Rupee's Next Destination
By : Mr. K Venu Babu

Volatility continues in the currency market with the rupee losing heavily or gaining handsomely every day for the past few days. This fluctuation has sparked a debate on the government’s intentions, the RBI’s role and the likely impact on the economy at large. After dipping close to Rs 47 to a dollar, the Indian currency recovered smartly for the past few weeks. The recent escalation in international crude prices leading to a heavy pressure on Balance of Payments had battered the Indian currency. Meanwhile, a study conducted recently by Institute of Economic Growth (IEG) has revealed that the rupee-dollar exchange rate is expected to break yet another psychological level of Rs 47 in four months' time. And the Indian government has predicted the rupee to cross 50 level by 2002. What are the various factors that affect the rupee movement?

After crossing the barrier of 40 mark against a dollar during the nuclear tests in 1998, the rupee gradually depreciated to 45 level in 2000 and had touched a low of around 47 in the same year, though recovered later. However, RBI did not enter the market, and it had asked nationalised banks to sell more than $500 million this financial year to steady the rupee which plunged by over 1.5 per cent. This year it has shed more than 5 per cent of its value in terms of the dollar.

The recent international crude price has crossed $32 per barrel resulting in the increase in the oil pool deficit at Rs.85 billion ($1.88 billion). Other economic indicators, barring agriculture, look bleak and the country might be in for difficult times in future. Had the same prices continued, the deficit would have stood at Rs.120 billions ($2.66 billion) by March 2001. The subsidy bill on kerosene, diesel and LPG had been rising. A fall in the rupee against the dollar has made the entire fiscal calculation awry.

Is the fall of a rupee good for anyone? Economists are a divided lot. Some favour a cheaper rupee to spur exports and to make imports costly and thus discourage the flow of consumer goods under the WTO rules. That and higher import duty should partly shield small scale industries from fierce competition from Chinese and South Korean manufacturers. Others fret that costly imports will add to the inflationary pressure and make nonsense of industrial growth revival and lower interest regime.

The debate of rupee depreciation and appreciation continues as it is not easy to determine the equilibrium real exchange rate of the rupee. Ideally this is defined as the value that equates the current account and the capital account of the balance of payment, over the time. That is, current account deficits must be financed by sustainable capital account deficits. Since future periods are involved, market expectations enter the fray. Before the eighties the determination of the exchange rate was simpler. It was dominated largely by trade flows. But now capital transactions dominate. The exchange rate behaves more like an asset price; expectations of market traders and bandwagon effects, as they learn from each other, can lead to large price movements.

Sustaining the nominal exchange rate above the value expected by the market requires high interest rates to prevent capital from flowing out of the country. Over the time this harms domestic investment, output and productivity and therefore causes a depreciation in the equilibrium real exchange rate. To maintain the level of the nominal exchange rate will then require even higher interest rates; it is not a sustainable strategy. South East Asian countries made this mistake: nominal exchange rates were fixed in the nineties and did not vary sufficiently while their interest rates exceeded world interest rates.

A rupee on a roller-coaster dampens inflow of capital; this year foreign exchange reserve has come down by 7 per cent — from $38.34 billion to $ 35.67 billion. NRIs have deposited over $10 billion and could take it out any time. Foreign funds dealing in the stock market brought in another $10 billion. Then there is trade deficit. A wary RBI has asked exporters to bring back half of the balance in foreign banks. This meant an addition of $1 billion to the reserve. But its psychological effect in market nervousness would be strong. It is plain that the usual lag and lead factors are behind the value swings and not speculative activities. Once this works itself out, the rupee is expected to remain stable around the present level.

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