THE RISING RUPEE: TOO HOT TO HANDLE?

The effects of a high rupee are not all negative

Devangshu Datta

Circa June 1991, one US dollar cost Rs 17 at the official rate. In order to buy that dollar, you filled in multiple forms. In the end, you got an allowance of $1 a day for foreign trips. You could short-circuit this process and buy $1 at hawala instead — it cost about Rs 31.

It was a criminal offence to hold forex, let alone invest abroad. Even state-owned corporations were hobbled — ongc was refused sanction for the $1 million it needed as earnest money to tender for a Vietnamese oilfield.

Crude was then at around $45 per barrel, after a spike caused by the First Gulf War. Energy was then, as now, by far the largest import component. India had less than $1 billion in reserves — sufficient to meet just a week of imports. Famously, Yashwant Sinha pledged gold reserves to keep the black gold flowing.

Circa June 2007, one US dollar costs Rs 40.75 and crude is at $66 a barrel. Is India bankrupt? Nope. There’s over $200 billion sitting in reserves, which are growing at $3 billion a week. You don’t need to fill endless forms to draw on these. An individual can, in fact, invest up to $100,000 abroad every year in a wide range of assets.

Most analysts believe the rupee is a little too strong for its own good! Between mid-1991 and 2006, the rupee hit a low of around Rs 47-48 versus the dollar (it slid against other currencies as well). There were several benefits. One, exports grew quickly since they were relatively cheap. Two, foreign investments came in because rupee-assets were cheap. Three, Indian businesses competed easily with imports as the rupee depreciation provided a cushion.

Rupee depreciation wasn’t “natural”. The RBI intervened to ensure that the rupee stayed low. It bought forex at slightly inflated rates to do this. Over the past 12 months, the RBI has allowed the rupee to climb about 10 percent. It has eased restrictions on Indians investing abroad, raising foreign debt and buying foreign firms. In March 2007, the RBI became a much less active manager. And the rupee has shot up six percent since then. The flood of inflows has continued and demand for rupee-assets has led to a strengthening of the currency.

The RBI is on the horns of a dilemma, which is sometimes called “the impossible trinity”. Assuming free forex flows, it’s not possible to control both forex rates and local money supply. The central bank can manage one or the other, not both. Local money supply has a direct impact on inflation and that is a political hot potato. So the RBI has concentrated on controlling inflation, and let exchange rates go. Unless inflation is drastically reduced, political compulsion will ensure this focus remains until the next general elections.

Naturally, exporters are screaming. it companies for example, gave revenue and income guidances for 2007-8 assuming a rupee-dollar rate of Rs 43. But it was naïve to assume that the RBI would perpetually manage the rate and ensure movement was one-way.

It’s not as though all the effects of a high rupee are negative. A higher rupee has reduced the impact of high crude. It has forced domestic manufacturers to keep prices low to counter cheaper imports. It has eased burdens on businesses with capital imports. Telecom firms, construction firms, oil explorers — they aren’t that unhappy.

In the short run, a rising rupee ensures that “hot” money inflows continue. Rupee appreciation offers a quick buck for hedge funds. The effect can be seen in the relative returns of the Nifty — up 3.5 percent since January 2007, versus its dollar-twin, the Defty, which has gained 12 percent in the same period.

Delving back into history, in 1991, Finance Minister Manmohan Singh devalued the rupee in one shot to around Rs 29 to a dollar as part of his New Economic Policy. This was the first step in making exports competitive and it undercut the hawala trade. In the 1993 Budget, Singh promised full convertibility. Once that comes, people can buy yen, dollars, sterling, euro, etc, without filling in forms or proffering reasons.

We’re not there yet. Once it does happen, the rupee will fluctuate just like other currencies. Currency exposures can be hedged (Dubai has just introduced a new rupee-dollar futures contract, for example).

It is up to the prudent to hedge both directions. That’s what people do in hard-currency markets. You cannot have liberal norms on capital imports and investments abroad and expect that the rate will be managed. The RBI’s hands-off policy offers good practice for full convertibility, as and when it comes.

Datta is consulting editor, Living Media

Jun 23 , 2007