Currency Conundrum: Is the Strong Rupee Good or Bad for India?
Knowledge@Wharton
Published: July 26, 2007
History has been unkind to Canute. The 10th century king of England was so tired of his fawning courtiers that he took them to the shore and commanded the waves to roll back. It was to be a demonstration of the limitation of his powers. But Canute in popular perception is the man who tried to turn the tide and failed.
Today, India's finance minister P. Chidambaram and Y.V. Reddy, the governor of the Reserve Bank of India (RBI), India's central bank, face Canute's predicament. In the public mind, they seem to be trying to reverse an inexorable inflow of dollars and its consequence -- an appreciating currency. Once traded at 47 or 48, the rupee now hovers at 40 to the dollar. Observers call it the fastest appreciation of the Indian currency in three decades.
Is the rising rupee good or bad for India? What impact will it have on the global competitiveness of Indian firms? Should the RBI or the Finance ministry intervene? Responding to these questions and more, experts at Wharton and elsewhere say that the rupee's rise is the result of India's growing ability to attract global capital. While this creates problems for some companies that earn most of their revenues in dollars -- including IT giants such as Wipro, Infosys and TCS -- it also creates opportunities for Indian firms by making it less expensive for them to acquire overseas assets. In addition, a strong rupee is good for the Indian consumer. It would be unwise for the government to intervene to force down the rupee's value, they note.
What's Driving the Rise?
Dollars are pouring into India. Net investments by foreign institutional investors (FIIs) were $10.16 billion during January-June 2007. This is more than the $8 billion recorded in the whole of 2006. July has beaten all records with an inflow of $5.81 billion (so far). The FIIs are chasing Indian stocks and taking the markets to what many feel are levels of irrational exuberance. The bellwether Bombay Stock Exchange (BSE) Sensitive Index (Sensex) was 15,732 on July 23 against 12,455 on April 2. (Incidentally, that day's low -- the Sensex plunged 617 points during the day -- was caused by the RBI's attempts to control the rupee.)
The foreign direct investment (FDI) numbers are equally impressive. In 2006-07, FDI inflows touched $19.53 billion, a 153% increase over the previous year. (This figure includes private equity and also $3.5 billion in reinvested earnings.) The government is looking at a target of $30 billion in 2007-08. Foreign exchange reserves stood at $214.84 billion on July 6. This is a far cry from $5.8 billion in the dire days of March 1991, when India had to pledge its gold to stave off a default crisis.
External commercial borrowings of Corporate India were $12.1 billion in April-December 2006, an increase of 33%. Remittances from Indian workers abroad -- principally in the Gulf -- rose 15% to $19.6 billion in the same period. And non-resident Indian (NRI) deposits, attracted by better interest rates, were also up 35% in 2006-07 to touch $3.8 billion. These foreign exchange inflows have pushed the exchange rate to around Rs 40 to the dollar. The rupee has risen nearly 10% against the dollar this year. It has appreciated more than 14% from a low of 47.04 in July 2006.
Painful Squeeze
Wharton finance professor Jeremy Siegel notes (in his podcast) that a rising currency can cause distress. "This is painful. It's been the strongest appreciation of the rupee in over 30 years as I look back at some of the data," he says. CEOs of IT companies would agree with that assessment. Speaking at a press conference at Wipro's Bangalore headquarters on July 19, chairman Azim Premji complained about the "strong headwinds faced by us in the form of the appreciating rupee." Wipro reckons that its operating margins were lower by 2.4% in the first quarter because of the currency appreciation. Most IT companies -- the poster-boys of India's economic liberalization -- are in the same boat; they have been unable to meet their forecasted quarterly earnings. Their shares have been beaten down on the bourses, even as the markets are hitting new peaks.
Infosys chief mentor N.R. Narayana Murthy notes, "It (the rupee rise) is a macro-economic issue. I am not worried about factors which are out of my control." Others aren't taking it as easy. "A rising rupee can have a large impact on Indian exports and it could erode our competitiveness in the global market," IT firm Satyam founder and chairman B. Ramalinga Raju told The Economic Times recently. "Countries such as China are continuously suppressing the value of their currencies. So they may have an edge over us.... The government should intervene to bail out exporters who have been hit by the strengthening rupee." (The Indian government has announced a $3.5 billion package to provide relief to exporters in several sectors. But that has been deemed by many as insufficient.)
