Decoding the strength of Indian Rupee

USD/INR (Source: XE.com)

If you take a look at the Rupee performance against USD on a 10 year chart, you will notice that the last year’s performance was really a strong one. It stopped devaluating and even went against it to regain some of the value it had lost. How do we explain this? We just need two charts to decode it.

Shrinking Trade Deficit & offsetting it: How do we get the Dollars or other foreign currencies (inflow)? Through exports, remittances, FDI, Loans based in foreign currency etc. And how do we lose dollars? Through Imports mostly and other factors are not that significant. If we take a look at Trade balance (Export – Import), India has a deficit but that has come down significantly, thanks to what happened to Oil and Gold prices. Now it is in the range of $5B -$10B a month. Our FDI, remittances are to the tune of $5B+, so many months we should be able to offset the trade deficit with our forex inflow. In net, the pressure on Rupee is off.

India's Trade Deficit (Source: tradingeconomics.com)

Forex reserves with RBI: When RBI buys dollars from open market, it impacts the exchange rate. It weakens the Rupee. RBI keeps dollar reserves to safeguard India against external shocks and to prevent damage to Rupee when there are sudden outflows. In that case RBI would sell their reserves to avoid volatility. But how much reserves do you really need? It was $300B three years ago but now it is close to $400B. It is enough to take care of 40 months of trade deficit. If you think of equity/debt market exits from FII, they too are fought nicely with ever increasing of SIP of Mutual Funds and EPF pumping money into stock market. So in summary, threats to foreign investments are taken care to a larger extent and it means RBI need not keep on buying dollars. On another note, how RBI buys the dollars? It has to print new money to buy it. But there is so much liquidity now, it limits the need for our central bank to do that.

India's Forex Reserves (Source: tradingeconomics.com)

The takeaway is, dollar outflows are shrinking while inflows remain strong and the need for RBI to increase reserves is reducing, it all points to one thing – stable Rupee. So don’t bet against it.