The recent appreciation of the rupee vis-a-vis the US dollar has come as something of a surprise to many people, who had assumed that the primary objective of the Reserve Bank of India with respect to exchange rate management was to resist its appreciation.
Over the last year and a bit, the RBI absorbed a significant proportion of forex inflows. In order to offset the impact of this absorption on domestic liquidity (sterilisation), it sold government securities. After several months of unabated sterilisation, it found itself running out of government securities to sell, which prompted the introduction of a special purpose sterilisation bond under a new Market Stabilization Scheme.
From January 1, 2003 until January 1, 2004, the rupee appreciated against the US dollar by a little over 5 per cent, notwithstanding the sterilised absorption that was going on. Between January 1, 2004 and April 8, 2004, the rupee appreciated by almost as much, most of this taking place in the last three weeks or so. The new bonds have been put into play, but the early indications do not point to an immediate counter to the appreciation pressure.
The sudden spurt has obviously provoked the question: does this development reflect a change in the attitude of the RBI (or the government in general) as to the optimal exchange rate? Has the earlier "preserve external competitiveness" justification of a policy of resistance been substituted by a "strong rupee means strong economy" view?
A certain rationale for the change emerges when the situation is viewed from a political economy perspective. This essentially views policy positions as the outcome of the interplay between interest groups. A change in a particular policy, then, indicates that a group whose interests were not being protected by the previous scenario has now been able to make a persuasive argument in favour of change. Typically, change is more likely when a variety of interests converge to a new scenario that takes care of their multiple objectives.
The competitiveness justification for resisting appreciation clearly takes care of the interests of exporters who trade in dollar-denominated prices. Also, given that our commodity export basket has a relatively high proportion of labour-intensive goods, an exchange rate induced loss of competitiveness runs the risk of putting many jobs at risk.
However, looking at the broader pattern of exchange rate fluctuations over the last year, it is clear that the appreciation of the rupee is more a result of a broader movement away from the dollar than of a particular attraction for the rupee. Between January 1, 2003 and January 1, 2004, the rupee depreciated by more than 5 per cent against the pound and the yen and more than 14 per cent against the euro. In the recent spurt, this trend has reversed somewhat. Between January 1, 2004 and April 8, 2004, the rupee appreciated by 1.4 per cent, 2.8 per cent and 7.6 per cent against the pound, yen and euro respectively.
India's commodity exports to the United States in 2001-02 (the latest year for which the regional break-up is available) were 19.5 per cent of its total. Service exports, of course, are far more heavily skewed towards the US. Exports to the euro zone constituted about 16 per cent of the total, while the United Kingdom and Japan accounted for about 5 per cent and 3.5 per cent respectively.
Assuming that these shares have not changed dramatically, the impact of the rupee-dollar rate on exports to major trading partners seems to have been offset by the rupee's reverse movement against the other currencies.
Of course, the recent appreciation against these currencies, if it persists, may affect overall export prospects. But, from a slightly longer-term perspective, if the appreciation against the dollar is accompanied by a depreciation against the other major currencies, an unambiguous position against appreciation vis-a-vis the dollar is difficult to arrive at.
Who are the beneficiaries from appreciation? Clearly, anybody who imports from dollar-linked countries and any foreigner who invests dollars in India. Private sector players who import their commodity inputs will clearly enjoy the savings that come from lower rupee prices in a global scenario of price increases for many commodities.
Also in the last few months, going by the persistence of the industrial recovery, there are increasing signs of willingness to expand capacity amongst businesses.
A significant proportion of the new plant and machinery will undoubtedly be imported, what with the very favourable trade regime for capital goods. If, say, 50 per cent of the capital cost of a new project is spent on imports from countries transacting in dollars, a 10 per cent appreciation of the rupee will mean an effective discount on capital costs of 5 per cent.
Presumably, many projects will become more attractive than before as a result of this. The sustainability of the industrial recovery depends critically on a revival of investment; even if a lot of imports take place, there will still be substantial spending on domestic products.
But, there is a further interest at work here, which also favours appreciation. Between January 2003 and March 2004, the price of crude oil (measured by the per barrel dollar price of US-delivered Brent crude) increased by over 11 per cent.
Over this period, this is only slightly higher than the appreciation of the rupee against the dollar, which means that, in rupee terms, the price of crude oil hasn't changed much.
More generally, the value of an appreciating currency to check domestic inflation has become somewhat more obvious at a time when global commodity prices are soaring. Tariff reductions are certainly an equivalent way to deal with rising prices, but the rates for both capital and intermediate goods are already quite low.
In the immediate context, there isn't much room to exploit this instrument, although from a longer-term perspective, the delivery of promises to move towards Asean rates across-the-board becomes that much easier when the availability of foreign exchange is not a constraint.
For foreign investors, appreciation is self-fulfilling. Fewer rupees are required to generate a given amount of dollar returns. The required rupee rate of return on investments goes down, which means more money will flow in from outside, other things remaining the same.
The immediate policy question is whether the benefits to these groups compensate for the losses to exporters. The longer term question is whether the huge rise in inflows is a temporary or permanent phenomenon.
If it is the latter, then the use of short-term instruments (like absorption and sterilisation) can be justified. If it is the former, then the best response would be to create a full-fledged market for the rupee (meaning full convertibility) and then just let the rupee be.
The writer is chief economist, Crisil. The views expressed are personal.
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