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| What
the Rising Rupee Signals |
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The
Indian rupee is on the rise. While its appreciation
vis-à-vis the dollar began in June 2002, when
it had touched a low of more than Rs. 49 to the dollar,
it has been rising vis-à-vis the Euro as well
over the last four months. During these periods of ascent,
it has appreciated by close to 12 per cent vis-à-vis
the dollar in 22 months and by a significant 9 per cent
vis-à-vis the Euro in a short period of 4 months.
Not surprisingly, exporters have begun to get restive;
since a loss of 10 per cent in the rupee price of their
exports can shave off margins on past fixed-price dollar/euro
contracts and make it difficult to win new orders.
The rise of the rupee is partly attributable to the
depreciation of the other currencies, especially the
dollar against those of its competitors. That this was
true for some time is reflected in the fact that while
the rupee was appreciating against the dollar for close
to two years, it was depreciating vis-à-vis the
euro for much of this period. This is, however, only
small cause for comfort, since most export contracts
are denominated in dollar terms. Moreover, in recent
months, as noted above, the rupee has been appreciating
against the euro as well.
Two factors have influenced this rise of the rupee vis-à-vis
various currencies. First, the excess supply of foreign
currency, relative to demand for current and capital
account transactions from resident individuals, agencies
and institutions, other than the Reserve Bank of India.
Second, the willingness of the central bank to buy foreign
currencies to add to its reserves and, thereby, increase
the demand for these currencies in the market. The role
of market demand and supply in determining exchange
rates and the consequent shift to market mediated intervention
by the central bank has been the natural outcome of
the adoption of a liberalised exchange rate system over
the 1990s.
The pressure on the rupee leading to its appreciation,
which is affecting export competitiveness adversely,
arises because India, which has recorded a current account
surplus since financial year 2001-02, has encouraged
and attracted large inflows on its capital account.
India's current account surplus, we must note, is not
a reflection of its strong trade performance. Rather,
it is because, net inflows under what is called the
''invisibles'' head of the current account of the balance
of payments has been more than adequate to finance a
large and recently rising merchandise trade deficit.
The principal sources of current account inflows have
been buoyant remittance flows and inflows under the
''software services'' head. That is, transfers made
by Indian workers abroad, either on short or long-term
contracts, have helped overcome the adverse balance
of payments consequences of India's lack of competitiveness
reflected in a large trade deficit. Inflows on account
of software services rose from $5.75 billion in 2000-01
to $6.88 billion in 2001-02, $8.86 billion in 2002-03
and $9.09 billion over the first nine months of 2003-04,
while private transfers (mainly remittances) touched
$14.81 billion in 2002-03 and $14.49 billion during
April-December 2003, after having fallen from $12.8
billion to $12.13 billion between 2000-01 and 2001-02.
In an intensification of this trend, during the first
nine months of the recently ended financial year 2003-04,
net inflows on account of invisibles stood at $18.22
billion, well above the $15 billion deficit on the trade
account.
Even while India's current account was relatively healthy
on account of the foreign exchange largesse of Indian
workers abroad, the country's liberalised capital markets
have attracted large inflows of capital amounting to
a net sum of $10.57 billion in 2001-02, $12.11 billion
in 2002-03 and a massive $17.31 billion during the first
nine months of 2003-04. Expectations are that, because
of the huge portfolio capital inflows during the last
three months of 2003-04 encouraged by the government's
privatisation drive, net capital account inflows during
2003-04 will be in excess of $20 billion.
There are two issues that arise in this context. The
first relates to the nature of the capital inflows during
these years. The second to the implications of these
inflows for the value of the rupee under India's liberalised
exchange rate management system. Three kinds of inflows
have dominated the capital account. An early and important
source of inflow during the years of financial liberalisation
has been in the form of NRI deposits in lucrative, repatriable
foreign currency accounts. On a net basis, such inflows
accounted for $2.32 billion, $2.75 billion, $2.98 billion
and $3.5 billion respectively in 2000-01, 2000-02, 2002-03
and April-December 2003 respectively. They reflect the
attempt by richer non-residents to exploit arbitrage
opportunities offered by the higher (relative to international
rates) interest rates on repatriable, non-resident,
foreign exchange accounts, to earn relatively easy surpluses.
