India’s forex reserves down USD 100 bn fighting global headwinds

RBI may need to go forlarger rate hikes to bring stability to the INR

The double whammy of persistent geopolitical conflicts and aggressive policy tightening by the US Federal Reserve has rattled the currency markets across the globe. To recall, the US Federal Reserve has raised interest rates by 75 bps for the third consecutive time (cumulative 300 bps between Mar-Sep’22) taking the policy rate to 3.0-3.25% with a view to combat the 40-year high inflation and tighten the labour market that is causing a wage-price spiral. The forecast from the dot-plot is also much more hawkish in Sep-22 that showed a 4.4% median Fed Funds rate by Dec-22 (3.4% in Jun-22) and a terminal Fed Funds rate of 4.6% next year (3.8% in Jun-22), higher than the current market expectations. The persistent rate hikes by the US Fed have triggered the safe haven demand for the greenback, causing steep depreciation in most other currencies including the INR.

A combination of high inflation, geopolitical instability and the consequent risk-off sentiments have driven the demand for the world’s primary reserve currency significantly higher. As such, the dollar index has appreciated by nearly 15% since the start of FY23, to a 20-year high level. Given the Fed’s focus on taming price pressures, it is likely to keep its monetary policy extremely tight for an extended period of time, which may cause the US dollar to appreciate further. 

Chart 1: Rise in interest rate increases the USD appeal

Both EM and DM currencies have been facing pressures from continued dollar strength with hard currencies such as EUR (-13.2%), GBP (-18.2%) and Yen (-18.2%) depreciating at a much faster pace in FY23 vs the INR so far. Before Fed’s recent policy outcome on 21st Sep-22, INR had outperformed many of its peers, however, in just a span of a week, the INR has depreciated by 2.4% (currently at 81.85 against the USD) making it one of the worst performing EM currencies. Nevertheless, overall INR depreciation (-7.6%) in FY23 so far has remained in single digits as compared to other EM currencies such as KRW (-16.9%), PHP (-14.3%), THB (-13.3%), and CNY (-12.8%) amidst significant RBI intervention in the currency market.  

Chart 2: INR’s resilient performance so far as compared to its peers

The RBI has so far shielded the rupee from runaway depreciation by drawing on its foreign currency reserves as a much faster clip than the 2013 taper tantrum episode. Compared to 2013 where the forex reserves declined by USD 22 bn between Apr-Sep-13, the RBI’s total FX reserves has dwindled by almost around USD 100 bn from the peak of USD 642 bn in Oct-21 to a two-year low of USD 545 bn as on 16th Sep-22. Although a larger pool of reserves this time would continue to provide the first line of defence against excessive volatility in INR, the overall import cover is slowly moderating (from its peak of over 19-months of in early 2021 to nearly 9 months currently). With global economic environment becoming increasingly choppy for the EM currencies, the RBI is unlikely to stop intervening in currency markets. However, it may dial down the speed of the drawdown of its reserves and allow the rupee to adjust to market realities, albeit in an orderly fashion.

Chart 3: RBI intervention moderates its reserves position

While the dollar supportive environment continues to power ahead on the global front, pressures have intensified on India’s Balance of Payments (BoP) and Current Account Deficit (CAD) on the other hand. Cumulative trade data for the first five months (Apr-Aug) of FY23 shows a significant expansion of the merchandise deficit to USD 124.5 bn vs. USD 53.8 bn seen in the corresponding period in FY22. The monthly trade deficit prints may however, moderate in the coming months as impact of somewhat lower commodity prices (with CRB Index down ~10% since its Jun-22 peak) trickle down and global supply chain pressures ease. Further, the government could also consider easing some of the administrative restrictions imposed on exports this year amidst buildup of the pressure on the INR.

While the strain on the BoP persists, we expect the size of the current account deficit to sequentially moderate in H2 FY23 vs H1 FY23 as: 

·    Prospects of a global hard landing coupled with Zero Covid policy in China would keep a lid on commodity prices.

·  Portfolio flows seem to have turned somewhat neutral after consistent FII sell down over Q3 FY22 and Q1 FY23.

·    Recently announced macroprudential measures by the RBI to augment capital inflows in the near term could offer mild reprieve.

·  Likelihood of India’s inclusion in global bond indices in Apr-23 could attract some positioning related debt flows (though anticipated quantum of USD 25-30 bn passive inflow from such a move would happen later over FY24-FY25).

While this could help in moderating the pressure on BoP deficit in the coming quarters, INR could continue to carry a depreciation bias as (i) exchange rate adjustment would be a natural stabilizer for any deterioration in the current account deficit, and (ii) excessive use of reserves to curb depreciation pressures amidst the backdrop of broad-based dollar strength would increase INR’s real effective overvaluation vis-à-vis peers.

Says Suman Chowdhury, Chief Analytical Officer, Acuité Ratings & Research “RBI’s monetary policy actions will continue to be primarily driven by the inflation trajectory but the stability on the external front is also likely to be an important consideration in the current context. Although the absolute level of forex reserves continues to be a comfort, the drawdown of ~USD100 bn over the last one year has been unprecedented. The central bank may opt for additional rate hikes in Dec’22 and beyond in case global monetary tightening continues unabated. With USD-INR having breached our earlier target of 81, there is a likelihood of a moderate depreciation in the short term from the current levels but once the tightening pauses, a partial reversal is expected by Mar’23.” 

Chart 4: India’s REER remained overvalued at 103.9 in Aug-22