The rupee's rapid rise .

In economic theory, the balance of payments must, by definition, always be in balance because a deficit on the current account — imports minus exports — is automatically made up by an equivalent surplus on the capital account. But this accounting tautology tells us nothing about the management of the exchange rate which, economic theory assumes, is left to adjust on its own. Given this and two other facts — that India has a record deficit on the current account and an unprecedented level of capital inflow — how should the exchange rate be managed, if at all? The Reserve Bank of India (RBI) appears to have decided to let the rupee-dollar rate to bear the brunt by allowing the rupee to appreciate. In the last year or so, with overseas capital gushing in, the rupee has appreciated by almost 12 per cent. In April 2009, it was at about Rs 50 to the dollar. Today it is at Rs 44. The real effective exchange rate is also higher by a similar amount. India must thus be the only country that allows its currency to appreciate when it is faced with a current account deficit. The usual response of countries whose export receipts fall alarmingly short of the import bill is to try and export more. Since productivity gains and increased competitiveness accrue only over time, the quick-fix solution is to depreciate the currency so that exports become cheaper. This is what India used to do. But it has stopped now.

All changes in price — and the exchange rate is just a price — involve gainers and losers. When the rupee appreciates, the exporters lose and the importers gain because the former earn less and the latter pay out less. Traditionally, India has sought to compensate exporters not just via the exchange rate but also by giving them subsidies. These subsidies, direct or indirect taken together, as also in terms of revenue foregone, amount to almost 2 per cent of GDP. So it can be argued that, to the extent that 30-35 per cent of exporters' costs are met by the taxpayer, it is only their profit margins that shrink. An appreciating rupee can spur them on to improve their productivity to retain their profit margins. Lastly, it must also be pointed out that cheaper imports because of the appreciating rupee could also end up hurting domestic producers as imports from China displace them. Since China refuses to appreciate its currency by anything like what it needs to, is RBI policy ending up helping China?

So the RBI needs to explain why there has been a change in policy and that there is a convincing explanation grounded in sound economics and/or geo-political or fiscal considerations for the reversal of established practice.

Source : Business Line