The Reserve Bank of India has nearly exhausted all its tools to defend the currency: rate hikes, attracting overseas deposits, and deploying billions of dollars in market intervention, yet the rupee remains close to a record low.
The rupee is now just 0.2% away from its all-time low of 96.97 hit in May, reflecting investor concerns over elevated crude oil prices combined with surging global yields.
In the four weeks through October 2, the RBI's foreign exchange intervention operations shrank foreign exchange reserves by $51 billion, while the first rate hike in nearly four years barely curbed the rupee's decline.
Ritesh Bhansali, Deputy CEO of Mecklai Financial Services, said: "The sharp decline in RBI reserves is worth watching, and the market is paying close attention. Currently, it is only central bank intervention that is keeping the rupee at its current level."
As the RBI introduced a special window to absorb dollar deposits, foreign exchange reserves had reached a peak of $785 billion in the week of September 4; since then, they have declined for a fourth consecutive week, falling to $734 billion last Friday.
The sharp shrinkage in reserves means that more than one-third of the dollar funds absorbed that year have been depleted, and the strengthening of the dollar has also contributed to the decline in reserves on paper to some extent.
RBI Governor Sanjay Malhotra tried to reassure the market on Wednesday, saying that foreign exchange reserves remain ample, covering about 11 months of imports, with a external debt ratio of 94.4%.
He also stated that the rupee may be undervalued and that short-term market moves may be irrational.
The rupee has fallen more than 7% this year, the worst performance among major Asian currencies. As a major oil importer, India is highly vulnerable to Middle East conflicts.
Global investors have net sold nearly $30 billion in Indian domestic stocks this year. Surging US Treasury yields have weakened the appeal of Indian assets to foreign investors, further weighing on the rupee.
Traders said the RBI is selling dollars in the spot market to prop up the rupee on one hand, while recovering excess liquidity through sell/buy swap operations in the forward market on the other. Both operations will reduce on-paper foreign exchange reserves.
The central bank's forward book has a negative position of $200 billion, representing its forward repayment obligations, meaning actual usable reserves are even lower.
The RBI shifted to a gradual tightening policy on Wednesday, signaling continued rate hikes amid intensifying inflationary pressures. But the rupee continued to weaken, with traders believing existing measures are insufficient to offset depreciation pressure.
Supported by central bank intervention, the rupee rose as much as 0.1% intraday to 96.68 per dollar, with overall movement limited on Thursday.
Ashish Vaidya, Head of Treasury at DBS Bank Mumbai, said: "The central bank is in a very passive position. In my view, the only way to break this depreciation spiral is a one-time large rate hike of about 100 basis points. The longer geopolitical conflicts persist and oil prices stay elevated, the narrower our window to manage the exchange rate."
HDFC Bank predicts that in the second half of the fiscal year ending next March, the USD/INR will fluctuate in the 96-98 range. Mecklai believes that once the 97 mark is breached, the rupee may drop to 98.50.
Sakshi Gupta, Chief Economist at HDFC Bank, wrote in a research report: "Rate hikes have limited short-term protective effect on the local currency. The current rupee weakness is driven by multiple macro factors, including oil prices, stock valuations, foreign institutional investor outflows, AI trading capital flows, and dollar strength."
She expects the RBI to "continue proactive intervention in the foreign exchange market to control the pace of rupee depreciation."