RBI's forex market action vital, but rupee must not appreciate further

The Indian rupee (INR) came under pressure in the last week of September 2024 when foreign institutional investors (FIIs) turned net sellers in India’s capital market, resulting in capital outflows. However, to maintain orderly conditions, the Reserve Bank of India (RBI) intervened in the forex market, raising concerns in some quarters about whether it was an appropriate strategy.

 

FIIs started withdrawing from the Indian equity market from September 25 — a day after the People’s Bank of China introduced the monetary stimulus. This was soon followed up by fiscal stimulus in China.  As equity valuations in China were quite cheap and stimulus measures boosted prospects for a rise in stock prices, FIIs booked profits in India — mainly due to its higher valuations — to invest in China.

 

The second factor driving portfolio outflows was the disappointing Q2 results from Indian corporations, particularly some well-known fast-moving consumer goods (FMCG) companies, suggesting a weakening of consumption in India. This made valuations of Indian equities look even more expensive, prompting FIIs to continue selling in the Indian equity market.

 

The third element that caused portfolio outflows was the result of US Presidential elections on November 6. Anticipating that the new administration’s policies could be inflationary and that the US Fed might not be able cut the Fed funds rate to the extent it was expected, the dollar index (which measures the strength of the US dollar against a basket of six major currencies), which was already elevated at 103.4, surged to 105.1 on the day the result was declared and continued to strengthen, reaching 107 on November 26 before retreating to 106.1 on November 27. This indicated a strong US dollar and a risk-off sentiment among FIIs. A strong dollar has generally been negative for emerging market economies, including India, as it leads to capital outflows from both debt and equity markets.

 

The rupee depreciated by 0.7 per cent against the US dollar in nominal terms between September 27 and November 25. However, this depreciation was much lower compared to the currencies of most other major emerging and advanced economies during the same period. For instance, the Russian ruble depreciated by 10.1 per cent, while the Japanese yen, Malaysian ringgit, Thai baht, Brazilian real, South Korean won, British pound, euro, South African rand, and the Philippine peso depreciated by 5 to 7.6 per cent. The Indonesian rupiah, Mexican peso, Argentine peso, and Chinese yuan depreciated ranging from 3.2 to 4.8 per cent, and the Turkish lira by 1.3 per cent.

 

Total portfolio outflows by FIIs were of the order of $14.3 billion between September 25 and November 25, which could have led to disorderly conditions in the forex market. Therefore, keeping in mind its policy of maintaining orderly conditions in the forex market, the RBI intervened in the forex market, depleting its foreign exchange reserves by $47 billion — from the peak of $705 billion on September 27, 2024, to $658 billion on November 15, 2024.

 

It is significant that the depletion of reserves was partly due to valuation effects, as other reserve currencies also depreciated against the US dollar, as mentioned earlier, and bond prices declined following an increase in the 10-year US bond yield from 3.79 per cent on September 25 to 4.27 per cent on November 25. However, despite the depletion in reserves during October-November, the RBI’s forex reserves remained higher by $35 billion on a calendar-year basis and by $12 billion on a financial-year basis (up to November 15, 2024).

 

In all the recent episodes of capital reversals,  the INR depreciated sharply, i.e, by 16.0 per cent during the North-Atlantic Financial Crisis (August 2008- March 2009);  15.4 per cent during the taper tantrum in 2013 ( May 23-August 30); by 8.7 per cent during  China slowdown/yuan devaluation (April 2015-February 2016); by 5.0 per cent during the Covid-19 pandemic (February-April 2020);  and by 6.5 per cent during geopolitical concerns emanating from the Russia-Ukraine war (October 2021-July 2022). Therefore, capital reversals of the order of $14 billion would have created disorderly conditions in the forex market and harmed the real economy had the RBI not intervened as it did.

 

Foreign exchange reserves in large emerging economies with floating exchange rates, such as India, are primarily built for precautionary purposes. The underlying rationale is to mitigate the risk of adverse conditions in the forex market from materialising in the first place. However, should adverse conditions materialise, central banks should use these reserves to maintain orderly conditions in the forex market. In fact, of all the motives for building forex reserves, the most common and least controversial is to manage sudden stops or reversals in capital flows to protect the real economy from the harmful effects of disorderly conditions in the forex market. It is significant that even after the depletion, India’s forex reserves still cover more than 96 per cent of its external debt obligations as of end-June 2024. This broadly satisfies the most widely used measure to assess the vulnerability of a country open to capital account, which suggests that reserves should be sufficient to cover all debt obligations falling due in the coming year.

 

The rupee weakened to an all-time low (84.49 per dollar) on November 21. However, the 40-currency real effective exchange rate (REER) was at 107.2 in October, suggesting that the rupee was overvalued. It appreciated by 1.8 per cent in October and by 2.7 per cent compared to the end of March 2024. Though backward-looking, REER is a useful measure of export competitiveness, especially for merchandise exports. Now that the risk of further capital outflows has receded and both the forex and equity markets have stabilised — with FIIs turning net buyers in last four days (November 22-27) after being relentless net sellers for about two months, it is important to ensure that the rupee in REER terms, does not appreciate further.

 

The author is senior fellow, Centre for Social and Economic Progress, New Delhi