Indian Rupee Appreciation and its Effects

The Indian currency is issued by the Reserve Bank of India (RBI). The Indian rupee exchange rate is measured against six currency trade weighted indices. These currencies belong to countries that have a strong trade relationship with India.
The exchange rate of the Indian rupee (or INR) is determined by market conditions (demand and supply). However, in order to maintain effective exchange rates, the RBI actively trades in the USD/INR currency market. The rupee currency is not pegged to any particular foreign currency at a specific exchange rate. The RBI intervenes in the currency markets to maintain low volatility in exchange rates and remove excess liquidity from the economy.

First, let’s understand how exchange rates are adjusted by market conditions. In Indian economy factors like high inflation would encourage the RBI to hike its interest rates to curb the money supply in the market. Money supply reduces because loans become expensive and savings become attractive. But this higher return on investment becomes attractive for foreign investors as well especially as Indian markets become more stable compared to other markets. Hence, foreign currency (capital) flows in, increasing demand for Indian currency resulting in currency appreciation. These foreign investments are directly reflected in the stock markets. Hence stock markets rise as currency appreciates. However exports are adversely affected. Indian Exports become less competitive in the global markets fetching lower returns. IT Industry, textiles, manufacturing industry and other export oriented industries are affected. As money supply is curbed, the purchasing power reduces and with the exports decreasing, market sentiment becomes negative. This reduces flow of money supply in the market. RBI therefore reduces the interest rates so that people once again borrow and buy. Money supply increases. Thus the Indian currency depreciates. This is the basic cycle how exchange rate adjusts back.
Now, let’s relate this logic to what’s happening currently. The rupee is again appreciating, after a lull of eight months. In the week ended April 9, it climbed by 2.9 per cent to a 19-month high of Rs44.29 a dollar on the back of surging FII inflows into equity and debt market. In the 12 months to April 9, 2010, it has appreciated by 11.5 per cent from Rs. 50.02.

However, Indian economy is running a high current account deficit of over 3 per cent of GDP and a trade deficit of around 10 per cent of GDP. Hence to increase exports by making them more competitive, one would expect rupee to depreciate. But the opposite seems to have happened and rupee is appreciating.
The rupee is appreciating because of inflows of foreign capital into India’s stock and debt markets. With interest rates on the rise here (RBI increased CRR by 75bp to absorb liquidity in Jan and on March 19 increased repo and reverse repo rate by 25bp) and rates in the West still hovering near zero, the debt market too has become more attractive than ever. Foreign fund managers are bullish on Indian growth story. In 2010 so far, As per Sebi figures, FIIs have poured $5.35 billion in the stock market and another $4.73 billion in the debt market. This has driven the Sensex past 18000.

As I said, this appreciation of currency is adversely affecting the exports. It hurts industry, agriculture and traded services, and is particularly damaging to the recovery prospects for employment-intensive manufactured exports such as garments, textiles, leather products and gems, which suffered setback during global recession. Shares of software companies have taken a beating on bourses on fears of smaller revenues and narrower margins.

Broadly, what seems to be happening is that the US dollar is depreciating (in real terms), and so is the Chinese yuan, against all other currencies. This means that as net exports (exports minus imports) from the US and China increase smartly, the burden of absorbing this increment in net exports falls on the rest of the world.
Given its current account deficit, a rise in US net exports makes sense. However, having a relatively flexible rupee when China manages its currency aggressively makes little sense for India. That is why RBI needs to take some action to depreciate it. Right now, RBI is following a hands-off policy towards the currency, mainly because inflation heads its list of concerns (meaning the need to have high interest rate to curb inflation as explained above). Inflation had been on a year-on-year basis at 9.9 per cent in February 2010 exceeding its baseline projection of 8.5 per cent for end-March, therefore containing overall inflation has become imperative. Injecting additional liquidity into the system by buying up dollars to contain the rupee would clash with its objective of inflation control. And if it were to mop up this liquidity by selling government bonds, it would complicate the job of managing government’s borrowing programme, besides imposing financial costs. RBI therefore has no good option. The alternative course of action may be to moderate net capital inflows. There are various instrumentalities, including tightening of P-Note regulations, reduction of external commercial borrowing limits etc.

In fact, the currency market seems to believe that some weakening of the rupee is inevitable. This may be because of fall in exports and reduced purchasing power of people. Thus exchange rates are expected to adjust back as different economies stabilize and Indian interest rates go down.
Looking at past also, we see that the recent surge in the value of the rupee seems like the reminiscent of the sudden, sharp appreciation of the currency in the spring of 2007. At that time, the driving factors were an accelerating surge in capital inflows and a sudden policy shift by RBI (generally believed to have been dictated by the finance ministry) in favour of non-intervention in the currency market. In January 2008, the stock market had crashed after reaching a peek of 21000, at that time, the rupee rate had appreciated to 38 against the dollar, it was for the first time that rupee was so strong.

In 2008, Post-Lehman (Sept 15, 2008) collapse, dollar inflow declined with oil companies and investors purchasing more and more dollars. Persistent outflow of foreign funds increased the pressure on the rupee, causing it to decline. 2008 was really bad for stock markets and in January 2009, the market reached its lowest close to 8000, from its peak at 21000. The rupee on the other hand had depreciated through out the year reaching a high of 52 on 5th March when the stock market was its lowest.

However, since the later half the stability of the Indian economy attracted substantial foreign direct investment, while high interest rates in the country led to companies borrowing funds from abroad resulting in a healthy rebound in 2009-10.
And therefore, since January 2009, the market is steadily moving up and so is the rupee getting strengthened. However in the next 3-6 months, RBI would increase interest rates and so we expect Rupee to weaken to some extent.