India’s exchange rate has been hammered for the better part of this year and the rupee has been sinking to new lows. At roughly 78.20 to a dollar on June 13, another record low, the currency is 5 percent down since January.
The root cause of the rupee’s distress can be found in elevated oil prices, as India meets almost 85 percent of its fuel needs through imports. The country’s crude oil basket price has risen to a decadal high to top $120 a barrel now.
Elevated oil prices aren't the only enemy. Here are the four factors that are working against the rupee:
1: Foreign fund outflows
The incessant dollar outflows from Indian equity and bond markets have kept the rupee under pressure in 2022. Depending on the intensity of the global risk-off sentiment, foreign institutional investors (FII) have pulled out more dollars every day from the domestic market. Since January, the outflow amounts to a whopping $24 billion.
The weak sentiment is reflected in the sharp fall in benchmark equity indices as well. Both the Nifty and the 30-share BSE Sensex have dropped more than 10 percent since January. If the current momentum of dollar outflows continues, the exchange rate is likely to breach new lows, according to dealers.
2: The Fed’s rate hike worries
In response to the unprecedented retail inflation in the US, the Federal Reserve is expected to hike its policy rates fast and furious in the coming months. Markets are now factoring in a 75 basis point hike at the Federal Reserve meeting later this week. One basis point is one hundredth of a percentage point.
Larger rate hikes by the Fed would increase the return on dollar assets compared with those of emerging markets such as India. The Reserve Bank of India (RBI), too, is on a policy tightening path, but the Fed’s larger rate hikes will lure money away from India. Local bond markets are particularly vulnerable to interest rate differentials. India’s bond market has been starved of dollars for the past year, an indication of unfriendly FII sentiment.
3: The spectre of inflation
Inflation seems to be the biggest enemy globally, with even advanced economies such as the US witnessing an unprecedented pace of price rises. Data showed last week that US retail inflation surged to a 40-year high of 8.6 percent in May, data showed last week. The persistent snags in global supply chains, worsened by the war between Russia and Ukraine, have meant that prices of goods and services are likely to stay elevated.
India’s retail inflation rose to 7.79 percent in April, and the finance ministry will release the print for May later in the day. While inflation is expected to cool somewhat, as suggested by a Moneycontrol poll, it will still be above 7 percent. Imported inflation, along with domestic demand pressures, portends a prolonged period of price pressures. Since the same number of goods and services requires more money, the value of the currency needs to go down. To that extent, the rupee is expected to stay weak.
4: Current account deficit threat
Yet another fallout of high global commodity prices is the widening of the current account deficit (CAD) for India. For Q3FY22, the CAD was 2.7 percent of the gross domestic product (GDP), up from 1.3 percent in the preceding quarter. Most economists expect the deficit to increase to 3–3.5 percent of the GDP for FY23. This could widen further if oil prices stay high or rise more. In the previous episode of external sector weakness in 2013, the CAD had risen to 5 percent of the GDP and India was lumped with other vulnerable economies called the "Fragile Five".
Though a similar pressure is unlikely this time, a deficit in excess of 3.5 percent of the GDP is termed unsustainable for the country. The wider the CAD, the more dollars India needs to finance it, and the pressure on the rupee is palpable.