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Indian Rupee - Gravitational forces

Jun 6, 2007

Trying to simultaneously hang on to an inflation target as well as an exchange rate level for any central bank in an open economy is like stepping on two unstable stones in the midst of a fast flowing river. In India's case, thankfully the central bank stuck to inflation, probably also nudged there by a political sense that has to face a spate of impending elections all over the country. In the era of dollar appreciation worldwide, the Indian Rupee kept to the global values; the Rupee depreciated from Rs44/US$ to touch Rs49/US$ in June 2002. Since then, the dollar itself has slid against global currencies and so did the Rupee gradually strengthen to Rs 44 levels, where the Reserve Bank of India (RBI) was content to keep it by buying dollars and releasing rupees into the banking system. The resultant inflation put a brake on RBI's dollar acquisition spree, and as a result the Rupee strengthened to Rs 40.50 (8.8% appreciation) in barely seven weeks.

Varied vistas for exports
The prime incentive in holding the Rupee down is better export growth. But the evidence so far suggests otherwise. For, though the Rupee has been gradually appreciating against the US dollar since June 2002, it depreciated against the Euro in the same time period. This was accompanied also by a change in trading partners - developing countries including the Central Asian Republics and China that accounted for just over a quarter of India's trade in 1995, have increased their share to a half in the last one decade. China alone accounts for 10% of India's trade, a 5 times increase in as many years.

A better gauge is the RBI's Real Effective Exchange Rate - REER is an index of India's trade-weighted exchange rate against 36 countries, all adjusted for their domestic inflations. It remained between 95 and 100 for most of this period, showing that India¡¦s exports were price competitive as against her trading partners as well as her major competitors.

(Source: RBI) exports-REER.xls from may ecoselect

The resultant growth in exports is significantly higher than ever since 1991. Exports have benefited largely from better productivities as technologies improved and better economies of scale as restrictive policies were phased out.

A weaker dollar has its uses
The export lobby has always been trumps, as India needed the precious foreign exchange for funding crude oil imports. But in order to keep the exporters happy, if the RBI supports the US$, it releases money. To sterilise this increased money supply, the only non-inflationary tool available to the RBI is to raise interest rates, which affects domestic growth as also the as-yet-precarious fiscal balance. But, this also raises the cost of imports, that in turn will increase the cost of production within the country further as we import crude oil for transport, capital goods to enhance domestic capacities, and gems for re-exports.

The argument for intervention weakens further when we substantiate that the exporters can easily hedge their exposures, something they have never done because, a) RBI never gave them room to believe that it would deviate from the policy of guarding its anti-gravity exchange rate policy, and b) currency future markets are as yet banned in India. The first premise has already been altered, and so can the second one too.

A short-term gain
Lack of details in our reform process that potentially would have reduced costs, accompanied by a slowly appreciating REER has already had their toll on export growth in the fourth quarter of FY07. We expect this downtrend to continue over the next 12 months. As yet financial reforms are slow in putting together vehicles to invite foreign participation in the Indian growth story. Thus the likelihood of big-ticket FDI inflows inflating dollar supplies in FY08 is lower. At the same time, freeing up of capital controls on currency flows from India has seen Indian companies acquiring assets abroad, and thus further increasing the demand for dollars.

As imports become cheaper and therefore more numerous, while the exports inflow dries up, the pressure will be on the Rupee to lose its recently gained appreciation against the US Dollar. We do not foresee the dollar appreciating beyond the first few months of FY08 from the current levels of Rs40.6 to a US$. A more realistic level to end this fiscal year would be around Rs44 per US$, given our balance of payments expectations.

But return to problems of plenty later
The worldwide consensus is for a further strengthening of the Euro and the Pound against the US dollar over 2007. If the government can be persuaded to give up its stranglehold on the Indian economy, things will move very fast. With much higher returns in India, in the long run (about two years onwards), however we look at it, the money flows will be into India rather than out. And the domestic inflation-higher interest rate dilemma will see the RBI wary of supporting a globally weakened dollar.

Globalisation in its truest sense needs greater financial integration with the world currency markets. In such a scenario, the Rupee will find its equilibrium contingent to the dollar's international movements against the other world currencies.

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