A couple of months ago, one could not open a newspaper or magazine without coming across some reference to the raging inflation. The Central government and the Reserve Bank of India tried to control the price rise with a variety of policy instruments, including some, which were potentially inimical to growth. However, the rate of inflation continued to persist above 6 per cent. Fortunately, seasonal factors came to the rescue in the form of an increased supply of agricultural commodities. Prices of several food items fell and helped to bring down the rate of inflation to more tolerable levels. This brought much-needed relief to the finance ministry and the RBI bigwigs.

Unfortunately, the relief has been short-lived. The steady appreciation in the external value of the rupee is now threatening to cause sleepless nights to the same set of officials as well as to exporters. The rupee has been rising against all the major currencies — the dollar, pound sterling and the euro. The global weakness of the dollar has meant that the appreciation of the rupee against the dollar has been particularly alarming with the rupee recording an 8 per cent appreciation vis-à-vis the dollar.

Indian exporters earn their revenues in foreign exchange. And unless an industry is highly import-intensive, the bulk of its costs are incurred in rupees. So, every increase in the external value of the rupee means a corresponding drop in their net revenues. The sharp setback to the export industry comes just when the industry was being talked about as one of the leading engines of growth for the overall Indian economy. Not surprisingly, both the finance and commerce ministers have been talking about the need for remedial measures to restore profitability of the export sector.

The government has two broad sets of options available. It, or more correctly the RBI, can refrain from intervention in the foreign exchange market, but use “micro” policies specifically directed to boost profitability of the export industries. Alternatively, it can take the “macro” route — namely, tackle the problem at its source by reversing or at least controlling the appreciation of the rupee through intervention in the foreign exchange market. Of course, it can avoid either extreme by adopting a mix of the two sets of policies.

The micro route has its attractions. A mix of duty drawbacks and export subsidies in some form or the other will counteract the fall in net revenues due to the rupee appreciation. At the same time, the appreciating rupee reduces the price of imported goods and so has a beneficial impact on the level of prices. However, as economists are fond of pointing out, “there is no free lunch”. Of course, the government has to finance the duty drawbacks and export subsidies, and this acts as a direct cost.

There is also a more subtle indirect cost. The duty drawbacks and subsidies distort relative prices — firms may be tempted to enter the export sector simply in order to take advantage of the package of incentives even if their comparative advantage lies elsewhere. This tendency can have deleterious effects on the overall efficiency of the economy. That is why it is important to ensure that such schemes are only of short duration.

What about macroeconomic policies? At the risk of gross oversimplification, the scope for appropriate macroeconomic policies in this context is heavily influenced by the relative priority that the government gives to three related objectives. There is first the need to ensure some degree of price stability. The second objective is to maintain conditions in the domestic economy that are conducive to growth. Finally, there is also the need to maintain stable exchange rates. Macroeconomic policy-making would be considerably simpler if these three objectives were mutually compatible. Unfortunately, they are not — at least, not always.

The proximate cause for the appreciating rupee is the steep and continuing rise in the inflow of foreign exchange into the country. Until recently, the performance of Indian exporters was exemplary, with the rate of growth touching almost 30 per cent. Indeed, the economy actually achieved a current account surplus — a rare event for the Indian economy. This was complemented by large inflows of foreign exchange for investment in the stock market.

Despite several attempts by the government to encourage the outflow of foreign exchange, there has been a large and steadily increasing net inflow of foreign exchange. This translates into an excess demand for rupees. Like any other good or service, the excess demand for rupees results in an increase in the price of the rupee.

Of course, monetary authorities need not be silent spectators — the RBI can and often does intervene in the foreign-exchange market. It can reduce the excess demand for rupees by buying up foreign exchange. The cost of RBI intervention is an increase in domestic money supply. If the scale of intervention is large, then this could mean a significant increase in liquidity. Unless the RBI takes any further steps, the excess liquidity can result in a substantial increase in inflationary pressures.

That is why the Central bank typically adopts simultaneous steps to reduce money supply. It can try to put a lid on inflationary pressures by following tight money policies. For instance, the RBI can sell government securities in its portfolio in the domestic market. The RBI can withdraw the proceeds obtained from such sales from circulation, so as to contract the supply of money in the economy. However, there are limits to the volume of government securities that the public is willing to buy. Also, tight money policies, if pursued too vigorously, may constrain credit expansion so much that industry can be starved of funds. Thus, the Central bank and the government are faced with a trade-off between growth and inflation.

The RBI has also been incurring a loss whenever it undertakes these open-market operations. This is because the interest cost of the securities that it sells to the public far exceeds the returns that it gets on the foreign exchange deposits held by it. But perhaps the RBI has been too conservative and risk-averse in its investment decisions. It goes in for absolutely safe investments that promise very low rates of return.

The Chinese government has accumulated huge stocks of foreign exchange because its economy has been running up very large surpluses in its current account over several years. Newspapers report that the Chinese have struck a deal with a big US financial house, which will buy foreign assets on behalf of the Chinese government. China has adopted this strategy in order to increase earnings on its foreign-exchange deposits. Perhaps, the RBI can follow the same strategy.

What weights should the RBI attach to the different priorities? The current relatively low rate of inflation has given it a degree of freedom that it did not have even a few weeks ago. Perhaps, the time is appropriate for the RBI to intervene in the foreign-exchange market, but not attempt to control the increase in domestic liquidity completely. This may help exporters and promote growth, but possibly at the cost of a slight increase in inflation.