Decoding the Rupee Depreciation: Capital Market Outlook

Donald Trump's election and the announcements made since are sending shockwaves around the world. The leadership transition in Washington DC will have far-reaching ripple effects, influencing global economic and political dynamics. Key considerations include changes in US monetary policy, potential tariff hikes and their effect on other currencies. Domestically, the rupee, which was stable for much of last year, saw a sharp depreciation in December. At recent India CFO Forum sessions across the country, Manoj Goel, Managing Director & Head of Corporate Sales, Markets & Securities Services for HSBC India, examined the impact of Mr Trump’s presidency, global currency trends, the Rupee’s outlook under new RBI leadership and key priorities for CFOs in the coming year.

World Growth – Better than Expected

Global growth exceeded expectations in 2024. Among the developed markets, America was a clear outlier, while the UK and Europe, though continuing to grow slowly, also exceeded expectations. Chinese growth continued to slow, coming in at ~4%. Inflation, a key concern in recent years, moved down quickly from 7-8% to 3-3.5% over the course of 2024, but appears to have become sticky at those levels. It is unlikely that the 2% target set by central banks in most developed economies will be met in 2025. As a result, and also owing to Mr Trump’s policy announcements, the yield on US 10-year Treasurys has surged from 3.88% at the start of 2024, to 4.57% currently, while the dollar index (DXY) has climbed by 8%. Market volatility also re-emerged later in the year, driven by shifting rate expectations and geopolitical events, including the US election cycle. Brent crude oil prices, which had stabilised at USD 70-75/barre, have edged higher, raising concerns.

An Inflationary Trump Agenda

The markets correctly anticipated (and even welcomed) Mr Trump’s return to office, and this time, they are better prepared for a quick execution of his agenda, which centres on anti-China policies, American nationalism and deregulation. The key themes guiding his agenda include tariffs, immigration and tax cuts: 

• Tariffs: The threatened hike in tariffs will be inflationary, with the US likely to target China (at 10-60% rates), Mexico and Canada (25% each). Europe and Japan may seek tariff concessions in return for increased defence spending and bigger purchases of US exports. While tariffs may not pose a significant direct concern for India, the broader impact on trade and supply chains warrants close attention.

• Immigration: Stricter immigration policies are likely to prove inflationary for the US.

• Tax cuts: While the newly formed DOGE aims to reduce government spending, most of the budget is tied to non-discretionary expenditures, such as debt interest, welfare and Medicare, leaving limited scope for meaningful cuts. As a result, tax cuts are expected to add to inflationary pressures.

On net, these policy shifts will be inflationary, driving US rate expectations higher. Compared to earlier expectations of 75 bps (or more) of rate cuts through 2025, markets now anticipate no more than a 50 bps reduction (to ~3.75%), with US futures currently reflecting an even smaller, 30-35 bps cut. There is even a possibility that the Fed may hike rates later this year or in 2026. Higher rates may strain the US economy while benefiting banks through improved deposit earnings. Deregulation could positively impact the economy, though these benefits will take time to materialise, with the negative effects likely to emerge sooner.

Implications for the Dollar

The US dollar is expected to remain strong in the near term, driven by several factors. For one, higher US interest rates – standing in contrast to rate-cutting in the Eurozone and UK – favour the Greenback. (Given Europe’s, and particularly Germany’s, economic struggles – exacerbated by falling Chinese demand – the ECB may cut rates by as much as 100 bps. In contrast, the BoJ is set to gradually increase rates, with expectations of it reaching 1% by year-end or early next year. Inflation control is a primary focus after two decades of low rates, though the BoJ will proceed cautiously to avoid undermining the SME sector.) Despite America’s 6% fiscal deficit, the dollar continues to attract investors due to its status as a reserve currency. The US economy's outperformance, despite all the challenges it faces (often referred to as ‘US exceptionalism’) reinforces the dollar’s strength. Historically, such trends have been observed, such as during the 2016 election, when expectations of a Trump victory initially strengthened the dollar. The dollar index surged amid rate-cut expectations but stabilised as political developments were factored in. While a strong dollar may impact US export competitiveness, measures like the CHIPS Act aims to counteract this effect by bolstering local manufacturing.

The China Outlook

Like in 2016, China is likely to devalue the yuan (RMB) as a policy response to US-imposed tariffs. Analysts expect a 1-8% devaluation, depending on the extent of tariffs on China. (Typically, a 10% tariff corresponds to a 1% RMB devaluation.) A 7-8% RMB devaluation could set off ripple effects for other currencies, including the INR. China's GDP growth (~4-5%) is subdued compared to its historic double-digit expansion. While a slowdown helps reduce global inflation by weakening commodity demand and forcing China to export goods at discounted rates, it also highlights China's internal pressures, such as maintaining political stability and high employment. A 1% drop in Chinese growth significantly affects global GDP growth, emphasising its central role in commodity pricing and trade. In response to its slowdown, China is shifting from an export-driven to a consumer-led model, focusing on sustainable, domestically-driven growth. Some of the short-term measures being pursued include fiscal and monetary stimulus to address issues like a real estate and shadow banking slump; and redirecting trade surpluses into foreign investments, particularly in the ASEAN and European regions.

Outlook for the Rupee

India’s trade deficit in the first 10 months of FY25 stood at ~USD 291 billion (or USD 25–27 billion monthly), more than double the pre-Covid levels of USD 14-15 billion a month. While service exports remain robust, growth is slowing, primarily due to a weakening IT industry. GCC earnings, which have been rising at high double-digit rates for several years, appear to be plateauing, too. Although remittances have been steady, rising income outflows (mainly interest payments) and weakening inbound FDI are exerting strains. As a result, the overall Balance of Payments (BoP) has turned negative, leading to a depletion of foreign reserves, which are estimated to have fallen from a peak of USD 700 billion last year to USD 625 billion currently. Of this ~USD 75 billion drop, USD 15 billion is attributable to FPI outflows, USD 8 billion to FDI outflows and USD 15 billion to the current account deficit (CAD). In addition, however, there is over USD 50 billion currently lying in speculative positions in the forward market. This has reduced India’s effective reserves to around USD 575 billion – implying a total drop of ~USD 125 billion.

Worryingly, even as India has seen a sharp reduction in reserves, global volatility has increased, limiting the RBI’s capacity to manage further shocks. In 2024, the INR ranked 8^th among currencies with the best spot returns against the USD, depreciating by 2.8%. It outperformed many global peers, including the Euro (-6.3%), JPY (-10.4%) and KRW (-12.5%), but trailed the GBP (-1.7%) and RMB (-2.7%). The rupee was likely cushioned by RBI interventions and steady capital inflows. Going forward, however, a strong dollar and declining reserves will weigh on the INR. 

In the medium term, the rupee is expected to depreciate by 2.5-3% annually, guided by interest rate differentials and other external factors, including FDI outflows and a large US fiscal deficit. Such a depreciation could, however, help rebalance the trade deficit and support exports. In the short term, the rupee may experience considerable volatility, with daily moves of 30-40 paise, and it is likely to fall to 88-89/USD by year-end, barring any unexpected shifts in global markets or further speculative pressures. Despite fiscal challenges, including slowing GST revenue growth and rising expenditure pressures, the government and the RBI are likely to accept controlled rupee depreciation to achieve their broader economic objectives. In terms of interest rates, the RBI is likely to cut rates by 25 bps twice in the first half of the year.