Are we trapped?

We all are surprised by the sudden surge in Sensex, appreciation of rupee, rising interest rates, lower than expected inflation rate and a government which is watching this inactively. Some of us are happy with the stock exchange moves and others are equally sad for the appreciating rupee. There also is a class of people which is apprehensive about all these things, without knowing the fact that all these things are inter-related. It would be quite interesting to know this relation. Let us start with the rising Sensex.

The current rally in exchange is driven by the buying momentum created by the FIIs (Foreign Institutional Investors). These institutions bring in dollars to invest in the Indian market, but they can’t invest the dollars in the Indian markets. So they sell these dollars to buy rupees. Lately FIIs have increased their investment in Indian markets multifold and this has resulted in a large inflow of dollar for sell in the currency market. The most capable entity in India to buy these dollars in exchange for rupee is RBI (Reserve Bank of India). But RBI is not buying these dollars, so the condition in the currency market is unbalanced; there is a large demand for and less supply of rupee. Naturally the value of rupee against dollar is increasing. If RBI starts buying dollars and infuses rupee to control this demand-supply unbalance then rupee would be devalued. You must be thinking what is problem with the appreciating rupee. The appreciating rupee makes the Indian exports in the American markets costlier and affects the overall exports. IT industry, exporting its services to America is hardest hit. On the other side, the same appreciating rupee makes imports cheaper and results in increased imports. The overall situation (increasing imports and lowering exports) increases the trade deficit which is not good for the economy of a developing nation.

Another effect of appreciating rupee is on RBI itself. All the dollar reserves of India are held by RBI. And when the dollar gets devalued, the assets of RBI are getting devalued. Then why doesn’t RBI buy those dollars floating in the currency market and keep dollar’s value intact? The answer lies in the economic indicator called inflation. If we remember, rising inflation had been considered a reason for the defeat of ruling government in state elections few months back. Since then RBI has kept (or government has made it keep) on increasing the interest rates. Increased interest rates suck the liquidity out of economy and when there is less cash in the economy, the inflation starts decreasing. RBI, with its policy of increasing the interest rates has successfully brought down the inflation. And the concern in buying the dollars floating in currency markets is that, this will result in increased money flow in the market and will pull the inflation up. Obviously RBI doesn’t want the inflation to rise and hence letting rupee to appreciate.

In the last few weeks the inflation has risen by a quarter percent and the general talk in the market is that RBI may again raise the interest rates to bring down the inflation. With America lowering its interest rates and India increasing its interest rates, the gap is going to increase. This will keep India a favorite investment destination for global financial firms. The net result will be more dollar inflows and more appreciation of rupee.

Some economists believe that for a country whose GDP is growing at more than 8% p.a. should learn to live with somewhat high inflation levels (5-6 %). Current inflation in India is less than 3.5%. The RBI’s take on this is that for the country like India, which is largely dependent on the oil imports for its energy needs, (while global oil markets becoming more and more volatile) it is necessary to keep a strong break on inflation. I don’t hope that the government will intervene to change the situation as its too busy fighting to get India the nuclear deal. I can’t predict what will be next move of whom, so let’s wait and watch.