12 Aug 2015 21:49 IST

What drives the rupee?

Apart from reactions to events such as yuan devaluation, it is impacted by foreign portfolio flows, crude oil prices and the current account deficit

The rupee is once more in the limelight with China devaluing its currency by 2 per cent. While knee-jerk reactions to events such as these are common and affect the Indian currency in the short term, other factors have a more sustained impact on the currency’s trajectory.

Here are three such indicators.

Foreign money flows

In an emerging market like India foreign money flows wield a strong influence on financial markets.

Earlier, most foreign portfolio flows were received by the equity markets, with minimal flows into debt. But since 2011, money flow into the debt segment has also gained traction. The rupee has therefore now become sensitive to the movement of the equity market as well as

interest rate movements, as both these factors influence the decision of foreign investors to plough money into India.

The rout in the rupee after the US announced its decision to taper the quantitative easing (QE) in 2013, is a classic example of how the currency has fallen prey to foreign money flows. This decision made foreign portfolio investors (FPIs) pull out $13 billion from the Indian debt market between June and November 2013. In the ensuing panic, the rupee fell to its all-time low of 68.85 by August 2013.

That said, the same foreign money has prevented the rupee from tumbling against the dollar in recent times. The debt segment has attracted a whopping inflow of $32.63 billion since 2013. This accounts for about 58 per cent of the cumulative inflow of $55.86 billion until July this year.

This has limited the fall in the rupee at a time when its emerging market peers have tumbled against the greenback. Since 2013, the rupee is down just 3.64 per cent against the dollar, while its other emerging peers, such as the Brazilian Real and Russian Ruble, have fallen 30.96 per cent and 46.73 per cent respectively against the dollar over the same period.

It is due to this link that the currency market is nervous about the impending interest rate cut in the US. As bond yields in US climb higher after this move, there could be another exodus of FPI flows out of Indian debt that can apply pressure on the rupee.

The crude factor

Crude oil price is another key driver of the rupee as oil imports account for around 30 per cent of India’s total import bill. There is a strong correlation between India’s crude basket price released every month by the Ministry of Petroleum and Natural Gas and the country’s import bill.

A surge in crude oil price has taken the import bill also to highs and vice-versa. For instance, the surge in the crude basket price, from about $40 per barrel in December 2008 to a high of $118 per barrel in April 2011, saw the import bill surging from $19.45 billion to $36.6 billion, an increase of 88 per cent in the import bill. Higher imports will keep the trade deficit high and further pressure the rupee.

While the recent fall in the crude oil price has helped pare the import bill from about $43 billion in September 2014 to $33 billion in June this year, any sharp reversal in crude oil will remain a threat to the rupee.

Current Account Deficit

The current account balance is widely used to gauge the strength of an economy. India runs a deficit in its current account. The deficit widening in the two financial years (FY) 2011-12 and 2012-13 was a major cause for the Indian rupee to dip below the psychological 50 level. India’s current account deficit (CAD) widened from $17 billion in the first quarter of FY11-12 to about $32 billion in the third quarter of FY12-13. CAD worries saw the rupee spiralling lower from a high of near 44 levels to below 55 levels against the dollar in this period.

The trade balance forms a major part of the current account. The recent fall in the import bill has helped the trade deficit to narrow from $16 billion in November 2014 to about 11 billion in June 2015. The current account deficit currently stands at $1.5 billion as on March 2015, down from $10 billion recorded in the September quarter last year.

Though the lower import bill is a positive, the slowdown in Indian exports remains a worry. India’s exports are down for seven consecutive months now — from $26.4 billion in November 2014 to $22.3 billion in June this year. So, even if the CAD narrows further due to low oil prices, it might be hampered by slower export growth.

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