Sinhgad Technical Education Society’s

Vadgaon (Bk), Sinhgad road Pune-411041



Introduction……………………………….. ………………03 Current scenario………………………… ……….……...04 Causes …………………………………… ………………..…05 Impact...………..………………………… …….……………09 Corrective measures………………….… ………….….15 Future……………………………………… …………………17 Conclusion………………………………… ………………..18 Bibliography……………………..……… ………………...19









The recent sudden and fast appreciation of the rupee has many economists, bankers, and treasury managers running from pillar to post to find answers. They want answers to, first, what happened, then why and how and, lastly, what will happen down the road. Currencies appreciate when the economies are doing well and the rise in their values is a cause for celebration. The high value of the deutsche mark when Germany was the trendsetter for the world economy in the 1960s and the 1970s, the high value of the yen in the 1980s when Japan Inc seemed set to take over the world and the dollar's high value in the later 1990s when the US new economy brooked no competition were sources of immense pride for their respective countries. An appreciating currency is the natural corollary of a booming economy with rising exports and is normally looked on favorably. The high-decibel lamentation over the rupee's appreciation, therefore, needs closer examination. The causes for rupee's appreciation after years of continuous depreciation are readily apparent. The current account surplus for the first time in years (it has since reversed), due to increased merchandise exports and invisibles, has resulted in supplies of foreign currency going up sharply. The huge FII inflows into financial asset markets and increasing reliance on low cost foreign loans add to the supply glut, and help power the rupee higher. The rupee's appreciation is a result of forces of demand and supply operating in the forex markets and involves no cost to the exchequer. The heartburn on the rupee's appreciation against the dollar is due to the fact that most of India's external trade is invoiced in dollars and any change in the dollar's rupee value has a disproportionate effect on the various stakeholders in the rupee's

external value such as importers, exporters, borrowers, lenders and consumers of imported goods. The Indian consumer is a big beneficiary too, as costs of a host of imported goods — from petro products to electronic, electrical and consumer items — would be higher but for the rupee's appreciation. The rupee's appreciation is one of the reasons to lower the inflation rate. However, as the rupee continues to rise, the demands for intervention are likely to become shriller. An artificially managed depreciation would result in higher cost to Indian importers and to the consumer in exchange for a probable boost to exports.

Whenever currency of a country moves up, it’s usually implicit that the economy of country is doing well. The rupee against dollar has appreciated from Rs 46 in July 06 levels to 39.50 levels in October 07, an increase of more than 10 % in last year. The fig shows the Rupee appreciation within different periods. The fig shows the trend of rupee with different periods. US dollar is the predominant currency in which billing for exports are done. 73% of the Exporters make exclusive use of the dollars for conducting export transactions.
1 Week ( 0.1% ) 2 Weeks ( -0.87% ) 1 Month ( -2.97% )

3 Months ( -2.48% )

6 Months ( -5.85% )

1 Year ( -13.14% )


This ‘vehicle currency’ status of the dollar is further reinforced as the remaining 27% of the exporters use a combination of USD and other foreign currencies for billing exports. It is to be noted that in case of those exporters who use more than one foreign currency, the dollar on average accounts for nearly 75% of the total billing portfolio. The present heavy dependence on the dollar is reflected by the exporters’ concern with regard to the situation at hand. A significant aspect of the billing practice of exporters is that none of the exporters have any inbuilt protective clause in their contracts, which could perhaps have saved them from unpredictable change in (Rs-USD) exchange rate.

When it comes down to the reasons for the appreciation, many put forward. There have been accusations that the Reserve Bank of India is pandering to the Finance Ministry by letting the rupee appreciate so as to bring down inflation. Then, there are more reasonable explanations that the appreciation is because of the increased demand for rupee, a result of massive capital inflows.


Capital inflows

The currency of any country is set on the basis of demand and supply, much the same as any commodity such as oil. All major currencies are set based on trading in exchanges and the higher the demand for a commodity, the stronger it becomes and vice-versa. However, some currencies are not traded on international exchanges, such as the Indian rupee. In such cases, the value of the currency depends of inflows of money from other countries/sources.

