Introduction:

In 1999, Goldman Sachs (BRIC Report) predicted that India's GDP at current prices will
overtake that of France and Italy by 2020 and that Germany, UK and Russia by 2025,
By 2035, India is expected to be of 3rd largest economy in the world behind US and
China overtaking Japan. Goldman Sachs had made these predictions based on India's
expected growth rate of 5.3 to 6.1% in various periods in the past, at present India is
registering more than 9% growth rate. Jim O'Neal, head of the Global Economics Team
at Goldman Sachs, had said on the BBC, "In thirty years, India's workforce could be as
big as that of the United States and China combined." He also added that "India could
overtake Britain and be the world's fifth largest economy within a decade as the
country's growth accelerates."

Presently India is the third largest economy in the world as measured by Purchasing
Power Parity (PPP) and twelfth largest in the world as measured in USD exchange-rate
terms, with a GDP of US $1.0 trillion. Amongst the major economies of the world, India
is the second fastest growing economy with a GDP growth of 9.4% for fiscal year 2006-
2007. The main reason for this is its diverse economy which encompasses agriculture,
handicrafts, textile, manufacturing and a multitude of services.

However, the BRIC (Brazil, Russia, India, China) report ignored the effect of rapid
decline in Purchasing Power Parity ratios of economies as they approach maturity,
resulting in PPP that eventually tend toward 1.0 (as compared to nearly 5.0 for India and
China in this current year i.e. the value of 1 US$ in India and China after conversion into
local currency at currency exchange rates was 5 times of that in the US due to their
cheaper currencies). This decline is attributed to the following,

• Inflation
• Appreciation of the local currency

Normally, currencies appreciate when the economies are doing well and the rise in their
value 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
yen in the 1980s when Japan seemed set to take over the world and the dollar's high
value in the late 1990s when the US economy brooked no competition were sources of
immense pride for their respective countries.

The Indian journey from 1990s to the mid 2000s:

The Indian rupee (INR) has appreciated by nearly 10% since late 2006, posing an acute
dilemma for Indian policymakers. In some ways, the present strength of the currency,
this is now hovering just above the symbolic Rs. 40: US $1 exchange rate is an enviable
position. It suggests that the country's attractiveness to foreign investors is increasing
and signals optimism about the future of Indian economy in general. However, the
concerns of export intensive corporations, who have a crucial role of India's economic
resurgence, and whose goods become more and more expensive for overseas buyers
need to be examined critically and addressed in a timely and effective manner.

The recent strengthening of the rupee is a dramatic departure from the past trends. The
currency depreciated steadily for a decade after being floated in 1993, dropping from an
average annual rate of Rs. 31.37: US $1 in the 1993-94 fiscal year (April-March) to Rs.
48.40: US $1 in 2002-03 (an average annual depreciation of nearly 5%). Between 2003-
04 and 2005-06, however, the rupee appreciated against the dollar by 3% an on
average a year—although there was considerable two-way movement of the
rupee from month to month. The trend of steady month-on-month appreciation
began in September 2006 and has been continuous since then.
Although the Indian rupee-US dollar exchange rate has a significant impact on the Indian
economy and business sector, the rupee has also appreciated against other currencies as
well. In January-July 2007, the rupee's value in terms of Pounds, Euros and Yen rose by
8%, 6.9% and 11.2%, respectively. According to the Reserve Bank of India (RBI) during
2005-06, 86% of Indian exports and 89% of imports were invoiced in US dollars. The
Euro was a distant second, with shares of 8% in exports and 7% in imports.

Why the Indian rupee appreciated?

The main reason for the INR's appreciation since late 2006 has been a flood of foreign-
exchange inflows, especially US dollars. The surge of capital and other inflows into India
has taken a variety of forms, ranging from FDIs to remittances sent home by Indian
expatriates. In each case, the flow seems unlikely to slacken. The main impact of these
various types of flows is examined below:

