Monday, August 13, 2007

India's concerns on appreciating rupee

Since April last the rupee has moved up sharply from Rs 44 to a dollar to its current level of between Rs 40 and Rs 41. Thus compared to few months ago, the Rupee has become stronger against the US dollar by between 8 and 10%. Such sharp increase in the value of rupee vis-à-vis dollar over a short period of time is bound to have a considerable impact on companies and businesses that have dominant overseas revenue/expenditure stream.

Last month Infosys technologies lowered its profit and revenue outlook for 2007-08 although it raised its guidance in terms of dollars marginally. Here the rupee's recent rise is the issue. Its earnings from software exports expressed in dollars would be worth less in rupees. TCS, Wipro and Satyam followed suit reporting pressure on their gross margins in the wake of stronger rupee. These companies are reporting loss in profit despite the fact that they hedge their funds in international banks and institutions .

The appreciation of rupee in recent weeks has put few of our monetary economists and obviously the non IT exporters also in a spot of bother. Exporters are worried about declining profits and monetary economists are worried about sustaining the current account deficit in the wake of less rupee value for our exports.

While their apprehensions are duly acknowledged, few more equally fundamental macro-economic concerns need careful considerations.


Rising prices are affecting millions of people throughout the country. Inflation has hit the poor and the poorest the hardest. Ours being predominantly a rural nation needs to address issues concerning the largest section of the society on priority. Skyrocketing inflation numbers which crossed 7% in the early months of this year has put considerable pressure on many families. It is important to note here the though the inflation number reduced to around 5% in the recent weeks, it is not the time to be complacent. The official inflation numbers based on whole sale price index is not the actual measure of the kind of pressure experienced by families across length and breadth of the nation. A more realistic measure namely the consumer price index (Which is the official measure of inflation in many western countries) is still hovering above the comfortable mark. Though it has dipped in the recent weeks, the value is still more than 7%.
The situation can get complicated if food and cash crop do not register a significant increase compared to 2006-07. The monsoon is satisfactory so far, but the flash floods and accompanying loss of crops in parts of U.P., Karnataka and Rajasthan in recent weeks is likely to put considerable pressure on production of pulses. If this case emerges, large scale imports of pulses will become inevitable.

Indirectly, inflation also becomes a reason for a stronger domestic currency. Higher inflation will result in higher interest rates(because of increased demand of money and also by intervention of central bank to tighten the supply side of money).The recent hike in CRR to 7% will only add up to the higher interest rates of the bank. The higher interest rate will buttress the capital inflow from outside the country. This will further add up to liquidity in the system resulting in inflation. This is exactly opposite to what the doctor ordered. The RBI will again have to resort to hike in CRR or in open market operations. For a year now, the RBI is resorting to hiking CRR at regular intervals and also running out of government securities. This is not a very healthy sign for the road to capital account convertibility. So the RBI is caught up in the vicious circle of sterilization-capital inflow-sterilization. In other words, an increase in interest rate is bringing more capital flows, to stop this capital's entry into the system, the RBI increases CRR which will again bring in more capital. How the RBI will cope up with this is being curiously watched by the academic world.

Moreover, the high Repo rate regime is not helping control inflation either. The relative ease with which the business and international banks can borrow funds from outside the country with lower rate of interest is not putting any pressure on commercial banks to borrow from RBI. This technique inevitably brings in foreign exchange leading to making the rupee dearer vis-à-vis dollar.
The finance ministry has rightly acknowledged that the present inflation is due to the supply side constraints. So this situation is not going to ease out immediately if tackled purely from the domestic platform. Imports are the only solution to ease the present supply side bottleneck.

It is estimated that subsidies on select petro products in 2007-08 are likely to exceed 60,000 crores. Also, the supply constraints due to inadequate output of Wheat, Pulses and Edible oils will fuel inflation if imports in required quantities cannot be secured. Inadequate supply of essential products coupled with high crude prices may push the whole sale price index inflation again to over 5%.

A stronger rupee will make our imports cheaper. Inflation targeting becomes much easier with a stronger rupee. If the RBI continues to intervene in the exchange rate market as it is been doing in the past few weeks to contain the appreciating rupee, it would actually be hampering the inflation curbing process. RBI certainly needs to protect our exporters, but its intervention to contain the appreciating rupee will be desirable when inflation (particularly primary goods prices) becomes sustainable and supply side of essential commodities augmented.
Most of India's export earnings are trough software and services. Businesses of these goods and services operate at greater profit margins. So an appreciating rupee must not hurt their profit margins to alarming levels as compared to alarming levels of inflation hurting millions of people. Yet the software companies are complaining about their reduced profit margins in spite of hedging their funds at reputed financial institutions.