Capital inflows that come into the country are in the form of foreign direct investment, portfolio inflows (foreign money that is invested in equity), External Commercial Borrowings by Indian companies, remittances by non-resident Indians, and many other sources. During the April-May period of 2007-08, India attracted total capital inflows of over USD 7 billion, where half of the investment was received from the foreign direct investment and the rest came from the portfolio component. Dollars are pouring into India. Net investments by foreign institutional investors (FIIs) were $10.16 billion during January-June 2007. This is more than the $8 billion recorded in the whole of 2006. July has beaten all records with an inflow of $5.81 billion (so far). The FIIs are chasing Indian stocks and taking the markets to what many feel are levels of irrational exuberance. The bellwether Bombay Stock Exchange (BSE) Sensitive Index (Sensex) was 15,732 on July 23 against 12,455 on April 2. (Incidentally, that day's low -the Sensex plunged 617 points during the day -- was caused by the RBI's attempts to control the rupee.) The foreign direct investment (FDI) numbers are equally impressive. In 2006-07, FDI inflows touched $19.53 billion, a 153% increase over the previous year. (This figure includes private equity and also $3.5 billion in reinvested earnings.) The government is looking at a target of $30 billion in 2007-08. Foreign exchange reserves stood at $214.84 billion on July 6. This is a far cry from $5.8 billion in the dire days of March 1991, when India had to sell its gold to stave off a default crisis. Therefore, when there is strong inflow of the above, the rupee will appreciate and vice-versa.


Big trade surplus

Another way a currency can appreciate is if it has a big trade surplus (when exports are more than imports) as there is a greater demand for the local currency because exporters have to change their foreign earnings into the local currency. However, the above only happens when a central bank of country does not intervene in the currency market and manipulate the level of the currency. These exchange rates of these currencies are known as `floating exchange rates' because they move as result of regular market actions. Countries that typically do not intervene in the currency markets are the UK and the US.

However, central banks of Asian countries, such as India and China, do not suffer from such compunctions. The central banks in this region regularly manipulate the level of their currencies. The most egregious `offenders' have been China and Japan; both have expended billions upon billions to depress the level of their currencies. These currencies are called `managed currencies' or `partially floating currencies' for obvious reasons. The central banks of these countries artificially depress the value of their currencies in order to become more `competitive'. They become competitive because their artificially cheaper currency makes goods produced in their countries cheaper vis-à-vis those of other nations and that has the potential to boost their exports. China is case in point. This type of manipulation of currencies is also known as `mercantilism' whereby a country manipulates its currency so as to promote trade. Indian Merchandise exports have picked up by 18.11% during the first quarter of 2007-08, touching USD 34.3 billion. However the exports growth in the first quarter of current fiscal could not match the growth pace, of over 30% recorded in the corresponding quarter of 2006-07. The low growth pace is mainly due to a host of constraints that include high rate of exchange, rising cost of raw material and increase in borrowing rate.

Imports however have clocked a growth of 34.30%, much higher than what was posted in the same period a year ago. The growth in imports has primarily come from high growth of 50.36% in the non-oil segment. The oil segment however saw growth rise by only 4.21% during the three-month period.


Fixed Currencies (RBI interventions)

Then there are the `fixed currencies'. They are fixed by design. Usually a country will anchor its currency against a set value of another country's currency and will do anything and everything to maintain this value. This is also known as `pegging'. This policy is followed for several reasons and one of them is the mercantilist reason. Another reason is to combat inflation. The theory behind this is that if a currency latches itself on to another one, the central bank of the latching country is forced to mimic the responsible monetary policies of the `latchee' country.

Since this ensures better monetary policies, it is presumed that it will lead to lowered inflation rates though that is a matter of debate. Some countries also fix the value of their currencies against a `currency board' which consists of several currencies. The RBI periodically intervenes in the currency market to ease the pressure. To do so, it simply sells rupees in lieu of dollars and this usually takes the pressure off. However, the caveat is that it can only do so when the pressure is moderate otherwise it will have to expend huge amounts. Further, RBI buying of US dollars will create a surplus of rupees in the public's possession, which RBI will have to suck up by selling bonds in exchange for rupees. This, in technical terms, is called sterilization. In effect, it leads to bonds becoming cheaper, due to oversupply. This, in turn, implies an interest rate rise, which will attract more forex inflow — a vicious cycle.


