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RBI policy and rupee-dollar enigma

The rupee has moved from strength to strength against the dollar

THE FOREX markets have continued to be in the news. The rupee's strong run against the dollar seemed unstoppable at one stage. From a level of above 44 in March, the rupee has been gaining spectacularly breaching several records in the process. On April 26, the rupee was at a nine year high when it closed at 40.60 to the dollar but in the following week moved down to close above 41 on April 30.

A two-way movement of the currency is more `normal' but the causes that propelled such a sharp appreciation in a matter of six weeks are still a matter of intense speculation. Predicting the future course of the rupee therefore becomes particularly hazardous when its recent behavior cannot be used as a guide. One explanation for the recent rise is that the Reserve Bank of India did not intervene or intervene aggressively enough to stem the rupee appreciation.

Under the exchange rate policy of the country that has been followed since 1993, the rupee has been on a `managed float,' largely market-determined, with an unstated target for its external value in a scenario of partial controls on the capital account. Within those broad parameters the RBI has been intervening aggressively to maintain a competitive exchange rate.

The rupee's exchange rate is benchmarked against the 1993-94 values of originally five (now six) currency trade-weighted indices (REER or real effective exchange rate). These currencies are of countries with which India has a large share of trade. The benchmark is for guidance only and is not meant to be a formal target. In REER terms the rupee has appreciated to 112 in April this year from 101 a year earlier.

Taking into account the RBI's strong interventionist stance of the past its recent hands-off approach might suggest a radical departure. However, it is highly unlikely that the RBI will abandon its stance that has served the country so well. A stable exchange rate policy has helped in macro-economic management and economic growth. One definite clue pointing in the direction of continuity is the raising of ceilings for the outstandings under the market stabilisation scheme (MSS).

The RBI has now been enabled to issue a larger amount (outstandings Rs. 110,000 crore) of bonds and treasury bills to drain liquidity. In fact, the most recent reversal of the rupee came after the announcements of the enhanced limits. That should set at rest any lingering doubts over the future course of the exchange rate policy.

This year the rupee has moved from strength to strength against the dollar to become the strongest major Asian currency against the greenback.

This relative strength is what weighs with Indian exporters who had for long depended on a cheaper rupee to boost exports. China having seven times the value of Indian exports is still consciously keeping its currency the yuan extremely competitive. Indian exporters are at a serious disadvantage. That is one major reason why the recent rupee appreciation might not continue over the medium term.

Supply versus demand

For all the apparent complications surrounding the rupee-dollar equation, it is really a question of supply of dollars exceeding demand. India's commendable economic performance has attracted the attention of global investors, not just of the portfolio variety but the more stable foreign direct investment (FDI) as well. Interest rates in India have been rising and foreign investors are spotting a huge opportunity in select sectors such as real estate.

FII inflow (both debt and equity) since the beginning of 2006 has been closer to $10 billion. Non-resident Indians too have been patronising the country, although the last credit policy has sought to place some disincentives in their way. (That is one of the few direct measures to stem the supply of dollars). Higher interest rates in India have encouraged companies to borrow from abroad. The higher visibility that some Indian companies now have coupled with easier norms for raising resources abroad has led to a proliferation of dollar inflows into India.

For the common man, a stronger rupee has several implications. The bulk of India's trade is invoiced in dollars. Hence an appreciating rupee translates into a depreciating dollar. Indian exports will become expensive, possibly leading to lower volumes. The point has already been made that IT companies will take a hit.

Export earnings, both from merchandise trade and software and other `invisibles', constitute a growing and important part of the balance of payments.

On the other side, a strong rupee might encourage imports and hence widen the trade deficit further. For the FIIs, a strong rupee means fewer rupees to invest in Indian stocks. But when they repatriate their sale proceeds they should get more dollars.

C. R. L. NARASIMHAN

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