On 7th July, a front-page story in The Economic Times pointed out that almost US$268bn (billion) worth of external debt is due for repayment in the next nine months and contextualised this number as about 44% of India's foreign exchange reserves. The article opined that the rupee was clearly headed for a fall. The article was not wrong; the rupee is, indeed, headed lower; but not for the reasons cited in the piece. In fact, almost all of the short-term debt within the US$268bn is trade finance which will be rolled over. We need to dig deeper for the answer.
There has been much ignorant chatter about the need for a strong rupee reflecting the status of India, ignoring the tried and tested, export-led, weak currency strategy that has been hugely successful for Japan and the East Asian Tigers. Be that as it may, let us first understand that the INR-US dollar exchange rate is nothing but the price of the US dollar in terms of the rupee, not materially different from the price of a masala dosa or a ras malai. And like all prices, it is fundamentally determined by the forces of demand and supply, with some allowances for events that impact the local or global economy like the Russian invasion of Ukraine and resultant trade sanctions.
Remember the Indian rupee is convertible on the current account but not the capital account. That reduces the number of variables. What then are the components of demand and supply for dollars (the same logic applies to other currencies, though for simplicity, this article speaks only of the dollar)? Let us begin with the biggest component, which is the value of merchandise trade (we will add other components shortly). Merchandise exporters earn dollars, which they need to use for their imports, or convert into rupees as per the FEMA (Foreign Exchange Management Act) regulations. This then is the supply of dollars. Similarly, merchandise importers need dollars to pay for their imports, and this is the demand for dollars.
In the past fiscal year 2021-22, merchandise exports were valued at US$422bn, while merchandise imports were substantially larger at US$613bn, giving rise to a balance of trade deficit of US$191bn.
Simplifying a bit, the local forex (foreign exchange) markets would see sales of US$422bn for rupees and also purchases of US$613bn against rupees, during 2021-22. The forex market trades on weekdays and is also closed on Indian bank holidays as well as overseas market holidays (currency specific). That would be approximately 230 trading days in the year.
If we assume that the inflows and outflows are reasonably smooth over the year, then every trading day, the average supply of dollars would be 422/230 or approximately US$1.83bn, while the average demand for dollars would be 613/230 or approximately US$2.67bn. Thus, every single trading day, the demand for dollars would exceed the supply of dollars by US$0.84bn. Inevitably, the rupee would have depreciated. In reality, it barely budged between 31 March 2021 and 31 March 2022 (average rate Rs74.2/dollar during FY20-21 and Rs74.5/dollar during FY21-22).
What have we missed out? Yes, services trade, of course! Merchandise trade is the largest component of demand and supply for the dollar, but there are other components too. Let us look at the services trade. Here, we have a bit of a paradox. India is the rare case of an emerging market economy running a surplus on services trade.
In 2021-22, services exports were valued at US$255bn, while services imports were substantially lower at US$147bn, giving rise to a services surplus of US$108bn. Simplifying a bit once again, the local forex markets would see sales of US$255bn for rupees and also purchases of US$147bn against rupees, during 2021-22.
Using the same base of 230 trading days explained earlier, then every trading day, the average supply of services exports dollars would be 255/230 or approximately US$1.11bn, while the average demand for services imports dollars would be 147/230 or approximately US$0.64bn. Thus, every single trading day, the supply of dollars would exceed the demand for dollars by US$0.47bn.
Combining the balance of merchandise trade and the balance of services trade, we get exports valued US$677bn and imports valued US$760bn, yielding a net deficit of US$83bn. However, in looking at the current account, we also need to factor in primary and secondary income (net remittances, and net dividend).
Leaving out the details, India registered a current account deficit of US$39bn during 2021-22. Applying our metric of 230 trading days, we arrive at a daily excess demand for dollars over supply of dollars at 39/230, i.e., US$0.17bn every trading day. Much less now, than the merchandise deficit we saw earlier; but, nevertheless, a deficit and, hence, an excess of demand for dollars over the supply of dollars. Inevitably, the rupee would have depreciated; but, as we saw earlier, it barely budged between 31 March 2021 and 31 March 2022.
What is the solution to this mystery? It lies in the fact that we have so far looked at flows coming under current account transactions but have ignored the capital account. Once we look at the capital account, the answer becomes very clear. During 2021-22, net inflows of foreign direct investment amounted to US$52.9bn, while foreign portfolio investment saw a net outflow of US$14.1bn.
Taken together, that was net inward investment of US$38.8bn, or using our 230 trading days metric, an average of US$0.17bn. By sheer coincidence and rounding off, this exactly offsets the daily deficit of US$0.17bn from the current account and, therefore, suggests that the rupee would have remained almost unchanged.
There is more to the story, of course. Trade follows are not smooth during the year but rather lumpy. importers and exporters may hedge their payables and receivables, altering the flows, and exporters may retain their dollars overseas to the extent permitted by RBI or use them for other permitted purposes.
There are also flows of debt—multilateral, commercial, bonds—that impact the demand and supply equation. And, of course, RBI intervenes in the spot and forward markets from time to time. We have not considered any of these factors as data is hard to come by. However, the numbers above will serve to demonstrate the proposition.
Thus, the key lesson is that during 2021-22, the positive impact of a services trade surplus and net foreign investment inflows almost exactly balanced the merchandise trade deficit and this enabled the rupee to remain more or less stable.
The million-dollar question, of course, is: What will happen this year in 2022-23.
First of all, the merchandise trade deficit in the first quarter of 2022-23 has widened very significantly. In the April-June quarter of the current financial year, India's merchandise exports rose to US$117 billion, approximately 22% higher than the US$96bn recorded in April-June 2021-22. However, India's merchandise imports in April-June 2022-23 shot up to US$187bn, almost 47% higher than the US$127bn in April-June 2021-22. As a result, the merchandise trade deficit in April-June 2023, at US$70bn, was almost triple the US$26bn recorded in April-June 2021-22.
Data on services trade comes with a lag and hence, June 2022 numbers are not available. However, if we use April-May 2022 as a proxy, the first two months of the current year showed services exports of US$46bn (US$36bn last year) and services imports of US$28bn (US$20bn last year), with a services trade surplus of US$18bn (US$16bn).
In other words, the merchandise trade account has swung sharply into deeper deficit, while the services trade account showed only a slightly larger surplus.
Data on foreign investment flows and remittances is not yet available for the quarter ended 30 June 2022. Remittances are likely to be more or less unchanged as of now. Anecdotal evidence from the media is suggests strong net outflows of funds from both the Indian debt market as well as the equity market during April-June 2022. If this current trend is maintained, it is highly unlikely that last year's surplus on the capital side will again be enough to compensate for a sharply higher merchandise trade deficit; in fact, it may be negative for the full year.
Rather, the heavy merchandise trade deficit and the (likely) net outflow of foreign direct/portfolio investment is more likely to overwhelm the slightly positive services surplus and Remittances. In fact, we have seen RBI supplying rupees to the markets in a valiant bid to slow or smoothen the depreciation of the rupee which is now threatening the Rs80 level after opening the fiscal year at Rs74.50 per dollar. Barring a sharp change in direction, viz., a surge in merchandise exports, and / or a curtailment of merchandise imports, and/or a reversal of foreign investment back into positive territory, the rupee has only one direction to go and that is down.
So the Economic Times article was correct in its conclusion, though for the wrong reasons!
(Artha Shastry is a banker who wishes to remain anonymous.)