By Nimesh Vora and Dharamraj Dhutia
MUMBAI (Reuters) – India’s central bank will need to rethink its foreign exchange strategy and loosen its hold on the rupee in 2025, economists said, with the currency at its strongest against peers in at least two decades in trade-weighted terms.
The rupee’s 40-currency trade-weighted real effective exchange rate (REER) stood at 108.14 in November, indicating the currency was overvalued by around 8%, the Reserve Bank of India’s latest bulletin showed.
The rupee’s overvaluation relative to its trading partners makes India’s exports more expensive. This is the most overvalued the rupee has been since 2004, RBI data showed. Data prior to 2004 is not available.
The rupee’s overvaluation on a REER basis reflects its appreciation in nominal terms against its peers and the widening interest rate differentials, economists said.
The former is largely thanks to a central bank that has intervened regularly in the forex markets to slow the pace of rupee’s decline, keeping volatility in check.
In fact, the RBI’s repeated two-sided intervention this year has meant the rupee has been the least volatile Asian currency after the pegged Hong Kong dollar.
But that could change in 2025.
“Given the rise in rupee’s overvaluation…the pace of RBI forex intervention will need to slow,” said Gaura Sen Gupta, India economist at IDFC FIRST Bank. That would mean the currency is likely to weaken and witness higher volatility.
There is already evidence of this. The rupee’s 30-day daily realised volatility is at a six-month high and the currency is on course to post its biggest monthly decline in two years having dropped 1.2% so far in December.
Last Friday, the rupee dropped to an all-time low of 85.8075 against the U.S. dollar and traded in a 50-paisa range, the widest this year.
Considering the “flagging” overvaluation, there is likely to be further rupee depreciation, said Kanika Pasricha, chief economic advisor at Union Bank of India.
MULTIPLE HEADWINDS
A shallow rate cut cycle by the U.S. Federal Reserve, worries over the likely impact of Donald Trump’s trade policies, rising U.S. bond yields and India’s growth slowdown will be challenges for the rupee.
“It is after several years that both ‘pull’ (growth slowdown) and ‘push’ factors (external headwinds) for portfolio flows are not in favour of the rupee,” said Dhiraj Nim, an economist and FX rates strategist at ANZ. “So, an adjustment is warranted.”
NEW RBI GOVERNOR
The appointment of Sanjay Malhotra as the RBI’s new governor earlier this month, a development that market participants had not expected, is further fuelling expectations of a change in how the rupee is managed.
“The RBI governor plays an important role in driving the central bank’s currency management strategy,” Nomura said in a note released immediately after the change in guard at RBI.
“It is possible that a bit more flexibility is allowed in currency fluctuations, going forward, as compared to the relatively tighter leash seen over the last one year and more.”
(Reporting by Nimesh Vora and Dharamraj Dhutia; Editing by Sam Holmes)
