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THE RUPEE AND THE DOLLAR

ON MONDAY, DECEMBER 6, 2004, the rupee closed at an eight month high of 43.64 to the dollar. Since November, the appreciation has been 140 paise. The rupee, which was quoting at 45.60 in January, sharply appreciated to 43.35 by April but again moved back to 46.50 in August. Thus the rupee-dollar exchange rate has been characterised by extreme volatility this year. During periods of sharp rupee appreciation, the Reserve Bank of India has intervened to check the dollar's fall. However, at a time when the dollar has generally been bearish against major currencies, the Indian central bank's efforts have not been wholly successful. Large funds flowed into the country at the time of the divestment of the oil companies in March-April, 2004. More recently, a surge in foreign portfolio inflows has pushed Indian stock market indices to unprecedented highs. On both occasions, the rupee appreciated sharply. Interestingly, there has been no gain against other major currencies — the pound, the euro, and the yen. These currencies have moved up against the dollar to an even greater extent than the rupee.

For India, there are important implications from these currency movements. A large part of international trade to and from India has traditionally been invoiced in dollars. Given the weakness of the American currency over an extended period, there have been efforts to denominate a portion of trade in a few other currencies, notably the euro. The idea clearly is to benefit exporters who stand to receive more rupees by invoicing in a currency that is stronger than the dollar. Importers, on the other hand, stand to gain during a period of dollar weakness: they will be paying less in rupee terms. In fact, it appears that the authorities have, on occasion, deliberately stayed away from propping up the dollar so as to lower the impact of the huge oil imports that are always dollar denominated. That, in turn, has implications for a policy of containing inflation. The dollar's decline has reportedly prompted a reappraisal among the world's central banks of the strategies to manage external reserves. It is quite conceivable that many of them will move a larger portion of their assets away from the American currency. In India too, where the bulk of reserves has been invested in dollar-denominated securities, the process of giving greater weightage to other major currencies seems to be in progress. However, no one expects the dollar to surrender easily its pivotal position either in international trade or in global financial markets.

There is growing recognition that the dollar's current weakness is attributable to the United States' record trade deficit, which by year end might soar to $600 billion on the back of high oil prices. Simultaneously, many overseas investors and central banks have become wary of continuing to finance the deficit. Publicly at least, the Bush administration has remained unperturbed by the dollar's fall and the ineffectiveness of the steps taken in response. Even the calibrated rise in U.S. interest rates has not rekindled the appetite of investors for dollar securities. However, tensions are building up in the European Union and Japan since their currencies are appreciating unrelentingly and might soon make their exports uncompetitive. The fear is that this will choke the nascent recoveries of several of the world's developed economies. On the other hand, countries such as China and Japan have hinted at the possibility of letting their currencies appreciate specifically to help the U.S. narrow the trade deficit. Evidently the dollar's persistent weakness has called forth a range of responses, some of them contradictory, from its major trading partners, including India.

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