India's Currency Conundrum

An undervalued rupee puts pressure on the monetary system, while a rising currency hurts exporters. Is there a middle ground? Ask China

The year 2007 has been characterized by appreciating currencies across the Asia-Pacific region. Between January and November, the currencies of all the major economies in the region appreciated by varying degrees against that of the U.S., the largest trading partner outside the region for many of the countries affected. Four of the currencies—the Australian dollar, the Philippine peso, the Indian rupee, and the Thai baht—appreciated by more than 10%. The only exception to the pattern was the Indonesian rupiah, which depreciated by about 2% during this period.

Let me focus on the debate that this development has provoked in India, since it captures the dilemma faced by the region as a whole. The appreciation is the inevitable consequence of supply and demand. The high rate of growth in a stable macroeconomic context makes India an enormously attractive investment destination. Funds have been pouring in—as portfolio investment into listed equity, as private equity investments into promising companies in sunrise sectors, as direct investment, and as loans to Indian companies, many of which have stopped borrowing from domestic sources as a result.

As strong as the fundamental drivers of these capital inflows are, they are clearly reinforced by an exchange-rate policy, which, as in most of Asia, kept the currency undervalued. The elimination of depreciation risk made investments in the region even more attractive than they already were.

Harder to Mop Up Excess Liquidity

The motivations for this were, of course, to keep India's goods and services competitive in both export and domestic markets. This tended to narrow the current-account deficit, which had been overwhelmed by capital inflows. Growing balance-of-payments surpluses were simply absorbed by the central bank and added to a mounting stock of foreign-exchange reserves. These in turn caused the money supply to grow.

However, the central bank's ability to sell bonds to the public in order to mop up some of that additional liquidity became more and more difficult. So India, like some other countries in the region, created a special category of market stabilization bonds on which the government paid interest, but proceeds from which it could not use for any other purpose. The government budget thus assumed the costs of exchange-rate management. Regulators also raised cash reserve ratios for the banking system, in effect taxing the banks in order to rein in domestic liquidity.

But this can only continue for so long, particularly when there are inflationary pressures, as was the case in India early this year. That's why the Reserve Bank of India sharply reduced its absorption of foreign exchange in March, which is when the appreciation began. This position continued for about four months, during which time the rupee experienced much of its 2007 appreciation. Since July, when the central bank resumed intervention, the rupee has appreciated at a far more moderate rate.

Debating An Exchange-Rate Peg

This sharp appreciation clearly had an impact on the viability of exports. While exports in dollar terms did not show significant signs of flagging, they certainly did when converted into rupees. Operating margins of exporters took a beating, and there was a concerted effort on the part of exporters' associations to stem the appreciation. The government expanded its subsidies to exporters, but this clearly was not enough to offset the impact.

This is where the issue stands. There is a strong body of opinion in favor of a competitiveness-driven exchange-rate peg. Exporters cite their experience during the recent episode of sharp appreciation to bolster their argument that a stronger rupee hurts growth by weakening the viability of some of the country's most employment-intensive sectors. There is an opposing view, however, which sees the exchange-rate peg as a red flag for foreign investment, particularly short-term investment. This view advocates floating the rupee and letting it find its market value.

Persisting with a peg, even at the new rate, is in my opinion untenable because the same situation will arise sooner or later. As long as the currency is undervalued, the balance-of-payments surplus will keep widening, increasing the pressure on the monetary system and government finances. On the other hand, as we saw between March and July, a free rise, with its attendant uncertainties with respect to both the eventual level and the volatility along the way, can be disruptive to producers, who are not yet equipped to deal with it. With both extremes not looking very palatable, is there a middle ground?

Looking to China as an Example

Yes, in the form of managed appreciation along the lines of what China is doing. China decided in 2005 that a 3% annual appreciation in the Chinese yuan would address its chronic balance-of-payments surplus situation without disrupting export activity. The government clearly believed that exporters would be able to offset this moderate appreciation with productivity gains. India's experience is similar. Between 2002 and 2007, the rupee appreciated by about 10%; exports of both goods and services continued to grow at healthy rates during this period.

However, China's strategy is not necessarily replicable in its entirety. It is incomplete because it provides no time frame for a float, which is a critical requirement. India's time frame is provided by the prevailing road map for full convertibility of the rupee, which includes the development of reasonable opportunities to efficiently hedge against exchange-rate risks.

Furthermore, a transition period encourages short-term investors to rush in and take advantage of the guaranteed appreciation. This has very likely contributed to the recent boom in Chinese stock markets. The transition plan will, therefore, have to contain measures that neutralize this, without deterring long-term investment flows. The middle ground is not without challenges. Yet, in the circumstances in which India and many other Asian economies find themselves, it may provide the least costly and most enduring solution.

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