The Indian rupee has appreciated by a massive 18 per cent over the year March 2009 to March 2010, as measured by the RBI’s six-currency, trade-weighted, real effective exchange rate (REER) index. This is by far the biggest rupee appreciation in a year, ever since the unified, market-responsive exchange rate system was initiated in March 1993. Actually, it’s the largest 12-month appreciation of the rupee ever, no matter what the exchange rate system. Even if one omits the unusually low level of the REER index in March 2009 and takes April 2009 as the base instead, the appreciation since then to March 2010 has been a hefty 14 per cent. These numbers would be even higher if the REER index calculation used consumer prices (as for the other partner countries) instead of wholesale prices. The last comparable bout of rupee appreciation occurred between May 2006 and May 2007, when the REER appreciated by 11 per cent, including a steep 7 per cent surge between March 2007 and May 2007.
What’s going on and why? As I pointed out in my last column (“Rupee rises despite higher deficits!”, April 10), the current bout of massive appreciation comes at a time of widening current account deficits in the balance of payments and high inflation, which has been eroding the international competitiveness of our enterprises. Indeed, our recent high inflation (relative to trading partners) is a good part of the explanation for sharply elevated REERs. My anxiety over recent exchange rate trends deepened when a senior policy-maker asked me last week why there had been relatively little public complaint about the current, unprecedented bout of rupee appreciation from either industry (exporters and import-competers) or newspaper analysts? Especially when one compares to the widespread concern expressed during the rupee surge of spring 2007, a concern which led to corrective policy steps. Is everyone asleep at the wheel today?
I have thought about the policy-maker’s intriguing question and have come up with the following answers. First, and most importantly, both industry and analysts (and perhaps policy-makers) seem to suffer from “dollar fixation”, that is they focus almost exclusively on trends in the dollar-rupee parity. If you do that, then an average dollar rate of around Rs 45 in March 2010 does not seem particularly worrisome, especially when compared to the Rs 40 per dollar rate that prevailed over much of 2007-08 (see graphs). Indeed, the rupee was at 44 per dollar before the steep appreciation of spring 2007. So what’s the big deal about Rs 44-45 per dollar today? The simple answer is that if you are interested in competitiveness, as we should be, then looking at single-currency nominal parities is wholly inadequate. You have to take into account the behaviour of other relevant currencies and India’s inflation relative to major trading partners and competitors. That’s precisely what a REER index tries to do. The brute fact is that whereas a Rs 44 per dollar rate coexisted with a REER index of 107 in March 2007, today that dollar rate goes with an REER level of around 114, which is much too high to sustain healthy industrial development and a sustainable current account deficit.
Second, the present bout of rupee appreciation has been more slow and steady (though cumulatively greater) than in the previous episode. It has taken seven months for the REER to appreciate 11 per cent since September 2009; in 2007 it surged 7 per cent in just two months between March and May. In a way, the rupee appreciation problem has crept up on us when we were distracted by other pressing priorities like economic recovery and inflation.
A third possible reason for misplaced complacency about recent exchange rate trends is the fact of a strong, ongoing industrial recovery and a more modest but noticeable export recovery, from the steep downturns induced by the global crisis of 2008-09. Why worry about the exchange rate when industry and exports are bouncing back at double-digit annualised growth rates? We have to worry now (and take corrective policy action) if we want to sustain strong industrial growth in the future and beef up the somewhat anaemic recovery of exports recorded so far (exports are still running well below levels two years ago). It is worth remembering that a 10 per cent rupee appreciation is like a 10 per cent tax on exports and a 10 per cent subsidy for imports.
Fourth, the relatively muted reaction to the massive rupee appreciation may be because those being hurt the most, in the first round, are relatively weak-voiced. These are the small scale units in labour-intensive sectors such as garments, textiles, leather products, gems, metal-working and so forth, catering to both external and domestic markets. Indications are that they were hit hard by the global recession and now their recovery is being throttled by a steadily appreciating rupee. If the government (and RBI) are really serious about all their slogans about “inclusive growth” and supporting small scale units, their most potent policy step could be to reverse at least some of the real rupee appreciation that has already occurred.
Actually, the volume of concern and commentary about the recent rupee appreciation may not remain quite as muted as my interlocutor supposed. Not if you judge by the rising frequency of newspaper articles and editorials expressing concern about the subject. Industry associations may not be far behind. And once television channels get hold of it, well… Shashi Tharoor could tell you a thing or two about how quickly perceptions can change.
Finally, I am somewhat concerned about the apparent change of approach in RBI on exchange rate management in recent months. From March 1993 to March 2007, successive RBI governors subscribed to a policy of “managed float”, in which the central bank conducted forex market intervention not only to iron out short-term volatility but also to ensure a broadly competitive exchange rate policy. Then came a year of deliberate rupee appreciation, which probably contributed more to the initial industrial slowdown than the usual suspect of monetary policy. The year 2008-09 was the year of global crisis. Since June 2009 RBI appears to have deliberately adopted a much less interventionist stance, in line with a more “free market” doctrine. If true, this would be ironic, as it comes at a time when empirical research is increasingly supporting the more eclectic and interventionist approach to exchange rate management that stood India in good stead for 15 years. Actually, it would be more than ironic. It could constitute a serious policy error.
However, I am hopeful. Ten days ago, the government and RBI agreed to “replenish” the Market Stabilisation Scheme to the tune of Rs 50,000 crore, thus arming the central bank with significant capacity to sterilise forex purchases. Let’s wait and see.
The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views expressed are personal