Capital flows can support the rupee, but exports must sustain its strength

Tax breaks and RBI measures may attract foreign funds and support the rupee, but lasting currency strength depends on exports, FDI and competitiveness

The government and the Reserve Bank of India (RBI) have moved in tandem to attract foreign funds and steady the rupee. Whether this is a wise policy is another matter. The RBI says it does not target any exchange rate and intervenes only to curb excessive volatility. Yet, the timing and design of the latest measures suggest clear anxiety that the rupee should not weaken beyond the 95-to-a-dollar zone. 

On Friday, the government exempted foreign portfolio investors (FPIs) from income tax on interest income and capital gains from government securities, with effect from April 1 this year. The removal of withholding tax on interest is important. Earlier, such income and gains suffered tax, reducing the post-tax return for overseas investors. The hope is that the concession will bring more foreign money into the sovereign bond market, deepen that market, and reduce pressure on the rupee. 

On the same day, the RBI and government announced a package to pull in foreign currency. The fully accessible route (FAR) was expanded to include new issuances of 15-year, 30-year and 40-year government securities. The short-term investment, concentration and individual security limits under the general route were removed. The limits for investment by non-resident Indians (NRIs) and overseas citizens of India (OCIs) in listed equity instruments, without registering with the Securities and Exchange Board of India (Sebi), were increased and the facility was extended to persons resident outside India (PROIs). Public Sector Undertakings (PSUs) were offered concessional forex swaps for overseas borrowings. Banks were given an incentive to mobilise three-to-five-year foreign currency non-resident (bank), or FCNR(B) deposits from NRIs, with RBI bearing hedging costs till September 30 this year. The period for realisation of export proceeds was brought back to nine months from fifteen months. 

The rupee strengthened. Government securities rallied. Equity markets, however, were less convinced. They opened higher on Friday but ended with losses after investors looked at the RBI’s growth and inflation signals, foreign fund outflows, geopolitical risks and weak Asian cues. Markets may welcome steps that bring in foreign money, but they notice the anxiety behind such steps. 

Quite obviously, the government and RBI are worried about the inflationary effect of a weak rupee, especially when the continuing West Asia war and disruption around the Strait of Hormuz have increased crude oil and natural gas risks. Anxiety about a possible shortfall in rains due to El Niño and its impact on agricultural production has played a role. The RBI has, therefore, chosen to wait before tweaking interest rates or its monetary stance, while saying it will act as more data emerges. 

For exporters facing container shortages, longer voyages and elevated freight rates, the small relief that a weaker rupee gave has now been taken away. Import-dependent producers may see some reduction in costs and working capital requirements. Domestic producers who enjoyed additional protection because of a weaker rupee will face more competition from cheaper imports. 

The rupee weakened for many reasons, including stagnant merchandise export growth, volatile portfolio flows, modest net foreign direct investment (FDI) and heavy dependence on imported energy. The latest measures mainly address foreign portfolio flows. They may buy time. They do not address the structural weaknesses that caused pressure on the rupee. Foreign money attracted by tax relief and subsidised hedging can leave when global conditions change. Such inflows can help steady the rupee, but durable external strength will still depend on export competitiveness, stable FDI, lower logistics costs and productivity.

Email: tncrajagopalan@gmail.com