Indian rupee a threat to sovereign credit? Find out here

The continuing rupee plunge, which touched 70.15 levels last week, does not pose much risks to the sovereign rating, as the fall is largely reflective of the shifts in market sentiment towards emerging markets after global monetary tightening, says a report.

Last week the rupee had closed for the first time at 70.15 against the American dollar and many still believe the the rupee is still overvalued by at least Rs 2-3 more.

"The impact of the rupee weakness on sovereign credit is limited with relatively strong external finances, especially the low level of external debt which is just 13 per cent of GDP. But this could add to existing pressures in corporate and banking sectors," global rating agency Fitch said in a report.

According to the report, one of the key factors that will help the country tide over the rupee crisis is the relatively low foreign currency debt.

"Only around 7 per cent of government debt is denominated in foreign currency (against BBB median of 38 per cent), while total forex external debt including private sector, is equivalent to just 13 per cent of GDP, which is one of the lowest among major emerging markets," the report said.

The rupee has been the worst among the emerging-market peers, hit by global monetary tightening and, more recently, contagion from the Turkey crisis. The rupee lost around 9 per cent since January making it the worst-performing major currency in Asia.

Key domestic factors that have contributed to the fall is the widening trade deficit, which in July had posted the largest gap since May 2013. The first quarter CAD rose to 1.9 per cent and many believe the gap will be 2.6 per cent of GDP for the full year.

Net portfolio outflows through mid-August totalled USD 5.5 billion for the year, mostly in bonds, compared to inflows of USD 27.9 billion over the same period in 2017, the report said, adding FDI inflows have also weakened and no longer cover the CAD. This means that the balance of payment has turned negative.

"However, the country's vulnerability to currency risks and capital outflows is unlikely to translate into significant pressure on the sovereign credit profile or pose external financing risks," it said.

The report notes that due to the rising crude prices, the Q1 CAD widened to 1.9 per cent, up from 1.6 per cent in Q1 of FY17, but is still well below the 5 per cent of GDP recorded around the time of the 2013 taper tantrum.

"We expect the full-year CAD to remain below 3 per cent of GDP in fiscal 2019," the report said.

The continuing rupee fall and the resultant RBI intervention in the market has seen "the foreign exchange reserves declining by a little less than USD 24 billion since mid-April, but still cover 7.2 months of current account payments, compared to the 'BBB' median of 6.6, providing a buffer should the Reserve Bank feel it necessary to intervene on a larger scale," the report said.

Also, risk of currency pressures triggering a sudden spike in domestic borrowing costs is mitigated by the RBI's relatively narrow focus on its inflation objective, as opposed to countering external pressures, the report said and noted that "this is in contrast to the approach of Indonesia, where the central bank has responded to currency pressures with aggressive interest rate increases."

But it warned that "external pressures may be enough to prompt another 25 bps hike this year, but dramatic moves by the RBI to defend the currency appear unlikely".

Also, the corporate sector is less dependent on foreign borrowing than in most other emerging markets, though they have very limited hedging.

Similarly, the banking sector has relatively low direct foreign currency exposure at 10.9 per cent of total loans as of March 2018, down from 12.1 per cent in March 2017. But, rupee loans to corporates with unhedged forex borrowings can face increased repayment risks, it warned.