Last Tuesday, the Indian rupee dipped to an historic low of 52.7 against the US dollar. It has fallen approximately 15 per cent against the dollar over the past three months. At the same time, the Reserve Bank of India, rather than aggressively selling dollars to reverse the rupee’s depreciation, has limited its intervention in currency markets to periods of extreme volatility.
Such restraint on the part of India’s authorities is credit positive.
The immediate effect of a falling rupee is clearly negative for unhedged importers and borrowers in foreign currency. Moreover, it raises the government’s petroleum products related subsidy burden, widening an already high fiscal deficit.
Currency depreciation can also further fuel inflation, which is already above 9 per cent.
Nonetheless, the monetary authorities’ decision not to spend large quantities of international reserves to support a higher rupee over the past three months is credit positive for two reasons.
First, intervention would have expended reserves without reversing the depreciation effectively, since global risk aversion and India’s widening current account deficit would have forced the rupee to fall further against the dollar despite the intervention.
Second, effective globalization requires market participants to adjust their investment, consumption and borrowing plans according to the availability of foreign capital and import costs.
Over the past few years, external borrowing by Indian firms has risen significantly in response to the differential between higher domestic and lower foreign interest rates. Foreign borrowing has also funded rising imports.
Recent currency depreciation highlights that exchange rate risk, along with interest rate differentials, ought to be incorporated into private sector decisions about external leverage.
Had authorities used official reserves to maintain the exchange rate at a level higher than dictated by market forces, they would have assisted importers and foreign borrowers at the expense of exporters and import-competing domestic producers. This would have delayed or distorted private sector adjustment to global market signals.
We expect that currency depreciation, by making imports more expensive and exports cheaper, will ultimately force an adjustment, and help narrow the current account deficit over the next few quarters.
However, as long as India’s inflation remains higher than that of its trading partners, it will limit the competitiveness impact of depreciation. Moreover, global growth trends indicate a weak outlook for export growth.
Besides some intervention to stem steep declines in rupee value, authorities have recently relaxed certain capital controls to buoy the currency. These have included raising caps on interest rates on non-resident Indian deposits, on commercial borrowing, and on foreign participation in domestic bond markets.
These efforts may marginally raise capital inflows and thus keep the rupee’s value from falling precipitously. However, a sustained appreciation of the rupee will be difficult if the current account deficit (currently estimated at about 3 per cent of GDP) widens and global risk aversion remains high.
Atsi Sheth is the Vice President - Senior Analyst at Moody's Investors Service while Andrew Schneider is Associate Analyst at Moody’s Investors Service.