Sunday, May 27, 2007

Reasons for Rupee Appreciation

Current inflation has eroded the value of the rupee — it buys fewer goods, fewer services and less of everything. Yet as things stand today, the rupee fetches more dollar: nearly 13 per cent more than it did just 10 weeks ago. How did this happen?

Since the inflation rate in India is relatively higher than in many other countries that we trade with, the rupee should have depreciated against other currencies. Instead, the exchange value of the rupee has risen significantly. Economists attribute this to a number of factors, but the most immediate and important reason is that the RBI seems to have suddenly lost its appetite for the dollar.

When the exchange rate of a currency is market-determined, as is the case with the rupee which is on a free float, supply and demand forces come into play. There has been plenty of dollar supply in the market. In the past, RBI mopped up excess dollars to ensure that the value of the rupee did not shoot up beyond limits, for that would have hurt the country’s exports. In the process, the RBI kept adding to the country’s foreign exchange reserves which have risen to $200 billion.

This process of RBI intervention in the market has a cost. For all the dollars the RBI buys, it must release equivalent rupees into the system which goes on to increase money supply in the economy. That was not such a major concern as long as domestic inflation was benign. But now, faced with the paramount task of containing inflation by all means, the RBI, in the last couple of months or so, has let the rupee gain in strength. With the main dollar buyer thus missing from the market, the rupee has reached its highest level in nine years.

A stronger currency is not a matter of national virility. As economists will tell you, it is normally an indicator of the growing strength of the national economy. By all available indicators, the Indian economy is going through an unprecedented phase of growth. The external sector of the economy in particular, as RBI governor YV Reddy maintains, has been strong and resilient.

As Goldman Sachs economist Tushar Poddar notes: “The movement of the rupee is, to a large extent, determined by the interplay of three factors — the current account deficit, the strength of capital inflows, and RBI intervention to curb volatility”.

India is running up a deficit in its current payments to, and receipts from, the rest of the world. But this was a moderate deficit of about $18.2 billion last year. The Indian economy is, against that, attracting unprecedented amounts of capital inflows. Just to cite two examples: FDI inflows, which stagnated around $5 billion in previous years, jumped to over $15 billion last year, while foreign portfolio investments added another $8.5 billion.

Despite a surge in the oil import bill and a 30 per cent growth in overall merchandise imports; despite a larger number of Indians travelling abroad and splurging more than $7.6 billion last year; and despite Indian companies investing large amounts in overseas takeovers, there is just not enough demand for the dollar that would put pressure on the rupee. Even though the RBI, through its April 24 monetary policy, has sought to encourage a dollar outflow, the point is why would anyone take out dollars when high return on assets in India seems to be attracting a deluge of dollar inflow?

Source: DNA Sunday