A second important source of capital inflows has been
portfolio capital flows, reflecting investments by foreign
bodies, especially foreign institutional investors,
in India's stock and debt markets, encouraged more recently
by the disinvestment of shares in profitable public
sector undertakings. On a net basis, such inflows had
fallen from $2.59 billion in 2000-01 to $1.95 billion
in 2001-02 and just $944 million in 2002-03, but rose
sharply to $7.62 billion in the first nine months of
2003-04. As compared with this, net foreign direct investment
has been relatively stable, at $3.27 billion in 2000-01,
$4.74 billion in 2001-02, $3.61 billion in 2002-03 and
$2.51 billion during April-December 2003.
The third important source of capital inflows was a
financial liberalisation-induced increase in the net
liabilities of commercial banks (other than in the form
of NRI deposits), which rose from a negative $1.43 billion
in 2000-01 to $2.63 billion in 2001-02, $5.15 billion
in 2002-03 and $2.56 billion during April-December 2003.
This is possibly explained by the expansion of the operations
of international banks in the country.
In sum, capital inflows that create new capacities either
in manufacturing or in the infrastructural sectors have
been limited. Much of the capital inflow has consisted
of financial investments that expect to earn higher
annual returns than available in international markets
or obtain windfall gains from the appreciation of the
value of such investments, as has recently been witnessed
in India's stock markets.
Given the determination of the exchange rate of the
rupee by supply and demand conditions in the market,
this large inflow of foreign capital in the context
of a current account surplus was bound to exert an upward
pressure on the rupee. When inflows contribute to an
appreciation of the rupee, foreign investors also gain
from the larger pay off in foreign currency that any
given return in rupees involves. This tends to increase
the volume of inflows. The real losers are exporters,
on the one hand, who find that the foreign exchange
prices of their products are rising, eroding their competitiveness,
and domestic producers, on the other, who find that
the prices of competing imports are falling or rising
less that their own costs of production.
However, this potential loss of competitiveness on account
of surging capital inflows was stalled for long by the
intervention of the central bank. By purchasing foreign
currency from the domestic market and adding it to its
reserves, the Reserve Bank of India increased the demand
for foreign currency and dampened the rise of the rupee.
The foreign exchange assets of the central bank rose
sharply, from $42.3 billion at the end of March 2001
to 54.1 billion at the end of March 2002, $75.4 billion
at the end of March 2003 and $113 billion at the end
of March 2004. This implies that even after discounting
for the increase in reserves resulting from the appreciation
of the dollar value of the RBI's Sterling, Yen and Euro
reserves, the foreign exchange assets of the central
bank were rising by around $980 million a month in 2001-02,
$1.4 billion a month in 2002-03 and $2.5 billion a month
during 2003-04. Further, because of inflows on account
of the sale of equity in companies such as ONGC and
ICICI bank, foreign exchange assets rose to $116.1 billion
during the first nine days of 2004, or by a whopping
$3.1 billion.
These magnitudes have two implications. First, they
suggest that the RBI has had to sustain a rapidly rising
rate of acquisition of foreign currency in order to
dampen the rise of the rupee and preserve export competitiveness.
Second, that despite this sharp rise in the foreign
exchange assets of the central bank the task of managing
the rupee's exchange rate is proving increasingly difficult
leading to a rise in its value.
The task of managing the rupee is daunting because,
when the central bank increases its foreign currency
assets to hold down the value of the local currency,
there would be a corresponding matching increase in
the liabilities of the central bank, amounting to the
rupee resources it releases within the domestic economy
to acquire the foreign exchange assets. If forced to
continuously acquire such assets, the resulting release
of rupee resources would lead to a sharp increase in
money supply, undermining the monetary policy objectives
of the central bank. Since financial liberalisation
implies abjuring direct measures of intervention to
curb credit and money supply increases, the central
bank has sought to neutralise the effects of reserve
accumulation on its asset position, by divesting itself
of domestic securities through sale of government securities
it holds.
