Managing the rupee

Foreign institutional investors have been pouring money into the stock market, and the influx of dollars has in turn led to a sharp appreciation of the rupee.

The appreciation has been particularly sharp in recent days, with the rupee up more than 2 per cent in six trading sessions. One reason for the sharp rise has been the removal of the cap on FII investment in corporate debt, which has not only led to the rupee shooting up but also firmed up forward premia, as FIIs investing in debt hedged their exposures.

The impact of that announcement was reversed on Thursday, when the rupee corrected immediately after Sebi announced a $500 million cap on FII inflows into corporate debt.

Dollar inflows have led to currency appreciation in several other Asian countries, and the Korean, Taiwanese and Singapore currencies have all hit multi-year highs against the dollar.

The reason is simple: the US has been running up huge current account deficits, and Bush's re-election led market participants to believe that the policies that stoked that deficit, such as tax cuts and large fiscal deficits, would continue.

That put downward pressure on the dollar, a pressure that increased when US government officials adopted a policy of talking down the dollar as a means of correcting the current account deficit. These factors have pushed the dollar to all-time lows against the euro.

And although Asian central banks, including the Reserve Bank of India, have traditionally been staunch defenders of their currencies, the pressure has been telling on them as well.

That said, the fall in the rupee this year has been less than 3 per cent, much lower than the decline in the major currencies. The export lobby would argue, however, that the Chinese yuan is pegged to the dollar, as is the Malaysian ringgit, while the Indonesian and Filipino currencies have actually appreciated against the dollar this year.

The rupee therefore has lost competitiveness against these currencies this year, making a case for RBI intervention.

However, it also needs to be pointed out that the RBI did not intervene in a significant way in the dollar's recent fall, stepping in only when the decline seemed too steep.

One reason could be that rupee appreciation is an anti-inflationary tool, helping to cool oil and commodity price increases. That's apart from the fact that buying dollars will add to money supply, which the RBI cannot afford to do at this juncture.

On the export front also, Indian exports have become more value-added over the years, and a small appreciation is unlikely to make much of a difference.

The key to exports lies in higher demand in the importing countries, and global economic growth has so far been robust. Also, exporters can always hedge. Rupee appreciation would also be welcome because rising investment demand is expected to lead to higher capital goods imports.

At the same time, however, the RBI will need to ensure that the dollar decline is orderly and the markets do not, as is their tendency, overshoot.

The central bank has already raised the issue of large unhedged corporate exposures which could become dangerous if the market turns. And the best way to ensure that corporates act prudently and to prevent the market from overshooting is for the RBI to surprise the markets once in a while.