Rupee Appreciation: Should RBI Intervene?

The Indian Rupee is again on the rise, touching its 25-month high of 44.12 to the dollar in mid-October. The strong foreign investment inflows have contributed to the rupee appreciation even though governments around the world are trying to keep their currencies weaker as a weak dollar has eroded the competitiveness of their exports. The story is same for all emerging market economies, especially India and Brazil, which are flooded with capital inflows, thereby struggling to resist currency appreciation. Over and above in India, things are complicated by inflationary pressures which makes the option of fiscal measures like interest rate cuts to control exchange rate, not feasible. But unlike other emerging economies, Indian government has not responded with large scale interventions in foreign exchange markets and intensification of capital controls. Finance Minister Pranav Mukherjee had stated that the rupee appreciation is normal and the aggressive FII inflows are only reflective of foreign investors’ confidence in the Indian growth story.

The major impact of a stronger rupee is the reduced competitiveness of Indian goods and services in the export markets. The rupee has gained more than 5% since the start of the year, mainly triggered by a huge quantum of FII inflows this year to the tune of over INR 1 trillion. The current trade account deficit is high and the net inflow of capital is positive. The last burst is probably related to the fact that overseas people are ready to buy in IPOs of public sector companies. The initial public offering (IPO) from Coal India has attracted foreign inflows of around INR 1.2 trillion from overseas funds, more than the total influx of such money in the equities markets in 2010.

The textile industry has been worst hit by the appreciating rupee. According to various news reports, the appreciation of the Indian rupee against the US dollar is forcing more and more small and medium enterprises in the textile sector to lay off workers or close down. According to a few industry experts in the southern textile hubs of Tirupur and Bangalore, a factory closes every week. The industry, which was on the path of recovery in the post-recession phase, had seen a dip of about 8% in exports from April to October this year. Garment manufacturers who had booked orders when the dollar was worth Rs 48-49, are facing severe margin reduction. Appreciation of the Indian rupee has also adversely affected the outsourcing industry. This is because, while the local costs of the industry have increased due to rising staff salaries, appreciation of the rupee has reduced their revenues.

It is generally estimated that every 1% of rupee appreciation has a negative impact on the net profit of software companies by roughly 1.6%. The Federation of Indian Export Organisations (FIEO) – the apex body for the country's exporters has already demanded an increase in duty drawback rates by 2% for all export sectors for a limited period of one year.
So the debate that is heating up is whether RBI’s policy of refraining from large scale interventions in foreign exchange markets is the correct way forward or not. The RBI has resorted to open market operations and purchased dollars in the past to ensure the competitiveness of India’s exports. But this time over the last 18 months RBI has let the exchange rate absorb modest capital volatility, leaving policy level interventions to tackle more volatile capital flows. Most of the capital inflows from the developed world are due to portfolio rebalancing of the foreign investors, rather than seeking of short-term interest differential or appreciation gains. These rebalancing acts have been reinforced by ECB’s recent liquidity support for servicing peripheral European debt and by the declaration of a second round of quantitative easing by the US Fed. Without any near-term apprehension of liquidity or redemption pressure in the developed markets, these capital inflows will continue.

Enforcing stringent capital control measures is not likely to curb the FII inflows. Rather adopting policy interventions in exchange markets will carry the risk of raising the expectations for future currency expectations, thereby increasing speculative flows. Brazil, for example, has enforced massive interventions in the foreign exchange markets to curb currency appreciation by increasing its foreign reserves by 18%. Still its currency has gained over 38% in the last two years, thereby making it one of the most over-valued currencies in the world. So apparently it seems that RBI’s policy of allowing the exchange rate to absorb capital volatility is the right step forward from long term perspectives. It is expected that once the current round of quantitative easing in the US subsides with the withdrawal of the stimulus packages and liquidity pressures are created in the developed markets, the foreign investors will exit and the rupee will again depreciate to the levels of 46-47 to the dollar
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