Appreciating Indian Rupee Vs. Rising Inflation: Dichotomy for RBI
The problem facing Indian Economy in general and Reserve Bank of India in particular can be described by "Dutch Disease", a situation where there are large inflows of foreign exchange which in turn leads to
appreciation of the currency undermining the export industries.
And if we add the rising inflation which makes it imperative to let the currency appreciate to control inflation, it exacerbates the problem further.
Appreciation of Rupee
The Indian Rupee (denoted by INR) has appreciated 10% against major currencies of the world in less than three months and it's at an all time high in last 9 years. That was a serious cause of worry for RBI for the reason the "Herd Effect" such sudden appreciations bring along.
The graph below shows the movement of INR against US $.
Source: www.x-rates.com which tracks exchange rates on the basis of data provided by Federal Reserve Bank
First let's have a look at the dynamics of currency movement. Just like any other commodity, the currency of any economy is based on dynamics of supply and demand, and its value depends on trading in currency exchanges all over the world. Higher the demand for a currency on an exchange, the stronger it becomes and vice versa. However, for currencies like INR which are not traded on exchanges, the value depends on capital inflows in the country.
These capital inflows can be in the form of: -
Since the Indian Economy and the Indian Stock Markets have been on a roll, the capital inflows to India has been pretty strong which has primarily led to the appreciation of INR.
Implications of Rising Indian Rupee
First and foremost, the appreciating Rupee puts pressure on export competitiveness of any economy. The exporters earn their income in dollars which is spent in Rupees back home for further investment or consumption. If the Rupee appreciates (taking their dollar earnings to be same), the earnings in Rupee terms fall.
To explain it better. Say that exchange rate is US 1 $ = 50 INR. If an exporter X earns US $ 1000 by exporting his goods/services to US, his earnings in Rupee terms is Rs. 50,000. If the Rupee appreciates to US 1 $ = 40 INR, then in rupee terms the earnings of exporter will be Rs. 40,000. A fall in earnings despite the exports being constant. But the exporter who is based in India has to spend in INR in India; he has less money at his disposal constraining his further growth by way of limiting his investment capacity.
The IT and ITES have been primary contributor to exports, and for 1% appreciation in INR, their earnings fall by 0.75%. Then the factor of competition with China comes into play. For long, Chinese Remnibi has been kept artificially low thereby making their exports cheaper compared to India's. And hence, Chinese getting an edge in exports where both countries compete head-on.
However, the rising Rupee doesn't mean bad news on all fronts. Appreciating Rupee brings a good news on Imports front and corporate borrowings front. Since India imports close of 70% of its Petroleum requirements, appreciating Rupee makes the oil imports cheaper, thereby putting less pressure on India's forex reserves. Another aspect where rising rupee brings benefits is in sense that Indian corporates can raise the money from foreign markets on much cheaper terms and it also makes it cheaper for them to buy assets abroad.
Controlling Appreciation of Rupee
The RBI typically controls the appreciation by manipulating demand-supply dynamics of currency market. It purchases dollars (to create more demand for dollar) and sells rupees (to increase supply of INR, thereby decreasing its value).
And precisely, there comes the dichotomy. As RBI sells more rupees, the money supply increases which means too much money chasing same (or less) number of goods, thereby leading to inflation. So in effect one act of RBI creates another problem.
Rising Inflation
As mentioned above, the measures taken by RBI to control appreciating rupee contributes to rising inflation and same was assumed this time around when recently inflation crossed 5% mark. There was criticism of RBI for not controlling appreciating rupee but the primary reason for not doing so was to control the inflation, under direction from Finance Ministry. However, the point to note here is that this time around the inflation was not primarily because of money supply dynamics alone. Supply constraints on part of many commodities (like pulses) and rising crude price (which has a trickle-down effect on transportation sector and many other commodities alongside) also played a major part in rising inflation this time around.
Controlling Inflation
The factors which contribute to rising inflation can be controlled to keep inflation in check. The Demand Pull & Cost Push induced inflation can't be controlled by RBI but it uses other monetary tools to control inflation, which primarily include manipulation of money supply by various means.
RBI can suck the excess money from the system, and apart from issuing bonds in market (method called Sterilization), it can do that by regulating interest rates. Being a Banker to banks, it regulates interest rates by changing its Reserve Requirements, etc., which leads banks to change interest rates. An increase in interest rates controls inflation (actually control money supply which may control inflation) in two ways:
a) Rising interest rates provide an incentive for saving. So the money which otherwise had been available for consumption is deposited in banks leading to a decrease in money supply.
b) Rising interest rates makes it difficult to borrow from banks, thereby decreasing consumption, thereby decreasing the demand for money.
So the RBI has to design the monetary policy to balance the interests of each and every sector of economy and to achieve a balanced economic growth.
