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Strengthening rupee calls for lower interest rates

A moderation in aggregate demand, in course of time, will help relieve the pressure that a currency will face in the foreign exchange markets, says T. B. Kapali.

A KEY point in international economics is the relationship between exchange rates and interest rates. In open or even partially open economies (that is, countries that have opened up their domestic markets — goods, financial and services — to varying degrees of integration with the global markets), this relationship is found to hold in large measure.

The higher the interest rate on a currency vis-à-vis another, the stronger it is in the foreign exchange markets. Lower interest rates, on the other hand, tend to weaken a currency.

Short term and medium term exceptions, of course, can be found. This is in the very nature of economics. For instance, interest rates on the Japanese yen have been almost zero for some years now but the external price of the yen has been rising over the past few years.

The markets here are focusing on low interest rates helping a revival in the overall economy. Investors are therefore buying Japanese assets hoping that these will appreciate in value. (For sure, Japanese bond yields also have been inching up in very recent times, tracking the tentative recovery in Japan).

The above linkages have obviously meant interest rates being used by global central banks as an important tool for affecting currency values. Contemporary experience in this regard is also available. For instance, official interest rates on the Brazilian currency (an economy comparable in size and nature with that of India's) are still in the high teens (16 / 17 per cent). The central bank / government are trying to re-establish the credibility of the currency from the crisis of the closing years of the last century.

From a macro economic angle, high interest rates help contain and weaken aggregate demand in the economy. A moderation in aggregate demand, in course of time, will help relieve the pressure that a currency will face in the foreign exchange markets. High interest rates, in fact, have a double round effect in providing strength to a currency. The first round effect is through immediate price action in the foreign exchange market. A more enduring effect will flow from a slowdown in aggregate demand.

Relevance to the rupee

Given the foregoing, what can one infer about the level of interest rates in a currency when its external value is going through a spell of sustained appreciation?

The reference here is to the almost 10 per cent appreciation of the Indian rupee's external value (from Rs.49.05 against the U.S. dollar in May 2002 to around Rs.43.60 now) in the past two years. Given the high likelihood of the Indian currency continuing to appreciate, what can one infer about the appropriateness of the current level of interest rates in the currency?

If the momentum seen in the rupee's rise is any indication, it would appear that there is scope for local interest rates to come down further. In a broad sense, the pace and magnitude of rupee appreciation indicate that local interest rates are not low enough to spark off a strengthening of aggregate demand in the overall economy. Such a strengthening in aggregate demand will not only apply downward pressure on the rupee's external value from a trade perspective. It will also manifest itself in a higher level of inflation in the economy than witnessed now.

In other words, the appreciation of the rupee signals that the overall economy can support a higher level of trade deficit and a higher level of inflation than now. And till such time the tide turns — that is, till the markets determine that a certain level of trade deficit or inflation pressure is unsustainable without either a fall in the rupee's external value or a rise in domestic interest rates — the rupee's exchange rate will continue to rise and local interest rates will continue to fall.

Any attempt to hold back either of these two variables — exchange rate or interest rate — may only result in the other variable moving to compensate for such deliberate action. For instance, an attempt to hold interest rates at particular levels may see the rupee's external value moving up more than proportionately. Per contra, if the currency's exchange rate were to be held tight, interest rates would move down, at least in the wholesale financial markets.

On an overall reckoning, if the quantum and speed of dollar flows in recent times can be taken as an indicator of confidence in the Indian economy, the current interest rates structure does not seem to fully reflect that confidence.

(The author is Associate Vice President (Treasury), ING Vysya Bank. These are purely his personal views and do not represent those of his employer).

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