rise of rupee

Strong rupee: Causes, consequences
Alok Ray
The rupee has been appreciating against the dollar. What are the implications for the Indian economy, the corporate sector, and for the rupee itself, especially vis-à-vis other major currencies? And what can the RBI do? Alok Ray looks at the various scenarios.

THE underdog rupee has begun to flex its muscles. Instead of depreciating the rupee has gained more than 4 per cent against the US dollar over the past 12 months. India's current account balance of payments is in surplus for the first time in 25 years.
What are the major causes and the possible consequences for the Indian economy of all this? The trade deficit is being more than offset by remittances from Indians abroad and export of services, in particular software exports. As a result, the country has a current account surplus. In addition, there has been a steady flow of foreign funds.
The interest rate in India is 4-5 per cent above that in the US. The rupee has started appreciating, instead of depreciating, against the dollar and the market generally believes that it may appreciate further.
So, people perceive little risk of losing money in converting rupees into dollars in the near future. Thus, it is clearly profitable for NRIs to borrow in the US at, say, 1.5-2 per cent and invest in India at 6 per cent and reconvert rupees into dollars after the maturity period. The Indian corporate sector and banks, too, are finding it lucrative to borrow funds from abroad at such low interest rates. The LIBOR (London Inter-bank Offer Rate) stands at 1.5 per cent.
The RBI has two options. It can allow the rupee-dollar rate to be determined by the market forces of demand and supply. Given the current excess supply of dollars, the market-determined price of dollar should fall.
The other option is for the RBI to buy up the excess dollars from the market at some target price. The result would then be a further addition to the RBI's stock of foreign exchange, which has already crossed $78 billion.
The dollar was Rs 26.40 in March 1991. The rupee has been steadily coming down since then and reached the bottom at Rs 49.08 to a dollar in May 2002.
Since then, it has been going up against dollar and is currently around Rs 46.80. In fact, the appreciation of the rupee against the dollar would have been even more had the RBI not purchased dollars from the market on a massive scale, adding to its reserves.
It now seems the RBI has finally accepted the inevitability of rupee appreciation. It may well reduce its dollar purchase and allow a more market-determined value of the rupee in the foreseeable future.
The addition to reserves is proving fairly costly for the RBI. It earns a low rate of return (say, 2 per cent) when invested in US government securities whereas the NRIs have to be paid the market rate of, say, 6 per cent.
Though the rupee has been rising against the dollar over the last 12 months, it has still been depreciating against other major currencies, such as the euro and the yen. In fact, the recent sharp rise in rupee's value against the dollar is largely due to the falling value of the greenback against the euro and other currencies rather than any rise in the rupee's value against a basket of major international currencies.
The dollar's fall is primarily due to a big and rising current account deficit of the US, not matched by capital inflows. Foreigners (and Americans, too) are not too keen to invest their money in the US what with collapsing interest rates and stock markets.
The rupee's rise against the dollar would mean that Indian goods would be more expensive in dollar terms. Alternatively, if the dollar price of our goods is kept fixed (such as consultancy fees of software engineers), the corresponding rupee realisation would be less.
Either way, India's export earnings may suffer. This has already affected bottomlines and share prices of some software companies. The same may happen to other export industries, especially in the US market. On the import side, however, the rupee cost of oil and other goods (whose prices may be fixed in dollars) would fall which may help to keep inflation rate down.
A question immediately arises: India's exports grew at the rate of 16 per cent over 2002-03, despite the rupee rising against the dollar. Does this mean that the exchange rate does not matter? The answer is: No. First, as already stated, the rupee has been depreciating against other major non-dollar currencies. In fact, based on the trade-weighted average of the currencies of India's five major economic partners, the rupee actually depreciated by 5 per cent in nominal terms over March-December 2002.
Even in real terms (which takes into account the difference in inflation rates in India and the five other countries) the rupee depreciated 3 per cent. So, the international price competitiveness of Indian goods in global markets overall was not affected by the rupee's depreciation against the dollar.
Second, the impact of any change in exchange rate on trade flows takes time to manifest since past export-import contracts remain valid for some time. So, if the rupee continues its upward journey, not only against the dollar but other currencies as well, and the inflation rate in India also picks up, the country's export growth may well be affected. Of course, a few other things may happen. For instance, some Indian companies may decide to fix the prices of export products in the euro (or even rupees for consultancy services), rather than in dollar.
If rupee depreciates against euro but appreciates against dollar, then Indian exporters will gain in terms of rupee earnings.
If dollar continues to depreciate against euro, even OPEC may want to fix oil prices in euro at some point in future. In that case, the downward impact on the rupee cost of oil as a result of dollar sliding against rupee will no longer be available.
Some Indian companies may choose to shift their factories to, say, China if they get a better exchange rate from there. Some may prefer to do cost cutting and quality upgrading to beat the adverse impact of rupee appreciation on exports.
As the RBI Governor has rightly warned, one should not think that the rupee would necessarily continue to appreciate against the dollar in future.
It may depend on the timing of the US' economic recovery, the interest rate policy of th Fed, the state of world oil market and so on. The depreciation of the dollar against other major currencies is boosting American exports and cutting down imports. This is adding to demand for US goods and helping economic recovery.
But the expectation of continuous dollar depreciation is reducing the attractiveness of the greenback as a store of value. The US President, Mr George Bush, may well decide that any further depreciation is hurting overall US interests and take corrective action.
Many Indian corporates (and even banks) are borrowing dollar funds at low interest rates abroad and they are not even covering the exchange rate risk ("hedging"). One way of covering the exchange risk is to have export earnings in dollar to service future dollar debt. Many Indian companies do not have that automatic cover.
Another way to limit risk is to buy dollars in the forward market. The cost is that they will have to pay a premium on forward dollar purchase. Right now, this premium is at an all-time low (below 1 per cent) but even then many prefer not to hedge. The same is true for many exporters and importers.
The upshot is that a large number of players in the market are gambling on further rupee appreciation. In addition, investors everywhere are guided by the "herd instinct".
If suddenly some operators decide to sell rupees and buy dollars expecting the latter to appreciate and as a result the rupee tends to fall, others may immediately follow. This may suddenly end the rupee's upward journey.
Of course, the RBI, with its $78-billion reserves, is in a much better position today to smooth out price fluctuations by purchase or sale of foreign exchange. Given the absence of capital account convertibility for Indians, an East Asian-type crisis is not very likely in India. Yet, the risk of some people suffering heavily as a result of unhedged foreign exchange position seems fairly high.