- by Vijay Singh Poonia
The problem facing Indian Economy in general and Reserve Bank of India in particular can be described by "Dutch Disease", a situation where there are large inflows of foreign exchange which in turn leads to
appreciation of the currency undermining the export industries.
And if we add the rising inflation which makes it imperative to let the currency appreciate to control inflation, it exacerbates the problem further.
Appreciation of Rupee
The Indian Rupee (denoted by INR) has appreciated 10% against major currencies of the world in less than three months and it's at an all time high in last 9 years. That was a serious cause of worry for RBI for the reason the "Herd Effect" such sudden appreciations bring along.
The graph below shows the movement of INR against US $.
Exhibit 1
Source: www.x-rates.com which tracks exchange rates on the basis of data provided by Federal Reserve Bank
First let's have a look at the dynamics of currency movement. Just like any other commodity, the currency of any economy is based on dynamics of supply and demand, and its value depends on trading in currency exchanges all over the world. Higher the demand for a currency on an exchange, the stronger it becomes and vice versa. However, for currencies like INR which are not traded on exchanges, the value depends on capital inflows in the country.
These capital inflows can be in the form of: -
- Foreign Direct Investment
- Portfolio Inflows (Foreign Investment in Equity)
- External Commercial Borrowings by Indian Companies Abroad
- Remittances to India by Non-Resident Indians
Since the Indian Economy and the Indian Stock Markets have been on a roll, the capital inflows to India has been pretty strong which has primarily led to the appreciation of INR.
Implications of Rising Indian Rupee
First and foremost, the appreciating Rupee puts pressure on export competitiveness of any economy. The exporters earn their income in dollars which is spent in Rupees back home for further investment or consumption. If the Rupee appreciates (taking their dollar earnings to be same), the earnings in Rupee terms fall.
To explain it better. Say that exchange rate is US 1 $ = 50 INR. If an exporter X earns US $ 1000 by exporting his goods/services to US, his earnings in Rupee terms is Rs. 50,000. If the Rupee appreciates to US 1 $ = 40 INR, then in rupee terms the earnings of exporter will be Rs. 40,000. A fall in earnings despite the exports being constant. But the exporter who is based in India has to spend in INR in India; he has less money at his disposal constraining his further growth by way of limiting his investment capacity.
The IT and ITES have been primary contributor to exports, and for 1% appreciation in INR, their earnings fall by 0.75%. Then the factor of competition with China comes into play. For long, Chinese Remnibi has been kept artificially low thereby making their exports cheaper compared to India's. And hence, Chinese getting an edge in exports where both countries compete head-on.
However, the rising Rupee doesn't mean bad news on all fronts. Appreciating Rupee brings a good news on Imports front and corporate borrowings front. Since India imports close of 70% of its Petroleum requirements, appreciating Rupee makes the oil imports cheaper, thereby putting less pressure on India's forex reserves. Another aspect where rising rupee brings benefits is in sense that Indian corporates can raise the money from foreign markets on much cheaper terms and it also makes it cheaper for them to buy assets abroad.
Controlling Appreciation of Rupee
The RBI typically controls the appreciation by manipulating demand-supply dynamics of currency market. It purchases dollars (to create more demand for dollar) and sells rupees (to increase supply of INR, thereby decreasing its value).
And precisely, there comes the dichotomy. As RBI sells more rupees, the money supply increases which means too much money chasing same (or less) number of goods, thereby leading to inflation. So in effect one act of RBI creates another problem.
Rising Inflation
As mentioned above, the measures taken by RBI to control appreciating rupee contributes to rising inflation and same was assumed this time around when recently inflation crossed 5% mark. There was criticism of RBI for not controlling appreciating rupee but the primary reason for not doing so was to control the inflation, under direction from Finance Ministry. However, the point to note here is that this time around the inflation was not primarily because of money supply dynamics alone. Supply constraints on part of many commodities (like pulses) and rising crude price (which has a trickle-down effect on transportation sector and many other commodities alongside) also played a major part in rising inflation this time around.
Controlling Inflation
The factors which contribute to rising inflation can be controlled to keep inflation in check. The Demand Pull & Cost Push induced inflation can't be controlled by RBI but it uses other monetary tools to control inflation, which primarily include manipulation of money supply by various means.
RBI can suck the excess money from the system, and apart from issuing bonds in market (method called Sterilization), it can do that by regulating interest rates. Being a Banker to banks, it regulates interest rates by changing its Reserve Requirements, etc., which leads banks to change interest rates. An increase in interest rates controls inflation (actually control money supply which may control inflation) in two ways:
a) Rising interest rates provide an incentive for saving. So the money which otherwise had been available for consumption is deposited in banks leading to a decrease in money supply.
b) Rising interest rates makes it difficult to borrow from banks, thereby decreasing consumption, thereby decreasing the demand for money.
So the RBI has to design the monetary policy to balance the interests of each and every sector of economy and to achieve a balanced economic growth.