0.38, the Chinese Yuan is increasingly getting flexible, INR close to ~1 is mimicking a peg [0 represents a fully flexible currency and 1 represents currency peg].
This mercantilist approach is contrary to RBI’s de-jure position that the rupee is a managed float, with interventions utilised only for the purpose of managing large volatility. Since October 2024, RBI’s foreign currency assets (FCA) declined by US $ 47 billion, leading to a drain of Rs 4 trillion of domestic liquidity drain. This in turn led to a deficit liquidity situation notwithstanding the 50-basis point cash reserve ratio cuts and collateralised lending against government securities by RBI.
But this position is becoming untenable as the rapid strengthening of dollar is accentuating the misalignment. An aggressive rundown of forex reserves may reduce RBI’s ability to control markets, leading to speculative currency attacks.
‘Growth’ story
On the domestic front, the discord between the perceived growth and actual situation is converging with the successive downscaling of growth projections by RBI and the Central Statistical Office from 7.2% to the latest 6.4%. The shift in narrative has manifested from the vocal concerns from Indian corporates over the shrinking middle class, and the inability to associate with the official claims of robust growth.
But earlier, demand slackness manifested in prolonged weakness in rural demand, even as the truncated post-pandemic rebound in urban demand and leveraged consumption camouflaged persistent household fragility. Receding productivity at the broader level is demonstrated in rising ruralisation, increased dependence of workers on agriculture, contracting real income per worker, declining value addition in the unorganised sector and eroding household savings. These glaring symptoms were overlooked in the official and consensus assessments. Thus, any downside surprises can expose the rupee to greater vulnerability.
The 10% resurge in the US dollar index since September 2024 aligns with the US economy emerging stronger than expected, forcing the US Fed to scale back two out the guided four rate cuts in 2025. With Trump 2.0, the impact of his expansionary impact of corporate tax cuts and tariff hikes could be elevated inflation and the US Feds remaining hawkish.
What has bolstered the US dollar valuation matrix is the widening growth divergences with eurozone that continues to face persistent economic challenges.
Further, China has been running down its dollar reserves while also adopting greater currency flexibility to counter slowdown and the prospective impact of Trump 2.0 mercantilism. This will have a bearing on the dollar emerging markets (EM) index. And the added sliver is the surging geo-political risks inducing increased global policy uncertainty.
An investment plan
As these global and domestic impulses pan out, the capital flows into EMs and India, including portfolio flows, FDI and external commercial borrowings, can see increased volatility. A modest 8.3% YoY return from the benchmark India equity indices, Nifty, and Sensex, is significantly lower than 26% from US S&P 500. And with a 3% INR/USD depreciation, the underperformance is starker. Pervasive demand weakness and margin pressure forebode further moderation even for the coming years. Consensus Nifty earnings-per-share growth for FY25-FY27 is placed at 11% compound annual growth rate. These compared weaker than the projected earnings for US S&P 500. A relatively lower price/earnings to growth ratio for the US markets may continue to impact foreign institutional investor flows.
How RBI and the government respond to the impending rupee weakening will demonstrate the expanse of policy options. To us it appears limited as the landscape, including monetary policy, fiscal headroom, peak credit-deposit ratio of banks, rising retail defaults and languid private capex, is muddled with multiple constraints. The RBI’s currency inflexibility may have been motivated by the desire to sustain a façade of macro-financial robustness, but it has constricted growth.
Thus, it will be imperative for the RBI to let go of currency inflexibility, and allow greater depreciation, thereby limiting liquidity tightness and ease the pressure on the economy. The attempts to limit the imbalances in the banking system, to contain reckless retail lending, can be hastened. As the real policy rate differential of India versus the US Fed rate is negative, the RBI’s window to ease policy rate is narrow. This is specially so as the US Fed has rolled back two out of four cuts guided earlier for 2025; in fact, there are chances that the US rate cut cycle can just halt. In any case, given the structural underpinnings, monetary easing by the RBI will largely be futile from the growth standpoint.
Given the rising traction in NRI deposits, in response to outward migration and easing of statutory requirement on NRI deposits, there is a high possibility of falling back on an NRI deposit scheme of the type mobilised in the aftermath of the Taper Tantrum in 2013.
Dhananjay Sinha is co-head of Equities and head of Research of Strategy and Economics at Systematix Group.
