The recent depreciation of the rupee against the dollar has been sizeable but orderly, packed within a short time, and caught almost all off-guard. Interestingly, the Reserve Bank of India (RBI) has not intervened in the foreign exchange market. There are four key factors behind the recent depreciation: (1) recovery of the US dollar; (2) higher global crude oil prices, which widen the current account deficit and also increase dollar buying by oil companies; (3) slowdown in capital inflows, which decreases the supply of dollars; and (4) unwinding of positions that were betting on rupee appreciation to check inflation.
Analysing the evolving balance of payments dynamics is crucial for figuring out where the rupee is headed. Surging crude oil import bill, continued strength in domestic demand, and expectations of moderating export growth suggest that the current account deficit will worsen this fiscal year, probably to slightly more than 2% of GDP. A $10/bbl increase in crude oil prices increases the merchandise trade deficit by around $6.5-7.0 billion. Higher global crude oil prices also boost remittances, but the net effect of higher oil prices on the current account deficit is still a large negative.
Capital inflows are unlikely to maintain their strength in recent years, though funding the wider current account deficit should not be a problem. The overall balance of payments surplus will probably narrow to a mere $24 billion (1.8% of GDP) in 2008-09 after the multiyear high of around $90 billion (7.6% of GDP) estimated for last year....