How can RBI contain rupee depreciation?

The Indian rupee turned super senior citizen last month as it crossed the 80-level mark. Much has been said about the recent fall - for some, the depreciating rupee is good, while others believe the fall is too steep.

If you look at the rupee-dollar equation, the rupee has depreciated nearly 10% since the start of the year. The Reserve Bank of India has no choice but to prevent the rupee depreciation. How can RBI do it? Before we answer this question, let us understand why the rupee is falling.

The falling rupee - Reasons for fall

Reason 1 - Interest rate hike in the US

An indirect reason for the falling rupee is the Federal Reserve's increasing interest rate in the US. 

Investors like to move to investment options where the interest rate is increasing. Assume you invested in the equity market because the fixed deposit rates were low. You made good returns on your equity investment, and at the same time, the fixed deposit rates are increasing. Would you not withdraw your money from equity and invest in fixed deposits?

The same is happening in the US. The Fed has increased policy rates by 75 basis points for the third consecutive time. As a result, the funds from India are moving to the US. The demand for the local currency (rupee) has declined, and it has fallen.

Second, we are witnessing a rare scenario where inflation is higher in the US compared with India. The Fed has no choice but to increase the interest rate. With rising interest rates, the interest rate differential between the US and India has come down to 2.6%. The difference has also led to the recent depreciation of the rupee.

Reason 2 - Crude Oil prices

The crude oil prices have increased sharply in the last year or so. India imports 86% of its oil demand - millions of barrels a day and the crude oil transactions are done in the dollar. 

The equation is simple - when the crude oil prices go up, we need to buy more dollars to purchase oil by selling the rupee. The US dollar becomes stronger, and the rupee value depreciates. The same has happened recently and caused the rupee depreciation.

What can RBI do to stop further rupee depreciation?

We import crude oil in billions. Hence, the depreciation of the local currency is harmful to the economy. RBI has to intervene to stop the sharp depreciation. Below are some ways RBI can stop the rupee depreciation:

• Sell forex reserves: RBI can sell (it is already doing it) a part of its foreign forex reserves to control the falling rupee. In 2021, India's foreign exchange reserves stood at $642 billion. The latest data (September last week) show that the forex reserves have fallen to $545 billion. It had prevented a sharp fall in the Indian rupee, unlike other currencies. 

Not everyone is happy about the depleting foreign forex reserves, but the purpose of having high forex reserves was to use them in situations like these, right? It is important to note that this measure is only to counter volatility and cannot be RBI's policy.

• Boost capital inflows in NRI accounts: The RBI can take measures to encourage capital flows in NRI deposits. When the NRIs start to deposit money in India, they would be selling dollars to convert it to a rupee, which will help the cause. RBI can reach out to banks so banks can offer non-residents higher interest rates on deposits and short-term bonds.
• Buy/sell swap: In a buy/sell swap, the Indian currency is injected into the banking system, while taking out dollars. The swap will help the RBI keep the currency rates in check, although, in a limited way.

Can RBI continue to sell foreign reserves?

Of all the measures mentioned above, the one that works in real-time is selling forex reserves. Can RBI continue to sell it? The answer is No. 

The RBI has to keep an adequate level of foreign exchange reserves. It is measured in relation to import cover and short-term foreign currency debt. 

India's import bill in September 2022 was nearly $60 billion. As per a conservative estimate, India needs to have a reserve equivalent of 10–11 months. By this estimation, RBI won't be comfortable selling further as we are down to 9 months reserve equivalent.

Another way to look at adequate forex reserves is to check the country's total short-term debt due in the next one year. For India, it is over $100 billion. According to this method, RBI will be comfortable.

Conclusion

The rupee-dollar equation is not simple, and one cannot take a side - falling rupee is good or bad? RBI's role is to look at the Indian economy from all angles - not just the dollar-rupee equation. 

It has to prepare for the worst-case scenario - the FDI outflows happen, the trade deficit has to be financed by the RBI, and short-term debt has to be serviced. In all these situations, forex reserves will be vital. 

We hope the article helped you understand the rupee-dollar equation, what RBI can do, and to what extent.

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