Thursday, January 24, 2008

Rupee appreciation: whats the alternative?

There's been a lot of noise in the Indian economy recently about the seemingly unstoppable appreciation of the rupee (INR). The IT Services sector has been particularly hard-hit, with every USD of revenue earned realising ever-smaller amounts of INR earnings. The fledgling manufacturing sector is hard-hit as well...as is the textile industry.

India is not as export-earnings dependent for the health of its economy as say, China...yet, exports do contribute significantly to our GDP. As a result, there have been vociferous calls by the industry as a whole, for the country's central bank (RBI) to intervene in the currency markets to stem this rise of the Rupee. To do this, the RBI has been buying $$$ by the drumfuls to offset the increased demand for its own currency.

The trade-off is that the Central Bank has been printing extra currency to buy the foreign currency. This has introduced extra Money supply into the economy, fueling inflation. Inflation is then typically controlled by selling “sterilization bonds” to the government, thereby draining the economy of excess liquidity.

Now, this all works seemingly well theoretically but there are significant disadvantages to taking such intervention too far. For one, by buying these bonds, the government ends up investing its capital sub-optimally since it earns very poor returns. This capital could be more efficiently utilized by investing in the private sector, which has consistently shown higher returns than govt. bonds. Alternatively, the money could be invested in infrastructure, alleviating the ever-growing supply constraints of our economy.

Second, these $$$ purchased now need to be invested somewhere and this is typically done in US Treasury bills. Interest rates in the US have been lower than that in India for a long time now, resulting in lower returns on these investments.

Finally, higher interest rates in India and higher returns from Indian equity markets will continue to attract foreign capital inflow. This will continually push the rupee higher, leaving us in an infinite intervention loop! Where is the end?

Rather than fighting this appreciation full-on, we need to utilise these incoming funds to improve the supply-side of our economy. This means infrastructure, education, health services. In addition, access to extra capital must be provided to the private sector to leverage its ability to operate efficiently and squeeze out maximum returns.

An appreciating currency is simply a macroeconomic reality of a growing, open economy such as India's. Eventually, this cannot be fought away. Its upto us whether to pander to domestic fears and continually intervene OR to follow a more balanced approach by investing in the future.

3 Comments:

At 10:57 AM, February 02, 2008, Anonymous Anonymous said...

http://www.financialexpress.com/news/India-may-face-export-funds-flow-risks/266070/

 
At 1:30 PM, February 18, 2008, Anonymous Anonymous said...

Long time no writing?

 
At 1:34 AM, February 27, 2008, Anonymous Anonymous said...

The govt does not buy those bonds.. the market does thereby taking out market liquidity.

 

Post a Comment

<< Home