Since January, the rupee has declined by 7.8% against the American dollar, falling to its lowest conversion rate ever of 69.10 last week. In the same time, the Indian currency has dropped by 4.65% against the euro, 9.7% against the yen and 5.28% against the pound sterling.

Other emerging market currencies have slid in similar fashion. A proximate cause of the decline is heavy selling by Foreign Portfolio Investors, or FPIs, that have pulled over $19 billion out of major emerging markets between January and June.

In India, FPIs have sold Rs 4,693 crore of equity and Rs 41,397 crore of debt, adding up to net sales of Rs 46,090 crore, in the first six months of this year. Actually, they were net buyers between January and March. But since April, FPIs have sold in excess of Rs 59, 000 crore, the highest outflow ever from India.

Another reason for the weakening rupee is the rising trade deficit. India exported goods worth $303 billion in 2017-’18 but ran up an import bill of $459 billion. The trade deficit will worsen in 2018-’19 because of high oil prices. India enjoys a trade surplus in services and “invisibles”, such as tourism and remittances, but its current account, which represents the difference between net forex inflows and net outflows, is in deficit.

In 2017-’18, the current account deficit hit 1.9% of the Gross Domestic Product, up from 0.6% in the previous financial year. In absolute terms, the net outflows rose from $15 billion to $48 billion. Kotak Institutional Research did a sensitivity analysis. Assuming the Indian crude basket averages $67.50 per barrel in 2018-’19, it projects a current account deficit of 2.6%. The credit rating agency ICRA estimates a deficit of 2.4%, which is in the same ballpark.

If, as expected, crude prices move higher, the current account deficit may widen further: Kotak reckons a deficit of 2.9% at $72.50 per barrel and of 3.3% deficit at $80 per barrel. For the first quarter of 2018-’19, India’s crude basket has been running at an average of $72.80.

As the current account deficit widens, and currency weakens, it creates a natural barrier to imports as they become more expensive. It also makes exports more competitive.

India’s key imports, however, are energy commodities such as crude oil and gas. In fact, over 80% of crude and 30% of gas consumed by the country is imported. No matter how expensive crude may get – it was over $100 per barrel for three years to 2013-’14 – energy imports must continue. At the same time, a cheaper rupee may not help Indian exports gain competitive advantage as China, Vietnam, Bangladesh, Indonesia and the Asian Tigers have seen their currencies depreciate as well.

Controlling volatility

Nevertheless, the rupee should be allowed to weaken as it offers a chance to rebalance trade equations. An overvalued currency along with a high current account deficit is a terrible recipe. A strong rupee will increase the deficit since imports remain cheap. And when the market reacts to the imbalance, there could be a sudden currency collapse.

The Reserve Bank of India should focus on controlling volatility to make the rate of rupee’s decline steady and predictable, rather than sudden and jerky. But the government will want a stronger rupee since expensive energy imports equal higher inflation and that is a politically sensitive variable. Going by the experience of demonetisation, the RBI, which is theoretically an autonomous organisation, will do what the government wants, even if that is not a sensible course of action.

Could the rupee decline further and what can the government, or the RBI, do about it?

Most traders use what is known as the “covered interest arbitrage” calculation to judge if a currency is worth buying. It goes like this:

  • Convert the dollars into rupees at the current rate.
  • Invest in rupee debt instruments that yield safe returns such as a 364-day Treasury Bill.
  • Calculate how many rupees you will have at maturity.
  • Take a forward contract to convert the rupees into dollars.
  • Compare the dollar returns from this investment to the returns from dollar debt instruments such as Treasuries.

Note that these are guaranteed returns and the calculation is based on data that is publicly available. Of course, traders also invest in more risky debt and equity but this is a basic calculation. If there is a surplus return visible, traders will buy rupees until one, or more, of several things happens. Rupee interest rates may change. Dollar interest rates may change. The forward rate could change, wiping out yield differentials. In effect, this means the currency exchange rates are going to change.

As of now, the United States Federal Reserve is expected to raise interest rates. The RBI is expected to do the same. US government debt is yielding roughly 3% and it will rise. Rupee Treasury Bill yields are at just below 8%. The differential between dollar and rupee yields has narrowed compared to six months ago. The forward rate has changed, implying more rupee depreciation. So traders are cautious about investing in rupee assets.

Overvalued rupee

The RBI’s own calculations suggest the rupee is overvalued. The RBI evaluates currency levels with a tool called the REER, or Real Effective Exchange Rate. REER compares the purchasing power of the rupee to a basket of foreign currencies, weighted by India’s trade ratios with those nations. It also adjusts nominal exchange rates by relative inflation rates in those countries. The RBI makes REER calculations for two baskets of 36 currencies and six currencies. Currently, both baskets indicate overvaluation.

The rupee’s trading characteristics are that of a “dirty float”. It is heavily traded but not freely convertible, and the RBI can intervene easily in the forex market as well as impose currency controls. The RBI can also ask commercial banks to offer good terms for interest-bearing forex accounts from the overseas Indian community. Raghuram Rajan, as RBI governor, did this in late 2013. The RBI set up a swap, asking banks to open forex deposits and guaranteeing that the central bank would bear the exchange rate risk. This built a war chest.

As of now, the RBI has forex reserves of $415 billion. That is good for about 10-11 month of imports and amounts to about 18% of the GDP. On the surface, comfortable. However, India’s cumulative FPI exposure is about $190 billion. That money could, in theory, exit very quickly.

There are also multiple overseas debt commitments, with the total external debt amounting to $529 billion by the end of March, 2018. About 42% of it, or about $222 billion, matures w within the next 12 months – and that’s over 50% of the reserves. Since these loans must be serviced, the reserves are not as ample as they seem at first sight.

India’s reserves fell from $423 billion on April 20 to $415 billion on May 18. The $8 billion drop was, at least, partially, triggered by the RBI selling dollar on the open market to prop up the rupee. In 1997, Thailand, then an economy of about $180 billion, blew up its reserves of $40 billion (over 22% of the GDP), unsuccessfully defending the baht. The Thai economy contracted to about $120 billion as the baht collapsed. It is a cautionary tale about what can happen if policymakers panic.

The conventional way to defend a currency is to raise interest rates and increase returns. Of course, higher rates also slow down economic activity. But given a weak currency and rising inflation, raising interest rates may be necessary anyway. Indeed, its last Monetary Policy review indicated the RBI will hike the rates.

In the long term, improving economic efficiency – ease of doing business by reducing red tape, creating better infrastructure and simpler tax systems, maintaining law and order – and, thereby, accelerating the growth rate is the best way to defend any currency.

Of course, there is an election in the short term.