Time to free the rupee

For one, it will plug hot money inflows and attendant problems

Arjun Parthasarathy

MUMBAI: An artificially held-down rupee is giving a free run to dollar bears across the world, who are pouring speculative money into India. A better approach, therefore, would be to let the rupee find its true value and make investors work for their returns.

The week ended February 9, 2007, saw a $5 billion accretion to foreign exchange reserves, taking the total foreign exchange reserves of the country to $185 billion. The impact of the foreign inflows on domestic liquidity is over Rs 20,000 crore, given that part of rise in reserves is due to revaluation gains.

And the impact on the rupee? Zero. Zed. Zilch. It was rock steady against the dollar at around Rs 44.10 levels. Because the Reserve Bank of India (RBI) keeps buying greenbacks to keep the rupee thus. But the liquidity impact of the central bank’s currency intervention is being felt in the form of large surpluses in the banking system.

Initially, in the early part of the current decade, excess liquidity went into government securities and credit spreads. Interest rates and credit spreads fell sharply as banks bought heavily into fixed-income securities.

The economy was yet to pick up strength and demand for credit was low. However, with increasing foreign exchange flows coupled with government spending, the economy started gathering pace and banks were seen lending heavily to the retail segment which borrowed to buy property, cars and other consumer durables.

This fuelled the start of the economic recovery, and an 8% plus GDP growth over the last few years. It also led to the rise in the stock markets and the property boom. Foreign investors flocked in droves, leading to more capital inflows, adding to the liquidity. A self-fulfilling cycle was thus on, leading to both positive and negative consequences.

The positive ones were increased wealth, higher investments and more jobs, while the negatives were a pick-up in inflation and widening rich-poor divide. Through all this, the rupee was held back by the RBI - by soaking up the dollar flows. In the current context, with inflation as measured by the wholesale price index at 6.73% as on February 4, 2007, and becoming increasingly a political issue with state elections in the offing, the central bank and the government are in firefighting mode.

The RBI has raised the cash reserve ratio of banks by 100bps over the last two months to reduce lendable resources and has also increased the overnight lending rate — or the repo rate — by 50bps over the last two monetary policy reviews.

It has also refrained from hiking the benchmark signalling rate, the reverse repo, worrying about the liquidity impact of interest rate arbitrage.

The government, on its part, has cut fuel prices and curbed price rises in essential commodities. Through all this, the rupee was held back by the RBI - by soaking up the dollar flows. The point here is, if the RBI stops protecting the rupee, many of the negatives mentioned above would lessen in effect.

On the liquidity front, the strong flow of foreign money into Indian assets would ease as the true value of the rupee would deter currency speculators.

As there is no free float of the rupee, currency speculators are using the stock markets, property markets, foreign exchange deposit accounts and other means to go long on the rupee.

Many of these flows would stop, leading to a soft landing of the economy. A stronger rupee would make goods cheaper, bringing down inflation. The RBI and the government can breathe more easily with a strong currency.

Yes, the ramification of this would be felt in exports. Exporters may face falling margins and lose some of their competitiveness to countries such as China. But China, too, has restrained the yuan from gaining its true value.

However, India is not highly dependent on exports as is China - our exports contribute to under 10% of GDP. There will be protests from the exporter lobby, especially technology firms whose margins will be hurt. Tech firms enjoy margins of over 20% compared with domestic-oriented companies’ margins of around 10 to 15%, so it should not be a big worry.

In the longer run, the technology firms will become more competitive without the support of an artificially low currency.

Following the Chinese model of artificially holding the currency and giving large sops to exporters is not a good idea, as again in the longer run, it will only lead to inefficiencies and unproductive use of resources.