The taming of the rupee

Indian Express, 10 May 2007

Commerce Minister Kamal Nath has sought the Prime Minister's help on the strengthening rupee. Over the last one month the rupee has risen sharply. Exporters are raising alarm bells that the rise of the rupee will reduce export growth, shut down industries and raise unemployment. If you were an exporter and your income is in dollars, an appreciation of the rupee-dollar rate would immediately translate into a fall in your rupee income. Instead of USD 10,000 translating into Rs.4.5 lakh at Rs.45 a dollar, it only yields Rs.4 lakh at Rs.40 per dollar. This is the immediate provocation for protest.

Is the rupee appreciation going to translate into the kind of disaster that is being predicted for exporters? Faced with lower profits, an exporter could try to lower his costs of production. In the longer term, what determines the volume of exports is also the domestic cost of production in comparison to the cost of production in other countries. Further, if India witnesses high inflation, sooner or later this will get reflected in the cost of production. Even if the rupee dollar rate remains constant, the dollar price of Indian exports must rise if India suffers from inflation.

THe "real effective exchange rate" (REER) puts together fluctuations of all the exchange rates and all the inflation rates of various countries. It is measured in a number of ways. The RBI computes it by taking into account 6 and 36 trading partners and weighing exchange rates (and their respective inflation rates) by exports and by trade which includes both exports and imports. The IMF also includes exchange rates and inflation rates of trading partners. The Bank of International Settlements (BIS) REER which uses weights that reflect the latest trading patterns and adjust for China-HongKong. The 6 country REER computed by RBI has been showing visible signs of appreciation and is often used to raise alarm when it is cited as proof that India is losing competitivness. However, neither the 36 country index, nor the IMF or BIS indices, are showing appreciation. This means that compared to a few currencies, mainly the dollar and currencies pegged to the dollar that dominate the 6 country index, we have an appreciation but compared to a fuller set of currencies, India has not lost competitivess.

Not only is the nominal rupee dollar rate not the key player in the story, it can also be counter-productive to focus on the rupee dollar rate. Until the end of March the government was working to actively subsidise exporters. There was active intervention in foreign exchange markets to prevent appreciation. But while this was able to achieve a stable 'nominal' rupee dollar dollar rate, the supply of rupees in the system were growing, which drove up inflation. If this strategy had continued, eventually the 36 country index would have appreciated through higher prices. In addition, the RBI's attempt to suck rupees out of the system by selling government bonds was raising interest rates in the economy. Given the threat that higher interest rates pose to growth, given the unacceptability of higher inflation, and given that nowhere in the world are central banks able to manipulate the real exchange rate in the long run, the best policy option was for the RBI to step away from the foreign exchange market.

The only thing wrong about the rise in the rupee in the last one month was the lack of planning, forewarning and transparency. The conflicts being faced were visible and predictable. The markets and exporters could have been better prepared for what was coming if over the last few months RBI intervention in the forex market had reduced slowly. Instead, RBI chose to keep up huge levels of intervention -- in February its intervention was the highest ever at USD 11.9 billion -- and then step away abruptly. Exporters had been lulled by the RBI into thinking that it will keep on intervening. If the objective was to protect exporters it could have been done much better, with adequate warning to exporters. In the anticipation that RBI may have to step away, firms could have been encouraged to hedge their exposures.

There is confusion about what the RBI would do next. Has the rupee become a float? Or, will the RBI go back to intervening in currency markets? The recent increase in MSS ceiling from Rs 80,000 crore to Rs 1 lakh crore is creating expectations of a return to intervention. Exporters argue that the policy of sterilised intervention should be brought back -- the RBI should intervene in forex markets and then sell government bonds under the monetary stabilisation scheme (MSS). It is, indeed, possible to do this for a few weeks. But the question is whether this is desirable even in the short run. Every policy has trade-offs. When something is kept cheap for one person, someone else pays. Here it is households and producers producing for the domestic economy who will pay through higher interest rates in order to help exporters. In addition, we would turn away cheaper imports that a stronger rupee provides. Even exporters will not be happy with Rs.40/dollar when it comes with higher inflation, higher interest rates and costly raw materials.

The Commerce Minister should not waste his time trying to argue for rupee manipulation. Export promotion requires setting up a currency futures market so that exporters can handle fluctuations in exchange rate; improving infrastructure; changing labour laws; and removing reservations for the small scale sector. Higher productivity through genuine reform is the only sustainable way to improve export growth. The RBI, for its part, should make a clear statement about its currency policy. Keeping the market in a state of confusion will hurt everyone, most of all exporters whom it is supposed to have been protecting for years.

Back up to Ila Patnaik's media page
Back up to Ila Patnaik's home page