Watch the rupee

Weekend Ruminations

Any finance minister who has just celebrated double-digit economic growth after a 15-year gap, will also be wondering about the new year and how to make sure that the momentum is sustained on last year's high base.

Historically, the Indian economy has had successive years of rapid growth in only one phase, the mid-1990s. There is the opportunity now to repeat that accomplishment, because of the clear prospect of an investment revival "" not just in manufacturing, where the existing capacities are getting used up more than before, but also in the infrastructure sectors where policies and rules are at last becoming investor-friendly.

The international mood on India just now is so positive that it is also reasonable to expect good financial flows from overseas. So what could go wrong?

A strong rupee, that's what. India's currency has already climbed by an unprecedented 9 per cent in the last financial year, and seems set to climb further in the coming weeks.

The Reserve Bank has more or less stayed out of the market in recent days, unlike earlier, and that has been signal enough that the RBI does not think it wise to try and stop the rise of the rupee. This may be in part because it already has enough dollar reserves to take care of any contingencies, and therefore does not want to buy any more dollars.

There has also been the technical problem that the RBI doesn't have too many government securities left that it can sell and thereby mop up the rupees that get released as it buys up dollars.

That situation will change in the new financial year, for the government is about to issue market stabilisation bonds, which can be used by the RBI for its dollar-rupee operations.

But it is also true that the RBI's declared policy is not to try and influence the value of the rupee (whether going up or down) as much as to prevent harmful volatility. If the central bank stays true to that aim, then the assurance of heavy inflows should normally prevent it from betting against the market.

Why is all this important? Because, in trade terms, the rupee is now climbing faster than might be warranted. If the rupee continues to strengthen, one argument would be that the market will eventually correct itself "" for Indian producers get priced out of export markets and imports get cheaper, so the rupee will stop climbing once the trade balance shifts.

The counter-argument is that, if the export of software and business process outsourcing continue to grow at their current rate, then a rising rupee is guaranteed by the resultant dollar inflows and this would hit the competitiveness of the manufacturing sector just when it is coming into its own.

Another issue is India's interest rates. They are higher than in the developed economies, and if there is the general perception that the rupee will strengthen, in relative terms India's interest rates become even more attractive. This would attract even more foreign money than might otherwise be the case, and in a perverse result the rupee strengthens still further as a consequence.

If the finance minister is to take any position other than to simply assert that the market will eventually find its own balance, and that individual players must learn to adjust to a strengthening rupee, then he has to do two things.

One is to open up on the trade account as soon as possible after the elections, by slashing customs duties further so as to bring about a balance in flows. The second is to force down interest rates in the banking system, through the usual signalling process and by controlling the government's own borrowing programme.

This must be done not just to prevent hot money from flowing in but also to ensure that Indian business is able to get debt capital at reasonable cost at a time when new investments are being planned.

A third set of options would involve opening up further on capital account convertibility, so that Indians can go and invest more easily overseas, and therefore buy up some of the dollars that are coming in.

If none of this is done, and the rupee continues to climb, expect howls of protest from India's business community, and some denting of the feel-good factor.