This process of ''sterilising'' the effects of foreign
capital inflows through sale of government securities
has, however, proceeded too far. The volume of rupee
securities (including treasury bills) held by the RBI
has fallen from Rs. 150,000 crore at the end of March
2001 to Rs.140,000 crore at the end of March 2002 and
Rs. 115,000 crore at the end of March 2003, before collapsing
to less than Rs.30,000 crore by the end of March 2004.
The possibility of using its stock of government securities
to sterilise the effects of capital flows on money supply
has almost been exhausted. Foreign investors have made
a complete mockery of the much-trumpeted ''autonomy''
of the central bank won by curbing the government's
borrowing from the RBI.
In the current context, there are only two options available
with the government for preventing a capital flow-induced
appreciation of the rupee that could not just reduce
India's exports but also deindustrialise the economy
and devastate agriculture by cheapening imports that
are now free. The first is to resort to measures that
could reduce the volume of inflows. A feeble effort
in that direction has been the gradual reduction in
the differential between interest rates paid on non-resident
foreign exchange deposits and those prevailing in the
international market, as reflected by the LIBOR. The
ceiling on interest on non-resident external deposits
had earlier been linked to the LIBOR and set at 0.25
per cent above it. Now the ceiling has been set at the
LIBOR itself.
But NRI inflows during April-December 2003-04 only accounted
for around a fifth of net capital inflows into the country,
and that ratio is likely to be much smaller in the subsequent
months. Managing the rupee by controlling capital inflows
requires targeting portfolio flows. That is the signal
that the rising rupee sends out. Unwilling to heed that
signal, the government has decided to encourage outflows
on the current and capital account by removing the few
import controls that remain, reducing duties, easing
access to foreign exchange for current account transactions
like travel, education and health and, most important,
relaxing outflows on the capital account by permitting
firms and individuals to transfer money abroad for investment
purposes.
The dangers of blowing up in this manner the foreign
exchange obtained in the form of volatile capital flows
should be obvious. What is more, it is unclear whether
this would resolve the problem. The process of liberalisation
may, in the short run, make India an even more favoured
destination for foreign investors. The rupee could appreciate
further. Exports could shrink. Further liberalisation
aimed at increasing foreign exchange outflows could
damage the domestic production system. All of which
could finally encourage investors to walk out on India,
in the perennial search of markets that have not yet
been destabilised. That would deliver an economic scenario
that no one would want to conjure for this country. |
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Table
for Chart |
Dollar |
Euro |
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01/02/2001 |
46.40 |
43.67 |
01/03/2001 |
46.53 |
42.95 |
03/04/2001 |
46.64 |
41.26 |
02/05/2001 |
46.81 |
41.82 |
01/06/2001 |
47.05 |
39.87 |
02/07/2001 |
47.07 |
39.87 |
01/08/2001 |
47.13 |
41.51 |
03/09/2001 |
47.13 |
42.87 |
01/10/2001 |
47.93 |
43.61 |
01/11/2001 |
48.00 |
43.24 |
02/12/2002 |
48.32 |
47.97 |
01/02/2002 |
48.53 |
41.68 |
01/03/2002 |
48.75 |
42.27 |
02/04/2002 |
48.80 |
42.90 |
02/05/2002 |
48.96 |
44.36 |
03/06/2002 |
49.02 |
45.72 |
01/07/2002 |
48.84 |
48.55 |
01/08/2002 |
48.67 |
47.55 |
02/09/2002 |
48.48 |
47.56 |
01/10/2002 |
48.36 |
47.76 |
01/11/2002 |
48.34 |
47.87 |
02/12/2003 |
45.71 |
54.77 |
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