The Telegraph
Since 1st March, 1999
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When India started liberalizing imports in 1991, the biggest worry was that its foreign exchange reserves would vanish in no time and it would perennially be at the mercy of the International Monetary Fund and the World Bank. Its reserves in 1991 were barely enough to cover 15 days of imports. Today, India’s reserves have crossed $76 billion. Instead of depreciating, the rupee has gained about 4 per cent against the dollar over the past 12 months. India’s current account balance of payments shows a surplus for the first time in 25 years. Why is this so and what are its implications for India’s economy'

The import of goods still exceeds exports. But this trade deficit is being more than offset by remittances from Indians abroad and export of services, particularly software exports. In addition, there has been a steady flow of foreign funds from abroad. The capital inflow has received a big boost as the interest rate in India is 4 to 5 per cent more than the interest rate in the United States of America. Moreover, the rupee has started appreciating, and is believed to appreciate further. So people perceive little risk of losing money in converting rupees into dollars in the near future. Thus, it is profitable for non-resident Indians to borrow money in the US at, say, 1.5 per cent interest and then invest in India at 6 per cent and reconvert rupees into dollars after the maturity period. The Indian corporate sector, too, is finding it lucrative to borrow funds from abroad at such low interest rates.

All these are adding to the supply of foreign exchange in the market. The Reserve Bank of India has two options. It can allow the rupee-dollar rate to be determined by the market forces. Given the current excess supply of dollars, the market-determined price of dollar should fall. The other option is to buy up the excess dollars from the market at some target price and add to the stock of foreign exchange. From Rs 26.40 against a dollar in March 1991, the rupee came down to Rs 49.08 to a dollar in May 2002. Since then, it has been going up and is currently around Rs 47. The appreciation of the rupee against the dollar would have been more had the RBI not purchased dollars from the market on a massive scale, adding to its reserves. It now seems that the RBI has finally accepted the inevitability of rupee appreciation. It may well reduce its purchase and allow a more market-determined value of the rupee. The RBI has come to believe that it has a comfortable level of reserves and further addition to reserves will prove costly. It earns a low rate of return (say 2 per cent) when invested in US government securities, whereas NRIs have to be paid the market rate of interest at, say, 6 per cent.

What would be the implications of a rising rupee against dollar' First, note one important point. Though the rupee has started rising against the dollar, it has still been depreciating against other major currencies, like euro or yen. In fact, the recent sharp rise in the rupee’s value against the dollar is largely due to the falling value of the dollar against the euro and other currencies rather than any rise in the rupee’s value against a basket of major international currencies. The fall of the dollar is primarily due to a big and rising current account deficit of the US. Foreigners (and Americans) are not too keen to invest their money in the US with collapsing interest rates and stock markets.

A rise in the rupee’s value against the dollar would mean that our goods would be more expensive in dollar terms, which may reduce our sales abroad. Alternatively, if the dollar price of our goods is kept fixed (like consultancy fees of our software engineers), the corresponding rupee realization would be less. Either way, our export earnings may suffer. This has already affected the bottom lines and share prices of some of our 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 keep the inflation rate down.

One may raise a question here. Our exports grew at the rate of 18 per cent over the 2002-03 fiscal year, despite the rising rupee against dollar. Does this mean that the exchange rate is irrelevant to exports' The answer is no. First, as already stated, the rupee has been depreciating against other non-dollar currencies. In real terms (which takes into account the difference in inflation rates in India and the five other countries) the rupee depreciated by 3 per cent. So, the international price competitiveness of Indian goods in global markets was not affected adversely 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. People need time to revise their contracts, even when exchange rates are changing.

All these may imply that if the rupee continues its upward journey, not only against the dollar but other currencies as well, the inflation rate in India picks up, then India’s export growth may well be adversely affected. A lot may depend on business strategies. For example, Indian companies may decide to fix the prices of export products in euro rather than in dollars. If the rupee depreciates against the euro but appreciates against the dollar, then Indian exporters will gain in terms of rupee earnings. If the dollar continues to depreciate against the euro, even the Organization of Petroleum Exporting Countries may like to fix its price of oil in euro at some point. In that case, the downward impact on the rupee cost of oil as a result of dollar sliding against euro will no longer be available. Some Indian companies may choose to shift their factories to countries like 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.

One should not expect the rupee to continuously appreciate against the dollar. It may depend on the timing of US economic recovery, the US interest rate policy, the state of world oil market and so on. 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. One way of covering the exchange risk is to have export earnings in dollars with which they can easily service their dollar debt in future, even if the rupee depreciates against the dollar in the meantime. 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 are preferring not to hedge. The same is true for many exporters and importers.

In other words, a large number of players in the market are gambling on further rupee appreciation. Moreover, investors often behave in a herd fashion. If suddenly some investors decide to sell rupees and buy dollars, expecting dollar appreciation, others may immediately follow suit, creating large demand-supply gap and price pressures in the market. Of course, the RBI, with its more than $76 billion reserves, is in a much better position today to smooth out the fluctuations by purchase or sale of foreign exchange. An east Asia or Argentine type crisis is not likely in India. But the risk of instability remains.

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