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How strong is the rupee really?

How mindsets take time to adjust to changing circumstances was best exemplified once again by a recent press report. According to the report, for Pepsi to take over a sick bottling company in India, the ministry of finance has insisted that the funding must be entirely in foreign exchange.

In a way, one is somewhat sadly surprised that even the finance ministry, indeed the department of economic affairs, continues to be circumscribed by the "precious foreign exchange" syndrome, even as the central bank relaxes exchange controls to encourage outflows.

Incidentally, as for the latter, while liberalisation is welcome, it is worth noting that the major ones will remain in force only up to March 31: in other words, at the slightest pressure on the rupee, they are liable to be reversed. One wonders what is the point in introducing them for a period of just three months.

Besides this, much of the comment in the media on the strength of the rupee and the level of reserves seems overblown. One of the reasons for this is the interest arbitrage supposedly being undertaken by non-resident Indians between dollar and rupee interest rates, which has led to a surge of inflows.

If media reports are to be believed, the central bank itself seems to subscribe to this view and has "informally" asked public sector banks to reduce interest rates on NRI deposits.

To me, this seems to be a gross overreaction to a 2 per cent appreciation of the rupee against the dollar over a seven-month period - it is worth noting that, over the same period, the rupee has fallen 10 per cent against the euro, the second most important currency in the world.

As far as NRI inflows are concerned, the rise in non-resident deposits other than NRO, was 6.4 per cent in 2000-01, 9.11 per cent in 2001-02 and 5.6 per cent in the first five months of the current fiscal year, hardly evidence of a huge increase.

In absolute numbers, the rise was $ 1.4 billion during these five months, compared to an increase of $ 9 billion in reserves. Again, over this period, portfolio investment flows were probably negative (-$ 238 million over April - June), and so were debt flows (-$ 1.5 billion over April-June).

Moreover, if the central bank's informal advice is meant for only public sector banks, this will hardly help reduce the flows when private sector banks are merrily offering higher interest rates.

In short, to ascribe the strength of the rupee to capital inflows from NRIs does not seem to be an acceptable or plausible diagnosis. In any case, as far as the central bank's informal advice is concerned, one hopes that it will start looking at a couple of percentage point changes in exchange rates, with greater sang froid, rather than curb the freedom of banks to price deposits.

The first point to be noted about the appreciation of the rupee is that, after decades, we are registering surpluses on the current account.

Second, inflation remains low. While these two points represent the "muscle" part of the strength, much of it is, to my mind, also due to a "swelling", a sharp increase in short-term capital inflows.

These are in the form of short-term FCNR(B) loans, pre-shipment credit in foreign currency which, in effect brings forward foreign exchange receipts, and supplier's or buyer's credits on imports, leading to excess dollar supplies over demand.

Inflows from NRIs and foreign institutional investors perhaps have little do with the imbalance. (Unfortunately, not much published data is available under these heads). In the process, it seems that huge short dollar positions have been built by the corporate sector.

While I remain bullish about the exchange rate in the medium term, the likely scale of the short dollar positions is worrying, and the bubble is capable of being burst by a single grain of sand.

To use an analogy from physics, consider that fine grains of sand are being added to a pile on a plane surface. In due course, the pile will assume the shape of a small hill with some grains sliding down the slope but the overall height still on the rise.

This, of course, cannot, and does not, continue indefinitely. At some stage, one grain of sand changes the whole picture and the hill collapses. And the most advanced mathematical models using high-powered computers cannot predict exactly when that pile-shattering grain of sand will be added - even for a system which is purely physical, with no part for sentiment to play!

Something similar could happen in the case of the rupee's exchange rate - and sentiment will be important there.

This apart, one also cannot see why so many commentators are getting concerned about the rising reserves. The choice is between a significant appreciation of the rupee in US dollar terms, and allowing the reserves to rise.

Certainly, the first alternative is more in the interest of the real economy, constrained as it is by rigid labour laws, small scale industry reservations and poor infrastructure. An appreciating rupee is clearly capable of cutting short the recovery in the industrial sector which seems to be on.

One news magazine, with the shallowness to which it is prone, has quantified the "loss" because of rising reserves at $ 1.6 billion a year on $ 20 billion added in 2002. Really?

If reserves were to be stagnant, money supply would be lower by Rs 1,00,000 crore (Rs 1,000 billion). Where would interest rates then be for industry and also for the biggest borrower of them all in Delhi?

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