Rupee weakened by more than six percent
since the conflict in West Asia began on February 28. Indeed, the rupee is the
worst-performing currency in Asia, falling 7.2% against the US dollar in 2026.
Unlike in the past, it has also depreciated against the Yuan, Pound, and
Euro. It hit fresh lows against the Yuan,
Dirham, Singapore Dollar, and Euro.
The Reserve Bank of India (RBI) did intervene in the spot market for some time, perhaps to prevent it from breaching the 97 mark, but not aggressively. Looking at the prevailing geopolitical uncertainties, it is difficult to predict a near-term peak for the rupee vis-à-vis the dollar.
This continuous depreciation of the rupee can be attributed to three main factors. First, the geopolitical tensions in the Middle East and the resulting closure of the Strait of Hormuz through which 40 per cent of the world’s oil flows led to a rise in crude oil prices to almost $100 per barrel. Given our huge oil imports, the rise in oil prices automatically increased the demand for dollars sustainably.
Secondly, the prolonged
uncertainty caused by geopolitical tensions created a sort of defensive
behaviour in currency markets. In such a scenario, importers, corporates and
financial institutions started aggressively hedging future liabilities. This
increased the demand for dollars beyond the immediate trade needs. In such a
scenario, exchange rates overshoot the economic fundamentals.
Thirdly and importantly, it is
the persistent withdrawal of portfolio investments by FIIs that increased the
demand for dollars, creating pressure on the rupee. This indeed raises a
serious long-term concern, for they are viewing Indian equities as over-valued
vis-à-vis earnings potential, particularly in an environment of persistent
depreciation of the rupee. Over it, major Central Banks such as the US Fed
continue to maintain relatively high interest rates, which automatically makes
their assets more attractive for investment.
That aside, AI has today become
the technology platform for future productivity growth. As a result, it emerged
as the major attraction for investment. Much of global capital is today moving
towards countries that are positioned at the frontier of AI research,
semiconductor ecosystem and intellectual property creation. Since we are not in that conversation as yet,
there appears to be little or no chance of FIIs’ investment returning in the
near future.
Encouragingly, despite severe
external stress over recent months, the current account deficit stood at around
$ 13.2 bn – 1.3% of GDP in the latest quarter, which is not that alarming
vis-à-vis past crises. Similarly, due to the prudent monetary management by
RBI, inflation is well within the prescribed band. Even if the rupee depreciates further, say
touches 100 per dollar, economists believe that our economy is well-positioned
to absorb the accompanying inflationary pressure. Thus, India retains sufficient
macroeconomic buffers to manage the present exchange rate shock that is caused
mostly by external events over which India has no control.
Amidst this disturbing scenario, the
RBI rightly announced a $5 bn USD/INR buy-sell swap for a tenor of three years
and the same was oversubscribed by the banking system on May 29. Thus, in the
near-leg transaction on May 29 2026, RBI bought $5 billion from banks against
payment of equivalent rupees. In the far leg transaction on May 29 2029, RBI
shall sell back the dollars to banks against their rupees. This shall afford
durable liquidity to the banking system and thereby reduce pressure on the rupee.
It helps in credit growth. It also helps importers in reducing their hedging
costs of foreign exchange transactions. It may also result in the rupee appreciating
temporarily against the dollar. This confidence-building exercise is more
likely to smooth volatility.
Considering the overall macroeconomic
fundamentals that are pretty sound today, many economists opine that it is
prudent for the RBI to let the rupee depreciate. For burden sharing by oil
marketing companies, countercyclical deficits, stabilization funds shall
moderate the external shocks. This section of economists warns that trying to
defend the rupee will continue to bleed the reserves, which currently stand at
around $700 bn, until they are exhausted. As in the past, the over-depreciation of the rupee
is more likely to correct once the crisis is over. So, it may not make sense to
pay more to NRIs to acquire another few billion dollars.
Let us hope that the RBI resists psychological
temptations to defend the rupee as clamoured by political voices from within
the country and moves forward prudently.
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