A slew of recent announcements by the Reserve Bank of India (RBI) aimed at liberalising access to and utilisation of foreign exchange suggests that it is beginning to suffer an embarrassment of riches and is willing to further encourage the use of hard currency by resident Indians. A strong motivating factor is, without doubt, the appreciation of the rupee in recent weeks. Despite an increase in imports and a pick-up in growth, the rupee continues to appreciate. Between January and December 2002, the rupee has appreciated by about 15 per cent against the euro. As Saumitra Chaudhury of ICRA showed in his column this week (Dec 23), the nominal effective exchange rate (NEER), which is a trade weighted (five-country) basket, shows the rupee appreciating by 6 per cent between January and mid-November 2002. The real effective exchange rate (REER), which is inflation-adjusted and trade weighted, also shows an appreciation of 4 per cent during this period. Part of this is obviously driven by market sentiment and thus far the central bank has allowed that sentiment to have its way. There is a policy challenge and a dilemma facing the central banker. Will the rupees appreciation hurt exports even as it encourages imports If so, should it be discouraged There is no simple answer to this question given the increasing complexity of Indias export basket. There are many exports that are no longer very sensitive to the exchange rate and have acquired market shares based on quality, reliability and brand equity. Moreover, the real bottleneck on the export front is infrastructure rather than price.
Even so, a significant part of Indias exports are price sensitive and compete with countries that seem more willing to use price as a weapon to increase market share. The central bank cannot remain oblivious to this phenomenon. One thing it can do at this point, given the impact that forex flows are having on the exchange rate, is to discourage short-term flows that come in on the back of differential interest rates. India currently offers attractive rates of interest to non-resident Indian (NRI) depositors. There may be a case to do this for long-term deposits, however there is no longer any case for offering arbitrage opportunities on short to medium term deposits. The RBI can drastically reduce the interest rate offered on NRI deposits with maturity periods of 6-months and 12-months, even as it maintains the current rate for 36-month deposits. This will not only increase the stability of forex flows, by encouraging NRIs to move their funds from shorter term deposits to longer term deposits, but will also discourage arbitrage while reducing short-term forex flows and the current upward pressure on the rupee.