Forex

Indian Rupee Surges UnexpectedlyThe Indian Rupee has been tightly controlled by the country’s Central Bank, which has not allowed the currency to fluctuate much. A few months ago, however, the Rupee suddenly and rapidly began appreciating against all of the world’s major currencies. Now, the Rupee stands at a 9-year high against the USD. It turns out that India’s Central Bank deliberately allowed the Rupee to appreciate in order to combat inflation. The reasoning is that a more expensive currency would make imports less expensive and exports more expensive from the standpoint of foreigners, which would hopefully lead Indian exporters to release more supply domestically, thus lowering prices. While it remains to be seen whether the strategy was successful in reducing inflation, you can be sure India’s Central Bank will continue to aggressively pursue a policy of Rupee appreciation, until it inflation has decisively been held in check.The Reserve Bank of India follows a policy of managed float vis-à-vis the external value of the rupee. Till recently, it was mostly buying dollars from the market, adding to its foreign exchange reserves which have now crossed the $200-billion mark. If the RBI did not buy dollars, the additional inflows — primarily from remittances, export of services and capital flows — would have sent the rupee spiralling in terms of dollars thanks to the forces of demand and supply. This would have made Indian goods and services more expensive relative to foreign goods and services and affected India's balance of trade. CHANGED APPROACH But in the last few weeks, the RBI policy seems to have changed. The rupee has been allowed to rise and is currently at a nine-year high against the dollar. One important trigger for the reversal of policy has been the concern about the rising inflation rate. An appreciation of the rupee would make imported foreign goods (such as crude oil and petroleum products) cheaper (in rupees) in India. But, conversely, the rise in the rupee would make Indian goods costlier abroad and cut into exports. Alternatively, if the dollar price of exports is kept fixed, the corresponding rupee realisation would be less. Either way, exports would become less profitable, relative to home sales. This, it was hoped, would divert some export products to the domestic market. Consequently, the availability of goods would increase at home, pushing down prices, helping the Government tame inflation. There is yet another way by which the recent reversal of the policy on supporting the rupee is expected to bring down inflation. Under the earlier policy of buying dollars with rupees, an equivalent amount of rupees was being put into circulation. Other things remaining the same, this would push up the inflation rate. Of course, the RBI did not let other things remain the same. Quite often, it carried out "sterilisation" operations — that is, it sold government bonds to mop up the extra money going into the hands of the public as a result of the RBI buying up dollars from the market. But there are some problems with this policy. Borrowing more from the market with government bonds would push up the interest rate. This, in turn, would attract more funds from abroad and the RBI would have to do more sterilisation. A point may come when the public — financial institutions, in particular — may not be willing to buy more government paper. Indications are that such a point may have been reached in India where many banks are more willing to lend to private investors and consumers in a booming economy, rather than to the government at lower rates of return. In addition, the RBI has been running out of the stock of government bonds as it has for long been a net seller of bonds to the market. Together, all these factors (perhaps) forced the RBI to change its policy of artificially keeping the value of rupee low. THE IMPACT What are the likely consequences of this policy change? As already explained, the rupee appreciation should exert a downward pressure on the inflation rate. The profitability of exports is going to be affected. Up to a point, exporters can absorb the loss, if the profit margin is high enough to start with. But if the appreciation in the rupee continues unabated, they will feel the pinch and exports will suffer. Another important consideration is the exchange rate policy of competing countries. Since, at this time, the currencies of China and other East Asian countries are still virtually pegged to the dollar, suppliers from those nations will enjoy a competitive advantage over Indian exporters. For example, the dollar price of Chinese textiles in the US market will remain the same when that of competing Indian products is tending to rise. If the growth rate of our exports slows down (the average growth rate of exports was an exceptionally high 25 per cent per cent over the last 5 years), GDP growth rate would also suffer to