The rising value of the Indian rupee vis-à-vis the US dollar has received a lot of press. Should we be concerned about this? The answer is yes but there may not be too much that can be done about it without causing unacceptably high side effects.
In recent days the rupee-dollar exchange rate has been, on average, Rs 39.3 per dollar. A year ago it was 44.7. This means that the rupee has appreciated against the dollar by 13.7% in the last year. Put differently, for an Indian the average price of all American goods has fallen by 13.7% and, for Americans, goods from India have become more expensive. And this is the nub of the concern: Indian exports are likely to suffer because of this price rise. Moreover, this being an economy-wide phenomenon, there is little that individual producers can do to counter it. To the extent that anything can be done, this is in the hands of the Reserve Bank of India and, to a certain extent, the government. Contrary to the impression created by 'experts', there is no hard science of exchange rate management. One has to use a combination of economic theory, empirical evidence and intuition. A central bank chief has to be part scientist, part artist.
The standard method to counter currency appreciation is to buy up the currency against which it is appreciating. If RBI uses rupees to buy up dollars from the open market, this will boost the demand for dollars and supply of rupees, thereby stemming the rise in the value of the rupee. The catch with using this policy too extensively is that the extra rupees released on the market create inflationary pressure, imposing hardship on ordinary citizens. Government can, in turn, try to counter the inflation by selling securities and mopping up the excess currency-an operation that economists, in an effort to make it sound scientific, call 'sterilisation.' But it is not clear how effective sterilisation is, since people may not cut down the demand for goods just because they have changed a part of their portfolio from cash to bonds.
<b1>It needs to be understood that the source of the rupee appreciation is, largely, outside of India. Over the last year virtually all major currencies have been appreciating vis-à-vis the US dollar. The euro rose by 14.7%, the pound by 10.4%; the Canadian dollar by 23%, Sweden's kroner by 13.7% - the same as the Indian rupee. Vis-a-vis all major currencies, outside of the US dollar, the rupee has changed very little. The exception is China. Its currency has appreciated but only by 5.7%. China has a different strategy. It wants to keep up a sustained subsidy to its exporters and continue to build up dollar reserves. This is costly but it gives China muscle against the US. It can, for instance, threaten to bring down the dollar by selling its dollar reserves in case there is a showdown over Taiwan, thereby trying to ensure that there will not be such a showdown.
The Indian government and RBI's aim should be to curb short-term fluctuations in the exchange rate, since this upsets the plans of our industry and, especially, exporters. A gentle depreciation of the US dollar over the medium term seems to me to be unavoidable, given America’s over-spending. The big risk for India and the world is a sudden collapse of the dollar. This is unlikely, since a dollar meltdown is against the interest of all major players, but not impossible.
If China decides to move its reserves out of dollars to other currencies, this can cause a global stampede to sell dollars. Of course, China will lose out by this since so much of its wealth is held in dollars. But China’s loss will be even greater if it tries to get out of dollars after someone else causes the dollar to collapse. So this is one of those situations where a lot depends on hair-raising inter-country expectations. Fortunately, India is still a small enough global player not to have to shoulder this huge responsibility. At least, not for a few more years.
Kaushik Basu is Professor of Economics and Director, Center for Analytic Economics, Cornell University.