• Foreign Direct Investment (FDI) - India's outstanding economic growth has

created a large domestic market that offers promising opportunities for foreign
companies. Moreover, the country's rising competitiveness in many sectors has
made it an attractive export base. These factors have boosted FDI inflows into
the country. For example, in 2006-07, FDI amounted to around US $16bn, almost
three times the previous year's figure. More than half of these inflows arrived in
the final four months of the fiscal year (December 2006-March 2007).
• External Commercial Borrowings (ECBs) - Indian companies have borrowed
enormous amounts of money overseas to finance investments and acquisitions at
home and abroad. India's balance-of-payments (BoP) data reveal that inflows
through ECBs amounted to an enoromous US $12.1bn during April-December
2006, a year-on-year jump of 33%. The flood of borrowed money is likely to grow
in 2007. In the first three months of the year, Indian companies have notified the
RBI of their plans to raise nearly US $10bn in overseas debt markets.
• Foreign portfolio inflows - India's booming stock market embodies the
confidence of investors in the country's corporate sector. Foreign portfolio inflows
have played a key role in fuelling this boom. Between 2003-04 and 2006-07, the
net annual inflow of funds by Foreign Institutional Investors (FIIs) averaged US
$8.1bn. Trends during the first five months of 2007 indicate that this flood is
continuing, with net FII inflows amounting to US $4.6 billion. Another major
source of portfolio capital inflows has been overseas equity issues of Indian
companies via Global Depositary Receipts (GDRs) and American Depositary
Receipts (ADRs). Inflows from GDRs and ADRs amounted to US $3.8bn in 2006-
07, a year-on-year increase of 48%.
• Investments and remittances - Indians settled in other countries have also
been a major source of capital inflows, with many non-resident Indians (NRIs)
investing large amounts in special bank accounts. While NRIs' emotional
connection to their country of origin is part of the explanation for this, the
attractive interest rates offered on such deposits has also provided a powerful
incentive. In 2006-07, NRI deposits amounted to US $3.8bn, a 35% increase over
the previous year; the outstanding value of NRI deposits as of end-March 2007
was US $39.5bn. Another large source of foreign-exchange inflows has been
remittances from the huge number of Indians working overseas temporarily. Such
remittances amounted to a colossal US $19.6bn in April-December 2006, a 15%
year-on-year increase.

The Export Scenario:

Buoyant export growth has also built up India's foreign-exchange holdings. IT and
Business Process Outsourcing (BPO) exports have expanded at robust pace, with exports
of software services reaching US $21.8bn in April-December 2006 (a year-on-year
increase of 31%). However, the rupee's appreciation is alarming exporters, as it makes
their products more expensive in overseas markets and erodes their international
competitiveness.

The RBI's deputy governor, Mr. Rakesh Mohan has recently referred to the effects of the
rupee's appreciation as a case of 'Dutch disease'. The term refers to episodes where
large inflows of foreign exchange, usually as a result of the discovery of natural
resources or massive foreign investment, have lead to appreciation of the currency,
undermining a country's traditional export industries. ('Dutch disease' was originally
referred to as the adverse impact of the discovery of natural-gas deposits in the
Netherlands on that country's manufacturing exports.)

Trade Policies:

Indian policymakers face a difficult dilemma. On the one hand, the rupee's appreciation
has benefited the economy by making imports cheaper. This is no small benefit since
containing inflation has been high on the policy agenda during the past year, as the
annual inflation rate (as measured by the point-to-point change in wholesale prices) rose
to 6.1% in January 2007, compared to 4.2% a year ago. The inflation rate has
subsequently moderated. This may offer the RBI some comfort in it's battle against
inflation, but the bank's new, stricter inflation target (4.5-5% in 2007-08, down from 5-
5.5% in 2006-07) suggests that there will be one more increase in interest rates by the
end of 2007.

On the other hand, for both economic and political reasons, policymakers cannot afford
to ignore the problems of exporters. Although exports account for a relatively small
share of the economy, India's rapid export growth in recent years has been an important
catalyst of economic growth. Given the limited extent to which the RBI can intervene in
the foreign-exchange market in the face of large and sustained capital inflows,
policymakers can only stem rupee appreciation substantially by easing limits on domestic
firms' overseas investments or restricting inflows, for instance, through further controls
on ECBs. The RBI has already taken tentative steps in this direction, especially recent
ECB guidelines for Indian firms to borrow in foreign currency and eliminating the
exemption from ECB limits previously enjoyed by real-estate firms.

In confronting this dilemma, government policymakers are undoubtedly hoping that

there will be no need for a major intervention. However, the problem is unlikely to
disappear soon. The Economist Intelligence Unit forecasts an average annual exchange
rate of Rs. 41.3: US $1 in 2007 (a 13.5% real appreciation year on year) and Rs. 40: US
$1 in 2008 (6%).

Let us now look at the pros and cons of a rising rupee.

