Appreciating Rupee : What It Means

It is, no doubt a great surprise that after sliding from 58.9 to a dollar in May 2014 to 68.7 in November 2016, the rupee has appreciated to a high of 63.93 last week—an appreciation of about 5.6% vis-à-vis dollar, all in just the last four months. And, not only is this the sharpest spell of appreciation of Rupee but it has also outperformed its peers from the emerging markets despite a spell of sea-changes—pound sterling suffering a worst hit of about 20% against dollar after Brexit polls, dollar index breaking the psychological level of 100 after Donald Trump’s victory—in the global markets.

Indeed, a few from the government are feeling elated by the strengthening rupee, for they believe it is due to ‘strong fundamentals’: good growth, low inflation, fiscal consolidation, and low current account deficits. There is of course, certain merit in this observation, but one cannot get carried away by it for there are also other factors that contributed to this sudden appreciation, such as: Foreign Portfolio Investors’ funds—during March they put $3.92 bn and in April 3 billion that cumulatively exceeds the 7.4 billion received during the whole of the calendar year, 2015—into Indian debt market that was triggered in the second week of March by the ruling party’s victories in the State elections, of course, duly supported by the passing of GST bill by the Parliament.

The inflows into the Indian equity market too are significant: an amount of $6.38 bn has been received as against $3.19 and $43.18 bn during 2015 and 2016 respectively. This has lifted Nifty above 9,000 and Sensex above 30,000, simply outpacing the global indices, besides of course, strengthening rupee further. And, all this has happened as Trump’s remark that dollar is extremely strong exerting pressure on dollar, and the RBI unusually remaining reluctant to intervene in the market. Now the big question is: Is this appreciation spree of rupee good or bad? Of course, there is no ‘the’ answer to this question, for analysts are divided in their understanding of this whole phenomenon.

Nevertheless, it is true that rupee is overvalued in nominal and more so in terms Real Effective Exchange Rate (REER) against the currencies of our major trading partners. The six-currency trade weighted REER reported to be over valued around 30% in March. Any further appreciation is sure to erode the competitiveness of rupee in the international market. And this is what of course, would have prompted RBI to intervene in the currency market on Wednesday April 26th to tame rupee as it is surging to the top of currency charts. As most of our exports are of non-differentiated, commodity-kind of goods such as apparels, which are bought in the global markets mostly based on competitive price, an appreciating rupee means buyers switching over to imports from countries such as Bangladesh and Vietnam. Coming to IT firms which are already hit by the toughest visa restrictions in the US, an appreciating rupee means further erosion in their profit margins. Cumulatively, it is estimated that an appreciating rupee means shaving 4% off the earnings of companies such as IT firms, car makers, pharmaceuticals and textile firms that are dependent on exports during FY18. On the other hand, when it comes to the rest of India Inc. which uses imports for domestic operations will stand to gain from a strong rupee.

There is however a positive side to the appreciating rupee: it affords savings on imports. For instance, during FY17 India imported merchandise worth $380 bn. At an exchange rate of 68 a dollar this involves an outgo of Rs. 25.8 lakh cr. As against this at today’s exchange rate of 64 a dollar, the outgo would come down to Rs. 24.3 lakh cr, which means a neat saving of Rs. 1.5 lakh cr for the year. One may however perceive a downside to this: wouldn’t a stronger rupee make Indians crave more for imported products? Perhaps, not, for most our current imports are confine to industrial commodities and capital goods whose domestic demand is more dependent on economic activity than the exchange rate. That aside, an appreciating rupee also helps the nation in keeping the inflation at lower levels.

Over and above all this, an appreciating rupee would ease the burden of debt servicing by the corporates who have heavily borrowed from the global financial markets. According to one report, Indian banks and financial institutions had an outstanding debt of $159 bn in foreign currency while corporates had another $150 bn dues. And in their anxiety to keep their cost of loans minimal, left their foreign currency loans un-hedged. An appreciating rupee is therefore a bonanza to such corporates.

Although India’s exports are showing signs of recovery since September last year, there remains a disturbing trend:  trade deficit is not narrowing down. Which means, if imports continue to grow while exports shrink due to appreciating rupee, the trade deficit can widen further. This is certainly a negative for rupee. Yet, if FIIs continue with their honeymoon with Indian debt and stock markets, it can set off a virtuous cycle where a strong rupee attracting more inflow of foreign currency and more inflows further propping up the rupee further encouraging fresh inflows and so on….

Should this happen, rupee gets overvalued in terms of REER. This is certainly no good for the nation. For, a strong currency hurts domestic growth. Theory indicates that appreciating currency subsidises imports and taxes exports while it is the exports which create employment. On the other hand, depreciating currency functions as a kind of tariff on imports of goods and services which to that extent hurts employment domestically. So, in the long run, a strong currency may prove no good for the development of the nation.