Rupee Hits Record Low at 86: Will RBI Focus on Growth or Address Depreciation?

After navigating a relatively steady course against the dollar for nearly two years, the domestic rupee fell to an all time low in January crossing the Rs 86 per dollar mark. India is grappling with a growth slowdown, persistent inflation and an economic disparity where wealthy are splashing and the middle class cutting down even on essentials. It finds itself at a crossroads yet again just before two major fiscal and monetary policy decision making events scheduled for next month.

The rupee breached the 86-mark on January 13 this year, in less than a month after falling below the 85-mark on December 19, 2024. The rupee depreciated over 3% since September 2024 against the dollar. The pressure is mounting on policymakers to address the vulnerabilities exposed by this currency slide.

What Triggered the Depreciation?

Economists believe, from a global perspective, that a strong dollar supported by high US yields due to Fed rate repricing and the variance in Donald Trump policies are partly behind the rupee's weakness. A clear majority for Trump in the US election has altered the macroeconomic landscape, and the dollar is expected to remain more resilient now. But there are domestic factors as well.

"Domestically, slowing growth, a wider trade deficit and reduced foreign direct investment [FDI] are straining the balance of payments [BoP]. Additionally, the rupee appears overvalued compared to regional currencies, impacting competitiveness. With slower portfolio inflows, funding the growing deficit is challenging, driving the rupee's depreciation," says Dhiraj Nim, who is an economist at the ANZ Bank.

According to experts, the future of the rupee rests with the value of the dollar and it is projected to depreciate further mostly during the first half of the next financial year.

"With a heavy dip in foreign exchange reserves [FX reserves], we observe that the Reserve Bank of India [RBI] is allowing the rupee to slide. Under such a situation, it would be no surprise if the rupee depreciates by 5% in 2025. As a base case, we would like to work with 88 per dollar for now," says Namrata Mittal, chief economist at the SBI Mutual Fund.

Decoding the Way Forward

The emerging market currencies, including the rupee, are in the middle of significant volatility which tends to hurt foreign investor sentiments. Even as stability is preferred, HDFC Bank’s principal economist Sakshi Gupta, feels that the rupee's recent depreciation helps to correct its earlier overvaluation of around 8% in November and improves export competitiveness as peer currencies also weaken.

"However, sharp and persistent depreciation poses risks, such as higher import bills and a strained current account deficit, especially with rising oil prices," says Gupta.

Nim adds that amid growth slowdown, widened trade deficit, sticky and elevated headline inflation and dry FDI flow, a weaker currency is a basic economic adjustment and bodes well for India in the longer term as it will not lose competitiveness as a currency and an exporter.

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India’s structural current account deficit means it is reliant on foreign capital flows to prop up the rupee. Sharp moderation in net FDI inflow has increased the dependency on FPI flows. This was not a problem while India outperformed the global economy, but flows have slowed along with economic growth in recent months, Mittal notes.

Meanwhile, the RBI’s FX reserves have dropped by $70bn since September and its forward book stands at a net negative of $59bn as of November 2024.  Despite healthy forex reserves of $635bn as of January 5, experts caution that the RBI must be careful about further depletion to avoid concerns over India’s macroeconomic sustainability.

"India cannot afford to fritter away its forex defenses, especially if it means losing export competitiveness. In addition, it drains domestic liquidity, throwing sand in the wheels of an already weakening economy. If the dollar keeps strengthening, the RBI will have no choice but to loosen the rupee’s leash," says Mittal.

Will RBI Bow to A New Devil?

India's inflation-ridden economy forced the central bank to hold its repo rate at 6.5% since February 2023 even after holding a ‘neutral’ policy stance, which means that the central bank can lower or raise the interest rate. Even though India's retail inflation eased to a four-month low of 5.22% in December, it is still higher than its 4% target.

While India's growth projection for FY25 is projected at a four-year low of 6.4%, the anticipation around a rate cut has resurfaced, whether RBI will focus on stimulating growth or bow down to a new devil - the rupee depreciation.

Meanwhile, the finance ministry has also shifted responsibility to RBI in its November economic report for a slower economy, to which economists feel that growth depends on more than one factor than interest rates. They seem to be divided on the issue of RBI monetary policy action next month.

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"With inflation slowing and real rates already high, there’s room for the RBI to begin easing monetary policy, potentially with a modest 25-basis-point rate cut in the upcoming meeting. This aligns with the other central banks in Asia. Additionally, the RBI is expected to inject liquidity into the banking system to support easier monetary conditions," says Abhishek Upadhyay, who is an economist at ICICI Securities Primary Dealership.

Nim also feels the RBI should cut its rates unless the effects of this become large enough for them to have it delay till April.

Gupta, on the other hand, believes that given the inflation outlook over the next two to three quarters, there is room for RBI to cut the rate but the ongoing pressure on the rupee, uncertainties around global monetary policies (especially in the US) and rising oil prices—which could lead to imported inflation—might prompt the RBI to be cautious. She says that the central bank may opt for a "wait and watch" approach and potentially delay rate cuts until the April policy meeting.

Echoing the same sentiment, Mittal also sides in the camp of no change to policy rates in February, flagging liquidity support as the greater need of the hour.

With economists divided, it all boils down to what the new members of the RBI’s MPC, especially the governor, have to say about this debate next month.