Back above 40

The rupee's rise above an exchange rate of 40 per US dollar has not been a surprise. After the interest rate cut announced by the US Federal Reserve on Tuesday, this was very much on the cards as the dollar was universally expected to weaken. The only question was whether the Reserve Bank would intervene to keep it from crossing the psychological barrier of Rs 40 (though one of the dictums once espoused by a former RBI governor is that the central bank should never defend the rupee at a round number). In the event, the market has been allowed to find its own level.

The rupee has risen with unusual rapidity over the past year, gaining as much as 13.5 per cent against the dollar "" more than almost all other currencies, barring exceptions like oil-rich Venezuela's bolivar. Other currencies with comparable gains include the Thai baht and Turkish lira. The rise of the rupee therefore reflects something more than the dollar's general weakness against all currencies (including a fall of 9 per cent against the euro); India's currency is being propelled upward more than the others.

On the evidence available, it would seem that, despite the high inflation levels in India when compared to the US, and despite the country's widening current account deficit because of high oil import costs, India is now seen as a safe currency bet because it will have a net inflow of foreign currency as overseas investors continue to plough their funds into Indian companies, many of which have a good story to tell. The dollar is of course seen as a weak currency because of the imbalances in the US economy. It is this that explains why the rupee is now at the same level as it was against the dollar nine years ago "" though prices have risen much more in India during the intervening period. Indeed, many analysts forecast that the dollar will touch Rs 35 before the end of the decade.

This will raise cries of anguish from exporters, many of whom have been caught unprepared for the rupee's rise and had not taken forward cover for their dollar earnings. Domestic producers who compete against imports will also face the heat. Indeed, export margins have got squeezed all round, and export growth (in rupee terms) is now down to 3 per cent. Inevitably, there will be renewed demands for ameliorative measures, and some might indeed come in time. There is also the likelihood that the Reserve Bank will step in to prevent the rupee from climbing further, but this brings with it the risk of monetary expansion and therefore inflation. In any case, with the betting being in favour of the rupee continuing to climb, there is a limit to which the central bank can intervene to keep the rupee down.

Indian exporters therefore have to learn to live with a stronger rupee and focus on productivity gains to compensate for the currency appreciation. Indian software leaders are well on their way to doing this. If sectors like textiles and leather do not follow suit, the government will be able to do little to protect them, because the economic reforms that are required to bring about system-wide productivity gains are beyond the capacity of what is now a hobbled government. However, cheaper imports should be included in the calculus of costs and benefits, and these will act as a counter-inflationary force "" except of course when the government gets into the wheat import business.