Advantages of the rising rupee:

• Foreign debt service: Appreciation of the rupee helps in easing the pressure,
related to foreign debt servicing (interest payments on debt raised in foreign
currency), on India and Indian [Link] Indian companies taking
advantage of the United States soft interest rate regime and raising foreign
currency loans, known as external commercial borrowings (ECBs), this is a
welcome phenomenon from the point of view of their interest commitments on
the loans raised. This will help them avoid taking a bigger hit on their bottom-
line, which is beneficial for its shareholders.
• Outbound tourists/student bonanza: The appreciating rupee is a big positive
for tourists traveling or wanting to travel abroad. Considering that the rupee has
appreciated by over 10% against the US dollar since mid-2002, traveling to the
 US is now cheaper by a similar quantum in rupee [Link] same applies to
students who are still in the process of finalizing their study plans abroad. For
example, a student's enrollment for a $1,000 course abroad would now cost only
Rs.44,000 instead of the earlier Rs 49,000!
• Government reserves: Considering that the government has been selling its
stake aggressively in major public sector units in the recent past, and with a
substantial chunk of this being subscribed by FIIs, the latter will have to invest
more dollars to pick up a stake in the company being divested, thus aiding the
governments build up of reserves.

Disadvantages of the rising rupee:

• Exporters' disadvantage: The exporters are at a disadvantage owing to the

currency appreciation as this renders their produce expensive in the international
markets as compared to other competing nations whose currencies haven't
appreciated on a similar scale. This tends to take away a part of the advantage
from Indian companies, which they enjoy due to their cost competitiveness.
However, it must be noted that despite the sharp currency appreciation in recent
times, Indian exports have continued to grow. This is vindicated from the fact
that while in the month of February 2004, India's exports were higher by 35%
over the same month previous year, in the first 11 months of the current fiscal,
Indian exports have been higher by 15% year-on-year.
• Dollar denominated earnings hurt: The strengthening rupee has an adverse
impact on various companies/sectors, which derive a substantial portion of their
revenues from the US markets (or in dollar denominations). Software and BPO
are typical examples of the sectors adversely impacted by the appreciation of
rupee.

How will rupee appreciation impact Indian Multinationals?

Even though the INR fluctuates a lot, but it is still up 7% making it the best performing
currency against the USD in 2007. A month back it touched a nine-year high. Rupee
appreciation will be negative for overall earnings, says a recent Merrill Lynch research
report. According to the report, the companies that will be impacted negatively by
the rupee appreciating include global commodity stocks like Reliance, Hindalco, Tata
Steel and software companies like Satyam, Infy etc. And the gainers will be Jet Airways,
Reliance Communicationsand auto companies like Tata Motors, Maruti, Hero Hondaetc.

The Losers:

Global commodity companies price their products off landed costs. With a decrease in
landed costs, profits for these companies will be hit. As an example, Reliance's 70% of
revenues come from exports which again would be hit by the rising rupee thereby
eroding their profitability.

The rising rupee and the fluctuating dollar have affected the Indian IT industry
adversely. It has dented profits and at the same time, many foreign clients with a dollar
budget are finding it too expensive to use Indian service providers. That is, software
companies are also going to lose on the back of the appreciating rupee as their exports
are priced in foreign currency.

Infosys, CFO, V Balakrishnan, said that in the fourth quarter of the fiscal year 2006-07,
they have seen an impact of 100 bps on their operating margins because of the
movement of the rupee. "But that was more than offset by the increased non-operating
income that we have seen because the effective yield in the last quarter has increased
from 7% to 10%." He said that in this quarter the rupee appreciated by around 1.8%
and for every 1% change in the rupee dollar rate the company have an impact of 50
bps.

The management of MindTree, a global consulting house, predict that the rupee
appreciation will be the key hurdle for their future performance. Patni Computers has
seen rupee appreciation impacting their margins by 0.3% in the last quarter.

The Gainers:

On the other hand, sectors that are likely to gain from the currency gaining are auto,
engineering and aviation companies.

The biggest gainers in the auto sector are Hero Honda, Maruti, Tata Motors and Ashok
Leyland as the imported price of their raw materials will cost less. Engineering
companies like Suzlon also gain on raw material cost savings.

Jet Airways is the other gainer on its aviation fuel costs for its domestic routes. Though
its international revenues will get hurt, there will be more savings on account of fuel,
lease rentals, interest and depreciation. Deccan Aviation management has said that
rupee appreciation is having a favorable impact on the lease side.

