Rupee vs USD: The impact on mutual funds

The exchange rate between the Indian Rupee (INR) and the US Dollar (USD) is a critical factor influencing India’s economic environment, particularly the mutual fund industry. In recent years, the rupee has faced significant depreciation due to macroeconomic factors, external market shocks, and policy decisions.

As of March 2025, the rupee depreciated past 86.69 per USD, reflecting a weakening domestic currency amidst global uncertainties.

Mutual Funds (MF), particularly equity and debt funds, experience both direct and indirect repercussions from currency fluctuations. A depreciating rupee affects foreign investments, inflation, interest rates, corporate earnings, and investor sentiment, ultimately shaping MF returns. Meanwhile, international funds with exposure to US equities often benefit from currency depreciation.

This article explores the causes of rupee depreciation, its effects on mutual funds, and real-world examples to provide a comprehensive analysis of this dynamic.

Causes of Rupee Depreciation

The rupee’s value against the dollar is determined by multiple factors, including trade balances, capital flows, inflation, and interest rate differentials. The key causes of recent rupee depreciation include:

1. Foreign Portfolio Investment (FPI) Outflows

Foreign institutional investors (FIIs) and foreign portfolio investors (FPIs) significantly impact the rupee’s movement. In times of global uncertainty or a stronger US economy, FPIs often withdraw funds from Indian markets.

• In first two weeks of March 2025, FIIs sold Rs. 30, 015 cr. worth of equities amounting the total outflow during the fiscal year so far to Rs. 1.5 lakh cr.
• Such capital flight exerts downward pressure on the rupee, reducing liquidity in the forex market and making Indian assets less attractive.

2. Strengthening of the US Dollar

The USD is considered a safe-haven currency. Whenever global risks increase, investors move capital towards USD-denominated assets.

• The US economy has remained resilient, with robust job growth and rising interest rates, making the dollar more attractive compared to emerging market currencies.
• The US Federal Reserve’s hawkish monetary policy has increased demand for the USD, leading to rupee depreciation.

3. India’s Current Account Deficit (CAD)

India runs a current account deficit (CAD) due to higher imports (particularly crude oil) than exports.

• A high CAD means more demand for USD to pay for imports, further pressuring the rupee and vice-versa.
• The falling rupee increases the cost of imports, worsening inflation and pushing investors to reconsider their portfolios.

4. Speculative Trading & Market Sentiment

Currency markets are also influenced by speculative trading. Traders often short-sell the rupee when they anticipate further depreciation.

• Global uncertainties, such as US elections or geopolitical conflicts, increase volatility, leading to speculative bets against the rupee.
• India’s forex reserves, though robust, have been used to stabilise the rupee, but sustained interventions can deplete reserves.

Effects on Domestic Mutual Funds

The rupee’s depreciation influences different categories of mutual funds in various ways.

1. Impact on Equity Mutual Funds

Equity mutual funds are directly affected by rupee movements because they invest in listed companies. A weaker rupee influences corporate earnings, sector performance, and investor sentiment.

• Sectors that Benefit:
  • Export-driven sectors such as IT, pharmaceuticals, and textiles benefit from rupee depreciation since they earn revenues in USD.
  • IT stocks like TCS and Infosys often gain during INR depreciation, as their revenue largely comes from US clients.
• Sectors that Suffer:
  • Oil & Gas, Automobiles, and Aviation face margin pressures due to costlier imports of crude oil and raw materials.
  • Companies with significant foreign debt experience higher borrowing costs, affecting profitability.
• Mutual Fund Performance Example: As per AMFI, the net equity mutual fund inflow for February 2025 has slumped by 26% over a month ago to Rs 29,303.34 crore. Further, monthly systematic investment plan (SIP) inflows into mutual funds have also fell to a three-month low of Rs 25,999 crore in February as market selloff intensified.

2. Impact on Debt Mutual Funds

Debt mutual funds react to currency fluctuations through changes in interest rates, inflation, and RBI’s monetary policy.

• Inflationary Pressure:

A weaker rupee raises import costs, pushing inflation higher. If inflation surges, the RBI may hike interest rates, negatively impacting long-duration debt funds. For example, in 2022-23, when the rupee fell from 74 to 83, long-term gilt funds delivered negative returns due to rising bond yields.

• FPI Outflows from Bonds:

Foreign investors reduce bond holdings when rupee weakens, leading to a rise in yields and fall in bond prices. This negatively impacts corporate bond and government bond funds.

• Floating Rate Funds Gain:

Floating rate bond funds perform better in rising rate scenarios, making them a preferred choice for conservative investors.

3. Effects on International Mutual Funds

For mutual funds that invest in international stocks, rupee depreciation can be advantageous.

1. US Equity-Focused Mutual Funds

A stronger USD boosts returns for Indian investors holding US equity mutual funds. Suppose an investor invested ₹1 lakh in the S&P 500 at ₹70/USD, and the rupee later depreciates to ₹85/USD. Even if the US market stays flat, the investment value increases in rupee terms.

2. Hedging and Diversification Benefits

• International funds act as a natural hedge against rupee depreciation.
• Gold and commodities-focused mutual funds also benefit since gold prices tend to rise when the rupee weakens.

Real Data and Recent Examples

Strategies for Mutual Fund Investors

Given the rupee’s fluctuations, investors can adopt the following strategies:

1. Diversification Across Asset Classes:
   • Maintain exposure to domestic equity, debt, and international funds to hedge against currency risk.
2. Sector-Specific Allocation:
   • IT, pharma, and export-oriented funds perform better when rupee depreciates.
   • Oil & gas and import-heavy sectors may underperform.
3. Gradual SIP Investments:
   • Systematic Investment Plans (SIP) help mitigate volatility due to exchange rate fluctuations.
4. Gold and Commodities Exposure:
   • Adding gold ETFs or commodity-focused mutual funds provides additional protection against currency depreciation.

Wrapping Up!

The INR-USD exchange rate is a crucial factor affecting mutual funds in India. While a weakening rupee poses challenges for domestic equity and debt funds, it creates opportunities for international funds. Investors need to evaluate their portfolio mix carefully, considering both risks and potential hedging strategies. By adopting a diversified approach and understanding currency dynamics, mutual fund investors can better navigate the impact of exchange rate fluctuations on their investments.

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