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Informist, Wednesday, Jan. 15, 2025

MUMBAI – The rupee is seen falling to 87.5 a dollar by the end of 2025, given the strong dollar index and the recent shift in the Reserve Bank of India's intervention strategy in the foreign exchange market, according to ICICI Securities Primary Dealership. The central bank appears to be allowing the rupee to underperform the Chinese yuan when the Indian currency's real effective exchange rate is on the rise, the primary dealership said in a report.

"... RBI appears to prefer INR to underperform CNY (Chinese yuan) when REER is on the rise to curb the rise in latter give large weight of CNY in trade basket," the report said. "But that may not be practical this year in case the scenario of sharp fall in CNY plays out depending on US trade policy." To counter the tariff threats by US President-elect Donald Trump, China had said in early December that it might allow its currency to devalue in 2025, according to media reports.

The rupee's real effective exchange rate against a basket of 40 currencies, in terms of trade-based weights, rose to a record 108.14 in November from 107.20 in October. The November REER, the highest in over 20 years for which data is available, indicates that the Indian currency is overvalued by around 8%.

In the last year, the RBI's preference has been to keep a check on the rise in the REER. The fair value of the REER, as judged by the RBI, has been trading higher over the years, the report said. The RBI's foreign exchange intervention strategy rests on managing two main pillars, the REER and the movement in the dollar/yuan, it said.

Before the rupee started falling sharply in December, the RBI had been defending the rupee strongly. "RBI strategy to defend rupee strongly in last quarter may also have been informed by the view that the rupee is not overvalued despite elevated REER values," the report said. Recent academic research by the central bank estimated the fair value of the REER as per different metrics and found that the rupee was only modestly overvalued or even undervalued depending on the metric used, the report said.

The overvaluation of the rupee, as per REER, provides a strong case for the central bank to allow it to depreciate against a strengthening US dollar. However, the central bank should take into account the expectation of a fall in inflation, with stable commodity prices globally, while allowing the currency to depreciate, the report said. The downside risks to growth should also be taken into account by the central bank.

Due to the intervention in the spot, the RBI's foreign exchange reserves have also fallen significantly. The report estimated the RBI's foreign exchange intervention to have supplied dollars worth $35 billion – $40 billion in the spot market, with an additional $45 billion worth of forward dollar sales. ICICI projected India's balance of payments to be at a deficit of 3% of the GDP in Oct-Dec from a surplus of 2% in Jul-Sept. The RBI intervention in the last quarter was estimated at three times the balance of payments deficit, it said.

The RBI also intervened in the offshore (dollar/rupee) market, likely to curb the spillover effect of spot dollar sales on banking system liquidity. However, such "excessive intervention also incentivised further shorting and build-up of speculative positions in the backdrop of strong dollar sentiment," the report said.

From a record high of $704.89 billion in late September, reserves have fallen to $634.59 billion as on Jan. 3. The report said the "fall in 'true' FX reserves (FX reserves + forward book) was far more severe. 'True' FX reserves peaked near record highs of $690 billion in September, but is estimated to have declined by nearly $100 billion by December with RBI actively using the forward book."

The report said the RBI has a sufficiently large buffer of 'true' reserves, "with import cover estimated at more than 9 months, which is comfortably above the 7 months of import cover seen around the taper tantrum episode.  End

US$1 = INR 86.3625

IST, or Indian Standard Time, is five-and-a-half hours ahead of GMT

Reported by Sourabh Kumar

Edited by Saji George Titus

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