Is The Rupee Set For Prolonged Weakness?

The Indian rupee fell to a near six-month low this week, dropping below 75 against the U.S. dollar. The move reflected a perfect storm of factors—higher oil, a stronger dollar, higher U.S. bond yields, which could collectively mean that the rupee remains weak in the near term, said analysts.

The rupee will inch towards 75.50 and may even touch 76 against the dollar briefly, given the current scenario, said Imran Kazi, vice president at Mecklai Financial. The stream of big-ticket IPOs had allowed the rupee to remain strong relative to Asia peers over the past few months. However, the currency has "finally given in, with the negative factors intensifying", Kazi said.

The rupee, which has been the worst-performing Asian currency so far this month, may slip a bit further towards 75.50 a dollar, said Madhavi Arora, lead economist at Emkay Global.

Kotak Securities has a similar view. The rupee can trade within a range of 74.80-75.40, according to Anindya Banerjee, deputy vice president for currency derivatives and interest rate derivatives at Kotak Securities.

A key factor behind the rupee's weakness is the steady rise in oil prices.

Brent crude prices exceeded $80 per barrel on Oct. 4, 2021 and have since remained close to those levels. Given India's dependence on imported oil, higher crude prices mean trade and current account deficits.

While most emerging market currencies have taken a hit, the rupee has underperformed more than peers because of higher oil import dependence, Arora said.

As a rule of thumb, every $10 per barrel increase in crude prices leads to an additional $12.5 billion deficit, which is roughly 43 basis points of India’s GDP, according to an estimate by the RBI in 2019.

In 2018, faced with higher oil prices, the Indian rupee depreciated from 63.5 per dollar at the start of the year to 74 per dollar by October as crude prices moved from $65 per barrel to $85 per barrel. To be sure, other macroeconomic conditions also have a bearing on the currency.

Alongside higher oil prices, strength in the U.S. dollar is weighing on emerging market currencies.

The Dollar Index, which measures the value of the greenback against a basket of currencies, rose to 94.4 this week. It has gained over 5% since the start of the year. One factor behind this is the rise in U.S. bond yields, which can narrow the interest rate differential with emerging markets and make emerging-market assets less attractive for investors.

"Global uncertainty and fading growth momentum are the factors behind the dollar's strength. Stronger yields are also helping the dollar gain," Arora said. She added that in the short term, concerns around the U.S. hitting the debt ceiling are also keeping markets on edge.

Inflows and carry trades almost help determine the short-term direction of the rupee.

Foreign portfolio investors have invested a net Rs 67,695 crore in Indian equities so far this year. While inflows into debt were tepid earlier this year, a pick-up in carry trades brought in a net investment of Rs 24,948 crore in August and September.

The carry-trade positions had been building for some time and are also likely to have pushed the rupee lower on Wednesday, said Banerjee. Carry traders were forced to cover short positions once the rupee broke below 74.65 levels, creating a domino effect, he explained.

Every time there is a short covering-led rise in the rupee, it usually doesn't last for more than a day depending on the global risk aversion, he said. However, this time, a combination of high energy prices and the strengthening dollar index have meant extended weakness.

The RBI has been buying dollars in the forwards market for much of this year to keep the rupee from appreciating sharply. Intervention in the forwards market as opposed to the spot market prevents a large addition of local liquidity to an already surplus markets. As of July, the latest data available, the RBI had a outstanding position of $49 billion in the forwards market.

The upcoming Monetary Policy Committee meet on Friday may spell more volatility for the rupee.

If the RBI signals a slightly hawkish stance or suggests a winding down of excess liquidity accommodation, this will also have a likely bearing on the rupee, Banerjee said. Any such indication can add to the weakness in the rupee, said Kazi, adding that the U.S. non-farm payroll data is also important.

While the RBI will intervene, it is not likely to do so aggressively, Banerjee said. The rupee has barely seen any volatility in the past year and if it does depreciate in the medium term, it will help the RBI wind down its own forward book at a profit, he said.

The RBI is likely to intervene aggressively only if the rupee falls to 76 a dollar as this could add to inflation fears, Banerjee said. "Till then, the rupee is likely to be on a relatively free run."