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Monday, August 04, 2008

Rupee appreciation and inflation

Writing in The Times of India, Swaminathan S Anklesaria Aiyar says:

What will the Congress do to improve its chances? I offer two predictions. First, the government will seek to strengthen the exchange rate of the rupee, making imports cheaper and thus, creating downward pressure on prices. Second, after having raised interest rates thrice in the last two months, it will raise them further soon, but then lower them shortly before the poll date. This strategy will aim to check inflation right now, while reducing the sting of high EMIs before the election.

Some people seem to think that fluctuations of the exchange rate reflect genuine market forces, given that the Indian rupee is supposed to be a `market determined exchange rate'. It is argued that INR depreciation was `caused' by weak capital inflows and the current account deficit. There is ample statistical evidence which tells us that this is not the case. While there is a rupee-dollar market, it is a manipulated market, and the player who commands market power there - the RBI - controls what happens on this market. We should not have illusions about the role of market forces in fluctuations of the rupee. In a month where RBI does not do trading, it is because the RBI chooses to not trade.

Assuming the government decides that INR appreciation is required, how might this be achieved?

  1. Reversing the capital controls of 2007 : against private equity in February, against external commercial borrowing in August and against participatory notes in October. This will make a small difference to conditions on the currency market, but eliminate the distortions caused by these controls and the transactions costs suffered by economic agents in bypassing these controls.
  2. Easing capital controls, e.g. by placing FII investments in rupee denominated bonds on par with FII investments in equities
  3. Selling reserves. E.g. see this article about South Korea selling reserves in order to combat inflation.

1 comment:

  1. but if we look at the present indian scenario, where inflation is attributable to the shortage of food supply, are we really going to be salvaged by monetary tightening? or in otherwords are you trying to say that monetary tightening will not help much in the event of cost push inflation?


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