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The rupee is back in focus

After a fairly long period of relative calm, the exchange market has turned volatile from the beginning of this month. The rupee touched a ten-month low of Rs.44.25 against the dollar on October 7. Although in no way comparable to the frenzied activities in the stock markets (to which the forex markets are getting increasingly connected), the re-emergence of concerns over the decline of the rupee brings into sharper focus certain features of the external economy that require policy interventions over the short as well as the medium term. The trigger for the rupee's recent decline is said to be the long-overdue stock market correction that seems to have set in from last week. Besides, the dollar has been resurgent against the yen and the euro. Interest rates in the developed countries have been hardening. The economic outlook in the U.S. is more positive than it was just a month ago and Japan, after the recent elections, seems set to regain its economic prowess. For quite some time now, the rupee has been over-valued on the basis of the real effective exchange rate index. The recent RBI decision to include the yuan and the Hong Kong dollar in the basket of currencies, to which the exchange rate of the rupee is linked, is widely expected to encourage rupee depreciation.

Sooner rather than later, exchange rate management has to reckon with the competitiveness of India's exports. There is already a clamour for a cheaper rupee. The current account, which was in surplus for three years until 2003-04, went into a deficit of $6.3 billion last year. The deficit has continued into the first quarter of this year. The principal reason has been the widening of trade deficit from about $15.4 billion during 2003-04 to $38.1 billion last year. With the oil import bill not expected to come down and with non-oil imports too booming, there is little chance that the trade deficit can be narrowed (let alone bridged) in the foreseeable future, unless merchandise exports, already performing well, are boosted further. The critical dependence on exports is further underlined by the fact that foreign exchange remittances from abroad, one of the principal items in the current account, have been growing at a slower pace than anticipated. Capital account inflows have continued to be buoyant, rising sharply to $7.4 billion during 2004-05 from $4.2 billion a year earlier. That these inflows have been bridging the shortfall in the trade account is no unmixed blessing. A substantial part of these capital inflows comprises investments by foreign institutional investors, portfolio funds, and hedge funds as well as other forms of private capital. Many of these are not stable. Last week, foreign institutional investors who have been net buyers of Indian stocks turned sellers. Their considerations for remaining in India will be prompted by short-term factors. In any case the external sector could do with more dependable sources such as merchandise exports.

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