Future of Rupee - Part I

Now that the inflation in India is tamed, the central bank in India (RBI) started back to its good old ways - buying humongous loads of dollars and increasing money supply bringing down call rates and also simultaneously increase Cash Reserve Ratio, affecting the profit margins of banks.

In the last couple of months, after I wrote the article series - "Is RBI handling inflation correctly", I had been in touch with a few financial columnists in India, working for Bloomberg, Hindu Business line and Business Standard and a few of them were very apprehensive of the rupee's effect on exports and cite their good old model - China on how to manage the inflows. However, good China had been in energizing the economy, I dont think that it is an good example for everthing. It has its price.

To put it short, if you have to manage heavy inflows - you have to screw one or more among the four crucial variables
a) Inflation
b) Export competitiveness
c) Financial health of banks
d) Interest rates and capital availability

So, if you have allow all those dollars to flow into India, unhindered, you will immediately cause rupee to appreciate (by simple demand-supply) and India's export competitiveness will be eroded as exports will be costs compared to imports. So, if the central bank buys up the dollars and prints rupee to prevent appreciation, it will cause inflation by making more money available in the system and weakening the currency. Now, to keep money supply constant and prevent inflation, the central bank has to increase interest rates and cash reserve rates (the amount banks have to keep idle and not use for loans from their deposits) affecting the availability of domestic capital and affective investment in crucial sectors. Now the Chinese model - sanitise all those dollars and not cause inflation by arm twisting the market by fixing constant prices and wages. And use banking sector to fun unproductive enterprises and load them with debt. This way the banks will take all those blow associated with maintaining the dollar low.

Each of these paths have a price. Inflation is the worst and no elaboration is needed here. If managed wrong and allowed to go on a vicious cycle, can cause the worst nightmares as seen in the hyper-inflation in Greece, Germany in the early 20th century and in Latin America in 1980's and 90's. Interest rates are among the next worst as it affects needy companies from raising adequate capital and affects crucial investment opportunities. Corporations would be unable to raise debt at favourble prices and affect economic expansion. And financial institutions are very crucial for a good market economy and making them a scape goat for increasing exports will debiliate the economy in the long run. Its like smashing the leg to give more blood to the hair. The last comes exports - whose importance varies from economy to economy.

For economies like Japan, Korea, Singapore and even Germany, the domestic population is so small and spend allergic that there is no way that they can ensure good jobs by relying on producing for local markets. They are forced to export and to export they have to have good currency support and so artificially affect exchange rate even at significant costs to economy. But, this doesn't hold good for China or India. They have 1 billion+ customers each and a good economic history that they dont theoratically need any external markets for their goods. If they can stand on their own legs by developing good local markets, the enterprises have so much of room to grow that they can forget about currency manipulation. And given their rate of expected growth and scale of operation, they cannot afford to depress currencies forever. Elephants cannot afford to jump trees and hide in burroughs and the managers of these trillion+ dollar economies better know this.

(Next part: The reasons why should the RBI allow freer flows and there is a solution, where we could avoid screwing up any of these 4 variables, to a great extent)