The marked appreciation of the rupee in recent months comes against the backdrop of certain conflicting trends in India's external economy. On April 16, the rupee closed at 44.33 to the dollar, having closed the previous week at an 18-month high. Over a 13-month period ending April 16, the rupee had appreciated nearly by 13 per cent.

The Indian currency's strength has taken place despite a widening current account deficit on the external account. Intriguingly, there have been no concerted attempts by the Reserve Bank of India to check the rupee appreciation over a fairly long period.

The strong rupee has inevitably impacted the country's merchandise exports which had started recovering only by November 2009 after a prolonged period of slump. Exports of labour intensive manufactured goods, especially textiles, leather goods, gems and jewellery, stand to suffer the most.

Receipts from ‘Invisibles' comprising mainly software exports and workers' remittances, however, have not fared badly so far but it is only a matter of time before they too feel the impact of a firmer rupee. For the first nine months of 2009-10, merchandise trade balance was at minus 9.5 per cent.

Current account deficit

What are the factors driving up the rupee? Going by the latest available data on India's external economy, the rupee should be depreciating, not moving the other way. The RBI's balance of payments data for the third quarter (October-December) of 2009-10 show the current account deficit as a percentage of GDP at 3.4 per cent, only marginally lower than the 3.9 per cent of the previous quarter (July-October 2009). Over the first three quarters (April-December 2009), the current account deficit has widened from 2.2 per cent in the first quarter to 3.4 per cent.

There is every reason to think that for the whole year the current account deficit will remain above 3 per cent, the highest in a long long time. However, taking into account the healthy level of forex reserves with the RBI, around $280 billion, there is no major cause for alarm from the point of view of the balance of payments.

Crippling inflation

With such high and persistent current account deficits and resurgent inflation, the rupee should be weakening. Inflation weakens the growth impulses and has for a variety of reasons become the prime concern of monetary policy. Originally confined to supply side and the commodities, especially food items, inflation has since become a more generalised phenomenon spilling over to other sectors.

Yet the real effective exchange rate (REER), according to the RBI's six currency index, has appreciated by 5 per cent between September and December 2009. In fact, this pattern has persisted through 2009-10: the REER has appreciated by nearly 15 per cent between March 2009 and February 2010.

RBI's stand-off

What is intriguing that there has been no concerted action by the RBI to check the rupee's rise. The principal cause for the curency's rise is well known. Foreign institutional investors have been returning to Indian stock exchanges. The sharp rebound is also due to increased risk aversion on the part of portfolio managers who had fled the emerging markets during the height of the crisis. During 2009-10, net inflows have more than offset the current account deficit.

According to recently released RBI data on the balance of payments, net portfolio investments into the country during April-December 2009 amounted to $23.6 billion as against a net outflow of $11.3 billion a year ago. The full impact of the financial crisis was felt during the earlier period.

To understand the probable reasons for the RBI's inaction, it is necessary to take a look at the practical steps involved. Since the rupee appreciation is happening because of a surge in dollar inflows, it is necessary in the first instance to mop up the dollars flowing in. The rupee appreciation is to be understood as being caused by “an excess supply'' of dollars leading to an imbalance in its demand and supply.

The RBI's purchase of dollars would, however, involve a release of rupees. This would boost liquidity and in turn need to be sterilised by the RBI either through open market operation or through reviving the market stabilisation scheme (MSS). A third option — a hike in the cash reserve ratio — is also not ruled out. It is almost certain that during 2009-10, the RBI, charged with the task of managing a huge government borrowing programme, was mindful of the consequences of aggressively stabilising the rupee liquidity.

However, sooner perhaps than is realised, the RBI will have to intervene. Exporters and those receiving dollar denominated remittances including exporters of software and services suffer. The persistent deficit in the trade and current account balances cannot be ignored even if capital flows have buoyed the balance of payments. And talking of capital inflows, the RBI has for long pointed out that they can exit as quickly as they enter, a fact amply proved during the crisis years.

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