The INR is trading at record lows of below Rs 70 to the USD. There is the usual spotlight on the currency, with policy makers, economists, market pundits all weighing the impact of the falling INR on the economy. The genuine transactors, importers especially and exporters who hedge their receivables are the ones affected immediately by the INR fall. But once the initial shock impact settles down, the economy, markets and transactors adjust to the lower value of the INR and then it becomes business as usual.
The INR has been a steadily depreciating currency over the last 30 years. Chart 1. Despite the consistently falling value of the INR, the economy has seen steady growth, equity indices are at record highs and bond yields have more or less stayed steady after resetting to lower levels in the beginning of the the 2000 decade. Chart 2,Chart 3 and Chart 4.
Chart 1:Chart 2 :Chart 3:
The INR is a depreciating currency as the country runs twin deficits of fiscal and current account. India being a growth economy and an importer of oil has consistently been running twin deficits and this is likely to continue until such time as tax to GDP ratio picks up substantially and oil prices fall off the cliff or oil imports come off. These scenarios are not forseen in the near horizon.
Government funds its fiscal deficit through domestic debt and hence currency impact is minimal on the cost of its borrowings. Current account deficit is financed through capital flows, when excessive leads to strengthening INR and when negative leads to depreciating INR, as is the current case.
The Recent Fall in the INR
The Indian Rupee (INR) has been among the worst emerging-market currencies so far in 2018, largely affected by pressures from global monetary tightening, trade wars, rising crude oil prices, widening trade deficit, foreign fund outflows and, more recently, contagion effect from the Turkey crisis. The INR has depreciated by over 10% against the USD since the start of 2018 and fell below Rs 70 to the USD for the first time ever on the 14th of August 2018 and touched an all-time low level of Rs 70.40 to the USD. However, to place it in perspective, the INR after touching record lows of Rs 68.80 in August 2013, has only depreciated by around 2% from lows over the last five years.
Chart 8: USD INR
Chart 9: DXY (USD Index)
Chart 10: Crude Oil Prices
Chart 11: India 10-Year Benchmark Yields
Chart 12: Monthly FII Net Investments in INR Bonds
However, this time around the continuous depreciation of INR has not deterred the India’s economic growth prospects as slew of economic reforms like the goods and services tax (GST), the Insolvency and Bankruptcy Code (IBC) and the cleanup of the banking system over the last few years have provided much needed boost to the country’s economic growth. Further, the country’s economy is on a strong footing owing to better macroeconomic fundamentals compared to 2013 & 2008 as the GDP growth is at levels of 7.5% and inflation is hovering around 4-5% levels, which is well within RBI targeted level compared to double digit inflation in 2013 and higher single digit inflation in 2008.
The fiscal deficit, the current account deficit (CAD) and inflation are three major factors that determines the outlook of a currency. In 2013 when currency crisis happened, India’s fiscal deficit was at 4.8% of the gross domestic product and during 2008 crises it was at 6.07% of GDP. In 2013 and 2008, consumer prices were rising above 9% annually and CAD was at 3.6% of GDP in 2013 and at 2.8% of GDP in 2008.
Fiscal deficit has been brought down to 3.5% of GDP in FY18 against a targeted 3%, CAD collapsed to an estimated 1.9% and inflation fell to 4.17% in July. Fiscal deficit is pegged at 3.2% of GDP in fiscal 2018-19, CAD could be over 2% of GDP and inflation expectations are at levels of around 5%.
India also has relatively low foreign-currency debt. Only around 7% of government debt is denominated in foreign currency, while total foreign-currency external debt, is equivalent to just 20.5% of GDP at the end of March 2018, which is one of the lowest among major emerging markets. India’s external debt position remains healthy despite a rise in total external debt in fiscal year 2018. External debt ratios are not a concern given build up of foreign exchange reserves.
Chart 13: India GDP Growth
Chart 14: India Fiscal deficit (% of GDP)
Chart 15: India (CAD% of GDP)
Chart 16: CPI Inflation (%) Y-o-Y
In Q4FY18, the current account deficit has widened to 1.9% of GDP up from 1.6% in 2017 but it is still well below the level recorded during 2013. With rising oil prices, there are concerns that the current account deficit might rise in the current fiscal year. However, India’s foreign exchange reserve are at adequate levels to cover up to 8 months of current account payments, compared with the median of 6.6 month, providing a buffer should the Reserve Bank of India (RBI) feel it necessary to intervene in forex market on a larger scale.
India’s CAD is vulnerable every time crude oil prices rally as India imports more than 80% of its crude oil requirement. Every USD 10 per barrel increase in oil price would worsen the current account by 0.4% of the gross domestic product. It would push inflation by 30-40 basis points, hurt growth by 15 basis points and worsen the fiscal balance by 0.1% of GDP, as per market estimates.
In the year 2007-2008, the time crude oil prices were rising and peaked at levels of USD 140 a barrel in June 2008 before crashing to a level of USD 45 a barrel in Dec 2008, the rise in crude oil prices pushed India’s total import bill to around USD 32 billion and the forex reservse were at USD 279 billion, which was sufficient to cover around 8 months of the import bill. India’s total import bill for the month of July 2018 was at USD 43.79 billion and forex reserve are at USD 400.88 billion which is good enough to cover around 10 months of imports.
The major worry for the INR is rising crude oil prices and Fed rate hike expectation. The price of oil has hit its highest level since November 2014, reaching USD 75 a barrel, as geopolitical fears caused concerns on potential disruption to supplies.
The rally in global crude oil prices has led India’s oil import bill to rise by 57.41% to USD 12.35 billion in July 2018, as compared to USD 7.84 billion recorded in the corresponding month a year ago. This has pushed the country’s merchandise trade deficit to USD 18.02 billion in the month. India had imported 213.93 million tonnes (MT) of crude oil in 2016-17 for USD 70.196 billion. For 2017-18, the imports are pegged at 220.43 MT for USD 87.77 billion, according to the latest data available from oil ministry’s Petroleum Planning and Analysis Cell (PPAC).
Brent crude prices have increased by more than 45% as of Aug 2018 year-on-year. Crude prices have been on an upward trajectory since 2017 on the back of production cuts initiated by Organization of Petroleum Exporting Countries (OPEC), Russia and non-member allies, gnificant drop in Venezuelan oil production and the recent economic sanctions on Iran by the US.