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Rising inflation, falling dollar cause concern

Harish Damodaran

NEW DELHI, April 17

RISING inflation levels along with a weakening dollar is leading to a strange situation where the rupee is steadily losing its purchasing power at home even while emerging as a strong currency internationally.

And this, in turn, is posing questions as to how long the RBI can persist with its present soft interest rate bias.

The annual inflation rate, based on the Wholesale Price Index (WPI), has climbed to 6.2 per cent as on March 28, compared to 1.6 per cent at this time last year.

Not all of this is due to higher petro-product prices or drought. True, the `fuel, power, light and lubricants' group index, which has a 14.23 per cent weight in the WPI, has registered a 10.8 per cent year-on-year jump. But that still accounts for less than a quarter of the observed inflation level.

As regards drought, the `food articles' index has gone up by only one per cent over the last year. The impact of drought, if any, has been confined to oilseeds and edible oils, with their prices hardening by 26-27 per cent. According to Mr Saumitra Chaudhuri, Economic Advisor, ICRA Ltd, a true picture of the underlying inflationary tendency in the economy — which discounts for `volatile' components such as war-induced fuel price hikes — is provided by the WPI for manufactured goods.

"Manufacturing inflation is ruling now at 4.8 per cent, against zero last year, which, juxtaposed with the 5.8 per cent growth in manufacturing output, indicates that the industry is close to using up its excess capacity. If this suggests an underlying inflationary trend, it is something that the RBI cannot ignore", he said.

In the past, RBI would have responded by raising its repos/bank rate or prescribing higher cash reserve ratios for banks. This is more so given the general proclivity among central banks to address `expected' rather than `current' inflation and the perception that interest rate hikes are blunt instruments in a runaway price increase scenario.

But there are at least three reasons to believe that RBI will respond differently this time round.

For one, an increase in corporates' borrowing costs may derail the industrial recovery underway now. Second, the prevailing low interest rate regime suits the Government's own borrowing programme, though it does not benefit households, who contribute 80 per cent of the country's financial savings.

With three-year bank deposit rates averaging around 6.5 per cent, the real returns to savers are already approaching zero.

Third, raising interest rate would go against the global trend, where the chief concern of the central banks is to fight recession rather than inflation. As it is, interest rates here are relatively high, amounting to 4.5 per cent on 180-day non-resident external rupee (NRER) deposits, as against the current six-month dollar-denominated Libor of 1.33 per cent and the US Federal funds rate of 1.25 per cent.

And if the rupee's appreciation is factored in - the dollar is today fetching Rs 47.36 compared to Rs 48.92 a year ago - the effective interest rate differential (in dollar terms) works out even higher, offering considerable arbitrage opportunities for foreign capital.

This expectation of a strengthening rupee vis--vis the dollar - contrary to its weakening purchasing power back home - has, in itself, been a major source of capital inflows into the country.

A rise in interest rates would only accentuate the cycle of higher dollar inflows, resulting in an appreciating rupee and, in turn, triggering further inflows.

Dr C.P. Chandrasekhar of the Jawaharlal Nehru University, however, believes that domestic interest rates can be delinked from international rates through imposition of controls on capital inflows.

"There is nothing radical about this proposal. Even Chile, an acclaimed reformer, till recently had a policy mandating 30 per cent of capital inflows to be parked in non-interest bearing deposits, so as to enhance the central bank's control over domestic monetary policy," he noted.

While not favouring explicit capital controls, he said, however, there was a strong case to rationalise NRI deposit rates to a range "not more than 100 basis points over the Libor or the Fed rate".

Exporters are `sandwiched'

IT is the exporting community that stands to lose most from the unusual combination of rising inflation and a stronger rupee vis--vis the dollar.

While the domestic wholesale price index has surged by 6.2 per cent over the last one year, the same period has seen the rupee gain about 3.3 per cent against the dollar.

The exporter is, thus, sandwiched between rising production costs and falling realisations on his dollar earnings.

An exporter, who ships goods worth $ 10 million, would earn Rs 48.9 crore at today's exchange rate, as against Rs 47.4 crore a year ago.

The difference of Rs 1.5 crore in sales realisation would have come alongside his incurring higher production costs, especially on fuel.

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