Jagmohan Singh Raju, a professor of marketing at Wharton, points out that smaller firms, including those "that rely on the U.S. market are clearly hurting. Companies such as Infosys and Wipro are feeling the impact, [but] smaller companies -- garment exporters and auto-part suppliers -- are hurting even more. Many of them banked on the dollar appreciating routinely after signing a contract. Now it is the other way around. I think these companies will be affected more than IT companies."
The Confederation of Indian Industry (CII) says that the worst hit are the textile and leather sectors. While individual exporters and companies have their woes, some complain of damage at a macro-level. A survey by the Federation of Indian Chambers of Commerce & Industry (FICCI) says sectors such as automobiles, consumer durables, food and food processing, gems and jewelry, textiles, handicrafts, and metal and metal products will be particularly impacted. "While the market should determine the exchange rate in the long run, sharp fluctuations in the short term create problems of adjustment for domestic industry," says FICCI president Y.K. Modi. The most affected, he says, is the small and medium enterprises (SME) sector.
Government's Role
When companies and industry organizations complain about such issues, the veiled -- and sometimes not-so-veiled -- argument is that the government should step in to provide support. Should it?
"My feeling is no, they should not intervene," says Siegel in his podcast. "My historical studies showed that a lot of the 1997 crisis was because currencies did not appreciate. That was during the era of fixed exchange rates in Thailand, Taiwan, Indonesia and the Philippines. And by not letting them appreciate, they actually attracted more capital. By letting it appreciate, people are a little bit more cautious because it looks a little more expensive now. And all of the capital that came in -- they couldn't deploy it favorably, and the result was over-consumption, deficits and then finally devaluation."
"I think it is best not to interfere," agrees Wharton's Raju. "Some correction should take place by the end of next year as U.S. expenditures outside decrease." Raju adds that in the short run, "A case can be made to support the very small exporters. But the right way is to allow the rupees to flow out. Let Indians invest in the U.S. -- not just companies, but also individuals. Some recent steps are in the right direction. More can be done."
Montek Singh Ahluwalia, deputy chairman of India's Planning Commission and one of the principal architects of the country's economic reforms, believes that the Reserve Bank and Finance ministry face a difficult set of choices. In an interview in his New Delhi office, he told India Knowledge@Wharton that, "This is a balancing act that the Reserve Bank and the Finance ministry have to play. It is a reflection mainly of the trilemma that economists face; you can only have two out of three things. If you want to have a stable currency, an independent monetary policy and capital account convertibility, you can't have all three. You have to give up one."
According to Ahluwalia, "The positive feeling about the Indian economy is bringing in a lot of capital. The only way you can absorb this capital is to let the exchange rate appreciate." He recognizes that "many people feel the appreciation has gone beyond what is reasonable. But this is a balancing act. What else can the Reserve Bank do? It can intervene to stabilize the nominal exchange rate, and that will generate some liquidity. It can stabilize the liquidity, but that will impact the exchange rate. Whatever it does, there will be some problem. What the Economic Advisory Council has said is that it can do these three things, and it should do a little bit of each."
In an effort to force down the rupee's value, under normal circumstances, the RBI would have bought dollars from the market. This releases rupees which the RBI then tries to mop up by issuing debt instruments. But the RBI has bought some 28.4 billion in dollars between January and May 2007 and it has to draw the line somewhere.
The sloshing liquidity leads to inflation, which is not politically palatable either. Indeed, the RBI sees controlling inflation as its prime mandate. As measured by the wholesale price index, inflation has come down to around 4.3% now, against 6.7% in January. But analysts warn that the trend may reverse soon.
The RBI has pulled out all the weapons in its armory. It has raised benchmark interest rates seven times since October 2005. It has sought to suck liquidity out of the system by increasing the cash reserve ratio (CRR), the amount banks have to keep with the central bank. Explains S.S. Tarapore, former deputy governor of the RBI and the man who has prepared two roadmaps for the full convertibility of the rupee: "While, until recently, the RBI has been intervening in the foreign exchange market buying dollars, the resultant release of domestic liquidity has required the authorities to issue bonds under the Market Stabilization Scheme (MSS), absorb liquidity under the Liquidity Adjustment Facility (LAF) through the reverse repo facility (surplus liquidity in the market is placed with the RBI at a rate of interest of 6%) and to increase the CRR. All this has costs. But these measures have increased interest rates in India and stimulated even larger capital flows."