Expanding Base/Sterilized Interventions

However, when the RBI intervenes in the currency market by selling rupees, it creates another problem. The dollars that it gets enter the monetary base (high-power money supply) and this obviously leads to the base getting bigger. When this happens, considerable inflationary pressure mounts on the system because it becomes a case of `too much money chasing too few goods'; the definition of inflation. Therefore, to stave off this potential inflation, the RBI — any central bank for that matter — resorts to a tactic known as `sterilization'. As the word implies, the RBI sterilizes the rise in the money supply. For example, if the exchange rate is $1= INR42 and the RBI sells Rs 4200 crore, it receives $1 billion. To ensure that this $1 billion does not lead to a rise the money supply, the RBI issues bonds for exactly Rs 4200 crore and sucks out that amount out of the system. As a result, the money supply is the same as before the intervention. This is known in the business as a `sterilized intervention'. The cumulative MSBs (Market Stabilization Bonds) sold, is rising as the exchange rate level is appreciating. This means that the rupee appreciated willy-nilly as a result of capital inflows. The RBI did its best to contain the rise of the rupee, as is evidenced by the rise in the MSBs. This rise is even more pronounced in early March 2007.

On March 2, the number of outstanding MSBs stood at Rs 43,734 crore and this doubled to Rs 86,306 crore by June 8, reflecting the massive capital inflows. However, what is interesting is the dip is the MSBs towards the end. This is because the RBI started rethinking the policy on the MSBs and sterilized less. There is a good reason for this. When the RBI sells MSBs, it has to pay a certain rate of interest on those bonds. Selling all those bonds makes sterilization an incredibly expensive exercise, some thing the RBI is not keen to bear.


US dollar is Weak.

USD slid against all other major currency, as global market sentiment remained skeptical on the Dollar. In fact, the dollar hit fresh 26 year lows against the British pound, 24 year lows against the New Zealand dollar and 2.5 year lows against the Euro. One of the biggest reasons for the slump of the dollar is the bad news that is coming out the Asian countries especially those with large foreign exchange reserves, in particular, China.

While a strong rupee may delight the hearts of certain sections of markets such as importers, it brings tears to the eyes of exporters. The number of jobs at stake and the export volumes that are affected call for a multi-pronged approach that should attempt to address the fundamental problems. Let’s analyze the effects on different parts of economy one by one.



Widespread disruptions have been caused by the rising rupee. Even 39 rupees will fetch a dollar. This has seriously impacted the export prospects of many industries, in particular, textile, garments and software. Exporters get their sales proceeds in dollars, which, with the rising rupee, fetch lower number of rupees. Viewed alternatively, the exporter has to quote a lower rupee price to match the US market demand at a given dollar price. Rising costs and an appreciating local currency can apply pressure on both the cost and revenue sides and render export trade quite uneconomic According to the FICCI study, the most significant impact of the appreciating rupee is the pressure on margins, with 86 per cent of the exporter-respondents complaining about it. This is the crux of the matter behind the protest among some sections of exporters against the appreciation. 4.1.1 BASIC ECONOMICS An analysis of the maths is necessary to throw light on the underlying economics of the export trade at the individual exporter level. If not anything else, it may at least point to how important active hedging is for Indian exporters in the current and emerging environment. Assumption-the Total revenue TR, of Indian firm in selling its entire output in the US
A. The Total rupee revenue B. Total Cost of Production of quantity

TR = S * P * q C=c*q

Where, S= Exchange rate (number of rupee per dollar) P= Sales price in dollars in the US q= number of units sold c= Cost per unit in rupees


A profit maximizing (loss minimizing), in determining the amount to sell or equivalently in determining what price to charge,



Where, dTR, dTC are chance in total revenue and change in Total Cost respectively. By differentiating equation 1 and 2 with respect to q,


