Indian Economy: Growth -3

Naresh · 06-28-2007, 01:54 AM

[center]India's strong rupee[/center]

An enviable problem to have

The Indian rupee has appreciated by nearly 10% since late 2006, posing an acute dilemma for Indian policymakers. In some ways, the present strength of the currency, which is now hovering just above the symbolic Rs40:US$1 mark, is an enviable problem. It suggests that the country's attractiveness to foreign investors is increasing and signals optimism about the Indian economy more generally. However, the concerns of exporters, who are part of India's economic resurgence, are rising as their goods become more and more expensive for overseas buyers.

The recent strengthening of the rupee is a dramatic departure from past trends. The currency depreciated steadily for a decade after being floated in 1993, dropping from an average annual rate of Rs31.37:US$1 in the 1993/94 fiscal year (April-March) to Rs48.40:US$1 in 2002/03 (an average annual depreciation of nearly 5%). Between 2003/04 and 2005/06, however, the rupee appreciated against the dollar by 3% on average a yearâalthough there was considerable two-way movement of the rupee from month to month. The trend of steady month-on-month appreciation began in September 2006 and has been continuous since then. The average rupee-US dollar rate in May 2007 was the lowest since 1999/2000.

Although the rupee-US dollar exchange rate has the greatest impact on the Indian economy and business sector, the rupee has also appreciated against other currencies. In January-May 2007, the rupee's value in terms of pounds, euros and yen rose by 8%, 6.9% and 11.2%, respectively. During 2005/06, 86% of Indian exports and 89% of imports were invoiced in US dollars, according to the Reserve Bank of India (RBI, the central bank). The euro was a distant second, with shares of 8% in exports and 7% in imports.

Explaining the rupee's appreciation

The main reason for the rupee's appreciation since late 2006 has been a flood of foreign-exchange inflows, especially US dollars. The surge of capital and other inflows into India has taken a variety of forms, ranging from foreign direct investment (FDI) to remittances sent home by Indian expatriates. In each case, the flow seems unlikely to slacken. The main impact of these various types of flows is as follows:

* FDI. India's stellar economic growth has created a large domestic market that offers promising opportunities for foreign companies. Moreover, the country's rising competitiveness in many sectors has made it an attractive export base. These factors have boosted FDI; in 2006/07 FDI amounted to around US$16bn, almost three times the previous year's figure. More than half of these inflows arrived in the final four months of the fiscal year (December 2006-March 2007).

* External commercial borrowings (ECBs). Indian companies have borrowed enormous amounts of money overseas to finance investments and acquisitions at home and abroad. This borrowed money has returned to India, boosting capital inflows. India's balance-of-payments data (available to December 2006) reveal that inflows through external commercial borrowings (ECBs) amounted to an enormous US$12.1bn during April-December 2006, a year-on-year jump of 33%. The flood of borrowed money is likely to grow in 2007. In the first three months of the year, Indian companies notified the RBI of plans to raise nearly US$10bn in overseas debt.

* Foreign portfolio inflows. India's booming stockmarket embodies the confidence of investors in the country's corporate sector. Foreign portfolio inflows have played a key role in fuelling this boom. Between 2003/04 and 2006/07, the net annual inflow of funds by foreign institutional investors (FIIs) averaged US$8.1bn. Trends during the first five months of 2007 indicate that this flood is continuing, with net FII inflows amounting to US$4.6bn. Another major source of portfolio capital inflows has been overseas equity issues of Indian companies via global depositary receipts (GDRs) and American depositary receipts (ADRs). Inflows from GDRs and ADRs amounted to US$3.8bn in 2006/07, a year-on-year increase of 48%.

* Investments and remittances. Indians settled in other countries have also been a major source of capital inflows, with many non-resident Indians (NRIs) investing large amounts in special bank accounts. While NRIs' emotional connection to their country of origin is part of the explanation for this, the attractive interest rates offered on such deposits also provide a powerful incentive. In 2006/07 NRI deposits amounted to US$3.8bn, a 35% increase over the previous year; the outstanding value of NRI deposits as of end-March 2007 was US$39.5bn. Another large source of foreign-exchange inflows has been remittances from the huge number of Indians working overseas temporarily. Such remittances amounted to a colossal US$19.6bn in April-December 2006, a 15% year-on-year increase.

Export risks

Buoyant export growth has also built up India's foreign-exchange holdings. IT and business-process outsourcing (BPO) exports have expanded at an especially robust pace, with exports of software services reaching US$21.8bn in April-December 2006 (a year-on-year increase of 31%). However, the rupee's appreciation is alarming exporters, as it makes their products more expensive in overseas markets and erodes their international competitiveness.

The RBI's deputy governor, Rakesh Mohan, recently referred to the effects of the rupee's appreciation as a case of "Dutch disease". The term refers to episodes where large inflows of foreign exchangeâusually as a result of the discovery of natural resources or massive foreign investmentâleads to appreciation of the currency, undermining a country's traditional export industries. ("Dutch disease" originally referred to the adverse impact of the discovery of natural-gas deposits in the Netherlands on that country's manufacturing exports.)

There is already evidence in India of an export downturn in a number of sub-sectors. In the apparel sectorâone of India's major export industries--the strong currency has eaten into the value of exports to the US, which declined by 3.5% year on year in January-April 2007. During the same period, apparel exports to the US by China, India's most important competitor, rose by 57%. Moreover, for India the decline marks the reversal of a positive trendâapparel exports to the US rose at an average rate of 21% a year after import quotas were phased out at the beginning of 2005.

Policy dilemma

Indian policymakers face a difficult dilemma. On the one hand, the rupee's appreciation has benefited the economy by making imports cheaper. This is no small benefit--containing inflation has been high on the policy agenda during the past year, as the annual inflation rate (as measured by the point-to-point change in wholesale prices) rose to 6.1% in January 2007, compared with 4.2% a year ago. The inflation rate has subsequently moderated. This may offer the RBI some comfort in its battle against inflation, but the bank's new, stricter inflation target (4.5-5% in 2007/08, down from 5-5.5% in 2006/07) suggests that there will be one more increase in interest rates by the end of 2007.

On the other hand, for both economic and political reasons, policymakers cannot afford to ignore the problems of exporters. Although exports account for a relatively small share of the economy, India's rapid export growth in recent years has been an important catalyst of economic growth. Given the limited extent to which the RBI can intervene in the foreign-exchange market in the face of large and sustained capital inflows, policymakers can only stem rupee appreciation substantially by easing limits on domestic firms' overseas investments or restricting inflows--for instance, through further controls on ECBs. The RBI has already taken tentative steps in this direction, making it more difficult for Indian firms to borrow in foreign currency and eliminating the exemption from ECB limits previously enjoyed by real-estate firms.

In confronting this dilemma, government policymakers are undoubtedly hoping that there will be no need for a major intervention. However, the problem is unlikely to disappear soon. The Economist Intelligence Unit forecasts an average annual exchange rate of Rs41.3:US$1 in 2007 (a 13.5% real appreciation year on year) and Rs40:US$1 in 2008 (6%).

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