Economists and India's money mangers are divided on the virtues of a strong rupee and what the RBI should be doing about it. "I have always argued that we should not intervene much on ups and downs of exchange rates. Let market forces determine that," Satish C. Jha, economist and member of the Prime Minister's economic advisory council, told The Economic Times recently. "We can't forget that the rupee has remained undervalued for quite some time. I feel it will get stronger and will hover around 38 in the next two years. We have seen a strong inflow of foreign capital into the market. How can we expect the rupee to depreciate?"
The rupee will stay strong, says analyst Jamal Mecklai. Speaking to exporters at a seminar on "How to deal with the new improved rupee," held in Mumbai recently, he said this was a period of churn. Big export houses, he added, had weathered the storm because of their professionalism. The small companies should similarly get their act together.
"It is obvious -- from the recent paroxysm in inflation followed by the trauma in the forex market -- that control processes have run their course and, appearances notwithstanding, the Indian economy is being run largely by the free flow of capital," wrote Mecklai in Business Standard. "The increasingly aggressive bleating we are hearing about the strength of the rupee is clearly coming from sources that don't recognize this."
How Should Companies Respond?
"Exports are about job creation, not dollar creation," says Ajit Ranade, chief economist of the Aditya Birla Group. "Unlike earlier, we are not starved of dollars." Ranade says you cannot compare the situation in India with that prevailing in, say, the U.S. The so-called free markets in India are not free and allowing market forces full play has atypical outcomes. "Look at our export-import basket," he says. "Our three principal imports are crude, gems and jewelry, and capital goods. Crude prices are still administered. And gems and jewelry and capital goods do not affect inflation. It would be different in the U.S. But, in the Indian context, a stronger rupee does not mean lower inflation.
"Now look at our exports. Leave IT and software aside for the moment. Some 65% of our exports come from the SME segment. There are 15 million workers in this sector. The SMEs have profit margins of barely 5-10%. If the rupee rises, as it has, their entire profit gets wiped out."
If inflation is unpalatable, the scale of job losses that could take place in the SME sector is even more so. "Total exports are about 20-21% of GDP," points out Ranade. "The entire agricultural sector is less than that."
Wharton professors have words of advice for companies that feel stretched by the rising rupee. Krishna Ramaswami, a professor of finance, points out that Indian companies may not be affected much "if their international competitors' currencies have also appreciated, though he admits that they "may lose some share of their sales in the U.S. market and have their margins squeezed if not." He recommends that these companies could "hedge their currency exposure if they do not already."
Raju of Wharton's marketing department agrees. His advice to Indian firms that are feeling pinched by the rupee: "Do not rely on the U.S. market too much. Get more business in Europe. The euro and the British pound are appreciating with regard to the Indian rupee." Raju believes that just as some companies are hurt by the strong rupee, others benefit from it. "Airlines benefit. It is now cheaper for Indians to travel to the U.S. This is also a great time for Indian companies to buy equipment and technology products from the U.S. Companies that buy components from the U.S. are in good shape. It is a lot cheaper for an Indian PC manufacturer to buy an Intel chip or a Motorola phone. Mobile phone operators benefit from the strong rupee."
Management professor Saikat Chaudhuri recommends that companies would do well to stop complaining and take advantage of the rupee's rise to drive through essential changes. "I don't understand the cribbing," he says. "As the Indian economy grows, the rupee will grow stronger. You can't get the benefits of globalization without feeling the other effects. My view is that there should be a renewed imperative for IT firms to go for high-end work across all industries." Chaudhuri adds that the stronger rupee should make it easier for IT firms to set up operations abroad. "That would be a good trend. Also, resource utilization will have to become better."
As for manufacturers, one thing could make things easier for them, Chaudhuri points out. "Right now, costs are high because of weak infrastructure. As India's infrastructure improves, those costs will come down. As freight corridors are built and airports are finished, that will help the manufacturers absorb the downside of the appreciating rupee." He also believes that the strong rupee could help companies drive through some strategic deals. "The strong rupee is good for Indian companies seeking to make acquisitions abroad. When your deals are worth billions, it makes a difference. We all like it when our money is worth more."
According to Siegel, "It is painful for the exporters, but look at the other side of the coin -- the consumers. A strong currency is good for a country; it's not bad for a country. They shouldn't just be beholden to the exporters. They should listen to the consumers, who are going to gain undoubtedly because of the strong currency."
