Why rupee is falling despite high forex reserves?

The dollar inflows into financial markets are often called 'hot inflows' because they get in and get out very quickly. When the dollar inflows come, the currency of the receiving country generally appreciates and gives a feeling of safety and security from any external shocks. However, when the outflow happens, the currency depreciates in quick succession, leaving the country in a vulnerable situation.

India has been a beneficiary of dollar inflows into its equity as well as debt market over the last 10 years. During the period, the country saw a net investment of billions of dollar with the exception of two years - 2016 and 2018. The net outflows in these two years at Rs 23,090 crore and Rs 80,919 crore, respectively, were not significant. But in the first three months of 2020, the net outflows from equity and debt markets have already touched Rs 85,558 crore. If this trend continues because of uncertainty over Covid-19, there could be a massive outflow, leaving the value of Indian rupee against the US dollar quite vulnerable.

The rupee which has maintained a level of Rs 70 for the last two years has depreciated to Rs 76.15 levels in just three months. In March alone, it has slipped from Rs 73 to Rs 76 against the US greenback. The turmoil in the global financial markets of US and Europe is creating trouble as foreign investors are leaving en mass. The Covid-19 cases are yet to stabilise with Italy, Spain and the US witnessing a gradual rise in the cases.

The high volatility in rupee already indicates RBI intervention as the foreign exchange reserves have declined from the peak of $487.23 billion in the first week of March this year to $481.89 billion as on March 13, 2020. Over the last five years, India has added $130 billion into its foreign exchange kitty. Clearly, the outflow of Rs 85,558 crore from the equity and debt markets over the first three months of 2020 reflects in the rupee weakness.

There is another danger to rupee from the possible 'debt monetisation' by the Indian government if it decides to give a big stimulus by borrowing from the RBI. The finances of the government are constrained with fiscal deficit target at 3.5 per cent of GDP in 2020-21. The government may overshoot the deficit by borrowing more to respond to the Covid-19 risks. While the US, Europe and other countries have committed trillions of dollar to protect their economies, the response from the Indian government is still awaited.

Is India on a sound wicket in terms of its financials?

Clearly, India is relatively better placed than the earlier two crisis of East Asian currency turmoil of 1997 and taper tantrum in 2013 when its currency depreciated big time. The taper tantrum was the event in 2013  when the global central bankers decided to halt the bond buying under quantitative easing , which was used to create additional liquidity in the market to spur growth post 2008 financial crisis. A part of this additional money found its way into emerging markets including India, which helped in pushing the prices up in the financial market. The very fear of withdrawal of such money created a havoc in the financial markets across the world.  

Currently, the current account deficit (CAD) is at 1.5 per cent of the GDP in the first half of 2019-20. The CAD  was Much worse at 4.8 per cent during the taper tantrum of 2013.  A current account deficit against the current account surplus shows that the country  has a negative balance of payment because of higher imports than exports and the inflows by way of deposits and investments.

The CAD has, however,  seen a gradual decline in the six years mainly because of lower import bill on oil imports (lower oil prices) and dollar inflows into the country. While oil prices are still low, which could help in the current crisis, a currency depreciation has all the potential of increasing the import bill and also widen the CAD.

The high foreign exchange reserves, which could also vanish as things prolong, is a good cushion as of today. The CAD to forex reserve ratio is better at 4.8 per cent in the nine months of 2019-20. This ratio was very adverse at 30.2 per cent during the taper tantrum of 2013. Similarly, the ratios of external debt are sound, although the data of external debt is available only for the first quarter (April-June) of 2019-20.

The forex reserves to total external debt  is at 70 per cent in the first quarter of 2019-20. This ratio was close to 100 per cent in 2010 and 2011 and remained range bound between 70-80 per cent over the last eight years. This shows that the the external debt is also rising and keeping pace with foreign exchange reserves.

The short term debt to forex reserve ratio stands at 26 per cent for the first quarter of 2019-20. This ratio also remained in the range of 25-30 per cent indicating the reliance on higher short term debt. Clearly , the outflow of foreign money from equity as well as debt market would expose country's weak links especially the persistent CAD and the higher reliance on external debt.

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