The rupee may depreciate to around 77.5 against the US dollar by March 2023, as the widening of current account deficit (CAD) due to higher energy prices and capital outflow as a result of rate hikes by the US Federal Reserve are likely to put pressure on the local unit, says a report.

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According to Crisil Ratings, the domestic currency is likely to settle at 76.5 against the American currency in March 2022.

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"The rupee is already reacting to the external tensions and, we believe, will depreciate further and settle around 77.5/USD by March 2023.

"Two factors will play a pivotal role in driving the weakness: higher energy prices widening the current account deficit, and rate hikes by the US Fed resulting in some capital outflow," the rating agency said in a report on Thursday.

But with the Reserve Bank of India (RBI) expected to continue intervening in the forex markets (thanks to larger forex reserves) to manage volatility, a sharp depreciation in the rupee may be avoided though it could face volatility in the near-term, so long as geopolitical tensions persist, it said.

The US Federal Reserve has raised interest rates by 25 basis points (bps) and signalled six more rate hikes this year.

The agency expects the current account deficit to widen to 2.4 per cent of GDP in fiscal 2023, compared with an estimated 1.6 per cent in fiscal 2022 (with an assumption of crude oil at USD 85-90 per barrel for fiscal 2023).

"With the rising demand for dollars to pay for expensive oil imports, the depreciation pressure on the rupee will intensify. Already, in past episodes of crude oil price spikes, India has witnessed concomitant widening of current account deficit and, consequently, sharp depreciation of the currency," the report said.

It further said a rise in US policy rates hardens US long-term yields (on Treasury bills), reducing the interest rate differential between US assets and those in Emerging Markets.

This increases the relative attractiveness of US assets, leading to capital flows out of riskier assets of emerging markets. As a consequence, demand for domestic currencies reduces, putting depreciating pressure, the agency said.

This time too, as global liquidity reduces owing to the US Fed tapering and Fed rate hikes, foreign investors have been pulling out funds since October 2021.

"This fiscal, as of February, they have withdrawn USD 13.1 billion, the highest in the past decade. This is indicative of the additional downside pressure on the rupee owing to capital outflows," the report said.

The agency said that the depreciation in the rupee, however, is likely to be relatively less compared with the 2013 taper tantrum episode, as India's external account situation is more comfortable. Adequacy of foreign exchange reserves (around USD 630 billion) is also acting as a shield.

"The expected inflow of funds during the mega initial public offer of the Life Insurance Corporation of India and the inclusion of India's debt in the global bond index towards the later part of fiscal 2023 are expected to provide some support to the currency," it said.