RBI vs. Rupee Battle - Giant Leap Missing

Rupee’s relentless decline…
 
Indian Rupee has been witnessing a downward trend for the last few months and touching new lows. Pull out of foreign portfolio investors (FPIs) and widening trade deficit on the back of rising in oil, coal, and gold imports are the main reasons for this depreciation. High commodity imports are also a big culprit to bring the Indian forex market into this mess and there are increasing fears of a widening current account deficit beyond the targeted 3 percent (of GDP) mark by year-end.

..but more pain in sight

Has the rupee bottomed out? Not really. We believe the rupee may fall below 80 because of persistently high inflation in the US and a likelihood of continued and even higher rate hikes that would come in the coming months. Monetary policy tightening has been one of the prime reasons for FII money outflows from India. 
In response, RBI has come up with some baby steps to correct this decline. The latest of these is the settlement of international trade in Indian rupees. Why do we call them baby steps, we shall answer them later but let's first decode the latest guidelines  

RBI’s new guidelines 

RBI came up with a fresh set of guidelines this week to settle international trade in Indian rupees. As per this new mechanism, Indian exporters and importers can raise invoices, and settle transactions in the domestic currency. We believe this is being done to achieve three broad objectives. 

1. Ease of trade with sanctions-hit countries, especially Russia.

Due to the ongoing war, the West had placed restrictions on the use of dollars by Russian banks as well as the global financial system (SWIFT). The need to pay for high crude oil imports from Russia necessitated alternative payment mechanisms for India. FYI, India’s import of the cheaper Russian oil had surged to record highs and now accounts for 20 percent of India’s total oil imports. India’s imports from Russia stood at $2.5 billion each in April and May which translates to $30 billion annually. If Russia agrees, Indian firms can now settle these import bills in rupee and may end up saving a significant amount of dollars. For reference, RBI recently spent $40 billion to stabilize the Rupee and could spend another $40 billion in the coming weeks

2. Internationalize the Rupee -

Settlement in local currency if accepted by the counterparty can help increase the demand for the rupee and reduce the demand for the dollar

3. Take advantage of the forex reserves crisis in some countries like Sri Lanka and convince them to pay up in rupee





Will the new guidelines help arrest the Rupee decline?

We believe it is unlikely to help the rupee's currency value significantly because only a few countries may agree to trade in Rupee. These countries formed around 5 percent of India's trade basket in FY 2022. Moreover, the dollar continues to appreciate against major global currencies like Euro which is further putting downward pressure on the domestic currency.

Now let's come to the other baby steps 

RBI had off late announced a host of other measures to attract fresh foreign exchange inflows into India. Some of them include relaxation on regulations for non-resident deposits, increasing limits for foreign investments in Indian government and corporate debt, raising the ceiling for external commercial borrowings, and amendments in FCRA rules to allow more money to be transferred by NRIs to Indian relatives. Import duty on gold was also hiked this month to 15 percent to discourage dollar-denominated gold imports. 
 
Why baby steps?

We feel that these measures may not be significant enough to attract foreign flows and arrest the rupee's fall. Let's see why. 
Let's go back to history. If you think this is just a one-off situation that RBI has had to face and is therefore struggling to deal with it, it's not true. RBI has already seen such a situation before. 
 
The infamous taper tantrum

The infamous taper tantrum situation of 2013 is starkly similar to some of the recent developments and throws interesting learnings to help tide from this chaos. 

In 2013, US Fed conducted a quantitative tightening program after a significant economic boost was provided to tide over the 2008 financial crisis. 
This taper tantrum resulted in rate hikes and reductions in asset purchases, quite similar to now had caused widespread volatility in global markets and a sell-off in Indian markets. 
The Indian rupee depreciated by 18 percent in just 3 months in 2013 as FIIs pulled out money from emerging markets. 
Similar interventions like hiking interest rates, raising the import duty on gold, boosting flows from NRIs, and opening a separate swap window for oil importing companies were introduced back then. 

Quite a disturbing Deja Vu isn't it? But what happened then and how effective were these measures?

Increase in import duty on gold - 

Import duty on gold was raised thrice between June and September 2013, taking it from 6 percent to 15 percent. While this move had reduced gold imports, the large price differential significantly spiked smuggling. Hence hike in import duty may not see the desired effect as hoped by RBI. 

Flows from NRIs -

Through various measures, RBI was able to garner a large number of flows through NRI deposits back then. But this time RBI may not be able to achieve the same effect. The current interest rate differential on NRI deposits and similar assets in the foreign country is not attractive enough to attract more NRI inflows, particularly when US Fed is looking to hike rates further.
 
The Rupee is far from being truly global

While the latest guidelines could help streamline some of India’s bilateral agreements and attract some foreign flows back, a large-scale impact is unlikely. The dollar, Euro, and Pound are still the most preferred currencies. India is far away from making its currency truly international. Any step in that direction would require Rupee to become freely convertible. In other words, Rupee needs to be trusted by central banks worldwide and holders of the currency can freely convert it to any other currency at the prevailing exchange rate without any intervention. That's not the case right now. Despite China’s dominance in world trade, Remnibi is far away from becoming a major global currency. In such a case, India still has a very limited influence on the overall global trade.

Not to forget that internationalizing of currency comes with its associated risks of high exposure to global shocks, asset bubbles, and exchange rate volatility
 
The situation is under control but a giant leap seems unavoidable
 
Nevertheless, this is a step in the right direction and even if India manages to convert some of its import payments to the local currency, it will provide some breather. 
India’s current foreign exchange situation is not as precarious as in 2013. It still has a buffer of forex reserves equivalent to about 20 percent of its GDP or in other words equal to about 10 months of imports and is therefore resilient to handle any external shock.

That being said, all these steps are in the right direction and can help to reduce the volatility in the currency market. RBI however would still have to dip into its forex reserves to apply any significant brakes to this rupee weakening.
 
Disclaimer: This article is purely for educational purposes only