Indian Rupee: Where Next After Hitting A Record Low?

The Indian rupee fell to a record closing low of 76.97 against the U.S. dollar on Monday, weakened by soaring oil prices and a stronger dollar amid the Russia-Ukraine war.

A protracted conflict will mean that near-term pressure on the Indian currency will continue as oil prices could stay elevated, said analysts and economists. In the medium term, however, should oil prices ease, the Indian currency could recover, they said.

The higher oil prices are likely to push up India's current account deficit to near 3% of the GDP in FY23. In addition, foreign portfolio outflows, which added up to Rs 92,731 crore so far this calendar year, could also put pressure on India's balance of payments.

The risk of sharp weakness in the rupee remains elevated in the short-term, said Divya Devesh, head of ASEAN and South Asia forex research at Standard Chartered. Much of rupee's recent weakness can be explained by a combination of equity outflows, the euro's weakness and a higher risk premium, she said.

The rupee has fallen more than 5% in a month only nine times over the past two decades, Devesh said. In six of these instances, oil prices were above $100-a-barrel mark, while the other three were during the global financial crisis and the pandemic outbreak, she added.

As such, if crude oil prices were to sustain at above $100 per barrel, which Devesh expects, the rupee could underperform. Standard Chartered sees the rupee average 77.50 against the dollar in the October-December quarter.

Madan Sabnavis, chief economist at Bank of Baroda, expects the rupee to remain in the region of 77-78 against the dollar up to the July-September quarter, and strengthen to 75.5-76.5 in the three months after that. Assuming that the war ends by March-end, the global economy is expected to take a quarter to recover, which will keep the rupee low till June before there is a rebound, Sabnavis explained.

According to data from ICRA, the Indian rupee is the third worst performer in Asia after the Russian ruble and the Turkish lira. This could continue, said Aditi Nayar, chief India economist at ICRA. The rating agency sees the rupee trade between 76-79 against the dollar.

"While Asia is a net commodity importer, India's reliance on oil imports is relatively high and the RBI's interventions are expected to be limited to smoothening volatility," Nayar said. India imports 85% of its oil needs.

Not everyone sees the rupee weakness persist.

The risk of a flare-up in oil, and hence a fall in the rupee, is more short term than long term, said Anindya Banerjee, vice president for currency derivatives and interest rate derivatives at Kotak Securities. Banerjee sees pressure persist between March and April but expects it to ease once the conflict winds down.

"For the rest of the calendar year, we expect oil prices to drift lower as a compromise is struck over Ukraine and Iranian oil hits the market," Banerjee said. That will allow the rupee to reverse course and strengthen. Kotak Securities sees the rupee average 76.50 against the dollar between April-June 2022, before strengthening to average 75.5 in the July-September quarter.

Since the rupee is weakening in line with other emerging currencies, the real effective exchange rate may remain steady. This trade-weighted rate against a basket of 40 currencies measures the competitiveness of the Indian unit.

The real effective exchange rate has barely budged in this recent upmove in crude oil prices, Devesh said. "The terms of trade deterioration hasn’t led to a meaningful trade-weighted depreciation in the rupee."

RBI intervention has kept the rupee more or less a median performer over the last many months, Banerjee said.

Over the medium term, will the expectation of a steady depreciation in the rupee shift due to a change in the inflation balance? Theoretically, the inflation differential between a developed economy like the U.S. and a developing economy like India is a key factor driving depreciation in a currency.

Post the Covid-19 crisis, however, developed markets have seen a surge in inflation while India has seen more range-bound price pressures due to its new inflation targeting framework.

"The premise always was that inflation in India is higher than the U.S. and that the inflation differential is one reason the rupee will remain a depreciating currency. That differential has now come down," Nayar said.

DK Joshi, chief economist at Crisil, however, said this change in dynamics is transitory. "Central banks in advanced economies, including the U.S., are trying to bring down inflation and even their framework mandates a lower inflation rate than India's. As such, the current dynamics are unlikely to play out in the mid-term," said Joshi, adding that the weakening bias on the Indian currency will hold.