India’s central bank battles to protect rupee from Iran war fallout

India’s central bank is battling to prop up the rupee and keep down government borrowing costs, as the fallout from the US-Israeli war against Iran threatens to hit the world’s fastest-growing major economy.

Since the start of the conflict nearly three weeks ago, the Reserve Bank of India had burnt through more than $20bn in foreign exchange reserves, according to Mumbai bankers, trying to defend a currency that is down 2.6 per cent against the dollar over that period and that hit another record low on Friday.

The central bank’s net-short book — which gauges its forward selling of greenbacks — had grown to more than $100bn, bankers said.

The central bank has also undertaken record government bond purchases over the past year including 1tn rupees’ worth of debt ($10.7bn) this month, aimed at increasing bank liquidity and supporting the fixed income market. India’s 10-year bond yield has climbed almost 0.2 percentage points so far this year.

The country imports about 90 per cent of its crude oil and roughly half of its natural gas, both of which have soared in price since the start of the conflict, with India already grappling with widespread cooking gas shortages.

The Gulf region is also India’s largest trading partner and the source of more than $50bn in annual remittances from millions of Indian workers, which are a crucial buffer for India’s external accounts.

The rupee “is among the more exposed EM [emerging market] currencies to the Iran war, not least because about half of India’s energy imports come from the Gulf states”, said Priyanka Kishore, founder of research consultancy Asia Decoded.

A crude oil tanker, one of the first to reach India since the start of the Iran war, at the port in Mumbai © Imtiyaz Shaikh/Anadolu/Getty Images

“Also at risk is the sizeable flow of remittances from the Middle East, which plays an important role in containing the current account deficit in the face of a widening trade gap,” she said.

The RBI did not respond to a request for comment.

The rupee ranks among Asia’s worst-performing currencies this year, reflecting rising concern over India’s swelling energy import bill, inflation risks, capital outflows and the stability of its current account.

The RBI’s intervention has been substantial. From the start of the conflict until March 13, the central bank spent $17.5bn of foreign exchange reserves, reducing them to $555bn, according to official data.

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Nevertheless, economists at Goldman Sachs expect the rupee to weaken from about 93.5 to the dollar currently to 95 per dollar over the coming 12 months, ranking India alongside Thailand and the Philippines as among the most vulnerable Asian economies and currencies to the fallout from the war.

An extended war was likely to “trigger stress across all financial markets in India”, according to analysts at Mumbai-based Emkay Global Financial Services.

The RBI “cannot hold out if this situation persists”, they wrote this week, adding that the rupee could fall to 95 per dollar, the 10-year bond yield could rise from 6.7 per cent to 7 per cent and corporate bond spreads — the extra amount above government bonds that companies pay to borrow — could surge.

The RBI’s appetite to keep on propping up the rupee is likely to wane if India’s import cover falls to nine months from the current 10 © Dhiraj Singh/Bloomberg

The conflict threatens what RBI governor Sanjay Malhotra has described as a “sweet spot” for India’s economy, marked by strong growth and low inflation, and helped by New Delhi recently signing a long-delayed trade pact with Washington, which briefly buoyed the rupee.

Those favourable conditions would allow interest rates to remain low for a “long period”, Malhotra told the FT in December, following 1.25 percentage points of cuts, which weighed on the currency.

Even though growth and inflation rates were “likely to deteriorate, the need for a rate [rise] is less compelling unless the external sector comes under immense pressure”, said Anubhuti Sahay, head of India economic research at Standard Chartered.

“We are not there yet,” she added. “We expect rates to be on hold with focus on ensuring ample rupee liquidity in the banking system via various RBI measures — like bond purchases.”

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Exacerbating the situation, foreign funds have sold almost $10bn of equity investments this year — with just over $8bn exiting in March after the war broke out — continuing a long-running trend as overseas investors have stayed away or pulled their money out of the nation’s pricey stocks.

Even before the war, the rupee “was already under pressure”, said Tanay Dalal, economist at Axis Bank, who expects the currency’s depreciation “to remain gradual and protracted, given continued RBI intervention”.

The central bank had some “room to manoeuvre”, added Christian de Guzman, senior vice-president at Moody’s Ratings, pointing to India’s inflation rate, which is still below the central bank’s 4 to 6 per cent target band, as well as robust economic growth and reserves, including gold, that are still close to the all-time high of nearly $730bn reached at the end of February.

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Yet the RBI’s appetite to keep on propping up the rupee was likely to wane if India’s import cover — the number of months a country can pay for imports out of its foreign exchange reserves — falls to nine months from the current 10, according to analysis by Standard Chartered, which sees the current account deficit widening to as much as 2.5 per cent of GDP, up from a previous top-end estimate of about 1 per cent.

Economists at Citi forecast a $25bn, or 0.6 per cent of GDP, widening of India’s current account deficit, if oil and other commodity prices stay close to current levels for three months and Gulf remittances fall.

“India runs the risk of a third year of a balance of payments deficit,” said Standard Chartered’s Sahay. The rupee “has to be the shock absorber”.

Additional reporting by Michael Stott in New Delhi. Data visualisation by Ray Douglas