The Hindu Business Line : `On a structural basis, rupee may keep appreciating against dollar'

Chennai, June 11 The rupee's sharp rise in the past few months has become a major cause of concern in industry circles, especially in sectors like IT where a large percentage of companies are dependent on exports for bulk of their revenues.

Speaking to Business Line on the fallout of the strengthening rupee, Prof Ramkishen S. Rajan, forex expert and associate professor with the School of Public Policy of the US-based George Mason University, said that further strengthening may be seen in the very near term, thanks to lack of RBI intervention.

But, he added, the current spike is likely to be a purely temporary phenomenon as the apex bank may step in to intervene again at some stage.

The obvious concern with such a sharp nominal appreciation is that it could curtail the country's export competitiveness.

"As long as other Asian countries like China do not permit more flexibility, it is unlikely that India - which has become much more export-oriented and cost-conscious - will be willing to accept persistent rupee appreciation."

However, Prof Rajan said, on a structural basis the expected weakness of the dollar due to large-scale external imbalances and the strength of the Indian economy, along with rising domestic productivity and growing competitiveness, will see the rupee appreciating against the dollar.

Inflation

He added that the rising rupee should help reduce imported inflation, particularly that of necessities such as crude oil.

"In addition, some of the speculative capital inflows might reverse direction, as foreign investors choose to book profits following the capital gains they made due to the rupee appreciation. This may help ease the pressure on India's balance of payments surplus."

According to Prof Rajan, the rupee's strength has been driven by persistent balance of payments surpluses, "which, in turn, have been primarily driven by net capital inflows (FII and FDI)."

The RBI responded to the sharp influx of capital inflows through a combination of a gradual rupee appreciation vis-à-vis the dollar as well as by intervening directly in the forex market. This led to the steady rise in forex to over $200 billion by April 2007.

Without forex intervention by the RBI, the rupee would have risen much more sharply, he added.

"However, the effectiveness of monetary sterilisation to offset the liquidity consequences of the forex intervention has declined and costs have escalated."

In a paper on reserve stockpiling - `Managing its Monetary Consequences: The Indian Experience' - written with Prof Alice Ouyang, Prof Rajan has dealt with the concerns of whether the RBI could sterilise as aggressively it had been doing earlier.

"It is one of the few papers to actually broach the issue of monetary sterilisation in India systematically."

RBI intervention

According to him, if the RBI keeps intervening without sterilising, domestic liquidity would rise sharply, thus hurting efforts to rein in inflation.

"In view of the growing external balance of payments pressure and in the background of rising domestic inflation rates, the RBI appears to have decided to allow a much greater share of the impact of the capital inflows to be reflected in the rupee appreciation."

To partly counteract the impact of the appreciating rupee, there is some discussion in the Ministry of Commerce about establishing a scheme to refund local taxes and levies to labour-intensive industries with little import content, Prof Rajan said.

"This is not surprising. However, these policies are ad hoc and run against the attempts of the Government to trim the consolidated fiscal deficit."

Until 2002, the rupee had been weak against all major currencies. For instance, it was ruling at around 49 against the dollar in mid-2002. Since then there has been a major turnaround, with the rupee experiencing a definite and sustained strengthening.

The latest rate of 40 against the dollar was last seen in May 1998. "However, until 2006-end, part of the rupee's sustained rise was more a reflection of the dollar's generalised weakness over the 2002-2006 period," Prof Rajan said.

"This is evidenced by the fact that the bilateral exchange rates with respect to a number of other major currencies, such as the euro, pound, Canadian dollar and the Australian dollar, were fairly stable."

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