RBI's rupee rescue faces test from oil, inflation and outflows

India’s boldest effort in more than a decade to support the rupee may offer only temporary relief, with persistent currency weakness complicating the central bank’s task as it.

While the newly imposed measures propelled the rupee to its biggest gain in six months on Monday, longer-term pressures—from India’s dependence on energy imports to its twin deficits and volatile capital flows—are proving harder to counter, according to economists and investors. Failure to tackle those pain points may keep the rupee under strain, adding to inflation and forcing the Reserve Bank of India to be more aggressive in hiking interest rates.

Crude oil and gold account for a large share of India’s imports and trade deficit, making the economy particularly sensitive to swings in their prices. With both commodities becoming more expensive, India’s import bill has ballooned, increasing demand for dollars and straining the rupee.

The RBI’s latest steps aim to ease some of that pressure by supplying dollars directly to state-run oil companies and restricting banks from taking certain positions in the currency market.

“Such measures can influence the timing, venue and cost of dollar demand, but they can't eliminate genuine demand generated by trade, hedging requirements or capital outflows,” Barclays analysts Mitul Kotecha and Aastha Gudwani wrote in a note. The rupee may continue to depreciate gradually, though the pressure could now be more orderly, they said.

Rising global interest rates have added another layer of pressure. The extra yield investors receive for holding rupee-denominated debt rather than US assets is near a multi-decade low, reducing one of the incentives for foreign investors to put money into India.

That could make it harder for India to attract capital if foreign investors remain concerned about further currency losses and global risk appetite stays weak, further weakening the rupee.

Taxes are another deterrent for foreign investors. India levies a 12.5% tax on long-term gains from listed shares and 20% on gains from stocks sold within a year. Beyond tax rates, investors have raised concerns about the consistency of India’s tax regime. The country’s previous use of retrospective taxation hurt investor confidence, though the government scrapped the provisions in 2021.

JPMorgan Chase & Co. Chairman and Chief Executive Officer Jamie Dimon recently highlighted those concerns, saying uncertainty over tax treatment was weighing on investor sentiment. While global investors are broadly optimistic about India’s long-term prospects, companies often faced higher-than-expected tax bills on transactions, he said in an interview recently.

Those concerns have coincided with a sharp retreat by overseas investors. Foreigners have pulled a record net $32 billion from Indian stocks so far this year, contributing to a 14% drop in the benchmark Nifty 50 Index and leaving India among the world’s worst-performing major equity markets.

The selloff has erased much of the valuation premium that long made Indian stocks expensive relative to other markets. The Nifty 50 now trades at about 16.5 times expected earnings, its lowest since mid-2020 and well below its five-year average of more than 20 times.

“If global conditions remain adverse, defending the rupee will entail increasingly costly policy trade-offs, requiring a broader response spanning exchange-rate flexibility, liquidity and monetary policy, and structural reforms,” said Madhavi Arora, economist with Emkay Global Financial Services Ltd.

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