If you offer to exchange US dollars for Indian rupees, a person who is aware of market trends would probably decline the offer. The rupee is showing its mettle in the foreign exchange markets. It has appreciated to an eight-year high of Rs 42.90 against the dollar. Since January 2006 till date, it has appreciated by almost 4.8 per cent. During calendar year 2006, it went up more than 3 per cent.
Improving economic fundamentals and stronger growth prospects have led to a global interest in the Indian economy. Foreign money is pouring in to ride the economic boom and take advantage of the rising interest rates and stock and real estate prices.
The net FII inflow (debt and equity) since January 2006 was close to $10 billion. Non-Resident Indians also remitted home a considerable amount of dollars. The higher interest rates in the domestic market compelled companies to borrow in dollars in foreign markets (external commercial borrowings) to fund their expansions plans. Naturally, when the supply of dollars exceeded the demand, the rupee soared.
What implications does an appreciating rupee have on the economy and the common man?
Indian exports are denominated in dollars. If the rupee appreciates and the dollar depreciates (other currencies remaining stable), Indian exports will become expensive and uncompetitive, leading to lower volumes. The appreciating rupee could also adversely impact the employment generating software and outsourcing (BPOs and KPOs) sectors' income, which is also denominated in dollars.
Thankfully, the Indian economy is less export-dependent than some of its Asian peers, where falling exports slows growth and brings in higher unemployment. Exports constitute less than 20 per cent of India's GDP, yet they are an important part of the economy.
Higher imports may add to the trade deficit (imports minus exports), which is not always in the interest of the economy.
NRI deposits and remittances would fetch less rupees for their dollars if the rupee continues appreciating. With the trade deficit deteriorating sharply, these remittances have helped India remain in a surplus situation on the balance of payments.
FIIs usually get money in India in dollars to invest in stocks and other assets. A stronger rupee will mean that they get a lower amount to invest. A rising rupee will add to the dollar returns of FIIs that don't hedge the currency risk.In order to prevent a rapid appreciation of the rupee, the RBI buys dollars from banks and sells rupees, which enhances the liquidity in the banking system.
If this liquidity is not sterilised (absorbed) out of the banking system by the RBI, interest rates are likely to fall. These excess dollars usually find their way to the country's foreign exchange reserves. The RBI and the government incur costs on account of the sterilisation measures and maintenance of reserves.
Higher reserves can be helpful in the event of an external financial crisis, such as the foreign exchange crisis in India in 1991.
The long-term intrinsic value of a currency is a function of various other factors, such as interest rate differentials, trade equations, and so on. It should be kept in mind that the rupee has appreciated primarily on account of the excess dollars chasing the economic boom in India.
Any reversal of such flows due to a change in the global perception of India could put the rupee under pressure.