Valuing the dollar

Indian Express, 1 October 2009

The weakening of the US dollar in international markets and stronger foreign capital flows to India in recent weeks suggest that in the coming year the rupee could witness pressure to appreciate. Allowing the rupee to appreciate could be a way out of the policy dilemma of the RBI concerned about low growth and rising inflation. Preventing appreciation could, on the other hand, lead to either higher liquidity, if intervention is unsterilised, or to the familiar difficulties of sterilisation.

Despite the US being the epicentre of the global financial crisis, the dollar strengthened in the immediate aftermath of the financial crisis. This somewhat surprising development has been explained by the increase in risk aversion of investors from around the world who preferred the relative safety of US treasury bills. In the last six months the dollar has weakened. It moved from USD 1.26 to a Euro in early March to USD 1.47 in the last week of September. This weakening is being seen as the end of the phenonemon of the "flight to safety" or the "dollar as a safe haven".

As the risk appetite of global investors has increased in recent months, India has witnessed a return of foreign inflows. Both FDI and foreign portfolio flows have been strong. As the Indian economy grows at a relatively faster pace than the world economy and as the long run growth prospects of the Indian economy remain strong, India can be expected to attract capital inflows.

The global weakening of the dollar and continued capital inflows can put pressure on the rupee to appreciate. What should be RBI's response?

One response is to do nothing and allow the rupee to appreciate. This would offer RBI a way out of its current policy dilemma. It is presently faced with rising inflation and an economy just recovering from a big shock. If it were to raise interest rates, in response to inflationary expectations, it would be increasing the cost of borrowing for businesses and households. While the economic situation has improved compared to last year, it is too soon to make credit more expensive. GDP growth is still below the decadal average of 7 percent. The growth rate of non food bank credit (seasonally adjusted month on month) has certainly recovered from the post crisis sub 10 percent levels, but remains in the the range of 15 to 18 percent, and much below the pre-crisis level and the RBI target of 20 per cent. Business cycle conditions thus suggest that it is too soon for the RBI to raise interest rates.

What will rupee appreciation achieve? Most importantly, it will reduce the prices of goods which are either imported or priced at import-parity prices. While food prices, especially the prices of fruit and vegetables, have risen the fastest, this is a supply management problem that can be addressed separately. If the concern is about prices of manufactured goods rising, these can be reduced by having a stronger currency. The exchange rate pass through in India is both significant and quick.

But what about the effect of appreciation on exports? An appreciation of the rupee could hurt exports, which are already suffering a huge contraction. Rupee appreciation would make our exports more expensive for foreign consumers, who would consume less Indian goods as a consequence, and the export sector may have to adjust to cater more to the domestic market. But where should the demand contraction to contain inflation come from? If interest rates are raised, it is domestic consumers whose demand contracts, whereas if the currency appreciates, it is foreign consumers whose demand contracts. For the Indian consumer who gets imports cheaper, and does not have to tighen her belt (which she will have to were interest rates to be raised), rupee appreciation is preferable. For Indian companies whose raw material costs go down and who will not have to pay higher interest costs in already difficult times, a stronger rupee will be a better option.

The other response to the pressure on the rupee to appreciate, could be to prevent rupee appreciation. In this case, RBI would buy dollars. Remember that India does not have a case for building foreign exchange reserves further as we barely sold 10 percent of our foreign exchange reserves in the crisis. So the sole purpose of buying dollars would be to prevent rupee appreciation. This would lead to an increase in the monetary base. One option would be to leave the intervention unsterilised. This may raise concerns about higher inflation. To sterilise its intervention, the RBI would sell government bonds. But the RBI is already selling large amounts of government bonds thanks to the government's borrowing programme. Its capacity to sell more bonds is limited as bank are already holding more than 27 precent of their deposits as government bonds. And the government's borrowing programme for the second half of the year will also require the RBI to sell more government bonds. A more likely scenario is that there will be a partial sterilisation of its forex intervention and the consequent expansion in the monetary base will push the RBI to raise the Cash Reserve Ratio (CRR). Raising the CRR in the present conditions will make bank credit more expensive. Through this startegy India could thus end up with some unsterilised intervention, excess liquidity, a higher CRR and more expensive bank credit. By pegging the rupee to the dollar, a weakening currency, the effective exchange rate will depreciate and thus push up inflation.

In summary, a pressure on the rupee to appreciate would be a positive development. It offers RBI an easier option as it can avoid raising interest rates until business cycle conditions change further. Under this option the brunt of demand contraction will not be borne by Indian industry or households. The crucial question will be whether RBI can resist pressure from the exporter lobby.

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