Companies with foreign currency loans or Foreign Currency Convertible Bonds (FCCBs)
like Reliance Communications, Bharat Forge, Sun Pharma and Ranbaxy are also likely to
gain due to rupee appreciation. Allianz Global feels that a sharp rupee appreciation will
have a drag effect particularly on banks.

Present scenario:

The current impact of rupee appreciation is best demonstrated by what it has done to
our textile exports, a highly employment-intensive sector, driven by small and medium
enterprises (SMEs). From a healthy export growth rate of 21% in 2005-06, it has
plummeted to a mere 4.6% during the 11 months of 2006-07.

CRISIL, a leading credit rating agency has come out with a report (CRISIL Budget
Impact Analysis) on textile impact analysis and is of the view that the package for
exporters in the form of enhanced DEPB (Duty Entitlement Pass Book) and drawback
rates will marginally offset the impact of rupee appreciation and benefit the exporters.
The textiles industry is severely affected by the rise of the rupee against the dollar, since
currencies of most of our competitor countries have either remained stable or have
depreciated against the dollar during this period. Chinese Yuan has appreciated by
around 4%, Indonesian Rupiah by around 2.7%, Bangladeshi Taka has remained almost
stable and Pakistani Rupee has depreciated by 0.69%. There is an intense competition in
the export market. Small and medium exporters are unable to pass on their costs in
terms of currency appreciation to buyers. The consequent lowering of export proceeds
erodes the top line and profit margins of exporters. Therefore, players would be required
to find additional ways to overcome the additional loss through operational efficiencies
and moving up the value chain to maintain their existing margins.

Looking Ahead:

However certain sections of the economy have welcomed the rupee appreciation. This is
because of the following key reasons:

• Firstly, the IT industry which is strongly lobbying against the appreciation of the
INR should realize that its phenomenal growth during the last decade is partly
 because of INR depreciation too. INR depreciated by almost 100% against the
USD from a level of 25 in 1992 to 48 in 2003. Further, Indian economy needs
development of infrastructure which warrants huge investments. A big chunk of
the said investments must come from overseas. The host country's currency, viz.,
INR, must appreciate to instill confidence into overseas investors.
• Secondly INR appreciation is welcomed by those companies with overseas
borrowings. Significant levels of foreign currency – denominated, especially USD-
denominated loans generate forex gains because of reduced interest payout
occasioned by the rising INR. Companies like Ranbaxy and L&T have been able to
generate forex gains in the last quarter because they have substantial exposure
to ECBs.
• Thirdly, major Indian stock indices are able to scale new peaks because of recent
appreciation in the INR. It has been proved beyond any doubt that there is a very
strong correlation between our stock indices and the parity value of the rupee vis-
à-vis major currencies like the USD. Analysts point out that during the last year
Sensex and INR exhibited a correlation of approximately 80% as against the 30-
40% exhibited in the last three years. FII's who have heavily invested in India are
reluctant to sell off mainly because of the appreciating INR.
• Lastly and most importantly, INR appreciation has helped control inflation.( It
touches a 5 year low at 3.32%)

Government standpoint:

The government is working on schemes to offset impact of appreciating rupee. The

proposed scheme refunding local taxes and levies to labour-intensive industries with
little import content, to offset the impact of the appreciating rupee, which was at a nine-
year high. "The rupee appreciation is a cause of concern for exporters and
manufacturing firms. We are looking at framing a scheme for labour-intensive industries
with no or very little import content to refund the local taxes and levies," Minister of
Commerce and Industries Kamal Nath said on the sidelines of the 3rd India-GCC
Industrial Forum. "The rupee rise is a concern and the Ministry of Commerce is in
discussions with the RBI... the rise is also connected with international factors like fall in
the dollar."

Conclusion:

It can be inferred that the issue of INR appreciation will play a major role if India has to
become a superpower nation by 2020. We have seen that as the Indian stock market is
booming in the past few months, the rupee is becoming stronger as compared to the US
dollar. This implies as the abiding faith of foreign investors in robustness of the Indian
economy and the inflows are rising at exponential rates. But the exports are taking a hit
because of this phenomenon. This is the dilemma which the policy makers have to
address.

Though the strengthening of the rupee will benefit certain industries, others might face
the brunt. But the gain will be to the entire Indian economy. The basic foundation for
any country to become an economic superpower is to have a strong infrastructure. This
need for huge investments, are being met through FDIs & FIIs. Similar developments in
other key areas would truly help India to reach the position of the 3rd largest economy of
the world behind US and China by 2035.