Hope it will float

Indian Express, 8 September 2008

The Indian rupee has continued to depreciate over the last few days. It is paradoxical that even though a weak rupee increases domestic prices when inflation is already hurting badly, neither the media reaction to the weak rupee, nor the policy effort to prevent rupee depreciation matches the kind of response India saw last year when the rupee was appreciation. Remember that on balance we import more than we export. As a consequence, even if one were to narrowly think of exporters and importers, the losses from a weaker rupee are larger than the losses from a stronger rupee.

Part of the reason for this paradox is that for most of last year the impact of rupee depreciation on prices was mixed up with rising world oil and commodity prices. As a result, when prices of imported goods were seen to be rising, the rupee was only partly to blame. Oil companies, the biggest group of importers in India, were facing the double whammy of higher oil prices and a depreciating rupee. But then, they were protected by the government. Moreover, when the government stepped in by not allowing dometic fuel prices to rise, consumers did not feel the direct impact of the depreciation. Since not too many of our imports are consumer goods, even though rupee depreciation pushed up raw material prices, the impact on consumers is indirect and comes with a lag.

So while the hit to exporters' incomes from a stronger rupee is obvious when the exporter gets Rs 40 lakh instead of Rs 45 lakh, the impact is not as explicit in the case of importers. But there is no denying that in both situations, when the rupee becomes stronger, and when it gets weaker, there are winners and losers. Given which side you fall on, you can make a case for a weak rupee policy or a strong rupee policy. Last year, in 2007-08, we exported goods and services worth USD 303 billion, while imports amounted to USD 321 billion. Given the small difference there is no strong reason on the basis on which a policy maker can objectively be on the side of exporters or importers.

The Government of India has, however, over the past several years, preferred a weak rupee. RBI purchased dollars in currency markets to prevent the rupee from appreciating whenever there was pressure in currency markets to do so. The effect of a strong rupee on employment and profits in exporting industries appears to be the main factor behind this preference. The policy was so strongly in favour of a weak rupee that the RBI continued to buy dollars in the first half of 2008 even as the rupee depreciated.

News reports for the last few weeks have suggested that the RBI has been selling reserves to prevent the rupee from depreciating too fast. The pace of selling has been much slower than the pace at which the RBI bought when it was trying to prevent appreciation. But given that the RBI still holds more than USD 290 billion, it can go a long way by intervening and can prevent further depreciation if it wishes to. It could also use this opportunity to ease restrictions on capital inflows such as ECBs and PNs which were put in place to prevent rupee appreciation last year. While it may not be easy for sentiment to turn around quickly and for capital inflows to return to India, India is a fundamentally sound investment destination and strong strong capital flows are a long-term structural feature of our economy.

The more important question that needs to be asked today is about the longer term rupee policy of the goverment. If exports are going to remain the focus of policy makers and the RBI is going to continue to be expected to prevent rupee appreciation, then all the problems of this year are going to come back again. Instead of moving towards financial liberalisation and easing capital controls, every time the rupee starts getting stronger and the government succumbs to exporter pressure, there will be an attempt to bring back capital controls as the RBI will have to fight with higher liquidity, engage in sterilised intervention at an increasing cost, put the burden on banks and their consumers by raising the cash reserve ratio and raise interest rates to fight inflation.

It is only if the government is clear that it must not meddle with the rupee that the RBI can be free to carry out the agenda of reforms for the financial sector and for RBI. One good news on this front is the recent launch of the currency futures market. If the first few days of activity on this market are any indication, then the currency futures market can help free up the RBI from having to manipulate the rupee. Today the decision on a strong or weak rupee policy, or the decision to intervene, is made based on the view that firms will lose if the rupee gains. Instead of the rupee being manipulated on the basis of this judement, there now exist the means though which exporters and importers can look after their own interests. Whoever feels that he will lose if the rupee appreciates or depreciates can now hedge for himself. This can free up the RBI from having to provide a currency with low volatility as a public good. The rupee can move both ways without the government having to worry about business losses.

Governor Subbarao faces important challenges on many issues such as financial sector reform and capital account liberalisation that are now on the agenda. His most difficult challenge, I believe, is to convince the political class, that unless he is freed from the responsibility of manipulating the rupee, all else will be conversation.

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