What’s ailing the rupee this year and what lies ahead

Slicing India’s current account into its components reveals its structural vulnerabilities. One, the rupee is starkly exposed to international crude oil prices. Oil imports account for around 30% of India’s goods import bill, and have been at that level over the last decade. The conflict in West Asia and a recent upgrade in global oil demand have increased the upside risk for oil prices. Two, while dollar earnings from software and business services since 2021-22 have been enough to cover oil imports, a 2.7% fall in services exports in September 2023—the first contraction in 2023-24—puts this cushion at risk (data for October is provisional). Finally, 18 of India’s top 20 export partners are predicted to slow down in 2023 and 2024. The resulting loss in import demand could threaten goods exports from India. Each of these outcomes—with the potential to worsen the current account deficit—weigh on the exchange rate.

Policy doubts

Market expectations and Fedspeak have not aligned well after the interest rate pause. Federal Reserve officials have warned against assuming that the pause signals the end of the monetary tightening cycle. Yet, in the days after the Fed decision, expectations of lower rates have only become stronger. stronger. The pattern of downward shift in futures rates reflects the view that central banks have finished hiking, and will start cutting rates by mid-2024.

But there is no guarantee to that. Robust economic growth in the US does not justify rate cuts, and its $1.7-trillion (and rising) budget deficit will probably make it harder to sell Treasury bonds at low yields. In contrast, the cooling job market supports an easing in interest rates. Therefore, there is uncertainty about the direction and timing of rate cuts, which imperils emerging market currencies. International capital is likely to remain risk-off and invested in safer and high-coupon US debt rather than shift to markets such as India.

Pre-election jitters

The rupee has depreciated before each of the past three general elections. If this trend is maintained, then some weakening of the exchange rate is likely in the months leading up to Lok Sabha elections in April-May 2024. Elections create an environment of uncertainty. Perceived risks include the formation of an unstable coalition government, existing policies being discontinued or even overturned, and excessive pre-election expenditure to woo voters that could worsen the fiscal deficit. Investors react to political uncertainty by becoming cautious. Capital investment may be postponed until a favourable administration is elected and in office.

Assembly elections in five states have already started the season of freebies and pre-poll promises. Some of these, such as handouts and subsidies, boost consumption in the short run, but may be fiscally irresponsible, especially for states that are close to breaching their fiscal deficit limits.

Dollar returns

The rupee faced a double whammy last year: trade deficit soared after the pandemic, and dollar inflows dwindled with rising US interest rates. Foreign inflows remain volatile this year too, for which, ironically, the rupee’s depreciation is at least partly responsible. On top of the 10.8% fall in 2022, the rupee has depreciated by 0.7% in 2023 so far. A weaker rupee reduces dollar returns to foreign investors: some of the recent sell-offs by foreign portfolio investors in equities could be attributed to relatively poor returns on the dollex.

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The inclusion of India into the JP Morgan Government Bond Index for Emerging Markets from mid-2024 is expected to boost debt markets as well as the rupee. But until then, the spread between 10-year US and Indian treasuries, now at 2.7%, may not be attractive enough for foreign investors given the steady weakening of the rupee.