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Is appreciation of rupee inevitable?

April 16, 2010 10:29 IST

It is not in our interest for the rupeee to rise against the dollar in which our exports are invoiced, says Jaimini Bhagwati.

The Reserve Bank of India (RBI) deserves all the praise it received at the celebrations for the 75th anniversary of its founding at the beginning of this month. RBI's prudent and pre-emptive approach has steered India's economic ship through rocky and often shallow waters in the last several years.

RBI's interventions are crucial in determining domestic interest rates and the Indian rupee exchange rate, and movements in these two prices of the rupee have repercussions throughout the entire economy.

This article discusses whether the appreciation of the rupee in the last one year was justified or inevitable.

The nominal rupee exchange rate steadily depreciated over the period April 1992-April 2002, going from rupees 30.6 to 48.9 per US dollar. From 2002, the rupee reversed direction and appreciated every year, except in 2006, till it reached rupees 40 to a dollar in April 2008.

Over 2008-09, as the global financial crisis unfolded, the rupee depreciated sharply to 50 to the dollar by April 2009. Since then, the rupee has appreciated to 44.35 on April 12, 2010.

In comparison, the Indian trade account (oil plus non-oil) has been systemically negative over the last 30 years from 1980-81 till 2010. The current account has also been consistently negative from 1980-81 to the first nine months of 2009-10, except for the three-year period from 2001 to 2004.

It could be argued that nominal exchange rate numbers are not material and what matters are movements in the real effective exchange rate (REER). However, daily decisions of bank and corporate CFOs are influenced more by nominal than real exchange rates.

In any case, RBI's 36-currency, export-weighted rupee REER shows an appreciation of over 10 per cent since March 2009. By contrast, China has kept the renminbi pegged to the dollar since the start of the global economic slowdown in mid-2008.

One reason perhaps why the rupee has been allowed to appreciate is the periodic surges in forex (FX) inflows. For instance, FX reserves rose in fiscal 2007-08 by $92.2 billion, which was followed by a decrease of $20.1 billion in 2008-09 and again an increase of $11.3 billion in the first nine months of 2009-10.

Given such fluctuations in capital inflows, it has to be difficult for RBI to let the rupee gradually depreciate by adding to its FX balances. If there is an accretion in FX reserves, the consequent rise in rupee liquidity would have to be drained to contain inflationary pressures, which could lead to a rise in domestic interest rates.

This, in turn, could complicate the management of the government's burgeoning borrowing programme.

The arguments against rupee appreciation are that: (a) India's budget deficits have widened to worrisome proportions in the last two years; (b) current account deficits have moved from the 1-2 per cent range to around 3 per cent of GDP.

On a related note, net inward NRI remittances in 2007-08, 2008-09 and the first nine months of the current fiscal year were $41.7 billion, $44.5 billion and $39.5 billion, respectively, i.e. between 3-4 per cent of GDP. Most of these inward remittances are from the Gulf region and are vulnerable to shifts in the strategic political climate in that region.

An important element of the post-1991 reforms was the phased and orderly depreciation of the rupee. On balance, it cannot be in our interest for the rupee to appreciate, in nominal and real terms, against the dollar in which India's exports are invoiced and the currencies of our principal trade competitors.

If the on-going Greek tragedy teaches us anything, it is that countries which do have exchange-rate flexibility should use it, and in the right direction.

One of the past orthodoxies was that capital controls invariably result in inefficient allocation of capital and hence should not be used. Reasonable people are now inclined to look for practical ways to balance the requirements of competing priorities.

India could aim at discouraging FX inflows, whenever rupee appreciation pressures are heavy, without adversely impacting FDI or ECB debt inflows. There should be less concern about a reduction in portfolio capital inflows since the Sensex price-to-earnings (P/E) ratio, as of end-March 2010, has nearly doubled to about 22 in the last 12 months.

Potentially, a sustainable remedy could be a 1 per cent charge on all non-FDI and ECB inflows, and this number could be titrated up or down depending on the volumes of flows. Incidentally, since the beginning of 2009, US banks have been charging an additional 1 per cent foreign transaction fee for any credit card/ATM transaction outside the US.

As of now, the cap on foreign investments in Indian government securities is $5 billion and the ceiling for corporate bonds is $3 billion. These are not large amounts. However, foreign investments in government securities could be phased out.

At the same time, the ceiling for corporate bonds could be raised commensurately to redirect foreign investor interest to this market. As the table shows, yields on Indian treasury bills (T-bills) are considerably higher than on T-bills issued by the US, Japan or Germany, and the Indian sovereign's credit is better than what S&P and Moody's would have us believe.

Additionally, secondary market liquidity in Indian government securities is better than that for our corporate bonds.

Although all RBI policies are followed closely, there seems to be more scrutiny when there are changes in rupee interest rates and cash reserve ratio levels, than in exchange rate movements.

This is probably because the consequences of interest rate changes are immediately visible whether it is through returns on bank deposits or the cost of borrowings.

The average person would sense the consequences of changes in rupee exchange rates more directly if energy, including petroleum, and fertiliser prices were to be made more pass-through. If it is needed, this is yet another reason for reforms in energy pricing and fertiliser subsidies.

It is instructive to observe the continuing obfuscation of pertinent issues by financial sector lobbies in the global debate on regulatory reform. To sum up, financial sector interests tend to prevail over those of real sectors universally - can India be an exception?

The author is India's Ambassador to the European Union, Belgium and Luxembourg. Views expressed are personal.

Jaimini Bhagwati
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