SP 1+qP*dpdq=c

SP 1-1N=c



Where N=(dqq)/(dPP) = is price elasticity of demand, which is percentage change in quantity divided by percentage change in Price and is normally negative. Equation ‘D’ tells us the Indian company, how to set its price abroad in dollars according to the cost of production, the prevailing exchange rate and the elasticity of demand. It can be noted that the equation ‘D’ makes sense only when N > 1. It is only then that the marginal revenue will be positive and will be atleast equal to the marginal cost. Consider an Indian company which exports only to the US market. (This is quite a realistic scenario in Tirupur, for instance, where there are a number of mid-size exporters who sell almost entirely in dollars/ to the US market). Equation ‘D’ also brings out clearly how rising costs and an appreciating local currency can apply pressure on both the cost and revenue sides and render the export trade quite uneconomic. For example, assuming per unit cost of production is Rs 100, an exchange rate of Rs 45 to the dollar and a price elasticity of 2,

one can see that the unit dollar price for the exporter will be 100/45 (1-0.5) = 4.5. Now, if production costs rise and the local currency also appreciates (as has happened in the case of Indian exports), without any change in the price elasticity (elasticities are quite sticky in the short/medium term and also unlikely to change in the case of low value added items), the exporter will be literally priced out by his competitors who have not experienced such cost side pressures/local currency appreciation. Assuming that unit costs rise to Rs 120 and the rupee appreciates to 40 against the dollar, one can see that the equilibrium dollar price for the exporter should rise to at least $6 per unit. How many mid-size Indian exporters have the pricing power to increase negotiated and agreed upon prices? Compare the above workings with that for a Chinese exporter who has not experienced such cost side pressures and also, importantly, benefits from a relatively much more stable currency. The Chinese Yuan, for instance, has been allowed to rise around 9 per cent against the dollar in the two years since July 2005 — from 8.28 to 7.51 now — but the Indian currency is up 10 per cent in just the last 7 months. It is obvious that the Chinese exporter will have a significant price advantage which can be extremely useful in increasing market share — particularly in low value-added items. Equation ‘D’ tells in a very concise manner how critical it is for the exporter to protect the (initial) exchange rate based on which his export pricing has been worked out. Such protection is achieved only through active and systematic hedging. 4.1.2 IT & BPO sector There is rising concern over the steep appreciation in the rupee, while large IT companies were better placed to ease margin pressures through hedging and higher utilizations, it was putting a strain on BPOs and small and medium-sized firms. In the last quarterly results, although the rupee appreciated by 10 per cent the margins were not impacted to that extent, as companies took preventive action through currency hedging and increase in utilization levels. However, the impact is more severe in the case of BPOs as most of their expenses are in rupee. Also, the small and medium-sized companies, which are constantly under

cost pressure and have less levers to act on, are hit harder. The demand continues to be robust, and companies are in a position to capitalize this demand. To put the matter in right perspective, it is important to understand that the software industry, which has seen a meteoric rise the last 15 years, has been helped to a very large extent by the economy and the exchequer. The rupee depreciated from 1992 to 2003 by almost 100 per cent against the dollar (it depreciated from Rs 24.5 in 1992 to Rs 48.5 in 2003), and this definitely helped the software industry become the most profitable in the country.

4.1.3 CHEMICAL PRODUCTS The rising rupee will reduce the growth in export of chemicals and allied products to around five per cent from the current 10 per cent, according to the Chemicals and Allied Products Export Promotion Council. The worst-hit will be products such as books, glass and glassware, rubber products, paper and granites etc. However, the council is confident of doubling its export to $20 billion from the current $9.8 billion. After taking into account the rupee impact, they have kept a conservative target of doubling our exports in the next 10 years.

4.1.4 DOMESTIC MANUFACTURING INDUSTRY Among those affected are manufacturers whose products are substitutable by imports, which have turned cheaper as the rupee hardens. The trend is evident in a bevy of sectors such as chemicals, textiles, standardized auto components and tyres, where imports have been on the rise. L&T has a number of manufacturing units that are affected by imports from China. They are small units and hence overall the company is not affected much. However, the units – producing plastic and rubber machinery, valves and medical equipment – in Tamil Nadu and Karnataka have over 2,000 employees and get almost half their turnover from exports. Domestic suppliers to export firms are also taking a hit as exports falter. Further compounding the woes of the domestic manufacturing sector is the fact that India is fast turning into a highcost economy, with spiraling real estate prices, increasing interest

rates and high cost of infrastructural overheads such as power and freight costs, all of which translate into whittling down of margins. 4.2 IMPORTERS

