Why a free fall in the rupee seems unlikely

The period following those highs has been marked by foreign portfolio investors (FPI) pulling out money from India’s equity and debt markets. Their net sales amounted to $11.47 billion in October alone and another $2.54 billion in November. As these outflows – basically dollars leaving the country – put pressure on the rupee, the Reserve Bank of India (RBI) had to support the domestic currency. It did so by selling dollars from the official forex chest. That has, in turn, led to a depletion in the reserves, which are under its sole custody.

Sources of forex reserve movements

A depletion or accretion in forex reserves is, however, caused not just by FPIs taking out or bringing in money into Indian markets.

Reserve movements are a function of the country’s external balance of payments (BoP) transactions, both current and capital. Current account transactions basically cover exports and imports, of goods as well as services.

As far as trade in goods go, India has traditionally been more an importer than an exporter. In 2023-24, its merchandise exports, at $441.48 billion, were way below imports, at $683.55 billion, translating into a deficit of $242.07 billion. The accompanying table shows merchant trade deficits being run year after year, ranging from $102.15 billion in 2020-21 to $265.29 billion in 2022-23.

It’s been the other way round, though, in services – what is called the “invisibles” account. This account has consistently posted a surplus, while more than doubling from $98.03 billion in 2016-17 to $218.78 billion in 2023-24. This has been largely courtesy of two major invisible receipts items: Exports of software services and remittances from Indians living abroad.

Net software exports increased from $60.96 billion in 2011-12 to $70.76 billion in 2016-17 and further to $142.07 billion in 2023-24. Much of this was post the Covid pandemic, which spurred digitisation of business and government operations globally and gave an impetus to exports of Information Technology services from India.

Alongside software, there has been a jump in net exports of “business” and “financial” services, from $(-)361 million and $(-)424 million respectively in 2020-21, to $29.24 billion and $3.49 billion in 2023-24. This has probably had to do with the setting up of Global Capability Centres by multinational corporations in India, providing specialised solutions – from research and development to accountancy and customer support – to their parent offices and subsidiaries worldwide.

Private remittance transfers – dollars, dirhams, euros and pounds sent home by the Indian diaspora – fell from $63.47 billion in 2011-12 to $56.57 billion in 2016-17, before soaring to $101.78 billion in 2022-23 and $106.63 billion in 2023-24.

Current account relief

The net impact of expanding invisibles surpluses, together with widening merchandise trade deficits, has been to bring down the imbalances in India’s overall external current account.

The current account deficit (CAD), which had climbed to $78.16 billion in 2011-12 and $88.16 billion in 2012-13, narrowed to $23.29 billion in 2023-24. There have been years, like 2021-21, when the current account has even turned positive.

India is, in fact, one of the few countries with a CAD much lower than its merchandise trade deficit. China, in 2023, had a goods trade surplus of $593.90 billion – from exports of $3,179.19 billion and imports of $2,585.30 billion. But it also, unlike India, had a $340.91 billion invisibles deficit, reducing its aggregate current account surplus to $252.99 billion.

A robust and structurally surplus invisibles account – primarily thanks to exports of software services and remittances from overseas Indians – has kept India’s CAD at manageable levels. It has also attenuated the effects of structurally high goods trade deficits, perhaps reflecting the growing loss of competitiveness of the country’s manufacturing and tangible production (as opposed to services) sectors.

Capital account vulnerability

India’s BoP problems today stem mainly from the capital, and not current, account.

So long as CADs are modest, they can be financed through capital flows. In most years, net capital inflows have actually been higher than the CAD, with the excess being mopped up by the RBI and adding to the official forex reserves. Recent years have seen more accretions and depletions happening only in some, such as 2011-12, 2018-19 and 2022-23. The outstanding fiscal year-end reserves with RBI have gone up from $294.40 billion in 2011-12 to $646.42 billion in 2023-24, and further to $658.09 billion as on November 29, 2024.

Capital flows include those from foreign direct investment (FDI), FPIs, external commercial borrowings (ECB) and Non-Resident Indian (NRI) deposits.

Out of these, FDI flows are considered more stable, as they usually entail long-term investment in factories and physical assets, boosting the country’s productive capacity and job creation. The other three sources are either fickle (FPI) or short-term (ECB and NRI deposits), while prone to sudden outflows and withdrawals (foreign banks can demand accelerated repayment or even recall of loans from borrowers in uncertain times).

According to the RBI’s BoP data, FDI flows into India have dropped from $56.01 billion in 2019-20, $54.93 billion in 2020-21 and $56.23 billion in 2021-22 to $42.01 billion and $26.47 billion in the following two fiscals. Net FPI flows, by contrast, hit a record $44.08 billion in 2023-24.

The pressure on the rupee now from the capital account is different from the situation of 2011-12 and 2012-13. That was a time when India was also having large CADs. The drying up of capital flows – triggered by the US Federal Reserve’s decision to gradually unwind (“taper”) its bond purchases programme (read the printing of dollars) – only made things worse then, sending the rupee on free fall amid dwindling forex reserves.

This time, things don’t seem that bad, notwithstanding stagnant FDI and volatile FDI flows, plus uncertainties from the next Donald Trump US administration. The CAD isn’t as high as before and can be financed by some drawdown of reserves at worst.