The Hindu Business Line : The rise of the rupee

MR Nigel Lawson, the former Chancellor of UK Exchequer, discussing the intricacies of exchange rate policy, has a pithy quote from Oscar Wilde's play The Importance of Being Earnest.

A character in the play, the Governess Ms Prism, tells her ward "The chapter on the fall of the rupee you may omit. It is somewhat too sensational". We have been so used to the fall of the rupee that we have to turn Ms Prism's advice in its head. It is now the rise and rise of the rupee which is sensational.

Exchange rate policy has always been an arcane, albeit interesting subject. The media, especially the financial press, has been full of news about the US urging other economies to revalue their currencies. In effect, when an economy revalues or appreciates its currency with reference to the dollar, the dollar gets devalued. That is the policy objective of the US.

Per contra, Japan spends billions of yen to purchase the dollars that flow into its economy, with a view to keeping its currency yen from appreciating. Japan, in spite of its high level of current account surplus and huge reserves, wants to encourage its exporters.

China plays the same game by practising an exchange rate policy of keeping its currency at a fixed exchange rate to the dollar for the last decade or so, which it does by massive intervention in the market. As against this, we see India suddenly switching its stand in favour of a stronger rupee with reference to the dollar.

The rupee has appreciated nearly 10 per cent over the last year. Are we — unwittingly — listening to Uncle Sam's expostulations and helping the "poor" Americans to save their jobs?

Stories abound of different motivations behind RBI's change of stance, although I believe RBI has its own valid and objective reasons. True, RBI is sitting on a mound of forex of nearly $110 billion in reserves.

Further, RBI buying of US dollars will create a surplus of rupees in the public's possession, which RBI will have to suck up by selling bonds in exchange for rupees. This, in technical terms, is called sterilisation. In effect, it leads to bonds becoming cheaper, due to oversupply. This, in turn, implies an interest rate rise, which will attract more forex inflow — a vicious cycle.

There is also a practical reason for caution in intervention. The RBI is running out of the Government bonds in its armoury. This has been counteracted by a supply of "stabilisation" bonds issued to the RBI by the Government of India, which can play the same role as debt paper.

These stabilisation bonds amount, in effect, to the RBI lending to Government and creating rupee paper, which it can exchange for rupees paid out for dollars. The fact, however, remains that the RBI has stayed away from the market for quite a few days and "shocked" the market by a change in policy towards the rupee.

We have all been so used to seeing the rupee depreciate against the dollar that the recent change in its performance has created quite a surprise to some and shock to others. The surprise is for importers, who have to pay less rupees per dollar for their imports. Government policy-makers can also rest on their inflation-fighting oars since the imported crude price will not rise to the same extent.

Increases in prices of petroleum products can be put off. In effect, the incipient rise in inflation will get a breather, thanks to the stronger rupee. Also, corporations that have indulged in a bit of heavy borrowing in dollar markets abroad can breathe easy since their rupee costs will be lower.

Last but not least, foreign investors in Indian equity markets can carry back to their books higher dollar gains. All this is on the plus side.

What is material is to determine whether the cause of this turn of events — the inrush of dollars — will continue in spite of the appreciation of the rupee. To be sure, the extent of speculative inflows chasing a higher rupee will increase.

That may not be quite good news because it can reverse when the rise changes direction. What is more material is that the very rise of the rupee will have a counter-attractive impact on our exports.

Supporters of appreciation say that exports have been rising over the last year in spite of appreciation during the last year and that the rupee has depreciated against the euro. But the US is our dominant export destination. Ultimately, no one can deny that a stronger rupee will mean Indian goods and services will be less competitive in the main export markets, except to the extent they incorporate imports. India's exports to the US are mostly labour-intensive and especially so in respect of business process outsourcing. The impact of rupee appreciation can hit severely the thin profit margins of BPO, already under attack from the US and potentially from China.

Let us also note that China's currency, which is our principal competitor, is pegged to the dollar and is not appreciating. Its abundance of labour resources and relaxed attitudes to labour laws enable China to provide cheap goods to the global markets. Particularly is this true of its textile industry and its light and medium machinery segments.

If India is to compete in the global markets with China, it should not make its exporters suffer the handicap of a stronger rupee.

There seems to be a section of the political class, which apparently takes pride in a stronger rupee. "India Shining" seems to find an echo in a rupee rising. There are those who even dream of Rs 30 to a dollar. They even hope that this can catapult India into the league of developed countries because our "rupee" GDP will translate into higher dollars. But this will be a temporary relief.

There is no such thing as a free lunch in economics. Those, who gloat over a strong rupee and its benefits, will soon realise the immense disadvantages it confers to our exporters who after all bring in the inflow of dollars.

India should not be forced to revisit the episode of the Dutch disease, which afflicted Netherlands in the 1970s. Following huge gas discoveries, Netherlands faced a flood of foreign currencies, which led to the appreciation of its currency, the guilder. That, in a way, led to the decline of Dutch competitiveness and the economy going through a troublesome phase.

The strong guilder led in time to a weak Dutch economy. I hope India's pursuit of the mirage of a strong rupee does not end up by weakening the economy — by making exports decline and imports increase.

The rise and rise of the rupee may appear glamorous for some superficial observers. But it masks serious trouble to come. Not for nothing did Japan build its economy on the basis of strong exports founded on a weak yen. India has to learn from China and Japan — a strong domestic currency may not be the economy's best friend.

This is not to deny that there are problems with the RBI's policies of purchase of dollars and on-lending them to the US and other developed countries. Economists of the standing of Dr Ila Patnaik have pointed out the high quasi-fiscal costs of such policies of RBI. The answer is not to let the rupee appreciate and stop intervening.

Perhaps, there are other ways in which RBI can deploy its reserves.

It can lend part of these reserves to Indian scheduled banks to relent to our undertakings taking up various projects. In the process, a vicious cycle of external commercial borrowing by Indian undertakings from foreign banks can be diverted to the benefit of our own banks.

There is also scope for a careful forward movement in terms of greater capital account convertibility. All told, the quasi-fiscal costs of RBI's forex reserves cannot be held as the main logic behind stopping intervention to keep the rupee at a reasonable competitive level to help exporters and assist local industries to compete with imports.

Maybe, the strong rupee will create a few winners. But overall, it will create more losers, since the country has many activities that depend on value addition through labour, particularly farm-based industries and agriculture itself.

It is particularly necessary that the euphoria about a strong rupee is tempered with a detailed analysis of its impact on different segments of Indian economy and corrective steps to counter them.

The celebration of a strong rupee should follow — not precede — the study of its intended and unintended consequences. We should stop listening — even if unintentionally — to the calls from Washington to revalue our currency.

There is admittedly need for greater transparency in India's exchange rate management, although central bankers love obscurity and exchange rate markets are porous to even the slightest hints.

Hopefully, the coming Credit Policy will open the window a little bit. But, by then, it may be too late to help the struggling Indian exporter and manufacturer. "Strong" is "weak" in this Alice in Wonderland world of exchange rates.

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