But all is not gloomy here as the “Rupee at nine year high” is a sigh of relief for importers in the country. The oil marketing companies are already facing the volatility in crude prices resulting in under recoveries and so the appreciating rupee here comes to their rescue. According to an IOC official - “For every 1 Re appreciation the input cost of crude dips by 2%” The rising rupee will help the government to curb inflation, as the input cost of crude and electronic items will be lowered which will help in fighting the ongoing inflation and hence the interest rates. One of the biggest beneficiaries of rising rupee stands out the borrowers who have borrowed from international banks. The companies like Tata steel, McDowell to name a few for their takeover plans of Corus and Whyte & Mackay. As on Dec.2006 the country has an external debt of $142.65 billion dollar so a 7% appreciation in dollar means the external debt is reduced to $132.66 billion, (assuming no more borrowings are taken and no repayments made). This is again positive for increasing Gross Deficit of the country. 4.3 High Inflation, interest rates

Depreciation of the rupee had a huge impact on the domestic economy as also the manufacturing and other industries. Due to this unprecedented depreciation of rupee, the country has had a very high interest rate regime and also high inflation impacting the common man severely. All this to some extent impacted GDP growth as well. It was not only depreciating rupee that helped the software industry but also the way this sector was given the favorable treatment on all the fiscal policies. The Indian manufacturing industry has really put its house in order and managed rather well the shocks of high interest rates, the depreciating rupee and also the high cost of energy. It is only during last three years we have seen interest rate coming down, inflation

moderating and the rupee appreciating. The stable rupee for last three years and the little appreciation now have helped the country overcome to some extent the shock of high energy cost. Since India’s is not an export-led economy and external trade is just about 13 per cent of GDP, rupee appreciation will not really have a major negative impact on the growth. However, certain sectors which are largely dependent on exports, for instance, textiles, have been rightly given short-term relief that should help them to stand on their feet quickly. It is absurd to think of and ask for any relief to the software industry, which is not only very mature but also highly profitable. Its profit margins have at best been impacted by just about 3 per cent on an average margin of over 30 per cent and to think of any help at that level at the cost of economy is beyond reach.



To sustain the economic growth of 9 per cent, India needs to spend a huge amount of money on infrastructure projects. It is estimated that country would need over $400 billion in the next five years to spend on infrastructure. The domestic saving rate is rising very well but yet not sufficient to meet the total requirement of capital to build the required infrastructure. In this situation, it is crucial that the country attracts foreign capital for investing in infrastructure projects. Hitherto infrastructure growth was happening at a slow pace due to the high rate of interest, the high inflation levels and a depreciating currency. In view of huge requirement of foreign capital, it is of utmost importance that the country has an appreciating currency to instill the confidence among foreign investors. Thus, an appreciating currency is the need of the hour and any lobby against this is counterproductive and going against the economic growth story of India.




Bowing to exporters’ demands, Government announced a new set of relief measures for exporters in the wake of rapid appreciation of the rupee in recent weeks. The latest package comes on top of the estimated Rs 1,400crore financial relief measures, announced in July this year, which included accelerated reimbursement of dues to exporters, reduction in pre-shipment and post-shipment credit and revision in drawback and DEPB rates. The Finance Ministry had also in mid-September said that refund of service tax would be available in respect of four services, which are not in the nature of “input services” but could be linked to export of goods The relief measures announced included widening of the coverage as well as extension of the time period of the reduced export credit, refund of service tax on three more services, a provision to pay interest on exchange earners foreign currency (EEFC) accounts and an increase in the revenue ceiling on Vishesh Krishi and Gram Udyog Yojana (VKGUY). The coverage of the 2 per cent interest subvention, made available in July 2007 to nine specified sectors, has been expanded to include sectors such as solvent extracted de-oiled cake and plastics and linoleum. Also, jute and carpets (under textiles) and processed cashew, coffee and tea (under processed agricultural products) would be eligible for this. The three new services for which refund of service tax would be available to exporters are general insurance services, technical testing and analysis agency services and inspection and certification agency services At present Exchange Earners Foreign Currency (EEFC) accounts are non-interest-bearing accounts. It has now been decided to allow interest to be paid on these EEFC accounts subject to: Interest should be permissible on outstanding balances to the extent of US$1 million per exporter. Rate of interest may be determined by the banks. This measure would be valid up to


31/10/2008. Such accounts should be in the form of term deposits with a maturity of up to one year.



Cost cutting to be an important measure. This could be achieved through inventory control, reducing travel, advertising, and entertainment, logistic, selling and administrative expenses. Although a shift to any other currency is a difficult and challenging task for the exporters; FICCI survey showed that if a change in currency is an option then most preferable currency; 89% respondents acknowledging Euro as the most preferred currency, followed by GBP as the second best with 44% and then finally Japanese Yen with 22% vouching for it.

