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RBI’s dilemma over rupee appreciation

Many factors prevent effective intervention in forex market

The monetary authorities are in a quandary over fixing an optimum external parity of the rupee in terms of the U.S. dollar and other major currencies that will not hurt the export effort. At the same time they have to prevent a surge in non-oil imports that affects the domestic industry. The central bank has also to effectively check new inflationary pressures.

Though it is recognised that a dearer rupee will slow export growth and create problems for the textiles, leather and leather products, handicrafts, marine products and automobiles components industries and several segments of the services sector, the Reserve Bank of India has not been intervening effectively in the foreign exchange market to stem undue appreciation of the rupee. Even though the dollar has firmed up recently it is feared that the. 40 rupee barrier may even be crossed if forex inflow continues heavy as it did in April-June 2006. The rise in foreign exchange assets in the past year was as much as $44.9 billion against $23.4 billion in the previous year. Judging by the continuing heavy inflow aggregate foreign exchange assets may rise by even $60 billion in a whole year taking the total to over $260 billion.

As aggregate net invisible receipts may rise despite some services getting costlier with a dearer rupee, the RBI foresees a current account deficit of around $10 billion for 2007-08. In 2006-07, the CAD was not much changed at $9.6 billion. This favourable development was due to a net increase in invisible receipts nearly equal to the rise in trade deficit. But for the recent hardening of crude prices and large scale import of wheat, pulses and edible oils at prices higher than internal parity the CAD can be brought down further in 2007-08 to around $5 billion. Against this background, the Indian currency can be expected to harden steadily as net invisible receipts will continue to rise though at a slightly slower pace.

Much to the relief of exporters, the Finance Ministry has quickly recognised the problems of the affected industries and announced higher drawback facilities, almost across the board, that will benefit them to the extent of Rs. 1,400 crore in a year. Export credit also will be cheaper by two percentage points and banks may be compensated for any loss of income incurred in the process.

But the Ministry’s move will provide only short term benefit. In the meantime, decisions will be needed in making the industries concerned more competitive and fixing the external parity of the rupee against various currencies.

The anxiety of the monetary authorities as well as the Government is about a reassertion of inflationary pressures. This is because subsidies on select petro products in 2007-08 are likely to exceed Rs. 60,000 crore. Also, the supply constraints due to inadequate output of wheat, pulses and edible oils will fuel inflation if imports in required quantities cannot be secured even at high prices. If crude prices remain high and supply of essential items not augmented, the inflation rate may move up again to 5 per cent and more.

The situation may get complicated if food and cash crops do not register a significant increase as compared to 2006-07. The monsoon has been satisfactory so far in many regions and the output of foodgrains may be higher than in 2006-07. The deficit in wheat may be overcome while the demand-supply gap in pulses may be narrowed. Oil seeds production however may be hit by excessive rain in Rajasthan, Gujarat, Madhya Pradesh and Karnataka, which are major producers. Larger imports of items in short supply will have to be arranged until the new drive to intensify farm production starts yielding results.

The objective of controlling inflation can be realised even with a slightly cheaper rupee, as the net gain will be tangible if surplus dollars can be mopped in a significant measure.

Expectations in this regard are presumably responsible for the continued buoyancy on the bourses and an impression that there may not be a further rise in interest rates. Lending rates though may be raised in some directions to discourage borrowings by overheated sectors. The banking system has so far been successful in avoiding a squeeze in the money market as deposit growth has been on unprecedented lines and credit expansion can remain vigorous.

With continuing favourable developments in the external sector the authorities have wide options and the growth momentum should not be allowed to slow down in any way.

P. A. SESHAN

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