The strengthening of the rupee cannot be solely attributed to the relatively robust economic recovery in India. It is the resumption of FII flows into stock markets that is the principal cause.
On January 11 the rupee closed at a 16-month high of 45.34 to the dollar in the inter-bank currency market. At the end of last year (December 31) it was at 46.54. A dollar would have fetched Rs.1.20 less in ten days. In other words, fewer rupees would be needed to acquire dollars.
The rupee has been appreciating since April 2009, but the trend has become more pronounced recently. In the new year, the appreciation has been particularly sharp, by 2.6 per cent in 10 days.
Obviously such a sharp rise in the rupee's external value has major implications. Exporters will be hard hit as their competitiveness will be eroded in the global markets. These have started picking up only recently after more than a year of decline. The government had given a number of sops to export sectors to counter the fall in demand in importing countries. A new package has just been announced. Exporters of services including IT services have had to reckon with a strong rupee. A large portion of their billings is in dollars: they will consequently fetch fewer rupees.
Importers, on the other hand, stand to gain by the strengthening rupee. However, the petroleum import bill, forming a significant part of the overall import bill, may not see a sizable saving: high petroleum prices may offset the advantage in foreign exchange rates.
Crucial issues
There are a number of issues connected with the rupee's rise. Does it reflect the economic strength of the country at this juncture? Are there limits to policy intervention to maintain the rupee value at particular levels? The rupee's strength is more due to the weakness of the dollar over a fairly long period. Over a much narrower time span, the American currency has recently been under pressure in relation to most Asian currencies. The Korean won, the Thai baht and the Malaysian ringgit have all appreciated against the dollar recently. This phenomenon is attributed to the fact that these Asian economies have rebounded sharply in the post-recession period.
The U.S. economy, on the other hand, has had an uneven performance. More to the point, the Indian economy seems capable of growing by about 7 per cent this year. That rate will be one of the highest posted by any country and will be second only to that of China.
India's higher growth rate need not necessarily translate into a higher exchange rate for the rupee.
Large FII inflows
Currently, the major factor influencing exchange rates is the large flow of foreign institutional investment into Indian stock markets. Last year FII flows were estimated at $17.5 billion and their main motivation seems to be the prospect of higher returns in India and other emerging markets as compared to the U.S.
The outward flow of capital from the U.S. connotes slow economic recovery there. Investors are prepared to take higher risks elsewhere. Earlier, extreme risk aversion had caused a flight of capital into the U.S. In times of grave crisis, the role of the dollar as a safe haven currency was once again in view.
It is not just the safe haven status but the dollar's position as the world' s reserve currency and the currency of choice in trade and dealing rooms that makes analysts, currency traders and policy makers take note of every morsel of economic news from the U.S.
At the beginning of December, better than expected pay roll data boosted the dollar temporarily but since the improvement could not be sustained, the dollar's downtrend resumed.
While the FIIs' confidence in the Indian capital market is welcome, the flood of dollars coming in may not be an unmixed blessing. Such flows are not stable. In the recent past these investors have pulled out of India en masse, causing a sharp drop in the stock markets.
The RBI has not intervened this time probably because such intervention has been expensive in the past. Any mop up of dollars will add to reserves and increase domestic liquidity exponentially, thereby fuelling inflation. Sterilisation measures _ to suck out excess rupees in the system - will be expensive in the current context of abundant liquidity. In its forthcoming policy statement, the RBI is expected to announce measures impounding a portion of domestic liquidity.
Finally, any talk of discouraging FII inflows - through, for instance, a Brazil type Tobin tax - will have to reckon with the crucial role they play in shoring up the balance of payments.
