Monday, October 18, 2010

RBI purchase of Dollars to stop the strengthening rupee: Justified?

The rupee is appreciating or rather I should say, it is the dollar that is weakening (due to heavy quantitative easing i.e., dollar printing by the US Fed) against the major currencies of the world including Indian Rupee. Strengthening rupee is being closely watched by Indian government, particularly by the RBI officials, and the business people. All kinds of discussion is surfacing on the table. The focus of all these discussion is on, whether Indian government - through RBI's purchase of US dollar - should try to tame the rising rupee against the dollar? Actually, RBI has already started taming the rise in rupee by intervening in the currency market through their purchase of US dollars last Thursday. Is this RBI dollar purchase and rupee weakening policy justifiable from the sound economic perspective? To answer this crucial question we first need to understand the fundamentals of the currency market.

What determines the exchange rate of rupee against the other currencies?
The exchange rate i.e., the purchasing power of rupee vis-à-vis other currencies is determined by the demand for and supply of rupee in the international market. If the demand for rupee is high and supply stable (or falling) then rupee will appreciate in value against other currencies (assuming other currencies are stable in their value or their value is declining), and if the demand for rupee is falling or its supply is rising through RBI's printing of more rupee then it will weaken (depreciate) against other currencies (again assuming other currencies as stable). The demand for rupee in turn is determined by various factors, out of which the main factor is the strength of Indian economy. If Indian economy is very strong then foreigners will want to trade more with India (buy goods/services from India, as well as invest in Indian markets), which will increase the demand for rupee. Alternatively if Indian economy is weak then few people will want to trade with India, and few will want to invest in India which will result in low demand for rupee and its weak exchange rate against other world currencies.

Now, the above outlined fact should always be kept in mind while we analyze RBI's dollar buying and rupee weakening policy. If rupee is appreciating then it is a healthy sign because international community see India as a strong economy and thus are eager to spend and invest their resources in the Indian market. Of course this can also happen when foreign economies are becoming weaker, but it still proves the relative strength of the Indian economy during such dire times.

Why government don't want rupee to be strong against other currencies?
We need to understand that, why Indian government do not want rupee to appreciate? From an Indian consumer's perspective the policy of weakening Indian rupee makes no sense because as a customer Indians will benefit from the strong rupee, which will lower their import bills. The whole import sector will benefit from the strengthening rupee, and ultimately whole Indian economy will benefit as I will make clear in next few paragraphs.

A strong rupee is said to be the problem of the exporters. Export industry - mainly IT - is lobbying government for not allowing rupee to become stronger because that will, in short run, lower their earnings by making their exports costly in the international market. Is this demand of the export sector legitimate? We need to take a look at the import-export sector realities to fully comprehend the impact of government policy of deliberately weakening the rupee under the lobbying pressure of export industry.

Is this economic policy logically sound on economic grounds?
Henry Hazlitt's first lesson of economics says that, "the art of economics consists in looking not merely at the immediate but at the longer effect of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups."

So, let us see what is the impact of this policy of weakening rupee on all the sectors of the economy, and not only in short run but also for a longer run.

The export sector will surely be a beneficiary from a weak rupee, but the import sector will be a loser. What will happen to Indian economy? Will it be a net gainer or a net loser? Indian economy will be a net loser for sure because India imports more than what it exports. Since independence its current account is always in deficit because of higher imports than exports. For example, as per the latest data available from RBI, in 2008/9 India's total export was 8,40,755 crore rupees, and its total import was 13,74,436 crore rupees! A simple back of the envelop calculations show that, suppose in 2008/09 the Indian rupee would've appreciated to 44 rupees per 1 dollar (from 50:1 rupee dollar ratio of 2008/09) than India's export would've reduced to 7,39,864 crore rupees. But, on the other side the import bill would've also reduced to 12,09,503 crore rupees. At the original exchange ratio of 50:1 the trade deficit was 5,33,680 crore rupees, and now at a new strong rupee ratio of 44:1 the same deficit would be 4,69,638 crore rupees - A net gain of 64,042 crore rupees!!!

Indian economy will surely benefit from appreciating rupee. At the benefit of few exporters we cannot make the whole economy suffer by artificially making rupee weaker. And, as Japan's history tells, by appreciating currency the export sector might get hit in a very short time period, but over a longer time zone Japanese export industry became more competitive and their export actually increased because they cut down their cost and made their operations more efficient. Indian exporters also need to do the same. Instead of lobbying government for protection (through weakening rupee policy) they need to make their operations more efficient and should gear up for the international competition. The strong rupee is a sign of strong Indian economy, and exporters will also gain when Indian economy is strong. More investment will be forthcoming into these export industries which will help them becoming internationally more competitive by reducing their costs.

In any case, such artificial competitiveness can never make India's export grow over a long period of time. It will only hurt the economy overall. Exporters will never learn how to be competitive in the international market and so when other countries will compete heavily they will lose out because India cannot make its rupee very weaker. There is a limit to this policy. So, it is better that exporters become competitive and only then Indian economy can grow concretely.

RBI should start buying more GOLD instead of useless dollars
The way events are unfolding in USA, the dollar will continue its nose dive in the deep dark abyss. In such a scenario, one day the Indian government will have to reckon with the fact that it can no longer depreciate its currency against the ever weakening dollar. Once dollar is gone the world will move on to a new global reserve currency (or may be a world single currency in the form of Gold under a quasi or full gold standard!). And on that day India automatically no longer needs to depreciate the rupee against the dollar. If the world is gearing up for a gold based currency system then instead of wasting Indian rupees in buying useless dollars the Indian central bank needs to buy more Gold right now, as many other central banks are already doing (see here, and here), especially Chinese central bank (see here, and here). RBI did buy 300 tonnes of Gold in first quarter of this year, but that is not enough in a coming future currency regimes. RBI must buy more and more gold.

Conclusion
For India the sound economy policy is to let the rupee float freely in the international currency market and free the domestic economy from State's shackles. As Indian economy will embrace free market it will become stronger lifting standard of living of its more than billion people. An artificially weak rupee will benefit only export sector and that too in short run, but a strong economy and a strong rupee will benefit everyone of us. The choice is clear cut. We have to now see which path India takes.

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