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The rupee changes course

The Indian rupee, which was seemingly in an inexorable appreciation phase against the dollar throughout last year, has changed course since last January. Having touched a high of 38.50 to the dollar, the Indian currency, according to most experts, was expected to move up still further.

That is why its decline this year has caught everyone off guard .Most of the depreciation has occurred during May. Last week it breached the 43 barrier.

While interpreting exchange rate movements over a fairly long period, it is not the spot rates (that one sees in newspapers every day) that are as much important as the trends.

Therefore, even while the rupee moved both ways last year, and continues to do so even now on a day-to-day basis, it is the trends — sharp appreciation last year and steady depreciation this year — that are of greater and more general interest.

It is worth recalling here that in 2002 the rupee was quoting around 49 to the dollar. By last year, it had gained around Rs. 11. It needed only a little over Rs. 38 to buy one dollar last year. Of course, the rupee did not move in a straight line.

The question as to where the rupee is headed from now on cannot, however, be answered easily. The Indian currency is on a ‘managed float’.

The Reserve Bank of India has time and again mentioned that its exchange rate policy involves careful monitoring and is flexible. While it does intervene there is no fixed target or a pre-announced target or a band. Intervention therefore is based on its assessment of macro economic factors that may be affected by unanticipated swings in the rupee’s exchange rates.

Closely related to the exchange rate policy is the management of forex reserves, now well above $300 billion. There are obviously enormous implications for the policy makers from the rupee’s sudden weakness in relation to the dollar.

There has been no RBI intervention this time when the rupee went down. An appreciating rupee often invited strong intervention.

Since dollar flows into the stock market were primarily responsible for the rupee’s strength, the Reserve Bank of India (RBI) mopped up the dollars to check any imbalance between ‘oversupply’ of dollars and its demand. This needed to be followed up by sterilisation of the excess rupees released consequent to the dollar mop up.

A substantial portion of the reserves is built up through RBI’s action in buying dollars.

There is therefore an asymmetry in the central bank’s interventionist stance. Till now intervention has sought to check a runaway appreciation of the rupee and its decline has not prompted any central bank action. The macro economic implications are several.

A stronger rupee makes for cheaper imports but exports become costlier. In the context of the rising inflation there has been one school of thought that wanted a costlier rupee.

The petroleum import bill will become cheaper. But the flip side is that exporters lose their competitiveness and IT companies report sharply lower operating margins.

Merchandise exports have slowed down. There have been some major consequences in the form of job losses in industries such as textiles that are labour intensive.

Exporters lobbied and won incentive packages that were meant to partly compensate them for the adverse exchange rate.

With the rupee doing a sharp U-turn, exporters probably do not require special incentives.

However, once given it will be very difficult to withdraw concessions and incentives. Besides, there is a strong reason why promotion of merchandise exports should continue to receive top priority.

Understanding the balance of payments dynamics will help in tracking the immediate direction of the rupee. Merchandise trade deficit has widened not only because of the slower export growth .Obviously the sharply escalating oil import bill is an even more important contributor.

In turn the current account deficit will widen further this year, according to some reliable estimates, to around 2 per cent of the GDP. This may not be an unmanageable figure, but seen in the context of declining cross-border capital flows, is something that will force policy makers to take note.

Consequent on the crisis in U.S. financial markets, there has been an ongoing exercise at reprising risks.

That capital inflows to the stock market will forever shore up the BOP cannot be taken for granted. Even the RBI has talked of capital flows reversing.

Other things remaining the same, a cheaper rupee should be one of the obvious policy responses to the persistent trade deficits.

Other factors contributing to the rupee’s recent weakness have been the strengthening of the dollar in the global markets and of course the runaway global oil prices.

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