The Hindu Business Line : Chinks in Dr Reddy's armour?

Containing the appreciation of the rupee is of the highest priority, lest the crisis of the late 1980s visits us again. But rather than resort to desperate remedies, our forex abundance must be used to speed up technological investments and strengthen infrastructure. One trusts Dr Reddy will unravel the knotty problem, devising a policy that will spare us the unpleasant consequences of our own affluence.

DR Y. Venugopala Reddy's maiden Credit Policy has, as expected, won many plaudits and a few brickbats. In the after-light of events, chinks — if any — in Dr Reddy's armour are coming in for exploration and attack. Those who try to change the landscape of economies they preside over cannot escape this kind of criticism.

Predictably, the criticism has been most vocal about the appreciation of the rupee. Exporters are already facing competition, especially from Chinese manufacturers, who have had their currency pegged at 8.4 remninbi to the dollar.

While the appreciation of the rupee has not been too sharp, ranging as it has from 5 per cent to 10 per cent, the margins of exporters are wafer-thin. Exporters' organisations are severely complaining about the burdens of the strong rupee.

The Union Minister for Industry and Commerce, Mr Arun Jaitley, is knocking at the doors of the Finance Ministry for help in reducing the appreciation of the rupee. True, so long as the flood of dollars continues to come in, the rupee will tend to appreciate.

The exporters are asking for other means of support, such as restoration of the income-tax concessions under 80-HHC, which had virtually exempted export profits from income-tax. They are also asking for freight subsidies. Not the least important of their requests is easier access to cheaper export credit.

They argue that the RBI should encourage banks to lend to exporters from out of its abundant reserves at rates near Libor so that the interest costs of exporters are brought down.

The problem of appreciation of the rupee is, no doubt, an unintended consequence of our good fortune in respect of growth of "exports" of services as also goods. But the consequence of abundance of forex as a result of this, as well as capital inflows, forces the country into a paradoxical situation. The rupee inevitably appreciates.

The RBI does its best to contain the appreciation by mopping up the excess of dollars, thus making the dollar costlier than it would otherwise be. In so doing, it adds to the reserves, which carry their own cost in the shape of low returns earned on their investment abroad.

The inevitable consequences of forex abundance are complex, although the RBI has managed so far to contain the appreciation by its intervention. Never mind the excess costs of keeping high reserves, which are anyway a needed bulwark against possible speculative attacks.

It is a fact that there is an inherent difficulty in managing monetary policy and exchange rate policy successfully at the same time. As forex reserves swell with the banks and are exchanged for rupees, the central bank has to mitigate the unpleasant monetary consequences by sterilising the rupees by substituting them with Government bonds. This is known as sterilisation.

But sterilisation has its own price — the excess supply of bonds leads to their price getting lower, which leads to a rise in interest rates, which in turn attracts fresh forex inflow.

This is a game in which there are no winners. But it is a fact that the RBI has become expert in "handling" the monetary consequences of forex inflows. It has, however, to have an adequate stock of gilts of Government for sterilisation. Not a problem — given the fiscal Government's profligacy. The central bank may contend that in terms of "real" exchange rates — exchange rates after adjusting for inflation differentials — the problem of appreciation is not as serious as is shown by nominal exchange rates. Especially is this true when the real effective exchange rate is calculated based on weights attributable to the proportion of trade.

What is, however, important in trade transactions — both in goods and services — is not the so-called "real" effective exchange rate, but the "nominal" rate as perceived by the counter-parties. This is definitely an important argument in favour of containing the appreciation.

The Chinese have managed to mitigate this problem by pegging the remninbi to the dollar at a specified rate and maintaining the rate by central bank intervention. Whether this method or a modified form of pegging to a basket of currencies is preferable to the present trend of rupee floating higher and higher is not easily answered. We have to weigh the pros and cons of various options.

One result of rupee appreciation is that the imports become cheaper in terms of Indian currency. This increases the attractiveness for people in India for foreign goods. The double jeopardy — the decline in exports and increase in imports — does affect the balance of payments.

India's current account has been trembling on the brink of a reversal. While it is true that exports over the last half year have gone up 10 per cent, the growth is low compared to 18 per cent in the corresponding period last year. It is also significant that most of the growth took place in the first quarter of the year before the rupee appreciation became sharper.

It is often contended that the rupee has really depreciated against the euro. Most of our trade, however, is denominated in dollars and the appreciation of the rupee against the US dollar does hit our export prices. Particularly, it is critical for the continuing growth of our software exports, which are sensitive to the rupee-dollar relationship.

If the growth of our software and other service exports is to be maintained, it is important that the rupee appreciation is halted and reversed, if possible.

It is instructive to see the latest data available for Balance of Payments, which covers the period April to June 2003. The figures (see Table) show that there is an adverse trend exhibiting itself in the BoP statistics.

The worsening in merchandise balance as well as current account is to be noted. Media reports also highlight that the appreciation of the rupee together with the international developments has led to an increasing rush to import gold.

Available information discloses that gold and silver imports went up 99.9 per cent in the first quarter of 2003-04 rebounding from a dip of 40 per cent in the corresponding previous period. The growth in capital goods import has registered an increase of only 33 per cent compared to 30 per cent in the corresponding period last year.

The challenge before the Governor is complex. How he will convert the inevitable impact of the rush of dollars on the price of the rupee is a billion-dollar mystery. The RBI can very well turn around and say that, short of liberalising the capital account and/or running a big import bill, there is no way to reverse the appreciation of the dollar.

So far as restricting arbitrage-driven portfolio and other capital inflows are concerned, the central bank has already done its bit by capping the interest on FCNR deposits. Can we place a hurdle in the path of purely speculative inflows of portfolio capital as well as block access of Indian entities to external commercial borrowing?

The issues are complex and Governor Reddy may need a high-level Committee to help unravel the various options. Perhaps, the Governor will come out with a solution, which will attain the desirable objective of nurturing India's export growth, while not disrupting the viability of a free market environment in respect of exchange flows.

Containing the appreciation of the rupee deserves the highest level attention and priority, lest the crisis of the late 1980s is again visited on us.

The Chileans had, sometime back, experimented with placing certain obstacles to volatile forex flows by imposing taxes and penalties on such flows. Whether we should do the same is not clear, considering that it is only recently that we have become an attractive destination for foreign portfolio investors. Nor is it advisable to do anything to deter FDI flows.

Some experts have even advised that a lower tariff on imports will increase the import bill and lead to a reversal of rupee appreciation. Such desperate remedies are worse than the disease.

A more appropriate policy seems to be to use the forex abundance to speed up our technological investments as also strengthen our infrastructure. This is an option which deserves to be pursued in the context of our Tenth Plan objectives. But it cannot co-exist with our approach of going with the begging bowl to international aid agencies for assistance for such projects.

Reform must begin with abnegation of resort to loans from IBRD and ADB. Are we prepared for such options? The answers do not, again, rest only with Dr Reddy, but with the mandarins at North Block.

The policy options do concern the Finance Ministry, the tariff policies, as also the remit of SEBI in respect of foreign institutional investors, as well as the overall stance in regard to trade restrictions and barriers.

I do hope the RBI Governor will approach the problem with his characteristic earnestness and a holistic strategy and evolve a policy that will spare us the unpleasant consequences of our own affluence.

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