<b>T N Ninan:</b> Keep it down

The rupee has stabilised and gained ground marginally in recent weeks, like some other emerging market currencies. The trade deficit has shrunk, and along with it the current account deficit. International confidence in the Indian economy has grown - witness the flood of portfolio money coming in, and the "hope rally" on the stock market. The difference between last summer (when India was bracketed as one of the Fragile Five) and now is that the trade deficit has shrunk substantially. It is important to understand why.

Non-oil imports fell by a dramatic $40 billion (over two per cent of gross domestic product, or GDP) in the first 11 months of the last financial year - because gold imports have been artificially suppressed, because some commodity prices fell, and because demand in general was weak. Two of those factors could be transient. Note that the improvement in the trade deficit has had relatively little to do with export growth - about $13 billion in the 11 months to February.

There is a telling pattern to the export numbers. They fell every month till June. In July, a couple of months after the rupee began falling, export growth began. After the rupee hit a trough at 68.80 in August, export growth peaked, at 13.5 per cent in October. Then, as the rupee moved back up the charts to 62/63, export growth tapered off to about five per cent, before dipping in February - the first time since June that exports shrank. The link between exports and rupee value is too close to ignore, and the conclusion inescapable: a cheaper rupee helped exports, which have fallen off after the rupee gained in strength.

That is why the Reserve Bank of India's (RBI's) failure to prevent the rupee from appreciating (by buying up enough dollars) in recent weeks has been disconcerting. The RBI governor said the other day that the rupee would be too strong if it climbed to 55 against the dollar - the level that prevailed before the currency slide began a year ago. One wishes he had put the bar lower. More than one study argued last year that the correct exchange level would be about Rs 60 to the US dollar, a level endorsed by the finance minister - who, please remember, is not a fan of a cheap currency policy. The rupee today should be at least five per cent lower than that base number, to compensate for the higher inflation rate in India, and should not therefore be stronger than about Rs 63/dollar today. Instead, it has gained ground because of the rush of investment inflows. The implicit danger is that export growth will once again become difficult to achieve. Meanwhile, if there is a revival in domestic demand because the economy regains momentum, and/or because gold imports are freed again, overall imports would balloon, and the trade deficit with it.

Policymakers see some advantages in a strong currency. It makes imports cheaper and, therefore, helps control inflation. Since most petroleum products are subsidised, cheaper oil imports also help reduce the subsidy bill in the Budget. These are important considerations, but strictly secondary. The primary objective of currency policy, especially in emerging market economies that by definition are more prone to shocks, has to be achieving balance on the trade account so as to rule out an important source of macroeconomic instability and risk. The periods when India had balanced trade or a small surplus were when the rupee was weak. The rise in the current account deficit to the record level of four per cent of GDP a year ago was a direct consequence of the RBI allowing the rupee to move up the charts. No one should want that history repeated.