The 'stable' run for the rupee to continue

The rupee dipped by 0.9 per cent against the dollar between March 2023 and March 2024.  The US currency had fallen by 1.5 per cent against the euro. The rupee’s performance was better than that of the renminbi, won, rand, ringgit, rupiah, and baht. By March 2024, forex reserves had risen by $64.2 billion over end-March 2023 (foreign currency assets increased by $55.6 billion). This is a very impressive performance on the external front and it will probably also witness a low current account deficit (CAD) for FY24. The global economy, though stable, has still traversed uncertain times as the prospects varied from “hard landing” to “soft landing”, which triggered considerable speculation on central bank action.
 

 As the new financial year begins, there is less uncertainty. First, the conflicts in Ukraine and Palestine may not matter. Second, the world economy will be stable. Third, crude oil prices will not spike. Fourth, central banks, especially the Fed and European Central Bank, will be lowering rates, though the timing is open to discussion. This also means that the trend of the dollar strengthening witnessed in October-December 2022 will not be repeated. So, what does this mean for the future of the rupee?

The rupee will be driven by two sets of factors during the course of the year. The primary driving force would be the fundamentals of the balance of payments, which covers all inflows and outflows involving foreign currencies. The second would be the exogenous force defined by the strength of the dollar.
 

On the issue of fundamentals, the rupee appears to be on strong grounds. Export growth in FY24 was quite impressive at 12 per cent (for 11 months) at a time when the world economy was emitting mixed signals. With growth expected to stabilise in 2024 and recovery in commodity prices, exports can expect to witness positive tailwinds. The same holds for the export of services, which has gone contrary to expectations and registered a growth rate of around 5 per cent in FY24. Assuming stable crude oil prices in the range of $80-90 a barrel, the trade deficit and CAD should be in control. A CAD of 1 per cent or lower can be expected for FY25.
 

The higher level of optimism, however, stems more from the capital account. Here the inclusion of Indian government bonds in the JP Morgan bond index from June onwards, to be followed up with Bloomberg inclusion from January 2025, would add buoyancy to the flows of foreign portfolio investment (FPI). FPI has been largely equity-centric in the past few years ever since Western central banks went in for quantitative tightening to roll back the post-financial crisis emergency measures. This has meant a lower amount of allocable funds for investment in emerging markets (EMs). This, along with rising interest rates in the West, meant that EM debt became less attractive and funds gravitated to equity markets.
 

However, now with the inclusion of India in global bond indices, there would automatically be substantial passive investment taking place in the debt market, which augurs well for our balance of payments. The inclusion of Indian bonds in a phased manner to cover 10 per cent of the weighting in the index could trigger an inflow of $20-30 billion. Depending on how these flows come in, the onus would be on the central bank to ensure that liquidity and volatility are both managed. This is so as there can be some volatility in the rupee.
 

The other positive for the market would be higher dependence on external commercial borrowing (ECB). Currently it has been seen that the domestic financial system has been running deficits primarily due to growth in credit outpacing that in deposits. This may continue, albeit at a slower pace, in FY25. With central banks lowering rates and the rupee being stable, companies would tend to access ECB more intently, thus leading to larger inflows. ECB performance in FY24 was impressive with approvals of around $39 billion in the first 10 months of FY24  against $22 billion during the same period of FY23.
 

Foreign direct investment (FDI) has tended to slow in the past couple of years. In the first 10 months of FY23 and FY24, it averaged around $60 billion against $71 billion in FY21 and FY22. There could be a status quo on this, which would ensure stability.
 

Hence, on the whole, it can be expected that like FY24 there would be forex-accretive for the economy with the amount being in the range of $40-50 billion. This also means from the point of view of fundamentals there will be reason to expect the rupee to get stronger.
 

The exogenous force would have its role to play. When the dollar strengthened precipitously towards the end of 2022 to reach parity with the euro, it was the phase when the Fed was increasing rates and signalling more increases. This cycle has ended and the Fed has held the rate at 5.25-5.5 per cent; and there is discussion on lowering it, based on inflation perspectives. The dollar has weakened ever since the Fed pushed the pause button. As the Fed lowers the rate, which can be two-three times, and up to 75 basis points, the dollar can be expected to weaken further. This will also add weight to other currencies and help the rupee to get stronger.
 

A stable rupee in the average band of Rs 82.50-83.50 is possible with movements of +/-0.5 per cent intermittently, depending on how these factors play out. Hence, the Reserve Bank of India will have to continue to monitor the movements and be nimble to spot volatility in both directions and intervene selectively to reduce excess noise. 

The writer is chief economist, Bank of Baroda, and the author of Corporate Quirks: The Darker Side of the Sun. The views here are personal