<b>T N Ninan:</b> What's RBI smoking?

RBI is encouraging companies to borrow more overseas, which has added to the upward pressure on the rupee

A year ago, you could exchange a euro to get Rs 85; now you will get only about Rs 67. It’s a similar story with the British pound; a year ago it was worth Rs 101; now it is worth Rs 93. The rupee has also gained over the past year against the yen (which was worth 60 paise then, and now fetches only 52 paise). The only major currencies that have gained against the rupee over the past 12 months are the Chinese yuan (by about one per cent) and the US dollar (by slightly more than two per cent). Against these minor drops in rupee value, India’s currency has gained against the euro by about 20 per cent, against the pound by about eight per cent, and against the yen by about 13 per cent.

The stronger rupee is great news for those who want to travel to Australia to watch India’s semi-final match in the cricket world cup. You have to pay only Rs 48 to buy an Aussie dollar; a year ago it would have cost you Rs 55. In other words, the Australian dollar has dropped by about 13 per cent against the rupee. But what about travelers wanting to come to India? This country has become a more expensive destination for them — which puts a dampener on the tourism industry. Exporters have been put at disadvantage too, because the strength of the rupee has made India more expensive as a production base for exports, while imported competition has become cheaper. The country’s current account deficit (ie on trade in both goods and services) is still running at about $30 billion and more each year, despite cheaper oil. What is more, the export of goods is falling instead of rising.

The foreign exchange required to meet this deficit is met through imports of capital — as equity or borrowings. Indeed, Indian companies have been borrowing abroad more and more because international interest rates are much lower than in India, even after you pay the premium to insure against currency risk. Overall foreign currency debt has risen much more than the increase in foreign exchange reserves; so our external vulnerability has increased.

Figuring out these basics requires no great knowledge of economics or the currency market. What is a mystery though is what the Reserve Bank thinks it is doing in the midst of these trends. It has opened the window steadily wider for companies to borrow more overseas; the resulting inflow of dollars has added to the upward pressure on the rupee. Nor has RBI thought it fit to drop its interest rates in line with falling inflation. Consumer price inflation has dropped over the past year from 8.3 per cent to 5.4 per cent. Wholesale price inflation has dropped from five per cent a year ago to (-) two per cent — yes, we now have negative inflation. The drop in consumer price inflation is three percentage points, and in wholesale price inflation seven percentage points. Through this period, however, the Reserve Bank has dropped its main policy rate by just half of one percentage point.

So we have a currency policy that makes it difficult to close the trade gap. We have a commercial borrowing policy that encourages more foreign borrowings. And we have an interest rate policy that is way behind the curve, and therefore encourages companies to borrow abroad rather than borrow in India. At the same time, India’s banks say that they don’t get enough lending proposals!

Now, RBI has smart economists who know more about these things than most people. But sometimes you have to apply the simple tests. As Surjit Bhalla likes to say, if it looks like a duck, quacks like a duck and walks like a duck, then it is likely to be a duck. Similarly, if a policy looks, sounds and smells wrong, then you need to check your premise and give the thing a fresh look.