Last Monday in the run up to the Credit Policy, we had underscored the problem of keeping the managed float of the rupee at an appropriate level. In the limited sense, of more or less insulating our exporters from the adverse effects of higher domestic inflation vis-a-vis that of our competitors and in the markets we service. The Reserve Bank of India (RBI) in the Governor?s Statement of 29 April said, ?the inflation rate in 2003-04 on a point-to-point basis may be placed in the range of 5 to 5.5 per cent?.
If we understand this to refer to inflation in March 2004, then inflation on an average basis of the current fiscal year would be close to 6 per cent. Which means a domestic inflation rate that is likely to be 3 to 4 per cent higher than in the major markets of North America and Europe where our exports are headed. Also higher than that in our competitor countries, particularly China which has had deflation for some time now.
Since early 2002 the euro has jumped from US$ 0.89 to $1.12 presently. In this context, the rupee basically followed the US dollar down, depreciating massively against the euro, and gaining a bit vis-a-vis the dollar. The 5-country trade weighted index shows that the rupee depreciated 7 per cent in nominal terms and 4 per cent in inflation adjusted terms, against major currencies. However, this is cold comfort to our exporters of services whose principal market is the US. They have seen both nominal and real appreciation of the rupee.
In merchandise exports, markets which experienced more than the average growth of 22 per cent were South-east Asia and West Asia (about 40 per cent each), USA (31 per cent), East Asia, South Asia and Latin America (about 30 per cent in each). In contrast, exports of goods to Western Europe grew by 17 per cent, notwithstanding the large depreciation of the rupee vis-a-vis the euro, sterling and swiss franc.
Given these factors, it is difficult to see how in 2003-04 we can have both, inflation at 6 per cent and a further hardening of the rupee against the dollar, without serious adverse fallout on our exporting sectors. Particularly in services, but also in merchandise.
In the last four quarters for which we have data (Jan 2002 to Dec 2002), the overall balance of payments (BoP) surplus was $19 billion. For 2002-03, the figures are likely to be at comparable levels, and also for 2003-04. If the RBI does not buy these inflows, the rupee will shoot up. Hence, it has done so in the past and will have to do so in 2003-04.
The premium on forward dollar exchange contracts is today little below 1.5 per cent. Now, in theory such premium should equal the difference between the short-term borrowing cost in rupees and dollar. The cost of short-term money in dollars is little over 1.25 per cent, while the repo rate which has normally acted as the floor for short-term money in India is at 5 per cent. The difference works out to 3.75 percentage points, much higher than the premium of 1.5 per cent. In April 2003, heavy liquidity drove call money rates below the repo rate ? towards 3.5 per cent. But even at this level the premium is far too low, reflecting strong expectations of further appreciation in the rupee with respect to the dollar.
Which brings us back to the credit policy. By and large, it was in line with market expectations. However, one would have thought that RBI would hold over a change in the Bank Rate, which is a long-term signalling device, till end-July when the state of this year?s monsoon becomes clear. And that it would have reinforced the March repo rate cut with another cut of 50 basis points. In order to gently ease the rupee down, the large differential in short-term money rates obtaining in India and in overseas markets must be narrowed. Even then it will be difficult to work the currency down in the face of BoP surpluses, but at least it will provide the necessary preconditions by squeezing out arbitrage opportunities.
The author is economic advisor to ICRA (Investment Information and Credit Rating Agency)