Romancing Rupee Appreciation !

The cacophony of the written word on the phenomenon of rupee appreciation (it’s not a one-off incident), which dictates many of the economic policies, has somewhat obscured the critical issues, owing to the embellishments of variegated theorists. This piece intends view the causes and effects of the phenomenon from a novel perspective: through love, something that, quite ironically, money can never buy.

In love, absence makes the heart grow fonder: what makes the rupee appreciate?

Large inflows of any foreign currency (for instance, dollar), in the form of foreign investments by the FIIs and the FDIs , enters the market by buying out the rupee, leaving the market flooded with the dollar. The demand-supply law of economics proselytizes that the price of a product rises with an increase in its demand. So with the increase in the demand for the rupee, its supply in the market decreases, and hence there is an upswing in its price (remember this whenever your girlfriend acts pricy!). Hence, surge in capital inflow, leading to an increased demand for the rupee, is the chief harbinger of the rupee appreciation.

Who looses sleep over it? : The affected parties

The recent rupee rise against the dollar has occurred amidst squeals of protest by exporters of textiles and other manufactured goods, besides services. Software services have, particularly, seen their competitiveness suffer. In an environment where a sizeable portion of their income comes from export, the software behemoths are especially wary of an unbridled rupee rise washing out a chunk of their profits.

The reason for this hoopla is simple: the exporters get paid in dollars. While the number of dollars received for the goods/services exported remains the same, the subsequent conversion into rupee yields lesser than erstwhile used to. An item which would earlier fetch Rs 45/ dollar, now garners Rs 40 only. A simple solution would be to start charging in the currency (like euro or yen) that dominates the rupee. But obsequity on the part of the policy makers rules it out.

While for importers rupee appreciation is a delectable proposition, as it makes imports cheaper. Yet in stark contrast the domestic manufacturers go up in arms, fretful of their inability to compete with the higher quality imported products.

Undoubtedly the most flustered of the whole lot is the RBI, which is the pivot upon which the whole economy rotates. The RBI has to constantly intervene in the market, with rapt cogitation, to ensure balance between the capital inflows and the rupee flow (liquidity). One wrong move could snowball into a vicious capital inflow-rupee appreciation-liquidity-inflation-higher interest rates cycle.

“How to get her out of your head?” : government’s riposte to the effects of rupee appreciation

Numerous expedient measures have been tried in the past to tackle this conundrum.
A comprehensive package of Rs 1400-crore was doled out by the Central Government in July this year, as a palliative to the exporters. The package included: increased rates of tax refunds through the duty drawback scheme, and availability of pre and post-shipment bank credit at far easier terms. Alongside this another package of rs 600-crore was given to the SMEs(Small and Medium Enterprises).But these are short-term solutions . In the wake of a nearly twelve percent appreciation of the rupee against the greenback, only an increase in productivity and efficiency can truly make the Indian exports competitive at the global stage.

The software firms, which already enjoy a tax exemption, weathered the storm with minimal governmental assistance. A deliberate effort was made to diversify from the US (which takes up around two-thirds of the total Indian software export) to the developed markets of western Europe and Japan, and the developing markets in South America and eastern Europe. Also many of the software companies hedged their dollar income against the rising rupee by converting into the latter(a ruse offered by the government). Still, what will pinch the software firms is the fact that the lobbying in budget 2008 to extend the tax sop has come a cropper. Come 2009, and the net taxes for them would increase to 22% from the present subsidized rate of 15%, further cutting their profits( what role would that play in the placements this year?).

Hail the cupid: the RBI

In the theatre of the Indian economy, the RBI plays the protagonist. To control rupee appreciation, it primarily buys out the inflowing dollars . These then become our forex reserves. What the RBI effectively does is : increase the supply of rupee back into the market , and increase the demand of dollars by buying them out. Thus the value of rupee automatically decreases against the dollar, which is forced to rise.

But like any love story, this one too has its twists. Increasing the supply of rupee in the market could lead to floods(also termed as ‘liquidity’) .Though this boosts the purchasing power of the people, it also increases the demand of goods, leading to an increase in their prices. This simple phenomenon is complexly termed as ‘inflation’.

To counter this, the RBI must mop up the excess rupee from the market by selling government securities. This is termed as ‘sterilisation’. Yet even this method has limitations whose articulation is beyond the scope of this article.

Arguably, the best solution has been demarcated in the budget 2008. Heralding a distinct policy change, the RBI now plans to work in close tandem with the Central Government, and will restrict or/and direct the capital inflows itself.

But will the story have a happy ending? Just wait and watch...

Sudipta Mukherjee