The rupee has strengthened 4.3% this year and is trading at around 65 per dollar.
Despite the short term gains of increasing rupee value, it poses some risks for export-dependent sectors.
What are the causes for rupee appreciation?
Positive growth prospects among major economies created expectations that the rupee would appreciate.
This encouraged capital inflows, particularly into the equity market.
This was with the expectation that any rupee appreciation would also result in a proportionate increase in return on investment.
Further, relaxation in the capital account and lack of intervention by the RBI in regulating foreign capital inflows are also the reasons.
Mostly short-term in nature, these capital flows have played a major role in strengthening the rupee.
What are the concerns?
Exports - A higher currency makes a country's exports more expensive and imports cheaper.
Resultantly, the strengthening rupee is hurting exporters’ competitiveness and earnings.
This has the potential to create volatility in the external sector of the economy.
Employment - Many export-dependent industries such as gems and jewellery, textiles, leather and agricultural products are labour-intensive.
Also, the supply chain of export industries involves millions of SMEs.
Therefore, a rising rupee and decreasing exports would be unfavourable for employment opportunities as well.
Services sector - This is also negatively affected, when export earnings are foreign currency-dominated.
Evidently, in recent years software export, where India has dominated, is experiencing lower profit margins
Why is export-led growth important?
An export-led growth strategy with appropriate structural reforms (like liberalisation and an open economy) results in sustained productivity-led growth.
This is because exports promote better resource allocation, efficient management, and technology exchanges.
Evidently, China followed an export-led growth strategy and increased its participation in global value chains.
It also led to the expansion of tradable and manufacturing sectors as well as creation of jobs and growth pick up.
What are the challenges to rupee depreciation?
Among various structural reforms, one of the prime reasons for the success of China’s export-led growth was an under-valued exchange rate.
However, there are some limitations and challenges for India in employing this strategy.
The high fiscal deficit and high debt to GDP ratio give the RBI little space to allow the rupee to depreciate by intervening in the forex market.
Doing so also has the risk of leading to a higher inflation.
Inflation is a politically sensitive subject and, moreover, RBI has been favouring a stronger rupee to achieve its inflation targeting mandate.
Because, as a general rule, there is an inverse relationship between inflation and exchange rate of a country.
Lower inflation lead to increasing purchasing power relative to other currencies and thus in turn lead to an increase in currency value.
What lies ahead?
A rising rupee is not a bad thing as it has helped contain inflation through cheap imports.
Also, companies that have foreign currency-denominated debt have been benefitted by rising rupee.
However, the strategy may not be right to sustain growth in the long run.
Ensuring a productivity-led growth by pursuing structural reforms across sectors could reduce the inflation concern of rupee depreciation.
The government and the RBI should step in to correct the mis-alignment in the exchange rate and allow the rupee to depreciate to move towards its true value.