Dr Y.V.Reddy, governor of RBI in his inaugural address at a conference on advances in open economy macroeconomics held on 19 March in Mumbai said "If the domestic inflation rate of an economy, however low it may be, is higher than the average inflation rate of its trading partners, it puts pressure on exchange rate. In this context, the question of simultaneous balance of internal and external sector becomes a major issue if flexibilities in the economy are less than adequate. The conduct of monetary policy inevitably involves a careful judgment on relative weights assigned to domestic and global factors and conduct reassessment and rebalancing of these in response to evolving circumstances." We must note here that India's inflation is more than double compared to our primary trading partners ( U.S.A and U.K). Commensurate with this our central bank should keep itself away from the exchange rate market. On the longer run the market forces will automatically take care of exchange rate once the inflation difference between trading partners reaches manageable levels and movement of funds across seas stabilizes.

It's worthwhile to note here that the export earnings of India contribute to about 13 to 15% of GDP. The monetary authorities should not hurry up and express great apprehensions over appreciating rupee.

One needs to acknowledge and appreciate the row of measures taken by RBI in its monetary policies and our government in its supply side and fiscal policies. As the gestation period of these policies are long, the RBI needs to wait till these bears fruition before it again contemplates about buying dollars.

At the moment its better that RBI keeps itself away from the exchange rate market and allows the market forces to operate. On the other hand Fiscal and monetary authorities can take a few steps to help market forces stabilize exchange rates.
1)       Ban the dreaded Participatory notes (PNs). As suggested by Tarapore II, foreign institutional investors (FIIs) should be prohibited from investing fresh money raised through PNs. Existing PN holders should be provided an exit route and phased out completely within one year. This will have dual advantage-a) Huge quantities of illegal foreign currency   is stopped from entering India thereby reducing the supply of dollars and b)Prevents non SEBI registered  Indian brokers from hoarding illegal cash.

2)      A cap on external commercial borrowings will do a lot of good. Last week the government did introduce such a measure. It is a good sign. But these measures should be made more strict.  

Current account deficit:                                                                                

Certainly, there will be a heavy impact of a stronger rupee on our current account deficits. A weaker rupee can certainly cover up large deficits while a stronger rupee earns less rupee value for our exports.

RBI predicts a current account deficit of around $10 billion for 2007-08. In 2006-07, The CAD was not much lower at $9.6 billion. This rosy picture is due to net increase in invisible receipts almost equal to the growth of trade deficit. Merchandise trade deficit is only widening despite robust growth in the manufacturing sector and yet the current account deficits are balanced by net invisibles, foreign institutional investments and foreign direct investments.

According to securities and exchange board of India (SEBI), Aggregate investment by FIIs up to mid July in 2007-08 was to the tune of $8.45 billion considerably (more than 200%) higher than $2.8 billion a year ago.

It is however true that portfolio investment is not sustainable on a longer run. They are volatile. These investments can reverse as easily as they come even amidst strong macroeconomic fundamentals.

But certainly they can act as an immediate solution. As the rupee is appreciating and inflation yet to sustain, there would be more dollar inflows due to weaker dollar in terms of portfolio investments(The value of stocks growing higher in terms of rupees meaning more dollar value of the stock) which will cover the deficits caused by stronger rupee in our exports. On the flip side the very same investment can again cause appreciation of rupee. While this is true, the phenomenon can be controlled over the course of time.

The finance authorities can think of diversifying these investments into manufacturing sector. Our Current account on BOP is largely balanced by heavy foreign institutional investment. This is not a very encouraging situation. The very fact that huge merchandise trade deficits are balanced by net invisibles and FIIs mean that India is acting as a bank to foreign funds. There is growth of 200% in FIIs year on year compared to 9% growth in GDP.

So what is the solution? These heavy investments must be diversified. A window must be channelised to productively use this money(Our forex kitty is more than $200 billion). Investment of this money in interest bearing assets outside India as well as in India will at the same time a) prevent appreciation of rupee by reduced supply of dollars in India b) provide much needed funds for infrastructure development (Estimated to the tune of $320 billion in the XI plan) c) Reduce the growing deficit in merchandise trade deficit by easing the infrastructure bottle neck over a course of time.

A few monetary economists have expressed apprehensions over this issue. They are skeptical about the idea and bothered about the volatility of such funds. A risk however cannot be ruled out, but even if a few investors choose to withdraw their deposits, fresh investment into India is bound to continue for at least the foreseeable future (till 15-20 years). International rating agencies like Goldman Sacks and S& P have given Investment grade to India. In the wake of such macro economic fundamentals, investments into India are likely to continue into the foreseeable future.

To conclude, RBI and other fiscal and monetary authorities must move away from traditional instruments, come out of vicious circle of Sterilization-Capital inflows-sterilizations and creatively use the inflowing capital as real capital to fuel the growth of Emerging and enlightened India.

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