The rupee-dollar danger zone

January 3, 2011

An employee counts rupee notes at a cash counter inside a bank in Agartala December 31, 2010. REUTERS/Jayanta Dey/Files
(The views expressed in this column are the author’s own and do not represent those of Reuters)

The rupee has gone through a rollercoaster ride in the past year, being pushed up by foreign investment and down by trade deficit.

On balance, the rupee appreciated, reaching its lowest value in terms of dollars in July and the highest in October.

Trade and FII investment are not independent of the rate of exchange. The rate of return for foreign investors is the expected increase in stock prices plus the expected appreciation of the rupee.

When investment comes in, both these expectations get automatically fulfilled. It is a similar thing with trade as well. When the rupee is low, exports increase and imports decline both of which reduce the trade deficit and consequently harden the rupee.

These market pressures influence the exchange rate unless the RBI steps in. Such interventions in recent months have not been significant.

Not all countries allow the currency and the trade markets to function normally. The crisis of 2008-09 has made these temptations even stronger. That is what has perturbed the high-powered Financial Stability and Development Council which met on the eve of the new year.

“The effort to keep the value of currencies artificially low could have adverse impact on the competitiveness of Indian companies,” the Finance Ministry reported.

“If nations adopt protectionist measures it could have serious implications for the world economy,” it added.

Though the comments are general, they seem to point to two countries in particular.

The U.S. has been tempering with the exchange rate with quantitative easing. The explicit comment by Federal Reserve is that the additional money in circulation will increase consumption and investment. The unexpressed hope is that the dollar will depreciate and the U.S. will be able to export more, creating incomes and jobs for the Americans. That is what has been happening.

In the past 120 days, the dollar has lost against many Asian currencies, even the Chinese yuan which had been stubbornly tied to the dollar. The dollar lost 7.8 percent against the Korean won and 7.3 percent against the Singapore dollar.

It lost 5.5 percent against the rupee eroding our competitiveness to that extent. The yuan, in spite of the recent flexibility, continues to be severely undervalued which has enabled China to build trade surpluses and huge foreign exchange reserves.

The FSDC cannot do much about international currency and trade distortions. The money poured in by Federal Reserve has found its way to Asian markets appreciating their currencies with a negative impact on exports. This prompted Thailand, for instance, to adopt capital controls.

If there is no significant improvement in the U.S. economy this year, the FII investment will once again flood the market pushing up the exchange rate and asset values, both of which are undesirable.

The RBI intervention in the currency market in that case is therefore important. The rupee should not be allowed to go beyond 44 rupees to the dollar — where it will hurt exports — if necessary, with capital control.

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