Appreciating the Indian rupee
By Kunal Kumar Kundu

MUMBAI - The current international finance architecture is based on the US dollar as the dominant reserve currency. This iconic status of the dollar has helped America live beyond its means, unconstrained by the periodic shortages of foreign exchange that haunted other, less privileged nations.

Almost all foreign exchange reserves are held in five currencies: the US dollar, the euro, the Japanese yen, the British pound and the Swiss franc. Dollar reserve holdings are by far the largest, accounting for roughly 70% of the total at end-2003, up from 51% a decade ago.

Global reserve stocks (US$ billion)

	1999	2003	Change
Global	1,781	3,014	1,232
Developed countries	772	1,194	382
Japan	278	653	375
Euro area	228	188	-40
Developing countries	1,059	1,910	851
Africa	41	91	49
Asia	656	1,238	582
Europe	108	250	142
Middle East	103	140	37

Yet, the US share of global exports is less than 15% and its share of global imports less than 20%. And, with a current account deficit of $600 billion (over 5% of its GDP), America's status as the largest debtor nation is sealed. Given that its baby boomers will soon start retiring and the ratio of working to retired citizens will reach 1:1 over the next 20 years; who will repay the debt?

Today's America lives beyond its means more flagrantly than ever before. Its government will spend about $427 billion more than it raises in taxes this year. The nation as a whole is running a deficit of $571.9 billion on its current account with the rest of the world. The US needs about $1.8 billion a day in foreign capital to keep the dollar steady by funding its current account deficit, which grew to a record $166.2 billion in the second quarter. America's net overseas liabilities mounted to 23% of GDP at the end of last year, close to its record debt.

Not surprisingly, the dollar has already started going downhill, exacerbated by the fact that the US is no longer following a strong dollar policy. The Europeans have realized this and have allowed the euro to appreciate by 50% against the dollar. The Organization of Petroleum Exporting Countries has re-priced oil to reflect the debasement of the dollar. The new base price has been changed from $28 to $42.

The story is being repeated in all resource-rich countries, including Australia and South Africa, whose currencies are steadily rising. Yet, India continues to prevent its currency from appreciating, its stubbornness compounded by a huge foreign currency reserve. In this, its dollar behavioral pattern reflects the rest of Asia's.

Central banks in Asia have accounted for the bulk of recent global reserve growth. Of the roughly $1.2 trillion increase in global reserves from the end of 1999 to the end of 2003, $582 billion were purchases by developing countries in Asia and another $375 billion by Japan. Together, Asian central banks account for almost 80% of the increase in global reserves over the period. The pace of Asian reserve purchases accelerated in 2003, when central banks purchased $274 billion in reserves, almost twice the 2002 figure, and Japan bought $189 billion, roughly four times the 2002 figure.

Asia holds a staggering $1.24 trillion in reserves in dollars. It has funded the US deficit of the past four years. This means Asia has been exporting goods as well as providing the finance to American consumers without thinking about how and whether they will get repaid. Clearly, India's policy has been shaped by memories of past foreign exchange crises. But in a new world of complex economics, it's not just the export factor that should frame foreign exchange policy. It's time for a reality check.

India has been systematically under-pricing its exports and receiving dollar IOUs that will fall in value as the US debases the real value of its currency. Also, the stock of US dollar bonds that India holds will depreciate as interest rates rise in the US. Therefore, the reserves that India sits on are really depreciating assets that will impose a loss on the entire nation just to enable a few exporters to make merry. India is also providing an unintended subsidy to exporters to Europe, Australia or any non-US currency area since the Indian rupee (INR) has effectively depreciated 33% against their currencies.

By trying to keep the INR value steady against the US dollar, India is importing the US fiscal stance into India. This means that as the world demands higher interest rates from the US or imposes higher natural resource prices on them, India will import the twin shocks of higher interest rates and commodity price inflation. A weak rupee amounts to a tax on every ordinary Indian (or around 90% of our GDP - as around 10% of India's GDP comes from exports) who pays more for goods locally due to higher inflation and interest rates. This dampens consumption, prevents domestic industry from achieving economies of scale or spending on research and development, thereby hurting competitiveness and lowering GDP growth.

Eventually, this will alter competitiveness of even the hallowed exporter who will have to pay more for his input costs - for goods, wages and cost of capital. By keeping asset values low, India is inviting foreigners to buy assets cheap. Foreign institutional investors (FIIs) have already taken over most of India's showpiece IT, BPO, pharmaceutical, telecom and banking sectors. So while India buys depreciating US dollar bonds, foreigners buy appreciating Indian businesses.

India's priorities and needs are different from the US and even its Asian neighbors. The US needs forex inflows on capital account to finance its current account consumption. India does not need to provide this to them by building reserves. Most Asian countries lack a domestic market and are so dependent on exports to the US that they are happy to play along. India is clearly different. India has a large domestic market and a rapidly growing workforce. It is in a position to boost local consumption and invest in productive capacities and job creation. The very fact that a developing country like India has a current account surplus does indicate higher potential for imports to meet growth needs. Today, capital is a commodity in excess supply - what is in shortage is opportunity and enterprise, both available in abundance in India. The appropriate policy stance for India would thus be to allow its currency to appreciate significantly.

India should stop pandering to exporters. Conventional wisdom has it that when a currency begins to strengthen, it starts to hurt exports. But increasing efficiency of Indian corporates has ensured high export growth rates even when the rupee strengthens, as experience from the previous financial year shows. Moreover, in the longer term, a stronger rupee would be sound for the Indian economy. The rising strength of the Indian rupee will bring India's purchasing power on par with other currencies. The dollar's 12% plus decline versus the euro over the past year might have affected exporters (albeit marginally), but it's pulling capital India's way. A stable currency, as opposed to a volatile, weakening one, may be just the thing to attract more multinational companies.

What it would also do is trigger a virtuous circle of lower inflation, lower interest rates, stable currency and higher efficiency. The biggest upside to an appreciating currency is the gain of foreign capital. In the age of globalization, capital flows brought in by a firm currency are more important than the increased trade afforded by a softer one. Capital inflows help stock markets play a greater role in the economy and hold down interest rates. That boosts growth and helps companies raise money in the bond market. A firm currency also keeps inflation under wraps, allowing central banks to stimulate growth, not slow it. The most immediate benefit (given India's high dependence on imported crude) that India can reap is lessening of the oil shock as oil prices skyrocket.

India has demonstrated its abilities when import tariffs fell from 160% to 25%. The country can similarly win with a stronger rupee. Fears of a flood of imports from China are often raised as a bogey by vested interests. In reality, current Indo-Chinese trade of $10 billion is tilted by $2 billion in favor of India. Even if this were to reverse, it would only dampen domestic inflation and allow domestic demand to explode. That would further improve input prices and scale competitiveness of manufacturers as well as exporters.

Rising volumes will accelerate GDP and revenue accruing to the government can be spent on the much-needed fiscal correction and infrastructure creation. That will push up asset prices, attracting even more capital, the wealth effect facilitating the creation of even more investment, productive and employment capacities. A depreciating dollar also means India would repay more high-cost overseas debt before it matures, and a reduction in the government's cost of funds.

A virtuous circle that has worked for every successful nation can be put to work for India. It has the resources, the demographics and the hunger. All it needs is the confidence to exploit the huge opportunity that is knocking on its door.

Kunal Kumar Kundu is a senior economist with a leading bilateral Chamber of Commerce in India. He has a Masters in Economics with specialization in econometrics from the University of Calcutta.

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