Money Tree

The rupee has appreciated more than 10 percent in the last one year and the rally seems to be continuing. The exporters are holding their nerves witnessing this seemingly uncontrollable rise against the dollar. But why the rupee is appreciating and is RBI taking any measures to put reins on it and is it good for economy or will it create problems going ahead. We will endeavor to answer all these questions in the following discourse.

Effect of globalization : In the last few years the effect of globalization has increased, we are now more closely connected with other economies. Change in prices of commodities in US and Europe affect prices at home.

Rapid credit growth : Credit growth has risen by 30 percent per year in the last three years.

Shortages of food supplies : Poor harvests in the last few years and global increase in prices affected the prices of food supplies.

Development of commodities market : Speculators and cartels can control prices of agro and other commodities for their own gains.

Rise in demand : Due to high credit growth the demand of the essential goods and housing rose exponentially.

The rising inflation number

The above factors resulted in an increase in demand and a shortage of supply, too many funds chasing too few assets, resulting in an increase in inflation.

RBI hiked interest rates to counter inflation

With the rising inflation, the Government became concerned and RBI raised interest rates and hiked Cash Reserve Ratio (CRR) [CRR is the reserve money which the banks have to deposit with Reserve Bank of India and they do not get any interest on such reserves kept]. This increases the cost of borrowings and the credit growth declines, liquidity is squeezed from the market thus resulting in a drop in demand which should ideally result in a drop in prices of goods and the inflation number should come down.

High interest rates led to more foreign borrowings and inflow of more dollars resulting in the appreciation of rupee.

But this time it did not happen as the corporates turned to overseas for borrowings and the foreign money inflows by way of external commercial borrowings flooded the markets providing the necessary liquidity and therefore the inflation could not be controlled to a larger extent. The foreign direct investments (FDI) rose sharply during December 2006 and January 2007 and the External Commercial Borrowings (ECB) also rose significantly during the same period. This excess supply of money in dollars strengthened the rupee against the dollar.

Issue of bonds by RBI and further hike in CRR

The apex bank bought rupees by issuing bonds and hiked CRR further during the period February to April 2007 but the rupee kept appreciating, however, the inflation numbers came down to 5.5 levels. May be because the rising rupee also pushes the inflation down as it results in lowering the prices of imports particularly of oil, capital goods and basic raw material which in result reduces the end price of commodities.

But the issue of bonds and hiking of CRR have their own disadvantages. A hike in CRR reduces profitability of the Banks as they have to accept deposits on interest and deposit the reserves with RBI without any interest. On issue of bonds the Government has to pay interest for a very long term which is not required at all. Therefore, the Apex bank can not hike CRR beyond a level and issuing bonds is also not a great measure.

Let us now look at the advantages and disadvantages of an appreciating rupee.
An appreciating rupee reduces costs of import and thus results in lowering the costs of goods produced to make them available at competitive prices, hence is good for consumers or public at large, also it makes the nation richer as total GDP would measure more in dollars. An appreciating rupee also helps reducing inflation as discussed above.

It poses the biggest problems for the exporters. The goods of exporters become less competitive overseas and their margins shrink with the rising rupee. It may result in slow down in the growth of Indian exports. However, rupee has not risen against other currencies like Euro as much as it has risen against the dollar, implying that exporters exporting to the countries out side US and where the transaction is done in Euros or Pounds or other currencies, they are in a better position and a significant portion of our exports is done in non US dollar currencies.

Can the controlling of capital account be a solution?

An option can be controlling the inflows of foreign funds, by putting more regulations on raising the foreign money by Indian companies. Now this would mean the reversing of the liberalization and would not send good signals to business community at home and overseas, therefore it can not be done at a big level. A small measure was taken in this direction by reinterpreting the pre IPO capital inflows in real estate sector resulting in disqualifying them as FII investment.

Or can we liberalize the remaining controls on Outflows?

Well, this measure is aimed at countering the excess inflows by increasing outflows to strike a balance in the net inflows. The Reserve Bank of India has done this by increasing the limits of overseas investments by individuals, companies and mutual funds. Presently the overseas investment limits for an individual is $1,00,000, for a company is upto 300 percent of its net worth and for a mutual fund is upto $4 Bn.

Thus, more or less almost all the measures have been adopted by the Apex bank to keep the inflation numbers under the level of 5 and simultaneously to keep the exchange rate under control but the things have changed drastically and the economy has become more market driven and less controlled, perhaps the end result of globalization.

Tomorrow the inflation numbers will be out and once again the RBI will have to take a call, whether to further hike CRR or not, whether to issue bonds or not. Not only inflation, there are several other factors also which may contribute to the decision making. Some big public offerings by DLF and ICICI Bank are slated to come in the coming month, which would bring in a lot of foreign money and there would be about Rs. 10,000 crore coming into the system which the RBI might like to withdraw through another CRR hike.