Rupee breaches 87-level against dollar, raises worries about rise in imported inflation; all eyes on RBI policy review

The depreciation of the Indian rupee has a dual impact on the economy, presenting both advantages and disadvantages. On the downside, a weaker rupee increases the cost of imports, particularly crude oil, leading to higher production costs and inflationary pressures.

According to an Angel One report, a weaker rupee exacerbates inflation as imports become costlier. The contribution of imported inflation to the overall basket has been consistently rising. This scenario poses challenges for Indian companies with foreign debt, as they face higher loan servicing costs, straining their balance sheets and hindering investment. Moreover, reduced purchasing power and higher import costs erode consumer sentiment, affecting economic growth. A weakening rupee may also trigger capital flight and a decline in foreign direct investment (FDI) inflow, it said.

On the positive side, a weaker rupee enhances the competitiveness of Indian exports in the global market, boosting export earnings, especially for sectors like IT. Additionally, Indians living abroad benefit from a weaker rupee, as their remittances can go further in India, supporting the economy, particularly in regions reliant on remittances.

Export-oriented sectors, such as IT and pharmaceuticals, are expected to benefit from the rupee’s depreciation, as evident from the recent market trends.

However, the Reserve Bank of India (RBI) faces a dilemma in balancing growth, inflation, and currency concerns. While the RBI may prefer a free flow adjustment of the rupee to prevailing macros, can India afford it? Near-term pressures are expected, with the rupee potentially depreciating by 6.3 per cent to 88. However, this is not unprecedented. A February rate cut by the RBI remains a high-probability event, especially if the currency is not the primary concern, said an analyst.

The RBI’s monetary policy panel is scheduled to meet later this week to assess the situation and determine the best course of action.

What’s leading to rupee fall?

Foreign Institutional Investors (FII) have been on a selling spree in Indian markets since October 2024. Net sales of $11 billion by FIIs in the third quarter of FY25 have exerted additional pressure on the Indian rupee. Furthermore, the widening trade deficit, which has reached $188 billion in the current fiscal year to date and is expected to increase by 18 per cent over FY24, has also contributed to the downward pressure on the currency.

The rupee has depreciated by 3.6 per cent over the past 10 months.

In response, the Reserve Bank has adopted a more measured approach to intervention, selling foreign exchange reserves at an average of $3.3 billion over the past seven weeks.

Donald Trump’s decision to impose 25 per cent tariffs on all imports from Canada and Mexico is now a reality. Canada and Mexico announced that they would be taking similar action against imports from USA. Canada and Mexico export around $ 840 billion of goods to the US. The trade war can get nasty. There is the 10 per cent tariff hanging for China which exports around $ 400 bn to the US. The yuan has weakened as the dollar has strengthened and the rupee is witnessing collateral effects. The new measures by the US are likely to trigger a global trade war in the coming days, analysts said.

Madan Sabnavis, Chief Economist of Bank of Baroda, said an analysis had shown earlier that a rate of 87 per dollar appeared fair when only the global factor is considered and adjusted for relative inflation. The question is as to how much lower can the rupee go? It will depend a lot on what the RBI will do, he said.

There is already some panic as importers are rushing in to book dollars thus increasing demand. Will the RBI be selling dollars now or will it let the market decide? “The buy-sell swap had a good response which drew out dollars from the system last week and induced liquidity. Therefore, the puzzle is to manage rupee movements with liquidity because if dollars are sold, it will draw out liquidity. All eyes are on the RBI now for monetary action,” he said.

Robust US jobs data and expectations of higher interest rates have also propelled the dollar’s ascent. Additionally, dollar forward positions have increased, driven by rising US treasury yields, which remain attractive to investors. The US-German 10-year yield spread has also widened to a five-year high of 2.15 per cent. The prevailing risk-off sentiment, combined with a pro-US bias, has led to increased long dollar positions, indicating that the dollar may maintain its elevated levels throughout the current quarter, according to a report by Angel One.