Some of the exporters have also resorted to rationalization of manpower to bring down their employee cost. Protective Clause in Contracts: For protecting the business from unexpected exchange rate movements, volatility in exchange rates business contracts are covered or made safer with a protective clause/s, which safeguards the business from unlimited and unexpected There is a need to provide sustainable competitive edge to Indian exporters through improved infrastructure especially port facilities, highways and power availability.


Any forecast of beyond a year should be taken with a grain of salt. A forecast of the rupee is something that falls into that category as there is no standard quantitative model to forecast the rupee movement and most forecasts of the rupee are qualitative judgments. Many economist think on the rupee is fairly similar to the above. In the near-term, it should be in the 41.50-42 range. The reason is that the rupee gets heavily influenced by FII inflows. FIIs (hedge funds) are bringing in big sums because of the property market and Initial Public Offers by Indian corporates as well as the booming stock market. However, most of this money is short-term and will go out of the country fairly soon especially as stock market and real-estate valuations in India are generally thought to be in the expensive and over-valued. The rupee will start appreciating again in around 18 months because FDI money into infrastructure projects will start coming in and this money is going to be fairly large. However, it is unlikely to appreciate beyond the Rs 38 levels because the RBI will still view rupee appreciation as something that will affect the economy as it can hit the software and the export sectors fairly heavily. What the past few months have shown is that a currency that is managed just does not work in the long term. It gives the illusion of being a panacea but in effect only pushes problems into the future. The gist is that the rupee needs to be left to market forces. They may be some volatility in the beginning but then it usually will sort itself out. The RBI may have been a decent manager of the currency before but that was when capital flows were at a minimum. It would be fair to say that central banks are often out of their depth in this era of modern capital flows. The only way out of this predicament is to free the rupee and for the country to adapt itself to a free floating rupee as the costs of managing the rupee will soon outweigh any benefits.


With restructured operations helping it take on competition better, India Inc is not too worried by the rupee's rise against the dollar. The stronger rupee will also make imports cheaper, attract more FDI and soften the impact of the crude price spurt. Now is the time for the Government to use the bulging forex kitty to trigger an investment boom in the economy While the rupee's rise has helped some exporters to rein in costs and increase their competitiveness in the global market, in general, profit margins have eroded. Indian importers, borrowers of foreign currency and the consumer have, however, all gained. The clamor for government intervention to depreciate the rupee thus seems overdone. The rising rupee, however, does throw up short-term challenges and opportunities. It will force the IT industry to look beyond labour cost arbitrage to create value for its customers - what can be called the Third Wave approach. It will refocus the industry on driving new efficiencies and improving productivity. Intervening to artificially depreciate the rupee will involve outlay of public funds which can be better used elsewhere. And as data show, this may not result in any appreciable rise in exports as the past slowdown in export growth was determined by global economic conditions and not only by the rupee's value. The rupee's value seems to have but a marginal effect on export performance. The rupee, with centuries of history behind it, is capable of depreciating with elegance and appreciating with grace. If only we would let it.





BUSINESS LINE- Business Daily from THE HINDU group of publications

1. ‘Rupee-Stronger the better’-dated July 24 2007. 2. ‘Dynamics of Rising Rupee’-Dated June 25 2007. 3. Rising Re: ‘BPOs, small cos under pressure’-dated October 04

4. ‘Manufacturing







imports’-dated Oct 10 2007.
5. ‘Rising rupee to hit chemical products export growth’-dated

Sep 26 2007.
6. ‘Rupee appreciation upsets export arithmetic’-Dated Oct 4

7. Dollar Vs Rupee-Dated Oct 16 2007. 8. ‘Leave the rupee to the market’-dated July 02 2007.

Others. case for not currency sops, appreciation’-dated tame rising Re: Oct 2003to ECONOMICS TIMES

1. ‘The

2. ‘Efficiency,



exporters’-dated Sep 24 2007 The Financial Express


1. http://www.dbs.com/researchasset/econalert/2006/fxstrategy_w200 6sep06.pdf 2. www.rbi.org.in

3. www.thehindubusinessline.in 4. www.indianexpress.com