The Rising Rupee: Boon or Bane?

Rising Rupee

The rupee has been rising against the dollar for the last couple of months. But what has sent the alarm bells ringing is the speed with which the currency has risen (nearly 10% against the $$ in the last 6 months). Though everyone keeps talking only about the dollar, it is interesting to note that the Rupee has, in fact, also steadily risen against other currencies in the last 5-6 months (8% against the pound, 7% against the Euro and 11% against the yen).

Is this a problem or is this really good for the Indian economy?? One thing is for sure. This is a drastic departure from past policies and a strong rupee will have a really big impact on the Indian economy. The main reason for rupee's appreciation in the last 6 months has been the flood of foreign investments and remittances into India (esp. US$). These $ inflows are coming in the form of foreign direct investment (FDI) to remittances sent home by Indian expatriates. In each case, the flow seems unlikely to slow down anytime soon. That coupled with the Indian stock market's stellar performance has the foreign portfolio inflows booming. The large and steadily increasing net inflow of foreign exchange into India has translated into an excess demand for rupees. Like any other good or service, the excess demand for rupees has resulted in an increase in the price of the rupee.

The rupee's appreciation is alarming exporters, as it makes their products more expensive in overseas markets and erodes their international competitiveness. The software exporters for one are already starting to miss their earnings. The last month has seen all major software exporters taking a hit and there is already evidence in India of an export downturn in a number of other sub-sectors as well (Textiles and Commodities). This is mainly because Indian exporters earn their revenues in foreign exchange. So the more and more the rupee appreciates, the less and less they earn. The current situation has all the exporters screaming as the profit margins are being squeezed out. In a way this is like the shortest growth story as just when the Indian export industry is being talked about as a great economic engine, it looks like the exporters are already being forced to shut shop as they are unable to compete and losing out to their biggest rival, China.

An important factor in the central bank's policy change in allowing a stronger rupee is the rising inflation. The RBI typically controls the appreciation by manipulating demand-supply dynamics of currency market. In order to prevent the rupee’s rise, RBI bought close to $20 billion in the last four months to curb the rupee’s rise (Incidentally, India's foreign exchange reserves have now crossed the $200-billion mark). But as RBI purchased dollars (creating more demand for dollar) and sold rupees (increasing supply of INR, thereby decreasing its value), the money supply increased - which meant too much money chasing the same (or less) number of goods – and this led to increased inflation in the country. The increased liquidity therefore fuelled inflation and of course as we all know this comes with a 'Political Cost' attached to it. So the RBI backed off and let the rupee appreciate again. When RBI was buying billions of $$, inflation shot up in excess of 6%, but when they stopped buying $$$, the resulting large drop in money and credit growth lowered inflation significantly - The govt. has targeted a 5% inflation for 2007.

Of course on the flip side, all the importers are extremely happy as imports have become much more affordable. An appreciation of the rupee has made the import of foreign goods (such as crude oil and petroleum products) cheaper (in rupees) in India. The rupee appreciation should exert a downward pressure on the inflation rate. A strong rupee in nearly a decade may be good news for importers and those who see the currency as a symbol of economic prowess. However this does little to prevent the dilution of our country's competitiveness because a cheaper dollar makes imports easier and exports tougher. The profitability of exports is already being affected, and if the appreciation in the rupee continues unabated, they will feel the pinch and exports will suffer.

So is a strong rupee really curbing inflation?? Should RBI buy more $$ to curb the Rupee?? RBI has a difficult policy choice at hand. In which direction it will move will depend on which objective is given more important i.e inflation control, maintaining export growth or capital account convertibility. The government and RBI are keeping their fingers crossed and hoping that there will be no need for a major intervention. However, given the amount of $$ flowing into India the problem is unlikely to disappear soon.